<PAGE>
 
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                                 UNITED STATES
                      SECURITIES AND EXCHANGE COMMISSION
                            WASHINGTON, D.C. 20549
 
                               ----------------
                                   FORM 10-K
 
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
   ACT OF 1934
 
  FOR THE FISCAL YEAR ENDED: DECEMBER 31, 1997
 
                                      OR
 
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
   EXCHANGE ACT OF 1934
 
  FOR THE TRANSITION PERIOD FROM          TO
 
  COMMISSION FILE NUMBER: 0-23569
 
                          HEADLANDS MORTGAGE COMPANY
            (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
 
                               ----------------
                CALIFORNIA                           94-2851992
        (STATE OR OTHER JURISDICTION               (I.R.S. EMPLOYER
      OF INCORPORATION OR ORGANIZATION)           IDENTIFICATION NO.)


  1100 LARKSPUR LANDING CIRCLE, SUITE 101
         LARKSPUR, CALIFORNIA                           94939
    (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)          (ZIP CODE)
               

                                (415) 461-6790
             (REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
 
  Securities registered pursuant to Section 12(b) of the Act:
 
  NONE
 
  Securities registered pursuant to Section 12(g) of the Act:
 
  COMMON STOCK, NO PAR VALUE
     (Title of Class)
 
  Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [_]
 
  Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
 
  At March 25, 1998 the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $158,700,000.
 
  The number of shares of the Registrant's Common Stock outstanding on March
25, 1998 was 19,700,000.
 
  Documents Incorporated by Reference
 
NONE.
 
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<PAGE>
 
                           HEADLANDS MORTGAGE COMPANY
 
                          1997 FORM 10-K ANNUAL REPORT
 
                               TABLE OF CONTENTS
 
<TABLE>
<CAPTION>
                                                                           PAGE
                                                                           ----
 <C>      <S>                                                              <C>
                                      PART I

 Item 1.  BUSINESS......................................................     3

 Item 2.  PROPERTIES....................................................    30

 Item 3.  LEGAL PROCEEDINGS.............................................    30

 Item 4.  SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...........    30

                                      PART II

 Item 5.  MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
           MATTERS......................................................    30

 Item 6.  SELECTED FINANCIAL DATA.......................................    31

 Item 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
           AND RESULTS OF OPERATIONS....................................    33

 Item 8.  FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA...................    43

 Item 9.  CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
           AND FINANCIAL DISCLOSURE.....................................    43

                                     PART III

 Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT............    43

 Item 11. EXECUTIVE COMPENSATION........................................    45

 Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
           MANAGEMENT...................................................    48

 Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS................    49

                                      PART IV
         
 Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
           FORM 8-K.....................................................    51

 FINANCIAL STATEMENTS....................................................  F-1
</TABLE>
<PAGE>
 
ITEM 1. BUSINESS
 
THE COMPANY
 
  The Company is a specialty mortgage banking company in the business of
originating, selling, securitizing and servicing mortgage loans secured by
one- to four-family residences. The Company was incorporated in California and
commenced its mortgage banking business in 1986. As a specialty mortgage
lender, the Company's strategy is to focus on specialized mortgage loan
products for primarily high credit quality borrowers. The Company generally
places an emphasis on credit scores obtained from three major credit bureaus
to evaluate the credit quality of borrowers. The Company considers "high
credit quality borrowers" to be those whose credit scores equal or exceed
levels required for the sale or exchange of their mortgage loans through
Fannie Mae or Freddie Mac. The specialized mortgage loans targeted by the
Company provide a relatively greater "spread" (i.e., greater interest and
other income to the originator relative to the cost associated with funding
and selling the mortgage loans) compared to other mortgage loans that present
a similar credit risk. The Company believes that its wholesale lending channel
(which generates a majority of its total originations), supported by its
correspondent and retail lending channels, provides an efficient and
responsive origination system for the types of mortgage loans it seeks to
originate. The Company seeks the most efficient method of execution for sales
of its mortgage loans and in recent years has increasingly utilized
securitization in addition to traditional whole loan sales.
 
  The Company's business objective is to increase mortgage loan originations
through geographic expansion and by providing a diversified range of mortgage
loan products through its wholesale, correspondent and retail lending
channels. During the year ended December 31, 1997, the Company originated $3.8
billion of residential mortgage loans, 73% in California and 27% in other
states. During the year ended December 31, 1996, the Company originated $2.3
billion of residential mortgage loans, 77% in California and 23% in other
states. As of December 31, 1997, the Company's mortgage loan servicing
portfolio totaled $4.5 billion of mortgage loans.
 
  The Company is led by President Peter T. Paul, the founder and major
shareholder of the Company. Mr. Paul has 25 years of experience in the
residential mortgage industry. Mr. Paul and the Chief Financial Officer of the
Company have worked together since 1987, and various other members of the
executive management team have worked together for more than six years. See
"Directors and Executive Officers of the Registrant."
 
BUSINESS STRATEGY
 
 MORTGAGE LOAN ORIGINATION
 
  Mortgage Loan Product Development. An important element of the Company's
mortgage loan origination strategy is to provide a variety of mortgage loan
products that are designed to respond to consumer needs and competitive
factors and be readily saleable at prices that will generate the Company's
targeted rate of return. The Company seeks those mortgage loan products with
relatively greater spreads compared to mortgage loans that present a similar
credit risk and chooses not to rely on discount pricing to increase mortgage
loan origination volume. This approach generally focuses the Company's
development process on mortgage loans that fail to satisfy one or more of the
standardized criteria (other than credit quality of the borrower) required for
sale or exchange through one of the Agencies or one of the national privately-
sponsored mortgage conduits. To date, the Company has tailored its loan
products primarily for high credit quality borrowers as described above.
 
  The Company's secondary marketing department identifies a variety of new
mortgage loan products that it believes will respond to consumer needs and
that in many cases are not being widely offered by competitors. Such new
mortgage loan products may be created by the Company itself or may be
introduced by a competitor and identified by the Company as attractive for
origination. The Company generally requires that all of its
 
                                       3
<PAGE>
 
mortgage loan products be readily saleable through the Company's
securitization programs or to secondary market investors.
 
  The Company presently promotes a variety of mortgage loan products. Among
the products that the Company has launched on a pilot basis is a mortgage loan
for high credit quality borrowers that permits a higher loan-to-value ratio
than is permitted in mortgage loans currently being originated by the Company.
Another product to be introduced is a mortgage loan that is designed primarily
for lower credit quality borrowers which will require more extensive mortgage
insurance than is required on the Company's other mortgage loan products. All
new mortgage loan products introduced by the Company are carefully pre-tested
in the market over a period of time to assess both marketability to consumers
and performance of the mortgage loan product as an investment for secondary
market investors.
 
  Current Mortgage Loan Products. The Company presently offers a broad range
of mortgage loan products in order to provide maximum flexibility to borrowers
and the mortgage brokers and other entities through which it originates
mortgage loans (the "Mortgage Sources"). The Company offers approximately 85
different mortgage loan programs at any given point in time, including a full
range of single-family mortgage loan products. Mortgage loan applicants can
choose among fixed-rate mortgage loans with several different term options,
including standard 15-year and 30-year terms, and "balloon" mortgage loans
with relatively shorter terms, such as five or seven years, and longer
amortization schedules, such as 30 years. An array of adjustable rate mortgage
loans with rates tied to various indices is also available. The Company offers
a wide variety of combinations of interest rates and origination fees
("points") on many of its mortgage loan products so that borrowers may elect
to pay higher points at closing and lower interest over the life of the
mortgage loan, or pay a higher interest rate and reduce or eliminate points
payable at closing. In addition, the Company offers buydown-type mortgage
loans which allow a borrower to make lower monthly payments for the first one,
two or three years of the loan. Of the mortgage loans originated during the
year ended December 31, 1997, 1996 and 1995, fixed rate mortgage loans
comprised 79%, 73% and 75%, respectively, adjustable rate mortgage loans
comprised 21%, 27% and 25%, respectively.
 
  The Company's broad range of current mortgage loan products can be
categorized as follows:
 
 .  Agency Mortgage Loans. These mortgage loans conform to the underwriting
    ---------------------
    criteria for sale or exchange through one of the Agencies.
 
 .  Non-agency Mortgage Loans. These mortgage loans fail to satisfy the
    -------------------------
    criteria to be Agency mortgage loans for one or more reasons. Certain of
    these mortgage loans (i.e., Jumbos) generally meet the Agency criteria but
    exceed the maximum loan size (currently $227,150 for single-family, one-
    unit mortgage loans in the continental United States). Jumbos are
    generally eligible for sale to one of the national privately-sponsored
    mortgage conduits.
 
    Certain other non-agency mortgage loans may fail to satisfy other elements
    of the Agency underwriting criteria, such as those relating to
    documentation, employment history, income verification, loan-to-value
    ratios, qualifying ratios or required borrower net worth. Beginning in
    1995, the Company began to emphasize the origination of mortgage loans
    which failed to satisfy one or more of the Agency and national conduit
    underwriting criteria but which, from a credit risk standpoint as
    determined primarily by credit score, presented a comparable risk profile.
    The Company refers to this category of mortgage loans generally as
    "Alternative A" mortgage loans. The Company focuses on an applicant's
    credit score, in conjunction with other factors, in underwriting its
    Alternative A mortgage loans. While some Alternative A mortgage loans
    exceed the maximum loan size eligible for sale through one of the
    Agencies, many have principal balances within the Agency limits.
 
 .  Home Equity Mortgage Loans. Home equity mortgage loans are generally
    --------------------------
    secured by second liens on the related property. Home equity mortgage
    loans can take the form of a home equity line of credit (i.e., HELOC) or a
    closed-end loan. Both types of home equity mortgage loans are designed
    primarily for high credit quality borrowers and are underwritten according
    to the Company's criteria for second-lien mortgage
 
                                       4
<PAGE>
 
    loans. HELOCs generally provide for either a 5-year or 15-year draw
    period, during which the borrower may make cash withdrawals, and a 10-year
    repayment period during which the amount outstanding at the end of the
    draw period is repaid. Only interest payments are made during the draw
    period. Home equity mortgage loans that are closed-end loans are fixed in
    amount at the time of origination and amortize over their terms. HELOCs
    generally bear adjustable interest rates while closed-end home equity
    loans typically bear fixed interest rates. Home equity mortgage loans are
    originated in some instances in conjunction with the Company's origination
    of a first-lien mortgage loan on the related property.
 
 .  Other Mortgage Loans. This category consists of mortgage loans for
    --------------------
    borrowers who have impaired or limited credit profiles or higher debt-to-
    income ratios than would be acceptable for sale of such loans to one of
    the Agencies. Such mortgage loans may also fail to satisfy the Agency
    underwriting criteria in other ways. The Company categorizes these
    mortgage loans as "A-" or "B" loans and believes they would generally be
    considered "subprime" mortgage loans in the secondary mortgage market. The
    Company does not originate mortgage loans that it would categorize as "C"
    or "D" loans.
 
  In 1994, the Company originated a substantial volume of non-agency mortgage
loans in the form of Jumbos which it sold to national mortgage conduits and
other private investors. In 1995, the Company's volume of Jumbo originations
declined with the general decrease nationwide in the origination volume of
residential mortgage loans and the general increase in competition that
reduced the spread available for this mortgage loan product. The increase in
originations of non-agency mortgage loans and home equity loans in 1996
reflects the Company's successful development of its Alternative A mortgage
loan products and its HELOC and closed-end second-lien products and the launch
of the Company's securitization programs for such mortgage loan products. This
increase in originations continued in 1997. The following table summarizes the
Company's originations of the above categories of mortgage loans:
 
<TABLE>
<CAPTION>
                               YEAR ENDED DECEMBER 31,
                           ----------------------------------
                              1997        1996        1995
                           ----------  ----------  ----------
                                    (DOLLARS IN THOUSANDS)
<S>                        <C>         <C>         <C>         
Agency Mortgage Loans
 Number of mortgage
  loans..................       5,445       7,093       4,546
 Volume of mortgage
  loans..................  $  689,650  $  885,050  $  562,778
 Percent of total
  volume.................       18.36%      38.75%      41.52%
Non-agency Mortgage Loans
 Number of mortgage
  loans..................      13,331       6,068       4,380
 Volume of mortgage
  loans..................  $2,475,384  $1,137,572  $  695,253
 Percent of total
  volume.................       65.90%      49.81%      51.29%
Home Equity Mortgage
 Loans
 Number of mortgage
  loans..................      11,715       5,482       1,767
 Volume of mortgage
  loans..................  $  551,530  $  234,308  $   72,580
 Percent of total
  volume.................       14.68%      10.26%       5.35%
Other Mortgage Loans
 Number of mortgage
  loans..................         329         250         214
 Volume of mortgage
  loans..................  $   39,638  $   26,910  $   24,993
 Percent of total
  volume.................        1.06%       1.18%       1.84%
Total Mortgage Loans
 Number of mortgage
  loans..................      30,820      18,893      10,907
 Volume of mortgage
  loans..................  $3,756,202  $2,283,840  $1,355,604
 Average principal
  balance................  $      122  $      121  $      124
</TABLE>
 
                                       5
<PAGE>
 
  The Company's origination of home equity loans has increased as a percentage
of total mortgage loans originated in recent years. In 1994, the Company's new
product development group identified home equity loans as an attractive
potential product for the Company. The origination volume of this type of
mortgage loan has increased steadily as the Company's lending and servicing
staff has gained experience in marketing and servicing this specialized
mortgage loan product. The following table illustrates the growth in home
equity mortgage loan production and provides detail regarding the breakdown of
home equity mortgage loans between HELOCs and closed-end mortgage loans.
<TABLE>
<CAPTION>
                                                            YEAR ENDED
                                                           DECEMBER 31,
                                                       ----------------------
                                                        1997    1996    1995
                                                       ------  ------  ------
<S>                                                    <C>     <C>     <C>
PERCENT OF MORTGAGE LOANS ORIGINATED (BASED ON
 PRINCIPAL BALANCES):
First mortgage loans..................................  85.32%  89.73%  94.63%
Home equity mortgage loans
  HELOC...............................................  11.39    8.42    4.36
  Closed-end..........................................   3.29    1.85    1.01
                                                       ------  ------  ------
   Total home equity mortgage loans...................  14.68   10.27    5.37
                                                       ------  ------  ------
                                                       100.00% 100.00% 100.00%
                                                       ======  ======  ======
</TABLE>
 
  Mortgage Loan Origination Channels. The Company originates mortgage loans
through its wholesale, correspondent and retail lending channels.
 
  Wholesale Lending. The Company's wholesale lending channel, established in
  -----------------
1986, obtains its mortgage loan volume through a network of approximately
5,000 independent mortgage brokers approved by the Company. Mortgage brokers
are qualified to participate in the wholesale program after satisfactory
completion of a formal application process administered by the Company's
Quality Assurance Department. The responsibilities of the Quality Assurance
Department include the review of licensing, financial statements and resumes
on key personnel combined with credit and reference investigations to
determine the history, reputation and general lending expertise of the
applicant. Approved mortgage brokers are monitored by the Company's wholesale
account executive staff and the broker management division within the Quality
Assurance Department. The Company underwrites each mortgage loan application
obtained from its mortgage brokers and funds those mortgage loans which meet
the Company's underwriting criteria. No single Mortgage Source accounts for
more than 5% of the total mortgage loan originations of the Company.
 
  The Company's wholesale lending channel generally enables the Company to
achieve a relatively high volume of mortgage loan originations at a lower net
cost than traditional retail mortgage loan originations because mortgage
brokers perform most of the labor intensive functions of the origination
process (in return for receipt of a mortgage loan origination fee), such as
taking and processing the mortgage loan application. The building of the
Company's mortgage loan origination volume through wholesale originations has
been cost efficient for the Company because it has increased economies of
scale, generated fee-based income, decreased overhead expenses and enabled the
Company to centralize its quality assurance and other support functions.
 
  The Company believes that its wholesale lending channel is well-suited to
originate the types of mortgage loans that the Company seeks to originate. The
wholesale lending channel permits the Company to respond quickly to changes in
market conditions and consumer preferences. The Company can move quickly to
introduce a new mortgage loan product by disseminating it throughout the
broker network. By revising the terms on which it will fund mortgage loans
submitted by its mortgage brokers, the Company may also move quickly to
increase the level of origination of some loan products or to decrease
originations of other loan products that, due to market or other changes, may
no longer meet the Company's targeted rate of return or other origination
objectives. The Company believes that its flexibility would be reduced if it
maintained a large retail branch system with the attendant fixed investment
and overhead costs.
 
                                       6
<PAGE>
 
  The wholesale lending channel also permits the Company to obtain non-agency
and other types of mortgage loans from mortgage brokers that generally only
originate Agency mortgage loans. The Company builds its relationship with
those mortgage brokers by providing access to specialty mortgage loan
products.
 
  The Company's wholesale origination system currently operates out of the
Larkspur headquarters office and ten branch offices producing mortgage loans
in the western and southeast regions of the United States. The wholesale
lending channel originates mortgage loans through its sales force of
approximately 80 wholesale account executives. Each branch office's account
executives are responsible for developing and maintaining relationships with
mortgage brokers in specified territories. The quality of the approved
mortgage broker client base is supported by the branch sales and inside sales
support staff, who provide information and training in the appropriate
marketing and proper packaging of mortgage loan products as well as updates on
changes in underwriting practices. Additional and separate personnel in each
branch office underwrite all mortgage loans originated in that office.
Mortgage loan fundings remain centralized at the Company's Larkspur
headquarters.
 
  The Company plans to continue the expansion of its wholesale lending channel
on a nationwide basis. The Company is actively seeking to expand its wholesale
lending channel pursuant to selected demographic statistics and other criteria
developed by the Company, which are intended to identify the most attractive
markets for the Company's mortgage loan products. The Company typically enters
into a new market using its national sales team, which initially penetrates a
market, to recruit selected brokers from the Company's unaffiliated wholesale
mortgage loan network. The Company's sales strategy is to limit the number of
branch centers in order to efficiently originate, process and underwrite
mortgage loans.
 
  The following table sets forth the geographic distribution of origination
volume according to location of the mortgaged property:
 
<TABLE>
<CAPTION>
                           YEAR ENDED DECEMBER 31,
                 ----------------------------------------------
STATE                 1997            1996            1995
-----            --------------  --------------  --------------
                                    (DOLLARS IN THOUSANDS)
<S>              <C>        <C>  <C>        <C>  <C>        <C>  
California.....  $2,745,448  73% $1,752,320  77% $1,003,354  74%
Other..........   1,010,754  27     531,519  23     352,250  26
                 ---------- ---  ---------- ---  ---------- ---
 Totals........  $3,756,202 100% $2,283,839 100% $1,355,604 100%
                 ========== ===  ========== ===  ========== ===
</TABLE>
 
  Correspondent Lending. The correspondent lending program is designed to
  ---------------------
allow the Company to acquire closed mortgage loans on terms similar to those
it acquires on a wholesale basis from its mortgage brokers. The correspondents
are generally small- to medium-sized mortgage companies, banks and thrifts
located throughout the U.S. who may have limited access to the capital
markets. The Company provides its correspondents with on-site sales support
and an interactive internet-based electronic link. The correspondents benefit
by gaining access to the Company's broad range of innovative mortgage loan
products without having to invest their resources in the development phase of
the mortgage loan products. The correspondents also benefit from attractive
pricing for sales to the Company, made possible by the Company's access to the
capital markets and the secondary mortgage loan markets.
 
  Retail Lending. The retail channel, through a centralized operation, markets
  --------------
to existing and new customers. The Company markets to existing customers
through inserts in the monthly mortgage statements, letters targeted to a
specific group (i.e., borrowers with interest rates above a designated level)
and outbound customer service calls. New customers are sought through national
direct mail campaigns, regional radio advertising and telemarketing. New
customers are also sought through several "affinity marketing" programs.
Groups targeted for affinity marketing purposes include banks and credit
unions for whom the Company will provide mortgage loan services from
processing through funding. Affinity marketing programs also target trade
groups and associations offering special pricing and discounts for group
members when the Company is endorsed by the respective group or association.
An additional segment targeted for affinity marketing are employers. Employees
of participating companies are offered the opportunity to apply for a mortgage
loan from the Company at a discounted price as part of the Company's standard
employee benefits package.
 
                                       7
<PAGE>
 
  The following table sets forth the volume of mortgage loan originations by
channel:
 
<TABLE>
<CAPTION>
                                       YEAR ENDED DECEMBER 31,
                       --------------------------------------------------------
                              1997               1996               1995
                       ------------------ ------------------ ------------------
                         VOLUME   PERCENT   VOLUME   PERCENT   VOLUME   PERCENT
                       ---------- ------- ---------- ------- ---------- -------
                                        (DOLLARS IN THOUSANDS)
<S>                    <C>        <C>     <C>        <C>     <C>        <C>
Wholesale............. $3,438,207    91%  $2,154,255    94%  $1,253,405    92%
Correspondent.........    211,907     6       72,832     3       95,704     7
Retail................    106,088     3       56,753     3        6,495     1
                       ----------   ---   ----------   ---   ----------   ---
 Total................ $3,756,202   100%  $2,283,840   100%  $1,355,604   100%
                       ==========   ===   ==========   ===   ==========   ===
</TABLE>
 
  Underwriting. The Company relies on its underwriting administrative
procedures and mortgage loan underwriting standards to implement its
origination strategy and achieve the quality of mortgage loans required by its
secondary market investors.
 
  Administration. Mortgage loan applications must be approved by the Company's
  --------------
underwriters in accordance with its underwriting criteria, including credit
scores, loan-to-value ratios, borrower income qualifications, investor
requirements, necessary insurance coverages and property appraisal
requirements. To maintain the consistency of underwriting quality, the
Company's mortgage loan production personnel, such as account executives and
telemarketers, are not permitted to underwrite the mortgage loan packages
submitted by Mortgage Sources. Mortgage loan applications are assigned to an
underwriter at the Company based on the size and complexity of the mortgage
loan and the underwriter's experience level. The Company's chief underwriter
is located in the corporate headquarters in Larkspur and is responsible for
disseminating all underwriting policies.
 
  The Company generally performs a pre-funding audit on each mortgage loan.
This audit includes a review for compliance with applicable underwriting
program guidelines and accuracy of the credit report and telephone
verification of employment. The Company performs a post-funding quality
control review on a minimum of 10% of the mortgage loans originated or
acquired for complete re-verification of employment, income and liquid assets
used to qualify for such mortgage loan. Such review also includes procedures
intended to detect evidence of fraudulent documentation and/or imprudent
activity during the processing, funding, servicing or selling of the mortgage
loan. Verification of occupancy and applicable information is made by regular
mail.
 
  One- to four-family residential properties are appraised by qualified
independent appraisers who are approved by the Company. All appraisals are
required to conform to the Uniform Standards of Professional Appraisal
Practice adopted by the Appraisal Standards Board of the Appraisal Foundation
and must be on forms acceptable to Fannie Mae and Freddie Mac. As part of the
Company's pre-funding quality control procedures, either field or desk
appraisal reviews are obtained on 10% of all mortgage loans.
 
  Standards. Conforming mortgage loans originated for sale to the Agencies
  ---------
must satisfy the underwriting standards for one of the programs sponsored by
such entities. All other mortgage loans originated or acquired by the Company
(including Alternative A loans and home equity loans) are underwritten by the
Company according to its credit, appraisal and underwriting standards. Such
underwriting standards are applied to evaluate the prospective borrower's
credit standing and repayment ability and the value and adequacy of the
mortgaged property as collateral. These standards, which are summarized below,
are applied in accordance with applicable federal and state laws and
regulations. Exceptions to the underwriting standards are permitted when
compensating factors are present.
 
  The Company's underwriting standards for purchase money or rate/term
refinance mortgage loans secured by one- to two-family primary residences
generally allow loan-to-value ratios at origination of up to 95% for mortgage
loans with original principal balances of up to $400,000, up to 90% for
mortgage loans secured by one- to four-family primary residences with original
principal balances of up to $400,000, up to 85% for mortgage loans with
original principal balances of up to $500,000 and up to 80% for mortgage loans
with original principal balances up to $650,000. The Company may acquire
mortgage loans with principal balances
 
                                       8
<PAGE>
 
up to $3,000,000 ("super jumbos") if the mortgage loan is secured by the
borrower's primary residence. The loan-to-value ratio for super jumbos
generally may not exceed 60%. For cash-out refinance mortgage loans, the
maximum loan-to-value ratio generally is 80%, and the maximum "cash out"
amount permitted is based in part on the original amount of the related
mortgage loan.
 
  The Company's underwriting standards for mortgage loans secured by
investment properties generally allow loan-to-value ratios at origination of
up to 90% for mortgage loans with original principal balances up to $250,000.
The Company's underwriting standards permit mortgage loans secured by
investment properties to have higher original principal balances if they have
lower loan-to-value ratios at origination.
 
  For each mortgage loan secured by a first lien with a loan-to-value ratio at
origination exceeding 80%, the Company generally requires a primary mortgage
insurance policy insuring a portion of the balance of the mortgage loan at
least equal to the product of the original principal balance of such mortgage
loan and a fraction, the numerator of which is the excess of the original
principal balance of such mortgage loan over 75% of the lesser of the
appraised value and selling price of the related mortgage property and the
denominator of which is the original principal balance of the related mortgage
loan plus accrued interest thereon and related foreclosure expenses. In
certain circumstances, however, the Company does not require primary mortgage
insurance on mortgage loans with principal balances up to $500,000 that have
loan-to-value ratios exceeding 80% but less than or equal to 85%. All
residences, except cooperatives and certain high-rise condominium dwellings,
are eligible for this program. Each qualifying mortgage loan will be made at
an interest rate that is higher than the rate would be if the loan-to-value
ratio was 80% or less or if primary mortgage insurance was obtained.
 
  In determining whether a prospective borrower has sufficient monthly income
available (i) to meet the borrower's monthly obligation on the proposed
mortgage loan and (ii) to meet monthly housing expenses and other financial
obligations, including the borrower's monthly obligations on the proposed
mortgage loan, the Company generally considers, when required by the
applicable documentation program, the ratio of such amounts to the proposed
borrower's acceptable monthly gross income. Such ratios vary depending on a
number of underwriting criteria, including loan-to-value ratios, and are
determined on a loan-by-loan basis.
 
  The Company also examines a prospective borrower's credit report. Generally,
each credit report provides a credit score for the borrower. Credit scores
generally range from 350 to 850 and are available from three major credit
bureaus: TRW, Equifax and Trans Union. The Company attempts to obtain for each
borrower a credit score from each credit bureau. If three credit scores are
obtained, the Company applies the middle score of the primary wage earner. If
two scores are obtained, the Company applies the lower score of the primary
wage earner. These scores estimate, on a relative basis, which mortgage loans
are most likely to default in the future. Lower scores imply higher default
risk relative to a higher score. Credit scores are empirically derived from
historical credit bureau data and represent a numerical weighing of a
borrower's credit characteristics over a two-year period. A credit score is
generated through the statistical analysis of a number of credit-related
characteristics or variables. Common characteristics include number of credit
lines (trade lines), payment history, past delinquencies, severity of
delinquencies, current levels of indebtedness, types of credit and length of
credit history. Attributes are the specific values of each characteristic. A
scorecard (the model) is created with weights or points assigned to each
attribute. An individual mortgage loan applicant's credit score is derived by
summing together the attribute weights for that applicant.
 
  The Company originates and acquires mortgage loans under one of five
documentation programs: full documentation, alternative documentation, limited
documentation, no ratio loan documentation and no income/no asset
verification.
 
  Under full documentation, the prospective borrower's employment, income and
assets are verified through written and telephonic communications. Alternative
documentation provides for alternative methods of employment verification
generally using W-2 forms or pay stubs. Generally, under a full documentation
program, a prospective borrower is required to have a minimum credit score of
620 and, under alternative documentation, a minimum credit score of 640.
 
                                       9
<PAGE>
 
  Under the limited documentation program, more emphasis is placed on the
value and adequacy of the mortgaged property as collateral and other assets of
the borrower than on credit underwriting. Mortgage loans underwritten using
the limited documentation program are limited to borrowers with credit
histories that demonstrate an established ability to repay indebtedness in a
timely fashion. Under the limited documentation program, a prospective
borrower is required to have a minimum credit score of 640. Under the limited
documentation program, certain credit underwriting documentation concerning
income or income verification and/or employment verification is waived.
Mortgage loans originated and acquired with limited documentation include
cash-out refinance loans, super jumbos and mortgage loans secured by investor-
owned properties. Permitted maximum loan-to-value ratios (including secondary
financing) under the limited documentation program, which range up to 80%, are
more restrictive than mortgage loans originated with full documentation or
alternative documentation.
 
  Under the no ratio loan documentation program, income ratios for the
prospective borrower are not calculated. Mortgage loans underwritten using the
no ratio loan documentation program have loan-to-value ratios less than or
equal to 80% and meet the standards for the limited documentation program. A
minimum credit score of 680 is required for this program.
 
  Under the no income/no asset verification program, emphasis is placed on the
value and adequacy of the mortgaged property as collateral and credit history
rather than on verified income and assets of the borrower. Mortgage loans
underwritten under no income/no asset verification are limited to borrowers
with excellent credit histories. A minimum credit score of 680 is required.
Under the no income/no asset verification program, credit underwriting
documentation concerning income, employment verification and asset
verification is waived and income ratios are not calculated.
 
