NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

 

NOTE  1.  Basis of Presentation

The accompanying Unaudited Condensed Consolidated Financial Statements (the “financial statements”) of M/I Homes, Inc. and its subsidiaries (the “Company”) and Notes thereto have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”) for interim financial information.  The financial statements include the accounts of M/I Homes, Inc. and its subsidiaries.  All intercompany transactions have been eliminated.  Results for the interim periods are not necessarily indicative of results for a full year.  In the opinion of management, the accompanying financial statements reflect all adjustments (all of which are normal and recurring in nature) necessary for a fair presentation of financial results for the interim periods presented.  These financial statements should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2007.

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during that period.  Actual results could differ from these estimates and have a significant impact on the Company’s financial condition and results of operations and cash flows.  With regard to the Company, estimates and assumptions are inherent in calculations relating to valuation of inventory and investment in unconsolidated limited liability companies (“LLCs”), property and equipment depreciation, valuation of derivative financial instruments, accounts payable on inventory, accruals for costs to complete, accruals for warranty claims, accruals for self-insured general liability claims, litigation, accruals for health care and workers’ compensation, accruals for guaranteed or indemnified loans, stock-based compensation expense, income taxes and contingencies.  Items that could have a significant impact on these estimates and assumptions include the risks and uncertainties listed in “Item 1A. Risk Factors” in Part II of our Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2008 and in “Item 1A. Risk Factors” in Part II of this report.

NOTE 2.  Impact of Accounting Standards

In September 2006, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 157, “Fair Value Measurements” (“SFAS 157”).  SFAS 157 defines fair value by clarifying the exchange price notion presented in earlier definitions and providing a framework for measuring fair value.  SFAS 157 also expands disclosures about fair value measurements.  SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those years.  The provisions of SFAS 157 relating to non-financial assets and liabilities measured on a recurring basis did not have an impact on the Company.  The FASB deferred the provisions of SFAS 157 relating to non-financial assets and liabilities that are not measured on a recurring basis, which are effective for financial statements issued for fiscal years beginning after November 15, 2008 and interim periods within those years.  The Company does not believe the adoption of SFAS 157 for non-financial assets and liabilities that are measured on a recurring basis will have a material impact on its consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”).  SFAS 159 allows companies to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value.  SFAS 159 also provides presentation and disclosure requirements that will enable users to compare similar types of assets and liabilities of different entities that have different measurement attributes.  The Company adopted SFAS 159 on January 1, 2008, and the adoption did not have a material impact on its consolidated financial statements.

In November 2007, the SEC issued Staff Accounting Bulletin (“SAB”) No. 109, “Written Loan Commitments Recorded at Fair Value Through Earnings” (“SAB 109”).  SAB 109, which revises and rescinds portions of SAB 105, “Application of Accounting Principles to Loan Commitments,” specifically states that the expected net future cash flows related to the associated servicing of a loan should be included in the measurements of all written loan commitments that are accounted for at fair value through earnings.  The provisions of SAB 109 are applicable to written loan commitments issued or modified in fiscal quarters beginning after December 15, 2007.  The Company adopted SAB 109 on January 1, 2008, and the adoption did not have a material impact on its consolidated financial statements.

In March 2008, the FASB issued SFAS No. 161, Disclosures About Derivative Instruments and Hedging Activities – an Amendment of FASB Statement No. 133 (“SFAS 161”).  SFAS 161 expands the disclosure requirements in SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“SFAS 133”), regarding an entity’s derivative instruments and hedging activities.  SFAS 161 is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.  The Company does not expect the adoption of SFAS 161 to have a material effect on its consolidated financial statements.

NOTE 3.   Fair Value Measurements

Effective January 1, 2008, the Company adopted and implemented SFAS 159 for its mortgage loans held for sale, and adopted SAB 109 for both mortgage loans held for sale and interest rate lock commitments (“IRLCs”).  Electing fair value allows a better offset of the changes in fair values of the loans and the derivative instruments used to economically hedge them.

