**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

**FORM 10-Q**

**QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

**For the Quarterly Period Ended September30, 2006**

**Commission File No. 0-22361**

**NETBANK, INC.**

(Exact name of registrant as specified in its charter)

| **Georgia**                               |   | **58-2224352**                           |
|-------------------------------------------|--------|------------------------------------------|
| (State of  incorporation)                 |   | (I.R.S. Employer  Identification Number) |
|                                      |   |                                     |
| **1015  Windward Ridge Parkway**          |   | ** **                               |
| **Alpharetta,  Georgia**                  |   | **30005**                                |
| (Address of  principal executive offices) |   | (Zip Code)                               |

 

**(770) 343-6006**

Registrant’stelephone number, including area code:

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90days:  YES x  NO o

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Exchange Act Rule 12b-2:

Large accelerated filer o          Accelerated filer x          Non-accelerated filer o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act):

YES o  NO x

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practicabledate:

| Class                         | ** ** | **Shares Outstanding at October 31, 2006** |
|-------------------------------|------------|--------------------------------------------|
| Common Stock,  par value $.01 |       | 46,400,456                                 |

 

 

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**NETBANK, INC.****TABLE OF CONTENTS**
| **Part I. Financial  Information**                                                                              | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                      | ** ** |
| **Item 1. Financial Statements (Unaudited)**                                                                    | ** ** |
| ** **                                                                                                      | ** ** |
| **Consolidated balance sheets as of September 30, 2006  and December 31, 2005**                                 | ** ** |
| ** **                                                                                                      | ** ** |
| **Consolidated statements of operations for the three  and nine months ended September 30, 2006 and 2005**      | ** ** |
| ** **                                                                                                      | ** ** |
| **Consolidated statements of shareholders’ equity for  the nine months ended September 30, 2006 and 2005** | ** ** |
| ** **                                                                                                      | ** ** |
| **Consolidated statements of cash flows for the nine  months ended September 30, 2006 and 2005**                | ** ** |
| ** **                                                                                                      | ** ** |
| **Notes to consolidated financial statements**                                                                  | ** ** |
| ** **                                                                                                      | ** ** |
| **Item 2. Management’s Discussion and Analysis of  Financial Condition and Results of Operations**         | ** ** |
| ** **                                                                                                      | ** ** |
| **Item 3. Quantitative and Qualitative Disclosures about  Market Risk**                                         | ** ** |
| ** **                                                                                                      | ** ** |
| **Item 4. Controls and Procedures**                                                                             | ** ** |
| ** **                                                                                                      | ** ** |
| **Part  II. Other Information**                                                                                 | ** ** |
| ** **                                                                                                      | ** ** |
| **Item  1. Legal Proceedings**                                                                                  | ** ** |
| ** **                                                                                                      | ** ** |
| **Item  1A. Risk Factors**                                                                                      | ** ** |
| ** **                                                                                                      | ** ** |
| **Item 2. Unregistered Sales of Equity Securities and  Use of Proceeds**                                        | ** ** |
| ** **                                                                                                      | ** ** |
| **Item 3. Defaults Upon Senior Securities**                                                                     | ** ** |
| ** **                                                                                                      | ** ** |
| **Item 4. Submission of Matters to a Vote of Security  Holders**                                                | ** ** |
| ** **                                                                                                      | ** ** |
| **Item  5. Other Information**                                                                                  | ** ** |
| ** **                                                                                                      | ** ** |
| **Item 6.  Exhibits**                                                                                           | ** ** |
| ** **                                                                                                      | ** ** |
| **Signature Page**                                                                                              | ** ** |
| ** **                                                                                                      | ** ** |
| **Index  to Exhibits**                                                                                          | ** ** |

 

2

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**Part I. Financial Information**