  Exceptions. On a case-by-case basis, the Company's underwriters may
  ----------
determine that the prospective borrower warrants an exception from its
underwriting guidelines. Such exceptions may include a debt service-to-income
ratio exception, a loan-to-value exception or an exception from certain
documentation requirements of a particular mortgage loan program. An exception
may generally be allowed if the application reflects certain compensating
factors, including among others: a high credit score; a low loan-to-value
ratio; cash reserves; stable employment; and the length of residence in the
subject property. Accordingly, the Company may classify certain mortgage loan
applications into a more extensive documentation program than other mortgage
loan applications that, in the absence of such compensating factors, would
only satisfy the criteria of a less extensive documentation program and may
fund mortgage loans that do not satisfy all of the criteria discussed above
for any particular documentation program.
 
                                      10
<PAGE>
 
  The following table sets forth for the periods indicated additional detail
on the Company's mortgage loan originations by category of mortgage loan:
 
<TABLE>
<CAPTION>
                                       FIRST QUARTER 1996                            SECOND QUARTER 1996
                         ---------------------------------------------- ----------------------------------------------
                           DOLLAR    AVERAGE  WEIGHTED WEIGHTED AVERAGE   DOLLAR    AVERAGE  WEIGHTED WEIGHTED AVERAGE
                           VOLUME   PRINCIPAL AVERAGE  AVERAGE  CREDIT    VOLUME   PRINCIPAL AVERAGE  AVERAGE  CREDIT
                         (IN 000'S)  BALANCE    LTV     COUPON   SCORE  (IN 000'S)  BALANCE    LTV     COUPON   SCORE
                         ---------- --------- -------- -------- ------- ---------- --------- -------- -------- -------
<S>                      <C>        <C>       <C>      <C>      <C>     <C>        <C>       <C>      <C>      <C>
Agency.................. $  284,499 $131,652     76%     7.34%    680   $  280,240 $124,000     75%     7.86%    680
Non-agency..............    218,617  177,882     74      8.25     679      237,718  190,327     74      8.44     706
Home equity loans.......     25,019   38,849     87      9.36     682       47,820   40,389     86      8.60     713
Other...................      5,663  106,849     69      9.41     615        7,613  131,263     73     10.33     598
                         ----------                                     ----------
 Totals................. $  533,798                                     $  573,391
                         ==========                                     ==========
<CAPTION>
                                       THIRD QUARTER 1996                            FOURTH QUARTER 1996
                         ---------------------------------------------- ----------------------------------------------
                           DOLLAR    AVERAGE  WEIGHTED WEIGHTED AVERAGE   DOLLAR    AVERAGE  WEIGHTED WEIGHTED AVERAGE
                           VOLUME   PRINCIPAL AVERAGE  AVERAGE  CREDIT    VOLUME   PRINCIPAL AVERAGE  AVERAGE  CREDIT
                         (IN 000'S)  BALANCE    LTV     COUPON   SCORE  (IN 000'S)  BALANCE    LTV     COUPON   SCORE
                         ---------- --------- -------- -------- ------- ---------- --------- -------- -------- -------
<S>                      <C>        <C>       <C>      <C>      <C>     <C>        <C>       <C>      <C>      <C>
Agency.................. $  169,375 $118,362     76%     8.18%    687   $  150,936 $120,460     75%     7.91%    700
Non-agency..............    291,587  192,339     75      8.53     700      389,650  186,793     74      8.31     710
Home equity loans.......     68,628   42,494     82      7.66     705       92,841   45,555     84      7.52     707
Other...................      7,070  112,218     75     10.43     632        6,564  123,852     77     10.16     621
                         ----------                                     ----------
 Totals................. $  536,660                                     $  639,991
                         ==========                                     ==========
<CAPTION>
                                       FIRST QUARTER 1997                            SECOND QUARTER 1997
                         ---------------------------------------------- ----------------------------------------------
                           DOLLAR    AVERAGE  WEIGHTED WEIGHTED AVERAGE   DOLLAR    AVERAGE  WEIGHTED WEIGHTED AVERAGE
                           VOLUME   PRINCIPAL AVERAGE  AVERAGE  CREDIT    VOLUME   PRINCIPAL AVERAGE  AVERAGE  CREDIT
                         (IN 000'S)  BALANCE    LTV     COUPON   SCORE  (IN 000'S)  BALANCE    LTV     COUPON   SCORE
                         ---------- --------- -------- -------- ------- ---------- --------- -------- -------- -------
<S>                      <C>        <C>       <C>      <C>      <C>     <C>        <C>       <C>      <C>      <C>
Agency.................. $  137,450 $123,717     75%     7.70%    696   $  164,577 $123,649     77%     7.92%    697
Non-agency..............    441,147  192,305     73      8.17     710      495,176  179,868     75      8.53     710
Home equity loans.......    104,429   47,082     84      7.95     707      155,999   49,904     84      8.17     704
Other...................      9,133  120,178     73      9.90     627        9,508  113,190     77     10.24     625
                         ----------                                     ----------
 Totals................. $  692,159                                     $  825,260
                         ==========                                     ==========
<CAPTION>
                                       THIRD QUARTER 1997                            FOURTH QUARTER 1997
                         ---------------------------------------------- ----------------------------------------------
                           DOLLAR    AVERAGE  WEIGHTED WEIGHTED AVERAGE   DOLLAR    AVERAGE  WEIGHTED WEIGHTED AVERAGE
                           VOLUME   PRINCIPAL AVERAGE  AVERAGE  CREDIT    VOLUME   PRINCIPAL AVERAGE  AVERAGE  CREDIT
                         (IN 000'S)  BALANCE    LTV     COUPON   SCORE  (IN 000'S)  BALANCE    LTV     COUPON   SCORE
                         ---------- --------- -------- -------- ------- ---------- --------- -------- -------- -------
<S>                      <C>        <C>       <C>      <C>      <C>     <C>        <C>       <C>      <C>      <C>
Agency.................. $  173,446 $126,327     77%     7.65%    706   $  214,177  131,397     75%     7.46     703
Non-agency..............    688,757  185,549     75      8.24     712      850,304  185,981     75      8.19     703
Home equity loans.......    140,355   46,552     84      7.91     707      150,747   44,911     85      8.11     702
Other...................      7,183  117,759     73      9.71     627       13,814  127,903     85     10.09     618
                         ----------                                     ----------
 Totals................. $1,009,741                                     $1,229,042
                         ==========                                     ==========
</TABLE>
 
                                      11
<PAGE>
 
  Quality Assurance. The Company's Quality Assurance Department (the "QAD")
consists of eighteen people who operate out of its corporate headquarters in
Larkspur but also includes a two-person staff based in Southern California
which performs pre-funding quality control reviews for the Company's Southern
California Region. Since the Company's wholesale loan origination process
relies heavily on its Mortgage Sources, one of the primary functions of the
QAD includes the approval and related monitoring of its Mortgage Sources.
Other related functions for the QAD include the approval and monitoring of
third-party appraisers, escrow companies and title companies.
 
  Another primary function of the QAD is to monitor overall mortgage loan
quality to seek to ensure that the mortgage loan originations comply with the
Company's quality standards as well as those of investors and mortgage
insurers. This is accomplished through a sampling of mortgage loan files for
review by the quality control unit within the QAD and through administration
of a verification of income program with the Internal Revenue Service. The
quality control unit of the QAD performs loan file reviews before funding and
has placed an increasing emphasis on its pre-funding review since early 1997.
The objective of pre-funding reviews is to ensure data integrity of the
information used by the Company's underwriters in evaluating mortgage loans.
The extent of the review may include validating all information or just
selected elements based on assessment of risk and other selection criteria.
The percentage of mortgage loans subjected to some form of additional
verification prior to funding either through the special IRS program or
through mortgage loan file reviews by the QAD is approximately 14% of loans
submitted for origination. The quality control unit of the QAD also selects
approximately 4% of funded loans for a post-funding review. A post-funding
review includes a full underwriting of the mortgage loan file, including a
reverification of credit, employment income and source of funds as well as a
review of various closing documents. The QAD also reviews mortgage loans which
revert to early payment default status. All material findings are submitted to
management for response. Reporting to senior management for the pre-funding
reviews occurs monthly and reporting for the post-funding reviews occurs
quarterly.
 
  The Company devotes substantial resources and attention to improving its
quality assurance functions. Notwithstanding these efforts, there can be no
assurance that the Company's quality assurance procedures will prevent or
mitigate losses on the mortgage loans produced or serviced by the Company.
 
 MORTGAGE LOAN SALES
 
  As a mortgage banker, the Company originates all of its mortgage loans with
the intent of selling such loans. A primary component of the Company's
business strategy is to seek the most efficient method of selling its mortgage
loans. In recent years, the Company has developed the capacity to access the
capital markets by securitizing its mortgage loans in addition to selling them
in whole loan sale transactions. The Company evaluates the sale of each
mortgage loan type and compares prices available for each alternative method
of sale, given current market conditions at the time and the risk
characteristics of the mortgage loan type to determine which method of sale to
utilize.
 
  The following table shows the method of sale for the Company's mortgage
loans for the periods indicated:
 
<TABLE>
<CAPTION>
                                            YEAR ENDED DECEMBER 31,
                                        --------------------------------
                                           1997       1996       1995
                                        ---------- ---------- ----------
                                              (DOLLARS IN THOUSANDS)
<S>                                     <C>        <C>        <C>        
Loans sold through securitization...... $1,706,472 $  597,965 $      --
Whole loan sales.......................  1,585,197  1,532,119  1,330,484
                                        ---------- ---------- ----------
  Total................................ $3,291,669 $2,130,084 $1,330,484
                                        ========== ========== ==========
</TABLE>
 
  Securitization. In the second half of 1996, the Company began to securitize
substantially all of its non-agency mortgage loans and home equity mortgage
loans. Securitization is the process of pooling mortgage loans and issuing
securities, such as mortgage pass-throughs, or collateralized mortgage bonds
or notes. Under SFAS No. 125, regardless of whether the securities issued are
in the form of equity or debt securities, the transaction
 
                                      12
<PAGE>
 
will generally be treated for accounting purposes as a sale of the underlying
mortgage loans. The Company intends to structure all of its securitizations to
qualify as sales for accounting purposes, with a resulting gain reflected at
the time of sale. Only the net retained interest in the securitized mortgage
loans and the servicing assets relating to the mortgage loans sold remain on
the balance sheet. Net cash proceeds from such securitizations will be
available to support new mortgage loan originations and to repay borrowings
under the Company's warehouse facilities. The Company carries out its
securitizations through its wholly-owned subsidiary Headlands Mortgage
Securities, Inc. ("HMSI"). HMSI maintains separate shelf registration
statements for the non-agency mortgage loan and home equity mortgage loan
securitization programs.
 
  The Company believes that its ability to access the capital markets through
securitization is important to its overall business strategy in several ways.
Securitization is a very efficient method of selling the Company's non-agency
and home equity mortgage loans. Under the non-agency mortgage loan
securitization program, the Company generally sells the more senior classes of
the securities produced by the securitization for cash and retains one or more
of the subordinated classes. Such securities are carried on the balance sheet
at their estimated fair market value (based on market prices for similar
securities) under the line item "retained interests in securitizations." Due
to the relatively high credit quality of the mortgage loans in these
securitizations, the amount of subordinated securities retained by the Company
represents a relatively small percentage (generally less than 2%) of the total
principal of the mortgage loans securitized. In addition, the market value of
the classes of securities sold generally permits the Company to receive cash
in an amount equal to or greater than its cost of funding the mortgage loans.
As a result, the securitization of the Company's non-agency mortgage loans to
date has not required a substantial amount of the Company's available cash. In
the future, the Company may elect to retain additional classes of securities
in such securitizations which would require additional funds.
 
  Under the home equity mortgage loan securitization program, the Company
generally sells the home equity mortgage loan securities for cash and a
retained trust interest that represents (i) an interest (which is subordinated
to payment on the securities sold) in the principal of the mortgage loans
securitized (the "Principal Amount") and (ii) the right to the excess of
future expected interest payments to be received on the mortgage loans
securitized over the future interest payments required to be made on the
securities sold (the "Interest-only Residual"). The estimated values of the
Principal Amount and is the Interest-only Residual are shown on the balance
sheet under the line item "retained interests in securitizations." The
securitizations of the Company's home equity mortgage loans generate negative
cash flow compared to the cost of the mortgage loans securitized. The Company
to date has elected to mitigate the extent of negative cash flow by selling a
portion of the Interest-only Residual in connection with the home equity
mortgage loan securitizations. In the future, the Company may elect to retain
the full amount of the Interest-only Residual in order to receive the future
cash flows generated thereby. In such event, the negative cash flow at the
time of effecting the securitization would be increased.
 
  Securitization also supports the Company's wholesale origination channel by
increasing its flexibility in competing for non-agency mortgage loans. The
parameters of mortgage loan characteristics that may be included in a pool to
be securitized are generally broader than would be the case if the pool were
to be sold in a traditional whole loan sale to a financial institution.
Mortgage loan characteristics in securitizations are subject to the
requirements of the rating agencies and of any third-party credit enhancer
that may be involved, such as a monoline insurance company. The Company
believes, however, that these requirements generally provide more flexibility
in originating mortgage loans than would be the case under a traditional whole
loan sale method. This additional flexibility enables the Company to compete
more aggressively for mortgage loans and provide better service to its
Mortgage Sources.
 
  The retained interests in the non-agency mortgage loan securitizations are
in the form of classes of subordinated securities which can be sold or pledged
by the Company. The retained interests in the home equity mortgage loan
securitizations are in the form of trust interests that are restricted as to
transfer and cannot be sold by the Company. The Company's retained interests
in its securitizations, regardless of the form, are subordinated to the
classes of securities issued to investors in such securitizations with respect
to future losses of principal and interest on the underlying mortgage loans.
Accordingly, any such losses incurred on the underlying mortgage
 
                                      13
<PAGE>
 
loans will be applied first to reduce the remaining amount of the Company's
subordinated retained interest, until reduced to zero. In addition, with
respect to the Interest-only Residual retained in the home equity loan
securitizations, to the extent the actual loss rates, prepayment rates or
other characteristics experienced on a pool of mortgage loans differ adversely
from the assumptions used to evaluate the residual interest at the time of
sale, a reduction in the fair value of such interest on the balance sheet may
be required in a future period, with a corresponding charge to income.
 
  Whole Loan Sales and Exchanges. Sales of mortgage loans and exchanges of
pooled mortgage loans for securities are conducted by the Company's Secondary
Marketing Department. The Company's whole loan sales and exchanges of mortgage
loans are generally made without recourse to the Company. The Company sells or
exchanges substantially all of its Agency mortgage loans through normal
secondary channels. The Company also generally sells its closed-end home
equity mortgage loans through whole loan sales rather than through the home
equity mortgage loan securitization program when the price received from whole
loan sales is more attractive to the Company. From time to time the Company
sells qualifying Jumbos to one of the privately-sponsored national mortgage
conduit programs; such Jumbos are also included at times in the Company's non-
agency mortgage loan securitization program along with the Alternative A
mortgage loans. The Company sells substantially all of its other mortgage
loans (i.e., subprime mortgage loans) on a whole loan basis (servicing
released) in order to avoid the credit risk associated with such mortgage
loans.
 
  Representations and Warranties. In connection with both securitizations and
whole loan sales and exchanges, the Company makes representations and
warranties to the buyers thereof which it believes are customary in the
industry relating to, among other things, compliance with laws, regulations
and program standards and accuracy of information. In the event of a breach of
these representations and warranties, the Company may be required to
repurchase these mortgage loans and indemnify the investors for damages caused
by the breach. If a repurchase request is made, the Company will either (i)
attempt to remedy the deficiency and have the investors rescind the rejection
of the mortgage loan or (ii) refinance or sell the mortgage loan, sometimes at
a loss. Mortgage loans repurchased from investors have represented an
insignificant percentage of total mortgage loan originations based on the
aggregate principal balance over the last three fiscal years. The Company has
implemented a stringent quality assurance program monitoring the most
important stages of the mortgage loan origination process to minimize the
number of mortgage loans rejected by investors.
 
 OPERATIONS AND INFORMATION SERVICES
 
  The Company's offering of a broad range of conventional and specialized
mortgage loan products requires the timely delivery of such mortgage loan
products to the branches and careful monitoring and tracking of the
origination of such mortgage loan products through delivery to the ultimate
investor. For this reason, the Company focuses on the development of its
operations and technology capabilities and has organized many of the
production and servicing functions under the Operations Department in order to
promote the coordination of these functions. The Operations Department
includes the following key functions:
 
<TABLE>
     <C>                                    <S>
     .Underwriting/Branch Operations        .Loan Delivery
     .Loan Closing/Document Tracking        .Quality Assurance
     .Systems Support                       .Corporate Training
     .Computer Services                     .Servicing
</TABLE>
 
Each department manager is responsible for the day-to-day activities of
specified areas and reports to the Executive Vice President of Operations with
respect to communications between departments, coordinating services to branch
offices and long range planning issues, such as technology development.
 
  The Company uses a mortgage loan origination and administration system
modified to meet the Company's specific needs, that has largely eliminated
many of the manual efforts associated with underwriting, funding and loan
delivery. This system provides real-time access to the information used by
each department in operations as
 
                                      14
<PAGE>
 
well as the secondary marketing and treasury departments. This Company-wide
system provides a smooth flow of data from the origination process until the
mortgage loan is purchased by the investor. These integrated systems also
improve data integrity because information is not re-keyed or transferred to
multiple mortgage loan-tracking systems.
 
  Prior to 1997, functions that were formerly conducted from a central
location in Larkspur were decentralized and moved to the branch offices.
Underwriting and closing document preparation are two such functions.
Decentralization of these functions has enabled the Company to offer prompt
and efficient service. Staffing each branch with management and staff who have
an understanding of the local market also increased the Company's ability to
assess mortgage loan quality and resolve broker-related issues more
efficiently. Operations functions which remain centralized include quality
assurance, systems programming and support, loan delivery and servicing.
 
  Branch operations management has substantial contact with and receives
direction from senior management at the Company's headquarters office. Typical
daily interaction between a branch operations officer and the headquarters'
staff include resolutions of underwriting exceptions, interpretation of
investor guidelines and requests from a branch for systems support. The
Company's operations procedure manual specifies workflow and communication
methods and underwriting requirements not specifically mentioned in investor
guidelines, but which the Company determines are prudent. The procedure manual
is also the vehicle by which internal procedures and controls are disseminated
to all operations personnel. All such procedures are designed to ensure
consistent, investment quality mortgage loan originations and an efficient
production environment.
 
  The Information Services Department is responsible for implementing,
supporting and improving the software and hardware technology employed in the
Company. Specifically, the Information Services Department concentrates on
applications programming, applications development and analysis of new
software technologies which can be used within the Company to improve
information flow and operating efficiencies. The Information Services
Department also focuses on the integration and support of hardware
technologies including those established in the branch offices.
 
 HEDGING ACTIVITIES
 
  The Company originates and purchases mortgage loans and sells them primarily
through securitizations and whole loan sales. The market value of fixed-rate
mortgage loans are sensitive to changes in market interest rates. If interest
rates rise between the time the Company commits to originate at a specific
rate ("rate lock") or originates or purchases the mortgage loans and the time
the mortgage loans are committed for sale, there may be a decline in the
market value of the mortgage loans. To protect against such possible declines,
the Company has adopted a hedging strategy.
 
  The Company retains the services of Tuttle & Co., an unaffiliated advisory
firm specializing in mortgage loan pipeline management to assist the Company
in seeking to minimize the interest rate risk associated with the time lag
between when loans are rate-locked and when they are committed for sale or
exchanged in the secondary market. Individual mortgage loan risks are
aggregated by note rate, mortgage loan type and stage in the pipeline, and are
then matched, based on duration, with the appropriate hedging instrument, thus
mitigating basis risk until closing and delivery. The Company currently hedges
its mortgage loan pipeline through a combination of forward sales of Fannie
Mae mortgage-backed securities and forward whole loan sales. The Company
determines which alternative provides the best execution in the secondary
market. As a managed account of Tuttle & Co., the Company is able to take
advantage of Tuttle's reporting services, including pipeline, mark-to-market,
commitment and position reporting.
 
  The Company believes that it has implemented a cost-effective hedging
program to provide a level of protection against changes in the market value
of its fixed-rate mortgage loans held for sale. However, an
 
                                      15
<PAGE>
 
effective hedging strategy is complex and no hedging strategy can completely
insulate the Company against such changes.
 
  The Company does not presently hedge against declines in value in its
servicing portfolio or retained interests in securitizations. Such declines
could occur due to market interest rate changes and the effects of early
prepayments of the mortgage loans serviced.
 
 MORTGAGE LOAN SERVICING
 
  General. Mortgage loan servicing includes collecting payments from borrowers
and remitting those funds to investors, accounting for mortgage loan principal
and interest, reporting to investors, holding custodial funds for payment of
mortgage-related expenses such as taxes and insurance, advancing funds to
cover delinquent payments, inspecting the mortgaged premises as required,
contacting delinquent borrowers, supervising foreclosures and property
disposition in the event of unremedied defaults, and otherwise administering
the mortgage loan.
 
  The Company's fees for servicing mortgage loans generally range from 0.25%
to 0.50% per annum on the outstanding principal balances of the mortgage
loans. Servicing fees are collected by the Company out of monthly remittances
to investors. Other sources of mortgage servicing rights revenues include late
charges, assumption and modification fees and prepayment penalties. The
Company must cover general overhead and other normal costs associated with
mortgage servicing rights, such as computer and personnel costs. The Company
is also required to pay certain costs in connection with foreclosure
proceedings on defaulted mortgage loans for which it may not be fully
reimbursed. Potential exposure to foreclosure costs is contrasted to losses on
principal amounts, as to which the Company has limited liability because
substantially all of the mortgage loans in its mortgage loan servicing
portfolio are sold or exchanged to investors in the secondary mortgage market
on a nonrecourse basis.
 
  In 1993, the Company established its Servicing Center in Santa Rosa,
California. The Servicing Center became operational in February 1994 and
presently occupies approximately 13,000 square feet. The Servicing Center is
fully integrated into the Company's networking system and employs a well-
established, experienced provider of computing services, Alltel Information
Services Inc. for its mortgage loan servicing computing services. The Company
believes that the Servicing Center has the capacity to substantially increase
the number of mortgage loans that it services without significantly increasing
its fixed operating costs. Prior to the time the Servicing Center became
operational, the Company's mortgage loan servicing portfolio was subserviced
by a separate servicing entity and the Company was not actively engaged in
servicing activities.
 
  The following table provides certain information regarding changes in the
Company's mortgage loan servicing portfolio:
 
<TABLE>
<CAPTION>
                                            YEAR ENDED DECEMBER 31,
                                            --------------------------
                                             1997      1996     1995
                                            -------  --------  -------
                                                 (DOLLARS IN MILLIONS)
   <S>                                      <C>      <C>       <C>      <C> <C>
   Beginning Servicing Portfolio........... $ 4,387  $  4,149  $ 4,779
   Add: Originations.......................   3,756     2,284    1,356
   Less: Bulk sales of servicing rights....  (1,963)   (1,033)    (943)
   Less: Amortization and prepayments......    (740)     (543)    (507)
   Less: Service released sales............    (913)     (470)    (536)
                                            -------  --------  -------
   Ending Servicing Portfolio.............. $ 4,527  $  4,387  $ 4,149
                                            =======  ========  =======
</TABLE>
 
 
                                      16
<PAGE>
 
  The following table sets forth certain information regarding the Company's
mortgage loan servicing portfolio:
 
<TABLE>
<CAPTION>
                                                YEAR ENDED DECEMBER 31,
                                               ----------------------------
                                                 1997      1996      1995
                                               --------  --------  --------
<S>                                            <C>       <C>       <C>       
Agency mortgage loans:
  Number of mortgage loans....................   13,330    17,118    15,835
  Percent of total number.....................    31.67%    49.82%    58.09%
  Principal amount (in millions).............. $  1,522  $  2,026  $  1,911
  Percent of total principal amount...........    33.62%    46.18%    46.06%
Non-agency mortgage loans:
  Number of mortgage loans....................   15,679    12,487    11,178
  Percent of total number.....................    37.24%    36.34%    41.00%
  Principal amount (in millions).............. $  2,502  $  2,192  $  2,228
  Percent of total principal amount...........    55.27%    49.97%    53.70%
Home equity mortgage loans:
  Number of mortgage loans....................   12,846     4,695       248
  Percent of total number.....................    30.51%    13.66%     0.91%
  Principal amount (in millions).............. $    474  $    161  $     10
  Percent of total principal amount...........    10.47%     3.67%     0.24%
Other mortgage loans(1):
  Number of mortgage loans....................      244        63       --
  Percent of total number.....................     0.58%     0.18%      --
  Principal amount (in millions).............. $     29  $      8       --
  Percent of total principal amount...........     0.64%     0.18%      --
Total mortgage loans serviced:
  Number of mortgage loans....................   42,099    34,363    27,261
  Principal balance (in millions)............. $  4,527  $  4,387  $  4,149
  Average principal balance .................. $107,532  $127,666  $152,195

  Average coupon--first lien..................     8.18%     8.05%     7.79%
  Average coupon--home equity.................    10.68%     9.60%     9.46%
</TABLE>
--------
(1) Consists of subprime mortgage loans.
 
  The following table sets forth certain information regarding the number and
aggregate principal balance of the mortgage loans serviced by the Company at
December 31, 1997, including both fixed and adjustable rate mortgage loans, at
various mortgage interest rates:
 
<TABLE>
<CAPTION>
                                                                         PERCENT OF
                             NUMBER  PERCENT OF TOTAL TOTAL PRINCIPAL     AGGREGATE
    MORTGAGE INTEREST RATE  OF LOANS NUMBER OF LOANS      BALANCE     PRINCIPAL BALANCE
    ----------------------  -------- ---------------- --------------- -----------------
                                                      (IN THOUSANDS)
   <S>                      <C>      <C>              <C>             <C>
   0.00-6.99%..............   4,872        11.57%       $  449,071           9.92%
   7.00-7.49...............   2,308         5.48           275,591           6.09
   7.50-7.99...............   4,791        11.38           702,473          15.52
   8.00-8.49...............   6,116        14.53           962,516          21.26
   8.50-8.99...............   8,143        19.34         1,192,413          26.34
   9.00-9.49...............   3,316         7.88           355,193           7.85
   9.50-9.99...............   2,080         4.94           153,790           3.39
   10.00 and over..........  10,473        24.88           436,025           9.63
                             ------       ------        ----------         ------
     Total.................  42,099       100.00%       $4,527,072         100.00%
                             ======       ======        ==========         ======
</TABLE>
 
                                      17
<PAGE>
 
  As of December 31, 1997, approximately 81% of the above mortgage loans
serviced by the Company were fixed interest rate mortgage loans. If mortgage
interest rates decline the Company's prepayment rate is likely to increase,
thereby negatively affecting the Company's income. This negative effect on the
Company's income may be offset by a rise in origination and servicing income
attributable to new mortgage loan originations, which historically have
increased as mortgage interest rates have declined, and a rise in termination
fee income.
 
  The Company believes the credit quality of the mortgage loans that it
originates, the relative age of mortgage loans it services and the economic
factors impacting the areas it serves, among other factors, have resulted in
relatively low delinquency ratios of the Company's mortgage loan servicing
portfolio compared to industry averages. The Servicing Center is responsible
for administering the collection of mortgage loans, maintenance of those
properties in foreclosure and REO. Pursuant to the Company's procedures, once
a borrower has missed a scheduled payment, over the next 45 days the Company's
collections department attempts to establish contact with the borrower both by
telephone and by sending two automatic notices of delinquency to solve the
delinquency. In many instances, the delinquency is resolved, but if it is not,
the collections department generally records a notice of default, subject to
prior notice to the borrower, and commences foreclosure proceedings.
Approximately seven months after the delinquency, and after meeting all the
legal requirements for foreclosure, the property is sold at a trustee sale
absent any intervening act by the borrower. The following table shows (with
the principal amount of delinquent and foreclosed mortgage loans as a
percentage of the principal amount of the Company's total mortgage loan
servicing portfolio) the Company's recent delinquency statistics:
 
<TABLE>
<CAPTION>
                                                          AT DECEMBER 31,
                                                         -------------------
                                                         1997   1996   1995
                                                         -----  -----  -----
   <S>                                                   <C>    <C>    <C>
   Delinquency of Mortgage Loans Serviced (at end of
    period):
     30 days............................................  1.41%  1.36%  1.03%
     60 days............................................  0.20   0.13   0.23
     90 days or more....................................  0.12   0.04   0.17
                                                         -----  -----  -----
       Total delinquencies..............................  1.73%  1.53%  1.43%
                                                         =====  =====  =====
   Foreclosures Pending.................................  0.18%  0.57%  0.53%
</TABLE>
 
  Purchase and Sale of Mortgage Servicing Rights. The Company intends to
increase the size of its mortgage loan servicing portfolio by retaining a
significant portion of the mortgage loan servicing rights related to the
mortgage loans it originates. The Company has no plans to increase its
mortgage loan servicing rights portfolio through bulk or flow purchase of
mortgage loan servicing rights from others, although it may do so if a
strategic purchase opportunity presents itself.
 