In the normal course of business, our financial services segment enters into contractual commitments to extend credit to buyers of single-family homes with fixed expiration dates.  The commitments become effective when the borrowers “lock-in” a specified interest rate within established time frames.  Market risk arises if interest rates move adversely between the time of the “lock-in” of rates by the borrower and the sale date of the loan to an investor.  To mitigate the effect of the interest rate risk inherent in providing rate lock commitments to borrowers, the Company enters into optional or mandatory delivery forward sale contracts to sell whole loans and mortgage-backed securities to broker/dealers or investors.  The forward sale contracts lock in an interest rate and price for the sale of loans similar to the specific rate lock commitments.  The Company does not engage in speculative or trading derivative activities.  Both the rate lock commitments to borrowers and the forward sale contracts to broker/dealers or investors are undesignated derivatives pursuant to the requirements of SFAS 133, and accordingly, are marked to fair value through earnings.  Fair value is determined pursuant to SFAS 157 and SAB 109, both of which the Company adopted on a prospective basis as of the beginning of 2008.  Fair value measurements are included in earnings in the accompanying statements of operations.  During the first quarter of 2008, the Company recognized a $1.4 million fair value adjustment to earnings as the result of including the servicing release premiums in the fair value calculation as required by SAB 109.

SFAS 157:  (1) establishes a common definition for fair value to be applied to assets and liabilities; (2) establishes a framework for measuring fair value; and (3) expands disclosures concerning fair value measurements.  SFAS 157 gives us three measurement input levels for determining fair value, which are Level 1, Level 2 and Level 3.  Fair values determined by Level 1 inputs utilize quoted prices in active markets for identical assets or liabilities that the Company has the ability to access.  Fair values determined by Level 2 inputs utilize inputs other than quoted prices included in Level 1 that are observable for the asset or liability, either directly or indirectly.  Level 2 inputs include quoted prices for similar assets and liabilities in active markets, and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.  Level 3 inputs are unobservable inputs for the asset or liability, and include situations where there is little, if any, market activity for the asset or liability.

The fair value is based on published prices for mortgage-backed securities with similar characteristics and the buyup fees received or buydown fees to be paid upon securitization of the loan. The buyup and buydown fees are calculated pursuant to contractual terms with investors.  To calculate the effects of interest rate movements, the Company utilizes applicable published mortgage-backed security prices, and multiplies the price movement between the rate lock date and the balance sheet date by the notional loan commitment amount.  The Company sells all of its loans on a servicing released basis, and receives a servicing release premium upon sale.  Thus, the value of the servicing rights included in the fair value measurement is based upon contractual terms with investors and depends on the loan type. The Company applies a fallout rate to IRLCs when measuring the fair value of rate lock commitments.  Fallout is defined as locked loan commitments for which the Company does not close a mortgage loan and is based on management’s judgment and experience.

The fair value of the Company’s forward sales contracts to broker/dealers solely considers the market price movement of the same type of security between the trade date and the balance sheet date.  The market price changes are multiplied by the notional amount of the forward sales contracts to measure the fair value.

Mortgage loans held for sale are closed at cost, which includes all fair value measurement in accordance with SFAS 133.

Loan Commitments: IRLCs are extended to home-buying customers who have applied for mortgages and who meet certain defined credit and underwriting criteria.  Typically, the IRLCs will have a duration of less than nine months; however, in certain markets, the duration could extend to twelve months.

Some IRLCs are committed to a specific third-party investor through the use of best-efforts whole loan delivery commitments matching the exact terms of the IRLC loan.  The notional amount of the committed IRLCs and the best-efforts contracts was $5.3 million and $2.1 million at September 30, 2008 and December 31, 2007, respectively.  At September 30, 2008, the fair value of the committed IRLCs resulted in a liability of $0.1 million and the related best-efforts contracts resulted in an asset of less than $0.1 million.  At December 31, 2007, the fair value of the committed IRLCs resulted in an asset of less than $0.1 million and the related best-efforts contracts resulted in a liability of less than $0.1 million.  For the three and nine months ended September 30, 2008, we recognized $0.1 million of income and $0.1 million of expense, respectively, relating to marking these committed IRLCs and the related best-efforts contracts to market.  For both the three and nine months ended September 30, 2007, we recognized less than $0.1 million of expense relating to marking these committed IRLCs and the related best-efforts contracts to market.

Uncommitted IRLCs are considered derivative instruments under SFAS 133 and are fair value adjusted, with the resulting gain or loss recorded in current earnings.  At September 30, 2008 and December 31, 2007, the notional amount of the uncommitted IRLCs was $65.5 million and $34.3 million, respectively.  The fair value adjustment related to these uncommitted IRLCs, which is based on quoted market prices, resulted in an asset of $1.0 million and $0.2 million at September 30, 2008 and December 31, 2007, respectively.  For the three and nine months ended September 30, 2008, we recognized income of $0.3 million and $0.8 million, respectively, relating to marking the uncommitted IRLCs to market.  For the three and nine months ended September 30, 2007, we recognized income of $0.7 million and expense of less than $0.1 million, respectively, relating to marking the uncommitted IRLCs to market.