**Item 1.Financial Statements (Unaudited)**

**NetBank,Inc.**

**Consolidated Balance Sheets**

**(in000s except share amounts)**
| ** **                                                                                                       | ** ** | **Sept. 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                       | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| ** **                                                                                                       | ** ** | **(unaudited)**    | ** ** | **(audited)**         | ** ** |
| **Assets**                                                                                                       | * *   | * *           | * *   | * *              | * *   |
| Cash and cash equivalents:                                                                                       |       |               |       |                  |       |
| Cash and due from banks                                                                                          |       | $                  | 347,980    |                  | $          | 126,666 |   |
| Federal funds sold                                                                                               |       | 21,995             |       | 23,590                |       |
| Total cash and cash equivalents                                                                                  |       | 369,975            |       | 150,256               |       |
| Investment securities available for sale-at fair value (amortized  costs of $257,614 and $638,919, respectively) |       | 252,546            |       | 626,077               |       |
| Stock of Federal Home Loan Bank of Atlanta – at cost                                                        |       | 36,507             |       | 67,049                |       |
| Loans held for sale                                                                                              |       | 946,475            |       | 1,233,918             |       |
| Loan and lease receivables – net of allowance for credit losses of  $26,477 and $27,601, respectively       |       | 1,910,770          |       | 2,224,363             |       |
| Mortgage servicing rights – net                                                                             |       | 39,076             |       | 201,880               |       |
| Accrued interest receivable                                                                                      |       | 16,555             |       | 16,698                |       |
| Furniture, equipment and capitalized software – net                                                         |       | 48,261             |       | 54,420                |       |
| Goodwill and other intangibles – net                                                                        |       | 53,849             |       | 85,097                |       |
| Due from servicers and investors                                                                                 |       | 113,624            |       | 26,557                |       |
| Other assets                                                                                                     |       | 61,770             |       | 85,304                |       |
| **Total assets**                                                                                                 |       | $                  | 3,849,408  |                  | $          | 4,771,619 |   |
|                                                                                                             |       |               |       |                  |       |
| **Liabilities, minority interests and  shareholders’ equity**                                               |       |               |       |                  |       |
| **Liabilities:**                                                                                                 |       |               |       |                  |       |
| Deposits                                                                                                         |       | $                  | 2,728,316  |                  | $          | 2,793,847 |   |
| Other borrowed funds                                                                                             |       | 654,033            |       | 1,348,240             |       |
| Subordinated debt                                                                                                |       | 32,477             |       | 32,477                |       |
| Accrued interest payable                                                                                         |       | 24,049             |       | 17,595                |       |
| Loans in process                                                                                                 |       | 31,843             |       | 34,060                |       |
| Representations and warranties                                                                                   |       | 21,550             |       | 20,668                |       |
| Accounts payable and accrued liabilities                                                                         |       | 65,633             |       | 123,877               |       |
| Total liabilities                                                                                                |       | 3,557,901          |       | 4,370,764             |       |
|                                                                                                             |       |               |       |                  |       |
| Commitments and contingencies – note 13                                                                     |       | —             |       | —                |       |
| Minority interests in  affiliates                                                                                |       | 909                |       | 676                   |       |
|                                                                                                             |       |               |       |                  |       |
| **Shareholders’ equity:**                                                                                   |       |               |       |                  |       |
| Preferred stock, no par (10,000,000 shares authorized; none issued  and outstanding)                             |       | —             |       | —                |       |
| Common stock, $.01 par (100,000,000 shares authorized, 52,820,308 and  52,820,308 shares issued, respectively)   |       | 528                |       | 528                   |       |
| Additional paid-in capital                                                                                       |       | 434,303            |       | 432,140               |       |
| Retained (deficit) earnings                                                                                      |       | (78,661            | )          | 39,005                |       |
| Accumulated other comprehensive loss, net of taxes of $1,758 and  $4,877, respectively                           |       | (3,310             | )          | (7,965                | )          |
| Treasury stock, at cost (6,423,602 and 6,423,691 shares,  respectively)                                          |       | (62,262            | )          | (62,276               | )          |
| Unearned compensation                                                                                            |       | —             |       | (1,253                | )          |
| **Total shareholders’ equity**                                                                              |       | 290,598            |       | 400,179               |       |
| **Total liabilities, minority interests and  shareholders’ equity**                                         |       | $                  | 3,849,408  |                  | $          | 4,771,619 |   |

 

See notes toconsolidated financial statements.

3

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**NetBank, Inc.**

**Consolidated Statements ofOperations**

**(unaudited and in 000s except per share amounts)**
| ** **                                                        | ** ** | **Three months ended Sept. 30,** | ** ** | **Nine months ended Sept. 30,** | ** ** |
|-------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                        | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Interest income:**                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Loans and leases                                                  |       | $                                                    | 52,170     |                                                | $          | 58,092 |   | $ | 164,443 |   | $ | 159,051 |   |
| Investment  securities                                            |       | 6,121                                                |       | 8,502                                               |       | 22,628 |   | 26,169 |   |
| Short-term  investments                                           |       | 360                                                  |       | 662                                                 |       | 1,209 |   | 1,557 |   |
| Total interest  income                                            |       | 58,651                                               |       | 67,256                                              |       | 188,280 |   | 186,777 |   |
|                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **Interest expense:**                                             |       |                                                 |       |                                                |       |   |   |   |   |
| Deposits                                                          |       | 24,554                                               |       | 20,178                                              |       | 69,567 |   | 48,992 |   |
| Other borrowed  funds                                             |       | 13,024                                               |       | 16,848                                              |       | 45,985 |   | 45,836 |   |
| Total interest  expense                                           |       | 37,578                                               |       | 37,026                                              |       | 115,552 |   | 94,828 |   |
| Net interest income                                               |       | 21,073                                               |       | 30,230                                              |       | 72,728 |   | 91,949 |   |
| Provision for credit  losses                                      |       | 2,407                                                |       | 2,708                                               |       | 6,483 |   | 7,389 |   |
| Net interest income  after provision for credit losses            |       | 18,666                                               |       | 27,522                                              |       | 66,245 |   | 84,560 |   |
|                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **Non-interest income:**                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Mortgage  servicing fees                                          |       | 8,982                                                |       | 13,292                                              |       | 33,496 |   | 38,746 |   |
| Amortization of  mortgage servicing rights                        |       | (7,061                                               | )          | (12,729                                             | )          | (27,512 | ) | (34,873 | ) |
| (Impairment)  recovery of mortgage servicing rights               |       | (1,474                                               | )          | 4,244                                               |       | (7,380 | ) | 3,224 |   |
| (Losses) gains  on derivatives                                    |       | (4,357                                               | )          | 795                                                 |       | (15,819 | ) | (149 | ) |
| (Losses) gains on sales of investment securities                  |       | (13,461                                              | )          | —                                              |       | (13,461 | ) | 4,182 |   |
| Service charges  and fees                                         |       | 5,524                                                |       | 5,296                                               |       | 15,320 |   | 15,139 |   |
| Gains on sales  of loans                                          |       | 5,190                                                |       | 28,308                                              |       | 40,833 |   | 83,270 |   |
| Losses on sales  of mortgage servicing rights                     |       | (29,797                                              | )          | (238                                                | )          | (30,096 | ) | (448 | ) |
| Other income                                                      |       | 1,857                                                |       | 2,180                                               |       | 5,961 |   | 7,759 |   |
| Total non-interest  income                                        |       | (34,597                                              | )          | 41,148                                              |       | 1,342 |   | 116,850 |   |
|                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| **Non-interest expense:**                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Salaries and  benefits                                            |       | 27,778                                               |       | 30,832                                              |       | 96,460 |   | 92,649 |   |
| Customer service                                                  |       | 2,674                                                |       | 3,596                                               |       | 8,546 |   | 10,116 |   |
| Marketing                                                         |       | 2,451                                                |       | 4,476                                               |       | 9,535 |   | 9,697 |   |
| Data processing                                                   |       | 4,716                                                |       | 4,318                                               |       | 13,953 |   | 13,105 |   |
| Depreciation and  amortization                                    |       | 5,896                                                |       | 6,080                                               |       | 17,578 |   | 17,693 |   |
| Office expenses                                                   |       | 4,520                                                |       | 3,600                                               |       | 12,223 |   | 9,422 |   |
| Occupancy                                                         |       | 7,020                                                |       | 6,558                                               |       | 20,812 |   | 18,411 |   |
| Travel and  entertainment                                         |       | 998                                                  |       | 1,583                                               |       | 3,677 |   | 4,223 |   |
| Professional  fees                                                |       | 3,021                                                |       | 4,471                                               |       | 9,770 |   | 13,276 |   |
| Prepaid lost  interest from curtailments                          |       | 537                                                  |       | 1,262                                               |       | 1,854 |   | 3,345 |   |
| Goodwill  impairment                                              |       | 23,187                                               |       | —                                              |       | 29,545 |   | — |   |
| Other expenses                                                    |       | 3,346                                                |       | 3,924                                               |       | 10,465 |   | 10,756 |   |
| Total non-interest  expense                                       |       | 86,144                                               |       | 70,700                                              |       | 234,418 |   | 202,693 |   |
| Loss before income  taxes                                         |       | (102,075                                             | )          | (2,030                                              | )          | (166,831 | ) | (1,283 | ) |
| Income tax benefit                                                |       | 28,794                                               |       | 659                                                 |       | 51,163 |   | 208 |   |
| **Net loss**                                                      |       | $                                                    | (73,281    | )                                                   | $          | (1,371 | ) | $ | (115,668 | ) | $ | (1,075 | ) |
|                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Net loss per common and  potential common shares outstanding:     |       |                                                 |       |                                                |       |   |   |   |   |
| Basic loss per share                                              |       | $                                                    | (1.58      | )                                                   | $          | (0.03 | ) | (2.50 | ) | $ | (0.02 | ) |
| Diluted earnings loss  per share                                  |       | $                                                    | (1.58      | )                                                   | $          | (0.03 | ) | (2.50 | ) | $ | (0.02 | ) |
|                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Weighted average common  and potential common shares outstanding: |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                             |       | 46,362                                               |       | 46,119                                              |       | 46,316 |   | 46,201 |   |
| Diluted                                                           |       | 46,362                                               |       | 46,119                                              |       | 46,316 |   | 46,201 |   |
|                                                              |       |                                                 |       |                                                |       |   |   |   |   |
| Dividends declared on  common stock per share                     |       | $                                                    | 0.00       |                                                | $          | 0.02 |   | $ | 0.04 |   | $ | 0.06 |   |

