Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Overview

The underlying trends in U.S. housing point toward an ongoing multi-year recovery supported by favorable demographics, an improving economy, mortgage interest rates near historic lows, and limited supplies of new and existing home inventories. Our results in 2013 showed significant improvement in the majority of our key operating metrics in the first half of the year, while demand conditions slowed for us in the second half of the year as consumers adjusted to higher home prices and a moderate rise in mortgage interest rates. For the full year 2013, the overall improvement in market conditions, in concert with our own tactical actions, contributed to our seventh consecutive profitable quarter. Home closings, revenues, average selling price, inventory turns, gross margin, overhead leverage, and income before income taxes all improved in 2013 compared with 2012.

Our net new orders declined 10% in 2013 compared with 2012. A lower number of active communities contributed to the decline in net new orders as we maintained 14% fewer active communities in 2013 compared with 2012. The lower active community count resulted from the close-out of a number of long-term projects and is consistent with our more disciplined land investment strategy. In addition, demand slowed in the second half of 2013 in response to higher home prices and a rise in mortgage interest rates. We will continue to calibrate sales pace in each community to improve our gross margins and maximize returns on invested capital. We expect that this approach will continue to result in a moderation in our net new order volume in the short-term relative to overall growth in the U.S. homebuilding industry and relative to certain of our competitors. While we believe higher mortgage interest rates are inevitable and may have a moderating effect on demand and pricing, we believe this impact will be outweighed in the long-term by other factors driving increased sales volume as overall new home sales in the U.S. remain low compared with historical levels.

The significant improvements reported for 2013 also allowed us to continue to enhance our financial position. We generated significant positive cash flow from operations in each of the last two years via a combination of improved profitability and inventory management. Our improved financial position provided additional flexibility to retire debt early and increase our planned future investments in new communities, while also paying a dividend and selectively repurchasing our common shares. Specifically, we accomplished the following during 2013:

•Increased our total cash balance to $1.7 billion;
•Proactively reduced our outstanding debt by $461.4 million;
•Increased our existing share repurchase authorization by $250.0 million and retired $127.7 million of shares;
•Reinstated a quarterly dividend;
•Increased our land investment spending to support future growth; and
•Lowered our ratio of debt to total capitalization from 53.4% to 30.7%, in part due to the reversal of a valuation allowance against our deferred tax assets.

In the short-term, we will continue to focus on maximizing our operating margins, despite the possibility of rising house cost pressures from material and labor prices, by using our existing land assets more effectively, allocating capital more effectively, and aggressively controlling unsold "spec" inventory to enhance our balance sheet. We believe we have positioned ourselves to deliver improved long-term returns. In planning for the longer term, we continue to maintain confidence that we are in the early stages of a broad, sustainable recovery in the U.S. new home market. While the U.S. macroeconomic environment continues to face challenges and each local market will experience varying results, we are continuing to pursue strategic land positions that meet our underwriting requirements in well-positioned submarkets and believe that sustained execution of our strategy will continue to result in increased profits and improved returns on invested capital over the housing cycle.

The following is a summary of our operating results by line of business ($000's omitted, except per share data):

Years Ended December 31,
201320122011
Income (loss) before income taxes:
Homebuilding$479,113$157,991$(275,830)
Financial Services48,70925,563(34,470)
Income (loss) from continuing operations before income taxes527,822183,554(310,300)
Income tax expense (benefit)(2,092,294)(22,591)(99,912)
Net income (loss)$2,620,116$206,145$(210,388)
Per share data - assuming dilution:
Net income (loss)$6.72$0.54$(0.55)
•The Homebuilding income (loss) before income taxes included charges related to the following items ($000's omitted):
201320122011
Land-related charges (see Note 4)$9,672$17,195$35,786
Loss on debt retirements (see Note 7)26,93032,0715,638
Settlement of contractual dispute at a closed-out community (see Note 13)41,170——
Goodwill impairments (see Note 2)——240,541
$77,772$49,266$281,965

For additional information on each of the above, see the applicable Notes to the Consolidated Financial Statements.

Our Homebuilding operating results in 2013 and 2012 improved significantly from the loss experienced in 2011 due to higher revenues and gross margins, improved overhead leverage, and lower charges, as listed in the above table.

•The increase in Financial Services income in 2013 compared with 2012 and 2011 was primarily due to lower loan loss reserves. There were no such loss reserves in 2013 compared with $49.0 million in 2012 and $59.3 million in 2011 (see Note 13 to the Consolidated Financial Statements). Additionally, loan origination volume increased in 2013 compared with 2012 and 2011, primarily as the result of increased Homebuilding closings. These favorable factors were partially offset in 2013 by margin compression caused by heightened competition in the mortgage industry compared with 2012.
•The income tax benefit in 2013 includes $2.1 billion related to the reversal of substantially all of the valuation allowance previously recorded against our deferred tax assets. See Note 10 to the Condensed Consolidated Financial Statements for additional information. The income tax benefits in 2012 and 2011 were attributable primarily to the favorable resolution of certain federal and state income tax matters.

Homebuilding Operations

The following is a summary of income (loss) before income taxes for our Homebuilding operations ($000’s omitted):

Years Ended December 31,
2013FY 2013 vs. FY 20122012FY 2012 vs. FY 20112011
Home sale revenues$5,424,30919%$4,552,41215%$3,950,743
Land sale revenues114,3357%106,69829%82,853
Total Homebuilding revenues5,538,64419%4,659,11016%4,033,596
Home sale cost of revenues (a)4,310,52812%3,833,45111%3,444,398
Land sale cost of revenues (b)104,42610%94,88060%59,279
Selling, general, and administrative expenses ("SG&A") (c)568,50011%514,457(1)%519,583
Equity in (earnings) loss of unconsolidated entities(993)(74)%(3,873)21%(3,194)
Other expense, net (d)80,75322%66,298(77)%293,102
Interest income, net(3,683)(10)%(4,094)9%(3,742)
Income (loss) before income taxes$479,113203%$157,991157%$(275,830)
Supplemental data:
Gross margin from home sales20.5%470 bps15.8%300 bps12.8%
SG&A as a percentage of home sale revenues10.5%(80) bps11.3%(190) bps13.2%
Closings (units)17,7668%16,5058%15,275
Average selling price$30511%$2767%$259
Net new orders:
Units17,080(10)%19,03925%15,215
Dollars (e)$5,394,566(1)%$5,424,30037%$3,953,829
Cancellation rate15%15%19%
Active communities at December 31577(14)%670(4)%700
Backlog at December 31:
Units5,772(11)%6,45865%3,924
Dollars$1,901,796(2)%$1,931,53882%$1,059,649
(a)Includes the amortization of capitalized interest. Home sale cost of revenues also includes land impairments of $2.9 million, $13.4 million, and $15.9 million for 2013, 2012, and 2011, respectively.
(b)Includes net realizable value adjustments for land held for sale of $3.6 million, $1.5 million, and $9.8 million for 2013, 2012, and 2011, respectively.
(c)SG&A includes costs associated with the relocation of our corporate headquarters totaling $15.0 million in 2013.
(d)Includes the write-off of deposits and pre-acquisition costs for land option contracts we elected not to pursue of $3.1 million, $2.3 million, and $10.0 million in 2013, 2012, and 2011, respectively, and net losses related to the redemption of debt totaling $26.9 million, $32.1 million, and $5.6 million in 2013, 2012, and 2011, respectively. Also includes charges resulting from a contractual dispute related to a previously completed luxury community totaling $41.2 million in 2013 and goodwill impairment charges of $240.5 million in 2011.
(e)Net new order dollars represent a composite of new order dollars combined with other movements of the dollars in backlog related to cancellations and change orders.

Home sale revenues

Home sale revenues for 2013 were higher than 2012 by $871.9 million, or 19%. The increase was attributable to an 11% increase in the average selling price combined with an 8% increase in closings. The increase in average selling price occurred in substantially all of our local markets and reflects an ongoing shift in our revenue mix toward move-up and active adult buyers and improved market conditions that have allowed for increased sale prices, including higher levels of house options and lot premiums. The increase in closings reflected improved consumer demand for new homes in the majority of our local markets.

Home sale revenues for 2012 were higher than 2011 by $601.7 million, or 15%. The increase was attributable to a 7% increase in the average selling price combined with an 8% increase in closings. The increase in average selling price reflected a shift in our revenue mix toward move-up and active adult buyers and improved market conditions. The increase in closings was concentrated primarily in our North and Southwest segments.