Forward sales of mortgage-backed securities (“FMBSs”) are used to protect uncommitted IRLC loans against the risk of changes in interest rates between the lock date and the funding date.  FMBSs related to uncommitted IRLCs are classified and accounted for as non-designated derivative instruments, with gains and losses recorded in current earnings.  At September 30, 2008 and December 31, 2007, the notional amount under these FMBSs was $64.0 million and $37.0 million, respectively, and the related fair value adjustment, which is based on quoted market prices, resulted in a liability of $0.2 million at both September 30, 2008 and December 31, 2007.  For the three and nine months ended September 30, 2008, we recognized expense of $0.3 million and income of $0.1 million, respectively, relating to marking these FMBSs to market.  For the three and nine months ended September 30, 2007, we recognized expense of $0.5 million and $0.2 million, respectively, relating to marking these FMBSs to market.

Mortgage Loans Held for Sale :   During the intervening period between when a loan is closed and when it is sold to an investor, the interest rate risk is covered through the use of a best-efforts contract or by FMBSs.

The notional amount of the best-efforts contracts and related mortgage loans held for sale was $0.9 million and $15.4 million at September 30, 2008 and December 31, 2007, respectively.  The fair value of the best-efforts contracts and related mortgage loans held for sale resulted in a net liability of less than $0.1 million at both September 30, 2008 and December 31, 2007 under the matched terms method of SFAS 133.  For the three and nine months ended September 30, 2008, we recognized income of less than $0.1 million and expense of less than $0.1 million, respectively, relating to marking these best-efforts contracts and the related mortgage loans held for sale to market.  For both the three and nine months ended September 30, 2007, we recognized income of less than $0.1 million relating to marking these best-efforts contracts and the related mortgage loans held for sale to market.

The notional amounts of the FMBSs and the related mortgage loans held for sale were both $33.0 million at September 30, 2008 and $43.0 million and $43.2 million, respectively, at December 31, 2007.  In accordance with SFAS 133, the FMBSs are classified and accounted for as non-designated derivative instruments, with gains and losses recorded in current earnings.  As of September 30, 2008 and December 31, 2007, the related fair value adjustment for marking these FMBSs to market resulted in a liability of $0.7 million and $0.4 million, respectively.  For the three and nine months ended September 30, 2008, we recognized expense of $1.3 million and $0.3 million, respectively, relating to marking these FMBSs to market.  For the three and nine months ended September 30, 2007, we recognized expense of $1.0 million and $0.5 million, respectively, relating to marking these FMBSs to market.

The table below shows the level and measurement of our assets measured at fair value:

NOTE 4.   Discontinued Operation

In December 2007, the Company sold substantially all of its West Palm Beach, Florida division to a private builder and announced it would exit this market.

In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”), results of our West Palm Beach division have been classified as a discontinued operation, and prior periods have been restated to be consistent with the September 30, 2008 presentation.  The Company’s Condensed Consolidated Balance Sheets reflect the assets and liabilities of the discontinued operation as separate line items, and the operations of its West Palm Beach division for the current and prior periods are reported in discontinued operation on the Unaudited Condensed Consolidated Statements of Operations.  Discontinued operation includes revenues from our West Palm Beach division of $10.7 million for the three months ended September 30, 2007, and $13.1 million and $27.8 million for the nine months ended September 30, 2008 and 2007, respectively.  It also includes pre-tax losses of $7.7 million for the three months ended September 30, 2007, and pre-tax losses of $0.1 million and $15.0 million for the nine months ended September 30, 2008 and 2007, respectively.  There was no activity in discontinued operation for the three months ended September 30, 2008.

Single-family lots, land and land development costs include raw land that the Company has purchased to develop into lots, costs incurred to develop the raw land into lots, and lots for which development has been completed but which have not yet been used to start construction of a home.

Land held for sale includes land that meets all of the following criteria, as defined in SFAS 144:  (1) management, having the authority to approve the action, commits to a plan to sell the asset; (2) the asset is available for immediate sale in its present condition subject only to terms that are usual and customary for sales of such assets; (3) an active program to locate a buyer and other actions required to complete the plan to sell the asset have been initiated; (4) the sale of the asset is probable, and transfer of the asset is expected to qualify for recognition as a completed sale, within one year; (5) the asset is being actively marketed for sale at a price that is reasonable in relation to its current fair value; and (6) actions required to complete the plan indicate that it is unlikely that significant changes to the plan will be made or that the plan will be withdrawn.  In accordance with SFAS 144, the Company records land held for sale at the lower of its carrying value or fair value less costs to sell.