 

See notes to consolidatedfinancial statements.

4

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**NetBank, Inc.**

**ConsolidatedStatements of Shareholders’ Equity**

**(unauditedand in 000s)**
| ** **                                                                                      | ** ** | **For the nine months ended** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                      | ** ** | **September 30,**                            | ** ** |
| ** **                                                                                      | ** ** | **2006**                                          | ** ** | **2005** | ** ** |
| **Common shares**                                                                               |       |                                              |       |   |   |
| Beginning balance                                                                               |       | 52,820                                            |       | 52,820 |   |
| Issuance of common  shares                                                                      |       | —                                            |       | — |   |
| Ending balance                                                                                  |       | 52,820                                            |       | 52,820 |   |
| **Common stock**                                                                                |       |                                              |       |   |   |
| Beginning balance                                                                               |       | $                                                 | 528        |   | $ | 528 |   |
| Issuance of common  stock                                                                       |       | —                                            |       | — |   |
| Ending balance                                                                                  |       | $                                                 | 528        |   | $ | 528 |   |
| **Paid-in capital**                                                                             |       |                                              |       |   |   |
| Beginning balance                                                                               |       | $                                                 | 432,140    |   | $ | 432,132 |   |
| Reclassification of  unearned balance upon adoption of SFAS 123R                                |       | 277                                               |       | — |   |
| Stock-based  compensation                                                                       |       | 2,627                                             |       | — |   |
| Re-issuance of shares  of common stock                                                          |       | (741                                              | )          | 70 |   |
| Ending balance                                                                                  |       | $                                                 | 434,303    |   | $ | 432,202 |   |
| **Retained (deficit) earnings**                                                                 |       |                                              |       |   |   |
| Beginning balance                                                                               |       | $                                                 | 39,005     |   | $ | 43,849 |   |
| Net loss                                                                                        |       | (115,668                                          | )          | (1,075 | ) |
| Cash dividends declared                                                                         |       | (1,853                                            | )          | (2,774 | ) |
| Reclassification of  unearned balance upon adoption of SFAS 123R                                |       | 265                                               |       | — |   |
| Loss on re-issuance of  shares of common stock                                                  |       | (410                                              | )          | (820 | ) |
| Ending balance                                                                                  |       | $                                                 | (78,661    | ) | $ | 39,180 |   |
| **Accumulated other comprehensive  loss**                                                       |       |                                              |       |   |   |
| Beginning balance                                                                               |       | $                                                 | (7,965     | ) | $ | (1,136 | ) |
| Realized loss (gain) on  sale of securities, net of taxes                                       |       | 8,749                                             |       | (2,593 | ) |
| Unrealized loss on  securities, net of taxes                                                    |       | (4,094                                            | )          | (2,363 | ) |
| Ending balance                                                                                  |       | $                                                 | (3,310     | ) | $ | (6,092 | ) |
| **Treasury stock, at cost**                                                                     |       |                                              |       |   |   |
| Beginning balance                                                                               |       | $                                                 | (62,276    | ) | $ | (61,087 | ) |
| Unearned compensation  from issuance of restricted stock, net of forfeitures                    |       | —                                            |       | 1,659 |   |
| Reclassification of  unearned balance upon adoption of SFAS 123R                                |       | (1,795                                            | )          | — |   |
| Re-issuance of shares  of common stock, net of purchases                                        |       | 1,809                                             |       | (3,200 | ) |
| Ending balance                                                                                  |       | $                                                 | (62,262    | ) | $ | (62,628 | ) |
| **Unearned compensation**                                                                       |       |                                              |       |   |   |
| Beginning balance                                                                               |       | $                                                 | (1,253     | ) | $ | (259 | ) |
| Amortization of  unearned compensation                                                          |       | —                                            |       | 246 |   |
| Unearned compensation  issued, net of employee forfeitures                                      |       | —                                            |       | (1,394 | ) |
| Reclassification of unearned  balance upon adoption of SFAS 123R                                |       | 1,253                                             |       | — |   |
| Ending balance                                                                                  |       | $                                                 | —     |   | $ | (1,407 | ) |
| **Total shareholders’ equity**                                                             |       | $                                                 | 290,598    |   | $ | 401,783 |   |
|                                                                                            |       |                                              |       |   |   |
| **Comprehensive loss**                                                                          |       |                                              |       |   |   |
| Net loss                                                                                        |       | $                                                 | (115,668   | ) | $ | (1,075 | ) |
| Realized loss  (gain) on sale of securities, net of taxes of $(4,712) and $1,589,  respectively |       | 8,749                                             |       | (2,593 | ) |
| Change in  unrealized loss on securities, net of taxes of $2,204 and $1,272,  respectively      |       | (4,094                                            | )          | (2,363 | ) |
| Comprehensive loss                                                                              |       | $                                                 | (111,013   | ) | $ | (6,031 | ) |