  The Company may from time to time sell portions of its mortgage loan
servicing portfolio, and may elect to sell mortgage loans it has originated on
a servicing-released basis, based on strategic factors, such as market
conditions and financial objectives. These sales increase revenue at the time
of sale but reduce future servicing fee income. Prices obtained for mortgage
loan servicing rights vary, and it is not possible to anticipate what price
the Company will receive for any future sales. Among the factors that
influence the value received for mortgage servicing rights are servicing fee
rates, anticipated prepayment rates, average mortgage loan balances, servicing
costs, custodial account balances, delinquency and foreclosure experience, and
purchasers' required rates of return. The Company's owned servicing portfolio
at December 31, 1997 consisted of servicing rights to mortgage loans with an
aggregate outstanding principal balance of $4.5 billion, of which $2.7 billion
was capitalized on the Company's balance sheet. During 1997, 1996 and 1995,
the Company sold mortgage servicing rights with aggregate principal balances
of $2.0 billion, $1.0 billion and $0.9 billion, respectively.
 
                                      18
<PAGE>
 
  In general, the decision to sell, buy or retain mortgage loan servicing
rights is based upon the market for and value of mortgage loan servicing
rights, the Company's current financial needs and objectives, including, among
other things, its cash and/or capital requirements and its debt-to-equity and
other financial ratios. The Company's ability to sell its servicing rights
under its various servicing agreements with investors is generally subject to
the consent of the investors. In addition, under the servicing provisions
governing the Company's securitizations, the successor servicer is subject to
prior approval of the rating agencies rating the subject securities.
 
  Credit and Contractual Risks. As a seller and servicer of mortgage loans,
the Company contractually obligates itself to assume certain risks with
respect to the mortgage loans that it sells and services. Mortgage loan
servicers, such as the Company, are also typically required to pay (or at
least advance) delinquent mortgage loan payments and certain costs in
connection with foreclosure proceedings on defaulted mortgage loans, for which
the servicers may not be fully reimbursed. The Company must bear the costs
associated with making such advances. The Company's underwriting, quality
assurance and internal audit procedures are designed in part to limit its
delinquency and default risk. The Company also follows policies and procedures
designed to minimize risks associated with representations and warranties made
by the Company with respect to mortgage loans that it sells.
 
  Mortgage loan servicing rights represent a contractual right and not a
beneficial ownership interest in the underlying mortgage loans. Failure to
service the mortgage loans in accordance with contract requirements may lead
to a termination of the mortgage loan servicing rights without the payment of
any compensation.
 
 MORTGAGE LOAN FUNDING AND BORROWING ARRANGEMENTS
 
  The Company utilizes short-term warehouse facilities and repurchase
agreements to fund mortgage loan originations and purchases. In October 1993,
the Company entered into a mortgage loan warehousing agreement (the "Warehouse
Facility"). Under the terms of the Warehouse Facility, the Company has
available a $230 million warehouse line of credit secured by the mortgage
loans the Company originates or purchases. The Company is required to comply
with various operating and financial covenants as defined in the agreements
governing the agreement. Such covenants include restrictions on (i) changes in
the Company's business that would materially and adversely affect the
Company's ability to perform its obligations under the facility, (ii) selling
any asset other than in the ordinary course of business, and (iii) maximum
debt and distributions allowed. Such covenants also contain requirements for
(i) minimum net worth and mortgage loan servicing portfolio balances and (ii)
maximum leverage ratios. In accordance with industry practice, the Warehouse
Facility is renewable by the lenders and currently expires on November 4,
1999. The Company expects, although there can be no assurance, that the
Warehouse Facility will continue to be available in the future. At December
31, 1997, the outstanding balance under the Warehouse Facility was
$195.7 million.
 
  In addition to the Warehouse Facility, the Company makes regular use of
certain uncommitted lines of credit, short-term credit facilities and purchase
and sale agreements (such as repurchase or "gestation" agreements) provided by
major investment banks and a major corporation. These facilities permit the
Company to diversify its borrowing resources, while accelerating the turnover
of mortgage loans in inventory, reducing interest costs and permitting greater
mortgage loan origination volumes.
 
  The Company currently has three uncommitted whole loan repurchase agreements
with major investment banks. Under the terms of these agreements, the Company
may pledge mortgage loans originated or purchased to obtain additional
liquidity while mortgage loans are held until securitization or are sold
through whole loan sales. Amounts outstanding under these agreements at
December 31, 1997 were $174.5 million, $238.6 million, and $21.3 million.
 
  In addition, the Company has entered into an uncommitted mortgage loan
purchase and sale agreement with a major investment bank. Under the terms of
this agreement, mortgage loans which are subject to a "take-out" commitment
between the Company and an investor, but have not yet been purchased, may be
sold to the investment bank with the accompanying trade assignment. This
allows the Company to accelerate turnover and provide additional liquidity to
fund additional mortgage loans.
 
                                      19
<PAGE>
 
  The last of the Company's warehousing facilities is a $15.0 million
warehouse line of credit with a major corporation. This agreement expires on
October 31, 1998. At December 31, 1997, the Company had $1.5 million
outstanding under this facility.
 
  The Company also has a $3.0 million operating line of credit from a group of
commercial banks who are also lenders in the Warehouse Facility. This
operating line of credit is secured by certain servicing contracts of the
Company and is limited by the amount of servicing pledged as security. This
operating line of credit, which has a conversion option to a three-year,
amortizing term loan, is renewable from time to time and expires on November
4, 1998. At December 31, 1997, the Company had no outstandings under this line
of credit.
 
  In addition to these financing sources, the Company also has various
repurchase agreements with major investment banks which are collateralized by
certificates reflecting interest in the Company's private securities. At
December 31, 1997, the Company had $4.8 million outstanding under these
agreements.
 
  The Company is required to comply with various operating and financial
covenants as provided in the agreements as described above, the most
restrictive of which are those relating to the Warehouse Facility as described
above.
 
  The Company relies on securitizations and whole loan sales to generate cash
proceeds for repayment of its warehouse facilities and to create availability
to purchase additional mortgage loans. Several factors affect the Company's
ability to complete securitizations of its loans, including conditions in the
securities markets generally, conditions in the asset-backed securities market
specifically, and the credit quality of the Company's portfolio of mortgage
loans. Unanticipated delays in closing a securitization could also increase
the Company's interest rate risk by increasing the warehousing period for its
mortgage loans.
 
COMPETITION
 
  The mortgage banking business is highly competitive. The Company competes
with other wholesale and retail mortgage banking entities, mortgage brokers
and financial institutions, many of which have substantially greater financial
and other resources than the Company. The market for mortgage loan
originations is also significantly influenced by interest rate levels and
changes as well as demographic and other factors. The Company expects greater
competition from its existing competitors. In addition, Fannie Mae and Freddie
Mac are currently developing technologies and business practices that will
expand the scope of mortgage loans eligible to be Agency mortgage loans to
include some Alternative A and subprime mortgage loans. The foregoing factors
may result in lower mortgage loan origination volume, compressed pricing
margins or other challenging or adverse effects for the Company. Mortgage
brokers compete on the basis of service, range of mortgage loan products and
pricing. Retail mortgage banking companies have direct access to borrowers and
generally are able to sell their mortgage loans to the same entities that
purchase the Company's mortgage loans. The Company depends primarily on
mortgage brokers for originating new mortgage loans. Competitors also seek to
establish relationships with mortgage brokers who are not obligated by
contract or otherwise to continue to do business with the Company. Although
independent mortgage bankers may not possess the financial resources of those
affiliated with larger financial institutions, management believes that such
independent companies have the potential to be more adept at adjusting to
changing market conditions.
 
EMPLOYEES
 
  As of December 31, 1997, the Company had 668 full-time employees, 17 part-
time employees and 4 temporary employees on its payroll. Approximately 312 of
the Company's employees were employed at the Company's headquarters in
Larkspur, California. The Company's employees are not represented by any
collective bargaining unit. The Company believes that it maintains good
relations with its employees.
 
                                      20
<PAGE>
 
RISK FACTORS
 
  In addition to the other information contained in this Form 10-K, the
following risk factors should be carefully considered in evaluating the
Company and its business.
 
CONTROL OF CERTAIN STOCKHOLDERS
 
  Peter T. Paul and his family beneficially own 42.6% (and have voting power
pursuant to a Voting Trust with respect to 53.3%) of the outstanding shares of
Common Stock following the closing of the Initial Public Offering.
Accordingly, Mr. Paul, who is the President of the Company, will have
effective control of the Company, with the likely ability to approve certain
fundamental corporate transactions (including mergers, consolidations and
sales of assets) and to elect a majority of the members of the Board of
Directors. See "Security Ownership and Certain Beneficial Owners."
 
INTEREST RATE FLUCTUATIONS MAY ADVERSELY AFFECT RESULTS OF OPERATIONS
 
  The Company's Mortgage Loan Origination and Sale Business May Be Adversely
Affected by Changes in Interest Rates. Changes in interest rates can have a
variety of effects on the Company's mortgage loan origination business. The
market value of fixed-rate mortgage loans has a greater sensitivity to changes
in market interest rates than adjustable-rate mortgage loans. To the extent an
interest rate is established for a mortgage loan in process prior to the time
such mortgage loan is funded (a "locked pipeline loan"), a gain or loss on the
sale of such mortgage loan may result from changes in interest rates during
the period between the time the interest rate is established and the time the
mortgage loan is committed for sale. In order to hedge this interest rate
risk, the Company sells (on a forward basis) a portion of its locked pipeline
loans (or an equivalent amount of the mortgage-backed securities into which
such mortgage loans may be converted). Since 1992, the Company has utilized
Tuttle & Co., an unaffiliated advisory and information services company based
in Mill Valley, California, for exposure analysis of its mortgage loan
pipeline. The Company determines the number of such forward sales it will make
based upon a daily probability analysis as to the principal amount of locked
pipeline loans that are likely to be funded by the Company. To the extent that
the probability analysis utilized by the Company differs from actual
experience, the resultant mismatching of commitments to fund mortgage loans at
certain interest rates and forward sales of mortgage loans with certain
interest rates may have a material adverse effect on the Company's results of
operations.
 
  In addition to the interest rate risk discussed above, the Company's
origination of mortgage loans that are ineligible for Agency programs ("non-
agency mortgage loans") involves risk to the extent the Company has not
obtained investor commitments to purchase such mortgage loans on a forward or
current basis at the time interest rates are established for such mortgage
loans (whether at mortgage loan funding or prior thereto). Specifically, until
such forward purchase commitments are obtained, the Company, in most cases,
hedges such non-agency mortgage loans with (i) forward sales of Fannie Mae
mortgage-backed securities or (ii) forward whole loan sales. The Company
determines which alternative provides the best execution in the secondary
market. To the extent movements in the interest rates on such securities do
not match the current pricing for non-agency mortgage loans in the secondary
market, the Company may recognize gains or losses upon the sale of such
mortgage loans. Non-agency, home equity and other non-conforming mortgage
loans made up 81.6% of the Company's mortgage loan originations during the
year ended December 31, 1997 and 61.3% of mortgage loan originations during
the year ended December 31, 1996.
 
  In addition to the foregoing, the Company's results of operations from its
origination of mortgage loans can be adversely affected to the extent rising
interest rates decrease the volume of mortgage loan originations and the
revenue derived therefrom.
 
  The Company's Servicing Operations May Be Adversely Affected by Changes in
Interest Rates. The Company's servicing operations are also affected by
interest rate levels. As mortgage interest rates fall, an increasing number of
borrowers can be expected to refinance and prepay their mortgage loans.
Prepayments of mortgage loans serviced by the Company result in termination of
the Company's future stream of servicing fees from such mortgage loans. In
addition, the Company capitalizes servicing rights on mortgage loans that it
originates based upon the net present value of future cash flows. If the rate
of prepayment of the related mortgage
 
                                      21
<PAGE>
 
loans exceeds the rate assumed by the Company, due to a significant reduction
in interest rates or otherwise, the value of the mortgage loan servicing
portfolio will decrease, which could adversely affect the Company's results of
operations. Interest rate changes can also adversely affect the ability of the
Company to sell mortgage loan servicing rights to a third party . The Company
does not presently hedge its mortgage loan servicing portfolio.
 
FAILURE TO EFFECTIVELY USE LEVERAGE TO FINANCE MORTGAGE LOAN ORIGINATIONS MAY
ADVERSELY AFFECT RESULTS OF OPERATIONS
 
  Unavailability of Funding Sources May Adversely Affect Results of
Operations. The Company funds substantially all of the mortgage loans which it
purchases and originates through borrowings under warehouse financing
facilities, repurchase agreements and internally generated funds. The
Company's borrowings are in turn repaid with the proceeds received by the
Company from selling such mortgage loans through securitizations or whole loan
sales. The Company is currently and may in the future be dependent upon a few
lenders to provide the primary credit facilities for its mortgage loans. In
addition, the Company's specialized mortgage loan products are often not
familiar to warehouse lenders. As new mortgage loan products are introduced,
such lenders must be familiarized with the loans and their marketability
before they determine whether such mortgage loans are eligible for financing
under the warehouse facilities. Any failure to renew or obtain adequate
funding under these facilities, or any substantial reduction in the size of or
pricing in the market for the Company's mortgage loans, could have a material
adverse effect on the Company's operations.
 
  Increased Cost of Borrowing May Adversely Affect Results of Operations. If
the return on the mortgage loans originated or acquired by the Company with
borrowed funds fails to cover the cost of the borrowing, the Company will
experience net interest losses and may experience net losses. In addition, the
cost of such borrowings can vary depending upon the lender, the nature and
liquidity of the underlying collateral, the movement of interest rates, the
availability of financing in the market and other factors. Further, the
Company may not be able to achieve the degree of leverage it believes to be
optimal, which may cause the Company to be less profitable than it might be
otherwise.
 
  Changes in Interest Rates May Adversely Affect Results of
Operations. Profitability may be directly affected by the levels of and
fluctuations in interest rates, which affect the Company's ability to earn a
spread between interest received on its mortgage loans and the cost of
borrowing. The profitability of the Company is likely to be adversely affected
during any period of unexpected or rapid changes in interest rates. For
example, a substantial or sustained increase in interest rates could adversely
affect the ability of the Company to originate and acquire mortgage loans and
could reduce the interest rate differential between newly originated mortgage
loans and the Company's cost of borrowing. A significant decline in interest
rates could decrease the size of the Company's mortgage loan servicing
portfolio by increasing the level of mortgage loan prepayments. While the
Company monitors the interest rate environment and generally will earn a
positive spread between interest paid on borrowed funds and interest earned on
mortgage loans, there can be no assurance that the profitability of the
Company would not be adversely affected during any period of changes in
interest rates.
 
  Failure to Refinance Outstanding Borrowings May Adversely Affect Results of
Operations. While the Company expects to be able to maintain existing
financing arrangements, or to obtain replacement financing as its lending
arrangements mature, there can be no assurance that such financing will be
obtainable on favorable terms. To the extent that the Company is not
successful in maintaining or replacing existing financing, it may have to
curtail its mortgage loan production activities, which could have a material
adverse effect on the Company's operations.
 
  Decline in Market Value of Mortgage Assets and Margin Calls May Adversely
Affect Results of Operations. A decline in the market value of the Company's
portfolio of mortgage loans may limit the Company's ability to borrow or
result in lenders initiating margin calls (i.e., requiring a pledge of cash or
additional mortgage loans to re-establish the ratio of the amount of the
borrowing to the value of the collateral).
 
                                      22
<PAGE>
 
The Company could be required to sell mortgage loans under adverse market
conditions in order to maintain liquidity. Such sales may be effected by the
Company when deemed by it to be necessary in order to preserve the capital
base of the Company. If these sales were made at prices lower than the
amortized cost of the mortgage loans, the Company would experience losses. A
default by the Company under its collateralized borrowings could also result
in a liquidation of the collateral, including any cross-collateralized assets,
and a resulting loss of the difference between the value of the collateral and
the amount borrowed.
 
DEPENDENCE ON SECURITIZATIONS FOR SUCCESSFUL OPERATIONS
 
  The Company plans to pool and sell through securitizations substantially all
of its non-agency mortgage loans and HELOC home equity mortgage loans and
expects that the gain recognized from such securitizations will continue to
represent a significant portion of the Company's future revenues and net
earnings. Further, the Company is dependent on the cash generated from such
securitizations to fund its future originations and repay borrowings under its
warehouse facilities. The Company's ability to complete securitizations of its
mortgage loans will depend on a number of factors, including conditions in the
securities markets generally, conditions in the mortgage-backed securities
market specifically, the performance of the Company's previous securitizations
or the securitizations of others and the Company's ability to obtain credit
enhancement. Adverse changes in the securitization market could impair the
Company's ability to sell mortgage loans through securitizations on a
favorable or timely basis and could have a material adverse effect upon the
Company's results of operations and financial condition. Furthermore, because
management of the Company expects that an important component of the Company's
income will be gain on sale, the Company's quarterly operating results may
fluctuate significantly as a result of the timing and level of
securitizations. If securitizations do not close when expected, the Company's
results of operations may be materially adversely affected for that period.
 
  In addition, in order to gain access to the HELOC securitization market, the
Company expects to continue to rely upon credit enhancements provided by one
or more monoline insurance carriers to enable it to obtain an AAA/Aaa rating
for the senior portion of its mortgage-backed securities. Any substantial
increase in the price charged by, or the required level of protection to be
provided to, the insurance companies, or any unwillingness of insurance
companies to guarantee these senior securities in the Company's mortgage loan
pools, could have a material adverse effect upon the Company's results of
operations and financial condition.
 
ESTIMATED VALUE OF RETAINED INTERESTS IN SECURITIZATIONS MAY BE REDUCED,
ADVERSELY IMPACTING RESULTS OF OPERATIONS
 
  The Company derives a substantial portion of its revenue and earnings by
recognizing gains on the sale of mortgage loans through securitizations.
Securitization is the process of pooling mortgage loans that the Company has
originated or purchased and issuing securities backed by such mortgage loan
pools. The Company generally sells the more senior classes of the securities
for cash and retains one or more of the subordinated classes. In its non-
agency mortgage loan securitizations, the retained subordinated classes of
securities generally have a stated principal amount and earn a fixed interest
rate. Management believes that it has made reasonable estimates of the market
value of such retained subordinated classes of securities on its balance
sheet, based on market prices for similar securities. If the mortgage loans
underlying such retained securities should experience delinquencies or losses
at rates greater than anticipated, the value of such securities would have to
be written-down with a corresponding charge to income. In its home equity
mortgage loan securitizations, the Company retains a trust interest that
includes an Interest-only Residual. To value the Interest-only Residual for
the balance sheet, the Company projects the expected cash flows over the life
of such retained interest, using prepayment and default assumptions that
market participants would use for similar financial instruments that are
subject to prepayment, credit and interest rate risks. The Company then
determines the present value of these cash flows using an interest rate which
it believes is commensurate with the risks involved. If the Company's actual
experience differs materially from the assumptions used in the determination
of the present value of such retained interests, future cash flows and results
of operations could be adversely affected. The Company could also be required
to reduce the fair value of its retained interests on its balance sheet. To
the Company's knowledge, there is currently no active market for the sale of
these retained interests. No assurance can be given that the retained
interests could be sold at their stated value, if at all.
 
                                      23
<PAGE>
 
INTENSE COMPETITION IN THE MORTGAGE LENDING INDUSTRY
 
  The Company faces intense competition, primarily from commercial banks,
savings and loans and other mortgage lenders. If the Company expands into
particular geographic markets, it will face competition from mortgage lenders
with established positions in such markets. There can be no assurance that the
Company will be able to successfully compete with these mortgage lenders.
Competition can take place on various levels, including convenience in
obtaining a mortgage loan, service, marketing, origination channels and
pricing. Many of the Company's competitors in the financial services business
are substantially larger and have more capital and other resources than the
Company. Many of the Company's competitors are well established in the
specialty mortgage loan market and a number of others are recent entrants into
that market seeking the relatively attractive profit margins currently
associated with specialty mortgage loan products. Fannie Mae and Freddie Mac
are currently developing technologies and business practices that will expand
the scope of mortgage loans eligible to be Agency mortgage loans to include
some Alternative A and subprime mortgage loans. To the extent market pricing
for the Company's mortgage loan products becomes more competitive, it may be
more difficult to originate and purchase mortgage loans with attractive yields
in sufficient volume to maintain profitability. There can be no assurance that
the Company will be able to compete successfully in this market environment
and any failure in this regard could have a material adverse effect on the
Company's results of operations and financial condition.
 
DEPENDENCE ON WHOLESALE BROKERS FOR SUCCESSFUL OPERATIONS
 
  The Company depends primarily on independent mortgage brokers and, to a
lesser extent, on correspondent lenders, for the origination and purchase of
its wholesale mortgage loans, which constitute a significant portion of the
Company's mortgage loan production. These independent mortgage brokers deal
with multiple lenders for each prospective borrower. The Company competes with
these lenders for the independent brokers' business on the basis of price,
service, loan fees, costs and other factors. The Company's competitors also
seek to establish relationships with such brokers, who are not obligated by
contract or otherwise to do business with the Company. The Company's future
results of operations and financial condition may be vulnerable to changes in
the volume and costs of its wholesale mortgage loans resulting from, among
other things, competition from other lenders and purchasers of such mortgage
loans.
 
PERMITTING UNDERWRITING EXCEPTIONS MAY ADVERSELY IMPACT RESULTS OF OPERATIONS
 
  On a case-by-case basis, the Company's underwriters may determine that a
prospective borrower warrants an exception from its underwriting guidelines.
Such exceptions may include a debt service-to-income ratio exception, a loan-
to-value exception or an exception from certain documentation requirements of
a particular mortgage loan program. An underwriting exception will generally
be allowed if the application reflects one or more compensating factors, such
as a high credit score, a low loan-to-value ratio, cash reserves, stable
employment, or a particularly long length of residency in the property.
Accordingly, the Company may fund mortgage loans that do not satisfy all of
the criteria for a particular mortgage loan program being offered by the
Company. The Company's historical experience in making such exceptions is
limited and, therefore, its historical delinquency and foreclosure rates to
date may not be indicative of future levels of performance. By permitting
underwriting exceptions, the Company may diminish the consistency and control
inherent in the strict application of underwriting guidelines. In addition, if
such mortgage loans cannot be included in a planned securitization or other
expected method of sale, the Company may be required to dispose of these
mortgage loans at a lower price than contemplated at the time of origination.
 
RELIANCE UPON MORTGAGE LOAN PRODUCT DEVELOPMENT FOR SUCCESSFUL OPERATIONS
 
  The Company plans to expand and refine its mortgage loan products in order
to maintain a variety of mortgage loan products with relatively attractive
"spreads" which are (i) responsive to the needs of consumers, originating
brokers and the secondary markets and (ii) available in the marketplace sooner
than similar mortgage loan products offered by its competitors. There can be
no assurance that the Company can continue to expand and refine its mortgage
loan product mix on a timely basis and the failure to do so could have a
material adverse effect on the Company's results of operations, financial
condition and business prospects.
 
                                      24
<PAGE>
 
POTENTIAL CREDIT LOSSES ON MORTGAGE LOANS MAY ADVERSELY AFFECT RESULTS OF
OPERATIONS
 
  The Company bears the risk of credit losses on mortgage loans held for sale
and on certain retained interests in securitizations which the Company has
elected or is required to hold. The Company has until recently sold its
mortgage loans on a non-recourse basis. Accordingly, the Company has no
significant historical experience with retention of risk of loss due to
mortgage loan defaults. Potential losses can arise from many factors as
summarized below:
 
  Real Estate Security and the Foreclosure Process. Many of the risks of
mortgage lending reflect the risks of investing directly in the real estate
securing the mortgage loans. In the event of a default on the underlying
mortgage loan, the ultimate extent of the loss, if any, may only be determined
after a foreclosure of the mortgage encumbering the property and, if the
lender takes title to the property, upon liquidation of the property. Factors
such as the title to the property or its physical condition (including
environmental considerations) may make a third-party unwilling to purchase the
property at a foreclosure sale or at a price sufficient to satisfy the
obligations of the related mortgage loan. Foreclosure laws in various states
may cause a protracted foreclosure process. In addition, the condition of a
property may deteriorate during the period of foreclosure proceedings. Certain
borrowers on underlying mortgage loans may become subject to bankruptcy
proceedings, in which case the amount and timing of amounts due may be
materially adversely affected. Even assuming that the underlying property
provides adequate security for the mortgage loan, substantial delays could be
encountered in connection with the liquidation of a defaulted mortgage loan
and a corresponding delay in the receipt and reinvestment of principal and
interest payments could occur.
 
  Adverse Real Estate Market Conditions May Affect Value of Collateral. The
Company's business may be adversely affected by periods of economic slowdown
or recession which may be accompanied by declining property values. Any
material decline in property values reduces the ability of borrowers to use
equity in the property to support borrowings and increases the loan-to-value
ratios of mortgage loans previously made, thereby weakening collateral
coverage and increasing the possibility of a loss in the event of default. In
addition, delinquencies, foreclosures and losses generally increase during
economic slowdowns and recessions.
 
  Non-agency, Home Equity and Other Mortgage Loans May Have Higher Delinquency
and Foreclosure Rates. Credit risks associated with non-agency, home equity
and other mortgage loans may be greater than those associated with Agency
mortgage loans. In originating such non-agency loans, the Company generally
places an emphasis on credit scores obtained from three major credit bureaus
to evaluate the credit quality of the borrowers. Such non-agency loans may
differ from Agency loans with respect to loan-to-value ratios, the credit and
income history of the borrowers, the documentation required for approval of
the borrowers, the types of properties securing the mortgage loans, mortgage
loan sizes and the borrowers' occupancy status with respect to the mortgaged
property. As a result of these and other factors, the interest rates charged
on the non-agency categories of mortgage loans are often higher than those
charged for Agency mortgage loans. The combination of different underwriting
criteria and higher rates of interest may lead to higher delinquency rates
and/or credit losses for these categories of mortgage loans as compared to
Agency mortgage loans. Further, to the extent the Company develops mortgage
loan products for lower credit quality borrowers, there may be a higher risk
of delinquency and foreclosure than with mortgage loans made to high credit
quality borrowers. Any failure by the Company to adequately address the higher
delinquency and foreclosure rates could have a material adverse effect on the
Company.
 
  Lack of Geographic Diversification. During the years ended December 31, 1997
and 1996, 73% and 77%, respectively, of the Company's mortgage loan
originations (as measured by principal balances) were secured by property
located in California. To the extent that properties underlying such mortgage
loans are located in the same geographic region, such mortgage loans may be
subject to a greater risk of delinquency or default in the event of adverse
economic, political or business developments and natural hazard risks that may
affect such region. If the region's real estate market should experience an
overall decline in property values, the rates of delinquency, foreclosure,
bankruptcy and loss on the mortgage loans may be expected to increase
substantially, as compared to such rates in a stable or improving real estate
market.
 
                                      25
<PAGE>
 
  Potential Environmental Liabilities. Certain properties securing mortgage
loans may be contaminated by hazardous substances. As a result, the value of
the property may be diminished. In the event that the Company is forced to
foreclose on a defaulted mortgage loan on that property, the Company may be
subject to environmental liabilities regardless of whether the Company was
responsible for the contamination. While the Company intends to exercise due
diligence to discover potential environmental liabilities prior to the
acquisition of any property through foreclosure, hazardous substances or
wastes, contaminants, pollutants or sources thereof (as defined by state and
federal laws and regulations) may be discovered on properties during the
Company's ownership or after a sale thereof to a third party. If such
hazardous substances are discovered on a property, the Company may be required
to remove those substances or sources and clean up the property at substantial
expense. The Company may also be liable to tenants and users of neighboring
properties. In addition, the Company may find it difficult or impossible to
sell the property prior to or following any such clean-up.
 
QUARTERLY FLUCTUATIONS IN EARNINGS
 
  The Company's revenues and net earnings have fluctuated in the past and are
expected to fluctuate in the future as a result of a number of factors,
including the size and timing of securitizations and whole loan sales,
expansion costs incurred by the Company and the volume of mortgage loan
originations and purchases. If the Company were unable to securitize
profitably a sufficient number of its mortgage loans in a particular quarter,
or were unable to complete a sufficient number of whole loan sales, then the
Company's revenues for such quarter would decline, which could result in lower
earnings or a loss reported for such quarter and have a material adverse
effect on the Company's results of operations, financial condition and
business prospects.
 
INABILITY TO SUSTAIN AND MANAGE GROWTH
 
  Although the Company has experienced rapid and substantial growth in
mortgage loan originations and total revenues in recent years, there can be no
assurance that the Company can sustain these rates of growth or that it will
be able to create an infrastructure or recruit and retain sufficient personnel
to keep pace with a prolonged period of growth. The inability of the Company
to sustain or keep pace with its rate of growth would have a material adverse
effect on the Company's results of operations, financial condition and
business prospects. Additionally, in light of such growth, the historical
financial performance of the Company may be of limited relevance in predicting
future performance.
 
GENERAL ECONOMIC AND FINANCIAL CONDITIONS MAY AFFECT RESULTS OF OPERATIONS
 
  The Company's results of operation will depend on, among other things, the
level of net interest income generated by the Company's mortgage loans, the
market value of such mortgage loans and the supply of and demand for such
mortgage loans. Prepayment rates, interest rates, borrowing costs and credit
losses depend upon the nature and terms of the mortgage loans, the geographic
location of the properties securing the mortgage loans, conditions in
financial markets, the fiscal and monetary policies of the United States
government and the Board of Governors of the Federal Reserve System,
international economic and financial conditions, competition and other
factors, none of which can be predicted with any certainty.
 