Home sale gross margins

Home sale gross margins were 20.5% in 2013, compared with 15.8% in 2012 and 12.8% in 2011. Gross margins during 2013 and 2012 benefited from lower land impairments of $2.9 million and $13.4 million, respectively, compared with $15.9 million in 2011. Excluding the impact of land impairments and capitalized interest amortization, adjusted home sale gross margins improved to 25.2% in 2013 from 20.9% in 2012 and 17.9% in 2011 (see the Non-GAAP Financial Measures section for a reconciliation of adjusted home sale gross margins). The gross margin improvement was broad-based as substantially all of our operating divisions experienced higher gross margins in 2013 compared with the prior year periods. These improved gross margins reflect a combination of factors, including an improved pricing environment, shifts in the product mix of homes closed toward move-up and active adult buyers, better alignment of our product offering with consumer demand, and contributions from our strategic pricing and house cost reduction initiatives.

Land sales

We periodically elect to sell parcels of land to third parties in the event such assets no longer fit into our strategic operating plans or are zoned for commercial or other development. Land sale revenues and their related gains or losses vary between periods, depending on the timing of land sales and our strategic operating decisions. Land sales had margin contributions of $9.9 million, $11.8 million, and $23.6 million in 2013, 2012, and 2011, respectively. These margin contributions included net realizable value adjustments related to land held for sale totaling $3.6 million, $1.5 million, and $9.8 million in 2013, 2012, and 2011, respectively.

SG&A

SG&A as a percentage of home sale revenues dropped to 10.5% in 2013 from 11.3% in 2012, and 13.2% in 2011. The gross dollar amount of our SG&A increased $54.0 million, or 11%, in 2013 compared with 2012. SG&A includes $15.0 million of employee severance, retention, relocation, and related costs attributable to our previously announced relocation of our corporate headquarters. The remaining increases in gross overhead dollars were primarily due to variable costs related to the higher revenue volume combined with higher incentive compensation accruals resulting from the Company's improved operating performance.

The gross dollar amount of our SG&A decreased $5.1 million, or 1%, in 2012 compared with 2011 due to improved overhead leverage, partially offset by higher incentive compensation resulting from our improved operating results.

Equity in (earnings) loss of unconsolidated entities

Equity in (earnings) loss of unconsolidated entities was $(1.0) million, $(3.9) million, and $(3.2) million for 2013, 2012, and 2011, respectively. The majority of our unconsolidated entities represent land development joint ventures. As a result, the timing of income and losses varies between periods depending on the timing of transactions and circumstances specific to each entity.

Other expense, net

Other expense, net includes the following ($000’s omitted):

201320122011
Write-offs of deposits and pre-acquisition costs (Note 4)$3,122$2,278$10,002
Loss on debt retirements (Note 7)26,93032,0715,638
Lease exit and related costs2,7787,3069,900
Amortization of intangible assets (Note 1)13,10013,10013,100
Goodwill impairments (Note 2)——240,541
Miscellaneous expense, net34,82311,54313,921
$80,753$66,298$293,102

For additional information on each of the above, see the applicable Notes to the Consolidated Financial Statements. Miscellaneous expense, net includes charges of $41.2 million in 2013 resulting from a contractual dispute related to a previously completed luxury community, and $5.1 million in 2012 and $17.1 million in 2011 related to the write-down of notes receivable.

Interest income, net

Interest income, net for 2013 decreased from the prior year based on the level of invested cash balances and low returns on invested cash available in the current interest rate environment.

Net new orders

Net new orders decreased 10% in 2013 compared with 2012 primarily due to selling from 14% fewer active communities in 2013 (577 at December 31, 2013) combined with slowed demand in the second half of 2013 in response to higher home prices and a rise in mortgage interest rates. The cancellation rate (canceled orders for the period divided by gross new orders for the period) was unchanged from 2012 to 2013 at 15%. Ending backlog units, which represent orders for homes that have not yet closed, decreased 11% at December 31, 2013 compared with December 31, 2012, due to the decrease in net new orders but only decreased by 2% over the prior year period as measured in dollars due to the increase in our average selling price.

Net new order levels increased 25% in 2012 compared with 2011 while selling from 4% fewer active communities in 2012 (we had 670 active communities at December 31, 2012). The cancellation rate was 15% in 2012 compared with 19% in 2011. Ending backlog units increased 65% at December 31, 2012 compared with December 31, 2011 due to the decrease in net new orders.

Homes in production

The following is a summary of our homes in production at December 31, 2013 and 2012:

20132012
Sold3,7234,162
Unsold
Under construction813753
Completed338503
1,1511,256
Models1,0341,119
Total5,9086,537

The number of homes in production at December 31, 2013 was 10% lower than at December 31, 2012. The reduced level of homes in production is consistent with our lower active community count and our inventory management strategies. Reducing our reliance on sales of spec homes is a component of our strategic pricing and inventory turns objectives, so we have focused on reducing the level of our spec home inventory, especially our completed specs ("final specs").

Controlled lots

The following is a summary of our lots under control at December 31, 2013 and 2012:

December 31, 2013December 31, 2012
OwnedOptionedControlledOwnedOptionedControlled
Northeast7,4232,76210,1859,2112,65511,866
Southeast12,7024,29616,99813,3722,75616,128
Florida21,8056,95628,76123,9063,68927,595
Texas12,0383,86015,89812,2183,68515,903
North11,7857,95219,73712,9462,60315,549
Southwest29,4592,44031,89931,4071,42732,834
Total95,21228,266123,478103,06016,815119,875
Developed (%)24%18%23%27%34%28%

Of our controlled lots, 95,212 and 103,060 were owned and 28,266 and 16,815 were under land option agreements at December 31, 2013 and 2012, respectively. While competition for well-positioned land has increased, we

continue to pursue strategic land positions that meet our underwriting requirements while also using our existing land assets more effectively.

The remaining purchase price under our land option agreements totaled $1.4 billion at December 31, 2013. These land option agreements, which generally may be canceled at our discretion and in certain cases extend over several years, are secured by deposits and pre-acquisition costs totaling $91.0 million, of which only $4.5 million is refundable.

Non-GAAP Financial Measures

This report contains information about our home sale gross margins reflecting certain adjustments. This measure is considered a non-GAAP financial measure under the SEC's rules and should be considered in addition to, rather than as a substitute for, the comparable GAAP financial measure as a measure of our operating performance. Management and our local divisions use this measure in evaluating the operating performance of each community and in making strategic decisions regarding sales pricing, construction and development pace, product mix, and other daily operating decisions. We believe it is a relevant and useful measures to investors for evaluating our performance through gross profit generated on homes delivered during a given period and for comparing our operating performance to other companies in the homebuilding industry. Although other companies in the homebuilding industry report similar information, the methods used may differ. We urge investors to understand the methods used by other companies in the homebuilding industry to calculate gross margins and any adjustments thereto before comparing our measure to that of such other companies.

The following table sets forth a reconciliation of this non-GAAP financial measure to the GAAP financial measure that management believes to be most directly comparable ($000's omitted):

Adjusted home sale gross margin
Years Ended December 31,
201320122011
Home sale revenues$5,424,309$4,552,412$3,950,743
Home sale cost of revenues4,310,5283,833,4513,444,398
Home sale gross margin1,113,781718,961506,345
Add:
Land impairments (a)—6,96910,498
Capitalized interest amortization (a)255,065224,291189,382
Adjusted home sale gross margin$1,368,846$950,221$706,225
Home sale gross margin as a percentage of home sale revenues20.5%15.8%12.8%
Adjusted home sale gross margin as a percentage of home sale revenues25.2%20.9%17.9%
(a)Write-offs of capitalized interest related to land impairments are reflected in capitalized interest amortization.

Homebuilding Segment Operations

Our homebuilding operations represent our core business. Homebuilding offers a broad product line to meet the needs of homebuyers in our targeted markets. As of December 31, 2013, we conducted our operations in 48 markets located throughout 27 states. For reporting purposes, our Homebuilding operations are aggregated into six reportable segments:

Northeast:Connecticut, Delaware, Maryland, Massachusetts, New Jersey, New York, Pennsylvania, Rhode Island, Virginia
Southeast:Georgia, North Carolina, South Carolina, Tennessee
Florida:Florida
Texas:Texas
North:Illinois, Indiana, Michigan, Minnesota, Missouri, Northern California, Ohio, Oregon, Washington
Southwest:Arizona, Nevada, New Mexico, Southern California

We also have a reportable segment for our financial services operations, which consist principally of mortgage banking and title operations. The Financial Services segment operates generally in the same markets as the Homebuilding segments.