 

See notes to consolidatedfinancial statements.

5

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**NetBank,Inc.**

**ConsolidatedStatements of Cash Flows**

**(unauditedand in 000s)**
| ** **                                                                                 | ** ** | **Nine months ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                 | ** ** | **September 30,**          | ** ** |
| ** **                                                                                 | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| Operating  activities:                                                                     |       |                            |       |   |   |
| Net loss                                                                                   |       | $                               | (115,668   | ) | $ | (1,075 | ) |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                            |       |   |   |
| Depreciation and  amortization                                                             |       | 17,578                          |       | 17,693 |   |
| Amortization of  premiums on investment securities, loan and lease receivables and debt    |       | 15,919                          |       | 14,648 |   |
| Origination of  loans held for sale                                                        |       | (7,837,643                      | )          | (10,060,223 | ) |
| Repurchase of  previously sold mortgages                                                   |       | (108,307                        | )          | (98,031 | ) |
| Proceeds from  sales of loans held for sale                                                |       | 8,271,885                       |       | 9,954,185 |   |
| Net gains on  sales of mortgage loans                                                      |       | (40,833                         | )          | (83,270 | ) |
| Net losses on  sales of servicing rights                                                   |       | 30,096                          |       | 448 |   |
| Capitalization  of mortgage servicing rights                                               |       | (19,519                         | )          | (17,049 | ) |
| Proceeds from  sales of mortgage servicing rights                                          |       | 5,669                           |       | 833 |   |
| Mark-to-market  adjustment on mortgage servicing rights                                    |       | (7,009                          | )          | (1,679 | ) |
| Impairment  (recovery) of mortgage servicing rights                                        |       | 7,380                           |       | (3,224 | ) |
| Amortization of  mortgage servicing rights, net of recoveries                              |       | 27,512                          |       | 34,873 |   |
| Provision for  credit losses                                                               |       | 6,483                           |       | 7,389 |   |
| Stock-based  compensation cost                                                             |       | 2,627                           |       | — |   |
| Amortization of  unearned compensation                                                     |       | —                          |       | 316 |   |
| Losses (gains)  on sales of investment securities, net                                     |       | 13,461                          |       | (4,182 | ) |
| Goodwill  impairment                                                                       |       | 29,545                          |       | — |   |
| Changes in  assets and liabilities which provide (use) cash:                               |       |                            |       |   |   |
| Decrease (increase) in accrued interest receivable                                         |       | 143                             |       | (4,600 | ) |
| Decrease in due from servicers and investors                                               |       | 7,703                           |       | 25,604 |   |
| Decrease (increase) in other assets                                                        |       | 23,534                          |       | (15,559 | ) |
| Increase in accrued interest payable                                                       |       | 6,454                           |       | 6,375 |   |
| (Decrease) increase in loans in process                                                    |       | (2,217                          | )          | 31,302 |   |
| (Decrease) increase in accounts payable and accrued  liabilities                           |       | (61,363                         | )          | 1,625 |   |
| Net cash provided by (used in) operating activities                                        |       | 273,430                         |       | (193,601 | ) |
|                                                                                       |       |                            |       |   |   |
| Investing  activities:                                                                     |       |                            |       |   |   |
| Purchases of  available for sale securities                                                |       | (16,402                         | )          | (457,128 | ) |
| Principal  repayments on available for sale securities                                     |       | 61,434                          |       | 91,363 |   |
| Sales and  maturities of available for sale securities                                     |       | 322,562                         |       | 330,315 |   |
| Bulk sale  (purchase) of mortgage servicing rights                                         |       | 23,905                          |       | (35,181 | ) |
| Sales  (purchases) of Federal Home Loan Bank Stock                                         |       | 30,542                          |       | (9,824 | ) |
| Proceeds from  sale of loan and lease receivables                                          |       | 131,243                         |       | — |   |
| Origination and  purchase of loan and lease receivables                                    |       | (372,291                        | )          | (584,719 | ) |
| Principal  repayments on loan and lease receivables                                        |       | 535,712                         |       | 513,562 |   |
| Purchases of  furniture, equipment and capitalization of software, net of disposals        |       | (8,747                          | )          | (13,035 | ) |
| Capitalization  of amortizable intangibles                                                 |       | (391                            | )          | (3,984 | ) |
| Acquisitions,  net of cash acquired                                                        |       | (578                            | )          | (176 | ) |
| Change in  minority interest                                                               |       | 233                             |       | 106 |   |
| Net cash provided by (used in) investing activities                                        |       | 707,222                         |       | (168,701 | ) |
|                                                                                       |       |                            |       |   |   |
| Financing  activities:                                                                     |       |                            |       |   |   |
| (Decrease)  increase in deposits                                                           |       | (65,531                         | )          | 367,702 |   |
| Proceeds from  other borrowed funds                                                        |       | 10,835,035                      |       | 6,843,083 |   |
| Repayments of  other borrowed funds                                                        |       | (11,529,242                     | )          | (6,710,556 | ) |
| Net proceeds  from issuance of subordinated notes                                          |       | —                          |       | 20,620 |   |
| Net re-issuances  (purchases) of treasury stock                                            |       | 658                             |       | (3,755 | ) |
| Dividend  payments on common stock                                                         |       | (1,853                          | )          | (2,774 | ) |
| Net cash (used in) provided by financing activities                                        |       | (760,933                        | )          | 514,320 |   |
| Net increase in  cash and cash equivalents                                                 |       | 219,719                         |       | 152,018 |   |
| Cash and cash  equivalents:                                                                |       |                            |       |   |   |
| Cash and cash  equivalents, beginning of period                                            |       | 150,256                         |       | 150,302 |   |
| Cash and cash  equivalents, end of period                                                  |       | $                               | 369,975    |   | $ | 302,320 |   |
|                                                                                       |       |                            |       |   |   |
| Supplemental  disclosures of cash flow information:                                        |       |                            |       |   |   |
| Cash paid during  the period for interest                                                  |       | $                               | 109,099    |   | $ | 88,453 |   |
| Cash paid during  the period for income taxes                                              |       | $                               | 2,323      |   | $ | 162 |   |