LEGISLATION AND REGULATION
 
  The Company's business is subject to extensive regulation, supervision and
licensing by federal, state and local governmental authorities and will be
subject to various laws and judicial and administrative decisions imposing
requirements and restrictions on part or all of its operations. Regulated
matters include, without limitation, mortgage loan origination marketing
efforts, credit application and underwriting activities, maximum finance and
other charges, disclosure to customers, certain rights of rescission on
mortgage loans, closing and servicing mortgage loans, collection and
foreclosure procedures, qualification and licensing requirements for doing
business in various jurisdictions and other trade practices. Mortgage loan
origination activities are subject to the laws and regulations in each of the
states in which those activities are conducted. Activities as a lender are
also subject to various federal laws. The Truth in Lending Act ("TILA") and
Regulation Z promulgated
 
                                      26
<PAGE>
 
thereunder, as both are amended from time to time, contain disclosure
requirements designed to provide consumers with uniform, understandable
information with respect to the terms and conditions of mortgage loans and
credit transactions in order to give them the ability to compare credit terms.
TILA also guarantees consumers a three-day right to cancel certain credit
transactions. TILA also imposes disclosure, underwriting and documentation
requirements on mortgage loans, known as "Section 32 loans," with (i) total
points and fees upon origination in excess of 8% of the mortgage loan amount
or (ii) an annual percentage rate 10% higher than comparably maturing U.S.
treasury securities. The Company is also required to comply with the Equal
Credit Opportunity Act of 1974, as amended ("ECOA"), which prohibits creditors
from discriminating against applicants on the basis of race, color, sex, age
or marital status. Regulation B promulgated under ECOA restricts creditors
from obtaining certain types of information from mortgage loan applicants. It
also requires certain disclosures by the lender regarding consumer rights and
requires lenders to advise applicants of the reasons for any credit denial. In
instances where the applicant is denied credit or the rate or charge for a
mortgage loan increases as a result of information obtained from a consumer
credit agency, the Fair Credit Reporting Act of 1970, as amended, requires the
lender to supply the applicant with a name and address of the reporting
agency. The Company is also subject to the Real Estate Settlement Procedures
Act ("RESPA") and the Debt Collection Practices Act and will be required to
file an annual report with the Department of Housing and Urban Development
("HUD") pursuant to the Home Mortgage Disclosure Act ("HMDA"). The Company is
also subject to the rules and regulations of, and examinations by, HUD, Fannie
Mae, Freddie Mac and state regulatory authorities with respect to originating,
processing, underwriting, selling and servicing mortgage loans. Failure to
comply with these requirements can lead to loss of approved status,
termination or suspension of servicing contracts without compensation to the
servicer, demands for indemnifications or mortgage loan repurchases, certain
rights of rescission for mortgage loans, class action lawsuits and
administrative enforcement actions. There can be no assurance that the Company
will maintain compliance with these requirements in the future without
additional expenses, or that more restrictive local, state or federal laws,
rules and regulations will not be adopted or that existing laws and
regulations will not be interpreted in a more restrictive manner, which would
make compliance more difficult and more expensive for the Company.
 
  The laws and regulations described above are subject to legislative,
administrative and judicial interpretation, and certain of these laws and
regulations have been infrequently interpreted or only recently enacted.
Infrequent interpretations of these laws and regulations or an insignificant
number of interpretations of recently enacted regulations can result in
ambiguity with respect to permitted conduct under these laws and regulations.
Any ambiguity under the regulations to which the Company is subject may lead
to regulatory investigations or enforcement actions and private causes of
action, such as class action lawsuits, with respect to the Company's
compliance with the applicable laws and regulations. The Company may also be
subject to regulatory enforcement actions and private causes of action from
time to time with respect to its compliance with applicable laws and
regulations.
 
ELIMINATION OF CERTAIN LENDER PAYMENTS TO BROKERS
 
  Class-action lawsuits have been filed against a number of mortgage lenders
alleging that such lenders have violated RESPA by making certain payments to
independent mortgage brokers. These lawsuits have generally been filed on
behalf of a purported nationwide class of borrowers and allege that payments
made by a lender to a broker in addition to payments made by the borrower to a
broker are prohibited by RESPA, and are therefore illegal. Several federal
district courts construing RESPA in these cases have reached conflicting
results. On January 9, 1998, in the only appellate decision addressing the
issue to date, the United States Court of Appeals for the Eleventh Circuit
ruled in Culpepper v. Inland Mortgage Corporation that the payment by the
lender to the broker in that case constituted a prohibited referral fee under
RESPA. The case was remanded to the district court for further proceedings.
 
  If the pending cases on lender payments to brokers are ultimately resolved
against the lenders, it may cause an industry-wide change in the way
independent mortgage brokers are compensated. The Company's broker
compensation programs currently utilize such payments. Future regulatory
interpretations or judicial decisions
 
                                      27
<PAGE>
 
may require the Company to change its broker compensation programs or subject
it to material monetary judgments or other penalties. Any such changes or
penalties may have a material adverse effect on the Company's results of
operations, financial condition and business prospects. See "Risk Factors--
Legislation and Regulation."
 
DEPENDENCE UPON KEY PERSONNEL FOR SUCCESSFUL OPERATIONS
 
  The Company's operations will depend heavily upon the contributions of Mr.
Peter T. Paul and the Company's other executive officers, Becky S. Poisson,
Gilbert J. MacQuarrie and Steven M. Abreu, each of whom would be difficult to
replace. The loss of any of these individuals or of other key personnel could
have a material adverse effect upon the Company's business and results of
operations. See "Management--Directors and Officers."
 
FUTURE REVISIONS IN POLICIES AND STRATEGIES AT THE DISCRETION OF THE BOARD OF
DIRECTORS
 
  The Company has established the operating policies and strategies set forth
in this Prospectus as the operating policies and strategies of the Company.
However, these policies and strategies may be modified or waived by the Board
of Directors without stockholder approval. The ultimate effect of these
changes may be positive or negative.
 
POSSIBLE LIABILITY UNDER THE TAX INDEMNIFICATION AGREEMENT
 
  The Company and the Existing Shareholders have entered into a tax
indemnification agreement (the "Tax Agreement") relating to their respective
income tax liabilities. Because the Company became fully subject to corporate
income taxation after the termination of the Company's S corporation status,
any reallocation of income and deductions between the period during which the
Company was treated as an S corporation and the period during which the
Company will be subject to corporate income taxation may increase the taxable
income of one party while decreasing that of another party. The Tax Agreement
generally provides that, if an adjustment is made to the taxable income of the
Company for a year in which it was treated as an S corporation, the Company
will indemnify the Existing Shareholders (up to an agreed maximum amount
described below) against any increase in the Existing Shareholder's income tax
liability (including interest and penalties and related costs and expenses)
with respect to such tax year to the extent such increase results in a related
decrease in the income tax liability of the Company (whether with respect to
the year of the adjustment or over future years). Additionally, the Existing
Shareholders will not be responsible for any portion of any deferred tax
liability recorded on the balance sheet of the Company upon the termination of
the S corporation status. The Company will also indemnify the Existing
Shareholders for all taxes imposed upon them as the result of an
indemnification payment under the Tax Agreement. In no event, however, will
the Company be obligated to make indemnification payments under the Tax
Agreement if such payments, together with the aggregate of prior payments,
would exceed the amount of the deferred tax liability which may be recorded by
the Company on the balance sheet of the Company at the time of the termination
of the Company's S corporation status ($20.3 million at December 31, 1997).
The Tax Agreement is not binding on the Internal Revenue Service and any
payment made by the Company to the Existing Shareholders as aforesaid may be
considered by the Internal Revenue Service or state taxing authorities to be
non-deductible by the Company for income tax purposes. Any payment obligation
of the Company under the Tax Agreement on the part of the Company, or the
amount thereof, is uncertain at this time; however, any such payment may be
material if an indemnification payment obligation arises.
 
SECURITIES ELIGIBLE FOR FUTURE SALE MAY ADVERSELY AFFECT THE MARKET PRICE OF
COMMON STOCK
 
  Following the closing of the Company's Initial Public Offering and the
exercise of the Underwriters' over-allotment option, there are 19,700,000
shares of Common Stock outstanding, of which 10,500,000 shares of Common Stock
are held by current shareholders and subject to a 180-day "lock-up" period
following the closing of the Initial Public Offering. These shares of Common
Stock are "restricted securities" within the meaning of Rule 144 ("Rule 144")
under the Securities Act. Such restricted securities will be available for
resale pursuant
 
                                      28
<PAGE>
 
to Rule 144 following a holding period ending one year from the date of
issuance, (subject to the volume and other limitations imposed by Rule 144)
and, unless held by affiliates of the Company will become unrestricted two
years from the date of issuance. In addition, upon termination or waiver of
the lock-up period, such restricted securities may be sold at any time through
an effective registration statement. Future sales of restricted securities
could have an adverse effect on the market price of the Common Stock. The
holders of the currently restricted shares of Common Stock have certain
registration rights with respect to such shares of Common Stock.
 
  As of December 31, 1997, options to purchase 518,000 shares of Common Stock
were outstanding under the Company's Stock Option Plan, which will vest on
various dates extending through 2001. The Company filed a Form S-8
registration statement following the closing of the Initial Public Offering to
permit shares issued pursuant to the options to be sold.
 
POSSIBLE VOLATILITY OF STOCK PRICE
 
  The market price of the Common Stock may experience fluctuations unrelated
to the operating performance of the Company. In particular, the price of the
Common Stock may be affected by general market price movements as well as
developments specifically related to the mortgage finance industry such as
interest rate movements and credit quality trends.
 
POTENTIAL ISSUANCE OF PREFERRED STOCK
 
  The Company's Articles of Incorporation authorize the Board of Directors to
issue shares of Preferred Stock designated in one or more classes or series.
The Preferred Stock may be issued from time to time with such designations,
rights and preferences as shall be determined by the Board of Directors.
Preferred Stock would be available for possible future financing of, or
acquisitions by, the Company and for general corporate purposes without any
legal requirement that further stockholder authorization for issuance be
obtained. The issuance of Preferred Stock could have the effect of making an
attempt to gain control of the Company more difficult by means of a merger,
tender offer, proxy contest or otherwise. The Preferred Stock, if issued, may
have a preference on dividend payments which could affect the ability of the
Company to make dividend distributions to the holders of Common Stock. As of
the date of this Report, no shares of Preferred Stock have been issued and the
Company has no plans to issue any Preferred Stock.
 
                                      29
<PAGE>
 
ITEM 2. PROPERTIES
 
  The principal executive and administrative offices of the Company occupy
approximately 69,600 square feet of commercial office space in Larkspur,
California, under three separate leases expiring on various dates in 2002 and
2003, and approximately 29,900 square feet of commercial office space in San
Rafael, California, under a lease expiring in 2004. The Company leases
approximately 13,000 square feet of additional space in Santa Rosa,
California, for its Servicing Center under a lease expiring November 30, 1998,
and an additional 50,900 square feet at various locations in connection with
its branch offices, with lease terms expiring at various dates from 1998
through 2002. The Company does not own any real estate except for its interest
in real estate held in the ordinary course of business (including real estate
owned as a result of foreclosure).
 
ITEM 3. LEGAL PROCEEDINGS
 
  The Company is not a party to any material litigation. Additionally, the
Company's management is not aware of any pending or threatened claims against
the Company that might materially adversely affect the Company's operating or
financial results.
 
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
 
  No matters were submitted to a vote of the Company's security holders during
the fourth quarter of 1997.
 
                                    PART II
 
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
 
MARKET FOR COMMON STOCK
 
  The Company's Common Stock is traded on the over-the-counter market and is
quoted on the Nasdaq National Market under the symbol HDLD. The Company's
Common Stock was held by approximately 7 holders of record on March 18, 1998,
and the total number of beneficial shareholders holding stock through
depository companies was approximately 620.
 
  The Company filed a Registration Statement on Form S-1 (Reg. No. 333-38267)
and a Registration Statement on Form 8-A/A (Reg. No. 000-23569) for its
Initial Public Offering, which Registration Statements were declared effective
on February 4, 1998. Thus, there were no available sales prices of shares of
common stock for 1997 or prior periods. The high and low closing sales prices
of shares of the Common Stock as reported on the Nasdaq National Market
composite tape for the period indicated was as follows:
 
FIRST QUARTER 1998
<TABLE>
<CAPTION>
                                                                   STOCK PRICES
                                                                   -------------
                                                                    HIGH   LOW
                                                                   ------ ------
   <S>                                                             <C>    <C>
   Period from February 5, 1998 to March 25, 1998(1).............. 17 1/4 11 1/2
                                                                   ------ ------
</TABLE>
--------
(1) The Company's Common Stock began trading on February 5, 1998. The Company
    does not intend to pay dividends.
 
RECENT SALE OF SECURITIES
 
  On March 5, 1998, upon exercise of the underwriters' overallotment option,
the Company completed the sale of its Common Stock in an initial public
offering of 5,700,000 shares at an aggregate offering price for the Company of
$68,400,000. In addition, 3,500,000 shares were sold by certain selling
shareholders at an aggregate offering price of $42,000,000. Underwriting fees
associated with this offering aggregated $7,728,000. The principal
underwriters associated with this offering were NationsBank Montgomery
Securities LLC, BT Alex. Brown Incorporated and UBS Securities.
 
  The net proceeds to the Company of approximately $63,612,000 were first used
to pay the Shareholders Distribution amount (approximately $15.1 million at
December 31, 1997), and next to pay in full outstanding principal and interest
on the stockholders notes beneficially owned by Peter T. Paul and Jessica M.
Paul (approximately $10.6 million). The remaining net proceeds are expected to
be used as follows: 50% to support increased mortgage loan origination
capacity (including through geographic expansion), 45% to support
securitization transactions and 5% for
 
                                      30
<PAGE>
 
general corporate purposes. Pending their ultimate application, the net
proceeds from the offering will be used temporarily to pay down outstanding
balances under the Company's warehouse credit facilities or to invest in
short-term, investment-grade, interest-bearing securities and deposit
accounts.
 
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
 
  The following selected consolidated financial data for the years ended
December 31, 1993 through 1997 are derived from the Company's audited
financial statements. The data set forth below should be read in conjunction
with the consolidated financial statements of the Company and the notes
thereto and "Management's Discussion and Analysis of Financial Condition and
Results of Operations" appearing elsewhere herein.
 
<TABLE>
<CAPTION>
                                         YEAR ENDED DECEMBER 31,
                          ----------------------------------------------------------
                             1993        1994        1995        1996        1997
                          ----------  ----------  ----------  ----------  ----------
                              (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S>                       <C>         <C>         <C>         <C>         <C>
INCOME STATEMENT DATA:
Revenues:
 Net gain on sales of
  mortgage loans........  $   26,163  $    6,131  $   12,307  $   25,599  $   53,342
 Loan administration in-
  come..................       8,027      14,737      13,427      11,120      10,078
 Gain from sale of mort-
  gage servicing
  rights................      11,438       7,449       8,836      11,083       9,420
 Production income......      14,107       6,044       3,832       5,830       9,398
 Net interest income....       1,797       2,709       1,814       5,624      12,524
 Net unrealized gain in
  valuation of retained
  interests in
  securitizations.......         --          --          --          --          668
                          ----------  ----------  ----------  ----------  ----------
 Total revenues.........      61,532      37,070      40,216      59,256      95,430
Operating Expenses:
 Personnel..............      20,363      19,610      15,515      20,545      29,835
 General and administra-
  tive..................      11,220      10,584      10,900      13,458      16,039
 Depreciation and amor-
  tization..............       1,373       2,965       3,484       2,919       2,818
 Amortization and im-
  pairment of OMSR......         --          --          958       2,093       5,813
 Occupancy and rents....       3,341       2,591       2,136       1,941       2,303
                          ----------  ----------  ----------  ----------  ----------
 Total operating ex-
  penses................      36,297      35,750      32,993      40,956      56,808
                          ----------  ----------  ----------  ----------  ----------
 Income before taxes....      25,235       1,320       7,223      18,300      38,622
 Net income.............  $   24,667  $    1,270  $    6,971  $   17,660  $   37,268
                          ==========  ==========  ==========  ==========  ==========
Pro Forma Information:
 Income before taxes....  $   25,235  $    1,320  $    7,223  $   18,300  $   38,622
 Pro forma income tax-
  es(1).................      10,599         541       3,034       7,686      16,221
 Pro forma net in-
  come(1)...............      14,636         779       4,189      10,614      22,401
 Pro forma earnings per
  share-basic(1)(2).....                                                  $     1.47
 Pro forma weighted av-
  erage number of shares
  outstanding-ba-
  sic(1)(2).............                                                      15,258
 Pro forma earnings per
  share-diluted(1)(2)...                                                  $     1.46
 Pro forma weighted av-
  erage number of
  shares-diluted(1)(2)..                                                      15,358
 Supplemental pro forma
  earnings per share-ba-
  sic(1)(2)(3)..........                                                  $     1.42
 Supplemental pro forma
  weighted average
  number of shares
  outstanding-
  basic(1)(2)(3)........                                                      16,133
 Supplemental pro forma
  earnings per share-di-
  luted(1)(2)(3)........                                                  $     1.41
 Supplemental pro forma
  weighted average num-
  ber of shares out-
  standing-
  diluted(1)(2)(3)......                                                      16,233
OPERATING DATA:
Loan Origination Volume
 (in thousands):
 Agency.................  $2,317,692  $  643,770  $  562,778  $  885,050  $  689,650
 Non-agency.............   2,310,237   1,736,830     695,253   1,137,572   2,484,650
 Home equity loans......         970      12,110      72,580     234,308     551,415
 Other..................         --       17,690      24,993      26,910      30,487
                          ----------  ----------  ----------  ----------  ----------
 Total..................  $4,628,899  $2,410,400  $1,355,604  $2,283,840  $3,756,202
                          ==========  ==========  ==========  ==========  ==========
Loan Origination Volume
 (in units):
 Agency.................      17,432       4,978       4,546       7,093       5,445
 Non-agency.............       8,608       8,212       4,380       6,068      13,400
 Home equity loans......          17         262       1,767       5,482      11,714
 Other..................         --          137         214         250         261
                          ----------  ----------  ----------  ----------  ----------
 Total..................      26,057      13,589      10,907      18,893      30,820
                          ==========  ==========  ==========  ==========  ==========
Loan Servicing Portfolio
 (at end of period)(3)..  $4,283,168  $4,779,411  $4,149,305  $4,386,814  $4,527,072
 Weighted average inter-
  est rate..............        6.94%       7.10%       7.80%       8.10%       8.44%
 Weighted average matu-
  rity (months).........         301         299         284         278         279
 Weighted average serv-
  ice fee rate..........        0.26%       0.31%       0.29%       0.29%       0.27%
 Total delinquencies in-
  cluding foreclo-
  sures(4)..............        1.73%       1.81%       1.96%       2.10%       1.91%
 Average mortgage loan
  size..................  $      162  $      164  $      152  $      128         108
</TABLE>
 
                                      31
<PAGE>
 
<TABLE>
<CAPTION>
                                             YEAR ENDED DECEMBER 31,
                                   -------------------------------------------
                                     1993    1994     1995     1996     1997
                                   -------- ------- -------- -------- --------
                                             (DOLLARS IN THOUSANDS)
<S>                                <C>      <C>     <C>      <C>      <C>
BALANCE SHEET DATA (AT END OF
 PERIOD):
Retained interests in
 securitizations.................. $    --  $   768 $    585 $ 15,128 $ 35,120
Mortgage loans held for sale,
 pledged..........................  321,536  74,623   97,088  238,172  651,080
Originated mortgage servicing
 rights, net(6)...................      --      --     7,083   20,276   26,127
Total assets......................  349,198  98,730  147,432  288,990  740,373
Warehouse and other operating
 debt.............................  307,566  76,278   91,234  241,343  636,416
Notes payable to stockholders.....      --      --       --     9,670    9,670
Total liabilities.................  322,297  79,827  121,558  259,846  673,841
Total stockholders' equity........   26,901  18,904   25,874   29,144   66,531
</TABLE>
--------
(1) Prior to the closing of the Company's Initial Public Offering, the Company
    was treated as an S corporation for federal and state income tax purposes.
    The pro forma presentation reflects the provision for income taxes as if
    the Company had always been fully subject to federal and state taxes as a
    C corporation at the tax rates effective for the periods presented (41%
    for 1992 and 1994; 42% for 1993 and 1995 through 1997).
(2) Pro forma net income per share has been computed by dividing pro forma net
    income by the pro forma weighted average number of shares outstanding. The
    pro forma weighted average number of shares includes all options issued
    below the initial public offering price within one year prior to the
    filing of the Registration Statement for the initial public offering and
    is calculated using the treasury stock method in accordance with SFAS No.
    128. The pro forma weighted average number of shares also includes the
    effect of the assumed issuance of 1,258,334 shares of Common Stock to
    generate sufficient cash to pay the Shareholders Distribution Amount of
    $15.1 million at December 31, 1997. The issuance of Common Stock was based
    on the $12.00 Initial Public Offering price. Historical earnings per share
    is not presented because it is not indicative of the ongoing entity.
(3) Supplemental pro forma net income per share reflects further adjustment
    for the effect of the add back, net of tax, of interest expense recorded
    since July 1996, the inception of the notes, to be repaid from the
    proceeds of the Initial Public Offering. In that calculation, weighted
    average shares outstanding include the effect of the assumed issuance of
    875,000 shares of Common Stock in July 1996 to retire the notes payable to
    stockholders and related accrued and unpaid interest ($10.5 million at
    December 31, 1997).
(4) The Company's mortgage loan servicing portfolio 1993 was subserviced for
    the Company by another servicing entity during 1993. See "Certain
    Relationships and Related Transactions--Notes Payable to Stockholders."
(5) Represents the mortgage loan balances past due 30 days or more (including
    those in foreclosure) as a percentage of the total mortgage loan servicing
    portfolio.
(6) At December 31, 1997, the Company's mortgage loan servicing portfolio
    totaled $4.5 billion of mortgage loans, including $1.8 billion for which
    no capitalized balance sheet value has been recorded.
 
                                      32
<PAGE>
 
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
       RESULTS OF OPERATIONS
 
OVERVIEW
 
  The Company is primarily engaged in the origination, purchase, sale,
securitization and servicing of mortgage loans secured by one- to four-family
residential units. The Company's total income represents revenues derived from
net gain from sales of mortgage loans, loan administration income, gain from
sales of mortgage servicing rights, production income, net interest income and
net unrealized gains in valuation of retained interests in securitizations.
The net gain from sales of mortgage loans consists of two components: (i) gain
on sale of mortgage loans sold through securitizations, which is recognized
based on the sum of the selling price of the portion sold and the value of the
portion retained less the carrying value of the mortgage loans sold; and (ii)
net gain on mortgage loans sold through whole loan transactions, which is
recognized based upon the difference between the selling price and the
carrying value of the mortgage loans sold. If a whole loan is sold servicing
released, the servicing release premium is included in the net gain on the
sale of the mortgage loan. Loan administration income includes fees earned as
servicer for mortgage loans owned by investors, net of fees paid to the
subservicer. The Company recognizes gain on the sale of mortgage servicing
rights which are sold separately from the mortgage loans, based upon the
difference between the selling price, net of selling expenses, and the
carrying value of the mortgage loan servicing rights. Production income
includes fees paid to the Company by borrowers for the preparation,
documentation and underwriting of mortgage loans. Net interest income consists
of the net spread between interest received by the Company on its mortgage
loans held for sale and interest paid by the Company under its credit
facilities. It also includes interest earned on retained interests in
securitizations net of interest expenses for the related investment financing.
 
  Prior to July 1, 1993, the Company's originated mortgage loans were arranged
through its Mortgage Sources and funded by, and in the name of, First
California Mortgage Company ("FCMC"), a related party of the Company. On July
1, 1993, the Company began originating mortgage loans in its own name as an
authorized seller/servicer with FCMC acting as subservicer for the Company
with respect to newly originated mortgage loans. By February 1994, the
Company's Servicing Center became operational, and all of the servicing
functions were transferred from FCMC to the Servicing Center by June 30, 1994.
See "Certain Relationships and Related Transactions--Notes Payable to
Stockholders."
 
  As of the date of this Report, the Company had 10 wholesale branches and a
                                                 --
network of approximately 5,000 mortgage brokers. In addition, the Company
                         -----
initiated its correspondent and retail lending divisions in 1994 to access new
mortgage loan origination markets. These strategies were designed to expand
and diversify the Company's mortgage loan origination network and decrease the
Company's reliance on the California real estate market.
 
  The Company has experienced significant growth in the last few years,
particularly since April 1, 1995. Management believes that this growth is
primarily attributable to (i) its changing mortgage loan product mix, (ii) the
Company's geographic expansion, (iii) the Company's further penetration into
its established markets, and (iv) the Company's increased access to additional
funding sources which has enabled the Company to accumulate larger pools of
mortgage loans for sales through securitizations.
 
  In connection with its growth, the Company has continued to focus its
resources on developing mortgage loan production from borrowers, brokers and
correspondents by designing mortgage loan products to meet the evolving needs
of these customers. Any future growth will be limited by, among other things,
the Company's need for continued funding sources, access to capital markets,
sensitivity to economic slowdowns, ability to attract and retain qualified
personnel, fluctuations in interest rates and competition from other mortgage
lenders and from new market entrants.
 
  The Company's primary source of mortgage loan servicing rights is from
mortgage loans originated or acquired and sold by the Company. Of the
Company's $4.5 billion of mortgage loans serviced at December 31, 1997, $3.8
billion were serviced for others and $0.7 billion were mortgage loans held for
sale by the Company.
 
                                      33
<PAGE>
 
Of the mortgage loans serviced for others, approximately $1.4 billion were
mortgage loans serviced for Fannie Mae or Freddie Mac, $2.1 billion were
mortgage loans included in securities created by the Company, and $0.3 billion
were mortgage loans serviced for private investors. Of the total mortgage
loans serviced for others (excluding mortgage loans held for sale or
investment) at December 31, 1997 and 1996, respectively, 1.7% and 1.5% were 30
days or more delinquent. As of December 31, 1997 and 1996, the Company had not
purchased mortgage loan servicing rights.
 
TERMINATION OF S CORPORATION STATUS AND INCOME TAXES
 
  On January 31, 1998, the Company's status as an S corporation terminated. In
connection with the termination of the Company's S corporation status, the
Company will distribute the Shareholders Distribution Amount. The Shareholders
Distribution Amount would have been $15.1 million calculated as of
December 31, 1997.
 
  As an S corporation, the Company's income, whether or not distributed, was
taxed at the shareholder level for federal and state tax purposes. Upon
termination of its S corporation status, the Company became fully subject to
federal and state income taxes and recorded a deferred tax liability on its
balance sheet. The amount of the deferred tax liability recorded as of the
date of termination of the S corporation status depends upon timing
differences between tax and book accounting relating principally to
recognition of gains on sale of mortgage loans. If the S corporation status
had been terminated as of December 31, 1997, the amount of the deferred tax
liability recognized would have been approximately $20.3 million. The pro
forma provision for income taxes in the selected consolidated financial data
shows results as if the Company had always been fully subject to federal and
state taxes at the tax rates effective for the periods presented.
 
RESULTS OF OPERATION
 
Year Ended December 31, 1997 Compared to Year Ended December 31, 1996
 
  Summary. The financial results for the year ended December 31, 1997 reflect
not only the growth in the Company's mortgage loan originations, but also its
ability to successfully securitize and market the mortgage loans in the
capital markets. Refinancing activity accounted for approximately 55% and 56%
of the mortgage loans originated by the Company during the years ended
December 31, 1997 and 1996, respectively.
 
  Net income for the year ended December 31, 1997 increased $19.6 million, or
111% to $37.3 million compared to $17.7 million for the same period in the
prior year. The percentage increase in net income was higher than the
percentage increase in revenue due to a relatively lower increase in operating
expenses for the year ended December 31, 1997 from the year ended December 31,
1996.
 
  Revenue. Revenue for the year ended December 31, 1997 increased $36.1
million, or 61%, to $95.4 million as compared to $59.3 million for the year
ended December 31, 1996.
 
  Net gain from sales of mortgage loans increased $27.7 million, or 108%, to
$53.3 million for the year ended December 31, 1997 compared to $25.6 million
for the previous year. The increase was the result of increased mortgage loan
originations and purchases as well as the corresponding increase in mortgage
loans sold through securitizations and on a whole loan basis. During the year
ended December 31, 1997, mortgage loan originations increased $1,472.4
million, or 64%, to $3,756.2 million compared to $2,283.8 million in 1996.
Mortgage loans either sold or securitized during the year ended December 31,
1997 increased $1,161.6 million, or 55%, to $3,291.7 million from
$2,130.1 million during 1996, with a weighted average net gain on sale as a
percentage of mortgage loans sold or securitized of 1.6% and 1.2%,
respectively. The increase in net gain on sale percentage is primarily due to
the Company's ability to obtain improved pricing by securitizing pools of
mortgage loans. The Company retains 100% of the servicing rights on mortgage
loans it sells through securitizations.
 
 
                                      34
<PAGE>
 
  Loan administration income decreased $1.0 million, or 9%, to $10.1 million
for the year ended December 31, 1997 from $11.1 million for the year ended
December 31, 1996. The decrease was due primarily to a 5% decrease in the
average monthly balance outstanding in the mortgage loan servicing portfolio
from $4.0 billion to $3.8 billion. The decrease in the average mortgage loan
servicing portfolio is primarily due to an increase of mortgage loan servicing
rights sold during the year ended December 31, 1997, compared to the year
ended December 31, 1996. Even though the average mortgage loan servicing
portfolio decreased, the outstanding mortgage loan servicing portfolio
increased to $4.5 billion at December 31, 1997 from $4.4 billion at December
31, 1996.
 
  The Company sold mortgage servicing rights relating to $2.0 billion and $1.0
billion of mortgage loan principal balances during the years ended December
31, 1997 and 1996, respectively, resulting in a pre-tax gain of $9.4 million
and $11.0 million, respectively. These gains represent a 47 basis point and
110 basis point gain based on the outstanding principal balance of the
underlying mortgage loans for the year ended December 31, 1997 and 1996,
respectively. The decrease in gain is due to a lower book value related to the
mortgage servicing rights sold in the prior period, as well as a decrease in
the weighted average sales price to 1.13% for the year ended December 31, 1997
from 1.23% for the year ended December 31, 1996. In general, the decision to
sell, buy or retain mortgage servicing rights is based upon the market for and
value of mortgage servicing rights, the Company's current financial needs and
objectives, including, among other things, its cash and/or capital
requirements and its debt-to-equity and other financial ratios. The Company's
ability to sell its mortgage servicing rights under its various mortgage loan
servicing agreements with investors is generally subject to the consent of the
investors. In addition, under the mortgage loan servicing provisions governing
the Company's securitizations, the successor servicer is subject to prior
approval of the rating agencies rating the subject securities.
 
  Production income increased $3.6 million, or 62%, to $9.4 million for the
year ended December 31, 1997 from $5.8 million for the year ended December 31,
1996. The increase is due primarily to the 64% growth in mortgage loan
originations and purchases.
 
  Net interest income increased $6.9 million, or 123%, to $12.5 million during
the year ended December 31, 1997 from $5.6 million during 1996. The increase
in net interest income was due to several factors: (i) a higher average
balance of mortgage loans held for sale during the year ended December 31,
1997 than 1996; (ii) earnings on subordinate certificates retained by the
Company relating to securitizations; and (iii) the Company's ability to obtain
a wider spread between mortgage coupons and borrowing rates primarily relating
to home equity lines of credit. These increases are offset by an additional
expense of $0.6 million during the year ended December 31, 1997 relating to
interest on the stockholders note payable of $9.7 million.
 
  Net unrealized gain in valuation of retained interests in securitizations
was $0.7 million for the year ended December 31, 1997. This gain was the
result of an increase in the market value of retained interests in
securitizations from December 31, 1996 to December 31, 1997.
 
  Expenses. Operating expenses increased $15.8 million, or 39%, to $56.8
million during the year ended December 31, 1997 from $41.0 million for 1996.
The increase in expense was primarily the result of additional personnel
required for the greater volume of mortgage loan originations, higher
operating expenses related to the increase in mortgage loan originations and
an increase in amortization and impairment of originated mortgage servicing
rights relating to the increase in the capitalized asset during the year ended
December 31, 1997 as compared to the year ended December 31, 1996.
 
  Personnel expense increased $9.3 million or 45% to $29.8 million during the
year ended December 31, 1997 from $20.5 million for 1996. The increase in
personnel expense was due primarily to increased staffing in the Company's
mortgage loan originations area. As of December 31, 1997, the Company employed
689 people compared to 512 people at December 31, 1996, a 35% increase.
 
                                      35
<PAGE>
 
  General and administrative expenses increased $2.5 million, or 19%, to $16.0
million during the year ended December 31, 1997 from $13.5 million for in
1996. The increase in general and administrative expenses is due primarily to
expenses incurred in connection with the increase in loan originations, and
includes such items as office supplies, telephone, computers and postage.
 
  Amortization and impairment of originated mortgage loan servicing rights
increased $3.7 million, or 176%, to $5.8 million for the year ended December
31, 1997, as compared to $2.1 million for the year ended December 31, 1996.
The increase in amortization and impairment of originated mortgage loan
servicing rights was due to an increase in the related asset.
 
 Year Ended December 31, 1996 Compared to Year Ended December 31, 1995
 
  Summary. The financial results for the year ended December 31, 1996
principally reflect the growth in the Company's mortgage loan originations.
The total volume of mortgage loans originated increased $0.9 billion or 64% to
$2.3 billion for 1996 compared to $1.4 billion in 1995. This increase reflects
both the expansion of the Company's mortgage loan origination network and the
market for its specialized mortgage loan products. During 1996, refinancing
activity accounted for approximately 56% of the mortgage loans originated by
the Company compared to approximately 55% during 1995.
 
  Net income for the year ended December 31, 1996 increased $10.7 million, or
153%, to $17.7 million as compared to $7.0 million for the prior year. The
percentage increase in net income was higher than the percentage increase in
revenue due to a relatively lower increase in operating expenses from 1995 to
1996.
 
  Revenue. Revenue for the year ended December 31, 1996 increased $19.1
million, or 48%, to $59.3 million as compared to $40.2 million for the same
period in 1995.
 
  Net gain from sales of mortgage loans increased $13.3 million or 108% to
$25.6 million for the year ended December 31, 1996 as compared to $12.3
million for the previous year. The increase was attributable to the following
factors: (i) an increase in the volume of mortgage loans sold of $0.8 million
or 62% to $2.1 million, as compared to mortgage loans sold of $1.3 million
during 1995; and (ii) the Company's ability to obtain improved pricing by
securitizing pools of mortgage loans as compared to whole loan sales.
 
  Loan administration income for the year ended December 31, 1996 decreased
$2.3 million or 17% to $11.1 million as compared to $13.4 million for the
previous year. The change resulted from a 12% decrease in the average balance
outstanding in the mortgage loan servicing portfolio for the year ended
December 31, 1996 from the year ended December 31, 1995, and a decrease in the
average principal balance per loan during the same period. See "Business--
Mortgage Loan Servicing."
 
  The Company sold mortgage servicing rights relating to $1.0 billion of
mortgage loan balances during 1996, resulting in a pre-tax gain of $11.1
million. The Company sold mortgage loan servicing rights relating to $0.9
billion of mortgage loan principal balances in the previous year, resulting in
a pre-tax gain of $8.8 million.
 
  Production income increased $2.0 million or 53% to $5.8 million for the year
ended December 31, 1996 from $3.8 million for the previous year, due to the
growth in mortgage loan origination volume.
 
  Net interest income increased $3.8 million or 211% to $5.6 million for the
year ended December 31, 1996 from $1.8 million in the prior year. This
increase is primarily attributable to the increase in average mortgage loans
outstanding, as well as improved borrowing rates obtained by the Company.
 
  Expenses. Operating expenses increased $8.0 million or 24% to $41.0 million
for the year ended December 31, 1996 from $33.0 million in 1995. This increase
resulted from growth in the Company's base operations primarily in personnel,
and from costs incurred by the Company for the negotiation and resolution of
all prior business activity with affiliates (the "Settlement Agreement"). See
"Certain Relationships and Related Transactions--Notes Payable to
Stockholders."
 
                                      36
<PAGE>
 
  Personnel expenses increased $5.0 million or 32% to $20.5 million for the
year ended December 31, 1996 as compared to $15.5 million in 1995. This
increase was attributable to a 27% increase in the number of employees to 512
at December 31, 1996 from 403 at the end of 1995. This increase was primarily
necessary to support the growth in the Company's mortgage loan origination
sale and servicing businesses.
 
  General and administrative expense increased $2.6 million or 24% to $13.5
million for 1996, as compared to $10.9 million for 1995. The increase was
primarily the result of the increase in mortgage loan originations and costs
relating to the Settlement Agreement between the Company and its affiliates,
including telephone, legal, computer services and miscellaneous expenses.
 
  Occupancy expense decreased $0.2 million or 10% to $1.9 million for the year
ended December 31, 1996 as compared to $2.1 million for 1995. This decrease is
the result of costs incurred during 1995 related to branches which were closed
in 1994.
 
  Depreciation and amortization expense decreased $0.6 million or 17% to $2.9
million for the year ended December 31, 1996 as compared to $3.5 million for
the same period in 1995. This decrease resulted from a 21% decrease in
property, equipment and leasehold improvements.
 
FINANCIAL POSITION
 
 December 31, 1997 Compared to December 31, 1996
 
  The balance of mortgage loans held for sale is affected by the timing of
securitizations and whole loan sales. Mortgage loans held for sale increased
$412.8 million, or 173%, to $651.0 million at December 31, 1997 from
$238.2 million at December 31, 1996. The increase in mortgage loans held for
sale resulted primarily from mortgage loan originations and purchases of
$3,756.2 million during the year ended December 31, 1997, partially offset by
sales into securities of $1,751.8 million, whole loan sales of $1,539.9
million and unused HELOC credit line capacity of $33.1 million.
 
  Borrowings under warehouse lines of credit increased $395.1 million, or
164%, to $636.4 million at December 31, 1997 from $241.3 million at December
31, 1996, reflecting the mortgage loan origination, purchase and sale activity
described above. The percentage increase in the borrowings under warehouse
lines of credit was less than the percentage increase in the mortgage loans
held for sale due to a combination of the Company's investment in the mortgage
loans held for sale and the repayment of the $12.0 million balance outstanding
under the servicing secured line of credit during the year ended December 31,
1997.
 
  Retained interests in securitizations increased $20.0 million, or 132%, to
$35.1 million at December 31, 1997 from $15.1 million at December 31, 1996.
The increase is due to six factors: (i) the Company retained subordinate
tranches in the seven securitizations it effected during 1997 with an
estimated market value of $23.6 million; (ii) the transferor interest in the
asset-backed securitization effected by the Company in December 1996 increased
by $1.9 million in the form of overcollateralization created as a result of
the excess cash flows of the security; (iii) the Company recorded an
unrealized gain of $0.7 million in the aggregate market value relating to the
retained interests it holds; (iv) the Company's reduction in its non-
subordinated net interest in an asset-backed security of $0.9 million; (v) the
sale of certain retained interests with a net book value at sale of $4.7
million; and (vi) principal payments received of $0.6 million.
 
  Accounts receivable increased $5.6 million, or 74%, to $13.2 million at
December 31, 1997 from $7.6 million at December 31, 1996. The increase
resulted primarily from an increase in servicing advances of $1.6 million or
35%, an increase in accrued interest receivable of $1.5 million or 136%, and
an increase of servicing sale proceeds receivable of $1.7 million. The
increase in servicing advances was due to a decrease in borrowers who made
monthly payments in advance, which offset the borrowers with delinquent
payments, as well as servicing advances required at the close of the Company's
HELOC security during the year ended December 31, 1997. The increase in
accrued interest receivable was primarily due to the increase in mortgage
loans held for sale. The increase in servicing sale proceeds
 
                                      37
<PAGE>
 
receivable was due to the timing of payments received on bulk servicing sales
in the last two quarters of 1997, compared to no servicing sales in the last
two quarters of 1996.
 
  Accounts payable increased $13.2 million or 300% to $17.6 million at
December 31, 1997 from $4.4 million at December 31, 1996. The increase
resulted primarily from capital leases entered into by the Company relating to
fixed asset purchases of $5.5 million, and an increase in interest payable on
warehouse lines of $1.5 million. Accounts payable also increased due to $0.6
million in interest owed on the subordinated debt, a $0.8 million increase of
unpaid expenses related to the bulk servicing sales as well as a general
increase due to the Company's increased mortgage loan production.
 
  Originated mortgage servicing rights increased $5.8 million, or 29%, to
$26.1 million at December 31, 1997 from $20.3 million at December 31, 1996.
The increase in originated mortgage servicing rights resulted from the sale of
mortgage loans with servicing rights retained with a relative fair value of
$23.0 million during the year ended December 31, 1997, partially offset by
amortization and impairment recorded of $5.8 million and capitalized servicing
sold with a net book value of $11.3 million.
 
  Property, equipment and leasehold improvements, net, increased $4.7 million,
or 157%, to $7.7 million at December 31, 1997 from $3.0 million at December
31, 1996. As a result of the Company's ongoing commitment to modern
technology, this growth reflects the purchase of upgraded computer equipment
of $5.5 million, upgraded office equipment of $1.8 million and additional
furniture of $0.2 million. These increases were offset by depreciation and
amortization of $2.8 million.
 
  Accrued liabilities increased $5.8 million, or 132%, to $10.2 million at
December 31, 1997 from $4.4 million at December 31, 1996. The increase was
primarily due to the following factors: (i) deferred revenue was recorded by
the Company in the amount of $2.6 million in connection with the building of
the asset-backed security's overcollateralization as described above; (ii) the
contingency reserve increased $1.4 million as a result of the Company
recording a provision for contingencies of $3.6 million and sustaining actual
losses of $2.2 million; and (iii) miscellaneous accrued liabilities increased
$1.8 million.
 
  Stockholders' equity increased $37.4 million, or 129%, to $66.5 million at
December 31, 1997 from $29.1 million at December 31, 1996, due to net income
for the year ended December 31, 1997 of $37.3 million, and additional paid in
capital relating to stock options granted of $0.1 million.
 
LIQUIDITY AND CAPITAL RESOURCES
 
  The Company's principal liquidity requirements include the funding or
payment of: (i) mortgage loan originations and purchases; (ii) investments and
overcollateralization requirements in connection with its securitization
program; (iii) fees and expenses incurred in connection with securitizations;
(iv) advances of delinquent principal and interest payments and escrow
balances required to be made as a mortgage loan servicer; and (v) ongoing
administrative and other operating expenses.
 
  The Company must be able to sell mortgage loans and obtain adequate credit
facilities and other sources of funding in order to continue to originate and
purchase mortgage loans. As a result of increased loan originations and
purchases as well as an increase in its securitization program, the Company
during 1995, 1996, and 1997, used cash of approximately $12.0 million, $147.0
million, and $386.7 million, respectively.
 
  The Company utilizes short-term warehouse facilities and repurchase
agreements to fund mortgage loan originations and purchases. Increased loan
production resulted in cash provided by financing activities of $40.0 million,
$120.4 million, and $395.2 million during 1995, 1996, and 1997, respectively.
 
  In October 1993, the Company entered into a mortgage loan warehousing
agreement (the "Warehouse Facility"). Under the terms of the Warehouse
Facility, the Company has available a $230 million warehouse line of credit
secured by the mortgage loans the Company originates or purchases. The
facility extends through November 4, 1999. The Company is required to comply
with various operating and financial covenants in the
 
                                      38
<PAGE>
 
Warehouse Facility. Such covenants include restrictions on (i) changes in the
Company's business that would materially and adversely affect the Company's
ability to perform its obligations under the facility, (ii) selling any asset
other than in the ordinary course of business, and (iii) maximum debt and
distributions allowed. Such covenants also contain requirements for
(i) minimum net worth and mortgage loan servicing portfolio balances, and (ii)
maximum leverage ratios. The Company's Warehouse Facility also restricts the
Company's ability to pay dividends. At December 31, 1997, the outstanding
balance under the Warehouse Facility was $195.7 million.
 
  In addition to the Warehouse Facility, the Company makes regular use of
certain uncommitted lines of credit, short-term credit facilities and purchase
and sale agreements (such as repurchase or "gestation" agreements) provided by
major investment banks and a major corporation. These facilities permit the
Company to diversify its borrowing resources, while accelerating the turnover
of mortgage loans in inventory, reducing interest costs and permitting greater
origination volumes.
 
  The Company currently has three uncommitted whole loan repurchase agreements
with major investment banks. Under the terms of these agreements, the Company
may pledge mortgage loans originated or purchased to obtain additional
liquidity while mortgage loans are held until securitization or are sold
through whole loan sales. Amounts outstanding under these agreements at
December 31, 1997 were $174.5 million, $238.6 million, and $21.3 million.
 
  In addition, the Company has entered into an uncommitted mortgage loan
purchase and sale agreement with a major investment bank. Under the terms of
this agreement, mortgage loans which are subject to a "take-out" commitment
between the Company and an investor, but have not yet been purchased, may be
sold to the investment bank with the accompanying trade assignment. This
allows the Company to accelerate turnover and provide additional liquidity to
fund additional mortgage loans.
 
  The last of the Company's warehousing facilities is a $15.0 million
warehouse line of credit with a major corporation. This agreement expires on
October 31, 1998. At December 31, 1997, the Company had $1.5 million
outstanding under this facility.
 
  In addition to these financing sources, the Company also has various
repurchase agreements with major investment banks which are collateralized by
certificates reflecting retained interests in securitizations effected by the
Company. At December 31, 1997, the Company had $4.8 million outstanding under
these agreements.
 
  The Company used cash of $0.9 million, $2.1 million, and $7.5 million for
the purchase of property, equipment and leasehold improvements during 1995,
1996, and 1997, respectively. The increase during 1997 represents upgrades to
computer equipment, office equipment and the purchase of additional furniture.
The Company has entered into various capital leases to fund a substantial
amount of these purchases.
 
  The Company also has a $3.0 million operating line of credit from a group of
commercial banks who are also lenders in the Warehouse Facility. This
operating line of credit is secured by certain servicing contracts of the
Company and is limited by the amount of servicing pledged as security. This
operating line of credit, which has a conversion option to a term loan, is
renewable from time to time and expires on November 4, 1998. At December 31,
1997, the Company had no outstanding balance under this line of credit.
 
  The Company is required to comply with various operating and financial
covenants as provided in the agreements as described above, the most
restrictive of which are those relating to the Warehouse Facility as described
above.
 
  The Company relies on securitizations and whole loan sales to generate cash
proceeds for repayment of its warehouse facilities and to create availability
to purchase additional mortgage loans. Further, gains on sales from the
Company's securitizations represent a significant portion of the Company's
revenue. Several factors affect the Company's ability to complete
securitizations of its mortgage loans, including conditions in the securities
markets generally, conditions in the asset-backed securities market
specifically, and the credit quality of the
 
                                      39
<PAGE>
 
Company's portfolio of mortgage loans. If the Company were unable to
securitize profitably a sufficient number of its mortgage loans in a
particular reporting period, then the Company's revenues for such period would
decline which could result in lower income or a loss for such period. In
addition, unanticipated delays in closing a securitization could also increase
the Company's interest rate risk by increasing the warehousing period for its
mortgage loans.
 
  The Company endeavors to effect timely and consistent public securitizations
of its mortgage loan pools. However, market and other considerations affect
the timing of such transactions. Any delay in the sale of a pool of mortgage
loans beyond a quarter-end would postpone the recognition of gain related to
such mortgage loans and would likely result in lower income or a loss for such
quarter being reported by the Company.
 
  The Company believes that the Company's current warehousing and other credit
facilities will adequately fund the Company's mortgage banking operations. The
liquidity needs of the Company arise in operating its mortgage banking
operations, not only to meet operating expenses but also for its contractual
obligation as a mortgage servicer. As a mortgage servicer, the Company is
required to make advances to investors when a borrower is delinquent in
meeting its payment obligations under a particular mortgage loan. Although
most of these advances are recaptured either when the borrower becomes current
or through a foreclosure proceeding, the uncertainty as to when an advance
will be necessary requires the Company to maintain adequate liquidity.
 
  There can be no assurance that the Company will be able to obtain financing
on a favorable or timely basis. The type, timing and terms of financing
selected by the Company will depend on its cash needs, the availability of
other financing sources and the prevailing conditions in the financial
markets.
 
CERTAIN ACCOUNTING CONSIDERATIONS
 
 Retained Interests in Securitizations
 
  The Company derives a substantial portion of its income by recognizing gain
on sale of mortgage loans sold through securitizations, which is partially
represented by the subordinate certificates and interest-only residual
interests that the Company retains. In the non-agency securitizations, the
Company sells mortgage loans that it has originated or purchased to a trust
for a cash purchase price and the subordinate certificates. The cash purchase
price is raised through an offering by the trust of pass-through certificates
representing senior interests in the trust. Following the securitizations, the
purchasers of the pass-through certificates receive their respective
allocations of the principal collected and the investor pass-through interest
rate on the principal balance.
 
  In home equity mortgage loan securitizations, the Company sells mortgage
loans that it has originated or purchased to a trust in return for a cash
purchase price and the interest-only residual interest. The Company also
retains a portion of the principal interest in the trust as a subordinate
credit enhancement for the senior certificate or note holders. The Company
receives its proportionate share of interest collected from borrowers relating
to the principal interest it retains, but receives principal distributions
only to the extent that the principal balance of the Company's interest
exceeds the minimum subordination requirements of the trust. In addition to
the distributions the Company receives relating to its principal interest, the
Company receives the excess of the interest rate payable by an obligor on a
mortgage loan over the interest rate passed through to the purchasers of the
notes or certificates with respect to the interest-only residual interests, as
well as the Company's normal servicing fee and other recurring fees.
 
  The subordinate and residual interests which are capitalized on the
Company's balance sheet are reduced as cash distributions are received. The
subordinate and interests-only residual interests are accounted for as trading
securities in accordance with SFAS 115, "Accounting for Certain Investments in
Debt and Equity Securities," and, as such, they are recorded at their fair
value. Changes in fair value are reflected in the statement of operations.
Fair value of the subordinate certificates is determined based on market
prices for similar securities, and the fair value of the interest-only
residual interests is determined based on various economic factors, including
considerations of mortgage loan type, size, date of origination, interest
rate, term, collateral value and
 
                                      40
<PAGE>
 
geographic location. Higher than anticipated rates of mortgage loan
prepayments or losses would require the Company to write down the fair value
of the interest-only residual interests, adversely impacting earnings.
Similarly, if delinquencies, or losses were greater than was initially
assumed, the fair value of the residual certificates would be negatively
impacted which would have an adverse effect on income for the period in which
such events occurred.
 
 SFAS No. 91
 
  In December 1986, the Financial Accounting Standards Board (the "FASB")
issued Statement of Financial Accounting Standards ("SFAS") No. 91,
"Accounting for Non-Refundable Fees and Costs Associated with Originating or
Acquiring Loans and Initial Direct Costs of Leases." SFAS No. 91 establishes
the accounting for nonrefundable fees and costs associated with lending,
committing to lend, or purchasing a loan or a group of loans.
 
  Under SFAS No. 91, direct loan origination costs, net of loan origination
fees, are recognized as a reduction of the loan's yield over the earlier of
the life of the related loan or the sale of the loan. In effect, SFAS No. 91
requires that origination fees be offset by their related direct loan costs
and that net deferred fees be recognized over the earlier of the life of the
loan or the sale of the loan, whether the loan is sold through securitization
or on a whole loan basis.
 
  Subsequent to the second quarter of 1996, the Company generally sold
mortgage loans through securitization on a bimonthly basis and, as such,
carried a larger inventory of mortgage loans on its books from quarter to
quarter and from year to year, which resulted in SFAS No. 91 adjustments being
made during those periods. The Company contemplates that in the future it will
sell substantially all of its mortgage loan originations and purchases on a
bimonthly basis primarily through securitizations and, to a lesser extent, on
a whole loan basis.
 
 SFAS No. 122
 
  In May 1995, the FASB issued SFAS No. 122, "Accounting for Mortgage
Servicing Rights," which amends SFAS No. 65 "Accounting for Certain Banking
Activities." Effective January 1, 1995, the Company adopted SFAS No. 122.
Because SFAS No. 122 prohibits retroactive application to years prior to
adoption thereof, the Company's historical financial results for periods prior
to 1995 have not been restated and, accordingly, are not directly comparable
to the financial results for 1995 and thereafter. Mortgage servicing rights
retained by the Company relating to loans originated prior to 1995 remain as
an "off-balance sheet" asset and the net income produced by this asset is
recognized over the life of the mortgage loans in the form of servicing income
or at the time the servicing rights are sold.
 
  SFAS No. 122 requires mortgage banking entities to recognize as a separate
asset the rights to service mortgage loans for others, regardless of how those
servicing rights are acquired. Mortgage banking entities that acquire or
originate mortgage loans and subsequently sell or securitize those mortgage
loans and retain the mortgage loan servicing rights are required to allocate
the total cost of the loans to the mortgage servicing rights and the mortgage
loans. The Company determines fair value based upon the present value of
estimated net future servicing revenues less the estimated cost to service
loans. The cost allocated to these servicing rights is amortized in proportion
to and over the period of estimated net future cash flows related to servicing
income. As a result of the adoption of SFAS No. 122, the Company recognizes
greater revenues at the time a mortgage loan is sold and smaller revenues
during the period such loan is serviced. To this end, adoption of SFAS No. 122
resulted in additional income recorded as net gain from sales of mortgage
loans of approximately $16.3 million and $8.0 million during the years ended
1996 and 1995, respectively. Additionally, as the amount of uncapitalized
mortgage servicing rights decreases, the Company's ability to obtain
significant gains from sales of mortgage servicing rights also decreases.
 
 
                                      41
<PAGE>
 
  SFAS No. 122 also requires impairment evaluations of all amounts capitalized
as servicing rights, based upon the fair value of the underlying mortgage loan
servicing rights. The Company periodically performs these evaluations on a
disaggregated basis for the predominant risk characteristics of the underlying
mortgage loans, including loan type and interest rate. Higher than anticipated
rates of loan prepayments or losses would require the Company to write down
the fair value of the mortgage loan servicing rights, adversely impacting
earnings.
 
  A key component of the Company's ongoing business strategy is the retention
of its originated servicing as financial and operational considerations allow.
The Company, however, may sell some of its servicing on a "bulk" or "flow"
basis to generate current earnings and cash flow, depending upon
circumstances. As a consequence, the Company's owned mortgage loan servicing
portfolio at December 31, 1997 consisted of servicing rights to mortgage loans
with an aggregate outstanding principal balance of $4.5 billion, including
$1.8 billion for which no capitalized balance sheet value has been recorded.
During 1996 and 1995, the Company sold mortgage loan servicing rights with
aggregate principal balances of $1.0 billion and $0.9 billion, respectively,
and for gains of 111 and 98 basis points, respectively. The prices at which
mortgage loan servicing rights may be sold vary over time according to
prevailing interest and prepayment rates among other factors. Accordingly,
there can be no assurance of a continued market for mortgage loan servicing
rights at prices received by the Company in the past. Moreover, mortgage loan
servicing rights sold by the Company have generally related to Agency mortgage
loans recently originated by the Company, and such servicing rights may,
during certain interest rate environments, have relatively higher market
values than non-agency or more seasoned mortgage loans in the Company's
mortgage loan servicing portfolio.
 
 SFAS No. 125
 
  In June 1996, the FASB issued SFAS No. 125, "Accounting for Transfers and
Servicing of Financial Assets and Extinguishment of Liabilities", which
superceded SFAS No. 122. SFAS No. 125 provides accounting and reporting
standards for transfers and servicing of financial assets and extinguishment
of liabilities. Those standards are based on consistent application of a
financial-components approach that focuses on control. Under that approach,
after a transfer of financial assets, an entity recognizes the financial and
servicing assets it controls and the liabilities it has incurred, derecognizes
financial assets when control has been surrendered, and derecognizes
liabilities when extinguished. SFAS No. 125 provides consistent standards for
distinguishing transfers of financial assets that are sales from transfers
that are secured borrowings.
 
  SFAS No. 125 requires that liabilities and derivatives incurred or obtained
by transferors as part of a transfer of financial assets be initially measured
at fair value, if practicable. It also requires that servicing assets and
other retained interest in the transferred assets be measured by allocating
the previous carrying amount between the assets sold, if any, and retained
interests, if any, based on their relative fair values at the date of the
transfer. SFAS No. 125 provides implementation guidance for assessing
isolation of transferred assets and for accounting for transfers of partial
interests, servicing of financial assets, securitizations, transfers of sales-
type and direct financing lease receivables, securities lending transactions,
repurchase agreements including "dollar rolls," "wash sales," loan
syndications and participations, risk participations in banker's acceptances,
factoring arrangements, transfers of receivables with recourse, and
extinguishment of liabilities. SFAS No. 125 is effective for transfers and
servicing of financial assets and extinguishment of liabilities occurring
after December 31, 1996, and is to be applied prospectively.
 
  In December 1996, the FASB issued SFAS No. 127, "Deferral of the Effective
Date of Certain Provisions of FASB Statement No. 125." The Statement defers
for one year the effective date of SFAS No. 125 relating to certain
transactions such as repurchase agreements and securities lending.
 
 Other Recent Accounting Pronouncements
 
  In February 1997, the FASB issued SFAS No. 128, "Earnings per Share." This
Statement specifies the computation, presentation, and disclosure requirements
for earnings per share for entities with publicly held common stock or
potential common stock. The Company adopted SFAS No. 128 as of December 31,
1997.
 
                                      42
<PAGE>
 
  In February 1997, the FASB issued SFAS No. 129, "Disclosure of Information
about Capital Structure." SFAS No. 129 became effective for financial
statements for both interim and annual periods ending after December 15, 1997.
The Company has complied with SFAS No. 129.
 
  In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income." This Statement establishes standards for reporting and display of
comprehensive income and its components (revenues, expenses, gains and losses)
in a full set of general-purpose financial statements. SFAS No. 130 shall be
effective for fiscal years beginning after December 15, 1997, and the Company
will comply with SFAS No. 130 beginning in 1998.
 
  In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information." SFAS No. 131 establishes standards for
the way that public business enterprises report information about operating
segments in annual financial statements and requires that enterprises report
selected information about operating segments in interim financial reports
issued to shareholders. SFAS No. 131 shall be effective for fiscal years
beginning after December 15, 1997, and the Company will comply with SFAS No.
131 beginning in 1998.
 
  In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits--an Amendment of FASB
Statements No. 87, 88, and 106". SFAS No. 132 revises employers' disclosures
about pension and other postretirement benefit plans. SFAS No. 132 shall be
effective for fiscal years beginning after December 15, 1997, and the Company
will comply with SFAS No. 131 beginning in 1998.
 