Homes under construction include homes that are finished and ready for delivery and homes in various stages of construction.  As of September 30, 2008 and December 31, 2007, we had 479 homes (valued at $82.3 million) and 632 homes (valued at $117.7 million), respectively, included in homes under construction that were not subject to a sales contract.

Model homes and furnishings include homes that are under construction or have been completed and are being used as sales models.  The amount also includes the net book value of furnishings included in our model homes.  Depreciation on model home furnishings is recorded using an accelerated method over the estimated useful life of the assets, typically three years.

The Company assesses inventory for recoverability in accordance with the provisions of SFAS 144, which requires that long-lived assets be reviewed for impairment whenever events or changes in local or national economic conditions indicate that the carrying amount of an asset may not be recoverable.  Refer to Note 6 below for additional details relating to our procedures for evaluating our inventory for impairment.

Land purchase deposits include both refundable and non-refundable amounts paid to third-party sellers relating to the purchase of land.  On an ongoing basis, the Company evaluates the land option agreements relating to the land purchase deposits.  In the period during which the Company makes the decision not to proceed with the purchase of land under an agreement, the Company writes off any deposits and accumulated pre-acquisition costs relating to such agreement.  For the three and nine months ended September 30, 2008, the Company wrote off $0.4 million and $1.6 million, respectively, in option deposits and pre-acquisition costs.  Refer to Note 6 below for additional details relating to write-offs of land option deposits and pre-acquisition costs.

NOTE 6.  Valuation Adjustments and Write-offs

The Company assesses inventory for recoverability in accordance with the provisions of SFAS 144, which requires that long-lived assets be reviewed for impairment whenever events or changes in local or national economic conditions indicate that the carrying amount of an asset may not be recoverable.

Operating communities.   For existing operating communities which may have impairment indicators, the recoverability of assets is measured by comparing the carrying amount of the assets to future undiscounted cash flows expected to be generated by the assets based on home sales.  These estimated cash flows are developed based primarily on management’s assumptions relating to the specific community.  The significant assumptions used to evaluate the recoverability of assets include:  the timing of development and/or marketing phases, projected sales price and sales pace of each existing or planned community; the estimated land development and home construction and selling costs of the community; overall market supply and demand; the local market; and competitive conditions.

Future communities.   For raw land or land under development that management anticipates will be utilized for future homebuilding activities, the recoverability of assets is measured by comparing the carrying amount of the assets to future undiscounted cash flows expected to be generated by the assets based on home sales, consistent with the evaluations performed for operating communities discussed above.

For raw land, land under development or lots that management intends to market for sale to a third party, but that do not meet all of the criteria to be classified as land held for sale as discussed above in Note 5, the recoverability of the assets is determined based on either the estimated net sales proceeds expected to be realized on the sale of the assets or the estimated fair value determined using cash flow valuation techniques.

If the Company has not yet determined whether raw land or land under development will be utilized for future homebuilding activities or marketed for sale to a third party, the Company assesses the recoverability of the inventory using a probability-weighted approach, in accordance with SFAS 144.

Land held for sale.   Land held for sale includes land that meets the six criteria defined in SFAS 144, as discussed above in Note 5.  In accordance with SFAS 144, the Company records land held for sale at the lower of its carrying value or fair value less costs to sell.  Fair value is determined based on the expected third party sale proceeds.

Investments in unconsolidated limited liability companies.   The Company assesses investments in unconsolidated limited liability companies (“LLCs”) for impairment in accordance with Accounting Principles Board (“APB”) Opinion No. 18, “The Equity Method of Investments In Common Stock” (“APB 18”), and SEC SAB Topic 5.M, “Other Than Temporary Impairment of Certain Investments in Debt and Equity Securities” (“SAB Topic 5M”).  When evaluating the LLCs, if the fair value of the investment is less than the investment carrying value, and the Company determines the decline in value is other than temporary, the Company would write down the investment to fair value.  The Company’s LLCs engage in land acquisition and development activities for the purpose of selling or distributing (in the form of a capital distribution) developed lots to the Company and its partners in the entity, as further discussed in Note 9.

A summary of the Company’s valuation adjustments and write-offs for the three and nine months ended September 30, 2008 and 2007 is as follows:

(a) Amounts are recorded within impairment of inventory and investment in unconsolidated LLCs in the Company’s Unaudited Condensed Consolidated Statements of Operations.

(b) Includes the Company’s $0.8 million share of the write-off of an option deposit in the three and nine month periods of 2007 that is included in equity in undistributed loss of limited liability companies in the Company’s Unaudited Condensed Statements of Cash Flows.