 

See notes toconsolidated financial statements.

6

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**NETBANK,INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**September30, 2006**

**(unaudited)**

**1.**             ORGANIZATION AND BASIS OF PRESENTATION

NetBank, Inc. is a financial holding company engaged primarily inretail banking, mortgage banking, business finance and providing ATM andmerchant processing services. NetBank, Inc. wholly owns the outstanding stockof:  NetBank (“NetBank, FSB” or the“Bank”), a federal savings bank; MG Reinsurance Company (“MG Reinsurance”), acaptive reinsurance company; NetInsurance, Inc. (“NetInsurance”), a licensedinsurance agency; and NB Partners, Inc., a corporation involved in strategicpartnering opportunities. NetBank, FSB owns all of the outstanding stockof:  Market Street Mortgage Corporation (“MarketStreet”), a retail mortgage company; NetBank Payment Systems, Inc. (“NPS”), aprovider of ATM and merchant processing services for retail and other non-bankbusinesses; Meritage Mortgage Corporation (“Meritage”), a wholesalenon-conforming mortgage provider; and Financial Technologies, Inc. (“FTI”), aprovider of transaction processing services to other financial servicescompanies. NetBank, FSB’s wholesale mortgage division operates as NetBankFunding Services (“NetBank Funding”); its business financing division operatesas “NetBank Business Finance”; its automobile financing division operates as“Dealer Financial Services”; and its recreational vehicle financing divisionoperates as “Beacon Credit Services”. The consolidated company is referred to herein as “we,” “us,”  “our,” “NetBank,” or “the Company”.

In the opinion ofmanagement, the unaudited consolidated financial statements included hereinreflect all adjustments, consisting only of normal recurring accruals, whichare necessary for the fair presentation of the financial condition and resultsof operations for the interim periods presented. Certain information andfootnote disclosures normally included in financial statements have beencondensed or omitted pursuant to applicable rules and regulations of theSecurities and Exchange Commission (“SEC”). The financial statements includedherein should be read in conjunction with the financial statements and notesthereto included in our Annual Report on Form 10-K filed with the SEC forthe year ended December 31, 2005 (“2005 Form 10-K”). The results ofoperations for the interim periods reported herein are not necessarilyindicative of results to be expected for the full year. Certain 2005 amountshave been reclassified for comparability with 2006 amounts.  

Unless otherwise noted, all dollar figures are presented in thousands(000s), except per share data.  All ofthe Company’s operations and assets are located within the United States ofAmerica.

**2.**             ACQUISITIONS

**During the nine monthsended September 30, 2006, NPS acquired certain assets or processing contractsof various smaller ATM and merchant processors. These acquisitions were accounted for as purchases, and as such,approximately $146 of amortizable intangibles were recorded.  Consideration for these assets and processingcontracts totaled $146.**

In December 2004, the Company, through itsMarket Street subsidiary, acquired 19 retail branch offices and certainassociated assets of Guaranty Residential Lending, Inc., a mortgagebanking business, pursuant to an Asset Purchase and Assignment Agreement. Theconsideration paid, including transaction costs, was approximately $2 million.The acquisition was accounted for as a purchase, and, accordingly, all assetsand liabilities were recorded at fair value. As such, $1.7 million in goodwill,including transaction costs, has been recorded in connection with theacquisition. The Company paid additional consideration in the first quarter of2006 of $576 and is obligated to pay an additional $788 in 2007 based onspecific production goals as identified in the Asset Purchase and AssignmentAgreement. The first quarter 2006 payment has been, and any additional paymentswill be, recorded as goodwill. The results of operations for the acquiredbranches have been included from the date of acquisition.

7

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**3.**             ACCOUNTING POLICIES

Reference is made to our accounting policies describedin the notes to consolidated financial statements contained in our 2005Form 10-K. The Company has followed those policies in preparing thisreport.

*Significant Estimates.*The preparation of theconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States (“GAAP”) requires management to makeestimates and assumptions that affect the amounts reported in the consolidatedfinancial statements and accompanying notes.  Such estimates relate to the Company’sallowance for credit losses; the fair values of loans held for sale, loan andlease receivables, mortgage servicing rights, servicing hedges and theCompany’s other hedging instruments; and reserves for estimated losses onrepresentations and warranties provided to purchasers of loans or mortgageservicing rights. Because of the inherent uncertainties associated with anyestimation process and due to possible future changes in market and economicconditions that will affect fair values, it is possible that actual futureresults and realization of the underlying assets and liabilities could differsignificantly from the amounts reflected as of the balance sheet date.