YEAR 2000
 
  During the year ended December 31, 1997, the Company addressed issues
related to required changes in computer systems for the year 2000. Issues
arise because some computer systems and related software have been designed to
recognize only dates that relate to the 20th century. Accordingly, if no
changes are implemented, these computer systems would interpret "1/1/00" as
January 1, 1900 instead of January 1, 2000. Additionally, some equipment,
being controlled by microprocessor chips, may not deal appropriately with a
year "00."
 
  Based on its current evaluation, the Company believes that, by December 31,
1998, substantially all issues related to Year 2000 will be addressed, either
by programming changes to the Company's custom software, by programming
changes implemented by third party vendors to purchased systems, or through
the upgrading or purchase of year 2000 compliant hardware and software.
Management believes there is no material risk that the Company will fail to
address year 2000 issues in a timely manner. It is currently expected that
costs related to Year 2000 will be immaterial.
 
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
 
  The financial statements of the Company and the related notes, together with
the Independent Auditor's Report thereon, are set forth on pages F-3 through
F-21 of this Form 10-K and incorporated herein by reference.
 
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
       FINANCIAL DISCLOSURE
 
  None.
 
 
                                      43
<PAGE>
 
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
 
  The directors and executive officers of the Company and their positions are
as follows:
 
<TABLE>
<CAPTION>
NAME                                                       POSITION
----                                                       --------
<S>                      <C>
Peter T. Paul........... President, Chief Executive Officer and Director
Becky S. Poisson........ Executive Vice President--Operations and Director
Gilbert J. MacQuarrie... Executive Vice President, Chief Financial Officer and Secretary and Director
Steven M. Abreu......... Executive Vice President, Production and Secondary Marketing and Director
</TABLE>
 
 Directors and Executive Officers
 
  Peter T. Paul, age 54, has been President, founder and major stockholder of
the Company since it began operations in 1986. He also holds the position of
Chief Executive Officer. Prior to founding the Company, he was Vice President
of United Century Mortgage in California and was responsible for wholesale
mortgage lending in several western states. From 1977 to 1980, Mr. Paul was
Executive Vice President and director of Lindsey & Co. in charge of all its
mortgage banking activities. Mr. Paul's substantial experience in the
secondary mortgage market includes positions in the Secondary Mortgage
Marketing Departments for Ticor and IMI, mortgage insurance companies, and as
a GNMA salesman for Weeden & Co. Mr. Paul received a B.A. degree in business
administration from the University of New Hampshire in 1967 and was awarded an
M.B.A. degree from Boston University in 1971. Mr. Paul has 25 years experience
in the mortgage banking industry and is a Director of the California Mortgage
Bankers Association.
 
  Becky S. Poisson, age 47, is Executive Vice President, Operations of the
Company and has served in such capacity since January of 1994. From 1992
through 1993, Ms. Poisson was Senior Vice President, Operations. She oversees
the day-to-day operations of the Company's underwriting, funding, branch
operations, mortgage loan delivery, information services, servicing and
Quality Assurance Department. Prior to joining the Company, Ms. Poisson was
Vice President of Operations at Bank of San Francisco. From 1988 to 1990, Ms.
Poisson was Vice President--Regional Underwriting Manager of Security Pacific
National Bank, and from 1986 to 1988 she was Vice President of Asset
Management of Unified Mortgage Company. From 1984 to 1986, Ms. Poisson was
Vice President of Loan Acquisitions/Sales for Farmers' Savings Bank, and from
1974 to 1984, Ms. Poisson was responsible for all closing operations for
Lindsey and Company, Inc. Ms. Poisson received a B.A. degree from the
University of Wisconsin in 1971. Ms. Poisson has 23 years experience in the
banking and mortgage banking industries.
 
  Gilbert J. MacQuarrie, age 43, is Executive Vice President, Chief Financial
Officer and Secretary of the Company and has served in such capacities since
1997. From 1994 to 1997, Mr. MacQuarrie served as Senior Vice President, Chief
Financial Officer and Secretary, and from 1987 to 1994 he served in both
capacities of Controller and Assistant Controller of the Company. As head of
the Company's Corporate Finance Group, Mr. MacQuarrie is responsible for
accounting, treasury, finance and human resources. Mr. MacQuarrie received a
B.A. degree from Sonoma State University and is a member of the American
Institute of Certified Public Accountants and the California Society of
Certified Public Accountants.
 
  Steven M. Abreu, age 33, is Executive Vice President, Production and
Secondary Marketing of the Company and has served in such capacity since 1997.
Mr. Abreu has been elected to serve as a director of the Company effective
upon the pricing of the Offering. Mr. Abreu served as Senior Vice President,
Production and Secondary Marketing since 1994 and 1996, respectively. He is
responsible for all of the Company's production offices, national expansion
and secondary marketing activities. Mr. Abreu served as Assistant Vice
President of Secondary Marketing from 1988 to 1992. Prior to rejoining
Headlands in 1994, Mr. Abreu was Vice President and Institutional Mortgage
Bond Salesman for Donaldson, Lufkin & Jenrette. Mr. Abreu has a B.S. degree
from the University of San Francisco.
 
 
                                      44
<PAGE>
 
 Additional Directors
 
  The Company elected three additional directors effective upon the pricing of
the Company's Initial Public Offering on February 4, 1998. Such directors are
"outside directors." An "outside director" is a director who is not (i) an
employee of the Company, (ii) a 5% stockholder of the Company, (iii) a
director, officer or general partner of a 5% stockholder of the Company, or
(iv) a director, officer or general partner of a general partner of a 5%
stockholder of the Company.
 
  Mark L. Korell, age 50, was elected to serve as a director of the Company
effective upon the pricing of the Company's Initial Public Offering. Mr.
Korell is president and chief executive officer of Industrywide Mortgage
Exchange ("IMX"), San Ramon, California, a recently formed software company
which facilitates mortgage loan sales between loan originators and mortgage
lenders. From 1995 to 1997, Mr. Korell served as group president and chief
executive officer of Norwest Mortgage, Inc., Des Moines, Iowa, a nationwide
mortgage lender and mortgage loan servicer. From 1993 to 1995, Mr. Korell
served as president and chief executive officer of GMAC Mortgage Group,
Minneapolis, Minnesota, and from 1986 to 1993, as president and chief
executive officer of Residential Funding Corp., Minneapolis, Minnesota. Mr.
Korell has a B.S. degree from the University of Wisconsin (Madison) and an
M.B.A. degree from Stanford Business School.
 
  Leonard Auerbach, age 51, was elected to serve as a director of the Company
effective upon the pricing of the Company's Initial Public Offering. Mr.
Auerbach is president of L, B, A and C, Inc., Orinda, California, which offers
consulting services to mortgage lenders. From 1989 to 1997, Mr. Auerbach and
L, B, A and C, Inc. served as general partners in Tuttle & Co., which offered
consulting services in connection with the management of residential mortgage
loan origination pipeline risk. Since 1987, Mr. Auerbach has served as a
trustee of the Robertson Stephens Investment Trust, San Francisco, California,
an investment trust of twelve publicly traded mutual funds. Mr. Auerbach has a
Ph.D. degree from the University of California (Berkeley).
 
  Mark E. Lachtman, age 54, was elected to serve as a director of the Company
effective upon the pricing of the Company's Initial Public Offering. Mr.
Lachtman is president of First Capital Group, Inc., San Rafael, California, a
mortgage brokerage company that he founded in 1983. He previously served as
director of production for Fair, Isaac & Co., San Rafael, California, from
1978 to 1982. He is a founding director and currently treasurer of the
California Association of Mortgage Brokers, North Bay Chapter. Mr. Lachtman
has a B.A. degree from the University of California (Berkeley) and a Ph.D.
degree from the University of Maryland.
 
COMMITTEES OF THE BOARD
 
  Audit Committee. The Company established an Audit Committee effective upon
the pricing of the Company's Initial Public Offering composed of Messrs.
Korell, Auerbach, Lachtman and MacQuarrie and Ms. Poisson. The Audit Committee
will make recommendations concerning the engagement of independent public
accountants, review with the independent public accountants the plans and
results of the audit engagement, approve professional services provided by the
independent public accountants, review the independence of the independent
public accountants, consider the range of audit and non-audit fees and review
the adequacy of the Company's internal accounting controls.
 
  Compensation Committee. The Company established a Compensation Committee
effective upon the pricing of the Company's Initial Public Offering composed
of the three outside directors. The Compensation Committee will determine the
compensation of the Company's executive officers and administer the Company's
stock option plan.
 
ITEM 11. EXECUTIVE COMPENSATION
 
  Management of the Company receives annual base salaries. Mr. Paul, Ms.
Poisson, Mr. MacQuarrie and Mr. Abreu currently receive base salaries of
$90,000, $120,000, $120,000 and $120,000, respectively. The base salaries may
be raised at the discretion of the Compensation Committee. In addition, the
Board of Directors has established a bonus incentive compensation plan for
executive officers of the Company. This program permits the Board of
Directors, in their discretion, to award cash bonuses annually to executive
officers of the Company.
 
 
                                      45
<PAGE>
 
  The following Summary Compensation Table sets forth information concerning
compensation earned in the years ended December 31, 1995, 1996 and 1997 by the
Company's Chief Executive Officer and its three other executive officers
serving at the end of the last completed fiscal year.
 
                          SUMMARY COMPENSATION TABLE
 
<TABLE>
<CAPTION>
                                                              LONG-TERM
                                                             COMPENSATION
                                                                AWARDS
                                         ANNUAL COMPENSATION  SECURITIES
                                         -------------------  UNDERLYING       OTHER
NAME AND PRINCIPAL POSITION         YEAR SALARY($) BONUS($)   OPTIONS(#)  COMPENSATION($)
---------------------------         ---- --------- --------- ------------ ---------------
<S>                                 <C>  <C>       <C>       <C>          <C>
Peter T. Paul.....................  1997 $  90,000 $ 510,287       --           --
President and Chief Executive       1996    90,000   510,750       --           --
Officer                             1995    90,000     8,000       --           --
Becky S. Poisson..................  1997 $ 113,000 $ 100,000    70,000          --
Executive Vice President,           1996    94,000    30,000       --           --
Operations                          1995    82,520    35,459       --           --
Gilbert J. MacQuarrie.............  1997 $ 113,000 $ 100,000    70,000          --
Executive Vice President,           1996    94,000    30,000       --           --
Chief Financial Officer and         1995    82,000    29,479       --           --
Secretary                                                                       --
Steven M. Abreu...................  1997 $ 117,800 $ 100,000    70,000          --
Executive Vice President,           1996   100,800    30,000       --           --
Production and                      1995   104,800       --        --           --
Secondary Marketing
</TABLE>
 
 Option Grants

  The following table sets forth information concerning stock options granted
during the 1997 fiscal year to each of the executive officers, adjusted to
give effect to the stock split. Each of the stock options to purchase Common
Stock of the Company becomes exercisable as follows: 25% in July 1998 and 25%
in each year thereafter.

<TABLE>
<CAPTION>

                                             INDIVIDUAL GRANTS                        VALUE AT ASSUMED
                         ---------------------------------------------------------     ANNUAL RATES OF
                           NUMBER OF    % OF TOTAL                                       STOCK PRICE
                          SECURITIES   OPTIONS/SARS                                     APPRECIATION
                          UNDERLYING    GRANTED TO                                     FOR OPTION TERM
                         OPTIONS/SARS  EMPLOYEES IN     EXERCISE OR     EXPIRATION -----------------------
NAME                     GRANTED(#)(1) FISCAL YEAR  BASE PRICE($/SH)(2)    DATE    0%($)  5%($)    10%($)
----                     ------------- ------------ ------------------- ---------- ----- -------- --------
<S>                      <C>           <C>          <C>                 <C>        <C>   <C>      <C>
Peter T. Paul...........       --           --               --              --     --        --       --
Becky S. Poisson........    70,000        13.51%           $4.06         7/22/07    --   $178,500 $452,900
Gilbert J. MacQuarrie...    70,000        13.51             4.06         7/22/07    --    178,500  452,900
Steven M. Abreu.........    70,000        13.51             4.06         7/22/07    --    178,500  452,900
</TABLE>
                   OPTION/SAR GRANTS IN CURRENT FISCAL YEAR
--------
(1) All options were granted without related divided equivalent rights
    ("DERs.")
(2) Estimated fair market value on the date of grant, as determined by
    independent third party appraisal.

                                      46
<PAGE>
 
 Option Exercises and Fiscal Year End Values
 
  The following table sets forth certain information with respect to the value
of the options as of December 31, 1997 held by the named executive officers,
adjusted to give effect to the stock split.
 
                         FISCAL YEAR END OPTION VALUE
 
<TABLE>
<CAPTION>
                               NUMBER OF SECURITIES      VALUE OF UNEXERCISED
                              UNDERLYING UNEXERCISED         IN-THE-MONEY
                                   OPTIONS AS OF             OPTIONS AS OF
                                 DECEMBER 31, 1997       DECEMBER 31, 1997(1)
                             ------------------------- -------------------------
NAME                         EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
----                         ----------- ------------- ----------- -------------
<S>                          <C>         <C>           <C>         <C>
Peter T. Paul...............     --           --           --           --
Becky S. Poisson............     --         70,000         --        $555,800
Gilbert J. MacQuarrie.......     --         70,000         --         555,800
Steven M. Abreu.............     --         70,000         --         555,800
</TABLE>
--------
(1) The dollar amounts set forth represent the difference between the initial
    public offering price of $12.00 per share and the exercise price of the
    options, multiplied by the applicable number of shares underlying the
    options.
 
COMPENSATION OF DIRECTORS
 
  Outside directors receive automatic stock options pursuant to the Company's
Stock Option Plan. Upon pricing of the Initial Public Offering, each outside
director was granted options to purchase 10,000 shares of Common Stock at the
initial public offering price. None of the directors of the Company has
received any separate compensation for service on the Board of Directors or on
any committee thereof. The Company pays outside directors $10,000 per year.
All directors will receive reimbursement of reasonable out-of-pocket expenses
incurred in connection with meetings of the Board of Directors. No director
who is an employee of the Company will receive separate compensation for
services rendered as a director.
 
EMPLOYMENT AGREEMENTS
 
  The Company entered into employment agreements with Mr. Paul, Ms. Poisson,
Mr. MacQuarrie and Mr. Abreu. Each agreement provides for a term through
December 31, 1999 and will be automatically extended for an additional year at
the end of each year of the agreement, unless either party provides a
prescribed prior written notice to the contrary. Each agreement provides for
an annual base salary and for participation by the subject officer in the
bonus incentive compensation plan. Each employment agreement provides for the
subject officer to receive his or her base salary and bonus compensation to
the date of the termination of employment by reason of death, disability or
resignation and to receive base compensation to the date of the termination of
employment by reason of a termination of employment for cause as defined in
the agreement. Each employment agreement also provides for the subject officer
to receive, in the event that the Company terminates the subject officer's
employment without cause, or if the subject officer resigns for "good reason"
(as defined in the agreement, including the occurrence of a "Change of
Control" of the Company as defined in the agreement), an amount equal to two
times the combined salary and bonus for the last fiscal year. Section 280G of
the Code may limit the deductibility of such payments by the Company for
federal income tax purposes. Each employment agreement also contains a "non-
compete" provision prohibiting the subject officer from competing with the
Company for a period of one year following termination of employment following
the Company's termination of the subject officer without cause or resignation
of the subject officer for "good reason" (including a "Change of Control"). In
addition, all outstanding options and Awards granted to the subject officer
under the Stock Option Plan shall immediately vest upon his or her termination
without cause or termination for "good reason" (including upon a "Change of
Control"). "Change of Control" for purposes of the agreements would include a
merger or consolidation of the Company, a sale of all or substantially all of
the assets of the Company, changes in the identity of a majority of the
members of the Board of Directors of the Company (other than due to the death,
disability or age of a director) or acquisitions of more than 25% of the
Company's capital stock, subject to certain limitations.
 
                                      47
<PAGE>
 
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
 
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
 
  The following table sets forth certain information known to the Company with
respect to beneficial ownership of the Company's Common Stock as of March   ,
1998, each person known to the Company to beneficially own more than five
percent of the Company's Common Stock.
 
<TABLE>
<CAPTION>
                                                          SHARES BENEFICIALLY
                                                              OWNED AS OF
                                                             MARCH   , 1998
                                                          -----------------------
   NAME AND ADDRESS OF BENEFICIAL OWNER                     NUMBER     PERCENT
   ------------------------------------                   ------------ ----------
   <S>                                                    <C>          <C>
   Paul Family Group
   1100 Larkspur Landing Circle, Suite 101
   Larkspur, California 94939
     Peter T. Paul(1)(2)................................    10,500,000    53.3%
     Jessica M. Paul(3).................................     1,680,000     8.5%
     Daniel W. Paul(3)..................................       840,000     4.3%
     Gilbert J. MacQuarrie(3)...........................       840,000     4.3%
     Paul Family Group (exclusive of the Voting Trust)..     8,400,000    42.6%
   Hart Family Group
   100 Larkspur Landing Circle, Suite 110
   Larkspur, California 94939
     Dennis M. Hart.....................................     1,400,000     7.1%
     Katherine E. Hart..................................       700,000     3.6%
     Hart Family Group..................................     2,100,000    10.7%
</TABLE>
--------
(1) Pursuant to a Voting Trust Agreement dated September 15, 1997, all of the
    outstanding shares of Common Stock of the Company have been transferred to
    Mr. Peter T. Paul, as Voting Trustee, 1100 Larkspur Landing Circle, Suite
    101, Larkspur, California 94939, with certain voting and investment
    powers. The Voting Trust Agreement will terminate on September 30, 2000.
(2) Peter T. Paul beneficially owns, through a living trust, 6,720,000 shares
    of Common Stock of the Company.
(3) Jessica M. Paul, daughter of Peter T. Paul, beneficially owns 1,680,000
    shares of Common Stock of the Company held in two trusts for her benefit.
    Daniel W. Paul, her uncle, and Gilbert J. MacQuarrie, the Company's
    Executive Vice President, Chief Financial Officer and Secretary, each
    serve as a trustee for one of those trusts, with sole voting and
    investment power with respect to the trust assets.
 
SECURITY OWNERSHIP BY DIRECTORS AND MANAGEMENT
 
  The following table sets forth certain information known to the Company with
respect to beneficial ownership of the Company's Common Stock as of March   ,
1998, by (i) each director, (ii) the Company's executive officers, and (iii)
all directors and executive officers as a group. Unless otherwise indicated in
the footnotes to the table, the beneficial owners named have, to the knowledge
of the Company, sole voting and investment power with respect to the shares
beneficially owned, subject to community property laws where applicable.
 
                                      48
<PAGE>
 
<TABLE>
<CAPTION>
                                                         SHARES BENEFICIALLY
                                                             OWNED AS OF
                                                            MARCH   , 1998
                                                         -----------------------
   NAME OF BENEFICIAL OWNER                                NUMBER     PERCENT
   ------------------------                              ------------ ----------
   <S>                                                   <C>          <C>
   Peter T. Paul(1).....................................   10,500,000    53.3%
   Becky Poisson........................................            0     --
   Gilbert J. MacQuarrie(2).............................      840,000     4.3%
   Steve Abreu..........................................            0     --
   Directors and executive officers as a group (7 per-
    sons)...............................................   11,340,000    50.5%
</TABLE>
--------
(1) See footnotes (1) and (2) to previous table.
(2) See footnote (3) to previous table.
 
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
 
NOTES PAYABLE TO STOCKHOLDERS
 
  The Company was incorporated in California and commenced its mortgage
banking business in 1986. From inception of operations, the Company conducted
certain of its business activities through a contractual arrangement with
First California Mortgage Company ("FCMC"). This arrangement was embodied in
an Agency Agreement dated December 11, 1992 (the "Agency Agreement").
 
  In 1993, the Company took steps to conduct all of its business activities
independently of FCMC through its own personnel and facilities in order to
facilitate the full implementation of its business strategy. In particular,
the Company entered into a Warehouse Facility in 1993 to enable it to fund its
own originations. Additionally, the Company commenced a transfer of servicing
rights from the FCMC servicing center to the Company's Servicing Center which
was substantially completed in 1994.
 
  Following completion of the steps described above permitting the Company to
operate independently of FCMC, a number of disputes arose between the Company,
FCMC and its successor in interest, Mortgage Service America Co. ("MSA"). At
approximately the same time, litigation ensued between Peter T. Paul ("PTP")
and Dennis M. Hart ("DMH") and between the Company and DMH in which the
Company and PTP alleged that loans previously made to DMH by the Company and
PTP were due and owing. These disputes and the litigation were resolved
pursuant to two settlement agreements (the "Settlement Agreements") which were
finalized in July 1996.
 
  The FCMC and Headlands Settlement and Mutual Release Agreement resolved the
dispute between the Company and FCMC over the amounts and rights related to
certain inter-company receivables and payables, and the Headlands Shareholders
Settlement and Mutual Release Agreement resolved the disputes arising between
PTP, DMH and the Company.
 
  Among the conditions of settlement, PTP agreed to make a loan to the
Company, the repayment of which would be subordinated to the lenders under the
warehouse lines of credit as required by such lenders. At the closing, PTP and
his daughter, Jessica M. Paul ("JMP") made loans to the Company pursuant to
unsecured promissory notes. At December 31, 1997, the principal amount of the
notes totaled $9,670,000 and interest expense on the notes was $0.9 million
during 1997. The notes bore interest at a variable rate equal to LIBOR for
one-year deposits, plus 5.0%. At December 31, 1997, the accrued and unpaid
interest was $0.9 million. The notes mature on June 29, 2000, but were repaid
in full from the proceeds of the Initial Public Offering.
 
TERMINATION OF S CORPORATION STATUS AND TAX INDEMNIFICATION AGREEMENT
 
  From inception of operations, the Company elected to be treated for federal
income tax purposes as an S corporation under Subchapter S of the Code, and as
an S corporation for certain state corporate income tax purposes under certain
comparable state laws. As a result, the Company's historical earnings have
been taxed
 
                                      49
<PAGE>
 
directly to the Company's shareholders, at their individual federal and state
income tax rates, rather than to the Company (except for certain state taxes).
On January 31, 1998 the Company's S corporation status was terminated and the
Company became fully subject to federal and state income taxes. At that time,
the Company recorded a deferred tax liability on its balance sheet, the amount
of which represents timing differences between tax and book accounting
relating principally to recognition of gains on sales of mortgage loans. If
the S corporation status had been terminated as of December 31, 1997, the
amount of the deferred tax liability recognized would have been approximately
$20.3 million.
 
  Since inception, the Company has made distributions to its shareholders of a
portion of the Company's income to permit the shareholders to pay their taxes
on such income. The aggregate amount of distributions to shareholders,
however, has been less than the aggregate amount of taxable income of the
Company during this period. The amount of this previously earned and
undistributed taxable income (including estimated taxable income up to January
31, 1998, with provision for adjustment based on final numbers) (the
"Shareholders Distribution Amount") will be distributed to the Existing
Shareholders out of the net proceeds of the Initial Public Offering. The
Shareholders Distribution Amount as of December 31, 1997 would have been
approximately $15.1 million.
 
  The Company and the Existing Shareholders have entered into a tax
indemnification agreement (the "Tax Agreement") relating to their respective
income tax liabilities. Because the Company will be fully subject to corporate
income taxation after the termination of the Company's S corporation status,
any reallocation of income and deductions between the period during which the
Company was treated as an S corporation and the period during which the
Company will be subject to corporate income taxation may increase the taxable
income of one party while decreasing that of another party. Accordingly, the
Tax Agreement is intended to assure that taxes are borne either by the Company
or the Existing Shareholders to the extent that such parties received the
related income. The Tax Agreement generally provides that, if an adjustment is
made to the taxable income of the Company for a year in which it was treated
as an S corporation, each party will indemnify the other against any increase
in the indemnified party's income tax liability (including interest and
penalties and related costs and expenses) with respect to such tax year to the
extent such increase results in a related decrease in the income tax liability
of the indemnifying party (whether with respect to the year of the adjustment
or over future years). However, the Tax Agreement specifically provides that
the Existing Shareholders will not be responsible for any portion of any
deferred tax liability recorded on the balance sheet of the Company upon
termination of the S corporation status. The Company will also indemnify the
Existing Shareholders for all taxes imposed upon them as the result of an
indemnification payment under the Tax Agreement. In no event, however, will
the Company be obligated to make indemnification payments under the Tax
Agreement if such payments, together with the aggregate of prior payments,
would exceed the amount of the deferred tax liability which may be recorded by
the Company on the balance sheet of the Company at the time of the termination
of the Company's S corporation status. Any payment made by the Company to the
Existing Shareholders pursuant to the Tax Agreement may be considered by the
Internal Revenue Service or state taxing authorities to be non-deductible by
the Company for income tax purposes. Neither parties' obligations under the
Tax Agreement are secured, and, as such, there can be no assurance that the
Existing Shareholders or the Company will have funds available to make any
payments which may become due under the Tax Agreement.
 
OTHER BUSINESS TRANSACTIONS WITH MANAGEMENT
 
  The Company had accounts receivable from Headlands Insurance Agency of
$118,000 and $56,000 at December 31, 1997 and 1996, respectively. The Company
had accounts payable due from Marin Conveyancing Corp. of $56,000 at December
31, 1997 and accounts receivable of $58,000 at December 31, 1996. The Company
provided administrative services to these related parties, and received fees
(included in production income) of $270,000 and $240,000 during the years
ended December 31, 1997 and 1996, respectively.
 
                                      50
<PAGE>
 
OTHER BUSINESS TRANSACTIONS WITH DIRECTORS
 
  Leonard B. Auerbach, who become a director of the Company on February 4,
1998, was a general partner of Tuttle & Co. from April 1989 until July 1997.
During 1997, the Company paid Tuttle & Co. for various hedging and other
advisory services a total of $472,426.00.
 
                                    PART IV
 
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
 
  (a) Documents files as part of this report:
 
    (1) Financial Statements
 
    (2) Schedules to Financial:
 
      All financial statements schedules not included have been omitted
    because they are either inapplicable or the applicable or the
    information required is provided in the Company's Financial Statements
    and Notes thereto, included in Part II, Item 8, of this Annual Report
    on Form 10-K.
 
    (3) Exhibits:
 
<TABLE>
<CAPTION>
     EXHIBIT
     NUMBER  EXHIBIT
     ------- -------
     <C>     <S>
     3.1*    Composite Articles of Incorporation of the Registrant
     3.2*    Amended and Restated Bylaws of the Registrant
     4.1*    Specimen common Stock Certificate
     9.1*    Voting Trust Agreement dated September 15, 1997, as amended
     10.1.1* Employment Agreement of Peter T. Paul
     10.1.2* Employment Agreement of Becky S. Poisson
     10.1.3* Employment Agreement of Gilbert J. MacQuarrie
     10.1.4* Employment Agreement of Steven M. Abreu
     10.2*   1997 Executive and Non-Employee Director Stock Option Plan dated
             July 22, 1997
     10.3*   Description of Bonus Incentive Compensation Plan
     10.4*   Amended and Restated Mortgage Loan Warehousing Agreement, dated as
             of August 29, 1997, among the Registrant and the Lenders therein
             named, as amended
     10.4.1* Second Amendment to Amended and Restated Mortgage Loan Warehousing
             Agreement
     10.4.2* Third Amendment to Amended and Restated Mortgage Loan Warehousing
             Agreement
     10.4.3  Fourth Amendment to Amended and Restated Mortgage Loan Warehousing
             Agreement
     10.5*   Amended and Restated Servicing Secured Credit Agreement, dated as
             of August 29, 1997, among the Registrant and the Lender named
             therein, as amended
     10.5.1* Second Amendment to Amended and Restated Servicing Secured Credit
             Agreement
     10.5.2* Third Amendment to Amended and Restated Servicing Secured Credit
             Agreement
     10.5.3  Fourth Amendment to Amended and Restated Servicing Secured Credit
             Agreement
     10.6*   Master Repurchase Agreement dated as of September 11, 1996, among
             Merrill Lynch Mortgager Capital, Inc., Merrill Lynch Credit
             Corporation and the Registrant, as amended
     10.7*   Tax Indemnification Agreement among the Registrant and the
             Registrant's shareholders prior to termination of S corporation
             status
     10.8*   Founders Registration Rights Agreement
     11.1    Statement regarding computation of per share earnings
     21.1*   List of Subsidiaries of the Registrant
     23      Consent of KPMG Peat Marwick LLP
     27      Financial Data Schedule
</TABLE>
--------
*Incorporated by reference to the correspondingly numbered exhibit to the
Registration Statement on Form S-1 (333-38267) filed by the Registrant with
the Securities and Exchange Commission on October 24, 1997.
 