(c) Amounts are recorded within general and administrative expense in the Company’s Unaudited Condensed Consolidated Statements of Operations.

(d)  Total impairment excludes impairment of our West Palm Beach, Florida division of $8.1 million and $16.0 million for the three and nine months ended September 30, 2007, respectively, which is included in discontinued operation in the Company’s Unaudited Condensed Consolidated Statements of Operations.  No impairment has been recorded for this discontinued operation for 2008.

(a)	Interest incurred includes $0.4 million and $1.2 million for the three and nine months ended September 30, 2008, respectively, and $0.9 million and $1.7 million for the three and nine months ended September 30, 2007, respectively, relating to amortization of debt issue costs.

Depreciation expense (excluding expense relating to model furnishings classified in Inventory) was approximately $3.2 million for the nine month periods ended both September 30, 2008 and 2007.

NOTE 9.  Investment in Unconsolidated Limited Liability Companies

At September 30, 2008, the Company had interests ranging from 33% to 50% in limited liability companies that do not meet the criteria of variable interest entities because each of the entities had sufficient equity at risk to permit the entity to finance its activities without additional subordinated support from the equity investors, and two of these LLCs had outside financing that is not guaranteed by the Company.  These LLCs engage in land acquisition and development activities for the purpose of selling or distributing (in the form of a capital distribution) developed lots to the Company and its partners in the entity.  In certain of these LLCs, the Company and its partner in the entity have provided the lenders with environmental indemnifications and minimum net worth levels of certain of the Company’s subsidiaries as more fully described in Note 10 below.  These entities had assets totaling $65.1 million and liabilities totaling $12.5 million, including third party debt of $11.7 million, as of September 30, 2008.  The Company’s maximum exposure related to its investment in these entities as of September 30, 2008 was the amount invested of $23.0 million plus letters of credit totaling $4.7 million and the possible future obligation of $11.7 million under the guarantees and indemnifications discussed in Note 10 below.  Included in the Company’s investment in LLCs at September 30, 2008 and December 31, 2007 are $1.0 million and $2.0 million, respectively, of capitalized interest and other costs.  The Company does not have a controlling interest in these LLCs; therefore, they are recorded using the equity method of accounting.

In the third quarter of 2008, the Company wrote-off its remaining investment of $2.5 million in one of its unconsolidated limited liability companies.  The unconsolidated limited liability company has received notice of default of its obligations under third-party financing to the unconsolidated limited liability company.  The Company does not believe that it has significant financial exposure to matters pertaining to the unconsolidated limited liability company or its financing.  The assets and liabilities of this limited liability company at September 30, 2008 were $40.8 million and $35.1 million (including third party debt of $29.0 million), respectively.

In accordance with APB 18 and SAB Topic 5M, the Company evaluates its investment in unconsolidated LLCs for potential impairment.  If the fair value of the investment is less than the investment carrying value, and the Company determines the decline in value was other than temporary, the Company would write down the investment to fair value.

NOTE  10.  Guarantees and Indemnifications

Warranty

In 2007, the Company implemented a new limited warranty program (“Home Builder’s Limited Warranty”) in addition to its thirty-year transferable structural limited warranty, on homes closed after the implementation date.  The Home

Builder’s Limited Warranty covers construction defects and certain damage resulting from construction defects for a statutory period based on geographic market and state law (currently ranging from five to ten years for the states in which the Company operates) and includes a mandatory arbitration clause.  Prior to this new warranty program, the Company provided up to a two-year limited warranty on materials and workmanship and a twenty-year (for homes closed between 1989 and 1998) and a thirty-year (for homes closed during or after 1998) transferable limited warranty against major structural defects.  The Company does not believe that this change in warranty program will significantly impact its warranty expense.

Warranty expense is accrued as the home sale is recognized and is intended to cover estimated material and labor costs to be incurred during the warranty period.  The accrual amounts are based upon historical experience and geographic location.  A summary of warranty activity for the three and nine months ended September 30, 2008 and 2007 is as follows:

Guarantees and Indemnities

In the ordinary course of business, M/I Financial Corp., our wholly-owned subsidiary (“M/I Financial”), enters into agreements that guarantee certain purchasers of its mortgage loans that M/I Financial will repurchase a loan if certain conditions occur, primarily if the mortgagor does not meet those conditions of the loan within the first six months after the sale of the loan.  Loans totaling approximately $89.1 million and $174.8 million were covered under the above guarantees as of September 30, 2008 and December 31, 2007, respectively.  A portion of the revenue paid to M/I Financial for providing the guarantees on the above loans was deferred at September 30, 2008, and will be recognized in income as M/I Financial is released from its obligation under the guarantees.  M/I Financial has not repurchased any loans under the above agreements in 2008 or 2007, but has provided indemnifications to third-party investors in lieu of repurchasing certain loans.  The total of these indemnified loans was approximately $2.8 million and $2.4 million at September 30, 2008 and December 31, 2007, respectively.  The risk associated with the above guarantees and indemnities is offset by the value of the underlying assets.  The Company has accrued management’s best estimate of the probable loss on the above loans.