*Stock-BasedCompensation.*Our stock-based compensation plans aredescribed in note 9 to these consolidated financial statements. Prior toJanuary 1, 2006, we accounted for these stock-based employee compensation plansunder the measurement principles and recognition provisions of AccountingPrinciples Board Opinion No. 25, *Accounting for StockIssued to Employees,*and related Interpretations. Accordingly, werecorded no stock option-based employee compensation cost for options grantedduring the three and nine month periods ended September 30, 2005, as alloptions granted under those plans had an exercise price equal to or greaterthan the market value of the underlying common stock on the date of grant. Wealso recorded no compensation cost during the three and nine month periodsended September 30, 2005 in connection with the NetBank, Inc. Employee StockPurchase Plan (“the Stock Plan”).  Inaccordance with Statement of Financial Accounting Standards No. 123 (“SFAS123”), *Accounting for Stock-Based Compensation – Transitionand Disclosure,*we provided pro forma net income or loss and netincome or loss per share for each period prior to January 1, 2006 as if we hadapplied the fair value-based method in measuring compensation cost for ourshare based compensation plans.

EffectiveJanuary 1, 2006, we adopted the fair value recognition provisions of Statementof Financial Accounting Standards No. 123(R) (“SFAS 123(R)”), *Share-Based Payment*, using the modified prospectivetransition method. Under the modified prospective transition method, resultsfor prior periods have not been restated. In March 2005, the SEC issued StaffAccounting Bulletin No. 107 (“SAB 107”), which provides supplementalimplementation guidance for SFAS 123(R). We have applied the provisions of SAB107 in our adoption of SFAS 123(R). See note 9 to these consolidated financialstatements for information on the impact of our adoption of SFAS 123(R) and theassumptions used to calculate the fair value of stock-based employeecompensation.

*Recent Accounting Pronouncements*

In September 2006, the FinancialAccounting Standards Board (“FASB”) reached a consensus on the guidanceprovided by Emerging Issues Task Force Issue 06-4 (“EITF06-4”), *Accounting for Deferred Compensation andPostretirement Benefit Aspects of Endorsement Split-Dollar Life InsuranceArrangements*.  The guidance is applicable to endorsementsplit-dollar life insurance arrangements, whereby the employer owns andcontrols the insurance policy, that are associated with a postretirementbenefit.  EITF 06-4 requires that for a split-dollar lifeinsurance arrangement within the scope of EITF 06-4, an employer shouldrecognize a liability for future benefits in accordance with FAS No. 106 (if,in substance, a postretirement benefit plan exists) or Accounting PrinciplesBoard Opinion No. 12 (if the arrangement is, in substance, an individualdeferred compensation contract) based on the substantive agreement with theemployee.  EITF 06-4 is effective for fiscal yearsbeginning after December 15, 2007.  The Company is currently evaluatingthe impact the adoption of EITF 06-4 will have on the Company’s results ofoperations or financial condition.

In September 2006, theFASB reached a consensus on the guidance provided by Emerging Issues Task ForceIssue 06-5 (“EITF 06-5”), *Accounting for Purchasesof Life Insurance—Determining the Amount That Could Be Realized in Accordancewith FASB Technical Bulletin No. 85-4, Accounting for Purchases of LifeInsurance*.  EITF 06-5 states that a policyholder shouldconsider any additional amounts included in the contractual terms of theinsurance policy other than the cash surrender value in determining the amountthat could be realized under the insurance contract.  EITF 06-5 alsostates that a policyholder should determine the amount that could be realizedunder the life insurance contract assuming the surrender of an individual-lifeby individual-life policy (or certificate by certificate in a group policy).EITF 06-5 is effective for fiscal years beginning after December 15,2006.  The Company is currently evaluating the impact the adoption of EITF 06-5will have on the Company’s results of operations or financial condition.

In September 2006, theSecurities and Exchange Commission issued Staff Accounting Bulletin (“SAB”) No.108, *Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements*,that requires public companies to utilize a “dual-approach” to assessing thequantitative effects of financial misstatements. This dual approach includesboth an income statement focused assessment and a balance sheet focusedassessment. SAB No. 108 is effective for annual financial statements coveringthe first fiscal year ending after November 15, 2006. The Company does notexpect that it will have a material effect on our consolidated results ofoperations, financial position and cash flows.

In September 2006, the FASB issued Statement of Financial Accounting Standards No. 157 (“SFAS157”), *Fair Value Measurements*. SFAS 157provides guidance for using fair value to measure assets and liabilitiesand provides expanded information about the extent to which companies measureassets and liabilities at fair value, the information used to measure fairvalue, and the effect of fair value measurements on earnings. The standard doesnot expand the use of fair value in any new circumstances. SFAS 157 iseffective for fiscal years beginning after November 15, 2007, and interimperiods within those fiscal years. Weare currently evaluating the effects that the adoption of SFAS 157 could haveon our consolidated results of operations, financial position and cash flows.

In July 2006, the FASB issued Final Interpretation No. 48 (“FIN 48”), *Accountingfor**Uncertainty in Income Taxes.*    FIN 48 clarifies the accounting for incometaxes by prescribing the minimum recognition threshold a tax position isrequired to meet before being recognized in the financial statements.  FIN 48 also provides guidance onderecognition, measurement, classification, interest and penalties, accountingin interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006.  We are currently evaluating the effects thatthe adoption of FIN 48 could have on our consolidated results of operations,financial position and cash flows.