The following table presents selected financial information for our reportable Homebuilding segments:

Operating Data by Segment ($000's omitted)
Years Ended December 31,
2013FY 2013 vs. FY 20122012FY 2012 vs. FY 20112011
Home sale revenues:
Northeast$784,0878%$722,6911%$714,609
Southeast842,85622%689,1632%675,124
Florida800,33129%620,15611%557,865
Texas804,80621%666,7598%615,319
North1,214,33223%989,51036%727,085
Southwest977,89813%864,13331%660,741
$5,424,30919%$4,552,41215%$3,950,743
Income (loss) before income taxes:
Northeast$110,24650%$73,345150%$29,320
Southeast121,05587%64,67844%45,060
Florida139,67390%73,47263%44,946
Texas111,43183%60,97983%33,329
North164,34894%84,597(b)(12,376)
Southwest179,163124%79,887118%36,647
Other homebuilding (a)(346,803)(24)%(278,967)38%(452,756)
$479,113203%$157,991157%$(275,830)
Closings (units):
Northeast1,8352%1,800(4)%1,880
Southeast3,02210%2,757(1)%2,771
Florida2,74717%2,3404%2,251
Texas3,7688%3,4875%3,327
North3,40110%3,10320%2,579
Southwest2,993(1)%3,01822%2,467
17,7668%$16,5058%15,275
Average selling price:
Northeast$4276%$4016%$380
Southeast27912%2502%244
Florida29110%2657%248
Texas21412%1913%185
North35712%31913%282
Southwest32714%2867%268
$30511%$2767%$259
(a)Other homebuilding includes the amortization of intangible assets, amortization of capitalized interest, and other items not allocated to the operating segments. Other homebuilding also includes: losses on debt retirements totaling $26.9 million, $32.1 million, and $5.6 million in 2013, 2012, and 2011, respectively; costs associated with the previously announced relocation of our corporate headquarters totaling $15.4 million in 2013; and charges resulting from a contractual dispute related to a previously completed luxury community totaling $41.2 million in 2013.
(b)Percentage not meaningful.

The following tables present additional selected financial information for our reportable Homebuilding segments:

Operating Data by Segment ($000's omitted)
Years Ended December 31,
2013FY 2013 vs. FY 20122012FY 2012 vs. FY 20112011
Net new orders - units:
Northeast1,834(8)%1,99714%1,749
Southeast3,1643%3,06616%2,642
Florida2,595(6)%2,74719%2,314
Texas3,563(13)%4,11726%3,278
North3,347(9)%3,66139%2,635
Southwest2,577(25)%3,45133%2,597
17,080(10)%19,03925%15,215
Net new orders - dollars:
Northeast$782,474(5)%$820,60922%$674,134
Southeast895,80014%787,28622%645,993
Florida820,03212%735,25026%581,778
Texas796,377(1)%807,45533%606,239
North1,233,071—%1,228,74364%748,089
Southwest866,812(17)%1,044,95750%697,596
$5,394,566(1)%$5,424,30037%$3,953,829
Cancellation rates:
Northeast13%12%14%
Southeast12%13%16%
Florida13%12%13%
Texas22%22%28%
North11%13%17%
Southwest19%15%19%
15%15%19%
Unit backlog:
Northeast621—%62246%425
Southeast1,05316%91151%602
Florida913(14)%1,06562%658
Texas1,250(14)%1,45576%825
North1,213(4)%1,26779%709
Southwest722(37)%1,13861%705
5,772(11)%6,45865%3,924
Backlog dollars:
Northeast$275,239(1)%$276,85155%$178,934
Southeast305,60021%252,65663%154,533
Florida308,8347%289,13366%174,039
Texas286,195(3)%294,62391%153,927
North465,4804%446,741115%207,507
Southwest260,448(30)%371,53495%190,709
$1,901,796(2)%$1,931,53882%$1,059,649

The following table presents additional selected financial information for our reportable Homebuilding segments:

Operating Data by Segment ($000's omitted)
Years Ended December 31,
2013FY 2013 vs. FY 20122012FY 2012 vs. FY 20112011
Land-related charges*:
Northeast$557(69)%$1,794(64)%$4,958
Southeast998(27)%1,363(44)%2,429
Florida1,076403%214(95)%3,999
Texas191(66)%556(33)%828
North3,434(24)%4,546(69)%14,867
Southwest472(79)%2,254(31)%3,263
Other homebuilding2,944(54)%6,46819%5,442
$9,672(44)%$17,195(52)%$35,786
*Land-related charges include land impairments, net realizable value adjustments for land held for sale, and write-offs of deposits and pre-acquisition costs for land option contracts we elected not to pursue. Other homebuilding consists primarily of write-offs of capitalized interest resulting from land-related charges. See Notes 4 and 5 to the Consolidated Financial Statements for additional discussion of these charges.

Northeast:

For 2013, Northeast home sale revenues increased 8% compared with 2012 due to a 6% increase in the average selling price combined with a 2% increase in closings. The increase in average selling price occurred primarily in New England and Mid-Atlantic. The increased income before income taxes was due to higher revenues and improved gross margins and overhead leverage. Net new orders decreased 8%, mainly due to lower order levels in the Mid-Atlantic due to fewer active communities, offset in part by an increase in orders in New England.

For 2012, Northeast home sale revenues increased 1% compared with 2011 due to a 6% increase in the average selling price, offset in part by a 4% decrease in closings. The increase in average selling price occurred primarily in the Northeast Corridor and Mid-Atlantic, while the decrease in closings was concentrated in the Northeast Corridor and was due to a significant decrease in active communities. The significant increase in income before income taxes was due to moderately improved gross margins and $21.9 million of expense in 2011 related to the write-down of a note receivable and unfavorable resolution of certain contingencies. Net new orders increased 14%, led by our operations in New England.

Southeast:

For 2013, Southeast home sale revenues increased 22% compared with 2012 due to a 12% increase in the average selling price combined with a 10% increase in closings. The increase in average selling price was concentrated in Raleigh and Tennessee. The increase in closing volumes was primarily due to increases in Charlotte and Raleigh. The increased income before income taxes was due to the higher revenues and moderately improved gross margins. Net new orders increased 3% in 2013 led by our operations in Raleigh.

For 2012, Southeast home sale revenues increased 2% compared with 2011 due to a 2% increase in the average selling price, partially offset by a 1% decrease in closings. The increase in average selling price was concentrated in Georgia and Tennessee. The decrease in closing volumes was primarily due to a moderate decrease in Raleigh. The increased income before income taxes was due to moderately improved gross margins. Net new orders increased 16% in 2012 and reflected increases across all divisions.

Florida:

For 2013, Florida home sale revenues increased 29% compared with 2012 due to a 10% increase in the average selling price and a 17% increase in closings. The increase in closings was concentrated in North Florida while the increase in average

selling price occurred in both North and South Florida. The increased income before income taxes for 2013 resulted from the higher revenues combined with improved gross margins and overhead leverage. Net new orders decreased by 6% in 2013 due to fewer active communities in North Florida.

For 2012, Florida home sale revenues increased 11% compared with 2011 due to a 7% increase in the average selling price and a 4% increase in closings. The increase in income before income taxes for 2012 was attributable to significantly improved gross margins and overhead leverage, as well as lower land-related charges. Net new orders increased by 19% in 2012 evenly across North and South Florida.

Texas:

For 2013, Texas home sale revenues increased 21% compared with the prior year period due to an 8% increase in closings combined with a 12% increase in average selling price. The increase in closings was most significant in Houston and Central Texas, while the increase in average selling price was led by our operations in Central Texas and Dallas. The increased income before income taxes for 2013 resulted from the higher revenues combined with improved gross margins and overhead leverage. Net new orders decreased by 13% for 2013 driven mainly by fewer active communities.