M/I Financial has also guaranteed the collectability of certain loans to third-party insurers of those loans for periods ranging from five to thirty years.  The maximum potential amount of future payments under these guarantees is equal to the outstanding loan value less the value of the underlying asset plus administrative costs incurred related to foreclosure on the loans, should this event occur.  The total of these costs are estimated to be $1.8 million as of September 30, 2008 and $1.9 million as of December 31, 2007, and would be offset by the value of the underlying assets.  The Company has accrued management’s best estimate of the probable loss on the above loans.

The Company has also provided certain other guarantees and indemnifications.  The Company has provided an environmental indemnification to an unrelated third-party seller of land in connection with the Company’s purchase of that land.  In addition, the Company has provided environmental indemnifications, a loan maintenance and limited payment guaranty and minimum net worth guarantees of certain of the Company’s subsidiaries in connection with outside financing provided by lenders to certain of our 50% owned LLCs.  Under the environmental indemnifications, the Company and its partner in the applicable LLC are jointly and severally liable for any environmental claims relating to the property that are brought against the lender.  Under the loan maintenance and limited payment guaranty, the Company and the applicable LLC partner have jointly and severally agreed to the third-party lender to fund any shortfall in the event the ratio of the loan balance to the current fair market value of the property under development by the LLC is below a certain threshold.  As of September 30, 2008, the total maximum amount of future payments the Company could be required to make under the loan maintenance and limited payment guaranty was approximately $11.7 million.  Under the above guarantees and indemnifications, the LLC operating agreements provide recourse against our LLC partners for 50% of any actual liability associated with the environmental indemnifications, land development completion guarantees and loan maintenance and limited payment guaranty.

The Company has recorded a liability relating to the guarantees and indemnities described above totaling $2.3 million as of both September 30, 2008 and December 31, 2007, which was management’s best estimate of the fair value of the Company’s liability.

The Company has also provided a guarantee of the performance and payment obligations of its wholly-owned subsidiary, M/I Financial, up to an aggregate principle amount of $13.0 million.  The guarantee was provided to a government-sponsored enterprise to which M/I Financial delivers loans.

NOTE 11.  Commitments and Contingencies

At September 30, 2008, the Company had sales agreements outstanding, some of which have contingencies for financing approval, to deliver 781 homes, with an aggregate sales price of approximately $212.2 million.  Based on our current housing gross margin, plus variable selling costs, less payments to date on homes in backlog of $105.1 million, we estimate payments totaling approximately $94.0 million to be made in 2008 relating to those homes.  At September 30, 2008, the Company also had outstanding options and contingent purchase agreements to acquire land and developed lots with an aggregate purchase price of approximately $97.9 million.  Purchase of such properties is contingent upon satisfaction of certain requirements by the Company and the sellers.

At September 30, 2008, the Company had outstanding approximately $88.4 million of completion bonds and standby letters of credit, some of which were issued to various local governmental entities that expire at various times through December 2015.  Included in this total are: (1) $47.8 million of performance bonds and $24.4 million of performance letters of credit that serve as completion bonds for land development work in progress (including the Company’s $2.3 million share of our LLCs’ letters of credit and bonds); (2) $10.5 million of financial letters of credit, of which $1.0 million represent deposits on land and lot purchase agreements; and (3) $5.7 million of financial bonds.

At September 30, 2008, the Company had outstanding $1.4 million of corporate promissory notes.  These notes are due and payable in full upon default of the Company under agreements to purchase land or lots from third parties.  No interest or principal is due until the time of default.  In the event that the Company performs under these purchase agreements without default, the notes will become null and void and no payment will be required.

At September 30, 2008, the Company had $0.2 million of certificates of deposit included in other assets in the Condensed Consolidated Balance Sheet that have been pledged as collateral for mortgage loans sold to third parties and, therefore, are restricted from general use.