In March 2006, the Financial Accounting Standards Board issuedStatement No. 156 (“SFAS 156”), *Accounting for Servicingof Financial Assets an amendment of FASB Statement No. 140*, *Accounting for Transfers and Servicing of Financial Assets and*

8

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* Extinguishments of Liabilities*.  SFAS 156 requires that all servicingassets and liabilities be initially measured at fair value and allows for twoalternatives in the subsequent accounting for servicing assets and liabilities:the amortization method and the fair value method.  The amortizationmethod requires that the servicing assets and liabilities be amortized over theremaining estimated lives of the serviced assets with impairment testing to beperformed periodically.  The fair value method requires the servicingassets and liabilities to be measured at fair value each period with an offsetto income.  SFAS 156 is to be adopted in the first fiscal year that beginsafter September 15, 2006 and early adoption is permitted.  An entity canelect the fair value method at the beginning of any fiscal year provided thatinterim financial statements have not been issued.  However, once the fairvalue election is made, an entity cannot revert back to the amortizationmethod. NetBank is currently evaluating the available alternatives.

In May 2005, the FASB issued Statement of Financial AccountingStandards No. 154 (“SFAS 154”), *Accounting Changes andError Corrections a replacement of Accounting Principles Board Opinion No. 20,Accounting Changes*, and Statement of Financial Accounting StandardsNo. 3, *Reporting Accounting Changes in Interim FinancialStatements,* which required the inclusion of the cumulative effect ofchanges in accounting principle in net income in the period of change. SFAS 154 establishes, unless impracticable, retrospective application to priorperiods’ financial statements as the required method for reporting a voluntarychange in accounting principle in the absence of explicit transitionrequirements specific to the newly adopted accounting principle.  SFAS 154is effective for accounting changes and corrections of errors made in fiscal yearsbeginning after December 15, 2005.  The Company will assess the impact ofa retrospective application of a change in accounting principle in accordancewith SFAS 154 if the need for such a change arises in the future.

In March 2004, theFASB’s Emerging Issues Task Force (“EITF”) supplemented EITF 03-1, *The Meaning of Other-Than-Temporary Impairment and Its Application toCertain Investments*. EITF 03-1 provides guidance for evaluatingwhether an investment is other-than-temporarily impaired and requires disclosuresabout unrealized losses on available for sale debt and equity securities. InNovember 2005, FASB Staff Position Statement of Financial AccountingStandards No. FAS 115-1 (“FSP FAS 115-1”) was issued to address EITF 03-1implementation issues and outlines a three step model for identifyinginvestment impairments. FSP FAS 115-1 carries forward the disclosurerequirements of EITF 03-1 and is effective for reporting periods beginningafter December 15, 2005.  The adoption ofFSP FAS 115-1 did not have a material impact on our consolidated results ofoperations, financial position and cash flows.

**4.**             LOAN AND LEASE RECEIVABLES

Our portfolio ofloan and lease receivables consists primarily of internally originated 1-4family first and second mortgage loans, home equity loans, automobile loans,business equipment financing leases, marine loans and recreational vehicleloans.

As of September30, 2006 and December 31, 2005, the Company had unamortized net premiumson its loan and lease receivables of $32,531 and $37,826, respectively. At September30, 2006 and December 31, 2005, $5 and $6, respectively, of the Company’snet premiums were associated with purchased as opposed to originated loans. Thefollowing is a summary of the Company’s loan and lease receivables portfolio:
|                                   | ** ** | **As of September 30, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                        | ** ** | **Amount**                                       | ** ** | **%**                                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| First mortgages                   |       | $                                                | 690,044    |                                            | 35.6       | % | $ | 824,431 |   | 36.6 | % |
| Second mortgages                  |       | 92,078                                           |       | 4.8                                             | %          | 115,188 |   | 5.1 | % |
| Leases                            |       | 436,473                                          |       | 22.5                                            | %          | 406,053 |   | 18.0 | % |
| Auto                              |       | 601,856                                          |       | 31.1                                            | %          | 610,924 |   | 27.1 | % |
| Home equity lines                 |       | 71,887                                           |       | 3.7                                             | %          | 257,991 |   | 11.5 | % |
| Consumer                          |       | 44,909                                           |       | 2.3                                             | %          | 37,377 |   | 1.7 | % |
| Total                             |       | 1,937,247                                        |       | 100.0                                           | %          | 2,251,964 |   | 100.0 | % |
| Less allowance for  credit losses |       | (26,477                                          | )          |                                            |       | (27,601 | ) |   |   |
| Total                             |       | $                                                | 1,910,770  |                                            |       |   | $ | 2,224,363 |   |   |   |

 

**Our lease receivablesconsist primarily of business equipment leases originated and serviced by theNetBank Business Finance division. In addition to originated lease receivables,NetBank, FSB owns a portfolio of purchased lease receivables originated byCommercial Money Center, Inc. (“CMC”). NetBank, FSB is involved inlitigation with three insurance companies who are sureties on the purchasedreceivables. Since the second quarter of 2002, the entire portfolio of leasereceivables originated by CMC has been on non-accrual status pending theoutcome of the litigation.  NetBank, FSBhas filed a claim against CMC and the insurance company sureties for allpayments that are currently past due, approximately $90 million at September30, 2006.  The recorded balance of CMCleases receivable as of September 30, 2006 was $25,505.**

9

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**5.**             NON-PERFORMING ASSETS AND ALLOWANCE FOR CREDIT LOSSES

The Companyconsiders a loan or lease receivable to be impaired when it is probable that itwill be unable to collect all amounts due according to the original terms ofthe loan or lease agreement.  The Companymeasures impairment of a loan or lease on a loan-by-loan or lease-by-leasebasis.  Amounts of impaired loans orleases that are not probable of collection are charged off immediately.

The following table details the Company’s non-accrual and troubled debtrestructurings:
|                                   | ** ** | **As of**               | ** ** | **As of**              | ** ** |
|-----------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                        | ** ** | **Sept. 30, 2006** | ** ** | **Dec. 31, 2005** | ** ** |
| Loan and lease  receivables (1)   |       | $                            | 32,805     |                        | $          | 33,049 |   |
| Loans held for sale  (1)          |       | $                            | 50,403     |                        | $          | 49,635 |   |
| Troubled debt  restructurings (2) |       | $                            | 7,827      |                        | $          | 6,782 |   |

 

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(1)   All loans and leases over 90 days contractually past due are placed onnon-accrual status.