For 2012, Texas home sale revenues increased 8% compared with the prior year period due to a 5% increase in closings combined with a 3% increase in average selling price. The increase in closings was experienced across all markets, but was concentrated in Houston and San Antonio. The increase in average selling price was concentrated in Central Texas and Dallas. The significant increase in income before income taxes for 2012 was attributable to moderately improved gross margins and overhead leverage. Net new orders increased by 26% for 2012 and reflected increases across all divisions.

North:

For 2013, North home sale revenues increased 23% compared with the prior year period due to a 10% increase in closings and a 12% increase in average selling price. The increase in closing volumes was primarily due to significant increases in Michigan and Northern California. The increase in average selling price was due to increases across all divisions. The increase in income before income taxes resulted from the higher revenues combined with improved gross margins in every division. Net new orders decreased by 9% in 2013 compared with 2012, mainly due to a decrease in Northern California, as we purposely slowed sales pace in a number of communities by raising prices and limiting lot releases.

For 2012, North home sale revenues increased 36% compared with the prior year period due to a 20% increase in closings and a 13% increase in average selling price. The increase in closing volumes was broad-based across all divisions, with the largest increases coming from our Michigan and Indianapolis operations. The increase in average selling price occurred at all divisions except Michigan, with the most significant increases in Minnesota and the Pacific Northwest. The substantial increase in income before income taxes, as compared with the loss experienced in 2011, was due to the higher revenues, significantly improved gross margins and overhead leverage, a significant reduction in land-related charges, and gains related to land sale transactions. Net new orders increased by 39% in 2012 compared with 2011, and reflected moderate to significant increases across all divisions, with the largest increases in Michigan and Northern California.

Southwest:

For 2013, Southwest home sale revenues increased 13% compared with the prior year period due to a 14% increase in average selling price offset by a 1% decrease in closings. The increase in average selling price occurred across all divisions. The decrease in closings was mainly due to decreases in Southern California and Las Vegas. The significant increase in income before income taxes was due to higher revenues and gross margins. Net new orders decreased by 25% in 2013 compared with 2012 primarily due to fewer active communities.

For 2012, Southwest home sale revenues increased 31% compared with the prior year period due to a 22% increase in closings and a 7% increase in average selling price. The increase in average selling price occurred across all divisions. The significant increase in income before income taxes was due to the higher revenues, moderately improved gross margins, and better overhead leverage. In 2011, the Southwest also benefited from land sale gains totaling $15.5 million. Net new orders increased by 33% in 2012 compared with 2011 with significant increases across all divisions, except Colorado.

Financial Services Operations

We conduct our Financial Services operations, which include mortgage and title operations, through Pulte Mortgage and other subsidiaries. In originating mortgage loans, we initially use our own funds, including funds available pursuant to credit agreements with either third parties or with the Company. Substantially all of the loans we originate are sold in the secondary market within a short period of time after origination, generally within 30 days. We also sell the servicing rights for the loans we originate through fixed price servicing sales contracts to reduce the risks and costs inherent in servicing loans. This strategy results in owning the servicing rights for only a short period of time. Operating as a captive business model primarily targeted to supporting our Homebuilding operations, the business levels of our Financial Services operations are highly correlated to Homebuilding. Our Homebuilding customers continue to account for substantially all loan production. We believe that our capture rate, which represents loan originations from our Homebuilding operations as a percentage of total loan opportunities from our Homebuilding operations, excluding cash closings, is an important metric in evaluating the effectiveness of our captive mortgage business model. The following table presents selected financial information for our Financial Services operations ($000’s omitted):

Years Ended December 31,
2013FY 2013 vs. FY 20122012FY 2012 vs. FY 20112011
Mortgage operations revenues$113,552(17)%$137,44365%$83,260
Title services revenues27,39917%23,44518%19,834
Total Financial Services revenues140,951(12)%160,88856%103,094
Expenses92,379(32)%135,511(2)%137,666
Equity in (earnings) loss of unconsolidated entities(137)(26)%(186)82%(102)
Income (loss) before income taxes$48,709(91)%$25,563(174)%$(34,470)
Total originations:
Loans11,8184%11,32219%9,482
Principal$2,765,50910%$2,509,92826%$1,986,225
Years Ended December 31,
201320122011
Supplemental data:
Capture rate80.2%81.9%78.5%
Average FICO score746743748
Loan application backlog$984,754$1,178,321$583,472
Funded origination breakdown:
FHA16%22%28%
VA11%12%13%
USDA3%3%2%
Other agency67%61%56%
Total agency97%98%99%
Non-agency3%2%1%
Total funded originations100%100%100%

Revenues

Total Financial Services revenues during 2013 decreased 12% compared with 2012. The decrease was primarily attributable to lower revenues per loan resulting from the increased competitiveness in the mortgage industry that occurred in 2013. The decline in revenues per loan more than offset the higher loan origination volume. Interest income, which is included in mortgage operations revenues, was moderately higher in 2013 than in 2012 due to the increase in loan originations.

Total Financial Services revenues during 2012 increased 56% compared with 2011 due to a 19% increase in loan origination volumes, an increase in average loan size, and improved loan pricing. The increase in loan origination volumes was due to a higher capture rate, higher Homebuilding closing volumes, and fewer cash sales. Interest income, which is included in mortgage operations revenues, was moderately higher in 2012 than in 2011 due to the increase in loan originations.

In recent years, the mortgage industry has experienced a significant overall tightening of lending standards and a shift toward agency production and fixed rate loans versus adjustable rate mortgages (“ARMs”) and unconventional loans. The substantial majority of loan production during 2013, 2012, and 2011 consisted of fixed rate loans, the majority of which are prime, conforming loans. The shift toward agency fixed-rate loans has contributed to profitability as such loans generally result in higher profitability due to higher servicing values and structured guidelines that allow for expense efficiencies when processing the loan. Additionally, historically low interest rates and the challenging regulatory environment has contributed to profitability by reducing the overall level of pricing competition in the market. Recently, however, competition has increased in the industry, partially as the result of the mortgage industry's lower refinancing volume. We expect this increased level of competition, and more challenging pricing environment, to continue for the foreseeable future.

Loan origination liabilities

Our mortgage operations may be responsible for losses associated with mortgage loans originated and sold to investors in the event of errors or omissions relating to representations and warranties made by us that the loans met certain requirements, including representations as to underwriting standards, the existence of primary mortgage insurance, and the validity of certain borrower representations in connection with the loan. If a loan is determined to be faulty, we either repurchase the loan from the investors or reimburse the investors' losses (a “make-whole” payment).

In recent years, we experienced a significant increase in losses as a result of the high level of loan defaults and related losses in the mortgage industry and increasing aggressiveness by investors in presenting such claims to us. To date, the significant majority of these losses relates to loans originated in 2006 and 2007, during which period inherently riskier loan products became more common in the mortgage origination market. During 2012 and 2011, we recorded additional provisions for losses as a change in estimate primarily to reflect projected claim volumes in excess of previous estimates. Losses related to loan origination liabilities totaled $49.0 million and $59.3 million in 2012 and 2011, respectively, and are reflected in Financial Services expenses. There were no such losses in 2013. Given the volatility in the mortgage industry and the uncertainty regarding the ultimate resolution of these claims, actual costs could differ from our current estimates. See our Critical Accounting Policies and Estimates and Note 13 to the Consolidated Financial Statements for additional discussion.

We entered into an agreement in conjunction with the wind down of Centex's mortgage operations, which ceased loan origination activities in December 2009, that provides a guaranty for one major investor of loans originated by Centex. This guaranty provides that we will honor the potential repurchase obligations of Centex's mortgage operations related to breaches of representations and warranties in the origination of a certain pool of loans. Other than with respect to this pool of loans, our contractual repurchase obligations are limited to our mortgage subsidiaries, which are included in non-guarantor subsidiaries (see Note 14 for a discussion of non-guarantor subsidiaries).

The mortgage subsidiary of Centex also sold loans to a bank for inclusion in residential mortgage-backed securities (“RMBSs”) issued by the bank. In connection with these sales, Centex's mortgage subsidiary entered into agreements pursuant to which it may be required to indemnify the bank for losses incurred by investors in the RMBSs arising out of material errors or omissions in certain information provided by the mortgage subsidiary relating to the loans and loan origination process. In 2011, the bank notified us that it has been named defendant in two lawsuits alleging various violations of federal and state securities laws asserting that untrue statements of material fact were included in the registration statements used to market the sale of two RMBS transactions which included $162 million of loans originated by Centex's mortgage subsidiary. Neither Centex's mortgage subsidiary nor the Company is named as a defendant in these actions. We cannot yet quantify Centex's mortgage subsidiary's potential liability as a result of these indemnification obligations. We do not believe, however, that these matters will have a material adverse impact on the results of operations, financial position, or cash flows of the Company. We are aware of six other RMBS transactions with similar indemnity provisions that include an aggregate $116 million of loans, and we are not aware of any current or threatened legal proceedings regarding those transactions.

Income before income taxes

The increased income before income taxes for 2013 as compared with 2012 was due to higher origination volumes and lower loss reserves related to loans originated in previous years, partially offset by less favorable loan pricing.

The income before income taxes for 2012 as compared with the loss before income taxes in the prior year period was due to higher origination volumes, improved loan pricing, and lower loss reserves related to loans originated in previous years.

Income Taxes

Our effective tax rate is affected by a number of factors, the most significant of which are the valuation allowance recorded against our deferred tax assets and changes in our unrecognized tax benefits. Due to the effects of these factors, our effective tax rates in 2013, 2012, and 2011 are not correlated to the amount of our income or loss before income taxes. The income tax benefit for 2013 resulted from the reversal of substantially all of the valuation allowance related to our deferred tax assets while the income tax benefits for 2012 and 2011 resulted primarily from the favorable resolution of certain federal and state income tax matters.

We evaluate our deferred tax assets each period to determine if a valuation allowance is required based on whether it is "more likely than not" that some portion of the deferred tax assets would not be realized. The ultimate realization of these deferred tax assets is dependent upon the generation of sufficient taxable income during future periods. We conduct our evaluation by considering all available positive and negative evidence.

Our income tax benefit for 2013 includes $2.1 billion related to the reversal of substantially all of the valuation allowance previously recorded against our deferred tax assets. In the third quarter of 2013, we evaluated the need for a valuation allowance against our deferred tax assets and determined that the valuation allowance against substantially all of our federal deferred tax assets and a significant portion of our state deferred tax assets was no longer required. When a change in valuation allowance is recognized in an interim period, a portion of the valuation allowance to be reversed must be allocated to the remaining interim periods. Accordingly, a portion of the remaining valuation allowance was reversed in the fourth quarter of 2013. The components of the valuation allowance remaining at December 31, 2013 relate primarily to state net operating losses that have not met the "more likely than not" realization threshold.

The principal positive evidence that led to the reversal of the valuation allowance in 2013 included: (1) our emergence from a three-year cumulative loss in 2013; (2) the significant positive income we generated during 2012 and 2013, including seven consecutive quarters of pretax income as of December 31, 2013; (3) continued improvements in 2013 over recent years in other key operating metrics, including revenues, gross margin, and overhead leverage; (4) our forecasted future profitability; (5) improvement in our financial position; and (6) significant evidence that conditions in the U.S. housing industry are more favorable than in recent years and our belief that conditions will continue to be favorable over the long-term. The following provides a further summary of the principal evidence considered in 2013:

•Recent operating results: We generated significant pretax income in 2012 and 2013. This included generating pretax income in seven consecutive quarters. Excluding asset impairments, we have been profitable in nine out of the last ten quarters. As a result of this improved profitability, we exited a three-year cumulative loss position in 2013, which had been a significant piece of negative evidence prior to 2013.
•Future operating results: We have a strong backlog of orders that, combined with other factors, provides evidence of our ability to continue to be profitable for 2014 and beyond. Based on detailed projections from each of our business units, we expect pretax earnings growth in the future, even if sales volumes remain at existing levels.
•Financial position: We continue to generate significant cash flow from operations and had $1.6 billion of unrestricted cash and equivalents at December 31, 2013. We have used our capital to both invest in our business and reduce our financial leverage. During 2013, we increased our authorized investments in new communities via land acquisition and development, retired significant amounts of debt prior to the stated maturity dates, increased our authorized and actual common share repurchases, and reinstated a common share dividend.
•Recovery period for deferred tax assets: For federal income tax purposes, we are allowed to carryforward net operating losses for 20 years and apply such losses to future taxable income to realize our federal deferred tax assets. We believe that we will realize all of our federal net operating losses and will be able to absorb substantially all federal deductible temporary differences as they reverse in future years.
•Operating actions taken: We have taken specific actions in recent years to improve our homebuilding operations, including: restructuring our overhead costs to align with current and projected volumes; improving inventory turns, including significant reductions in speculative home inventory; implementation of a robust risk-based portfolio approach to land acquisition approvals; monetization of under performing land assets; enhancing revenues through more strategic pricing, including establishing clear product offerings for each of our targeted consumer groups based on consumer-driven input, expanding the use of house options and lot premiums, and lessening our reliance on speculative home sales; and reducing our house construction costs through common house plan management, value-engineering house plans, and "should costing" our construction costs with our suppliers.
•Risk of future asset impairments: The frequency and magnitude of asset impairments has decreased dramatically in recent years as assets have been written-down or sold and as industry conditions have improved. While we remain at risk of future impairments if industry conditions worsen or if our strategy related to certain assets changes, we believe it unlikely that any future asset impairments would be at levels similar to those experienced during the U.S. housing industry downturn.
•Sales trends: Our home closings and home sale revenues increased 8% and 19%, respectively, in 2013 compared with 2012. We also have a strong backlog of orders that is amongst the highest in the U.S. homebuilding industry at $1.9 billion as of December 31, 2013. Additionally, the gross margin of orders within our backlog improved significantly from 2012 to 2013. While our net new order units declined 10% in 2013 compared with 2012, this resulted primarily from an expected reduction in the number of our active communities, which are down 14% at December 31, 2013 from December 31, 2012. The reduction in active communities and the lower level of net new orders is consistent with our expectations.
•U.S. housing industry outlook: Various housing indices have shown significant improvement in recent periods. U.S. single family new home sales of 306,000 in 2011 were at the lowest level since 1962, a drop of 76% from the 2005 cyclical peak of 1.3 million. In 2013 and 2012, U.S. new home sales increased 16% and 20%, respectively, over the prior year periods. The general consensus among industry analysts is that new home sales will increase significantly in each of the next several years. These forecasts are generally consistent with the 25-year average of approximately 735,000 annual new home sales. New home sales experienced volatility in the second half of 2013 period as consumers adjusted to higher home prices and an increase in mortgage interest rates. While we believe that higher interest rates are inevitable and may have a moderating effect on demand and pricing, we believe this impact will be outweighed by the other factors driving increased sales activity as overall new home sales remain low compared with historical levels. Ultimately, we believe that any sustained rise in interest rates will be indicative of a stronger macroeconomic environment that will support a continued recovery in the homebuilding industry.

After careful evaluation of all available positive and negative evidence, and giving more weight to objectively verifiable evidence over more subjective evidence, we concluded as of September 30, 2013 and again as of December 31, 2013, that it was "more likely than not" that substantially all of our federal deferred tax assets and a significant portion of our state deferred tax assets would be realized. Even if industry conditions weaken from current levels, we believe we will be able to adjust our operations to sustain long-term profitability.

Liquidity and Capital Resources

We finance our land acquisition, development, and construction activities and financial services operations by using internally-generated funds supplemented by credit arrangements with third parties and capital market financing. We routinely monitor current and expected operational requirements and financial market conditions to evaluate accessing other available financing sources, including revolving bank credit and securities offerings. Based on our current financial condition and credit relationships, we believe that our operations and borrowing resources are sufficient to provide for our current and foreseeable capital requirements. However, we continue to evaluate the impact of market conditions on our liquidity and may determine that modifications are appropriate.

At December 31, 2013, we had unrestricted cash and equivalents of $1.6 billion and senior notes of $2.1 billion. We also had restricted cash balances of $72.7 million, the substantial majority of which related to cash serving as collateral under certain letter of credit facilities. Other financing sources include various letter of credit facilities and surety bond arrangements.

We follow a diversified investment approach for our cash and equivalents by maintaining such funds with a diversified portfolio of banks within our group of relationship banks in high quality, highly liquid, short-term investments, generally money market funds and federal government or agency securities. We monitor our investments with each bank and do not believe our cash and equivalents are exposed to any material risk of loss. However, there can be no assurances that losses of principal balance on our cash and equivalents will not occur.

Our ratio of debt to total capitalization, excluding our Financial Services debt, was 30.7% at December 31, 2013, and 8.0% net of cash and equivalents, including restricted cash.

During 2013, we retired prior to their scheduled maturity dates $461.4 million of senior notes. We recorded losses related to these transactions totaling $26.9 million. Losses on these transactions included the write-off of unamortized discounts, premiums, and transaction fees and are reflected in other expense, net. During 2012 and 2011, we retired senior notes totaling $592.4 million and $323.9 million, respectively.

Credit agreements

We maintain separate cash-collateralized letter of credit agreements with a number of financial institutions. Letters of credit totaling $58.7 million were outstanding under these agreements at December 31, 2013. Under these agreements, we are required to maintain deposits with these financial institutions in amounts approximating the letters of credit outstanding. Such deposits are included in restricted cash.

We also maintain an unsecured letter of credit facility that expires in September 2014. This facility permits the issuance of up to $150.0 million of letters of credit for general corporate purposes in support of any wholly-owned subsidiary. Letters of credit totaling $124.4 million were outstanding under this facility at December 31, 2013.

Pulte Mortgage

Pulte Mortgage provides mortgage financing for the majority of our home closings by utilizing its own funds and funds made available pursuant to credit agreements with third parties or through intercompany borrowings. Pulte Mortgage uses these resources to finance its lending activities until the mortgage loans are sold in the secondary market, which generally occurs within 30 days.

Pulte Mortgage maintains a master repurchase agreement (the “Repurchase Agreement”) with third party lenders that expires in September 2014. Effective January 2014, Pulte Mortgage voluntarily reduced the borrowing capacity under the Repurchase Agreement from $150.0 million to $99.8 million subject to certain sublimits. We reduced the borrowing capacity in order to lower associated fees during seasonally low volume periods when the additional capacity is unnecessary. Borrowings under the Repurchase Agreement are secured by residential mortgage loans available-for-sale. The Repurchase Agreement contains various affirmative and negative covenants applicable to Pulte Mortgage, including quantitative thresholds related to net worth, net income, and liquidity. At December 31, 2013, Pulte Mortgage had $105.7 million outstanding under the Repurchase Agreement and was in compliance with all of its covenants and requirements. While there can be no assurances that the Repurchase Agreement can be renewed or replaced on commercially reasonable terms upon its expiration, we believe we have adequate liquidity to meet Pulte Mortgage's anticipated financing needs.

Stock repurchase programs

In July 2013, we increased our common share repurchase authorization to $352.3 million of common shares. In 2013, we repurchased 7.2 million shares under the repurchase authorization for a total of $118.1 million. There were no repurchases under these programs during 2012 or 2011. Such repurchases are reflected as a reduction of common stock and retained earnings. At December 31, 2013, we had remaining authorization to purchase $234.3 million of common shares.

Dividends

We reinstated our quarterly cash dividend in July 2013. During 2013, we declared three cash dividends of $0.05 per common share each.

Cash flows

Operating activities

Our net cash provided by operating activities in 2013 was $881.1 million, compared with $760.1 million and $17.3 million in 2012 and 2011, respectively. Generally, the primary drivers of our cash flow from operations are profitability and changes in inventory levels. Our positive cash flow from operations for 2013 was primarily due to our income before income taxes of $527.8 million combined with a net decrease in inventories of $265.1 million and a reduction of $28.4 million in residential mortgage loans available-for-sale. The inventory decrease resulted from a reduction in homes in production and lower land inventory consistent with the decline in the number of our active communities.

Our positive cash flow from operations for 2012 was primarily due to our net income of $206.1 million combined with a net decrease in inventories of $455.2 million. The inventory decrease resulted from lower reinvestment in land inventory combined with a significant reduction in spec homes in production, partially offset by an increase in sold homes in production.

The net losses for 2011 were largely the result of non-cash asset impairments and insurance reserve adjustments, so the cash flows from operations primarily related to changes in working capital. Our positive cash flow from operations in 2011 was primarily the result of a net decrease in inventories combined with income tax refunds, net of payments, of $62.2 million offset by financing Pulte Mortgage's lending operations, which reduced cash flows from operations by $52.8 million in 2011.

Investing activities

Investing activities are generally not a significant source or use of cash for us. Net cash used in investing activities totaled $46.0 million in 2013, compared with net cash provided by investing activities of $9.7 million in 2012 and net cash used in investing activities of $93.6 million in 2011. The use of cash from investing activities in 2013 was primarily due to $28.9 million of capital expenditures, a $12.3 million increase in residential mortgage loans held for investment, and a $4.2 million increase in the restricted cash we are required to maintain under our letter of credit facilities.

The positive cash flow from investing activities in 2012 was primarily due to a $28.7 million decrease in the restricted cash we are required to maintain under our letter of credit facilities, which resulted from a reduction in letters of credit outstanding, offset by capital expenditures and investments in unconsolidated entities.

The use of cash from investing activities for 2011 was due to $83.2 million of restricted cash we were required to maintain related to our letter of credit facilities, partially offset by proceeds from the sale of property and equipment related to the consolidation of certain facilities.

Financing activities

Net cash used in financing activities was $659.6 million in 2013, compared with net cash used of $448.2 million and $324.0 million in 2012 and 2011, respectively. During the last three years, we significantly reduced our outstanding senior notes through a variety of transactions, including scheduled maturities, open market repurchases, early redemptions as provided within indenture agreements, and tender offers. Completion of these transactions required the use of $479.8 million, $618.8 million, and $321.1 million of cash in 2013, 2012, and 2011, respectively. During 2013, we also repaid $33.1 million of borrowings under the Repurchase Agreement due to the lower balance of mortgages available-for-sale. We borrowed $138.8 million under the Repurchase Agreement in 2012, the year in which it was put in place. During 2011, we used internal funds to finance Pulte Mortgage's operations, the effects of which are reflected in cash flows from operating activities. Cash used in financing activities for 2013 also reflects funds used to repurchase common shares and pay dividends, partially offset by funds provided by the issuance of common shares in connection with employee stock option exercises.

Inflation

We, and the homebuilding industry in general, may be adversely affected during periods of inflation because of higher land and construction costs. Inflation may also increase our financing costs. In addition, higher mortgage interest rates affect the affordability of our products to prospective homebuyers. While we attempt to pass on to our customers increases in our costs through increased sales prices, market forces may limit our ability to do so. If we are unable to raise sales prices enough to compensate for higher costs, or if mortgage interest rates increase significantly, our revenues, gross margins, and net income could be adversely affected.

Seasonality

We experience variability in our quarterly results from operations due to the seasonal nature of the homebuilding industry. Historically, we have experienced increases in revenues and cash flow from operations during the fourth quarter based on the timing of home closings.

Contractual Obligations and Commercial Commitments

The following table summarizes our payments under contractual obligations as of December 31, 2013:

Payments Due by Period ($000’s omitted)
Total20142015-20162017-2018After 2018
Contractual obligations:
Long-term debt (a)$3,892,070$135,275$1,028,120$132,378$2,596,297
Operating lease obligations160,80828,11648,05028,40756,235
Other long-term liabilities (b)7,5531,9993,2942,260—
Total contractual obligations (c)$4,060,431$165,390$1,079,464$163,045$2,652,532
(a)Represents principal and interest payments related to our senior notes.
(b)Represents limited recourse collateralized financing arrangements and related interest payments.
(c)We do not have any payments due in connection with capital lease or long-term purchase obligations.

We are subject to certain obligations associated with entering into contracts (including land option contracts) for the purchase, development, and sale of real estate in the routine conduct of our business. Option contracts for the purchase of land enable us to defer acquiring portions of properties owned by third parties and unconsolidated entities until we have determined whether to exercise our option, which may serve to reduce our financial risks associated with long-term land holdings. At December 31, 2013, we had $91.0 million of deposits and pre-acquisition costs relating to option agreements to acquire 28,266 homesites with a remaining purchase price of $1.4 billion. We expect to acquire the majority of these lots within the next two years and the remainder thereafter.

At December 31, 2013, we had $173.3 million of gross unrecognized tax benefits and $33.1 million of related accrued interest and penalties. We are currently under examination by various taxing jurisdictions and anticipate finalizing the examinations with certain jurisdictions within the next twelve months. However, the final outcome of these examinations is not yet determinable. The statute of limitations for our major tax jurisdictions remains open for examination for tax years 2003 - 2013.