The Company and certain of its subsidiaries have been named as defendants in various claims, complaints and other legal actions incidental to the Company’s business.  Certain of the liabilities resulting from these actions are covered by insurance.  While management currently believes that the ultimate resolution of these matters, individually and in the aggregate, will not have a material adverse effect on the Company’s financial position, earnings, cash flows, or overall trends in results of operations, such matters are subject to inherent uncertainties.  The Company has recorded a liability to provide for the anticipated costs, including legal defense costs, associated with the resolution of these matters.  However, there exists the possibility that the costs to resolve these matters could differ from the recorded estimates and, therefore, have a material adverse impact on the Company’s net income for the periods in which the matters are resolved.

NOTE 12.  Notes Payable Banks

On May 22, 2008, M/I Financial entered into a secured credit agreement (“MIF Credit Agreement”) with a financial institution.  This agreement replaced M/I Financial’s previous credit facility that expired on May 30, 2008.

The MIF Credit Agreement provides M/I Financial with $30.0 million maximum borrowing availability, with an additional $10.0 million of availability from December 15, 2008 through January 15, 2009.  The MIF Credit Agreement, which expires on May 21, 2009, is secured by certain mortgage loans.  The MIF Credit Agreement also provides for limits with respect to certain loan types that can secure the borrowings under the agreement.  As of the end of each fiscal quarter, M/I Financial must have tangible net worth of at least $9.0 million and adjusted tangible net worth (tangible net worth less the outstanding amount of intercompany loans) of no less than $7.0 million.  The ratio of total liabilities to adjusted tangible net worth shall never be more than 10.0 to 1.0.  M/I Financial pays interest on each advance under the MIF Credit Agreement at a per annum rate of LIBOR plus 1.35%.

At September 30, 2008, we had $0.3 million of availability under the MIF Credit Agreement.  As of September 30, 2008, M/I Financial was in compliance with all restrictive covenants of the MIF Credit Agreement.

At September 30, 2008, the Company did not have any borrowings under the Second Amended and Restated Credit Agreement dated October 6, 2006 (as amended, the “Credit Facility”), compared to $115.0 million of borrowings at

December 31, 2007.  The Company was able to pay off the Credit Facility using the $49.0 million tax refund received in the first quarter of 2008 and cash generated from operations.

Under the Second Amendment to the Credit Facility, the most restrictive covenant is the minimum net worth requirement.  Under the minimum net worth requirement we are required to maintain tangible net worth (“Minimum Net Worth”) of at least $400 million less a deferred tax asset valuation of up to $65 million, plus 50% of net income earned for each full fiscal quarter ending after December 31, 2007 (with no deduction for net losses), plus 50% of the aggregated net increase in tangible net worth resulting from the sale of capital stock and other equity interests (as defined therein).  In no event can tangible net worth be less than $335 million.  At September 30, 2008, our tangible net worth exceeded the minimum tangible net worth required by this covenant by approximately $69.5 million.

NOTE 13.   Senior Notes

As of September 30, 2008, we had $200 million of 6.875% senior notes outstanding.  The notes are due April 2012.  The Credit Facility prohibits the early repurchase of our senior notes.

The indenture governing our senior notes contains restrictive covenants that limit, among other things, the ability of the Company to pay dividends on common and preferred shares or repurchase any shares.  If our “consolidated restricted payments basket,” as defined in the indenture governing our senior notes, is less than zero, we are restricted from making certain payments, including dividends, as well as from repurchasing any shares.  At September 30, 2008, our restricted payments basket was ($71.4) million.  As a result of this deficit, we are currently restricted from paying dividends on our common shares and our 9.75% Series A Preferred Shares, and from repurchasing any shares under our common shares repurchase program that was authorized by our Board of Directors in November 2005.  These restrictions do not affect our compliance with any of the covenants contained in the Credit Facility and will not permit the lenders under the Credit Facility to accelerate the loans.

 

NOTE 15.  Income Taxes

Deferred federal and state income tax assets primarily represent the deferred tax benefits arising from temporary differences between book and tax income which will be recognized in future years as an offset against future taxable income.  If, for some reason, the combination of future years’ income (or loss) combined with the reversal of the timing differences results in a loss, such losses can be carried back to prior years or carried forward to future years to recover the deferred tax assets.