                                      51
<PAGE>
 
                             INDEX OF DEFINED TERMS
 
<TABLE>
<CAPTION>
                                                                            PAGE
                                                                            ----
<S>                                                                         <C>
Change of Control..........................................................  48
Company....................................................................   3
DERs.......................................................................  46
DMH........................................................................  49
ECOA.......................................................................  27
FASB.......................................................................  41
FCMC.......................................................................  33
Hart Family Group..........................................................  48
Headlands..................................................................   3
HELOC......................................................................   4
HMDA.......................................................................  27
HMSI.......................................................................  13
HUD........................................................................  27
Interest-only Residual.....................................................  13
JMP........................................................................  51
Jumbos.....................................................................   4
Locked pipeline loan.......................................................  21
Mortgage Sources...........................................................   4
MSA........................................................................  49
Non-agency mortgage loans..................................................  21
Paul Family Group..........................................................  48
Principal Amount...........................................................  13
PTP........................................................................  49
QAD........................................................................  12
RESPA......................................................................  27
Settlement Agreement.......................................................  36
SFAS.......................................................................  41
Shareholders Distribution Amount...........................................  52
Tax Agreement..............................................................  52
TILA.......................................................................  26
Warehouse Facility.........................................................  19
</TABLE>
 
                                       52
<PAGE>
 
                   INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
 
<TABLE>
<CAPTION>
                                                                           PAGE
                                                                           ----
<S>                                                                        <C>
HEADLANDS MORTGAGE COMPANY

  Independent Auditors' Report............................................ F-2

  Consolidated Balance Sheets as of December 31, 1997 and 1996 ........... F-3

  Consolidated Statements of Operations for the Years Ended December 31,
   1997, 1996 and 1995 ................................................... F-4

  Consolidated Statements of Stockholders' Equity for the Years Ended De-
   cember 31, 1997, 1996, and 1995 ....................................... F-5

  Consolidated Statements of Cash Flows for the Years Ended December 31,
   1997, 1996 and 1995 ................................................... F-6

  Notes to Consolidated Financial Statements.............................. F-7
</TABLE>
 
                                      F-1
<PAGE>
 
                         INDEPENDENT AUDITORS' REPORT
 
The Board of Directors
Headlands Mortgage Company:
 
  We have audited the accompanying consolidated balance sheets of Headlands
Mortgage Company and subsidiary (the Company) as of December 31, 1997 and
1996, and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the years in the three-year period ended
December 31, 1997. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express
an opinion on these consolidated financial statements based on our audits.
 
  We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the consolidated financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the
consolidated financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as
well as evaluating the overall consolidated financial statements presentation.
We believe that our audits provide a reasonable basis for our opinion.
 
  In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects the financial position of Headlands
Mortgage Company and subsidiary as of December 31, 1997 and 1996, and the
results of their operations and their cash flows for each of the years in the
three-year period ended December 31, 1997 in conformity with generally
accepted accounting principles.
 
  As discussed in Note 2 to the consolidated financial statements, effective
January 1, 1997, the Company adopted Statement of Financial Accounting
Standards No. 125, "Accounting For Transfers and Servicing of Financial Assets
and Extinguishment of Liabilities."
 
                                                          KPMG Peat Marwick LLP
 
San Francisco, California
February 13, 1998
 
                                      F-2
<PAGE>
 
                           HEADLANDS MORTGAGE COMPANY
 
                          CONSOLIDATED BALANCE SHEETS
 
<TABLE>
<CAPTION>
                                                        DECEMBER 31,
                                                  -------------------------
                                                      1997         1996
                                                  ------------ ------------
<S>                                               <C>          <C>         
                     ASSETS
                     ------
Cash and cash equivalents........................ $  4,322,701 $  2,701,332
Retained interests in securitizations............   35,119,658   15,128,487
Accounts receivable..............................   13,166,574    7,558,494
Accounts receivable from related parties.........       61,539      119,513
Mortgage loans held for sale, pledged............  651,080,189  238,171,841
Originated mortgage servicing rights, net........   26,127,391   20,275,593
Property, equipment and leasehold improvements,
 net.............................................    7,715,431    3,016,423
Mortgage loans held for investment, net..........      824,307      692,816
Real estate owned, net...........................      118,772      880,462
Other assets.....................................    1,836,021      445,510
                                                  ------------ ------------
    TOTAL ASSETS................................. $740,372,583 $288,990,471
                                                  ============ ============
                 LIABILITIES AND
                 ---------------
               STOCKHOLDERS' EQUITY
               --------------------
Notes payable.................................... $636,415,929 $241,343,055
Notes payable to stockholders....................    9,670,000    9,670,000
Accounts payable.................................   17,558,962    4,390,082
Accrued liabilities..............................   10,196,453    4,443,093
                                                  ------------ ------------
    Total liabilities............................  673,841,344  259,846,230
                                                  ------------ ------------
Commitments and contingencies
Stockholders' equity:
  Common Stock (no par value; 14,700,000 shares
   authorized, 14,000,000 shares issued and
   outstanding)..................................        1,000        1,000
  Additional paid-in-capital-stock options.......      118,585          --
  Retained earnings..............................   66,411,654   29,143,241
                                                  ------------ ------------
    Total stockholders' equity...................   66,531,239   29,144,241
                                                  ------------ ------------
    TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY... $740,372,583 $288,990,471
                                                  ============ ============
</TABLE>
 
 
          See accompanying notes to consolidated financial statements.
 
                                      F-3
<PAGE>
 
                           HEADLANDS MORTGAGE COMPANY
 
                     CONSOLIDATED STATEMENTS OF OPERATIONS
 
<TABLE>
<CAPTION>
                                                  YEAR ENDED DECEMBER 31,
                                            -----------------------------------
                                               1997        1996        1995
                                            ----------- ----------- -----------
<S>                                         <C>         <C>         <C>
INCOME:
  Net gain from sales of mortgage loans.... $53,341,884 $25,598,792 $12,307,023
  Loan administration income...............  10,078,066  11,119,880  13,426,817
  Gain from sale of mortgage servicing
   rights..................................   9,420,066  11,083,549   8,836,293
  Production income........................   9,398,190   5,830,170   3,831,938
  Interest income, net of interest ex-
   pense...................................  12,524,096   5,624,446   1,813,858
  Net unrealized gain in valuation of re-
   tained interests in securitizations.....     667,979         --          --
                                            ----------- ----------- -----------
    Total income ..........................  95,430,281  59,256,837  40,215,929
EXPENSES:
  Personnel................................  29,835,335  20,545,181  15,514,731
  General and administrative...............  16,039,293  13,458,281  10,899,708
  Occupancy and rents......................   2,302,872   1,940,920   2,136,050
  Depreciation and amortization of
   property, equipment and leasehold
   improvements............................   2,817,587   2,919,314   3,483,647
  Amortization and impairment of originated
   mortgage servicing rights...............   5,812,857   2,093,037     958,372
                                            ----------- ----------- -----------
    Total expenses.........................  56,807,944  40,956,733  32,992,508
                                            ----------- ----------- -----------
    Income before income taxes.............  38,622,337  18,300,104   7,223,421
    Income taxes...........................   1,353,924     640,504     252,820
                                            ----------- ----------- -----------
    Net Income............................. $37,268,413 $17,659,600 $ 6,970,601
                                            =========== =========== ===========
PRO FORMA INFORMATION
 (UNAUDITED):
  Income before income taxes and pro forma
   data.................................... $38,622,337 $18,300,104 $ 7,223,421
  Provision for pro forma
   income taxes (unaudited)................  16,221,382   7,686,044   3,033,837
                                            ----------- ----------- -----------
    Pro forma net income (unaudited)....... $22,400,955 $10,614,060 $ 4,189,584
                                            =========== =========== ===========
    Pro forma earnings per share--Basic
     (unaudited)........................... $      1.47
                                            ===========
    Pro forma earnings per share--Diluted
     (unaudited)........................... $      1.46
                                            ===========
    Supplemental pro forma earnings per
     share--Basic
     (unaudited)........................... $      1.42
                                            ===========
    Supplemental pro forma earnings per
     share--Diluted
     (unaudited)........................... $      1.41
                                            ===========
</TABLE>
 
          See accompanying notes to consolidated financial statements.
 
                                      F-4
<PAGE>
 
                           HEADLANDS MORTGAGE COMPANY
 
                CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
 
<TABLE>
<CAPTION>
                                   ADDITIONAL PAID-                     TOTAL
                          COMMON      IN-CAPITAL       RETAINED     STOCKHOLDERS'
                           STOCK    STOCK OPTIONS      EARNINGS        EQUITY
                          -------  ----------------  ------------   -------------
<S>                       <C>      <C>               <C>            <C>
Balances at December 31,
 1994...................  $ 1,000               --   $ 18,902,520   $ 18,903,520
Net income..............      --                --      6,970,601      6,970,601
                          -------     ---------      ------------   ------------
Balances at December 31,
 1995...................    1,000               --     25,873,121     25,874,121
Net income..............      --                --     17,659,600     17,659,600
Distribution to stock-
 holders................      --                --    (14,389,480)   (14,389,480)
                          -------     ---------      ------------   ------------
Balances at December 31,
 1996...................    1,000               --     29,143,241     29,144,241
Net income..............      --                --     37,268,413     37,268,413
Stock option contribu-
 tion to capital........      --           $118,585           --         118,585
                          -------         ---------  ------------   ------------
Balances at December 31,
 1997...................   $1,000          $118,585   $66,411,654    $66,531,239
                          =======         =========  ============   ============
</TABLE>
 
 
 
 
          See accompanying notes to consolidated financial statements.
 
                                      F-5
<PAGE>
 
                           HEADLANDS MORTGAGE COMPANY
 
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
 
<TABLE>
<CAPTION>
                                             FOR THE YEAR ENDED
                                                DECEMBER 31,
                               ------------------------------------------------
                                    1997            1996             1995
                               --------------  ---------------  ---------------
<S>                            <C>             <C>              <C>
Cash flows from operating ac-
 tivities:
 Net income..................  $   37,268,413  $    17,659,600  $     6,970,601
 Adjustments to reconcile net
  income to net cash used in
  operating activities:
  Depreciation and
   amortization of property,
   equipment and leasehold
   improvements..............       2,817,587        2,919,314        3,483,647
  Amortization and
   impairment of originated
   mortgage servicing
   rights....................       5,812,857        2,093,037          958,372
  Compensation from stock
   options...................         118,585               --               --
  Gain from sale of mortgage
   servicing rights..........      (9,420,066)     (11,083,549)      (8,836,293)
  Net gain from sales of
   mortgage loans............     (53,341,884)     (25,598,792)     (12,307,023)
  Net (purchase of) proceeds
   from retained interests
   in securitizations........   (19,991,171)       (14,543,330)         183,181
  (Increase) decrease in ac-
   counts receivable.........      (5,608,080)      (5,675,635)       5,406,134
  Decrease (increase) in ac-
   counts receivable from
   related parties...........          57,974        3,421,760         (768,143)
  Mortgage loans originat-
   ed........................  (3,756,201,958)  (2,283,839,831)  (1,355,603,902)
  Proceeds from sale of
   mortgage loans............   3,211,218,543    2,146,944,916    1,342,791,085
  Principal payments re-
   ceived and Heloc undrawn
   availability on mortgage
   loans held for sale.......     190,041,795       22,643,693        3,362,146
  Decrease (increase) in de-
   ferred costs, net of
   fees......................      (4,624,844)      (1,233,435)        (707,571)
  Origination of mortgage
   servicing rights
   retained..................     (22,975,958)     (16,251,858)      (8,041,643)
  Proceeds from sale of
   mortgage servicing
   rights....................      20,731,369       12,050,048        8,836,293
  (Increase) decrease in
   other assets..............      (1,390,511)         (50,557)         539,825
  Increase (decrease) in ac-
   counts payable............      13,168,880        2,240,034          728,685
  Increase (decrease) in ac-
   crued liabilities.........       5,753,360        1,268,598        1,047,544
                               --------------  ---------------  ---------------
    Net cash used in
     operating activities....    (386,565,109)    (147,035,987)     (11,957,062)
Net cash provided by (used
 in) investing activities:
 Decrease (increase) in note
  receivable from
  stockholder................             --         1,365,389          (68,482)
 Purchase of property,
  equipment and leasehold
  improvements...............      (7,516,595)      (2,107,883)        (899,306)
 Net proceeds from sale of
  mortgage loans held for
  investment.................        (131,491)         382,462          710,294
 Net proceeds from sale
  (purchase of) real estate
  owned......................         761,690          824,987         (794,560)
                               --------------  ---------------  ---------------
    Net cash (used in)
     provided by in investing
     activities..............      (6,886,396)         464,955       (1,052,054)
Net cash provided by financ-
 ing activities:
 Borrowing on the warehouse
  line.......................   5,486,404,593    2,350,158,333    1,328,821,487
 Payments on the warehouse
  line.......................  (5,093,838,177)  (2,202,308,567)  (1,313,866,251)
 Net proceeds from notes
  payable....................       2,506,458        2,259,765              --
 (Repayment of) proceeds
  from line of credit with
  bank.......................             --       (25,000,000)      25,000,000
 Proceeds from note payable
  to stockholders............             --         9,670,000              --
 Distributions to stockhold-
  ers........................             --       (14,389,480)             --
                               --------------  ---------------  ---------------
    Net cash provided by
     financing activities....     395,072,874      120,390,051       39,955,236
                               --------------  ---------------  ---------------
Net increase (decrease) in
 cash........................       1,621,369      (26,180,981)      26,946,120
Cash and cash equivalents be-
 ginning of year.............       2,701,332       28,882,313        1,936,193
                               --------------  ---------------  ---------------
Cash and cash equivalents end
 of year.....................  $    4,322,701  $     2,701,332  $    28,882,313
                               ==============  ===============  ===============
Supplemental disclosures of
 cash flow information:
 Cash paid for interest......  $   30,351,536  $    11,946,721  $     4,513,602
 Cash paid for income tax-
  es.........................         576,600           54,552              800
</TABLE>
 
          See accompanying notes to consolidated financial statements.
 
                                      F-6
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
                  NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
1. ORGANIZATION
 
  Headlands Mortgage Company (the "Company") is a closely-held S corporation
which was organized in 1981. The Company is a full service mortgage banking
business, which consists of the origination, acquisition, sale and servicing
of residential mortgage loans secured by one-to four-unit family residences,
and the purchase and sale of mortgage servicing rights.
 
  The Company is headquartered in Northern California, and has production
branches in California, Washington, Oregon, Nevada, Florida, New Jersey,
Idaho, and Arizona. Loans are originated primarily on a wholesale basis,
through a network of independent mortgage loan brokers approved by the
Company. Other loan origination sources include correspondent and retail
lending. The market for the Company's mortgage banking operations is
predominantly California and the western United States.
 
  The consolidated financial statements include Headlands Mortgage Company
("HMC"), and its subsidiary Headlands Mortgage L.L.C. ("HMLLC") for the year
ended December 31, 1996, and additionally HMLLC's successor Headlands Mortgage
Securities Inc. ("HMSI") for the year ended December 31, 1997. The activity of
the subsidiaries is related to the Company's securitizations. All material
intercompany balances and transactions have been eliminated.
 
  In 1996, the Company diversified its residential mortgage loan sales
activities to include the securitization of such loans into Real Estate
Mortgage Investment Conduits ("REMICs") and Asset-Backed Securities ("ABS").
The REMICs, which consist of pooled fixed-rate first-lien mortgages, were
issued by the Company to the public through the registration statement of the
related underwriter during 1996, and through the registration statement of
HMSI during 1997. The ABS, which consist of revolving home equity loans and
closed-end second mortgages, were issued by the Company through HMLLC and the
registration statement of the related underwriter in 1996, and through the
registration statement of HMSI during 1997.
 
  The Company operates a loan servicing center which it opened in January
1994. The Company's source of servicing is from mortgage loans it has
originated and sold.
 
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
 (a) Cash and Cash Equivalents
 
  The Company considers all highly liquid investments with an original
maturity of 90 days or less to be cash equivalents, including restricted cash
and cash equivalents in the amount of $2,053,613 and $1,621,985 at
December 31, 1997 and 1996, respectively.
 
 (b) Mortgage Loans Held for Sale
 
  Mortgage loans held for sale consist of residential mortgage loans and home
equity lines of credit. Residential mortgage loans have contractual maturities
of up to 30 years, and home equity lines of credit have contractual maturities
of up to 25 years. The real property of the borrower is pledged as collateral
under either loan type. Mortgage loans held for sale are stated at the lower
of cost or aggregate market value.
 
  The cost of a mortgage loan held for sale is the outstanding principal
balance of the mortgage loan decreased by fees or discounts collected and
increased by fees and certain direct costs of origination. Fees and costs
incurred net of discounts collected are deferred and recognized as adjustments
to gain or loss when the related loans are sold.
 
 
                                      F-7
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The Company sells mortgage-backed and asset-backed securities through
forward delivery contracts. Such forward delivery contracts that have not been
completed at the end of an accounting period are used to determine the market
value of unsold loans. The Company also enters into commitments with private
and institutional investors. The market value of loans relating to such
commitments are determined by the outstanding commitments from investors or
current investor yield requirements. The fees paid for commitments are
recognized over the term of the commitment or as the commitment is filled.
 
  Gains or losses realized from mortgage loan sales are recognized at time of
settlement with investors based upon the difference between the proceeds from
sale and the carrying value of the mortgage loans sold, net of commitment fees
paid. Such sales ordinarily provide for a pass-through yield to the investor
and a yield retained by the Company for servicing. For mortgage loan sales
other than pursuant to securitizations, the yield retained for servicing has
not exceeded in material respect contractually specified servicing fees or
adequate servicing compensation and hence no excess servicing value has been
recognized. If the mortgage loans are sold with the servicing rights released
to the purchaser, the Company reflects the difference between the value paid
by the investor for the servicing rights and the carrying value of such
servicing rights in net gain from sales of mortgage loans. If the mortgage
loans are sold with the servicing rights retained by the Company, the Company
determines the relative fair value of the servicing rights and includes such
amount in the calculation of net gain from sales of mortgage loans.
 
 (c) Originated Mortgage Servicing Rights
 
  Originated mortgage servicing rights are stated at the lower of amortized
relative fair value or market value as determined by quoted market prices for
similar assets. The Company stratifies originated mortgage servicing rights
based on the loan type and note rate of the underlying loans. It is the policy
of the Company to amortize originated mortgage servicing rights in proportion
to and over the period of estimated net servicing income. To achieve this, the
Company computes amortization on a loan by loan basis using a cash flow model.
This method allocates the amortization expense over the servicing life of each
loan in the servicing portfolio in proportion to the corresponding net
servicing income. Valuation adjustments are charged to impairment expense on
an aggregate stratum basis.
 
  The Company recognizes gain or loss from the sale of mortgage servicing
rights when control of the mortgage servicing rights has transferred to the
purchaser. The gain recognized reflects the difference between the carrying
value of the servicing rights sold and the proceeds from sale, net of selling
expenses.
 
                                      F-8
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 (d) Retained Interests in Securitizations
 
  Retained interests in securitizations consist of subordinate certificates in
REMICs and ABS which were issued by the Company. All of the Company's
securities are classified as trading and stated at market value in accordance
with SFAS No. 115, "Accounting for Certain Investments in Debt and Equity
Securities."
 
  The Company pools mortgage loans that it has originated or purchased and
issues securities. The Company generally sells the more senior classes of the
securities for cash and retains one or more of the subordinated classes.
 
  The subordinate classes of the REMIC securities consist of classes with less
than an AAA rating due to reduced credit enhancement. Theses classes generally
have a stated principal amount and earn a fixed interest rate. Management
believes that it has made reasonable estimates of the market value of the
subordinated interests of market securities on its balance sheet, based on
market prices for similar securities.
 
  In an asset-backed securitization, the Company retains as an investment a
subordinate principal interest and the interest-only residual interest created
as a result of such securitization. A significant portion of the Company's
total income is recognized as net gain on sale of mortgage loans, which
partially represents the present value of the interest-only residual interests
and mortgage servicing rights. The Company recognizes such net gain on sale of
mortgage loans in the period in which such loans are sold, although cash is
received by the Company over the life of the loans. Management believes that
it has made reasonable estimates of the present value of the interest-only
residual interests of the home equity loan securities on its balance sheet.
The Company projects the expected cash flows over the life of the retained
interests, using prepayment and annual loss assumptions (approximately 40% and
0.5%, respectively) that market participants would use for similar financial
instruments that are subject to prepayment, credit and interest rate risks.
The Company then determines the present value of these cash flows using a 15%
discount rate, a rate which it believes is commensurate with the risks
involved.
 
 (e) Mortgage Loans held for Investment
 
  Mortgage loans held for investment are stated at the lower of cost or
aggregate fair value.
 
 (f) Real Estate Owned
 
  Real estate owned includes property acquired through foreclosure or deed
taken in lieu of foreclosure. The properties are predominantly located in
California, and are carried at the lower of cost or fair value less estimated
selling expenses.
 
 (g) Property, Equipment and Leasehold Improvements
 
  Property, equipment and leasehold improvements are stated at cost less
accumulated depreciation and amortization.
 
  Depreciation on property and equipment is calculated using the straight-line
method over the estimated useful lives of the assets, generally 3 to 5 years.
Amortization of leasehold improvements is calculated using the straight-line
method over the shorter of the lease term or estimated useful life of the
asset.
 
 (h) Fannie Mae Stock
 
  The Company is the owner of record of Fannie Mae shares in excess of the
minimum requirement. The Fannie Mae shares are held in accordance with the
Fannie Mae servicing agreement, and are included in other assets in the
accompanying consolidated financial statements.
 
                                      F-9
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 (i) Financial Statement Presentation
 
  The Company prepares its consolidated financial statements using an
unclassified balance sheet presentation as is customary in the mortgage
banking industry. A classified balance sheet presentation would have
aggregated current assets, current liabilities and net working capital as
follows:
 
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                    ---------------------------
                                                        1997          1996
                                                    ------------  -------------
       <S>                                          <C>           <C>
       Current assets.............................. $703,194,905  $ 263,560,678
       Current liabilities......................... (655,912,554)  (249,395,038)
                                                    ------------  -------------
       Net working capital......................... $ 47,282,351  $  14,165,640
                                                    ============  =============
</TABLE>
 
 (j) Loan Administration Income
 
  Loan administration income represents fees earned as master servicer for
residential mortgage loans owned by investors. The fees are calculated based
on a contractual percentage of the outstanding principal balances of the loans
serviced, and recognized when collected. Loan Administration income also
includes ancillary fees collected in conjunction with the servicing operation.
 
 (k) Production Income
 
  Production income consists of fees paid to the Company by borrowers for the
preparation, documentation and underwriting of loans. These fees and related
lending transaction costs are deferred until the related loan is sold. Upon
sale of the loan, the deferred fees are recognized as production income and
deferred costs are recognized in the applicable expense classification.
 
 (l) Income Taxes
 
  The Company has elected for both Federal and State income tax purposes to be
treated as an S corporation. Consequently, the net earnings of the Company are
taxed directly to the stockholders, rather than the Company. The Company,
however, was required to pay California Franchise tax on taxable income at a
rate of 3.5% for 1995 through 1997.
 
  Income taxes are based on an asset and liability approach for financial
accounting and reporting for income taxes. Deferred income taxes arise from
temporary differences in reporting income and expense for tax and financial
reporting purposes. The primary temporary differences relating to Company
operations stem from the recognition of additional net gain on sales of
mortgage loans required under SFAS No. 122 and SFAS No. 125, and the tax
treatment of the Company's loan securitizations.
 
 (m) Earnings per share
 
  On December 31, 1997, the Company adopted Statement of Financial Accounting
Standard No. 128 ("SFAS 128") "Earnings Per Share." This Statement provides
guidance for determining basic and diluted earnings per share (EPS). Under
SFAS No. 128, basic EPS excludes dilution and is computed by dividing income
available to common stockholders by the weighted average number of common
shares outstanding for the period. Diluted EPS reflects the potential dilution
that could occur if securities or other contracts to issue common stock were
exercised or converted into common stock or resulted from issuance of common
stock that shared in earnings.
 
 (n) Reclassifications
 
  Certain reclassifications were made to the prior balances to conform with
the current presentation.
 
                                     F-10
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 (p) Use of Management Estimates
 
  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts on the balance sheets at December
31, 1997 and 1996 and the statements of operations for each of the years in
the three year period ended December 31, 1997. Actual results could differ
significantly from those estimates.
 
 (q) Adoption of New Accounting Pronouncement
 
  On January 1, 1997, the Company adopted Statement of Financial Accounting
Standard No. 125 ("SFAS 125"), "Accounting for Transfers and Servicing of
Financial Assets and Extinguishment of Liabilities." This Statement provides
guidelines for distinguishing transfers of financial assets that are sales
from transfers that are secured borrowings. SFAS 125 supersedes SFAS 76, 77
and 122, while amending both SFAS 65 and 115. SFAS 125 is to be applied
prospectively, however, portions of SFAS 125 were deferred under SFAS 127,
"Deferral of the Effective Date of Certain Provisions of FASB Statement No.
125" until January 1, 1998. Earlier implementation is not permitted.
 
  Under SFAS 125, a transfer of financial assets in which control is
surrendered is accounted for as a sale to the extent that consideration other
than beneficial interests in the transferred assets is received in the
exchange. Liabilities and derivatives incurred or obtained by the transfer of
financial assets are required to be measured at fair value, if practicable.
Also, servicing assets and other retained interests in the transferred assets
must be measured by allocating the previous carrying value between the asset
sold and the interest retained, if any, based on their relative fair values at
the date of transfer. For each servicing contract in existence before January
1, 1997, previously recognized servicing rights that do not exceed
contractually specified servicing are required to be combined, net of any
previously recognized servicing obligations under that contract, as a
servicing asset or liability.
 
  SFAS 125 also requires an assessment of interest-only strips, loans, other
receivables and retained interests in securitizations. If these assets can be
contractually prepaid or otherwise settled such that the holder would not
recover substantially all of its recorded investment, the asset will be
measured like trading securities. This assessment is required for financial
assets held on or acquired after January 1, 1997.
 
3. MORTGAGE LOANS HELD FOR SALE
 
  Mortgage loans held for sale included net deferred fees and costs, and
consisted of the following at:
 
<TABLE>
<CAPTION>
                                                            DECEMBER 31,
                                                      -------------------------
                                                          1997         1996
                                                      ------------ ------------
      <S>                                             <C>          <C>
      Mortgage loans................................. $536,520,290 $217,297,135
      Home equity lines of credit....................  107,800,278   18,739,929
      Deferred costs, net of fees....................    6,759,621    2,134,777
                                                      ------------ ------------
                                                      $651,080,189 $238,171,841
                                                      ============ ============
</TABLE>
 
                                     F-11
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
4. ORIGINATED MORTGAGE SERVICING RIGHTS
 
  Originated mortgage servicing rights (OMSR) consist of the following:
 
<TABLE>
<CAPTION>
                                         ACCUMULATED  IMPAIRMENT       NET
                               OMSR      AMORTIZATION  ALLOWANCE      OMSR
                            -----------  ------------ -----------  -----------
<S>                         <C>          <C>          <C>          <C>
Balance at December 31,
 1994.....................  $       --    $     --    $       --   $       --
Current year additions....    8,041,643     (32,985)     (925,387)   7,083,271
Write-downs due to prepay-
 ments....................     (706,316)        --        706,316          --
                            -----------   ---------   -----------  -----------
Balance at December 31,
 1995.....................  $ 7,335,327   $ (32,985)  $  (219,071) $ 7,083,271
Current year additions....   16,251,858    (225,794)   (1,867,243)  14,158,821
Servicing sold............   (1,021,175)     12,638        42,038     (966,499)
Write-downs due to prepay-
 ments....................     (286,354)        --        286,354          --
                            -----------   ---------   -----------  -----------
Balance at December 31,
 1996.....................  $22,279,656   $(246,141)  $(1,757,922) $20,275,593
Current year additions....   22,975,958    (403,857)   (5,409,000)  17,163,101
Servicing sold............  (11,806,387)    125,418       369,666  (11,311,303)
Write-downs due to prepay-
 ments....................   (5,618,849)    126,059     5,492,790          --
                            -----------   ---------   -----------  -----------
Balance at December 31,
 1997.....................  $27,830,378   $(398,521)  $(1,304,466) $26,127,391
                            ===========   =========   ===========  ===========
</TABLE>
 
  The capitalized mortgage servicing rights were reported at fair value at
December 31, 1997 and 1996, which was lower than amortized relative fair value
at the time of loan sale. The fair value was estimated based on prepayment
speeds consistent with those published by various Wall Street securities
dealers for securities with similar characteristics to those in the Company's
portfolio, delinquency rates consistent with other California concentrated
portfolios, and estimated escrow, principal, interest and payoff float.
 
  The unpaid principal balance of mortgage loans for which the Company has
capitalized mortgage servicing rights was approximately $2,738 million, and
$2,017 million at December 31, 1997 and 1996, respectively. The Company held
off-balance sheet originated mortgage servicing rights with an estimated fair
value of approximately $17.9 million, and $22.9 million at December 31, 1997
and 1996, respectively. These estimated fair values may not represent actual
amounts that would be realized upon any sale or liquidation of the asset.
 
5. RETAINED INTERESTS IN SECURITIZATIONS
 
  Retained interests in securitizations consist of assets generated by the
Company's loan securitizations. These assets were as follows at:
 
<TABLE>
<CAPTION>
                                                             DECEMBER 31,
                                                        -----------------------
                                                           1997        1996
                                                        ----------- -----------
      <S>                                               <C>         <C>
      REMIC subordinate certificates................... $ 6,310,052 $ 3,953,659
      ABS Interest-only residual interest..............  18,831,600   7,689,529
      ABS principal interest...........................   6,422,286   2,563,177
      ABS overcollateralization........................   3,555,720     922,122
                                                        ----------- -----------
                                                        $35,119,658 $15,128,487
                                                        =========== ===========
</TABLE>
  The Company classifies REMIC and ABS securities as trading securities in
accordance with SFAS No. 115, "Accounting for Certain Investments in Debt and
Equity Securities" and carries them as current assets at market value.
 
  The Company is contractually bound by the Headlands Home Equity Loan (HHEL)
ABS Trust to retain it's principal interest and overcollateralization. While
the Company can sell these certificates, it would be considered a "Rapid
Amortization Event" under the terms of the trust, and would trigger rapid
amortization of the trust senior certificates.
 
                                     F-12
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
  The interest-only residual interest is recorded as a result of the Company's
securitization of home equity lines of credit through the HHEL trust. The
Company is subject to certain recourse provisions in connection with its
securitization and presents its obligation under these provisions as a
reduction in the carrying value of the asset. The Company estimates future
cash flows from this interest-only residual interest and values them utilizing
assumptions that it believes are consistent with those that would be utilized
by an unaffiliated third party purchaser. The interest-only residual interest
is recorded as a trading security at fair value. To the Company's knowledge,
there is no active market for the sale of this interest-only residual
interest.
 
  The fair value of the interest-only residual interest is determined by
computing the present value of the excess of the weighted average coupon on
the loans sold over the sum of: (1) the coupon on the senior interests, (2)
the contracted servicing fee, (3) expected losses to be incurred on the
portfolio of loans sold over the lives of the loans, (4) overcollateralization
and (5) fees payable to the trustee and the monoline insurer. Prepayment
assumptions used in the present value computation are based on market
prepayment rates for similar loans, and approximate 40%.
 
  The cash flows expected to be received by the Company are discounted at 15%,
an interest rate that the Company believes an unaffiliated third-party
purchaser would require as a rate of return on such a financial instrument. To
the extent that actual future excess cash flows are different from estimated
excess cash flows, the fair value of the Company's interest-only residual
certificate will be adjusted quarterly with corresponding adjustments made to
earnings in that period.
 
  The Company provided an initial overcollateralization on the security sold
and builds overcollateralization from the excess cash flows. The
overcollateralization reduces the certificate balance of the securities sold
by the amount required by the monoline insurer. The current amount of such
overcollateralization built through cash flows is recorded by the Company as
part of retained interests in securitizations, and earns a market rate of
interest.
 
6. MORTGAGE LOANS HELD FOR INVESTMENT
 
  During the normal course of business, the Company is required from time to
time to repurchase certain loans from investors. Mortgage loans held for
investment consisted of residential real estate mortgage loans at December 31,
1997 and 1996. All properties are located in the state of California. Interest
rates on these mortgage loans are at variable and fixed rates which range from
7.25% to 12.00% at December 31, 1997, and from 6.94% to 8.88% at December 31,
1996. The maturities range from 11 months to 28 years at December 31, 1997,
and from 1 year to 26 years at December 31, 1996.
 
7. REAL ESTATE OWNED
 
  Real estate owned, net, consists of the following at:
<TABLE>
<CAPTION>
                                                              DECEMBER 31,
                                                           --------------------
                                                             1997       1996
                                                           --------  ----------
      <S>                                                  <C>       <C>
      Residential real estate at cost..................... $165,463  $  932,717
      Less valuation allowance:
        Balance at beginning of year......................  (52,255)   (545,151)
        Additions to allowance............................ (164,016)   (645,279)
        Deductions related to real estate sold............  169,580   1,138,175
                                                           --------  ----------
      Real estate owned, net.............................. $118,772  $  880,462
                                                           ========  ==========
</TABLE>
 
                                     F-13
<PAGE>
 
                           HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
8. PROPERTY, EQUIPMENT AND LEASEHOLD IMPROVEMENTS
 
  Property, equipment and leasehold improvements, net, consist of the following
at:
 
<TABLE>
<CAPTION>
                                                            DECEMBER 31,
                                                      -------------------------
                                                         1997          1996
                                                      -----------  ------------
      <S>                                             <C>          <C>
      Furniture and fixtures......................... $ 1,483,317  $  1,253,607
      Office equipment...............................  17,940,908    11,713,822
      Leasehold improvements.........................   1,063,892       728,474
      Automobiles....................................      49,411        47,911
                                                      -----------  ------------
                                                       20,537,528    13,743,814
      Less accumulated depreciation and
       amortization.................................. (12,822,097)  (10,727,391)
                                                      -----------  ------------
                                                      $ 7,715,431  $  3,016,423
                                                      ===========  ============
</TABLE>
 
10. NOTES PAYABLE
 
  Notes payable consist of the following at:
 
<TABLE>
<CAPTION>
                                                           DECEMBER 31,
                                                    ---------------------------
                                                        1997          1996
                                                    ------------- -------------
<S>                                                 <C>           <C>
Warehouse line of credit with banks, expiring on
 November 4, 1999, $215 million at December 31,
 1997, and $185 million at December 31, 1996 and
 bearing variable interest rates, including a rate
 adjusted for compensating balances...............  $ 195,688,752 $ 166,457,268
Master repurchase agreement with an investment
 banker, expiring September 10, 1998, $250 million
 at December 31, 1997 and December 31, 1996,
 bearing variable interest rates based on the
 LIBOR............................................    174,542,715    57,973,407
Master repurchase agreement with an investment
 banker, bearing a variable interest rate based on
 the LIBOR........................................    238,613,472            --
Master repurchase agreement with an investment
 banker, secured by mortgage loans and expiring
 December 11, 1998, bearing a variable interest
 rate based on the LIBOR..........................     21,312,832            --
Warehouse line of credit with a major corporation,
 expiring October 31, 1998, $15 million at
 December 31, 1997, and $5 million at December 31,
 1996, and bearing variable interest rates based
 on the LIBOR.....................................      1,491,935     2,652,615
Servicing secured working capital line of credit,
 expiring on November 4, 1998, $12 million at
 December 31, 1997 and 1996, and bearing a
 variable interest rate based on the open Federal
 Funds rate or the LIBOR including a rate adjusted
 for compensating balances........................             --    12,000,000
Master repurchase agreement with an investment
 banker, secured by marketable securities, bearing
 a variable interest rate based on the LIBOR......      2,949,223     2,259,765
Master repurchase agreement with an investment
 banker, secured by marketable securities, bearing
 a variable interest rate based on the LIBOR......      1,817,000            --
                                                    ------------- -------------
                                                    $ 636,415,929 $ 241,343,055
                                                    ============= =============
</TABLE>
 
                                      F-14
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The warehouse lines of credit and master repurchase agreements are secured
by mortgage loans held for sale, except the two master repurchase agreements
which are secured by marketable securities, and the servicing secured line of
credit which is secured by a portion of the Company's servicing portfolio.
 
  The weighted average cost of funds as of December 31, 1997 and 1996 was 4.71
and 5.17 percent, respectively. Compensating balances averaged $34.6 million
and $24.6 million for the years ended December 31, 1997 and 1996,
respectively, and were comprised of corporate and custodial accounts.
Warehouse interest expense of $32.3 million, $12.8 million and $3.6 million
for the years ended December 31, 1997, 1996 and 1995, respectively, has been
netted with interest income in the consolidated statements of operations.
 
  The Company must comply with certain covenants provided in its loan
agreements, including requirements relating to net worth, working capital,
outstanding indebtedness, and the loan servicing portfolio. At December 31,
1997 and 1996, the Company was in compliance with the aforementioned loan
covenants. The Company's warehouse lines of credit restrict the Company's
ability to pay dividends in any fiscal year to an amount not to exceed 25% of
adjusted net income for such fiscal year. Adjusted net income is generally
defined to mean net income less gain (loss) on sale of mortgages and decrease
in deferred tax liability and plus service release premiums, amortization of
servicing rights, net book value of servicing assets sold and increase in
deferred tax lability.
 
11. NOTES PAYABLE TO STOCKHOLDERS
 
  The Company issued notes during 1996 to two of its stockholders. The
principal amount outstanding under the notes at December 31, 1997 and 1996 was
$9,670,000. The notes bear interest at a variable rate based on the LIBOR, and
mature on June 29, 2000. Principal and accrued interest are payable annually.
Any rights of the stockholders under the notes are subordinate to the
Company's warehouse lenders.
 
12. RELATED PARTY TRANSACTIONS
 
  The Company had loans receivable from employees (included in accounts
receivable) of $39,000 and $19,000 at December 31, 1997 and 1996,
respectively. The Company also had accounts receivable from Headlands
Insurance Agency, a related party, of approximately $118,000 and $56,000 at
December 31, 1997 and 1996, respectively. The Company had accounts payable to
Marin Conveyance Corporation, another related party, at December 31, 1997 of
$56,000, and accounts receivable from the same related party at December 31,
1996 of $58,000. The Company provided administrative services to these related
parties, and received fees (included in production income) of $270,000,
$240,000 and $180,000 during 1997, 1996 and 1995, respectively.
 
13. LOAN ADMINISTRATION
 
  The Company's portfolio of residential mortgage loans serviced aggregated
approximately $4.5 billion and $4.4 billion, at December 31, 1997 and 1996,
respectively. Of the Company's portfolio at December 31, 1997, 71% of the
loans serviced were located in California with 29% in other states. At
December 31, 1996, 81% of the loans serviced were located in California with
19% in other states. The delinquency ratio of the portfolio was 1.73%, 1.53%
as of December 31, 1997 and 1996 respectively.
 
  Principal balances serviced were as follows at:
 
<TABLE>
<CAPTION>
                                                          DECEMBER 31,
                                                  -----------------------------
                                                       1997           1996
                                                  -------------- --------------
<S>                                               <C>            <C>
Fannie Mae....................................... $  984,000,000 $1,367,000,000
Freddie Mac......................................    457,000,000    674,000,000
HMC securities...................................  1,774,000,000    489,000,000
Home equity lines of credit......................    422,000,000    148,000,000
Other investors..................................    890,000,000  1,709,000,000
                                                  -------------- --------------
                                                  $4,527,000,000 $4,387,000,000
                                                  ============== ==============
</TABLE>
 
 
                                     F-15
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The Company is required to advance corporate funds for principal, interest,
escrow and foreclosure costs relating to loans for which it services. These
advances (included in accounts receivable) were approximately $6.2 million and
$4.6 million at December 31, 1997 and 1996, respectively. A portion of these
advances is non-recoverable. The Company had reserved approximately $844,000
and $511,000 for unrecoverable advances and future foreclosure losses at
December 31, 1997 and 1996, respectively.
 
  Related trust funds on deposit in trustee bank accounts were approximately
$43.0 million at December 31, 1997 and $7.7 million at December 31, 1996, and
are not included in the accompanying consolidated balance sheets. Separate
bank accounts are maintained and such funds are not commingled with those of
the Company.
 
  The Company maintained errors and omissions and employee fidelity bond
insurance policies in the amount of $5.5 million at December 31, 1997, and
$5.0 million at December 31, 1996.
 
14. FAIR VALUE OF FINANCIAL INSTRUMENTS
 
  Because no market exists for certain of the Company's assets and
liabilities, fair value estimates are based on judgments regarding credit
risk, investor expectations of future economic conditions, normal cost of
administration and other risk characteristics, including interest rate and
prepayment risk. These estimates are subjective in nature and involve
uncertainties and matters of judgment and therefore cannot be determined with
precision. Changes in assumptions could significantly affect the estimates.
 
  In addition, the fair value estimates presented do not include the value of
anticipated future business and the value of assets and liabilities that are
not considered financial instruments.
  The estimated fair values of the Company's balance sheet financial
instruments at:
 
<TABLE>
<CAPTION>
                                               DECEMBER 31,
                            ---------------------------------------------------
                                      1997                      1996
                            ------------------------- -------------------------
                              CARRYING    ESTIMATED     CARRYING    ESTIMATED
                               AMOUNT     FAIR VALUE     AMOUNT     FAIR VALUE
                            ------------ ------------ ------------ ------------
<S>                         <C>          <C>          <C>          <C>
Financial assets
 Cash and cash equiva-
  lents...................  $  4,322,701 $  4,322,701 $  2,701,332 $  2,701,332
 Retained interests in
  securitizations.........    35,119,658   35,119,658   15,128,487   15,128,487
 Mortgage loans held for
  sale....................   651,080,189  653,483,037  238,171,841  241,883,738
 Mortgage loans held for
  investment..............       824,307      824,307      692,816      692,816
 Originated mortgage ser-
  vicing rights, net......    26,127,391   26,127,391   20,275,593   20,275,593
Financial liabilities:
 Notes payable............   636,415,929  636,415,929  241,343,055  241,343,055
 Notes payable to stock-
  holders.................     9,670,000    9,670,000    9,670,000    9,670,000
</TABLE>
 
  These estimated fair values do not represent actual amounts that may be
realized upon any sale or liquidation of the related assets or liabilities. In
addition, these values do not give effect to discounts to fair value which may
occur when financial instruments are sold in large quantities. The fair values
presented above represent the Company's best estimate of fair value using the
methodologies discussed below:
 
 (a) Cash and Cash Equivalents
 
  The carrying value is a reasonable estimate of fair value.
 
 (b) Retained Interests in Securitizations
 
  The fair value of subordinate interests is determined based on the market
price obtained for similar securities. The fair value of interest-only
residual interests is determined using estimated discounted future cash flows
taking into consideration anticipated prepayment rates and loss experience.
 
                                     F-16
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
 
 
 (d) Mortgage Loans Held for Sale, Mortgage Loans Held for Investment, Loan
Sale Commitments, and Locked Loan Origination Commitments
 
  Fair value of mortgage loans held for sale, mortgage loans held for
investment, commitments to originate mortgage loans and commitments to sell
mortgage loans are estimated using quoted market prices for similar loans,
mortgage-backed securities backed by similar loans or by prices obtained by
the Company in forward delivery contracts. The fair value of commitments to
originate mortgage loans includes a portion of the unrealized gain or loss
calculated using quoted market prices based on a historical estimate of the
percentage of such commitments that will actually result in mortgage loans
originated.
 
 (e) Originated Mortgage Servicing Rights, Net
 
  The fair value of originated mortgage servicing rights is determined based
on quoted market prices for similar assets.
 
 (f) Financial Liabilities
 
  The fair value of financial liabilities is believed to be equal to the
carrying amount because the terms of the debt are similar to terms currently
offered by lenders, and the interest rates are variable based on current
market rates.
 
 (g) Off Balance Sheet Financial Instruments
 
  At December 31, 1997, the locked pipeline was $256.6 million with a related
fair value of $261.3 million, and, net of related mandatory forward
commitments, had unrecognized gains at approximately $2.3 million. At December
31, 1996, the locked pipeline was $103.9 million with a related fair value of
$106.2 million, and, net of related mandatory forward commitments, had
unrecognized gains of approximately $1.8 million.
 
  Mortgage servicing rights retained relating to loans sold prior to January
1, 1995 are not financial instruments and, accordingly, are not included in
the above fair values. These servicing rights contribute substantial value to
the Company and are not reflected in the accompanying financial statements.
 
15. PROFIT SHARING PLAN
 
  On December 31, 1993, the Company adopted a new profit sharing plan. The new
plan has entry dates of January 1st and July 1st and any employee who has
completed six months of employment on those dates is automatically a member of
the plan. To participate in the current year's profit sharing, an employee
must be a member of the plan, must have worked 1,000 hours during the fiscal
year and must be employed as of the profit sharing plan year end. The plan
provides vesting ratably over two to six years. Contributions are at the
discretion of the Board of Directors. When made, contributions are credited to
each member's account in proportion to their annual compensation and time of
service. The Company did not contribute to the profit sharing plan during the
years ended December 31, 1997 and 1996.
 
 
                                     F-17
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
16. COMMITMENTS AND CONTINGENCIES
 
 (a) Leases
 
  The Company leases office space under various operating leases. Minimum
rental commitments under these operating leases with an initial or remaining
noncancelable lease term in excess of one year as of December 31, 1997 were as
follows:
 
<TABLE>
<CAPTION>
                                                           RELATED
                                                  LEASE    SUBLEASE   NET LEASE
                                               COMMITMENT   INCOME   COMMITMENT
                                               ----------- --------  -----------
      <S>                                      <C>         <C>       <C>
      1998.................................... $ 3,094,990 $(34,802) $ 3,060,188
      1999....................................   3,190,850       --    3,190,850
      2000....................................   3,122,636       --    3,122,636
      2001....................................   3,021,003       --    3,021,003
      2002....................................   2,945,193       --    2,945,193
      Thereafter..............................   1,779,385       --    1,779,385
                                               ----------- --------  -----------
                                               $17,154,057 ($34,802) $17,119,255
                                               =========== ========  ===========
</TABLE>
 
  Rent expense recorded by the Company for the years ended December 31, 1997,
1996 and 1995 was $2.3 million, $1.9 million and $2.1 million, respectively.
 
  In addition to the office leases described above, the Company entered into
leases for certain office equipment during 1997 and 1996. The future minimum
payments under these noncancelable lease terms as of December 31, 1997 were as
follows:
 
<TABLE>
<CAPTION>
                                                 OPERATING  CAPITAL     TOTAL
                                                  LEASES     LEASES     LEASES
                                                 --------- ---------- ----------
      <S>                                        <C>       <C>        <C>
      1998...................................... $ 69,741  $1,451,310 $1,521,051
      1999......................................   58,118   1,451,310  1,509,428
      2000......................................       --     989,908    989,908
      2001......................................       --     282,088    282,088
      2002......................................       --     188,269    188,269
                                                 --------  ---------- ----------
                                                 $127,859  $4,362,885 $4,490,744
                                                 ========  ========== ==========
</TABLE>
 
  Expense recorded by the Company under these equipment leases for the years
ended December 31, 1997 and 1996 were approximately $153,000 and $12,000,
respectively. There were no equipment leases during the year ended December
31, 1995.
 
 (b) Loan Commitments
 
  The Company made commitments to deliver loans to various investors. The
mandatory commitments outstanding were $580 million and $276.2 million at
December 31, 1997 and 1996 , respectively, with a related market cost of $2.3
million and $0.5 million at December, 1997 and 1996, respectively. The Company
had prepaid commitment fees of approximately $41,000 and $58,000 related to
these commitments at December 31, 1997 and 1996, respectively.
 
  The Company uses mandatory sell forward delivery commitments to buy and sell
whole loans, to issue private securities and to issue Fannie Mae and Freddie
Mac securities. These commitments, which are used as a hedge against locked
loan origination commitments whereby the Company has extended an interest rate
lock to the borrower, were included in the lower of cost or market valuation
of mortgage loans held for sale.
 
 
                                     F-18
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
  The Company is subject to interest rate risk on open commitments. This risk
results from differences between the market interest rate and the commitment
interest rate.
 
  The Company is contractually committed to fund the undrawn portion of home
equity lines of credit (HELOCs) which it has originated. This commitment
extends to HELOCs which are currently held for sale by the Company, and HELOCs
sold by the Company into the Headlands Home Equity Loan Trusts. As of December
31, 1997 and 1996, this unfunded commitment was approximately $108.8 million
and $38.2 million, respectively.
 
  Additionally, the Company is contractually committed to fund the undrawn
portion of mortgage loans originated under it's land/home program. The terms
of these loans allow borrowers to draw funds under their mortgage loans in
installments. As of December 31, 1997 and 1996, this unfunded commitment was
approximately $.4 million and $1.1 million, respectively.
 
 (c) Contingencies
 
  The Company is a defendant to a number of claims arising in the ordinary
course of business. Management is of the view that these matters will not have
a material adverse effect on the Company's financial position, net income or
liquidity.
 
17. STOCK OPTION PLAN
 
  The Company's 1997 Executive and non-employee Director Stock Option Plan
(the Plan) provides for the grant of qualified incentive stock options (ISOs),
stock options not so qualified (NQSOs), deferred stock, restricted stock,
performance shares, stock appreciation rights, limited stock appreciation
rights, and dividend equivalent rights (DERs). ISOs could be granted to the
officers and key employees of the Company. However, subsequent to December 31,
1997, the Plan was amended to qualify all employees as eligible for ISOs.
NQSOs and awards may be granted to the directors, officers, key employees,
agents and consultants of the Company or any subsidiaries. Unless previously
terminated by the Board of Directors, the Plan will terminate on September 15,
2007.
 
  In September 1997, options to acquire 518,000 shares of common stock were
granted to certain officers with an exercise price of $4.06 per share. The
Company used an independent appraisal firm to value the options granted in
1997. The independent appraisal firm considered three valuation approaches in
developing a value for the options, including (1) market comparison using
comparable public companies, (2) underlying asset method using the Company's
individual assets, and (3) discounted future returns analysis based on an
expected value discount model. The Board of Directors determined the estimated
fair value of the option shares at the time of grant by adjusting the
independent appraisal upward to take into consideration the probability of a
successful initial public offering. The options, along with the options
granted to non-officer directors, vest over four years and have ten year
terms. As of December 31, 1997, no options had been exercised or were eligible
to be exercised.
 
  In accordance with the provisions of APB Opinion No. 25, the Company will
recognize compensation expense over the vesting period for the difference
between such exercise price and the estimated fair value of the underlying
shares at time of grant, aggregating approximately $3.3 million. If the
Company had calculated compensation cost based on the fair value at the grant
date under Statement of Financial Accounting Standards No. 123, (SFAS No. 123)
"Accounting for Stock-Based Compensation," the Company's net income would have
been reduced to the pro forma amount indicated below:
 
 
                                     F-19
<PAGE>
 
                          HEADLANDS MORTGAGE COMPANY
 
            NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
 
<TABLE>
<CAPTION>
                                                                   PRO FORMA
                                                               AS C CORPORATION
                                                                  YEAR ENDED
                                                               DECEMBER 31, 1997
                                                               -----------------
                                                                  (UNAUDITED)
<S>                                                            <C>
Net income:
  As reported.................................................    $22,400,955
  Pro forma under SFAS No. 123................................    $22,373,915
EPS--Basic:
  As reported ................................................    $      1.47
  Pro forma under SFAS No. 123................................    $      1.46
EPS--Diluted:
  As reported.................................................    $      1.46
  Pro forma under SFAS No. 123................................    $      1.45
</TABLE>
 
The pro forma amounts above were based on the difference between the $6.41 per
option recorded by the Company under APB Opinion No. 25 and an option fair
value of $7.13 calculated using the Black-Scholes option-pricing model with
the following assumptions:
 
<TABLE>
      <S>                                                                 <C>
      Weighted average expected life (years).............................  3.25
      Risk-free interest rate............................................ 5.835%
      Volatility.........................................................   --
      Expected dividend yield............................................   --
</TABLE>
 
  Stock options activity during the year ended December 31, 1997 was as
follows:
 
<TABLE>
<CAPTION>
                                                              NUMBER OF EXERCISE
                                                               SHARES    PRICE
                                                              --------- --------
      <S>                                                     <C>       <C>
      Balance at December 31, 1996...........................      --      --
      Granted................................................  518,000   $4.06
      Exercised..............................................      --      --
      Canceled...............................................      --      --
                                                               -------   -----
      Balance at December 31, 1997...........................  518,000   $4.06
                                                               =======   =====
</TABLE>
 
  At December 31, 1997, all stock options had a remaining term of
approximately ten years and an exercise price of $4.06.
 
 
                                     F-20
<PAGE>
 
18. EARNINGS PER SHARE
 
  On December 31, 1997 the Company adopted Statement of Financial Accounting
Standard No. 128 ("SFAS 128") "Earnings Per Share" for calculating earnings
per share as shown below:
 
<TABLE>
<CAPTION>
                                                 YEAR ENDED DECEMBER 31, 1997
                                                 ------------------------------
                                                                 SUPPLEMENTAL
                                                   PRO FORMA      PRO FORMA
                                                 -------------- ---------------
<S>                                              <C>            <C>
Pro forma net income............................ $   22,400,955 $   22,400,955
Add: interest expense on shareholders notes.....            --         533,005
                                                 -------------- --------------
Adjusted pro forma net income................... $   22,400,955 $   22,933,960
                                                 ============== ==============
Weighted average shares outstanding.............     14,000,000     14,000,000
Add: Adjustment for Shareholder Distribution
 Amount.........................................      1,258,334      2,133,334
                                                 -------------- --------------
Weighted average shares - basic.................     15,258,334     16,133,334
Add: stock options..............................         99,968         99,968
                                                 -------------- --------------
Weighted average shares - diluted...............     15,358,302     16,233,302
Earnings per share - basic...................... $         1.47 $         1.42
                                                 ============== ==============
Earnings per share - diluted.................... $         1.46 $         1.41
                                                 ============== ==============
</TABLE>
 
19. PREFERRED STOCK
 
  The Company has authorized 5,000,000 shares of Preferred Stock. As of
December 31, 1997, none of the authorized shares have been issued.
 
20. UNAUDITED PRO FORMA INFORMATION
 
  Pro forma information has been presented to show what the significant
effects on the historical financial information might have been based upon the
revocation of the S corporation status. The number of shares used in all
calculations has been adjusted to reflect a 14,000-for-one stock split.
 
  Pro forma net income represents the results of operations adjusted to
reflect a change in the Company's income tax status from an S corporation to a
C corporation, using a pro forma income tax rate of 42% for each of the years
in the three-year period ended December 31, 1997. If the S corporation status
had been terminated as of December 31, 1997, the amount of the deferred tax
liability and corresponding reduction in retained earning recorded by the
Company would have been approximately $20.3 million. Any remaining retained
earnings after adjustments attributable to termination of S corporation status
would have been reclassified as common stock.
 
  Pro forma earnings per share is computed by dividing pro forma net income by
the weighted average number of shares of common stock and dilutive common
stock equivalents. For purposes of this calculation, outstanding stock options
are considered common stock equivalents and totaled 99,968 shares for the year
ended December 31, 1997 under the treasury stock method in accordance with
SFAS No. 128. The pro forma weighted average number of shares also includes
the effect of the assumed issuance of 1,258,334 shares of common stock to
generate sufficient cash to pay to shareholders upon termination of the
Company's S corporation status the amount of previously earned and
undistributed taxable income ($15.1 million at December 31, 1997). The
issuance of common stock was based on the $12.00 initial public offering
price. The weighted average shares outstanding for computing basic and diluted
earnings per share were 15,258,334 and 15,358,302, respectively, for the year
ended December 31, 1997.
 
  Supplemental pro forma basic and diluted earnings per share of $1.42 and
$1.41, respectively, for the year ended December 31, 1997, reflects further
adjustment for the effect of the add back, net of tax, of interest expense
recorded during 1997 relating to the Notes payable to stockholders, to be
repaid from the proceeds of the Company's Initial Public Offering. In that
calculation, weighted average shares outstanding of 16,233,302 include the
effect of the assumed issuance of 875,000 shares of common stock to retire the
Notes payable to stockholders ($10.5 million at December 31, 1997).
 
                                     F-21
<PAGE>
 
21. SUBSEQUENT EVENTS
 
  On January 31, 1998, the Company converted its tax status from an S
corporation to a C corporation. As a C corporation, the Company bears the tax
obligation relating to the net income earned for federal and state tax
purposes.
 
  On February 5, 1998, the Company commenced trading shares of its stock on
the Nasdaq under the symbol HDLD. A portion of the proceeds received form the
sale of its stock to the public were used to repay the $9,670,000 in notes
payable to shareholders.
 
 
                                     F-22
<PAGE>
 
                                 EXHIBIT INDEX
 
<TABLE>
<CAPTION>
     EXHIBIT
     NUMBER  EXHIBIT
     ------- -------
     <C>     <S>
     3.1*    Composite Articles of Incorporation of the Registrant
     3.2*    Amended and Restated Bylaws of the Registrant
     4.1*    Specimen common Stock Certificate
     9.1*    Voting Trust Agreement dated September 15, 1997, as amended
     10.1.1* Employment Agreement of Peter T. Paul
     10.1.2* Employment Agreement of Becky S. Poisson
     10.1.3* Employment Agreement of Gilbert J. MacQuarrie
     10.1.4* Employment Agreement of Steven M. Abreu
     10.2*   1997 Executive and Non-Employee Director Stock Option Plan dated
             July 22, 1997
     10.3*   Description of Bonus Incentive Compensation Plan
     10.4*   Amended and Restated Mortgage Loan Warehousing Agreement, dated as
             of August 29, 1997, among the Registrant and the Lenders therein
             named, as amended
     10.4.1* Second Amendment to Amended and Restated Mortgage Loan Warehousing
             Agreement
     10.4.2* Third Amendment to Amended and Restated Mortgage Loan Warehousing
             Agreement
     10.4.3  Fourth Amendment to Amended and Restated Mortgage Loan Warehousing
             Agreement
     10.5*   Amended and Restated Servicing Secured Credit Agreement, dated as
             of August 29, 1997, among the Registrant and the Lender named
             therein, as amended
     10.5.1* Second Amendment to Amended and Restated Servicing Secured Credit
             Agreement
     10.5.2* Third Amendment to Amended and Restated Servicing Secured Credit
             Agreement
     10.5.3  Fourth Amendment to Amended and Restated Servicing Secured Credit
             Agreement
     10.6*   Master Repurchase Agreement dated as of September 11, 1996, among
             Merrill Lynch Mortgager Capital, Inc., Merrill Lynch Credit
             Corporation and the Registrant, as amended
     10.7*   Tax Indemnification Agreement among the Registrant and the
             Registrant's shareholders prior to termination of S corporation
             status
     10.8*   Founders Registration Rights Agreement
     11.1    Statement regarding computation of per share earnings
     21.1*   List of Subsidiaries of the Registrant
     23      Consent of KPMG Peat Marwick LLP
     27      Financial Data Schedule
</TABLE>
--------
*Incorporated by reference to the correspondingly numbered exhibit to the
Registration Statement on Form S-1 (333-38267) filed by the Registrant with the
Securities and Exchange Commission on October 24, 1997.