The following table summarizes our other commercial commitments as of December 31, 2013:

Amount of Commitment Expiration by Period ($000’s omitted)
Total20142015-20162017-2018After 2018
Other commercial commitments:
Guarantor credit facilities (a)$208,699$208,699$—$—$—
Non-guarantor credit facilities (b)150,000150,000———
Total commercial commitments (c)$358,699$358,699$—$—$—
(a)$150.0 million of the $208.7 million in 2014 represents the capacity of our unsecured letter of credit facility, of which $124.4 million was outstanding at December 31, 2013, while the remaining $58.7 million in 2014 represents letters of credit outstanding under our cash-collateralized letter of credit agreements.
(b)Represents the capacity of the Repurchase Agreement, of which $105.7 million was outstanding at December 31, 2013, and which expires in September 2014. Effective January 2014, we voluntarily reduced the capacity from $150 million to $99.8 million.
(c)The above table excludes an aggregate $958.3 million of surety bonds, which typically do not have stated expiration dates.

Off-Balance Sheet Arrangements

We use letters of credit and surety bonds to guarantee our performance under various contracts, principally in connection with the development of our homebuilding projects. The expiration dates of the letter of credit contracts coincide with the expected completion date of the related homebuilding projects. If the obligations related to a project are ongoing, annual extensions of the letters of credit are typically granted on a year-to-year basis. At December 31, 2013, we had outstanding letters of credit of $183.1 million. Our surety bonds generally do not have stated expiration dates; rather, we are released from the bonds as the contractual performance is completed. These bonds, which approximated $1.0 billion at December 31, 2013, are typically outstanding over a period of approximately three to five years. Because significant construction and development work has been performed related to the applicable projects but has not yet received final acceptance by the respective counterparties, the aggregate amount of surety bonds outstanding is in excess of the projected cost of the remaining work to be performed.

In the ordinary course of business, we enter into land option agreements in order to procure land for the construction of houses in the future. At December 31, 2013, these agreements had an aggregate remaining purchase price of $1.4 billion. Pursuant to these land option agreements, we provide a deposit to the seller as consideration for the right to purchase land at different times in the future, usually at predetermined prices. In certain instances, we are required to record the land under option as if we own it. At December 31, 2013, we recorded assets of $24.0 million as land, not owned, under option agreements.

At December 31, 2013, aggregate outstanding debt of unconsolidated joint ventures was $12.4 million, of which our proportionate share was $4.4 million. Of this amount, we provided limited recourse guaranties for $0.8 million at December 31, 2013. See Note 6 to the Consolidated Financial Statements for additional information.

Critical Accounting Policies and Estimates

The accompanying consolidated financial statements were prepared in conformity with U.S. generally accepted accounting principles. When more than one accounting principle, or the method of its application, is generally accepted, we select the principle or method that is appropriate in our specific circumstances (see Note 1 of our Consolidated Financial Statements). Application of these accounting principles requires us to make estimates about the future resolution of existing uncertainties; as a result, actual results could differ from these estimates. In preparing these consolidated financial statements, we have made our best estimates and judgments of the amounts and disclosures included in the consolidated financial statements, giving due regard to materiality.

Revenue recognition

Homebuilding – Homebuilding revenue and related profit are generally recognized when title to and possession of the property are transferred to the buyer. In situations where the buyer’s financing is originated by Pulte Mortgage, our wholly-owned mortgage subsidiary, and the buyer has not made an adequate initial or continuing investment, the profit on such sale is deferred until the sale of the related mortgage loan to a third-party investor has been completed. If there is a loss on the sale of the property, the loss on such sale is recognized at the time of closing.

Financial Services – Mortgage servicing fees represent fees earned for servicing loans for various investors. Servicing fees are based on a contractual percentage of the outstanding principal balance, or a contracted set fee in the case of certain sub-servicing arrangements, and are credited to income when related mortgage payments are received or the sub-servicing fees are earned. Loan origination fees, commitment fees, and certain direct loan origination costs are recognized as incurred. Expected gains and losses from the sale of residential mortgage loans and their related servicing rights are included in the measurement of written loan commitments that are accounted for at fair value through Financial Services revenues at the time of commitment. Subsequent changes in the fair value of these loans are reflected in Financial Services revenues as they occur. Interest income is accrued from the date a mortgage loan is originated until the loan is sold. Loans are placed on non-accrual status once they become greater than 90 days past due their contractual terms. Subsequent payments received are applied according to the contractual terms of the loan.

Inventory

Inventory is stated at cost unless the carrying value is determined to not be recoverable, in which case the affected inventory is written down to fair value. Cost includes land acquisition, land development, and home construction costs, including interest, real estate taxes, and certain direct and indirect overhead costs related to development and construction. For those communities for which construction and development activities have been idled, applicable interest and real estate taxes are expensed as incurred. Land acquisition and development costs are allocated to individual lots using an average lot cost determined based on the total expected land acquisition and development costs and the total expected home closings for the community. The specific identification method is used to accumulate home construction costs.

We capitalize interest cost into homebuilding inventories. Each layer of capitalized interest is amortized over a period that approximates the average life of communities under development. Interest expense is allocated over the period based on the timing of home closings.

Cost of revenues includes the construction cost, average lot cost, estimated warranty costs, and commissions and closing costs applicable to the home. The construction cost of the home includes amounts paid through the closing date of the home, plus an appropriate accrual for costs incurred but not yet paid, based on an analysis of budgeted construction costs. This accrual is reviewed for accuracy based on actual payments made after closing compared with the amount accrued, and adjustments are made if needed. Total community land acquisition and development costs are based on an analysis of budgeted costs compared with actual costs incurred to date and estimates to complete. The development cycles for our communities range from under one year to in excess of ten years for certain master planned communities. Adjustments to estimated total land acquisition and development costs for the community affect the amounts costed for the community’s remaining lots.

We record valuation adjustments on land inventory when events and circumstances indicate that they may be impaired and when the cash flows estimated to be generated by those assets are less than their carrying amounts. For communities that demonstrate indicators of impairment, we compare the expected undiscounted cash flows for these communities to their carrying value. For those communities whose carrying values exceed the expected undiscounted cash flows, we calculate the fair value of the community. Impairment charges are required to be recorded if the fair value of the community’s inventory is less than its carrying value.

We generally determine the fair value of each community’s inventory using a combination of discounted cash flow models and market comparable transactions, where available. These estimated cash flows are significantly impacted by estimates related to expected average selling prices and sale incentives, expected sales paces and cancellation rates, expected land development and construction timelines, and anticipated land development, construction, and overhead costs. Such estimates must be made for each individual community and may vary significantly between communities. Due to uncertainties in the estimation process, the significant volatility in demand for new housing, and the long life cycles of many communities, actual results could differ significantly from such estimates.

Residential mortgage loans available-for-sale

In accordance with ASC 825, “Financial Instruments” (“ASC 825”), we use the fair value option for our residential mortgage loans available-for-sale. Election of the fair value option for residential mortgage loans available-for-sale allows a better offset of the changes in fair values of the loans and the derivative instruments used to economically hedge them without having to apply complex hedge accounting provisions. Changes in the fair value of these loans are reflected in revenues as they occur.

Loan origination liabilities

Our mortgage operations may be responsible for losses associated with mortgage loans originated and sold to investors in the event of errors or omissions relating to representations and warranties made by us that the loans met certain requirements, including representations as to underwriting standards, the existence of primary mortgage insurance, and the validity of certain borrower representations in connection with the loan. If a loan is determined to be faulty, we either repurchase the loan from the investors or reimburse the investors' losses (a “make-whole” payment).

In recent years, we experienced a significant increase in losses related to repurchase requests as a result of the high level of loan defaults and related losses in the mortgage industry and increasing aggressiveness by investors in presenting such claims to us. To date, the significant majority of these losses relates to loans originated in 2006 and 2007, during which period inherently riskier loan products became more common in the mortgage origination market. In 2006 and 2007, we originated $39.5 billion of loans, excluding loans originated by Centex's former subprime loan business sold by Centex in 2006. Because we generally do not retain the servicing rights to the loans we originate, information regarding the current and historical performance, credit quality, and outstanding balances of such loans is limited. Estimating these loan origination liabilities is further complicated by uncertainties surrounding numerous external factors, such as various macroeconomic factors (including unemployment rates and changes in home prices), actions taken by third parties, including the parties servicing the loans, and the U.S. federal government in its dual capacity as regulator of the U.S. mortgage industry and conservator of the government-sponsored enterprises commonly known as Fannie Mae and Freddie Mac, which own or guarantee the majority of mortgage loans in the U.S.

Most requests received to date relate to make-whole payments on loans that have been foreclosed. Requests undergo extensive analysis to confirm the exposure, attempt to cure any identified defect, and, when necessary, determine our liability. We establish liabilities for such anticipated losses based upon, among other things, the level of current unresolved repurchase requests, the volume of estimated probable future repurchase requests, our ability to cure the defects identified in the repurchase requests, and the severity of the estimated loss upon repurchase. Determining these estimates and the resulting liability requires a significant level of management judgment. We are generally able to cure or refute over 60% of the requests received from investors such that we do not believe repurchases or make-whole payments will ultimately be required. For those requests that we believe will result in repurchases or make-whole payments, actual loss severities are expected to approximate 50% of the outstanding principal balance.

During 2012 and 2011, we recorded provisions for losses as a change in estimate primarily to reflect projected claim volumes in excess of previous estimates. Given the ongoing volatility in the mortgage industry, our lack of visibility into the current status of the review process of loans by investors, the claim volumes we continue to experience, changes in values of underlying collateral over time, and other uncertainties regarding the ultimate resolution of these claims, actual costs could differ from our current estimates. For example, if the total number of loans we are required to repurchase is ultimately 10% lower or higher than our current estimates, the amount of future losses could decrease or increase by approximately $13.0 million.

Intangible assets

We have recorded intangible assets related to tradenames acquired with the Centex merger completed in 2009 and the Del Webb merger completed in 2001, which are being amortized over their estimated useful lives. The carrying values and ultimate realization of these assets are dependent upon estimates of future earnings and benefits that we expect to generate from their use. If we determine that the carrying values of intangible assets may not be recoverable based upon the existence of one or more indicators of impairment, we use a projected undiscounted cash flow method to determine if impairment exists. If the carrying values of the intangible assets exceed the expected undiscounted cash flows, then we measure impairment as the difference between the fair value of the asset and the recorded carrying value. To date, no impairments relating to tradenames have been recorded. However, if our expectations of future results and cash flows decrease significantly, or if our strategy related to the use of the intangible assets changes, the related intangible assets may become impaired.

Allowance for warranties

Home purchasers are provided with a limited warranty against certain building defects, including a one-year comprehensive limited warranty and coverage for certain other aspects of the home’s construction and operating systems for periods of up to ten years. We estimate the costs to be incurred under these warranties and record a liability in the amount of such costs at the time product revenue is recognized. Factors that affect our warranty liability include the number of homes sold, historical and anticipated rates of warranty claims, and the cost per claim. We periodically assess the adequacy of our recorded warranty liability for each geographic market in which we operate and adjust the amounts as necessary. Actual warranty costs in the future could differ from our estimates.

Self-insured risks

We maintain, and require our subcontractors to maintain, general liability insurance coverage. We also maintain builders' risk, property, errors and omissions, workers compensation, and other business insurance coverage. These insurance policies protect us against a portion of the risk of loss from claims. However, we retain a significant portion of the overall risk for such claims either through policies issued by our captive insurance subsidiaries or through our own self-insured per occurrence and aggregate retentions, deductibles, and claims in excess of available insurance policy limits.

Our general liability insurance includes coverage for certain construction defects. While construction defect claims can relate to a variety of circumstances, the majority of our claims relate to alleged problems with siding, plumbing, foundations and other concrete work, windows, roofing, and heating, ventilation and air conditioning systems. The availability of general liability insurance for the homebuilding industry and its subcontractors has become increasingly limited, and the insurance policies available require companies to maintain higher per occurrence and aggregate retention levels. In certain instances, we may offer our subcontractors the opportunity to purchase insurance through one of our captive insurance subsidiaries or to participate in a project-specific insurance program provided by the Company. Policies issued by the captive insurance subsidiaries represent self-insurance of these risks by the Company. This self-insured exposure is limited by reinsurance policies that we purchase. General liability coverage for the homebuilding industry is complex, and our coverage varies from policy year to policy year. Our insurance coverage requires a per occurrence deductible up to an overall aggregate retention level. Beginning with the first dollar, amounts paid on insured claims satisfy our per occurrence and aggregate retention obligations. Any amounts incurred in excess of the occurrence or aggregate retention levels are covered by insurance up to our purchased coverage levels. Our insurance policies, including the captive insurance subsidiaries' reinsurance policies, are maintained with highly-rated underwriters for whom we believe counterparty default risk is not significant.

At any point in time, we are managing over 1,000 individual claims related to general liability, property, errors and omission, workers compensation, and other business insurance coverage. We reserve for costs associated with such claims (including expected claims management expenses) on an undiscounted basis at the time product revenue is recognized for each home closing and evaluate the recorded liabilities based on actuarial analyses of our historical claims. The actuarial analyses calculate an estimate of the ultimate net cost of all unpaid losses, including estimates for incurred but not reported losses ("IBNR"). IBNR represents losses related to claims incurred but not yet reported plus development on reported claims. These estimates are subject to a high degree of uncertainty due to a variety of factors, including changes in claims reporting and resolution patterns, third party recoveries, insurance industry practices, the regulatory environment, and legal precedent. State regulations vary, but construction defect claims are reported and resolved over an extended period often exceeding ten years. In certain instances, we have the ability to recover a portion of our costs under various insurance policies or from our subcontractors or other third parties. Estimates of such amounts are recorded when recovery is considered probable.

The recorded reserves include loss estimates related to both (i) existing claims and related claim expenses and (ii) IBNR and related claim expenses. Liabilities related to IBNR and related claim expenses represented approximately 78% and 74% of the total general liability reserves, which represent the vast majority of the total recorded reserves, at December 31, 2013 and 2012, respectively. The actuarial analyses that determine the IBNR portion of reserves consider a variety of factors, including the frequency and severity of losses, which are based on our historical claims experience supplemented by industry data. The actuarial analyses of the reserves also consider historical third party recovery rates and claims management expenses.

Adjustments to estimated reserves are recorded in the period in which the change in estimate occurs. Because the majority of our recorded reserves relates to IBNR, adjustments to reserve amounts for individual existing claims generally do not impact the recorded reserves materially. However, changes in the frequency and timing of reported claims and the estimates of specific claim values can impact the underlying inputs and trends utilized in the actuarial analyses, which could have a material impact on the recorded reserves.

Our recorded reserves for all such claims totaled $668.1 million and $721.3 million at December 31, 2013 and 2012, respectively, the vast majority of which relate to general liability claims. Because of the inherent uncertainty in estimating future losses related to these claims, actual costs could differ significantly from estimated costs. Based on the actuarial analyses performed, we believe the range of reasonably possible losses related to these claims is $600 million to $750 million. While this range represents our best estimate of our ultimate liability related to these claims, due to a variety of factors, including those factors described above, there can be no assurance that the ultimate costs realized by us will fall within this range.

Income taxes

The provision for income taxes is calculated using the asset and liability method, under which deferred tax assets and liabilities are recognized by identifying the temporary differences arising from the different treatment of items for tax and accounting purposes. In assessing the realizability of deferred tax assets, we consider whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is primarily dependent upon the generation of future taxable income during the periods in which those temporary differences become deductible. In determining the future tax consequences of events that have been recognized in the financial statements or tax returns, judgment is required. Differences between the anticipated and actual outcomes of these future tax consequences could have a material impact on the consolidated results of operations or financial position.

Unrecognized tax benefits represent the difference between tax positions taken or expected to be taken in a tax return and the benefits recognized for financial statement purposes. We follow the provisions of ASC 740, “Income Taxes” (“ASC 740”), which prescribes a minimum recognition threshold a tax position is required to meet before being recognized in the financial statements. Significant judgment is required to evaluate uncertain tax positions. Our evaluations of tax positions consider a variety of factors, including changes in facts or circumstances, changes in law, correspondence with taxing authorities, and effective settlements of audit issues. Changes in the recognition or measurement of uncertain tax positions could result in material increases or decreases in income tax expense (benefit) in the period in which the change is made. Interest and penalties related to unrecognized tax benefits are recognized as a component of income tax expense (benefit).

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