In accordance with SFAS No. 109, “Accounting for Income Taxes” (“SFAS 109”), the Company evaluates its deferred tax assets, including net operating losses, to determine if a valuation allowance is required.  SFAS 109 requires that companies assess whether a valuation allowance should be established based on the consideration of all available evidence using a “more likely than not” standard.  In making such judgments, significant weight is given to evidence that can be objectively verified.  SFAS 109 provides that a cumulative loss in recent years is significant negative evidence in considering whether deferred tax assets are realizable and also restricts the amount of reliance on projections of future taxable income to support the recovery of deferred tax assets.  The Company’s current and prior year losses present the most significant negative evidence as to whether the Company needs to reduce its deferred tax assets with a valuation allowance.  Given the continued downturn in the homebuilding industry during 2008, we are now in a four-year cumulative pre-tax loss position during the years 2005 through 2008.  We currently believe the cumulative weight of the negative evidence exceeds that of the positive evidence and, as a result, it is more likely than not that we will not be able to utilize all of our deferred tax assets.  Therefore, during the second quarter of 2008, in accordance with paragraph 194 of SFAS 109, which relates to interim reporting, the Company recorded a valuation allowance of $58.0 million against its deferred tax assets, $22.1 million of which relates to beginning of the year deferred tax assets and $35.9 million of which relates to deferred tax assets that arose in 2008 as a result of 2008 operating activities.  Our valuation allowance for current and deferred taxes increased $21.6 million during the three months ended September 30, 2008 to a balance of $79.9 million.  The accounting for deferred taxes is based upon an estimate of future results.  Differences between the anticipated and actual outcomes of these future tax consequences could have a material impact on the Company’s consolidated results of operations or financial position.

At September 30, 2008, the Company had a $39.5 million income tax receivable primarily relating to the estimated cash refund to be realized upon the carryback of our current net taxable operating loss to 2006.  At September 30, 2008, the Company had a Federal net operating loss (“NOL”) carryback of approximately $120.8 million and a federal NOL carryforward of approximately $3.5 million.  The Company also had state NOL benefits of $7.2 million.  These state carryforward benefits will begin to expire in 2022.   The amount of taxable income that needs to be generated by the Company in order to realize our gross deferred tax assets is $214.2 million.   

NOTE 16.   Preferred Shares

The Company’s Articles of Incorporation authorize the issuance of up to 2,000,000 non-cumulative preferred shares, par value $.01 per share.  On March 15, 2007, the Company issued 4,000,000 depositary shares, each representing 1/1000th of a 9.75% Series A Preferred Share, or 4,000 Preferred Shares in the aggregate (the “Preferred Shares”).  The aggregate liquidation value of the preferred shares is $100 million.  As of September 30, 2008, total dividends paid on Preferred Shares in 2008 were approximately $4.9 million.

As discussed in Note 13, the indenture governing our senior notes contains a provision that restricts the payment of dividends when the calculation of the “consolidated restricted payments basket,” as defined therein, falls below zero.  At September 30, 2008, the restricted payments basket was $(71.4) million and, therefore, we are currently restricted from making any further dividend payments on our Preferred Shares.  We will continue to be restricted from paying dividends until such time as the restricted payments basket has been restored or our senior notes are repaid, and our Board of Directors authorizes us to resume dividend payments.

NOTE 17.  Universal Shelf Registration

On August 4, 2008, the Company filed a $250 million universal shelf registration statement with the SEC.  Pursuant to the filing, the Company may, from time to time over an extended period, offer new debt and/or equity securities.  The timing and amount of offerings, if any, will depend on market and general business conditions.

NOTE 18.  Business Segments

In conformity with SFAS No. 131, “Disclosure about Segments of an Enterprise and Related Information” (“SFAS 131”), the Company’s segment information is presented on the basis that the chief operating decision makers use in evaluating segment performance.  The Company’s chief operating decision makers evaluate the Company’s performance in various ways, including: (1) the results of our ten individual homebuilding operating segments and the results of the financial services operation; (2) the results of our three homebuilding regions; and

 

(3) our consolidated financial results.  We have determined our reportable segments in accordance with SFAS 131 as follows: Midwest homebuilding, Florida homebuilding, Mid-Atlantic homebuilding and financial services operations.  The homebuilding operating segments that are included within each reportable segment have similar operations and exhibit similar economic characteristics, and therefore meet the aggregation criteria in SFAS 131.  Our homebuilding operations include the acquisition and development of land, the sale and construction of single-family attached and detached homes and the occasional sale of lots to third parties.  The homebuilding operating segments that comprise each of our reportable segments are as follows:

The financial services operations include the origination and sale of mortgage loans and title and insurance agency services primarily for purchasers of the Company’s homes.

The chief operating decision makers utilize operating income (loss), defined as income (loss) before interest expense and income taxes, as a performance measure.  Selected financial information for our reportable segments for the three and nine months ended September 30, 2008 and 2007 is presented below: