**UNITED
STATES**
 **SECURITIES
AND EXCHANGE COMMISSION**
 
 **Washington,
D.C. 20549**
 
 **FORM
10-Q**
 
 **(Mark One)**
 **[x]**
    **QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
      1934**For
      the quarterly period endedMarch
      31, 2005
 
 **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:** **1-12109**
 
 
 
 **DELTA
FINANCIAL CORPORATION**
 (Exact
name of registrant as specified in its charter)
 
 **Delaware**
    
    **11-3336165**(State
      or other jurisdiction of
    
    (I.R.S.
      Employerincorporation
      or organization)
    
    Identification
      No.)
 
 **1000
Woodbury Road, Suite 200, Woodbury, New York 11797**
 
 (Address
of registrant’s principal executive offices including ZIP Code)
 
 **(516)
364 - 8500**
 
 (Registrant’s
telephone number, including area code)
 
 **No
Change**
 
 (Former
name, former address and former fiscal year, if changed since last
report)
 
 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 whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act).
 Yes [
]   No [ x
]
 
 As of May
4, 2005, 20,310,386 shares of the Registrant’s common stock, par value $0.01 per
share, were outstanding.
 
 
 **INDEX
TO FORM 10-Q**
 
 
 **Page
      No.****PART
      I - FINANCIAL INFORMATION**Item
      1.
    Financial
      StatementsConsolidated Balance Sheets as of March 31, 2005
      (unaudited) and December 31, 2004
    1Consolidated Statements of Operationsfor the three
      months endedMarch
      31, 2005 and 2004 (unaudited)
    2Consolidated Statement of Changes in
      Stockholders’ Equityfor the three monthsended
      March 31, 2005 (unaudited)
    3Consolidated Statements of Cash Flowsfor the three
      months endedMarch
      31, 2005 and 2004 (unaudited)
    4Notes to Consolidated Financial
    Statements
    5Item
      2.
    Management’s Discussion and Analysis of
      Financial Condition and Results of Operations
    18Item
      3.
    Quantitative and Qualitative Disclosures About
      Market Risk
    44Item
      4.
    Controls and Procedures
    48**PART
      II - OTHER INFORMATION**Item
      1.
    Legal Proceedings
    48Item
      2.
    Unregistered Sales of Equity Securities and Use of
      Proceeds
    50Item
      3.
    Defaults Upon Senior Securities
    50Item
      4.
    Submission of Matters to a Vote of Security
      Holders
    50Item
      5.
    Other Information
    50Item
      6.
    Exhibits
    50Signatures
    51
 
 
   
 **PART
I - FINANCIAL INFORMATION**
 
 **Item
1 - Financial Statements.**
 
 **DELTA
FINANCIAL CORPORATION AND SUBSIDIARIES**
 **CONSOLIDATED BALANCE SHEETS**
 *(Dollars
in thousands, except for share data)*
 
 **March
      31,**
      **2005**
    
    **December 31,      2004***(Unaudited)***Assets:**Cash
      and cash equivalents
    
    $
    7,281
    
    $
    5,187Mortgage
      loans held for investment, net of discounts and deferred
      origination fees
    
    
    2,933,994
    
    
    2,351,272Less: Allowance for loan losses
    
    
    (16,808
    )
    
    (10,278
    )Mortgage loans held for investment, net
    
    
    2,917,186
    
    
    2,340,994Trustee
      receivable
    
    
    44,332
    
    
    30,197Accrued
      interest receivable
    
    
    15,402
    
    
    12,280Excess
      cashflow certificates
    
    
    14,059
    
    
    14,933Equipment,
      net
    
    
    4,928
    
    
    4,298Accounts
      receivable
    
    
    9,164
    
    
    6,453Prepaid
      and other assets
    
    
    31,532
    
    
    26,125Deferred
      tax asset
    
    
    51,089
    
    
    50,326Total assets
    
    $
    3,094,973
    
    $
    2,490,793**Liabilities
      and Stockholders’ Equity****Liabilities:**Bank
      payable
    
    $
    1,589
    
    $
    1,110Warehouse
      financing
    
    
    118,693
    
    
    135,653Financing
      on mortgage loans held for investment, net
    
    
    2,845,031
    
    
    2,236,215Other
      borrowings
    
    
    2,941
    
    
    3,330Accrued
      interest payable
    
    
    5,828
    
    
    4,282Accounts
      payable and other liabilities
    
    
    27,751
    
    
    23,023Total liabilities
    
    
    3,001,833
    
    
    2,403,613**Stockholders’
      Equity:**Common
      stock, $.01 par value. Authorized 49,000,000 shares;
      20,425,787 and 20,403,187 shares issued and 20,308,987 and 
      20,286,387 shares outstanding at
      March 31, 2005 and December 31, 2004, respectively
    
    
    204
    
    
    204Additional
      paid-in capital
    
    
    119,565
    
    
    119,451Accumulated
      deficit
    
    
    (27,906
    )
    
    (28,950
    )Accumulated
      other comprehensive income (loss), net of taxes
    
    
    2,595
    
    
    (2,207
    )Treasury
      stock, at cost (116,800 shares)
    
    
    (1,318
    )
    
    (1,318
    )Total stockholders’ equity
    
    
    93,140
    
    
    87,180Total
      liabilities and stockholders’ equity
    
    $
    3,094,973
    
    $
    2,490,793
  See
accompanying notes to consolidated financial statements.
  **1**
  **DELTA
FINANCIAL CORPORATION AND SUBSIDIARIES**
 **CONSOLIDATED STATEMENTS OF OPERATIONS** (Unaudited)
 *(Dollars
in thousands, except share and per share data)*
 
 
 **Three
      Months Ended March 31,****2005**
    
    **2004**Interest
      income
    
    $
    54,876
    
    $
    7,284Interest
      expense
    
    
    27,783
    
    
    1,913Net interest income
    
    
    27,093
    
    
    5,371Provision
      for loan losses
    
    
    6,864
    
    
    432Net interest income after provision for loan losses
    
    
    20,229
    
    
    4,939Non-interest
      income:Net gain on sale of mortgage loans
    
    
    5,328
    
    
    7,740Other income
    
    
    2,815
    
    
    96Total
      non-interest income
    
    
    8,143
    
    
    7,836Non-interest
      expense:Payroll and related costs
    
    
    15,154
    
    
    11,559General and administrative
    
    
    9,795
    
    
    6,129(Gain)
      loss on derivative instruments
    
    
    (16
    )
    
    4,724Total
      non-interest expense
    
    
    24,933
    
    
    22,412Income
      (loss) before income tax expense (benefit)
    
    
    3,439
    
    
    (9,637
    )Provision for income tax expense (benefit)
    
    
    1,380
    
    
    (3,722
    )Net
      income (loss)
    
    $
    2,059
    
    $
    (5,915
    )**Other
      Comprehensive Income (Loss)**:Net unrealized holding gains on derivatives arising during theperiod, net of tax
    
    
    4,802
    
    
    --Other comprehensive income (loss)
    
    $
    6,861
    
    $
    (5,915
    )**Per
      Share Data:**Basic - weighted average number of shares outstanding
    
    
    20,295,874
    
    
    16,924,366Diluted - weighted average number of shares outstanding
    
    
    21,236,140
    
    
    16,924,366Net income (loss) applicable to common shares
    
    $
    2,059
    
    $
    (5,915
    )Basic earnings per share - net income (loss)
    
    $
    0.10
    
    $
    (0.35
    )Diluted earnings per share - net income (loss)
    
    $
    0.10
    
    $
    (0.35
    )
  
  See
accompanying notes to consolidated financial statements.
  **2**
  **DELTA
FINANCIAL CORPORATION AND SUBSIDIARIES**
 **CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’
EQUITY** (Unaudited)
 **For
the Three Months Ended March 31, 2005**
 *(Dollars
in thousands)*
 
 **Common
      Stock**
    
    **Additional**
      **Paid-in
      Capital**
    
    **Accumulated
      Deficit**
    
    **Accumulated
      Other Comprehensive Income (Loss), Net of Taxes**
    
    **Treasury
      Stock**
    
    **Total**Balance
      at December 31, 2004
    
    $
    204
    
    $
    119,451
    
    $
    (28,950
    )
    $
    (2,207
    )
    $
    (1,318
    )
    $
    87,180Stock
      options exercised, inclusiveof
      tax benefit
    
    
    --
    
    
    114
    
    
    --
    
    
    --
    
    
    --
    
    
    114Dividend
      declared and payable
    
    
    --
    
    
    --
    
    
    (1,015
    )
    
    --
    
    
    --
    
    
    (1,015
    )Net
      unrealized gain fromderivatives,
      net of tax
    
    
    --
    
    
    --
    
    
    --
    
    
    4,802
    
    
    --
    
    
    4,802Net
      income
    
    
    --
    
    
    --
    
    
    2,059
    
    
    --
    
    
    --
    
    
    2,059Balance
      at March 31, 2005
    
    $
    204
    
    $
    119,565
    
    $
    (27,906
    )
    $
    2,595
    
    $
    (1,318
    )
    $
    93,140
 
 See
accompanying notes to consolidated financial statements.
  **3**
  **DELTA
FINANCIAL CORPORATION AND SUBSIDIARIES**
 **CONSOLIDATED STATEMENTS OF CASH FLOWS** (Unaudited)
 *(Dollars
in thousands)*
 
 **Three
      Months Ended March 31,****2005**
    
    **2004**Cash
      flows from operating activities:Net
      income (loss)
    
    $
    2,059
    
    $
    (5,915
    )Adjustments
      to reconcile net income to net cash used in operatingactivities:Provision
      for loan losses
    
    
    6,864
    
    
    432(Recovery)
      provision for recourse loans
    
    
    (163
    )
    
    2Depreciation
      and amortization
    
    
    562
    
    
    434Deferred
      tax benefit
    
    
    (3,833
    )
    
    (4,251
    )Deferred
      origination (costs) fees
    
    
    (1,788
    )
    
    269Gain
      on change in fair value of excess cashflow certificates
    
    
    (2,738
    )
    
    --Amortization
      and fair value change of bond securitizationsdeferred
      cost and premiums
    
    
    (166
    )
    
    --Cash
      flows received from excess cashflow certificates, net ofamortization
    
    
    3,612
    
    
    364Proceeds
      from sale of mortgage servicing rights, net
    
    
    5,195
    
    
    2,407Changes
      in operating assets and liabilities:Increase
      in due from securitization trust
    
    
    --
    
    
    (143,711
    )(Increase)
      decrease in accounts receivable
    
    
    (2,711
    )
    
    11Decrease
      in mortgage loans held for sale, net
    
    
    --
    
    
    43,799Increase
      in trustee receivable, net
    
    
    (14,135
    )
    
    --Increase
      in accrued interest receivable
    
    
    (3,171
    )
    
    (2,292
    )Increase
      in prepaid and other assets
    
    
    (3,071
    )
    
    (5,958
    )Increase
      in accrued interest payable
    
    
    1,546
    
    
    346Increase
      in accounts payable and other liabilities
    
    
    5,055
    
    
    897Net
      cash used in operating activities
    
    
    (6,883
    )
    
    (113,166
    )Cash
      flows from investing activities:Increase
      in mortgage loans held for investment, net
    
    
    (584,935
    )
    
    (415,173
    )Purchase
      of equipment
    
    
    (1,192
    )
    
    (437
    )Net
      cash used in investing activities
    
    
    (586,127
    )
    
    (415,610
    )Cash
      flows from financing activities:Repayment
      of warehouse financing, net
    
    
    (16,960
    )
    
    (59,797
    )Proceeds
      of financing on mortgage loans held for investment, net
    
    
    612,873
    
    
    589,146(Repayment
      of) proceeds from other borrowings, net
    
    
    (389
    )
    
    404Increase
      (decrease) in bank payable
    
    
    479
    
    
    (1,065
    )Cash
      dividends paid on common stock
    
    
    (1,013
    )
    
    --Proceeds
      from exercise of stock options
    
    
    114
    
    
    119Net
      cash provided by financing activities
    
    
    595,104
    
    
    528,807Net
      increase in cash and cash equivalents
    
    
    2,094
    
    
    31Cash
      and cash equivalents at beginning of period
    
    
    5,187
    
    
    4,576Cash
      and cash equivalents at end of period
    
    $
    7,281
    
    $
    4,607Supplemental
      Information:Cash
      paid during the period for:Interest
    
    $
    25,022
    
    $
    1,567Income
      taxes
    
    $
    4,366
    
    $
    68Non
      cash transactions:Dividends
      payable
    
    $
    1,015
    
    $
    --Transfer
      of mortgage loans held for investment to REO, net
    
    $
    912
    
    $
    --
 
 See
accompanying notes to consolidated financial statements.
 
  **4**
  **DELTA
FINANCIAL CORPORATION AND SUBSIDIARIES**
 **NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 **(1)**  **Basis
of Presentation**
 
 Delta
Financial Corporation is a Delaware corporation, organized in August
1996.
 
 The
accompanying unaudited consolidated financial statements include the accounts of
Delta Financial Corporation and its wholly owned subsidiaries (collectively, the
“Company,” “we” or “us”). The consolidated financial statements reflect all
normal recurring adjustments that, in the opinion of management, are necessary
to present a fair statement of the financial position and results of operations
for the periods presented. Certain reclassifications have been made to
prior-period financial statements to conform to the 2005
presentation.
 
 Certain
information and footnote disclosures normally included in financial statements
prepared in accordance with U.S. generally accepted accounting principles
(“GAAP”) have been condensed or omitted pursuant to the rules and regulations of
the U.S. Securities and Exchange Commission (“SEC”). The
preparation of financial statements in conformity with GAAP requires our
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of income and
expenses during the reporting periods. Actual results could differ from those
estimates and assumptions.
 
 These
unaudited consolidated financial statements should be read in conjunction with
the audited consolidated financial statements and notes thereto included in our
Annual Report on Form 10-K. The results of operations for the three month period
ended March 31, 2005 are not necessarily indicative of the results that will be
expected for the entire year.
 
 The
accompanying unaudited consolidated financial statements have been prepared in
conformity with the instructions to Form 10-Q and Article 10, Rule 10-01 of
Regulation S-X for interim financial statements. Accordingly, they do not
include all of the information and footnotes required by GAAP for complete
financial statements.
 
 **(2)**  **Basis
of Consolidation**
 
 The
accompanying consolidated financial statements are prepared on the accrual basis
of accounting and include our accounts and those of our wholly owned
subsidiaries. All significant inter-company accounts and transactions have been
eliminated in consolidation.
 
 **(3)**  **Summary
of Significant Accounting Policies**
 
 ***(a)
Cash and Cash Equivalents***
 
 For cash
flow reporting purposes, cash and cash equivalents includes cash in checking
accounts, cash in interest bearing deposit accounts, amounts due from banks,
restricted cash and money market investments. Included in cash and cash
equivalents were $240,000 and $215,000 of interest-bearing deposits with select
financial institutions at March 31, 2005 and December 31, 2004,
respectively.
 
 Additionally,
cash and cash equivalents as of March 31, 2005 and December 31, 2004 included
restricted cash held for various reserve accounts totaling $565,000 and
$461,000, respectively.
 
 ***(b)
Mortgage Loans Held for Sale, Net***
 
 Until the
third quarter of 2004, we classified all mortgage loans originated by us and
held pending securitization or sale as mortgage loans held for sale. Commencing
in the fourth quarter of 2004, mortgage loans held pending securitization or
sale have been classified as mortgage loans held for investment -
pre-securitization. We changed this classification because we determined that we
would ultimately securitize the majority of the mortgage loans held through
securitizations structured as secured financings. The majority of these loans,
therefore, will remain on our balance sheet as mortgage loans held for
investment - securitized. While we may ultimately sell from time to time some of
the mortgage loans we hold, we usually do not make the determination regarding
which mortgage loans will be sold until the following reporting period. As such,
at March 31, 2005 and December 31, 2004, we did not classify any mortgage loans
as held for sale.
 
 **5**
 Prior to
the change in classification, mortgage loans held for sale, net represented
fixed-rate and adjustable-rate mortgage loans that had a contractual maturity of
up to 30 years. These mortgage loans were secured by residential properties and
were recorded at the lower of amortized cost or fair value, as determined on a
loan by loan basis. We typically held our mortgage loans held for sale for no
more than 120 days, and for 60 days on average, before they were sold and/or
securitized in the secondary market. During the period in which the loans were
held for sale, we earned the coupon rate of interest paid by the borrower, and
paid interest to the lenders that provide our warehouse financing to the extent
that we utilized such financing. We also paid a sub-servicing fee to a third
party during the period the loans were held for sale. Loan origination fees,
discount points and certain direct origination costs associated with loans held
for sale were initially recorded as an adjustment of the cost to the loan. Gains
or losses on sales of mortgage loans were recognized based upon the difference
between the selling price and the carrying value of the related mortgage loans
sold.
 
 ***(c)
Mortgage Loans Held for Investment, Net***
 
 Mortgage
loans held for investment, net represent loans we securitized through
transactions structured to be accounted for as secured financings (mortgage
loans held for investment - securitized) and loans we hold pending
securitization or sale (mortgage loans held for investment -
pre-securitization). Mortgage loans held for investment are stated at amortized
cost, including the outstanding principal balance, net of the allowance for loan
losses, net of discounts and net of deferred origination fees or
costs.
 
 The
allocated cost basis of mortgage servicing rights (“MSRs”) is recorded as an
asset with an offsetting reduction ( *i.e.* ,
discount) in the cost basis of the mortgage loans. Under Statement of Financial
Accounting Standards (“SFAS”) No. 140, “ Accounting
for Transfers and Servicing of Financial Assets and Extinguishments of
Liabilities-a replacement of FASB Statement No. 125,” the discount is measured
using the relative fair values of the mortgage loans and MSRs to allocate the
carrying value between the two assets. The MSRs
are generally sold to a third party servicer. The resulting discount is accreted
to interest income on a level yield basis over the contractual life of the
related loans, on a pool by pool basis, using the interest method
calculation.
 
 Additionally,
in accordance with SFAS No. 91, “ Accounting
for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans
and Initial Direct Costs of Leases—an amendment of FASB Statements No. 13, 60,
and 65 and a rescission of FASB Statement No. 17,” the net
deferred origination fees or costs associated with our mortgage loans held for
investment are amortized to income on a level yield basis over the contractual
life of the related loans, on a pool by pool basis, using the interest method
calculation.
 
 The
amount of deferred nonrefundable fees is determined based on the amount of such
fees collected at the time of loan closing. We determine the amount of direct
loan origination costs to be deferred based on the amount of time spent and
actual costs incurred by loan origination personnel in the performance of
certain activities directly related to the origination of funded mortgage loans
for that period. These activities include evaluating the prospective borrower’s
financial condition, evaluating and recording collateral and security
arrangements, negotiating loan terms, processing loan documents and closing the
loan. Management believes these estimates reflect an accurate cost structure
related to successful loan origination efforts for the three months ended March
31, 2005. Management periodically reviews its time and cost estimates to
determine whether revisions to the deferral amounts are necessary. Revisions
would be considered necessary if it was determined that the time spent and/or
costs incurred related to performing the above activities had significantly
changed from the previous period. This estimate is made for all loans originated
by our wholesale and retail segments.
  **6**
 The
secured financing related to the loans held for investment - securitized is
included in our consolidated balance sheet as financing on mortgage loans held
for investment. Once the loans are securitized, we earn the pass-through rate of
interest paid by the trustee and pay interest on our financing on mortgage loans
held for investment.
 
 ***(d)
Allowance and Provision for Loan Losses***
 
 In
connection with our mortgage loans held for investment, we established an
allowance for loan losses based on our estimate of losses to be incurred in the
foreseeable future. Provisions for loan losses are made for loans to the extent
that probable losses on these loans are borne by us. Provision amounts are
charged as a current period expense to operations. We charge-off uncollectible
loans against the allowance for loan losses at the time they are deemed not
probable of being collected. In order to estimate an appropriate allowance for
loan losses on mortgage loans held for investment, we estimate losses using a
detailed analysis of historical loan performance by product type, origination
year and securitization issuance. The results of that analysis are then applied
to the current long-term mortgage portfolio on a pool-by-pool basis and an
allowance estimate is created. In accordance with SFAS No. 5, “Accounting for
Contingencies,” we believe that pooling of mortgages with similar
characteristics is an appropriate methodology in which to calculate or estimate
the allowance for loan losses. We do not assess individual mortgage loans for
impairment due to the homogeneous nature of the loans.
 
 In
evaluating the adequacy of this allowance, there are qualitative factors and
estimates that must be taken into consideration when evaluating and measuring
potential expected losses on mortgage loans. These items include, but are not
limited to, current performance of the loans, economic indicators that may
affect the borrower’s ability to pay, changes in the market value of the
collateral, political factors and the general economic environment. As these
factors and estimates are influenced by factors outside of our control, there is
inherent uncertainty in these items and it is reasonably possible that they
could change. In particular, if conditions were such that we were required to
increase the provision for losses, any increase in the provision for losses
would decrease our income for that period. Management considers the allowance
for loan losses at March 31, 2005 to be adequate.
 
 Additionally,
in connection with loans sold on a recourse basis (prior to 1991), we have a
recourse reserve (included on the balance sheet within “accounts payable and
other liabilities”), which is based on our estimate of probable losses to be
borne by us under the terms of the recourse obligation. The methodology under
which the recourse reserve is calculated is similar to the methodology utilized
in determining the allowance for loan losses. Management considers the recourse
reserve at March 31, 2005 to be adequate.
 
 ***(e)
Trustee Receivable***
 
 Trustee
receivable principally represents any un-remitted principal payments collected
by the securitization trust’s third party loan servicer subsequent to the
monthly remittance cut-off date. Each month, the third party loan servicer, on
behalf of each securitization trustee, remits all of the scheduled loan payments
and unscheduled principal payoffs and curtailments received through a mid-month
cut-off date. Unscheduled principal payments and prepaid principal loan payments
received after the cut-off date for the current month are recorded by us as a
trustee receivable on the consolidated balance sheet. The trustee or third party
loan servicer retains these unscheduled principal payments until the following
month’s scheduled remittance date, at which time they principally will be used
to pay down financing on mortgage loans held for investment, net.
 
 ***(f)
Excess Cashflow Certificates***
 
 In
securitization transactions structured to be accounted for as sales (prior to
2004) ,  t he excess
cash flow certificates may represent one or all of the following assets: (1)
residual interest (“BIO”) certificates, (2) P certificates (prepayment penalty
fees), (3) payments from our interest rate cap providers, and (4) net interest
margin (“NIM”) owner trust certificates. Our excess cashflow certificates are
classified as “trading securities” in accordance with SFAS No. 115, “Accounting
for Certain Investments in Debt and Equity Securities.” The amount initially
recorded for the excess cashflow certificates at the date of a securitization
structured as a sale reflected their allocated fair value. The amount recorded
for the excess cashflow certificates is reduced for cash distributions received,
and is adjusted for income accretion and subsequent changes in the fair value in
accordance with SFAS No. 140. Any changes in fair value are recorded as a
component of “other income” or “other expense” in our consolidated statement of
operations. For the three months ended March 31, 2005, we recorded $2.7 million
of income due to an increase in the fair value of excess cashflow certificates.
For the three months ended March 31, 2004, we recorded no fair value adjustments
related to excess cashflow certificates.
 
 **7**
 We are
not aware of any active market for the sale of our excess cashflow certificates.
Accordingly, our estimate of fair value is subjective. Although we believe that
the assumptions we use are reasonable, there can be no assurance as to the
accuracy of the assumptions or estimates. The valuation of our excess cashflow
certificates requires us to forecast interest rates, mortgage principal
payments, prepayments and loan loss assumptions, each of which is highly
uncertain and requires a high degree of judgment. The rate used to discount the
projected cash flows is also critical in the valuation of our excess cashflow
certificates. Management uses internal, historical mortgage loan performance
data and forward London
Interbank Offering Rate (“LIBOR”) interest
rate curves to value future expected excess cash flows. We regularly analyze and
review our assumptions to determine that the expected return (interest income)
on our excess cashflows certificates is within our expected range.
 
 The
Emerging Issues Task Force (“EITF”) issued EITF 99-20, “Recognition of Interest
and Impairment on Purchased and Retained Beneficial Interests in Securitized
Financial Assets,” which provides
guidance on expected return (interest income) recognition and fair value
measurement for interests (excess cashflow certificates) retained in a
securitization transaction accounted for as a sale. In order
to determine
whether there has been a favorable change (increase to earnings) or an adverse
change (decrease to earnings) in the
excess cash flow certificates, a comparison is made between (1) the present
value of the excess cash flows at period end, and (2) the estimated carrying
value at period end - which is based on the change from the beginning period and
adjusted for the required rate of return within the period (currently, the
required rate of return is our discount rate of 15% per annum). If the present
value of the excess cash flows at period end is greater than the carrying value
at period end, the change is considered favorable. If the present value of the
excess cash flows at the end of the period is less than the carrying value, the
change is considered adverse. In both situations, the fair value adjustment, if
any, will be equal to the excess above or the deficit below the required rate of
return (the discount rate).
  ***(g)
Equipment, Net***
 
 Equipment,
including leasehold improvements, is stated at cost, less accumulated
depreciation and amortization. Depreciation of equipment is computed using the
straight-line method over the estimated useful lives of three to seven years.
Leasehold improvements are amortized over the lesser of the terms of the lease
or the estimated useful lives of the improvements. Ordinary maintenance and
repairs are charged to expense as incurred.
  Depreciation
and amortization are included in “general and administrative expenses” in our
consolidated statements of operations, and amounted to approximately $562,000
and $434,000 for the three months ended March 31, 2005 and 2004,
respectively.
 
 ***(h)
Real Estate Owned***
 
 Real
estate owned (“REO”) represents properties acquired through, or in lieu of,
foreclosure. REO properties are recorded at the lower of cost or fair value,
less estimated selling costs. REO properties are periodically evaluated for
recoverability and any subsequent declines in value are reserved for through a
provision. Gains or losses on the sale of REO properties are recognized upon
disposition.
 
 The
balance of REO is included in “prepaid expenses and other assets” on the
consolidated balance sheet. We had $1.2 million and $578,000 of REO properties
as of March 31, 2005 and December 31, 2004, respectively. No provisions were
made during the three months ended March 31, 2005 and 2004 as we did not
experience any declines in the values of REO held during the first quarter of
2005 and we held no REO properties during the first quarter of
2004.
 
 ***(i)
Warehouse Financing***
 
 Warehouse
financing represents the outstanding balance of our borrowings collateralized by
mortgage loans held pending securitization or sale. Generally, warehouse
financing facilities are used as interim, short-term financing which bear
interest at a fixed margin over an index, such as LIBOR. The outstanding balance
of our warehouse lines will fluctuate based on our lending volume, cash flows
from operations, other financing activities and equity
transactions.
 
 **8**
 ***(j)
Financing on Mortgage Loans Held for Investment, Net***
 
 Financing
on mortgage loans held for investment, net represents the securitization debt
(asset-backed pass-through certificates or notes, referred to as “asset-backed
pass-through securities”) used to finance loans held for investment -
securitized, along with any discounts on the financing. The balance of this
account will generally increase in proportion to the increase in mortgage loans
held for investment - securitized.
 
 Asset-backed
pass-through securities are secured, or backed, by the pool of mortgage loans
purchased by the securitization trust, which are recorded as mortgage loans held
for investment - securitized on our balance sheet. Generally,
the asset-backed pass-through security financing is comprised of a series of
senior and subordinate securities with varying maturities ranging generally from
one to 20 years and bearing either a fixed rate of interest or a variable rate
of interest (representing a fixed margin over one-month LIBOR). The
variable-rate asset-backed securities adjust monthly. Prior to
2004, we did not structure our securitizations as secured financings and we did
not have mortgage loans held for investment or related borrowings.
 
 Any
securitization debt issuance costs are deferred and amortized, along with any
discounts on the financing, on a level yield basis over the estimated life of
the debt issued. From time to time we may utilize derivative instruments (cash
flow hedges), such as interest rate swap contracts and corridors (corresponding
purchase and sale of interest rate caps with similar notional balances at
different strike prices), in an effort to maintain a minimum margin or to lock
in a pre-determined base interest rate on designated portions of our prospective
future securitization financing (collectively, the hedged risk). The changes in
fair value of the cash flow
hedges are reclassified from Other
Comprehensive Income or Loss (“OCI”) to
earnings through interest expense as the hedged risk affects
earnings.
 
 Our securitizations are structured legally as sales and thus, we are
not legally required to make payments to the holders of the asset-backed
pass-through securities.  The only recourse of the holders of these
asset-backed pass-through securities is related to the repayment from the
underlying mortgages specifically collateralizing the debt. The assets held by
the securitization trusts are not available to our general creditors. As with
past securitizations, we have potential liability to each of the securitization
trusts for any breach of the standard representations and warranties that we
provided in connection with each securitization.
 
 Under SFAS 140,
the securitizations are accounted for as financings. The securitization trusts
do not meet the qualifying special purpose entity (“QSPE”) criteria under SFAS
140 and related interpretations due to their ability to enter into derivative
contracts. Additionally, we have the option to purchase loans from the trust at
our discretion. Our
pre-2004 securitizations did meet the QSPE criteria, which required the
securitizations to be accounted for as a sale of mortgage loans.
 
 **(** ***k)***  ***Interest
Income***
 
 Interest
income primarily represents the sum of (a) the gross interest, net of servicing
fee, we earn on mortgage loans held for investment - securitized; (b) the gross
interest we earn on mortgage loans held for investment - pre-securitization
(held for sale); (c) securitization accrued bond interest (income received from
the securitization trust for fixed-rate pass-through securities at the time of
securitization settlement); (d) excess cashflow certificate income; (e) cash
interest earned on bank accounts; (f) prepayment penalty fees received; and (g)
amortized discounts, deferred costs and fees recognized on a level yield
basis.
 
 Interest
on mortgage loans is recognized as revenue when earned according to the terms of
the mortgages and when, in the opinion of management, it is deemed collectible.
Mortgage loans are placed on non-accrual status generally when the loan becomes
90 days past due or earlier when concern exists as to the ultimate
collectability of principal or interest. A non-accrual loan will be returned to
accrual status when principal and interest payments are no longer 90 days past
due, and the loan is anticipated to be fully collectible.
 
 **9**
 At March
31, 2005 and December 31, 2004, we had $32.9 million and $18.9 million,
respectively, of mortgage loans held for investment on non-accrual
status.
 
 ***(l)
Interest Expense***
 
 Interest
expense primarily represents the borrowing costs under (a) our warehouse credit
facilities to finance loan originations; (b) securitization debt; (c) equipment
financing; and (d) amortized discounts and deferred costs on a level yield
basis.
 
 ***(m)
Gain on Sale of Mortgage Loans***
 
 Gains and
losses on the sale of mortgage loans are recognized at settlement date and are
determined by the difference between the selling price and the carrying value of
the loans sold. These transactions are treated as sales in accordance with SFAS
No. 140.  Any
unamortized origination fees or costs at the date of sale are reflected as an
adjustment to gain on sale.
 
 We
generally sell loans on a servicing released basis and as such, the risk of loss
or default by the borrower has generally been assumed by the purchaser. However,
we are generally required to make certain representations and warranties by
these purchasers relating to loan documentation, collateral and the
accuracy of the information and documentation provided. To the
extent that we do not comply with such representations, or there are early
payment defaults, we may be required to repurchase loans or indemnify these
purchasers for any losses from borrower defaults.
 
 We
establish a reserve for the contractual obligation to rebate a portion of any
premium paid by a purchaser when a borrower prepays a sold loan within an agreed
period. The premium recapture reserve is recorded as a liability on our
consolidated financial statements when the mortgage loans are sold based on
our historical experience. The
provision for premium recapture is recognized at the date of sale and is
included in the consolidated statements of operations as a reduction of gain on
sale of mortgage loans.
 
 ***(n)
Mortgage Servicing Rights Sales***
 
 We
generally sell the mortgage servicing rights to a third party as of the
securitization date. Upon the sale we allocate a portion of the accounting basis
of the mortgage loans held for investment to the mortgage servicing rights,
which results in a discount to the mortgage loans held for investment. That
discount is accreted as an adjustment to yield on the mortgage loans over the
estimated life of the related loans, on a pool by pool basis, using the interest
method calculation. For the three months ended March 31, 2005 and 2004, we
received $5.2 million and $2.4 million, respectively, from a third party
servicer for the right to service the mortgage loans collateralizing our
securitizations that were structured to be accounted for as secured
financings.
 
 Prior to
the first quarter 2004 securitization, the mortgage servicing rights sold were
treated as a component of the net gain on sale of mortgage loans. For the three
months ended March 31, 2004, we received $661,000 from a third party servicer
for the right to service the mortgage loans collateralizing our securitization
that was structured to be accounted for as a sale. For the three months ended
March 31, 2004, we delivered $113.9 million of mortgage loans under a
pre-funding feature in our fourth quarter 2003 securitization and recorded
gain-on-sale revenue related thereto during the first quarter of
2004.
 ******
 ***(o) Derivative Instruments***
 
 We
regularly issue securitization pass-through securities collateralized by fixed-
and variable-rate mortgage loans. As a result of this activity, we are exposed
to interest rate risk beginning when our mortgage loans close and are recorded
as assets, until permanent financing is arranged, such as when pass-through
securities are issued. Our strategy is to use derivative instruments, in the
form of interest rate swap contracts, in an effort to effectively lock in a
pre-determined interest rate on designated portions of our prospective future
securitization financings. At times, we also use corridors that are designed to
limit our financing costs within the securitization by maintaining minimum
margins. Both the interest rate swaps and corridors are derivative instruments
that trade in liquid markets, and neither is used by us for speculative
purposes.
 
 **10**
 In
accordance with SFAS No. 133, “Accounting for Derivative Instruments and Hedging
Activities,” all derivatives are recorded on the balance sheet at fair value.
When derivatives are used as hedges, certain criteria must be met, including
contemporaneous documentation, in order to qualify for hedge accounting. Under
SFAS No. 133, cash flow hedge accounting is permitted only if a hedging
relationship is properly documented and qualifying criteria are satisfied. For
derivative financial instruments not designated as hedging instruments, all
gains or losses, whether realized or unrealized, are recognized in current
period earnings.
 
 Cash flow
hedge accounting is appropriate for hedges of uncertain cash flows associated
with future periods - whether as a consequence of interest to be received or
paid on existing variable-rate assets or liabilities or in connection with
intended purchases or sales.
 
 Under
cash flow hedge accounting treatment, derivative results are divided into two
portions, “effective” and “ineffective.” The effective portion of the
derivative's gain or loss is initially reported as a component of OCI and
subsequently reclassified into earnings when the forecasted transaction affects
earnings. The ineffective portion of the gain or loss is reported in earnings
immediately.
 
 To
qualify for cash flow hedge accounting treatment, all of the following factors
must be met:
 
 ·
    hedges
      must be documented, with the objective and strategy stated, along with an
      explicit description of the methodology used to assess and measure hedge
      effectiveness;
 
 ·
    dates
      (or periods) for the expected forecasted events and the nature of the
      exposure involved (including quantitative measures of the size of the
      exposure) must be explicitly documented;
 
 ·
    hedges
      must be expected to be “highly effective” both at the inception of the
      hedge and on an ongoing basis. Effectiveness measures must relate the
      gains or losses of the derivative to the changes in cash flows associated
      with the hedged item;
 
 ·  forecasted
transactions must be probable; and
 
 ·  forecasted
transactions must be made with different counterparties than the reporting
entity.
 
 If and
when hedge accounting is discontinued, typically when it is determined that the
hedge no longer qualifies for hedge accounting, the derivative will continue to
be recorded on the balance sheet at its fair value, with gains or losses being
recorded in earnings. Any amounts previously recorded in OCI related to the
discontinued hedge are classified to earnings over the remaining duration of the
debt.
 
 **(4)**  **Recent
Accounting Developments**
 
 In
December 2004, the Financial Accounting Standards Board (“FASB”) published SFAS
No. 123 (revised), “Share-Based Payment.” ** SFAS No.
123(R) replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” and
supersedes APB Opinion No. 25, “Accounting for Stock Issued to
Employees.” ** SFAS No.
123(R) also amends SFAS No. 95, “Statement of Cash Flows,” ** to
require that excess tax benefits be reported as a financing cash inflow rather
than as a reduction of taxes paid.
 
 SFAS No.
123(R) is intended to provide investors and other users of financial statements
with more complete and neutral financial information by requiring that the
compensation cost relating to share-based payment transactions be recognized in
financial statements. The cost will be measured based on the fair value of the
equity or liability instruments issued. We will be required to apply SFAS No.
123(R), as amended by the SEC on April 14, 2005, as of the annual reporting
period that begins after June 15, 2005 (or January 1, 2006). SFAS No. 123(R)
applies to all awards granted after the required effective date and will not be
applied to awards granted in periods before the required effective date except
to the extent that prior periods’ awards are modified, repurchased or cancelled
after the required effective date. The cumulative effect of initially applying
SFAS No. 123(R), if any, will be recognized as of the required effective date.
We are currently evaluating pricing models and the transition provisions of this
standard and will begin expensing stock options in the first quarter of
2006.
 
 **11**
 SFAS
No.123(R) provides two alternatives for adoption: (1) a "modified prospective"
method in which compensation cost is recognized for all awards granted
subsequent to the effective date of SFAS No. 123(R) as well as for the unvested
portion of awards outstanding as of the effective date; or (2) a "modified
retrospective" method which follows the approach in the "modified prospective"
method, but also permits the restatement of prior periods to record compensation
costs calculated under SFAS No. 123 for the pro forma disclosure. We plan to
adopt SFAS No. 123(R) using the modified retrospective method. Since we
currently account for stock options granted to employees in accordance with the
intrinsic value method permitted under Accounting
Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to
Employees,” no
compensation expense is recognized. The impact of adopting SFAS No. 123(R)
cannot be accurately estimated at this time, as it will depend on the market
value and the amount of share based awards granted in future periods. However,
had we adopted SFAS No. 123(R) in a prior period, the impact would approximate
the impact as described in the disclosure of pro forma net income and earnings
per share under SFAS No. 123 in Note 5 “- Stock-Based Compensation.” SFAS No.
123(R) also requires that tax benefits received in excess of compensation cost
be reclassified from operating cash flows to financing cash flows in the
consolidated statement of cash flows. This change in classification will reduce
net operating cash flows and increase net financing cash flows in the periods
after adoption.
 
 **(5)**  **Stock-Based
Compensation**
 
 In
December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based
Compensation—Transition and Disclosure,” which amended SFAS No. 123, “Accounting
for Stock-Based Compensation.” SFAS No. 148 provides three alternative methods
for a voluntary change to fair value accounting for stock-based compensation as
permitted under SFAS No. 123. SFAS No. 123 established accounting and disclosure
requirements using a fair-value-based method of accounting for stock-based
employee compensation plans. In accordance with SFAS No. 148, and as allowed by
SFAS No. 123, we continue to apply the intrinsic-value method of accounting
prescribed by APB Opinion No. 25 and related interpretations, including FASB
Interpretation (“FIN”) No. 44, “Accounting for Certain Transactions Involving
Stock Compensation, an Interpretation of APB Opinion No. 25,” to account for our
fixed-plan stock options. Under this method, compensation expense is recorded
over the vesting period only if the current market price of the underlying stock
exceeded the exercise price on the date of grant. Accordingly, no compensation
expense has been recognized for stock option awards granted through March 31,
2005 since the exercise price was at the fair market value of the Company’s
common stock on the grant date. We have elected to adopt only the disclosure
requirements of SFAS No. 123. The following table illustrates the pro forma net
income (loss) as if the fair-value-based method of SFAS No. 123 had been applied
to account for stock-based compensation expenses:
 
 **Three
      Months Ended March 31,***(Dollars
      in thousands, except share data)*
    
    **2005**
    
    **2004**Net
      income (loss), as reported
    
    $
    2,059
    
    $
    (5,915
    )Deduct
      total stock-based employee compensation expense
      determined under fair-value-based method
      for all
      awards, net of tax
    
    
    190
    
    
    71Pro
      forma net income (loss) applicable to common shares
    
    $
    1,869
    
    $
    (5,986
    )**Earnings
      per share:**Basic - as reported
    
    $
    0.10
    
    $
    (0.35
    )Basic - pro forma
    
    $
    0.09
    
    $
    (0.35
    )Diluted - as reported
    
    $
    0.10
    
    $
    (0.35
    )Diluted - pro forma
    
    $
    0.09
    
    $
    (0.35
    )
  **(6)**  **Mortgage
Loans Held for Investment, Net and Allowance for Loan
Losses**
 
 Mortgage
loans held for investment represents our basis in the mortgage loans that were
either delivered to securitization trusts (denoted as mortgage loans held for
investment - securitized) or are pending delivery into future securitizations or
sale on a whole-loan basis (denoted as mortgage loans held for investment -
pre-securitization), net of discounts, deferred fees and allowance for loan
losses. Prior to 2004, we did not structure our securitizations as financings
and we did not have mortgage loans held for investment.
 
 **12**
 Mortgage
loans held for investment - securitized is comprised of the mortgage loans
collateralizing our outstanding securitization pass-through securities. During
the three months ended March 31, 2005, we closed a securitization transaction
totaling $728.6 million structured as a secured financing and which was
collateralized by $750.0 million, or an additional $21.4 million, of mortgage
loans held for investment - securitized. During the year ended December 31,
2004, we closed four securitization transactions totaling $2.3 billion which
were structured to be accounted for as secured financings and which were
collateralized by $2.3 billion, or an additional $56.1 million, of mortgage
loans held for investment - securitized. Mortgage loans held for investment -
securitized had a weighted-average interest rate of 7.76% and 7.81% per annum at
March 31, 2005 and December 31, 2004, respectively.
 
 Mortgage
loans held for investment - pre-securitization is comprised of mortgage loans
waiting to be included in a securitization and, to a lesser extent, an amount of
loans that may be sold on a whole-loan basis. Included in our mortgage loans
held for investment - pre-securitization at March 31, 2005 and December 31,
2004, was approximately $118.7 million and $135.7 million of these mortgages
that were pledged as collateral for our warehouse financings at March 31, 2005
and December 31, 2004, respectively. Mortgage loans held for investment -
pre-securitization had a weighted-average interest rate of 7.78% and 7.86% per
annum at March 31, 2005 and December 31, 2004, respectively.
 
 The
following table presents a summary of mortgage loans held for investment, net at
March 31, 2005 and December 31, 2004:
 
 *(Dollars
      in thousands)*
    
    **At
      March 31, 2005**
    
    **At
      December 31, 2004**Mortgage
      loans held for investment - securitized
    
    $
    2,774,014
    
    $
    2,165,353Mortgage
      loans held for investment - pre-securitization
    
    
    184,100
    
    
    206,289Discounts
      (MSR related)
    
    
    (18,235
    )
    
    (14,570
    )Net
      deferred origination fees
    
    
    (5,885
    )
    
    (5,800
    )Allowance
      for loan losses
    
    
    (16,808
    )
    
    (10,278
    )Mortgage
      loans held for investment, net
    
    $
    2,917,186
    
    $
    2,340,994
 
 For the
three months ended March 31, 2005 and 2004, we recorded interest income related
to our mortgage loans held for investment - securitized, net of $45.9
million and $2.3 million, respectively. For the three months ended March 31,
2005 and 2004, we recorded interest income related to our mortgage loans held
for investment - pre-securitization (mortgage loans held for sale), net of
$6.9 million and $3.6 million, respectively.
 
 The
following table presents a summary of the activity for the allowance for loan
losses on all mortgage loans held for investment for the three months ended
March 31, 2005 and 2004. We did not have mortgage loans held for investment or a
related allowance prior to 2004.
 **For
      the Three Months Ended March 31,***(Dollars
      in thousands)*
    
    **2005**
    
    **2004**Beginning
      balance
    
    $
    10,278
    
    $
    --Provision
    
    
    6,864
    
    
    432Charge-offs
    
    
    (334
    )
    
    --Ending
      balance
    
    $
    16,808
    
    $
    432
  As of
March 31, 2005 and December 31, 2004, we had $32.9 million and $18.9 million,
respectively, of mortgage loans held for investment that were 90 days or more
delinquent under their payment terms, all of which were on non-accrual status.
At and for the quarter ended March 31, 2004, we had no mortgage loans held for
investment that were 90 days or more delinquent.
 **13**
  **(7)**  **Excess
Cashflow Certificates**
 
 The
following table presents the activity related to our excess cashflow
certificates for the three months ended March 31, 2005 and the year ended
December 31, 2004:
 
 *(Dollars
      in thousands)*
    
    **For
      the Three Months Ended March 31, 2005**
    
    **For
      the**
      **Year
      Ended**
      **December
      31, 2004**Balance,
      beginning of year
    
    $
    14,933
    
    $
    19,853Accretion
    
    
    488
    
    
    2,073Cash
      receipts
    
    
    (4,100
    )
    
    (8,359
    )Net
      change in fair value
    
    
    2,738
    
    
    1,366Balance,
      end of period
    
    $
    14,059
    
    $
    14,933
 
 In
accordance with EITF 99-20, we regularly analyze and review our assumptions to
determine whether the actual rate of return (interest income) on our excess
cashflows certificates is within our expected rate of return. The expected rate
of return is recorded as a component of interest income. Any return that is
either greater than or less than the expected rate of return is reflected as a
fair value adjustment and is recorded as a component of “other income” in the
consolidated statement of operations.
 
 Since we
structured our 2005 and 2004 securitizations to be accounted for as secured
financings, we no longer record excess cashflow certificates on the consolidated
balance sheet for our newly issued securitizations.
 
 **(8)**  **Warehouse
Financing**
 
 Our
warehouse lines of credit are collateralized by specific mortgage loans held for
investment - pre-securitization, the balances of which are equal to or greater
than the outstanding balances under the lines at any point in time. The amounts
available under these warehouse lines are based on the amount of the collateral
pledged. The amount we have outstanding on our committed facilities at any
quarter end generally is a function of the pace of mortgage loan originations
relative to the timing of our securitizations and whole loan sales.
 
 The
following table summarizes information regarding warehouse financing at March
31, 2005 and December 31, 2004:
 
 *(Dollars
in thousands)*
 **Facility**
      **Amount**
    
    
    
    **Balance
      at****Warehouse
      Line of Credit**
    
    
    **Interest
      Rate**
    ****
    **3/31/05**
    ****
    **12/31/04**
    
    **Expiration
      Date**RBS
      Greenwich Capital
    
    $
    350,000
    
    
    Margin
      over LIBOR
    
    $
    64,111
    
    $
    135,653
    
    
    October
      2005Citigroup
    
    
    350,000
    
    
    Margin
      over LIBOR
    
    
    54,582
    
    
    --
    
    
    March
      2006Friedman,
      Billings, Ramsey(1)
    
    
    200,000
    
    
    Margin
      over LIBOR
    
    
    --
    
    
    --
    
    
    November
      2005Total
    
    $
    900,000
    
    
    
    
    $
    118,693
    
    $
    135,653
 
 *(1)*  *The
Friedman, Billings, Ramsey (“FBR”) commercial paper conduit financing was
implemented during the fourth quarter of 2004.*
 
 As
securitization transactions are completed, a portion of the proceeds from the
long-term debt issued in the securitization are used to pay down our warehouse
lines of credit. Therefore, the outstanding amount of warehouse financing will
fluctuate from quarter to quarter, and could be significantly higher or lower
than the $118.7 million we held at March 31, 2005 as our mortgage production and
securitization programs continue.
 
 The terms
of our warehouse agreements require us to comply with various operating and
financial covenants, which are customary for agreements of this type. The
continued availability of funds provided to us under these agreements is subject
to, among other conditions, our continued compliance with these covenants. We
believe that we are in compliance with such covenants as of March 31,
2005.
 
 **14**
 **(9)**  **Financing
on Mortgage Loans Held for Investment, Net**
 
 Commencing
in 2004, we began to structure our securitizations to be accounted for as
secured financings, in accordance with SFAS No. 140. We have completed five
securitizations (one in 2005 and four in 2004) that were structured as secured
financings. Prior to March 2004, we structured our securitizations as
sales.
 
 For the
securitizations completed during the first quarter of 2005 and 2004, the
securitization trust or special purpose entity (“SPE”), holds mortgage loans,
referred to as “securitization loans,” and issues debt (and certificates in
2004) represented by securitization pass-through securities. Accordingly, the
securitization loans are recorded as an asset on our balance sheet under
“mortgage loans held for investment, net” and the corresponding securitization
debt is recorded as a liability under “financing on mortgage loans held for
investment, net.” Since these securitizations were structured as financings and
not sales, no gain-on-sale revenue was recorded at the time the securitizations
closed. Rather, we record interest income from the securitized loans and
interest expense from the pass-through securities issued in connection with each
securitization over the life of the securitization. Deferred securitization debt
issuance costs are amortized on a level yield basis over the estimated life of
the pass-through securities. We also allocate a portion of the accounting basis
of the mortgage loans held for investment to the MSRs, which results in a
discount to the mortgage loans held for investment. Both the discount related to
the MSRs and the net incremental direct fees and costs to originate the loans
are amortized on a level yield basis over the estimated life of the related
loans using the interest method calculation.
 
 We have
historically sold or financed our mortgage loans through the securitization
market, issuing pass-through securities. We will continue to build our loan
portfolio and match fund our mortgage loans using pass-through securities issued
in the securitization market. We believe that issuing pass-through securities
provides us a low cost method of financing our mortgage loan portfolio. In
addition, it allows us to reduce our interest rate risk on our fixed-rate loans
by securitizing them. Our ability to issue pass-through securities depends on
the overall performance of our assets, as well as the continued general demand
for certificates backed by non-conforming mortgage loans.
 
 At March
31, 2005 and December 31, 2004, the outstanding financing on mortgage loans held
for investment, net consisted of $2.8 billion and $2.2 billion,
respectively.
 
 The
following table summarizes the expected maturities on our secured financings at
March 31, 2005:
 *(Dollars
      in thousands)*
    
    **Total**
    
    **Less
      than**
      **One
      Year**
    
    **One
      to**
      **Three
      Years**
      **Three
      to**
    
    **Five
      Years**
    
    **More
      than**
      **Five
      Years**Securitization
      pass-throughsecurities,
      net
    
    $
    2,845,031
    
    $
    842,188
    
    $
    1,161,313
    
    $
    412,770
    
    $
    428,760
  Amounts
shown above reflect estimated repayments based on anticipated receipt of
principal and interest on the underlying mortgage loan collateral using similar
prepayment speed assumptions we use to value our excess cashflow certificates.
 
 **(10)**  **Derivative
Instruments**
 
 We
account for our derivative financial instruments such as corridors and interest
rate swaps as cash flow hedges. The corridors hedge our interest rate risk on
securitization variable rate debt and the interest rate swaps hedge uncertain
cash flows associated with future securitization financing. At March 31, 2005
and December 31, 2004, the fair value of our corridors totaled $19.1 million and
$16.1 million, respectively, and the fair value of our interest rate swaps
totaled a $274,000 gain and a $166,000 loss, respectively. The fair value of our
corridors and interest rate swaps are recorded as a component of other assets
and other liabilities. As of March 31, 2005, the effective portion of the
changes in fair value of the corridors, interest rate swaps and the loss on the
terminated swaps are recorded as components of accumulated other comprehensive
income and totaled, net of tax, $1.4 million loss, $167,000 gain and $1.1
million gain, respectively. As of December 31, 2004, the effective portion of
the changes in fair value of the corridors, interest rate swaps and the loss on
the terminated swaps are recorded as components of accumulated other
comprehensive loss and totaled, net of tax, $476,000 loss, $101,000 loss and
$1.6 million loss, respectively. Accumulated other comprehensive income or loss
relating to cash flow hedging is reclassified to earnings as a yield adjustment
to interest expense as the interest payments affect earnings. Derivatives that
were not designated as hedging instruments resulted in a loss of $4.7 million
for the three months ended March 31, 2004. As of March 31, 2005, all of the
outstanding derivates were designated as hedging instruments. Hedge
ineffectiveness associated with hedges resulted in a $16,000 gain for the three
months ended March 31, 2005. There was no gain or loss recorded related to hedge
ineffectiveness during the three months ended March 31, 2004.
 **15**
 
 The
following table summarizes the notional amount, expected maturities and
weighted-average strike price for the corridors that we held as of March 31,
2005:
 
 *(Dollars
      in thousands,**except
      strike price)*
    
    
    **Total**
    
    
    **One
      Year**
    
    
    **Two
      Years**
    
    
    **Three
      Years**
    
    
    **Four
      Years**
    
    
    **Five
      Years & Thereafter**Caps
      bought - notional
    
    $
    2,239,803
    
    $
    1,361,641
    
    $
    580,087
    
    $
    113,877
    
    $
    45,852
    
    $
    138,346Weighted
      average strikeprice
    
    $
    4.78
    
    $
    3.74
    
    $
    5.87
    
    $
    7.41
    
    $
    7.39
    
    $
    7.43Caps
      sold - notional
    
    $
    2,239,803
    
    $
    1,361,641
    
    $
    580,087
    
    $
    113,877
    
    $
    45,852
    
    $
    138,346Weighted
      average strikeprice
    
    $
    7.90
    
    $
    7.14
    
    $
    8.68
    
    $
    9.37
    
    $
    9.27
    
    $
    10.41
 
 The notional
amount of the caps bought and sold totaled $1.9 billion each at December 31,
2004.
 
 **(11)**  **Earnings
Per Share**
 
 Earnings
per share (“EPS”), is computed in accordance with SFAS No. 128, “Earnings Per
Share.” Basic
earnings per share are computed by dividing net income by the weighted average
number of common shares outstanding during each period presented. The
computation of diluted earnings per share gives effect to stock options (except
for those stock options with an exercise price greater than the average market
price of our common during the period) outstanding during the applicable
periods. The
following is a reconciliation of the denominators used in the computations of
basic and diluted EPS. The numerator for calculating both basic and diluted EPS
is net income (loss).
 
 **Three
      Months Ended**
      **March
      31,***(Dollars
      in thousands, except share and per share data)*
    
    **2005**
    
    **2004**Net
      income (loss), as reported
    
    $
    2,059
    
    $
    (5,915
    )Less
      preferred stock dividends
    
    
    --
    
    
    --Net
      income (loss) available to common shareholders
    
    $
    2,059
    
    $
    (5,915
    )Basic
      - weighted-average shares
    
    
    20,295,874
    
    
    16,924,366Basic
      EPS
    
    $
    0.10
    
    $
    (0.35
    )Basic
      - weighted-average shares
    
    
    20,295,874
    
    
    16,924,366Incremental
      shares-options(1)(2)
    
    
    940,266
    
    
    --Diluted
      - weighted-average shares
    
    
    21,236,140
    
    
    16,924,366Diluted
      EPS(1)(2)
    
    $
    0.10
    
    $
    (0.35
    )
 **
 *(1)*  *For
the three months ended March 31, 2004, in-the-money employee stock options of
approximately 1.1 million are excluded from the calculation of diluted earnings
per share since their effect is anti-dilutive.*
 
 **16**
 *(2)*  *For
the three months ended March 31, 2005, in-the-money employee stock options of
approximately 940,000 are included in the calculation of diluted earnings per
share, while approximately 63,000 of out-of-the-money employee stock options
have been excluded.*
 
 The
weighted-average share count for the first quarter of 2005 also reflects the
full impact of our public offering in the third quarter of 2004. On July 21,
2004, we announced the public offering of 4,375,000 shares of our common stock
at a price of $6.50 per share. The offering closed on July 26, 2004. We sold
3,137,597 of these shares from authorized but unissued shares and existing
stockholders sold 1,237,403 shares. In August 2004, the underwriters exercised a
portion of their over-allotment option, which resulted in existing shareholders
selling 85,000 additional shares on August 25, 2004. We received approximately
$18.7 million in net proceeds from the offering, which excludes the proceeds
related to those shares sold by existing stockholders and after underwriting and
other related professional fees. The proceeds were used to repay warehouse
financings and originate mortgage loans.
 
 **(12)**  **Series
A 10% Preferred Stock**
 
 In August
2001, as part of our August 2001 exchange offer, the holders of approximately
$139.2 million (of the initial $150.0 million) principal amount of our 9.5%
senior notes due 2004 exchanged their notes for, among other interests, 139,156
shares of our then newly issued Series A 10% Preferred Stock, having an
aggregate preference amount of approximately $13.9 million.
 
 On June
14, 2004, we redeemed all of our outstanding Series A 10% Preferred Stock at its
preference amount, or approximately $13.9 million. Holders of the Series A 10%
Preferred Stock were previously entitled to receive cumulative preferential
dividends at the rate of 10% per annum of the preference amount, payable in cash
semi-annually, commencing in July 2003.
 
 **(13)**  **Subsequent
Events**
 
 We paid a
cash dividend of $0.05 per common share on April 15, 2005 to shareholders of
record as of the close of business on March 31, 2005.
 
 In April
2005, Spencer I. Browne, a member of Delta Financial Corporation’s Board of
Directors, passed away. As a result of Mr. Browne’s passing, we were left with
less than a majority of independent Board of Directors members, which violates
an American Stock Exchange (“AMEX”) continued listing requirement. To afford our
Board of Directors ample time to find and appoint a new independent director, on
May 2, 2005, Richard Blass, executive vice president and chief financial
officer, agreed to resign his position on the Board of Directors, so we could
remain compliant with the AMEX’s listing requirements during the search process,
which has already begun. Once the Board of Directors appoints another an
independent Director, it is expected that Mr. Blass will re-join the Board of
Directors.
  **17**
  **Item
2. Management’s Discussion and Analysis of
Financial Condition and Results of Operations.**
 
 *This
Quarterly Report on Form 10-Q should be read in conjunction with the more
detailed and comprehensive disclosures included in our Annual Report on Form
10-K for the year ended December 31, 2004. In addition, please read this section
in conjunction with our Consolidated Financial Statements and Notes to
Consolidated Financial Statements herein, and please see “- Forward-Looking
Statements and Risk Factors.”*
 
 **General**
 
 We are a
specialty consumer finance company that originates, securitizes and sells and,
prior to May 2001, serviced non-conforming mortgage loans. Our loans are
primarily secured by first mortgages on one- to four-family residential
properties. Throughout our 23-year operating history, we have focused on lending
to individuals who generally do not satisfy the credit, documentation or other
underwriting standards set by more traditional sources of mortgage credit,
including those entities that make loans in compliance with conventional
mortgage lending guidelines established by Fannie Mae and Freddie Mac. We make
mortgage loans to these borrowers for purposes such as debt consolidation,
refinancing, education, home purchase and home improvements. We
provide our customers with a variety of loan products designed to meet their
needs, using a risk-based pricing strategy to develop products for different
risk categories. Historically, the majority of our loan production has been
fixed-rate with amortization schedules ranging from five years to 30
years.
 
 Our
mortgage business has two principal components. First, we make mortgage loans to
individual borrowers, which are a cash and expense outlay for us, because our
cost to originate a loan exceeds the fees we collect at the time we originate
the loan. At the time we originate a loan, and prior to the time we securitize
or sell the loan, we either finance the loan by borrowing under our warehouse
lines of credit or utilizing our available working capital. Second, from time to
time we either securitize loans or sell our loans on a whole loan basis, using
the net proceeds from these transactions to repay our warehouse lines of credit
and for working capital. Prior to 2004, we structured our securitizations to be
accounted for as sales, which required us to record cash and non-cash revenues
as gain-on-sale at the time the securitizations were completed. In 2004, we
began structuring our securitizations to be accounted for as secured financings,
which requires us to record revenues from these transactions over time. We
record interest income from the securitized loans and interest expense from the
pass-through securities issued in connection with each securitization over the
life of the loans or securities issued in the securitization. When we sell loans
on a whole loan basis, we record the premiums received upon sale as revenue.
(See “-Securitizations and Whole Loan Sales”).
 
 **Origination
of Mortgage Loans**
 
 We
originate mortgage loans through two distribution channels, wholesale and
retail. In the wholesale channel, we receive loan applications from independent
third-party mortgage brokers who submit applications on a borrower’s behalf. In
the retail channel, we receive loan applications directly from borrowers. We
process and underwrite the submission and, if the loan conforms to our
underwriting criteria, approve the loan and lend the money to the borrower. We
underwrite loan packages for approval through our Woodbury, New York office, our
Cincinnati, Ohio underwriting hub, or our Phoenix, Arizona, Jacksonville,
Florida and Boston, Massachusetts regional offices. If the loan package is
approved, we will fund the loan. We also purchase closed loans on a limited
basis.
 
 For the
three months ended March 31, 2005 and 2004, we originated the following loans by
origination channel:
 **For
      the Three Months Ended March 31,***(Dollars
      in thousands)*****
    
    **2005**
    
    **2004**Originations
      by channel:Wholesale
    
    $
    467,450
    
    $
    307,076Retail
    
    
    369,270
    
    
    196,897Total originations
    
    $
    836,720
    
    $
    503,973
  **18**
  For the
three months ended March 31, 2005, we originated $836.7 million of loans, an
increase of 66.0% over the $504.0 million of loans originated in the comparable
period in 2004. Of these amounts, approximately $467.4 million were wholesale
loans, representing 55.9% of total loan production, and $369.3 million were
retail loans, representing 44.1% of total loan production, compared to $307.1
million of wholesale loans, or 60.9% of total loan production, and $196.9
million of retail loans, or 39.1% of total loan production, during the three
months ended March 31, 2004.
 
 ***Wholesale
Loan Channel.*** Through
our wholesale loan distribution channel, which is principally conducted out of
our Woodbury, New York headquarters, we primarily originate mortgage loans
indirectly through independent mortgage brokers and other real estate
professionals who submit loan applications on behalf of borrowers. We currently
originate the majority of our wholesale loans in 29 states, through a network of
approximately 2,300 independent brokers. The broker’s role is to source the
business, identify the applicant, assist in completing the loan application, and
process the loans, including, among other things, gathering the necessary
information and documents, and serving as the liaison between the borrower and
us through the entire origination process. We review, process and underwrite the
applications submitted by the broker, approve or deny the application, set the
interest rate and other terms of the loan and, upon acceptance by the borrower
and satisfaction of all of the conditions that we impose as the lender, lend the
money to the borrower. Due to the fact that brokers conduct their own marketing
and employ their own personnel to complete loan applications and maintain
contact with borrowers - for which they charge a broker fee - originating loans
through our broker network is designed to allow us to increase our loan volume
without incurring the higher marketing and employee costs associated with
increased retail originations. Additionally, commencing in the third quarter of
2004, and on a limited basis, we purchased loans on a flow basis from select
independent correspondents. This typically involves purchasing individual loans
shortly after the loans are originated, as opposed to bulk purchases, which
entail purchasing typically larger pools of loans at one time. We re-underwrite
every correspondent loan, in accordance with our underwriting standards, prior
to purchasing.
 
 ***Retail
Loan Channel.***  Through
our retail distribution channel, we develop retail loan leads primarily through
our telemarketing system located in Cincinnati, Ohio, and also through Internet
leads, direct mail, radio advertising and our network of 11 origination centers
located in nine states. We continually monitor the performance of our retail
operations and evaluate current and potential retail office locations on the
basis of selected demographic statistics, marketing analyses and other criteria
that we have developed.
 
 Typically,
contact with the customer is initially handled  through
our telemarketing center. Through
our marketing efforts, the retail loan channel is able to identify, locate and
focus on individuals who, based on historic customer profiles, are likely
customers for our products. Our telemarketing representatives identify
interested customers and forward these potential borrowers to a branch manager
through our proprietary loan origination system, Click & Close ® (“C&C”).
The branch managers, in turn, distribute these leads to mortgage analysts via
C&C by queuing the loan to a mortgage analyst’s “to do” list in C&C. The
assigned mortgage analyst discusses the applicant’s qualifications and available
loan products, negotiates loan terms with the borrower, ensures
that an appraisal has been ordered from an independent third party appraisal
company (or may, when certain underwriting criteria have been met, obtain an Insured
Automated Valuation Model (“Insured AVM”) value ( the
coupling of a third party valuation estimate and insurance on that
value) , orders
a credit report from an independent, nationally recognized credit reporting
agency and
processes the loan through completion. Our
mortgage analysts are trained to structure loans that meet the applicant’s needs
while satisfying our lending guidelines. C&C
is utilized to queue the loan to underwriters at the appropriate times for
approvals and help to facilitate the loan application process through
closing.
 
 ***Competition.*** As an
originator of mortgage loans, we face intense competition, primarily from
diversified consumer financial companies and other diversified financial
institutions, mortgage banking companies, commercial banks, credit unions,
savings and loans, mortgage real estate investment trusts (“REITs”),
government-sponsored entities (such as Fannie Mae and Freddie Mac) and finance
companies. Many of these competitors in the financial services business are
substantially larger, have more capital and substantially greater resources than
we do, a lower cost of funds and a more established market presence than we
have. In addition, we have experienced increased competition over the Internet,
where barriers to entry are relatively low. Competition can take many forms,
including interest rates and costs of the loan, less stringent underwriting
standards, convenience in obtaining a loan, customer service, amount and term of
a loan and marketing and distribution channels. Furthermore, the level of gains
realized by us and our competitors on the sale of the type of loans originated
has attracted additional competitors into this market, which has lowered the
gains that may be realized by us on future loan sales. In addition, efficiencies
in the asset-backed market have generally created a desire for even larger
transactions, giving companies with greater volumes of originations a
competitive advantage, including a pricing advantage. In the wholesale channel,
we seek to compete with our competitors through an emphasis on quality of
service, diversified products, use of technology and competitive
pricing.
 
 **19**
 We depend
primarily on independent mortgage brokers for the origination of our wholesale
mortgage loans, which constitute the majority of our loan production. These
independent mortgage brokers have relationships with multiple lenders and are
not obligated by contract or otherwise to do business with us. We compete with
these lenders for the independent brokers’ business on the basis of pricing,
service, loan fees, costs and other factors. Competition from other lenders
could negatively affect the volume and pricing of our wholesale loans, which
could reduce our loan production.
  ***Pooling
of Loans Prior to Securitization or Whole Loan Sales.*** After we
fund a loan, we typically pledge the loan as collateral under a warehouse line
of credit to obtain financing against that loan. By doing so, we replenish our
capital so we can make new loans. Typically, loans are financed though a
warehouse line of credit for only a limited time - generally, not more than
three months - long enough to enable us to either securitize or sell the loans.
During the time we hold the loans prior to securitization or whole loan sale, we
earn interest income from the borrower. The income is partially offset by any
interest we pay to our warehouse creditors for providing us with financing.
Additionally, we pay a third party servicer a sub-servicing fee to perform the
servicing of the mortgage loans during this pre-securitization or sale holding
period.
 
 ***Securitizations
and Whole Loan Sales.*** We
securitize or sell all of the mortgage loans we originate. As a
fundamental part of our present business and financing strategy, we securitize
almost all of our mortgage loans. We may also choose to sell a portion of our
loans as whole loans when we believe that market conditions present an
opportunity to achieve a better return through such sales. We select
the outlet depending on market conditions, relative profitability and cash
flows.
 
 We apply
the net proceeds from securitizations and whole loan sales to pay down our
warehouse lines of credit - in order to make available capacity under these
facilities for future funding of mortgage loans - and utilize any additional
funds for working capital.
 
 The
following table sets forth certain information regarding loans sold through our
securitizations and on a whole-loan basis during the three months ended March
31, 2005 and 2004:
 **Three
      Months Ended March 31,***(Dollars
      in thousands)*
    
    **2005**
    
    **2004**Loan
      securitizations - gain on sale(1)
    
    $
    --
    
    $
    113,927Loan
      securitizations - portfolio based
    
    
    749,999
    
    
    415,118Whole
      loan sales
    
    
    105,419
    
    
    17,651Total
      securitizations and whole loan sales
    
    $
    855,418
    
    $
    546,696
  **
 *(1)
For the three months ended March 31, 2004, we delivered $113.9 million of
mortgage loans under a pre-funding feature in our fourth quarter 2003
securitization and recorded gain-on-sale related revenue during the first
quarter of 2004. Because the fourth quarter 2003 securitization was structured
as a sale, we recorded gain-on-sale revenue during the three months ended March
31, 2004 when we delivered the loans under the pre-funding feature to the
securitization trust in January 2004.*
 
 ***Securitizations.*** In a
securitization, we pool together loans, typically each quarter, and sell these
loans to a newly formed securitization trust. These trusts are established for
the limited purpose of buying our mortgage loans and are bankruptcy remote -
meaning that purchasers of asset-backed securities may rely on the cash flows
generated from the assets held by the securitization trust for payment and not
upon us for payment; likewise, the assets held by the securitization trust are
not available to our general creditors. We carry no contractual obligation
related to these trusts or the loans sold to them, nor do we have any direct or
contingent liability related to the trusts, except for the standard
representations and warranties typically made as part of a sale of loans on a
non-recourse basis, despite carrying the securitized loans and the
securitization financing on our financial statements. Furthermore, we provide no
guarantees to investors with respect to the cash flow or performance of these
trusts.
 
 **20**
 The
following table sets forth information about our securitized mortgage loan
portfolio, completed since the first quarter of 2004, at March 31,
2005:
 
 **Issue**
      **Date**
    
    **Current
      Loan**
      **Principal**
      **Balance****(1)**
    
    **Current**
      **Pass-Through**
      **Security
      Balance****(2)***(Dollars
      in thousands*)Asset-backed
      Security Series:2004-1
    
    
    March
      30, 2004
    
    $
    432,990
    
    $
    425,2902004-2
    
    
    June
      29, 2004
    
    
    459,728
    
    
    444,1282004-3
    
    
    September
      29, 2004
    
    
    590,304
    
    
    573,6642004-4
    
    
    December
      29, 2004
    
    
    586,928
    
    
    570,7282005-1
    
    
    March
      31, 2005
    
    
    749,999
    
    
    728,625Total
    
    
    
    
    $
    2,819,949
    
    $
    2,742,435
 
 *(1)*  *The
current loan principal balance shown includes amounts reflected on the
consolidated balance sheet as mortgage loans held for investment - securitized
(excluding discounts and net deferred origination fees), REO (at its trust basis
value) and trustee receivables.*
 
 *(2)*  *The
current pass-through security (financing on mortgage loans held for investment)
balance shown excludes discounts of $2.2 million at March 31,
2005.*
 
 The
securitization trust raises cash to purchase the mortgage loans from us
generally by issuing securities to the public. These securities, known as
“asset-backed pass-through securities,” are secured, or backed, by the pool of
mortgage loans held by the securitization trust. These asset-backed securities,
which are usually purchased by insurance companies, mutual funds and/or other
institutional investors, represent interests in the cash flows from the mortgage
loans in the trust, which entitle their holders to receive the principal
collected, including prepayments of principal, on the mortgage loans in the
trust. In addition, holders receive a portion of the interest paid on the loans
in the trust equal to the pass-through interest rate on the remaining principal
balance of the pass-through securities. We structured each of our
securitizations in 2005 and 2004 to be accounted for as a secured financing,
which is known as “portfolio accounting.” With portfolio accounting, the
mortgage loans held in the securitization trust (that underlie the excess
cashflow certificates and are sometimes referred to as “securitized loans”) are
recorded on our balance sheet as mortgage loans held for investment, together
with the related financing on the mortgage loans held for investment (which are
the senior securities or bonds issued by the securitization trust). Prior to
2004, we structured our securitizations to be accounted for as sales, which is
known as “gain-on-sale accounting.” With gain-on-sale accounting, we recorded an
upfront gain at the time of securitization and capitalized the excess cashflow
certificates on our balance sheet.
 
 Each
month the holder of an excess cashflow certificate will receive payment only
after all required payments have been made on all the other securities issued by
the securitization trust, because the excess cashflow certificates are
subordinate in right of payment to all other securities issued by the
securitization trust. In addition, before the holder of the excess cashflow
certificate receives payments, the excess cash flows are applied in a
“waterfall” manner as follows:
 
 ·
    first,
      to cover any losses on the mortgage loans in the related mortgage
      pool;·
    second,
      to reimburse the bond insurer, if any, of the related series of
      pass-through securities for amounts paid by or otherwise owing to that
      insurer;·
    third,
      to build or maintain the required level of the overcollateralization
      (“O/C”) provision, as described below, for that securitization trust by
      applying the funds as an accelerated payment of principal to the holders
      of the pass-through securities of the related series;·
    fourth,
      to reimburse holders of the subordinate securities of the related series
      of pass-through securities for unpaid interest and for any losses
      previously allocated to those securities; and·
    fifth,
      to pay “the net rate cap carryover” which relates to the interest on the
      related pass-through securities that exceeded the maximum net interest
      amount available from the mortgage loans underlying the securitization
      trust.
 
 **21**
 Each of
our securitizations contains an O/C provision which is a credit enhancement that
is designed to protect the securities sold to the securitization pass-through
investors from credit losses, which arise principally from defaults on the
underlying mortgage loans. In short, overcollateralization occurs when the
amount of collateral ( *i.e.* ,
mortgage loans) owned by a securitization trust exceeds the aggregate amount of
senior pass-through securities. The O/C is created to absorb losses that the
securitization trust may suffer, as loans are liquidated at a loss. Beginning
with our 2002 securitizations, and in each of our subsequent securitizations, we
created a fully-funded O/C at closing by initially selling pass-through
securities totaling approximately 97% to 98.5% of the total amount of mortgage
loans sold to the trust. For example, if a securitization trust contains
collateral of $100 million principal amount of mortgage loans, and our O/C
requirement is 2%, we issue approximately $98 million in senior pass-through
securities. Prior to 2002, we generally built up the O/C typically over the
first 18 to 24 months of a securitization (with the specific timing depending
upon the structure, amount of excess spread, and performance of the
securitization), by utilizing the cash flows from the excess cash flow to make
additional payments of principal to the holders of the pass-through securities
until the required O/C level was reached. We typically issued pass-through
securities for a par purchase price, or a slight discount to par - with par
representing the aggregate principal balance of the mortgage loans backing the
asset-backed securities. For example, if a securitization trust contained
collateral of $100 million of mortgage loans, we typically received close to
$100 million in proceeds from the sales of those securities, depending upon the
structure we used for the securitization.
 
 The O/C is generally expressed as a percentage of the initial mortgage loan or
collateral principal balance sold to the securitization trust. The required O/C
is initially determined by either the rating agencies and/or the bond insurer,
if any, using various factors, including:
 ·
    characteristics
      of the mortgage loans sold to the trust, such as credit scores of the
      borrowers and loan-to-value ratios;·
    the
      amount of excess spread between the interest rate on the pool of mortgage
      loans sold to the securitization trust and the interest paid to the
      pass-through security holders, less the servicing fee, and other related
      expenses such as trustee fees and bond insurer fees, if any;
      and·
    the
      structure of the underlying securitization (*e.g*.,
      issuing BBB- securities creates greater credit enhancement in the
      securitization transaction, which generally results in a lower
      O/C).
 Our
securitizations have typically required an O/C of between 1.05% and 3.0% of the
initial mortgage loans sold to the securitization trust. The required O/C can
increase or decrease throughout the life of the transaction depending upon
subordination levels, delinquency and/or loss tests and is subject to minimums
and maximums, as defined by the rating agencies and/or the bond insurer insuring
the securitization. In our securitizations prior to 2002, after the O/C
requirement was reached, the excess cash flows are then distributed to us if we
are the holder of the excess cashflow certificates in accordance with the
“waterfall” described above. Over time, if the cash collected during the period
exceeds the amount necessary to maintain the required O/C, all other required
distributions have been made, and there is no shortfall in the related required
O/C, the excess is remitted to us as holder of the excess cashflow
certificate.
 
 Each
securitization trust also has the benefit of either a financial guaranty
insurance policy from a monoline insurance company or a “senior-subordinated”
securitization structure, or a combination of the two (referred to as a
“hybrid”). In a securitization trust with a financial guaranty insurance policy,
all bonds are senior securities. The monoline insurance company guarantees the
timely payment of principal and interest to the senior security holders in the
event that the cashflows are not sufficient. In “senior-subordinated”
securitization structures, the senior security holders are protected from losses
(and payment shortfalls) first by the excess cash flows and the O/C, then by
subordinated securities which absorb any losses prior to the senior security
holders. In a hybrid structure, the senior securities generally have both the
subordinated securities to absorb losses and a monoline insurance company that
guarantees timely principal and interest payments.
 
 **22**
 In the
securitizations and related NIM transactions we completed prior to 2004, the
underlying securitization was structured as a sale under SFAS No. 140. In these
transactions, we recorded the net cash proceeds generated from the sale of the
NIM notes as a component of our net gain on sale of mortgage loans. The NIM
note(s) entitles the holder to be paid a specified interest rate, and further
provides for all cash flows generated by the excess cashflow certificate to be
used to pay all principal and interest on the NIM note(s) until paid in full,
which typically occurs approximately 20 to 25 months from the date the NIM
note(s) were issued. The excess cashflow certificate entitles us to all cash
flows generated by the excess cashflow certificate after the holder of the NIM
note(s) has been paid in full. Under this structure, we also retained, and
recorded as a component of our net gain on sale of mortgage loans, a relatively
small excess cashflow certificate. We recorded the excess cashflow certificates
at their estimated fair value, which normally ranged from 0.0% to 1.0% of the
securitized collateral.
 
 The
change to secured financing accounting from gain-on-sale accounting has not
changed the overall economics of the transaction. Only the timing of income
recognition and how it is recorded on our financial statements has been affected
by the change in accounting. The use of portfolio-based accounting structures
will result in differences in our future expected results of operations as
compared to historic results.
 
 ***Whole
Loan Sales*** *.* Whole
loan sales are the sale of pools of mortgage loans to banks, consumer
finance-related companies and institutional investors on a servicing-released
basis. We have found that, from time to time, we can receive better economic
results by selling some of our mortgage loans on a whole loan basis, without
retaining servicing rights, generally in private transactions to financial
institutions or consumer finance companies. We recognize a gain or loss when we
sell loans on a whole loan basis equal to the difference between the cash
proceeds received for the loans and our investment in the loans, including any
unamortized loan origination fees and costs. We generally sell these loans
without recourse, except that we provide standard representations and warranties
to the purchasers of such loans. During the three months ended March 31, 2005
and 2004, we sold whole loans without recourse and on a servicing-released basis
of $105.4 million and $17.7 million, respectively. The average premium, net of
reserves, we received for the whole loans sold during the three months ended
March 31, 2005 was 3.8%, compared to 5.1% for the comparable 2004
period.
 
 We
maintain a premium recapture reserve related to our contractual obligation to
rebate a portion of any premium paid by a purchaser when a borrower prepays a
sold loan within an agreed period of time. The premium recapture reserve is
established at the time of the loan sale through a provision for losses, which
is reflected as a reduction of the gain on sale of mortgage loans. The premium
recapture reserve is recorded as a liability on the consolidated balance sheet.
We estimate losses due to premium recaptures on early loan prepayments by
reviewing loan product and interest rate, borrower prepayment fee, if any, and
estimate the impact of future interest rate changes. The premium recapture
reserve totaled $333,000 and $262,000 at March 31, 2005 and December 31, 2004,
respectively.
 
 ***Other
Income.*** In
addition to the income and cash flows we earn from securitizations (accounted
for as sales and secured financings) and whole loan sales, we also earn income
and generate cash flows from:
 
 ·
    any
      fair value adjustments related to the excess cashflow
      certificates;
 
 ·
    distributions
      from Delta Funding Residual Exchange Company LLC (the “LLC”), an
      unaffiliated limited liability company, which holds excess cashflow
      certificates. We have a non-voting membership interest in the LLC, which
      entitled us to receive 15% of the net cash flows from the LLC through June
      2004 and, thereafter, 10% of the net cash flows from the LLC. We have not
      received our distributions since the second quarter of 2003 due to a
      dispute with the LLC’s President which has led us to commence a lawsuit to
      recover all of the amounts due to us. (See “-Part II, Item 1. - Legal
      Proceedings”); and
 
 ·
    miscellaneous
      interest income, including prepayment penalties received on some of the
      mortgage loans we sold in connection with our securitizations prior to
      2002.
 
 **23**
 **Summary
of Critical Accounting Policies**
 
 An
understanding of our critical accounting policies is necessary to evaluate our
financial results. These policies may require management to make difficult and
subjective judgments regarding uncertainties, and as a result, these estimates
may significantly impact our financial results. The accuracy of these estimates
and the likelihood of future changes depend on a range of possible outcomes and
a number of underlying variables.
 
 ***Excess
Cashflow Certificates*** **.** In
securitization transactions structured to be accounted for as a sale (prior to
2004), the excess cash flow certificates represent one or all of the following
assets:
 
 ·
    BIO
      certificate, which represents a subordinate right to receive excess
      cashflow, if any, generated by the related securitization pool. As a
      holder of the BIO certificate, we have the right to receive the
      difference, if any, between the interest payments due on the mortgage
      loans sold to the securitization trust and the interest payments due, at
      the pass-through rates, to the holders of the pass-through securities of
      the same series, net of contractual servicing fees, trustee fees, insurer
      premiums, reimbursements and other costs and expenses of administering the
      securitization trust. As a holder of the BIO certificate, we will receive
      cash payments (which, when we sell NIM notes, is only received after the
      NIM notes are paid in full) only to the extent that the cash received by
      the securitization trust exceeds the amounts owed on all of the securities
      issued by that securitization trust, including amounts needed for the
      payment of any trust related expenses.
 
 ·
    P
      certificate, which represents a right to receive prepayment penalties on
      the mortgage loans sold to the securitization trust. Generally, prepayment
      penalties are received from borrowers who pay off their loans within the
      first few years after obtaining their loans (which, when we sell NIM
      notes, is only received after the NIM notes are paid in
    full).
 
 ·
    cash
      flows from interest rate caps - we receive payments on interest rate caps
      from third party interest rate cap providers through the securitization
      trusts.
 
 The
excess cash flows we receive are highly dependent upon the interest rate
environment because “basis-risk” exists between the securitization trust’s
assets and liabilities. For example, in each of the securitizations that we
issued in 2003 and 2002, the excess cashflow certificates are impacted by the
securitization pass-through rate sold to investors, which is indexed against the
one-month LIBOR. As a result, the interest rate received by the pass-through
security holders from the securitization trust each month may adjust upwards or
downwards as the one-month LIBOR changes (liability) - while the majority of the
underlying mortgage loans (assets) in the securitization trust are fixed-rate
loans, or are at a fixed-rate for at least two to three years before becoming
adjustable-rate loans. As a result, as rates rise and fall, the amount of our
excess cash flows will fall and rise, respectively. This in turn will increase
or decrease the fair value of our excess cashflow certificates. The excess
cashflow certificates held at March 31, 2005 are those we acquired before we
began to structure our securitizations to be accounted for as secured financings
in 2004.
 
 In each
of our securitizations in which we sold NIM notes, we purchased an interest rate
cap, which helps mitigate the basis-risk for the approximate time that the NIM
notes are anticipated to be outstanding.
 
 The
accounting estimates we use to value excess cashflow certificates are deemed to
be “critical accounting estimates” because they can materially affect our
income. The valuation of our excess cashflow certificates requires us to
forecast interest rates, mortgage principal payments, prepayments, index rates
and loan loss assumptions, each of which is highly uncertain and requires a high
degree of judgment. The rate used to discount the projected cash flows is also
critical in the valuation of our excess cashflow certificates. Management uses
internal, historical mortgage loan performance data and forward LIBOR curves to
value future expected excess cash flows. We believe that the value of our excess
cashflow certificates at the date of a securitization reflected their fair
value. The amount recorded for the excess cashflow certificates is subsequently
reduced for cash distributions we receive, increased for the expected return and
adjusted for changes in fair value of these excess cashflow
certificates.
 
 **24**
 At the
closing date of each securitization transaction structured to be accounted for
as a sale, we determined the present value of the excess cashflow certificates
using the same assumptions we made regarding the underlying mortgage loans. The
excess cashflow certificate was then recorded on our consolidated financial
statements at its estimated fair value. The value of each excess cashflow
certificate represents the cash flow we expect to receive in the future based
upon our best estimates. Although we believe that the assumptions we use are
reasonable, there can be no assurance as to the accuracy of the assumptions or
estimates. Our estimates primarily include the following:
 
 ·
    future
      rate of prepayment of the mortgage loans - the expected amount of
      prepayments if the underlying borrowers pay off their mortgage loans prior
      to the expected maturity;
 
 ·
    credit
      losses (default rates) on the mortgage loans - our estimated amount of
      losses or defaults that will take place on the underlying mortgage loans
      over their life because the excess cashflow certificates are subordinated
      to all other securities issued by the securitization trust. Consequently,
      any losses sustained on mortgage loans comprising a particular
      securitization trust are first absorbed by the excess cashflow
      certificates;
 
 ·
    the
      LIBOR forward curve (using current LIBOR as the floor rate) - our estimate
      of future interest rates, which affects both the rate paid to the floating
      rate pass-through security investors (primarily the one-month LIBOR index)
      and the rates earned from the adjustable rate mortgage loans sold to the
      securitization trust (which typically provide for a fixed-rate of interest
      for the first 24 or 36 months and a six-month variable rate of interest
      thereafter using the six-month LIBOR index);
and
 
 ·
    a
      discount rate used to calculate present
value.
 
 We
monitor the performance of the loans underlying each excess cashflow
certificate, and any changes in our estimates resulting in a change in fair
value of the excess cashflow
certificates is reflected as a change in fair value of excess cashflow
certificates recorded in the statement of operations as a component of “other
income” or “other expense” in the period in which we make the change in our
estimate.
 
 In
determining the fair value of each of the excess cashflow certificates, we make
the following underlying assumptions regarding mortgage loan prepayments,
mortgage loan default rates, the LIBOR forward curve and discount
rates:
 
 A.  *Prepayments.* We base
our prepayment rate assumptions on our ongoing analysis of the performance of
the mortgage pools we previously securitized, and the performance of similar
pools of mortgage loans securitized by others in the industry. We apply
different prepayment speed assumptions to different loan product types based on
our experience with different loan product types exhibiting different prepayment
patterns. Generally, our loans can be grouped into two loan products -
fixed-rate loans and adjustable-rate loans. With fixed-rate loans, an underlying
borrower’s interest rate remains fixed throughout the life of the loan. Our
adjustable-rate loans are a “hybrid” between fixed- and adjustable-rate loans,
in that the interest rate generally remains fixed, typically for the first two
or three years of the loan, and then adjusts, typically every six months
thereafter. Within each product type, factors other than interest rates can
affect our prepayment rate assumptions. These factors include:
 
 ·
    whether
      or not a loan contains a prepayment penalty, which is the amount a
      borrower must pay to a lender if the borrower prepays the loan within a
      certain time period after the loan was originated. Historically, loans
      containing a prepayment penalty typically are not repaid as quickly as
      those without a penalty; and
 
 ·
    as
      is customary in our industry with adjustable-rate mortgage loans, the
      introductory interest rate we charge to the borrower is lower, between one
      and two full percentage points, than the rate for which the borrower would
      have otherwise qualified. Generally, once the interest rate begins to
      adjust, the interest rate payable on that loan generally increases, at
      times at a fairly substantial rate. This interest rate increase can be
      exacerbated if there is an absolute increase in interest rates. As a
      result of these increases, and the potential for future increases,
      adjustable rate mortgage loans typically are more susceptible to early
      prepayments.
 
 **25**
 There are
several reasons why a loan may prepay prior to its maturity, including but not
limited to:
 
 ·
    a
      decrease in interest rates;
 
 ·
    improvement
      in the borrower’s credit profile, which may allow the borrower to qualify
      for a loan with a lower interest rate;
 
 ·
    competition
      in the mortgage market, which may result in lower interest rates being
      offered to the borrower;
 
 ·
    the
      borrower’s sale of the home securing the
mortgage;
 
 ·
    the
      borrower’s need for additional funds; and
 
 ·  a default
by the borrower, resulting in foreclosure by the lender.
 
 It is unusual for a borrower to prepay a mortgage loan during the first few
months because:
 
 ·
    it
      typically takes at least several months after the mortgage loans are
      originated for any of the above events to
occur;
 
 ·
    there
      are costs involved with refinancing a loan;
and
 
 ·
    the
      borrower does not want to incur prepayment
penalties.
 
 We have
found that the rate at which borrowers prepay their loans tends to fluctuate. In
general, prepayment speeds are lowest in the first month after origination, as
described above. Thereafter, prepayment speeds generally increase until a peak
speed is reached. Generally, loans will continue to prepay at the peak speed for
some period of time, and then prepayment speeds typically begin to decline. We
use prepayment assumptions that reflect these tendencies. The following table
shows our current assumptions regarding the percentage of loans that will be
prepaid during the first month following the closing of a loan, and the peak
speed.
 
 **Loan
      Type**
    
    **Month
      One**
    
    **Peak
      Speed**Fixed
      rate
    
    4.00%
    
    35.00%
      to 40.00%Adjustable
      rate
    
    4.00%
    
    75.00%
 
 If
mortgage loans prepay faster than anticipated, we generally will earn less
income in connection with the mortgage loans and receive less excess cash flow
in the future because the mortgage loans have paid off. Conversely, if mortgage
loans prepay at a slower rate than anticipated, we generally earn more income
and more excess cash flow in the future, subject to other factors that can
affect the cash flow from, and our valuation of, the excess cashflow
certificates.
 
 B.  *Default
Rate.* The
default rate is the percentage of estimated total loss of principal, interest
and related advances that will take place over the life of the mortgage loans
within a loan pool to the total original principal balance of the mortgage loans
in the pool. A default rate is determined for each securitization reflecting the
overall credit scores, average loan sizes and layered risks on the fixed- and
adjustable-rate loans comprising each securitization trust. We apply a default
or loss rate to the excess cashflow certificate because it is the “first-loss”
piece and is subordinated in right of payment to all other securities issued by
the securitization trust. If defaults are higher than we anticipate, we will
receive less income and less excess cash flow than expected in the future.
Conversely, if defaults are lower than we expected, we will receive more income
and more excess cash flow than expected in the future, subject to the other
factors that can affect the cash flow from, and our valuation of, the excess
cashflow certificates. The current default rates applied on the excess cashflow
certificates range from 4.5% to 8.0%, with the majority ranging from 4.5% to
5.0%.
 
 C.  *LIBOR
Forward Curve.* The
LIBOR forward curve is used to project future interest rates, which affects both
the rate to the floating rate pass-through security investors (primarily
one-month LIBOR) and the adjustable rate mortgage loans sold to the
securitization trust (a fixed-rate of interest for either the first 24 or 36
months and a variable rate of interest thereafter using six-month LIBOR). Most
of our loans are fixed-rate mortgages, and a significant amount of the
securities sold by the securitization trust are floating-rate securities (the
interest rate adjusts based upon an index, such as one-month LIBOR). As such,
our excess cashflow certificates are subject to significant basis risk and a
change in LIBOR will impact our excess spread. If LIBOR is lower than
anticipated, we will receive more income and more excess cash flow than expected
in the future, subject to the other factors that can affect the cash flow from,
and our valuation of, the excess cashflow certificates. Conversely, if LIBOR is
higher than expected, we will receive less income and less excess cash flow than
expected in the future. In each of our securitizations in which we sold NIM
note(s), we purchased an interest rate cap, which helps mitigate the basis risk
for the approximate time that the NIM notes are outstanding. We have adjusted
the valuation of each excess cashflow certificate to use a forward interest rate
curve that represents both today’s rates and the expectation for rates in the
future. We use a forward LIBOR curve that we believe reflects the estimate of
future LIBOR rates.
 
 **26**
 D.  *Discount
Rate.* We use a
discount rate that we believe reflects the risks associated with our excess
cashflow certificates. Due to the unavailability of quoted market prices on
comparable excess cashflow certificates, we compare our valuation assumptions
and performance experience to our competitors in the non-conforming mortgage
industry. Our discount rate takes into account the asset quality and the
performance of our securitized mortgage loans compared to that of the industry
and other characteristics of our securitized loans. We quantify the risks
associated with our excess cashflow certificates by comparing the asset quality
and payment and loss performance experience of the underlying securitized
mortgage pools to comparable industry performance. The discount rate we use to
determine the present value of the cash flow from excess cashflow certificates
reflects increased uncertainty surrounding current and future market conditions,
including, without limitation, uncertainty concerning inflation, recession, home
prices, interest rates and conditions in the equity markets.
 
 We
utilized a discount rate of 15% at March 31, 2005 and December 31, 2004 on all
excess cashflow certificates.
 
 Our
valuation of retained excess cashflow certificates is highly dependent upon the
reasonableness of our assumptions and the predictiveness of the relationships
that drive the results of our valuation model. The assumptions we utilize,
described above, are complex, as we must make judgments about the effects of
matters that are inherently uncertain. As the number of variables and
assumptions affecting the possible future resolution of the uncertainties
increase, those judgments become even more complex.
 
 In
volatile markets, like those we have experienced over the past several years,
there is increased risk that our actual results may vary significantly from our
assumed results. The longer the time period over which the uncertainties exist,
the greater the potential for volatility in our valuation assumptions and thus
impacting the fair value of our excess cashflow certificates.
 
 For
example, assumptions regarding prepayment speeds, defaults and LIBOR rates are
used in estimating the fair value of our excess cashflow certificates. If loans
prepay faster than estimated, or loan loss levels are higher than anticipated,
or LIBOR is higher than anticipated, a reduction in the fair value of these
certificates will be recorded in earnings. We believe that our assumptions are
reasonable based upon the estimates using our historical loan performance and
the performance of similar mortgage pools from other lenders - in addition to
accessing other public information about market factors such as interest rates,
inflation, recession, unemployment and real estate market values, among other
things. However, these are just estimates and it is virtually impossible to
predict the actual level of prepayments and losses, which are also driven by
consumer behavior.
 
 ***Accounting
for Hedging Activities.*** We
regularly issue securitization pass-through securities, backed by fixed- and
variable-rate mortgage loans. As a result of this activity, we are exposed to
interest rate risk beginning when our mortgage loans close and are recorded as
assets, until permanent financing is arranged, such as when the pass-through
securities are issued. Our strategy is to use interest rate swap contracts in an
effort to lock in a pre-determined base interest rate on designated portions of
our prospective future securitization financing. At times, we also use corridors
that are designed to limit our financing costs within the securitization to
maintain minimum margins, with the possibility of allowing us to increase
margins in lower than anticipated interest rate environments. Both the interest
rate swaps and corridors are derivative instruments that trade in liquid
markets, and we do not use either of them for speculative purposes.
 
 In
accordance with SFAS No. 133 ,
“Accounting for Derivative Instruments and Hedging Activities,” we record
all of our derivatives on our balance sheet at fair value. For derivative
financial instruments not designated as hedging instruments, gains or losses
resulting from a change in fair value are recognized in current period earnings.
When derivatives are used as hedges, however, hedge accounting is permitted only
if we document the hedging relationship and its effectiveness at the time we
designate the derivative as a hedge instrument. If we meet certain requirements
under SFAS No. 133, we may account for the hedge instrument as a cash flow
hedge.
 
 **27**
 Cash flow
hedge accounting is appropriate for hedges of uncertain cash flows associated
with future periods - whether as a consequence of interest to be received or
paid on existing variable rate assets or liabilities or in connection with
intended purchases or sales.
 
 Under
cash flow hedge accounting treatment, the changes in the fair value of the
derivative instruments are divided into two portions, “effective” and
“ineffective.” The effective portion of the derivative's gain or loss is
initially reported as a component of OCI and subsequently reclassified into
earnings when the forecasted transaction affects earnings. The ineffective
portion of the gain or loss is reported in earnings immediately.
 
 To qualify for cash flow hedge accounting treatment:
 
 ·
    hedges
      must be documented, with the objective and strategy stated, along with an
      explicit description of the methodology used to assess and measure hedge
      effectiveness;
 
 ·
    dates
      (or periods) for the expected forecasted events and the nature of the
      exposure involved (including quantitative measures of the size of the
      exposure) must be explicitly documented;
 
 ·
    hedges
      must be expected to be “highly effective,” both at the inception of the
      hedge and on an ongoing basis. Effectiveness measures must relate the
      gains or losses of the derivative to changes in the cash flow associated
      with the hedged item;
 
 ·
    forecasted
      transactions must be probable; and
 
 ·
    forecasted
      transactions must be made with different counterparties other than the
      reporting entity.
 
 If and
when hedge accounting is discontinued, typically when it is determined that the
hedge no longer qualifies for hedge accounting, the derivative will continue to
be recorded on the balance sheet at its fair value, with gains or losses being
recorded in earnings. Any amounts previously recorded in OCI related to the
discontinued hedge are classified to earnings over the remaining duration of the
debt.
 
 ***Accounting
for Income Taxes.*** Significant management judgment is required in developing our provision for
income taxes, including the determination of deferred tax assets and liabilities
and any valuation allowances that might be required against the deferred tax
asset. Management
needs to consider the relative impact of negative and positive evidence related
to the ability to recognize a deferred tax asset. This evaluation takes into
consideration our recent earnings history, current tax position and estimates of
taxable income in the near term. If actual results differ from these estimates,
we may be required to record a valuation allowance on our deferred tax assets,
which could negatively impact our consolidated financial position and results
from operations. We recognize all of our deferred tax assets if we believe, on a
more likely than not basis, that all of the benefits of the deferred tax assets
will be realized. Management believes that, based upon on the currently
available evidence, it is more likely than not that we will realize the benefit
of our deferred tax asset. Therefore, at March 31, 2005 and December 31, 2004 we
did not maintain a valuation allowance against our deferred tax
assets.
 
 ***Allowance
for Loan Losses on Mortgage Loans Held for Investment.*** Commencing with our 2004 securitizations, which we structured to be accounted
for as secured financings with the underlying mortgage loans held for
investment, we established an allowance for loan losses based on an estimate of
losses to be incurred in the foreseeable future. We will charge-off
uncollectible loans at the time they are deemed not probable of
collection.
 
 In order
to estimate an appropriate allowance for losses on loans held for investment, we
estimate losses using detailed analysis of historical loan performance data.
This data is analyzed for loss performance and prepayment performance by product
type, origination year and securitization issuance. The results of that analysis
are then applied to the current long-term mortgage portfolio held for investment
and an estimate is created. In accordance with SFAS No. 5, “ Accounting
for Contingencies,” we
believe that pooling of mortgages with similar characteristics is an appropriate
methodology in which to evaluate the amount of the allowance for loan losses. A
provision for loan losses is charged to our consolidated statement of
operations. Losses incurred, if any, will be written-off against the
allowance.
 
 **28**
 While we
will continually evaluate the adequacy of this allowance, we recognize that
there are qualitative factors that must be taken into consideration when
evaluating and measuring potential expected losses on mortgage loans. These
items include, but are not limited to, current performance of the loans,
economic indicators that may affect the borrower’s ability to pay, changes in
the market value of the collateral, political factors and the general economic
environment. As these estimates are influenced by factors outside of our control
and as uncertainty is inherent in these estimates, it is reasonably possible
that they could change. In particular, if conditions were such that we were
required to increase the provision for loan losses, any increase in the
provision for loan losses may negatively impact our results of
operations.
 
 ***Amortization
of Deferred Loan Origination Fees and Costs.*** Interest
income is recorded on our mortgage loans held for investment portfolio based
upon a combination of interest accruals based on the outstanding balance and
contractual terms of the mortgage loans, adjusted by the amortization of net
deferred origination fees or costs accounted for in accordance with SFAS No. 91, “ Accounting
for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans
and Initial Direct Costs of Leases—an amendment of FASB Statements No. 13, 60,
and 65 and a rescission of FASB Statement No. 17 .” Our
net deferred origination fees/costs consist principally of origination fees,
discount points, and payroll and commissions associated with originating our
mortgage loans. For our loans held for investment, these net deferred fees or
costs are accreted or amortized as adjustments to interest income over the
estimated lives of the loans using the interest method. Our portfolio of
mortgage loans held for investment is comprised of a large number of homogeneous
loans for which we believe prepayments are probable. The periodic amortization
of our deferred origination fees or costs is based on a model that considers
actual prepayment experience to date as well as forecasted prepayments based on
the contractual interest rate on the mortgage loans, loan age, loan type and
prepayment fee coverage, among other factors. Mortgage prepayments are affected
by the terms and credit grades of the loans, conditions in the housing and
financial markets and general economic conditions. Prepayment assumptions are
reviewed regularly to ensure that our actual experiences, as well as industry
data, are supportive of the prepayment assumptions used in our model. Any
changes to these estimates are applied as if the revised estimates had been in
place since the origination of the loans, and current period amortization is
adjusted to reflect the effect of the changes.
 
 ***Amortization
of Deferred Debt Issue Discounts and Transaction
Costs.*** Interest
expense on our securitization financing is comprised of the accrual of interest
based on the contractual terms, cash receipts and amortization related to our
cash flow hedges (swaps and corridors), the amortization of deferred issue
discounts and transaction costs. The deferred issue discounts and transaction
costs are amortized as an adjustment to interest expense over the estimated
lives of the related debt using the interest method and take into account the
effect of estimated prepayments. Any changes made to these estimates are applied
as if the revised estimates had been in place since the issuance of the related
debt, and result in adjustments to the period amortization recorded to interest
expense.
 
 **Results
of Operations**
 
 ***Three
Months Ended March 31, 2005 Compared to the Three Months Ended March 31,
2004***
 
 **General**
 
 Our net
income for the three months ended March 31, 2005 was $2.1 million, or $0.10 per
share basic and diluted, compared to net loss of $5.9 million, or $(0.35) per
share basic and diluted, for the three months ended March 31, 2004. The increase
in net income recorded in the first quarter of 2005 relates primarily to the
quarter over quarter growth in the net interest income we realized from our
mortgage loans held for investment portfolio, which has grown since our
change from gain-on sale accounting to portfolio accounting in the first quarter
of 2004. The change to portfolio accounting resulted in recording
of interest income from the securitized loans and interest expense from the
pass-through securities issued in connection with the securitization over the
life of the securitization. The loss recorded for the three months ended March
31, 2004 reflected the effect of this change in accounting, coupled with a $4.5
million pre-tax loss we realized relating to the interest rate swaps used to
hedge $542.3 million of the March 2004 securitization variable-rate debt that
were not accounted for as hedge instruments. This loss was partially offset by a
$6.8 million pre-tax gain recorded upon the delivery
of $113.9 million of mortgage loans in connection with our fourth quarter 2003 securitization
(which was structured to be accounted for as a sale), under a pre-funding
feature.
 
 **29**
 We
recorded net interest income after provision for loan losses of $20.2 million
during the first quarter of 2005, an increase of $15.3 million from $4.9 million
in the same period in 2004. The increase in interest income after provision for
loan losses primarily reflects the net effect of recognizing interest income on
$2.9 billion of mortgage loans held for investment at March 31, 2005 compared to
$562.8 million of these loans held at March 31, 2004. Similarly, the increase in
interest expense primarily reflects the net effect of recognizing interest
expense on $2.8 billion on financing on mortgage loans held for investment at
March 31, 2005, compared to $589.1 million of financing on mortgage loans held
for investment at March 31, 2004. During the three months ended March 31, 2005,
total non-interest income increased $307,000 and total non-interest expense
increased by $2.5 million, compared to the same period in 2004. The increase in
non-interest income primarily reflects the impact of the increase in the fair
value of our excess cashflow certificates we experienced during the first
quarter of 2005, while the increase in non-interest expense primarily reflects
the increases in origination volume and personnel.
 
 We
originated $836.7 million of mortgage loans for the three months ended March 31,
2005, representing a $332.7 million, or 66.0%, increase from $504.0 million of
mortgage loans originated for the first quarter of 2004. We securitized and/or
sold $855.4 million of loans during the three months ended March 31, 2005,
compared to $546.7 million of loans (including $113.9 million of loans delivered
in the first quarter of 2004 under a pre-funding feature in connection with our
fourth quarter 2003 securitization accounted for as a sale) during
the same period in 2004.
 
 **Net
Interest Income**
 
 We
recorded net interest income of $27.1 million during the first quarter of 2005,
an increase of $21.7 million, from the $5.4 million recorded in the same period
in 2004. The increase in net interest income primarily reflects the increase in
the average balance of mortgage loans held for investment and the related
financing in 2005 compared to 2004. Net interest income represents the
difference between our interest income and our interest expense, each of which
is described in the following paragraphs.
 
 ***Interest
Income.***  Interest
income increased $47.6 million to $54.9 million for the three months ended March
31, 2005, from $7.3 million for the comparable period in 2004. The increase is
primarily due to (1) the increase in interest income of $43.6 million on our
loans held for investment - securitized, which totaled $2.8 billion at March 31,
2005 as compared to $415.1 million at March 31, 2004; (2) the increase in
interest income of $3.2 million related to the increase in the average amount of
mortgage loans we originated and held pending securitization or sale during the
three months ended March 31, 2005 compared to the same period in 2004; and (3)
the increase in pass-through interest received from securitization trusts on
fixed-rate pass-through securities at the time of settlement - due to the
increase in fixed-rate pass-through securities issued during the three months
ended March 31, 2005, compared to the pass-through securities issued in the same
period of 2004.
 
 The
following table is a summary of interest income:
 **For
      the Three Months Ended March 31,***(Dollars
      in thousands)*
    
    **2005**
    
    **2004**Interest
      income on mortgage loans held for sale, net
    
    $
    --
    
    $
    3,644Interest
      income on mortgage loans held for investment - pre-securitization,
      net
    
    
    6,854
    
    
    --Interest
      income on mortgage loans held for investment - securitized,
      net(1)
    
    
    45,926
    
    
    2,334Interest
      income on excess cashflow certificates
    
    
    488
    
    
    706Pass-through
      security interest
    
    
    1,607
    
    
    549Miscellaneous
      interest income
    
    
    1
    
    
    51Total
      interest income
    
    $
    54,876
    
    $
    7,284
 
 **30**
 *(1)*  *The
amount for the three months ended March 31, 2005 includes $2.2 million of
prepayment penalty fees. No such fees were recorded during the three months
ended March 31, 2004.*
 
 ***Interest
Expense.*** Interest
expense increased by $25.9 million to $27.8 million for the three months ended
March 31, 2005 from $1.9 million for the comparable period in 2004. The increase
was primarily due to the increase in interest expense related to the
securitization debt and, to a lesser extent, the increase in loans originated
and financed during the first quarter of 2005 on our warehouse facilities,
compared to the same period in 2004. Additionally, contributing to the increase
in interest expense was the slightly higher warehouse financing costs due to a
higher average one-month LIBOR rate, which is the benchmark index used to
determine our cost of borrowed funds. The rate increased on average to 2.64% for
the first three months of 2005, compared to an average of 1.10% for the same
period in 2004.
 
 The
following table presents the components of interest expense:
 
 **For
      the Three Months Ended March 31,***(Dollars
      in thousands)*
    
    **2005**
    
    **2004**Interest
      expense on warehouse financing
    
    $
    4,046
    
    $
    1,480Interest
      expense on mortgage loans held for investment financing
    
    
    23,668
    
    
    361Interest
      expense on other borrowings
    
    
    69
    
    
    72Total
      interest expense
    
    $
    27,783
    
    $
    1,913
 
 **Provision
for Loan Losses**
 
 A
provision for loan losses on mortgage loans held for investment is recorded to
maintain the related allowance for loan loss at an appropriate level for
currently existing probable losses of principal. We recorded a provision for
loan losses of $6.9 million and $432,000 for the quarter ended March 31, 2005
and 2004, respectively, related to mortgage loans held for investment. The
amount of the provision for loan losses is primarily driven by our
securitization activities conducted during the respective quarter.
 
 **Non-Interest
Income**
 
 Total
non-interest income increased by $307,000 to $8.1 million for the three months
ended March 31, 2005, from $7.8 million for the comparable period in 2004. The
increase in non-interest income primarily resulted from the increase in the fair
value of the excess cashflow certificates of $2.7 million recorded during the
first quarter of 2005, offset by a $2.4 million decrease in the net gain on sale
of mortgage loans recorded quarter over quarter. In the first quarter of 2005,
we recorded a net gain on the sale of mortgage loans of $5.3 million on the sale
of $105.4 million of mortgage loans on a whole-loan basis as compared to a $7.7
million gain recorded during the same quarter in 2004 on the sale, on a
whole-loan basis or through a securitization structured to be accounted for as a
sale, of $131.6 million of mortgage loans. During the first quarter of 2004, we
delivered $113.9 million of mortgage loans in connection with our fourth quarter
2003 securitization (which was structured to be accounted for as a sale), under
a pre-funding feature.
 
 ***Net
Gain on Sale of Mortgage Loans.*** Net gain
on sale of mortgage loans for the quarter ended March 31, 2005 and 2004 is
comprised of the premium received from selling whole loans on a
servicing-released basis, together with any deferred origination costs or fees
associated with mortgage loans sold. The first quarter of 2004 also reflects the
$113.9 million of mortgage loans we delivered in January 2004 in connection with
our fourth quarter 2003 securitization, which was structured to be accounted for
as a sale under a pre-funding feature. Through the end of 2003, our
securitizations were structured to be accounted for as sales under SFAS No. 140.
Accordingly, we recorded gain-on-sale revenue upon the closing of each such
securitization. For the quarter ended March 31, 2004, net gain on sale of
mortgage loans included the following in addition to the gains recorded from
whole-loan sales:
 
 **31**
 (1)
    the
      sum of:a)
    the
      cash purchase price we received in connection with selling (i) a NIM note,
      net of overcollateralization amount and interest rate cap and (ii) an
      interest-only certificate;b)
    the
      fair value of the excess cashflow certificates we
  retained;c)
    the
      premium received from selling mortgage servicing rights;
    andd)
    the
      difference between the selling price and the carrying value of the related
      mortgage loans sold;(2)
    less
      the:a)
    costs
      associated with the securitization structured as a
sale;b)
    any
      hedge loss (gain) associated with such securitization accounted for as a
      sale; andc)
    any
      loss associated with loans sold at a discount, together with any deferred
      origination costs or fees associated with mortgage loans
    sold.
 
 The following
table is a summary of our net gain on sale of mortgage loans for the three
months ended March 31, 2005 and 2004:
 
 **Three
      Months Ended March 31,***(Dollars
      in thousands)*
    
    **2005**
    
    **2004**Net
      Gain on Sale of Mortgage Loans:Loans
      sold(1)
    
    $
    105,419
    
    $
    131,578NIM
      proceeds, net
    
    $
    --
    
    $
    4,712Interest-only
      security proceeds
    
    
    --
    
    
    1,293Excess
      cashflow certificate (owner trust certificate)(2)
    
    
    --
    
    
    --Mortgage
      servicing rights(3)
    
    
    36
    
    
    661Gain
      on whole loan sales
    
    
    3,996
    
    
    900Net
      loan origination fees
    
    
    1,296
    
    
    658Less:
      securitization transaction costs
    
    
    --
    
    
    (484
    )Net
      gain on sale recorded
    
    $
    5,328
    
    $
    7,740Net
      gain on sale recorded as a percent of loans sold
    
    
    5.05
    %
    
    5.88
    %
 
 *(1)*  *For
the three months ended March 31, 2004, we delivered $113.9 million of mortgage
loans under a pre-funding feature in our fourth quarter 2003 securitization and
recorded gain-on-sale revenue related thereto during the first quarter of 2004.
Because the fourth quarter 2003 securitization was structured as a sale, we
recorded gain-on-sale revenue during the three months ended March 31, 2004 when
we delivered the loans under the pre-funding feature to the securitization trust
in January 2004.*
 
 *(2)*  *We
did not record any excess cashflow certificates in the first quarter of 2005 or
2004. (See “-Summary of Critical Accounting Policies - Excess Cashflow
Certificates”).*
 
 *(3)*  *For
the three months ended March 31, 2005, we recorded a $36,000 gain from the sale
of mortgage servicing rights related to the $750.0 million of mortgage loans
collateralizing the first quarter of 2005 securitization.*
 
 Net gain
on sale of mortgage loans decreased $2.4 million to $5.3 million for the three
months ended March 31, 2005, from $7.7 million for the comparable period in
2004. This decrease was directly related to our delivery of $113.9 million of
mortgage loans in connection with our fourth quarter 2003 securitization (which
was structured to be accounted for as a sale), under a pre-funding feature in
the first quarter of 2004. In the first quarter of 2005, we sold $105.4 million
(at a weighted average sales price of 3.8%) of mortgage loans on a whole loan
servicing-released basis, compared to $17.7 million (at a weighted average sales
price of 5.1%) for the same period in the prior year.
 
 **32**
 The
weighted average net gain on sale ratio for the three months ended March 31,
2005 and 2004 was 5.05% and 5.88%, respectively. The weighted-average net gain
on sale ratio is calculated by dividing the net gain on sale by the total amount
of loans securitized and sold.
 
 ***Other
Income.*** Other
income increased $2.7 million to $2.8 million for the quarter ended March 31,
2005, from $96,000 for the quarter ended March 31, 2004. The increase in other
income primarily relates to a fair value adjustment on our excess cashflow
certificates of $2.7 million for the quarter ended March 31, 2005. The
increase in the fair value of our excess cashflows for the quarter ended March
31, 2005 was primarily driven by lower losses on the underlying loans. We did
not record a fair value adjustment on our excess cashflow certificates during
the first quarter of 2004.
 
 **Non-interest
Expense**
 
 Total
non-interest expense increased by $2.5 million, or 11.2%, to $24.9 million for
the three months ended March 31, 2005, from $22.4 million for the comparable
period in 2004. The increase is primarily due to an increase in payroll and
related costs associated with a 66.0% increase in our mortgage loan production
and a 28.0% increase in personnel, coupled with an increase in other production
related expenses.
 
 ***Payroll
and Related Costs.*** Payroll
and related costs include salaries, benefits and payroll taxes for all non-loan
production related employees and non-deferrable loan production related
employees cost.
 
 Payroll
and related costs increased by $3.6 million, or 31.1%, to $15.2 million for the
three months ended March 31, 2005, from $11.6 million for the comparable period
in 2004. The increase was primarily the result of higher compensation and
related payroll cost associated with an increase in our staff. As of March 31,
2005, we employed 1,169 full- and part-time employees, an increase of 28.0% over
our 913 full- and part-time employees as of March 31, 2004. Additionally,
payroll and related costs were higher due to the higher loan commissions paid as
a result of a 66% increase in loan production during the first quarter of 2005
compared to the same period in 2004.
 
 ***General
and Administrative Expenses.*** General
and administrative expenses consist primarily of office rent, insurance,
telephone, depreciation, legal reserves and fees, license fees, accounting fees,
travel and entertainment expenses, advertising and promotional
expenses.
 
 General
and administrative expenses increased $3.7 million, or 59.8%, to $9.8 million
for the quarter ended March 31, 2005, from $6.1 million for the quarter ended
March 31, 2004. The increase was primarily due to an increase in expenses
associated with a 66% increase in loan production during the first quarter of
2005 compared to the same period in 2004 (which includes higher advertising,
promotional and marketing expenses), the consequent 28.0% increase in personnel
and expenses related to our ongoing expansion of our wholesale and retail
divisions. Also contributing to the increase in general and administrative
expenses was an increase in legal, accounting and professional fees. The primary
increase in accounting and professional fees relates to our on-going
Sarbanes-Oxley Act Section 404 initiatives.
 
 ***(Gain)
Loss on Derivative Instruments.*** The gain
on derivative instruments recorded during the three months ended March 31, 2005
represents the realized gain on the interest rate swaps used to lock in a
pre-determined interest rate on designated portions of our prospective future
securitization financing, offset by the decline in the fair value of our
corridors we use to protect the variable-rate financing.
 
 During
the quarter ended March 31, 2005 we recorded a net gain on derivative
instruments of $16,000 as opposed to a net loss on derivatives of $4.7 million
during the quarter ended March 31, 2004. During the first quarter of 2005 we
recorded a gain of $16,000 on the ineffective portion of caps and interest rate
swaps, compared to a $177,000 loss recorded on the ineffective portion of caps
and interest rate swaps during the first quarter of 2004. Additionally, during
the first quarter of 2004, we recorded a net loss of $4.5 million on the
interest rate swaps used to hedge approximately $542.3 million of securitization
variable-rate debt that did not qualify for hedge accounting.
 
 **33**
 **Income
Taxes**
 
 Deferred
tax assets and liabilities are recognized based upon the income reported in the
financial statements regardless of when such taxes are paid. These deferred
taxes are measured by applying current enacted tax rates.
 
 We
recorded an income tax expense of $1.4 million for the three months ended March
31, 2005 due to the pretax income recorded for the period (utilizing an
effective tax rate of approximately 40.1%). We recorded a tax benefit of $3.7
million for the three months ended March 31, 2004 on a pre-tax loss of $9.6
million (utilizing an effective tax rate of approximately 38.6%).
 
 **Financial
Condition**
 
 ***March
31, 2005 Compared to December 31, 2004***
 
 ***Cash
and cash equivalents*** *.* Cash and
cash equivalents increased $2.1 million, or 40.4%, to $7.3 million at March 31,
2005, from $5.2 million at December 31, 2004. This increase was primarily
related to timing of cash received and disbursed from normal
operations.
 
 ***Mortgage
Loans Held for Investment, Net*** .
Mortgage loans held for investment, net increased $576.2 million, or 24.6%, to
$2.9 billion, from $2.3 billion at December 31, 2004. This account represents
our basis in the mortgage loans that were either delivered to the securitization
trusts (denoted as mortgage loans held for investment - securitized) or are
pending delivery into future securitizations or sale on a whole-loan basis
(denoted as mortgage loans held for investment - pre-securitization), net of
discounts, deferred fees and allowance for loan losses.
 
 The
following table sets forth a summary of mortgage loans held for investment,
net:
  *(Dollars
      in thousands)*
    
    **At
      March 31, 2005**
    
    **At
      December 31, 2004**Mortgage
      loans held for investment - securitized
    
    $
    2,774,014
    
    $
    2,165,353Mortgage
      loans held for investment - pre-securitization
    
    
    184,100
    
    
    206,289Discounts
      (MSR related)
    
    
    (18,235
    )
    
    (14,570
    )Net
      deferred origination fees
    
    
    (5,885
    )
    
    (5,800
    )Allowance
      for loan losses
    
    
    (16,808
    )
    
    (10,278
    )Mortgage
      loans held for investment, net
    
    $
    2,917,186
    
    $
    2,340,994
 We
maintain an allowance for loan losses based on our estimate of losses to be
incurred in the near foreseeable future (generally an 18-month period) on our
mortgage loans held for investment. At March 31, 2005 and December 31, 2004, we
established an allowance for loan losses totaling $16.8 million and $10.3
million, respectively. The increase in the allowance for loan losses is
primarily driven by the growth in our mortgage loans held for investment
portfolio.
 
 The
following table sets forth a summary of the activity in the allowance for loan
losses for the three months ended March 31, 2005 and the year ended December 31,
2004:
 
 **Three
      Months Ended March 31,****2005**
    
    **Year
      Ended December 31,****2004***(Dollars
      in thousands)*Allowance
      for loan losses - beginning of period
    
    $
    10,278
    
    $
    --Provision
      for loan losses
    
    
    6,864
    
    
    10,443Charge-offs
    
    
    (334
    )
    
    (165
    )Allowance
      for loan losses - end of period
    
    $
    16,808
    
    $
    10,278
 
 ***Trustee
Receivable.*** Trustee
receivable principally represents any un-remitted principal payments collected
by the securitization trust’s third party loan servicer subsequent to the
monthly remittance cut-off date. The unscheduled principal payments and prepaid
loan payments received after the remittance cut-off date as of March 31, 2005
and December 31, 2004 totaled $44.3 million and $30.2 million, respectively,
relating to the securitizations accounted for as secured financings. The trustee
will remit these amounts on the following month’s scheduled remittance date, at
which time they principally will be used to pay down principal on the related
mortgage loans held for investment, net.
 
 **34**
 ***Accrued
Interest Receivable.*** Accrued
interest receivable increased $3.1 million, or 25.4%, to $15.4 million at March
31, 2005, from $12.3 million at December 31, 2004. The increase is due to the
28.1% increase in mortgage loans held for investment - securitized from December
31, 2004, offset slightly by the 10.8% decrease in mortgage loans held for
investment - pre-securitization during the same period.
 
 ***Excess
Cashflow Certificates*** . The
following table presents the activity related to our excess cashflow
certificates for the three months ended March 31, 2005 and the year ended
December 31, 2004:
 
 *(Dollars
      in thousands)*
    
    
    **Three
      Months Ended March 31,****2005**
    
    
    **Year
      Ended    December 31,****2004**Balance,
      beginning of period
    
    $
    14,933
    
    $
    19,853Accretion
    
    
    488
    
    
    2,073Cash
      receipts
    
    
    (4,100
    )
    
    (8,359
    )Net
      change in fair value
    
    
    2,738
    
    
    1,366Balance,
      end of period
    
    $
    14,059
    
    $
    14,933
 
 Since we
began structuring our securitizations in 2004 to be accounted for as secured
financings, we no longer record excess cashflow certificates (but rather the
underlined mortgage loans) on newly issued securitizations on the consolidated
balance sheet. We did not sell any excess cashflow certificates during the three
months ended March 31, 2005 or during the year ended December 31,
2004.
 
 ***Accounts
Receivable.***  Accounts
receivable increased $2.7 million, or 42.0%, to $9.2 million at March 31, 2005,
from $6.5 million at December 31, 2004. This
increase is primarily due to an increase in amounts due from the third party
servicer. The increase in servicer receivables relates to the increase in our
mortgage loans held for investment portfolio during the first quarter of 2005.
The servicer receivables are generally comprised of the interest portion of
mortgage payments collected by our loan servicing provider during the month
which are remitted to us on a one month lag ( *i.e.* ,
interest collected by the third party servicer after our March 2005 remittance
cut-off date will be remitted to us in April 2005).
 
 ***Equipment,
Net*** .
Equipment, net, increased $630,000, or 14.7%, to $4.9 million at March 31, 2005,
from $4.3 million at December 31, 2004. This increase is primarily due to
increased purchases of computer equipment and office furnishings during the
first quarter of 2005, which reflects the 4.1% increase in employees over
December 31, 2004 and the effect of our office expansions.
 
 ***Prepaid
and Other Assets.*** Prepaid
and other assets increased $5.4 million, or 20.7%, to $31.5 million at March 31,
2005, from $26.1 million at December 31, 2004. The increase is primarily due to
(1) a $4.4 million increase in prepaid securitization transaction costs, net,
which will be recognized as a yield adjustment to interest expense over the
estimated life of the secured financing; and (2) a $670,000 increase in
REO.
 
 At March
31, 2005 and December 31, 2004, we held $1.2 million and $578,000, respectively,
of REO, which we carry at the lower of cost or fair value, less estimated
selling costs. No
provisions were made for declines in the fair value of REO properties during the
three months ended March 31, 2005. We did not experience any declines in the
fair values of REO properties held through the end of the first quarter of 2005.
We had no REO properties as of March 31, 2004.
 
 ***Deferred
Tax Asset.***  The
deferred tax asset increased by $763,000, or 1.5%, to $51.1 million at March 31,
2005, from $50.3 million at December 31, 2004. The increase is primarily due to
temporary differences (1) between gain-on-sale accounting (for securitizations
entered into prior to 2004) or portfolio accounting (for securitizations entered
into commencing in 2004) on the one hand and Real Estate Mortgage Investment
Conduit ("REMIC") tax accounting on the other hand; and (2) relating to book
allowance for loan losses. The increase was partially offset by a $3.1 decrease
in deferred taxes related to the fair value of the hedge instruments within
accumulated other comprehensive income.
 
 **35**
 Commencing
in the first quarter of 2005, we began issuing our securitizations from a newly
created subsidiary that we elected to treat as a  REIT (also referred to as
a “Captive REIT”) under the Internal Revenue Code of 1986, as amended (the
“Code”). The securitization was structured as a “debt-for-tax” transaction. Our
prior securitizations were all structured as “sale-for-tax” transactions. The
tax structure was changed to more closely conform to the GAAP accounting
treatment.
 
 ***Bank
Payable.*** Bank
payable increased $479,000, or 43.2%, to $1.6 million at March 31, 2005, from
$1.1 million at December 31, 2004. Bank payable represents the amount of checks
written against our operating account which are subsequently covered as they are
presented to the bank for payment by either drawing down our lines of credit or
from subsequent deposits of operating cash.
 
 ***Warehouse
Financing.*** Our
warehouse financing decreased $17.0 million, or 12.5%, to $118.7 million at
March 31, 2005, from $135.7 million at December 31, 2004. The decrease was
primarily due to a $22.2 million decrease in the amount of mortgage loans held
for investment - pre-securitization. Additionally impacting the amount of
outstanding borrowings under our warehouse credit facilities was the decrease in
the amount of self-funded loans from December 31, 2004 to March 31, 2005. At
March 31, 2005, we self-funded $65.4 million of these mortgage loans, as
compared to $70.6 million at December 31, 2004.
 
 ***Financing
on Mortgage Loans Held for Investment, Net.*** Financing on mortgage loans held for investment, net increased $608.8 million,
or 27.2%, to $2.8 billion at March 31, 2005, from $2.2 billion at December 31,
2004. This increase in securitization pass-through securities corresponds to the
increase in loans held for investment - securitized in the first quarter of
2005. The balance of this account will generally increase in proportion to the
increase in mortgage loans held for investment - securitized.
 
 ***Other
Borrowings.***  Other
borrowings decreased $389,000, or 11.7%, to $2.9 million at March 31, 2005, from
$3.3 million at December 31, 2004. The decrease was due to a decrease in the
amount of financed equipment during the first quarter of 2005. The increase in
equipment financing directly relates to increases in our loan originations and
in the number of our mortgage origination offices.
 
 The
following table summarizes certain information regarding other borrowings at the
respective dates:
  (Dollars
in thousands)
 **Capital
      Leases**
    
    **Range
      of Interest Rates**
    
    **Balance**
    
    **Range
      of Expiration Dates**At
      March 31, 2005
    
    3.29%
      to 12.45%
    
    $      
      2,941
    
    October
      2005 to December 2007At
      December 31, 2004
    
    3.29%
      to 12.45%
    
    $      
      3,330
    
    October
      2005 to December 2007
 
 ***Accrued
Interest Payable.*** Accrued
interest payable increased $1.5 million, or 36.1%, to $5.8 million at March 31,
2005, from $4.3 million at December 31, 2004. This increase was directly related
to the accrued interest on the securitization debt issued in the first quarter
of 2005. Accrued interest payable related to warehouse borrowings represented
$45,000 and $101,000 of the balance at March 31, 2005 and December 31, 2004,
respectively.
 
 ***Accounts
Payable and Other Liabilities.*** Accounts
payable and other liabilities increased $4.8 million, or 20.5%, to $27.8 million
at March 31, 2005, from $23.0 million at December 31, 2004. The increase was
primarily due to (1) an $789,000 increase in current taxes payable, (2) a $2.0
million increase in payroll accruals for payroll related items ( *i.e.* , salary
and commissions) due to a combination of the 4.1% increase in personnel and
timing of commission payments, (3) a $1.2 million increase in accrued servicer
payables related primarily to our accounting for loan securitizations as a
secured financings in 2004, and (4) a $923,000 increase in accrued professional
fees.
 
 **36**
 ***Stockholders’
Equity.*** Stockholders’ equity increased $5.9 million, or 6.8%, to $93.1 million at March
31, 2005 from $87.2 million at December 31, 2004. This increase is primarily due
to the recording of $2.1 million in net income for the three months ended March
31, 2005 and the $114,000 of proceeds (and tax benefits) we received from the
exercise of 22,600 stock options from authorized but unissued shares during the
same period, offset by the accrual of $1.0 million in common stock dividends
that were declared on March 31, 2005 and paid on April 15, 2005.
 
 Additionally,
stockholders’ equity increased due to a $4.8 million increase in the cumulative
other comprehensive gain related to the net unrealized gains from derivatives,
net of tax. The cumulative other comprehensive income, net of tax, recorded at
March 31, 2005 denotes the changes in fair value of our hedges, net of
reclassification to earnings for the three months ended March 31, 2005. The
deferred gain amounts will be recognized as a yield adjustment to interest
expense over the life of the previously hedged variable rate debt.
 
 **Contractual
Obligations**
 
 The
following table summarizes our material contractual obligations as of March 31,
2005:
 *(Dollars
      in thousands)*
    
    **Total**
    
    **Less
      than**
      **One
      Year**
    
    **One
      to**
      **Three
      Years**
    
    **Three
      to**
      **Five
      Years**
    
    **More
      than**
      **Five
      Years**Securitization
      pass-through securities(1)
    
    $
    2,845,031
    
    $
    842,188
    
    $
    1,161,313
    
    $
    412,770
    
    $
    428,760Operating
      leases
    
    $
    19,839
    
    $
    5,386
    
    $
    10,834
    
    $
    3,134
    
    $
    485Capital
      leases
    
    $
    2,941
    
    $
    1,554
    
    $
    1,387
    
    $
    --
    
    $
    --
 *(1)*  *Amounts
shown above reflect estimated repayments based on anticipated receipt of
principal and interest on underlying mortgage loan collateral using the same
prepayment speed assumptions we use to value our excess cashflow
certificates.*
 
 **Loan
Commitments**
 
 We
provide commitments to fund mortgage loans to customers as long as all of the
proper conditions are met. Our commitments have fixed expiration dates. We quote
interest rates to customers, which are generally subject to change by us.
Although we typically honor these interest rate quotes, the quotes do not
constitute future cash requirements, minimizing the potential interest rate risk
exposure. We do not believe these non-conforming mortgage loan commitments meet
the definition of a derivative under GAAP. Accordingly, they are not recorded in
the consolidated financial statements. At March 31, 2005, and December 31, 2004,
we had outstanding origination commitments to fund approximately $105.7 million
and $92.2 million, respectively, in mortgage loans.
 
 **Off-Balance
Sheet Trusts**
 
 Substantially
our entire off-balance sheet arrangements relate to securitizations structured
as sales prior to 2004. In connection with our securitization transactions that
were structured as sales (and where we have recorded an economic interest, *i.e.* the
excess cashflow certificates), there is $1.2 billion in collateral (primarily
mortgage loans) owned by off-balance sheet trusts as of March 31, 2005. These
trusts have issued pass-through securities secured by these mortgage loans. We
have no obligation to provide funding support to either the third party
investors or the off-balance sheet trusts. The third party investors or the
trusts have no recourse to our assets or us and have no ability to require us to
repurchase their loans other than for non-credit-related recourse that can arise
under standard representations and warranties.
 
 **Liquidity
and Capital Resources**
 
 The term
“liquidity” refers to our ability to generate adequate amounts of cash to fund
our operations, including our loan originations, loan purchases, operating
expenses and planned dividend payments. We
require substantial amounts of cash to fund our loan originations,
securitization activities and operations. We generate working capital primarily
from the cash proceeds from our quarterly securitizations, including the sale of
MSRs. Our current cost structure has many embedded fixed costs, which are not
likely to be significantly affected by a relatively substantial change in our
loan origination volume. If we can continue to originate a sufficient amount of
mortgage loans and continue our practice of securitizations, we expect to
generate sufficient cash proceeds from our securitization financings, whole loan
sales and the cash flows from our growing portfolio of mortgage loans held for
investment to offset our current cost structure and cash uses. However, we may
choose to not sell MSRs or reduce the amount of securitization debt we issue,
which will negatively impact our cash flow in any period we do so.
 
 **37**
 We
believe we must generate sufficient cash from the following in order to sustain
our current level of working capital:
 
 ·
    the
      proceeds we receive from selling or financing pass-through asset-backed
      securities in connection with our
securitizations;
 
 ·
    the
      proceeds from the sale of MSRs to a third party mortgage
      servicer;
 
 ·
    the
      premiums we receive from selling whole loans on a servicing released
      basis;
 
 ·
    origination
      fees collected on newly closed loans;
 
 ·
    the
      cash flow from caps;
 
 ·
    excess
      cashflow certificates we retained in connection with our securitizations
      prior to 2004; and
 
 ·
    principal
      and interest payments we receive on our loans held for
      investment.
 
 
 Currently,
our primary uses of cash requirements include the funding of:
 
 ·
    mortgage
      loans held for investment - pre-securitization which are not
      financed;
 
 ·
    interest
      expense on warehouse lines of credit, financing of mortgage loans held for
      investment, and other financings;
 
 ·
    scheduled
      principal pay-downs on financing of mortgage loans held for investment and
      other financings;
 
 ·
    transaction
      costs, derivative costs and credit enhancement (O/C) in connection with
      our securitization program;
 
 ·
    general
      ongoing administrative and operating expenses, including the cost to
      originate loans;
 
 ·
    tax
      payments, including those on excess inclusion income generated from our
      excess cashflow certificates; and
 
 ·
    common
      stock dividends.
 
 Historically,
we have financed our operations utilizing securitization financings, various
secured credit financing facilities, issuances of corporate debt, issuances of
equity, and MSRs sold in conjunction with each of our securitizations to support
our originations, securitizations, and general operating expenses.
 
 Currently,
our primary sources of liquidity, subject to market conditions, continue to
be:
 
 ·
    warehouse
      financing and other secured financing
facilities;
 
 ·
    financing
      related to the securitization of mortgage
loans;
 
 ·
    sales
      of whole loans and MSRs;
 
 **38**
 ·
    cash
      flows from our mortgage loans held for
investment;
 
 ·
    origination
      fees, interest income and other cash revenues;
and
 
 ·
    cash
      flows from retained excess cashflow
certificates.
 
 We have
repurchase agreements with several of the institutions that have purchased
mortgage loans from us in the past. Some of the agreements provide for the
repurchase by us of any of the mortgage loans that go to foreclosure sale. At
the foreclosure sale, we will repurchase the mortgage, if necessary, and make
the institution whole. The dollar amount of loans that were sold with recourse
and are still outstanding totaled $932,000 and $1.1 million at March 31, 2005
and December 31, 2004, respectively. Included in “accounts payable and other
liabilities” is an allowance for recourse loans related to those loans sold with
recourse of $671,000 and $837,000 at March 31, 2005 and December 31,
2004.
 
 Subject to our ability to execute our business strategy and the various
uncertainties described above (and described in more detail in “- Forward
Looking Statements and Risk Factors”), we anticipate that we will have
sufficient cash flows from operations, short-term funding and capital resources
to meet our liquidity obligations for at least the next twelve months, however,
there can be no assurance that we will be successful in this
regard.
 
 **Financing
Facilities**
 
 We need
to borrow substantial sums of money each quarter to originate mortgage loans. We
have relied upon a limited number of counterparties to provide us with the
financing facilities to fund our loan originations. Our ability to fund current
operations and accumulate loans for securitization depends to a large extent
upon our ability to secure short-term financing on acceptable terms. There can
be no assurance that we will be able to either renew or replace our warehouse
facilities at their maturities at terms satisfactory to us or at all. If we are
not able to obtain financing, we will not be able to originate new loans and our
business and results of operations will be negatively impacted.
 
 To
originate and accumulate loans for securitization, we borrow money on a
short-term basis through committed secured warehouse lines of credit and
committed repurchase agreements. The material terms and features of our
financing facilities in place at March 31, 2005 are as follows:
 
 ***RBS
Greenwich Capital Warehouse Line of Credit*** *.* We have
a $350.0 million facility with RBS Greenwich Capital Financial Products, Inc.,
which bears interest based upon a fixed margin over the one-month LIBOR. This
facility provides us with the ability to borrow against first and second lien
loans and “wet” collateral, which are loans that have closed and have been
funded, but for which we have not yet received the loan documents from the
closing agent. The facility provides the ability to borrow at the lesser of 98%
of fair market value or 100% of the par amount of the mortgage loans between
0-59 days delinquent. Mortgage loans between 60-89 days delinquent may be
financed at lower borrowing percentages. This facility expires in October 2005.
As of March 31, 2005, the outstanding balance under the facility was $64.1
million.
 
 ***Citigroup
Warehouse Line of Credit.*** We have
a $350.0 million facility with Citigroup Global Markets Realty Corp., which
bears interest based upon a fixed margin over the one-month LIBOR. This facility
provides the ability to borrow against first and second lien loans and wet
collateral. The facility provides us with the ability to borrow at the lesser of
98% of fair market value or 100% of the par amount of the mortgage loans between
0-59 days delinquent. Mortgage loans between 60-89 days delinquent may be
financed at lower borrowing percentages. This facility expires in March 2006. As
of March 31, 2005, the outstanding balance under the facility was $54.6
million.
 
 ***Freidman,
Billings, Ramsey (“FBR”) Line of Credit.***  We have a
$200.0 million multi-seller asset-backed commercial paper facility with FBR, which
bears interest based upon a fixed margin over the one-month LIBOR . This
facility allows for the funding and aggregation of mortgage loans using funds
raised through the sale of short-term commercial paper. This facility will
expire in November 2005. As of March 31, 2005, we had no outstanding balance under the facility .
 
 **39**
 Our
warehouse agreements require us to comply with various operating and financial
covenants. The continued availability of funds provided to us under these
agreements is subject to, among other conditions, our continued compliance with
these covenants. We believe we were in compliance with these covenants as of
March 31, 2005.
 
 **Interest
Rate Risk**
 
 Our
primary market risk exposure is interest rate risk. Our results of operations
may be significantly affected by the level of and fluctuation in interest rates.
(See “- Item 3. Quantitative and Qualitative Disclosures About Market Risk -
Interest Rate Risk”).
 
 **Valuation
Risk**
 
 In
connection with the securitizations structured as sales, we have retained
certain assets for which the market is limited and illiquid. As a result,
valuations are derived using complex modeling and significant assumptions and
judgments, in the absence of active market quotations or sale information to
value such assets. These retained assets are primarily comprised of excess
cashflow certificates. The fair value of these assets could vary significantly
as market conditions change. (See “- Item 2. Management’s Discussion and
Analysis of Financial Condition and Results of Operations - Summary of Critical
Accounting Policies - Excess Cashflow Certificates”).
 
 **Credit
Risk**
 
 A
significant portion of our loans held for investment have been made to non-prime
credit borrowers and are secured by residential property. There is no guarantee
that, in the event of borrower default, we will be able to recoup the full
principal amount and interest due on a loan. We have adopted underwriting and
loan quality monitoring systems, procedures and credit policies, including the
establishment and review of the allowance for loan losses, that management
believe are prudent and appropriate to minimize this risk by tracking loan
performance, assessing the likelihood of nonperformance and diversifying our
loan portfolio. Such policies and procedures, however, may not prevent
unexpected losses that could adversely affect our results.
 
 We also
sell loans on a whole-loan basis to banks and other financial institutions. When we
sell mortgage loans on a whole-loan basis we are normally subjected to standard
mortgage industry representations and warranties, which may require us to
repurchase one or more of the mortgage loans. These representations and
warranties include provisions requiring us to repurchase a mortgage loan if a
borrower fails to make one or more of the first loan payments due on the
mortgage loan. In these
instances, we are subject to repurchase risk in the event of a breach of
standard representations or warranties we make in connection with these
whole-loan sales.
 
 **Geographical
Concentration**
 
 Properties
securing our mortgage loans held for investment are geographically dispersed
throughout the United States. For the three months ended March 31, 2005,
approximately 28% and 10%, based upon principal balance, of the mortgage loans
we originated were on properties located in New York and Florida, respectively,
with no other state representing more than 7% of the originations.
 
 **Environmental
Matters**
 
 To date,
we have not been required to perform any environmental investigation or clean-up
activities, nor have we been subject to any environmental claims. There can be
no assurance, however, that this will remain the case in the future. Although we
primarily lend to owners of residential properties, in the course of our
business, we may acquire properties securing loans that are in default. There is
a risk that we could be required to investigate and clean-up hazardous or toxic
substances or chemical releases at these properties, and may be held liable to a
governmental entity or to third parties for property damage, personal injury and
investigation and clean-up costs incurred in connection with the contamination.
In addition, the owner or former owners of a contaminated site may be subject to
common law claims by third parties based on damages and costs resulting from
environmental contamination emanating from the property.
 
 **40**
 **Inflation**
 
 Inflation
most significantly affects our loan originations and values of our excess
cashflow certificates, because of the substantial effect inflation can have on
interest rates. Interest rates normally increase during periods of high
inflation and decrease during periods of low inflation. (See “-Item 3.
Quantitative and Qualitative Disclosures About Market Risk - Interest Rate
Risk”).
 
 **Impact
of New Accounting Standards**
 
 In
December 2004, the FASB published SFAS No. 123(R). ** SFAS No.
123(R) replaces SFAS No. 123, and supersedes APB Opinion No. 25. ** SFAS No.
123(R) also amends SFAS No. 95 to require that excess tax benefits be reported
as a financing cash inflow rather than as a reduction of taxes
paid.
 
 SFAS No.
123(R) is intended to provide investors and other users of financial statements
with more complete and neutral financial information by requiring that the
compensation cost relating to share-based payment transactions be recognized in
financial statements. The cost will be measured based on the fair value of the
equity or liability instruments issued. We will be required to apply SFAS No.
123(R), as amended by the SEC on April 14, 2005, as of the annual reporting
period that begins after June 15, 2005 (or January 1, 2006). SFAS No. 123(R)
applies to all awards granted after the required effective date and will not be
applied to awards granted in periods before the required effective date except
to the extent that prior periods’ awards are modified, repurchased or cancelled
after the required effective date. The cumulative effect of initially applying
SFAS No. 123(R), if any, will be recognized as of the required effective date.
We are currently evaluating pricing models and the transition provisions of this
standard and will begin expensing stock options in the first quarter of
2006.
 
 SFAS
No.123(R) provides two alternatives for adoption: (1) a "modified prospective"
method in which compensation cost is recognized for all awards granted
subsequent to the effective date of SFAS No. 123(R) as well as for the unvested
portion of awards outstanding as of the effective date; or (2) a "modified
retrospective" method which follows the approach in the "modified prospective"
method, but also permits the restatement of prior periods to record compensation
costs calculated under SFAS No. 123 for the pro forma disclosure. We plan to
adopt SFAS No. 123(R) using the modified retrospective method. Since we
currently account for stock options granted to employees in accordance with the
intrinsic value method permitted under APB Opinion No. 25, no compensation
expense is recognized. The impact of adopting SFAS No. 123(R) cannot be
accurately estimated at this time, as it will depend on the market value and the
amount of share based awards granted in future periods. However, had we adopted
SFAS No. 123(R) in a prior period, the impact would approximate the impact as
described in the disclosure of pro forma net income and earnings per share under
SFAS No. 123 in Note 5 to our consolidated financial statements “- Stock-Based
Compensation.” SFAS No. 123(R) also requires that tax benefits received in
excess of compensation cost be reclassified from operating cash flows to
financing cash flows in the consolidated statement of cash flows. This change in
classification will reduce net operating cash flows and increase net financing
cash flows in the periods after adoption.
 
 **Forward-Looking
Statements and Risk Factors**
 
 Except
for historical information contained in the report, certain matters discussed in
this Form 10-Q are “forward-looking statements” as defined in the Private
Securities Litigation Reform Act of 1995 (“PSLRA”), which involve risk and
uncertainties that exist in our operations and business environment and are
subject to change on a variety of important factors. A forward-looking statement
may contain words such as “anticipate that,” “believes,” “continue to,”
“estimates,” “expects to,” “hopes,” “intends,” “plans,” “to be,” “will be,”
“will continue to be,” or similar words. These statements include, but are not
limited to, the anticipated impact to our financial statements of our change to
our accounting for securitizations, our future profitability, our future cash
flows and liquidity requirements, the impact of changes in interest rates, our
future hedging strategy, and our ability to realize benefits from our deferred
tax asset. Such statements are subject to the “safe harbor” provisions of the
PSLRA. We caution readers that numerous important factors discussed below, among
others, could cause our actual results to differ materially from those expressed
in any forward-looking statements made in the report. The following include
some, but not all, of the factors or uncertainties that could cause our actual
results to differ from our projections:
  ·
    Our
      ability or inability to earn a sufficient spread between our cost of funds
      and our average mortgage rates to generate sufficient revenues and cash
      flows to offset our current cost structure and cash
  uses;
 
 **41**
 ·
    The
      effects of interest rate fluctuations and our ability or inability to
      hedge effectively against these fluctuations in interest rates, the effect
      of changes in monetary and fiscal policies, social and economic
      conditions, unforeseen inflationary pressures and monetary
      fluctuation;
 
 ·
    Our
      ability or inability to originate a sufficient amount of mortgage loans,
      and subsequent sale or securitization of such loans, to offset our current
      cost structure and cash uses;
 
 ·
    Our
      ability or inability to continue our practice of securitizing mortgage
      loans, as well as our ability to utilize optimal securitization structures
      (including the sale of MSRs, at the time of securitization) at terms
      favorable to us to generate sufficient cash proceeds to offset our current
      cost structure;
 
 ·
    The
      impact of changes in our accounting policies, including our change to
      on-balance sheet treatment of our
securitizations;
 
 ·
    Our
      ability or inability to continue to employ on-balance sheet
      securitizations to generate cash flows and earnings from net interest
      spread income;
 
 ·
    Our
      ability or inability to continue to access lines of credit at favorable
      terms and conditions, including without limitation, warehouse and other
      credit facilities used to finance newly-originated mortgage loans held for
      sale and our ability or inability to comply with covenants contained in
      these lines of credit;
 
 ·
    Increased
      competition within our markets, particularly in the wholesale loan
      channel, where an increasing number of lenders are competing for business
      from independent mortgage brokers;
 
 ·
    The
      risks of defaults on the loans that we make to non-prime credit borrowers,
      and that our underwriting and loan quality monitoring systems will not be
      sufficient to minimize the impact from these
defaults;
 
 ·
    The
      potential effect that possible conflicts with other sovereign nations,
      including the conflict in Iraq, or terrorist acts and/or threats, may have
      on the U.S. economy and capital markets, and in particular the
      asset-backed market;
 
 ·
    The
      effect that the adoption of new, or amendments in, federal, state or local
      lending laws and regulations and the application of these laws and
      regulations may have on our ability to originate loans within a particular
      area, or to ultimately sell those loans through securitization or on a
      whole-loan basis. In some instances, we may choose or be forced to
      severely limit, or even cease our lending activities in a particular area.
      Many states and local municipalities have adopted and/or are considering
      adopting laws that are intended to further regulate our industry. Many of
      these laws and regulations seek to impose broad restrictions on certain
      commonly accepted lending practices, including some of our practices. In
      addition, enacted federal, state and local laws could impact
      overcollateralization requirements set by the rating agencies, which could
      decrease the cash proceeds we may receive from our
      securitizations;
 
 ·
    Our
      ability or inability to find alternative methods of generating retail
      leads and originating retail loans in light of the Federal Trade
      Commission (“FTC”) “do no call” registries, which was implemented in 2003
      and may limit our ability to utilize telemarketing to generate retail
      leads and originate retail loans. Our marketing operations are or may
      become subject to various federal and state “do not call” list
      requirements. Under the FTC’s regulations, consumers may have their phone
      numbers added to the national “do not call” registry. Generally, we are
      prohibited from cold calling anyone on that registry. These regulations
      may restrict our ability to market effectively our products and services
      to new customers. Furthermore, compliance with these regulations may prove
      costly and difficult, and we may incur penalties for improperly conducting
      our marketing activities;
 
 ·
    The
      risk that we will be subject to claims under environmental
      laws;
 
 **42**
 ·
    The
      risk that using Insured AVM's in lieu of appraisals could increase our
      losses.  An AVM maybe considered a less accurate measure to value a
      property than a full appraisal with an interior inspection performed by a
      licensed appraiser.  If the values received from the AVM are higher
      than the actual property values, we may incur higher losses.  While
      we do obtain an insurance policy on the AVM value at the time of
      origination, there can be no assurance that we will recover claims from
      this policy in the event of a loss.
 
 ·
    Costs
      associated with litigation and rapid or unforeseen escalation of the cost
      of regulatory compliance, generally including but not limited to, the
      adoption of new, or changes in, federal, state or local lending laws and
      regulations and the application of such laws and regulations, licenses,
      environmental compliance, the adoption of new, or changes in accounting
      policies and practices and the application of such policies and practices.
      Failure to comply with various federal, state and local regulations,
      accounting policies and/or environmental compliance can lead to the loss
      of approved status, rights of rescission for mortgage loans, class action
      lawsuits, demands for indemnification or loan repurchases by purchasers of
      our loans and administrative enforcement action again
  us;
 
 ·
    Our
      ability or inability to detect misrepresentations, fraudulent information
      or negligent acts on the part of loan applicants, mortgage brokers, other
      vendors or our employees in our loan originations prior to funding and the
      effect it may have on our business, including potentially harming our
      reputation or resulting in poorer performing
loans;
 
 ·
    The
      risk that we may need to repurchase loans securitized or sold on a
      whole-loan basis if we breach the representations and warranties that we
      make in connection with the sales;
 
 ·
    Our
      ability or inability to continue monetizing our existing excess cashflow
      certificates, including without limitation, selling, financing or
      securitizing such assets;
 
 ·
    The
      accuracy of our estimates of the value of our excess cashflow
      certificates;
 
 ·
    Periods
      of general economic slowdown or recession may be accompanied by decreased
      demand for consumer credit and declining real estate values. Because of
      our focus on credit-impaired borrowers, the actual rate of delinquencies,
      foreclosures and losses on loans affected by the borrowers’ reduced
      ability to use home equity to support borrowings could be higher than
      those generally experienced in the mortgage lending industry. We are
      particularly subject to economic conditions in the northeastern U.S.,
      where approximately 28% of our loans were originated during the three
      months ended March 31, 2005. Any sustained period of increased
      delinquencies, foreclosure, losses or increased costs could adversely
      affect our ability to securitize or sell loans in the secondary
      market;
 
 ·
    The
      effect that poor servicing or collections by third-party servicers that
      service the loans we originate, and/or regulatory actions and class action
      lawsuits against these servicers, could have on the value of our excess
      cashflow certificates, the net interest spread we earn and/or our ability
      to sell or securitize loans in the future;
 
 ·
    The
      effect that an interruption in, or breach of, our information systems
      could have on our business;
 
 ·
    Our
      ability or inability to adapt to an implement technological changes to
      become and/or remain competitive and/or
efficient;
 
 ·
    Unpredictable
      delays or difficulties in the development of new product
      programs;
 
 ·
    Regulatory
      actions, which may have an adverse impact on our lending;
 
 ·
    Changes
      in regulations issued by the Office of Thrift Supervision may limit our
      ability to charge prepayment penalties on some of the mortgage loans we
      originate, which could have an adverse impact on our securitizations and
      related profitability; and
 
 ·
    The
      unanticipated expenses of assimilating newly-acquired business, if any,
      into our structure, as well as the impact of unusual expenses from ongoing
      evaluations of business strategies, asset valuations, acquisitions,
      divestitures and organizational structures.
 
 **43**
 ·
    Our
      inability to comply with REIT qualification tests for our Captive REIT on
      a continuous basis, would subject our securitization trusts issued by our
      Captive REIT to federal income tax as a corporation and not allow it to be
      filed as part of consolidated income tax return with any other
      corporation. The REIT rules require compliance with asset, income and
      ownership tests. The ownership test prohibits five or fewer
      stockholders from owning more than 50% of our common stock. Currently,
      members of the Miller family own approximately 48% of the common stock
      (including employee stock options as required by the Code calculation).
      There can be no assurance that we will be able to comply with these tests,
      or remain compliant. In such an event, a tax imposed upon these
      securitization trusts would reduce cash flow that would otherwise be
      available to make payments on the offered asset-backed securities and
      reduce the amount that we would receive from the securitization trusts. In
      such event, this would significantly affect our access to the
      securitization markets and warehouse and other credit facilities. In
      addition, it could harm our results of operations, financial condition and
      liquidity.
 
 **Item
3. Quantitative and Qualitative Disclosures About Market
Risk.**
 
 We
originate mortgage loans and then securitize the mortgage loans or sell them
through whole loan sales. As a result, our primary market risk is interest rate
risk. In turn, interest rates are highly sensitive to many factors,
including:
 
 ·
    Governmental
      monetary and tax policies;
 
 ·
    Domestic
      and international economic and political considerations;
    and
 
 ·
    Other
      factors that are also beyond our control.
 
 Changes
in the general interest rate levels between the time we originate mortgage loans
and the time we securitize or sell the mortgage loans can affect their value
and, consequently, our net interest income revenue by affecting the “excess
spread” between the interest rate on the mortgage loans and the interest paid on
the asset-backed pass-through securities issued by the securitization trusts. If
interest rates rise between the time we originate the loans and the time we
securitize or sell the loans, the excess spread generally narrows, resulting in
a loss in value of the loans and lower net interest income for us on mortgage
loans we securitize and a lower net gain on sale for us on whole loan sales.
Since we close and fund mortgage loans at a specified interest rate with an
expected spread to be earned over their life in the case of securitizations and
an expected gain on sale to be booked at the time of their sale, our exposure to
decreases in the fair value of the mortgage loans arises when moving from a
lower to a higher interest rate environment. A higher interest rate environment
results in our having a higher cost of funds. This decreases both the fair value
of the mortgage loans and the net spread we earn between the mortgage interest
rate on each mortgage loan and our cost of funds under available warehouse lines
of credit used to finance the loans prior to their securitization or sale. As a
result, we may experience lower spreads on securitized loans and a lower gain on
whole loan sales.
 
 The
following table demonstrates the sensitivity, at March 31, 2005, of the
estimated fair value of our excess cashflow certificates caused by an immediate
10% and 20%, respectively, adverse change in the key assumptions we use to
estimate fair value:
 
 *(Dollars
      in thousands)*
    
    **Fair
      Value of**
      **Excess
      Cashflow**
      **Certificates**
    
    **Decrease
      (Increase)**
      **To
      Earnings****(Pre-tax
      basis)**Fair
      value as of March 31, 2005
    
    $
    14,05910%
      increase in prepayment speed
    
    
    14,459
    
    $
    (400
    )20%
      increase in prepayment speed
    
    
    14,887
    
    
    (828
    )10%
      increase in credit losses
    
    
    11,773
    
    
    2,28620%
      increase in credit losses
    
    
    9,561
    
    
    4,49810%
      increase in discount rates
    
    
    13,872
    
    
    18720%
      increase in discount rates
    
    
    13,691
    
    
    36810%
      increase in one and six-month LIBOR
    
    
    12,338
    
    
    1,72120%
      increase in one and six-month LIBOR
    
    
    10,752
    
    
    3,307
 
 **44**
 The
sensitivities are hypothetical and are presented for illustrative purposes only.
Changes in the fair value resulting from a change in assumptions generally
cannot be extrapolated because the relationship of the change in assumption to
the resulting change in fair value may not be linear. Each change in assumptions
presented above was calculated independently, without changing any other
assumption. However, in reality, changes in one assumption may result in changes
in another assumption, which may magnify or counteract the sensitivities. For
example, a change in market interest rates may simultaneously impact prepayment
speeds, credit losses and the discount rate. It is impossible to predict how one
change in a particular assumption may impact other assumptions.
 
 To reduce
our financial exposure to changes in interest rates, we may hedge our mortgage
loans held for sale through hedging products that are correlated to the
pass-through securities issued in connection with the securitization of our
mortgage loans ( *e.g* .,
interest rate swaps). (See “-Item 2. - Summary of Critical Accounting Policies -
Accounting for Hedging Activities”). Changes in interest rates also could
adversely affect our ability to originate loans and/or could affect the level of
loan prepayments, impacting the amount of mortgage loans held for investment
and/or the size of the loan portfolio underlying our excess cashflow
certificates and, consequently, the value of our excess cashflow certificates.
(See “-Interest Rate Risk/Market Risk” and “-Item 2. - Forward Looking
Statements and Risk Factors”).
 
 **Interest
Rate/Market Risk**
 
 Our
general investment policy is to maintain the net interest margin between assets
and liabilities.
 
 ***Loan
Price Volatility*** *.* Under
our current mode of operation, we depend heavily on the market for wholesale
non-conforming mortgage loans. To conserve capital, we may sell loans we
originate. Our financial results will depend, in part, on our ability to find
purchasers for our loans at prices that cover origination expenses. Exposure to
loan price volatility is reduced as we acquire and retain mortgage
loans.
 
 ***Interest
Rate Risk*** *.* Interest
rates affect our ability to earn a spread between interest received on our loans
and the cost of our borrowings, including the cost of corridors, if any, that
are tied to various interest rate swap maturities, LIBOR, and other interest
rate spread products, such as mortgage, auto and credit card backed receivable
securities. Our profitability is likely to be negatively impacted during any
period of unexpected or rapid changes in interest rates. A substantial and
sustained increase in interest rates could impact our ability to originate
loans. A significant decline in interest rates could increase the level of loan
prepayments, which would decrease the size of the loan servicing portfolio
underlying our securitizations. To the extent excess cashflow certificates have
been capitalized on our financial statements, higher than anticipated rates of
loan prepayments or losses could require us to write down the value of these
excess cashflow certificates, which adversely impact our earnings. In an effort
to mitigate the effect of interest rate risk, we periodically review our various
mortgage products and identify and modify those that have proven historically
more susceptible to prepayments. However, there can be no assurance that these
modifications to our product line will mitigate effectively any interest rate
risk in the future.
 
 Periods
of unexpected or rapid changes in interest rates, and/or other volatility or
uncertainty regarding interest rates, also can harm us by increasing the
likelihood that asset-backed investors will demand higher spreads than normal to
offset the volatility and/or uncertainty, which decreases the value of the
excess cashflow certificates we receive in connection with a
securitization.
 
 Fluctuating
interest rates may also affect the net interest income we earn, resulting from
the difference between the yield we receive on the loans held pending sale and
the interest paid by us for funds borrowed under our warehouse facilities. In
the past, from time to time, we have undertaken certain measures to hedge our
exposure to this risk by using various hedging strategies, including Fannie Mae
mortgage securities, treasury rate lock contracts and/or interest rate swaps.
See “- Item 2. - Summary of Critical Accounting Policies - Accounting for
Hedging Activities.” Fluctuating interest rates also may significantly affect
the excess cash flows from our excess cashflow certificates, as the interest
rate on some of our asset-backed securities change monthly based on one-month
LIBOR, but the collateral that backs such securities are comprised of mortgage
loans with either fixed interest rates or “hybrid” interest rates (fixed for the
initial two or three years of the mortgage loan, and adjusting thereafter every
six month) which creates basis risk. See “- Item 2. - Summary of Critical
Accounting Policies - Excess Cashflow Certificates.” With our transition to
on-balance sheet portfolio securitizations in 2004, we may undertake to hedge
our exposure to interest rate risk as described above in “- Item 2. - Summary of
Critical Accounting Policies - Accounting for Hedging Activities.”
 
 **45**
 When
interest rates on our assets do not adjust at the same rates as our liabilities
or when the assets have fixed-rates and the liabilities are adjusting, our
future earnings potential is affected. We express this interest rate risk as the
risk that the market value of assets will increase or decrease at different
rates than that of the liabilities. Expressed another way, this is the risk that
net asset value will experience an adverse change when interest rates change. We
assess the risk based on the change in market values given increases and
decreases in interest rates. We also assess the risk based on the impact to net
income in changing interest rate environments.
 
 Management
primarily uses financing sources where the interest rate resets frequently. As
of March 31, 2005, borrowings under all of our financing arrangements adjust
daily or monthly. On the other hand, very few of the mortgage assets we own
adjust on a monthly or daily basis. Most of the mortgage loans are fixed-rate;
the remainder contains features where their rates are fixed for some period of
time and then adjust frequently thereafter. For example, one of our loan
products is the “2/28” loan. This 30-year loan is fixed for its first two years
and then adjusts every six months thereafter.
 
 While
short-term borrowing rates are low and long-term asset rates are high, this
portfolio structure enhances our net interest income during the relevant period.
However, if short-term interest rates rise rapidly, the earnings potential is
significantly affected, as the asset rate resets would lag behind the borrowing
rate resets.
 
 ***Interest
Rate Sensitivity Analysis.*** To
assess interest sensitivity as an indication of exposure to interest rate risk,
management relies on models of financial information in a variety of interest
rate scenarios. Using these models, the fair value and interest rate sensitivity
of each financial instrument, or groups of similar instruments, is estimated and
then aggregated to form a comprehensive picture of the risk characteristics of
the balance sheet.
 
 We
measure the sensitivity of our net interest income to changes in interest rates
affecting interest sensitive assets and liabilities using various interest rate
simulations. These simulations take into consideration changes that may occur in
the forward LIBOR curve and changes in mortgage prepayment speeds.
 
 As part
of various interest rate simulations, we calculate the effect of potential
changes in interest rates on our interest-earning assets and interest-bearing
liabilities and their affect on overall earnings. The simulations assume
instantaneous and parallel shifts in interest rates and to what degree those
shifts affect net interest income. First, we project our net interest income for
the next 12 months and 36 months using current period end data along with a
forward LIBOR curve and the prepayment speed assumptions we used to estimate the
fair value of our excess cashflow certificates.
 
 We refer
to the one-year and the three-year projections of net interest income as the
“base case.” Once the base case has been established, we “shock” the base case
with instantaneous and parallel shifts in interest rates in 100 basis point
increments upward and downward. Calculations are made for each of the defined
instantaneous and parallel shifts in interest rates over or under the forward
LIBOR curve used to determine the base and including any associated changes in
projected mortgage prepayment speeds. The following tables present the results
of each 100 basis point change in interest rates compared against the base case
to determine the estimated dollar and percentage change to net interest income
at March 31, 2005:
 
 **46**
 *(Dollars
      in thousands)*
    
    **Base
      Case**
    
    **Up
      100 Basis Points**
    
    **Up
      200 Basis Points**
    
    **Down
      100 Basis Points**
    
    **Down
      200 Basis Points***********One
      Year Projection:***Net
      interest income(1)(2)
    
    $
    95,383
    
    $
    94,944
    
    $
    94,293
    
    $
    97,844
    
    $
    102,980Percentage
      change from base
    
    
    
    
    
    (0.46
    )%
    
    (1.14
    )%
    
    2.58
    %
    
    7.96
    %***Three
      Year Projection:***Net
      interest income(1)(2)
    
    $
    170,848
    
    $
    164,821
    
    $
    159,191
    
    $
    180,630
    
    $
    191,256Percentage
      change from base
    
    
    
    
    
    (3.53
    )%
    
    (6.82
    )%
    
    5.73
    %
    
    11.94
    %
 
 *(1)*  *Net
interest income from assets (income from mortgage loans held for sale, mortgage
loans held for investment and interest rate caps) less expense from liabilities
(financing on mortgage loans held for investment and warehouse interest expense)
in a parallel shift in the yield curve, up and down 1% and 2%.*
 
 *(2)*  *Assumes
warehouse interest expense through June 30, 2005.*
 
 ***Hedging*** *.* From an
interest rate risk management perspective, we use interest rate swaps and
corridors in an effort to offset the potential adverse effects of our exposure
during a period of rising rates. In this way, management intends generally to
hedge as much of the interest rate risk as determined to be in our best
interest, given the cost of hedging transactions.
 
 We seek
to build a balance sheet and undertake an interest risk management program that
is likely, in management’s view, to enable us to maintain an equity liquidation
value sufficient to maintain operations given a variety of potentially adverse
circumstances. Accordingly, the hedging program addresses income preservation,
as discussed in the first part of this section.
 
 Corridors
are legal contracts between us and a third party firm or “counterparty.” The
counterparty agrees to make payments to us in the future (net of the
in-the-money interest rate cap sold as part of the corridor) should the one- or
three-month LIBOR interest rate rise above the strike rate specified in the
contract. We have chosen to pay the premiums to the counterparties at the
beginning of each contract. Each contract has both a fixed or amortizing
notional face amount on which the interest is computed, and a set term to
maturity. When the referenced LIBOR interest rate rises above the contractual
strike rate, we earn corridor income (net of the in-the-money interest rate cap
sold as part of the corridor). Payments on an annualized basis equal the
difference between actual LIBOR and the strike rate. Interest rate swaps have
similar characteristics. However, interest rate swap agreements allow us to pay
a fixed-rate of interest while receiving a rate that adjusts with one-month
LIBOR.
 
 **Maturity
and Repricing Information**
 
 The
following table summarizes the notional amount, expected maturities and weighted
average strike rates for corridors that we held as of March 31,
2005.
 
 *(Dollars
      in thousands,**except
      strike price)*
    
    **Total**
    
    **One
      Year**
    
    **Two
      Years**
    
    **Three
      Years**
    
    **Four
      Years**
    
    **Five
      Years & Thereafter**Caps
      bought - notional
    
    $
    2,239,803
    
    $
    1,361,641
    
    $
    580,087
    
    $
    113,877
    
    $
    45,852
    
    $
    138,346Weighted
      average strikePrice
    
    $
    4.78
    
    $
    3.74
    
    $
    5.87
    
    $
    7.41
    
    $
    7.39
    
    $
    7.43Caps
      sold - notional
    
    $
    2,239,803
    
    $
    1,361,641
    
    $
    580,087
    
    $
    113,877
    
    $
    45,852
    
    $
    138,346Weighted
      average strikePrice
    
    $
    7.90
    
    $
    7.14
    
    $
    8.68
    
    $
    9.37
    
    $
    9.27
    
    $
    10.41
 
 **47**
 **Item
4. Controls and
Procedures.**
 
 Prior to
the filing of this report, management, including the Chief Executive Officer and
Chief Financial Officer, evaluated the effectiveness and operation of our
disclosure controls and procedures. Our Chief Executive Officer and Chief
Financial Officer concluded that, as of March 31, 2005, these disclosure
controls and procedures were effective to ensure that information required to be
disclosed in the reports we file and submit under the Securities and Exchange
Act is recorded, processed, summarized and reported as and when required. Our
Chief Executive Officer and Chief Financial Officer have concluded that our
disclosure controls and procedures are also effective to ensure that the
information required to be disclosed in the reports that we file or submit under
the Exchange Act is accumulated and communicated to management, including our
Chief Executive Officer and Chief Financial Officer, as appropriate to allow
timely decisions regarding required disclosure. There have not been any changes
in our internal controls over financial reporting that occurred during the first
quarter of 2005 that materially affected, or are reasonably likely to materially
affect, our internal controls over financial reporting. There were no
significant deficiencies or material weaknesses identified during the course of
this evaluation.
 
 **Part
II - OTHER INFORMATION**
 
 **Item
1. Legal Proceedings.**
 
 Because
the nature of our business involves the collection of numerous accounts, the
validity of liens and compliance with various state and federal lending laws, we
are subject, in the normal course of business, to numerous claims and legal
proceedings, including class actions. The current status of the pending class
actions and other material litigation is summarized below:
 
 ·
    In
      or about November 1998, we received notice that we had been named in a
      lawsuit filed in the United States District Court for the Eastern District
      of New York. In December 1998, the plaintiffs filed an amended complaint
      alleging that we had violated the HOEPA, TILA, and Section 349 of the New
      York State General Business Law, which relates to consumer protection for
      deceptive practices. The complaint sought: (a) certification of a class of
      plaintiffs, (b) declaratory judgment permitting rescission, (c)
      unspecified actual, statutory, treble and punitive damages, including
      attorneys’ fees, (d) injunctive relief and (e) declaratory judgment
      declaring the loan transactions as void and unconscionable. On December 7,
      1998, plaintiff filed a motion seeking a temporary restraining order and
      preliminary injunction, enjoining us from conducting foreclosure sales on
      11 properties. The District Court Judge ruled that in order to consider
      the motion, plaintiff must move to intervene on behalf of these 11
      borrowers. Thereafter, plaintiff moved to intervene on behalf of three of
      these 11 borrowers and sought injunctive relief on their behalf. We
      opposed the motions. On December 14, 1998, the District Court Judge
      granted the motion to intervene and on December 23, 1998, the District
      Court Judge issued a preliminary injunction that enjoined us from
      proceeding with the foreclosure sales of the three interveners’
      properties. We filed a motion for reconsideration of the December 23, 1998
      order. In January 1999, we filed an answer to plaintiffs’ first amended
      complaint. In July 1999, the plaintiffs were granted leave, on consent, to
      file a second amended complaint. In August 1999, the plaintiffs filed a
      second amended complaint that, among other things, added additional
      parties but contained the same causes of action alleged in the first
      amended complaint. In September 1999, we filed a motion to dismiss the
      complaint, which was opposed by plaintiffs and, in June 2000, was denied
      in part and granted in part by the Court. In or about October 1999,
      plaintiffs filed a motion seeking an order preventing us, our attorneys
      and/or the NYSBD from issuing notices to a number of our borrowers, in
      accordance with the settlement agreement entered into by and between the
      NYSBD and us. In the fourth quarter of 1999, we and the NYSBD submitted
      opposition to the plaintiffs’ motion. In March 2000, the Court issued an
      order that permitted us to issue an approved form of the notice. In
      September 1999, the plaintiffs filed a motion for class certification,
      which we opposed in February 2000, and which was ultimately withdrawn
      without prejudice by the plaintiffs in January 2001. In February 2002, we
      executed a settlement agreement with the plaintiffs, under which we denied
      all wrongdoing, but agreed to resolve the litigation on a class-wide
      basis. The Court preliminarily approved the settlement and a fairness
      hearing was held in May 2002. We submitted supplemental briefing at the
      Court’s request in or about April 2004. In August 2004, the Court
      conditionally approved the settlement, subject to our submitting
      supplemental documentation regarding a change in the settlement agreement
      and proposed supplemental notices to be sent to those borrowers who either
      opted out or objected. We, plaintiffs and certain objectors submitted our
      respective supplemental submissions in August 2004 and the Court granted
      its final approval to the settlement in January 2005. In February 2005,
      certain objectors filed a notice of appeal. We believe the appellate court
      will uphold the settlement, but if it does not, we believe we have
      meritorious defenses and intend to vigorously defend this suit, but cannot
      estimate with any certainty our ultimate legal or financial liability, if
      any, with respect to the alleged claims.
 
 **48**
 ·
    In
      or about March 1999, we received notice that we and certain of our
      officers and directors had been named in a lawsuit filed in the Supreme
      Court of the State of New York, New York County, alleging that we had
      improperly charged certain borrowers processing fees. The complaint
      sought: (a) certification of a class of plaintiffs, (b) an accounting and
      (c) unspecified compensatory and punitive damages, including attorneys’
      fees, based upon alleged (i) unjust enrichment, (ii) fraud and (iii)
      deceptive trade practices. In April 1999, we filed an answer to the
      complaint. In September 1999, we filed a motion to dismiss the complaint,
      which was opposed by the plaintiffs, and in February 2000, the Court
      denied the motion to dismiss. In April 1999, we filed a motion to change
      venue and the plaintiffs opposed the motion. In July 1999, the Court
      denied the motion. We appealed, and in March 2000, the Appellate Court
      granted our appeal to change venue from New York County to Nassau County.
      In August 1999, the plaintiffs filed a motion for class certification,
      which we opposed in July 2000. In or about September 2000, the Appellate
      Court granted the plaintiffs’ motion for class certification, from which
      we appealed. The Appellate Court denied our appeal in December 2001. In or
      about June 2001, we filed a motion for summary judgment to dismiss the
      complaint, which was denied by the Court in October 2001. We appealed that
      decision, but the Appellate Court denied our appeal in November 2002. We
      filed a motion to reargue in December 2002, which was denied by the
      Appellate Court in January 2003. Discovery is continuing in the lower
      Court. We believe that we have meritorious defenses and intend to
      vigorously defend this suit, but cannot estimate with any certainty our
      ultimate legal or financial liability, if any, with respect to the alleged
      claims.
 
 ·
    In
      July 2003, we commenced a lawsuit in the Supreme Court of the State of New
      York, Nassau County, against the LLC, Delta Funding Residual Management,
      Inc. (“DFRM”), and James E. Morrison, President of the LLC and DFRM,
      alleging that (1) the LLC breached its contractual duties by failing to
      pay approximately $142,000 due to us in June 2003, and (2) that Mr.
      Morrison and DFRM knowingly and intentionally caused the default, thereby
      breaching their respective fiduciary duties to the LLC. The complaint
      seeks: (a) payment of amounts past due under our agreement with the LLC,
      plus interest; (b) specific performance of the LLC’s obligations to us in
      the future; and (c) monetary damages for breach of fiduciary duty, in an
      amount to be determined by the Court. In September 2003, Mr. Morrison, the
      LLC and DFRM filed a motion to dismiss our complaint and the LLC and DFRM
      filed a countersuit in the Supreme Court of the State of New York, New
      York County, against several of our directors and officers and us seeking,
      among other things, damages of not less than $110 million. The countersuit
      alleges misrepresentation, negligence and/or fraud by defendants in that
      case relating to our August 2001 exchange offer. In October 2003, we filed
      our opposition to the motion to dismiss and cross-moved to consolidate the
      two actions in Nassau County. In November 2003, we answered the New York
      County action. In February 2004, the Nassau County Court denied Mr.
      Morrison’s motion to dismiss our causes of action seeking (a) payment of
      amounts due under our agreements with the LLC and (b) monetary damages for
      breach of fiduciary duty, and granted Mr. Morrison’s motion to dismiss our
      cause of action seeking specific performance to preclude future defaults
      by Morrison and the LLC. The Court also granted our motion to consolidate
      the cases in Nassau County. In April 2004, we filed a motion to dismiss
      Mr. Morrison’s countersuit, which the Court denied in September 2004.
      Discovery is proceeding. We believe we have meritorious claims in our
      lawsuit and meritorious defenses in the countersuit. We intend to
      vigorously prosecute our claims and vigorously defend ourselves against
      the countersuit. We cannot estimate with any certainty our ultimate legal
      or financial recovery and/or liability, if any, with respect to the
      alleged claims in the countersuit.
 
 ·
    In
      or about December 2003, we received a notice that we had been named in two
      lawsuits filed by the same plaintiff in the Circuit Court, Third Judicial
      Circuit in Madison County, Illinois. One alleged that we had improperly
      charged certain borrowers fax fees, and one alleged that we improperly
      retained extra per diem interest when loans were satisfied. The complaints
      seek: (a) certification of a class of plaintiffs, (b) direction to return
      fax fees charged to borrowers, and (c) unspecified compensatory and
      statutory damages, including prejudgment and post judgment interest and
      attorneys’ fees, based upon alleged: (1) breach of contract, (2) statutory
      fraud and (3) unjust enrichment. In February 2004, we filed a motion to
      dismiss the case pertaining to fax fees claims. The plaintiff was granted
      leave to file a motion to amend his complaint in the fax fee case, which
      rendered our February 2004 motion to dismiss moot. The plaintiff filed an
      amended complaint in July 2004 and we filed a new motion to dismiss in
      August 2004, which the court denied in January 2005, and we have since
      filed an answer in that case. In March 2004, we filed a motion to dismiss
      the case pertaining to per diem interest claims, which the court denied in
      September 2004. We have since filed an answer in that case and plaintiffs
      filed a motion to dismiss our affirmative defenses, which the Court
      granted, permitting us leave to replead the defenses with more
      particularity, which we have done. Discovery has commenced in both cases.
      We believe that we have meritorious defenses and intend to vigorously
      defend these suits, but cannot estimate with any certainty our ultimate
      legal or financial liability, if any, with respect to the alleged
      claims.
 
 **49**
 ·
    In
      our about November 2004, we received notice that we have been named in a
      lawsuit styled as a collective action filed in the United States District
      Court of the Western District of Pennsylvania, alleging that our Fidelity
      subsidiary did not pay its loan officers overtime compensation and/or
      minimum wage in violation of the Federal Fair Labor Standards Act. The
      complaint seeks: (1) an amount equal to the unpaid wages at the applicable
      overtime rate, (2) an amount equal to the minimum wages at the applicable
      minimum wage, (3) an equal amount as liquidated damages, (4) costs and
      attorneys fees, (5) leave to add additional plaintiffs and (6) leave to
      amend to add claims under applicable state laws. We filed an answer and
      discovery has commenced. In April 2005, the plaintiffs filed a motion for
      class certification and our opposition papers are due in May 2005. We
      believe that we have meritorious defenses and intend to vigorously defend
      this suit, but cannot estimate with any certainty our ultimate legal or
      financial liability, if any, with respect to the alleged
      claims.
 
 **Item
2. Unregistered Sales of Equity Securities and Use of
Proceeds.**
 
 None.
 
 **Item
3. Defaults Upon Senior Securities.**
 
 None.
 
 **Item
4. Submission of Matters to a Vote of Security
Holders.**
 
 None.
 
 **Item
5. Other Information.**
 
 Pursuant
to Section 202 of the Sarbanes-Oxley Act of 2002, our Audit Committee has
approved all auditing and non-audit services performed to date and currently
planned to be provided in 2005 by our external auditors, KPMG LLP. The services
include the annual audit, quarterly reviews, issuances of consents related to
SEC filings, and certain tax compliance services.
 
 **Item
6. Exhibits.**
 
 **Exhibit
      No.**
    
    **Filed**
    
    **Description**31.1
    
    (a)
    
    Rule
      13a-14(a)/15d-14(a) Certification of the Chief Executive
      Officer31.2
    
    (a)
    
    Rule
      13a-14(a)/15d-14(a) Certification of the Chief Financial
      Officer32.1
    
    (a)
    
    Section
      1350 Certification of the Chief Executive Officer32.2
    
    (a)
    
    Section
      1350 Certification of the Chief Financial
Officer
  (a)
    Filed
      herewith.
  **50**
  
 
 **SIGNATURES**
 
 Pursuant
to the requirements of the Securities and Exchange Act of 1934, as amended, the
Registrant has duly caused this Report on Form 10-Q to be signed on its behalf
by the undersigned, thereunto duly authorized.
 
 
 ****
    ****
    ********
    **DELTA FINANCIAL
      CORPORATION** (Registrant)****
    ****
    ******Dated:**  May
      13, 2005
    By:
    /s/ Hugh MillerTitle:  President and Chief
      Executive Officer
 By:
    /s/ Richard
BlassTitle:  Executive Vice
      President and Chief Financial Officer
 
 **51**