(2)   Includes only those troubled debtrestructurings which were less than 90 days past due as of the periodsreported. Troubled debt restructurings over 90 days past due have been includedin the non-accrual categories.

Non-performingloan and lease receivables as of September 30, 2006 and December 31, 2005included $25,505 and $26,054, respectively, of non-performing lease receivablesrelated to the CMC lease portfolio.

On average, the Company held approximately $73,779 and $57,806 of restructured and non-accrual loans duringthe three months ended September 30, 2006 and 2005, respectively. Foregoneinterest for the three months ended September 30, 2006 and 2005 wasapproximately $1,225 and $835, respectively. Foregone interest for the ninemonths ended September 30, 2006 and 2005 was approximately $4,056 and $2,894,respectively. The Company had $13,357 and $7,963 in repossessed assetsconsisting primarily of residential mortgage loan foreclosures at September 30,2006 and December 31, 2005, respectively.

The following is asummary of the allowance for credit losses:
|                                                                       | ** ** | **Three months ended** | ** ** | **Nine months ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                            | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Beginning  balance**                                                |       | $                                | 27,371     |                            | $          | 25,792 |   | $ | 27,601 |   | $ | 24,462 |   |
| Provision for  credit losses                                          |       | 2,407                            |       | 2,708                           |       | 6,483 |   | 7,389 |   |
| Charge-offs:                                                          |       |                             |       |                            |       |   |   |   |   |
| First mortgages                                                       |       | (2                               | )          | (14                             | )          | (10 | ) | (22 | ) |
| Second mortgages                                                      |       | (109                             | )          | (136                            | )          | (215 | ) | (664 | ) |
| Leases                                                                |       | (2,227                           | )          | (1,491                          | )          | (5,991 | ) | (4,165 | ) |
| Auto                                                                  |       | (1,252                           | )          | (1,180                          | )          | (3,809 | ) | (2,872 | ) |
| Home equity lines                                                     |       | (650                             | )          | (143                            | )          | (706 | ) | (300 | ) |
| Consumer                                                              |       | (15                              | )          | (13                             | )          | (44 | ) | (89 | ) |
| Total charge-offs                                                     |       | (4,255                           | )          | (2,977                          | )          | (10,775 | ) | (8,112 | ) |
| Recoveries:                                                           |       |                             |       |                            |       |   |   |   |   |
| First mortgages                                                       |       | —                           |       | 6                               |       | — |   | 7 |   |
| Second mortgages                                                      |       | 15                               |       | 10                              |       | 107 |   | 97 |   |
| Leases                                                                |       | 506                              |       | 779                             |       | 1,465 |   | 1,652 |   |
| Auto                                                                  |       | 430                              |       | 350                             |       | 1,470 |   | 888 |   |
| Home equity lines                                                     |       | 3                                |       | 62                              |       | 126 |   | 347 |   |
| Consumer                                                              |       | —                           |       | —                          |       | — |   | — |   |
| Total recoveries                                                      |       | 954                              |       | 1,207                           |       | 3,168 |   | 2,991 |   |
| Total charge-offs, net                                                |       | (3,301                           | )          | (1,770                          | )          | (7,607 | ) | (5,121 | ) |
| **Ending  balance**                                                   |       | $                                | 26,477     |                            | $          | 26,730 |   | $ | 26,477 |   | $ | 26,730 |   |
|                                                                  |       |                             |       |                            |       |   |   |   |   |
| Allowance for credit  losses as a percent of average loans and leases |       | 1.3                              | %          | 1.2                             | %          | 1.2 | % | 1.2 | % |

 

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**6.**             FAIR VALUE AND IMPAIRMENT OF MORTGAGE SERVICING RIGHTS

The Company accounts for its entire mortgage servicing rights (“MSR”)portfolio at the aggregate of the lower of cost or market (“LOCOM”). Forpurposes of evaluating the MSR portfolio for impairment, the Companydisaggregates its MSR portfolio into two primary groupings: available for saleand held for sale.

The segment of the portfolio designated as available for sale iscomposed of MSRs that were retained out of production pursuant to individualportfolio retention decisions or purchased in bulk transactions. The availablefor sale portfolio is disaggregated for purposes of measuring potentialimpairments according to defined risk tranches. The Company has defined these risktranches based upon interest rate band and product type.  With respect to each such risk tranche, thefair value thereof, which is based upon an internal analysis that considerscurrent market conditions, prevailing interest rates, prepayment speeds, defaultrates and other relevant factors, is compared to amortized MSRs for purposes ofmeasuring potential impairment.  

During the third quarter of 2006, the Company completed the sale of$141,755 of MSRs which, in aggregate, had an underlying unpaid principalbalance of $8.5 billion and represented a substantial portion of the Company’sMSR portfolio.   As a result of thissale, the Company recognized pre-tax a loss on sale of MSRs of $29,702.   

The segment of the portfolio designated as held for sale is composed ofrecently produced MSRs that are scheduled for sale and have been allocated tospecific forward servicing sales contracts. The held for sale portfolio is disaggregated for purposes of measuringpossible impairments according to the specific forward sales contracts to whichthe MSR is allocated. For each such risk tranche, the fair value is based uponthe allocated forward committed delivery price, which is compared to amortizedcarrying value for purposes of measuring potential impairment.

Thefollowing amounts relate to the Company’s MSR portfolio:
|                                             | ** ** | **Available for sale** | ** ** | **Held for sale** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **Sept. 30,**               | ** ** | **Dec. 31,**           | ** ** | **Sept. 30,** | ** ** | **December 31,** | ** ** |
| ** **                                  | ** ** | **2006**                         | ** ** | **2005**                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| Unpaid Principal  Balance (“UPB”) |       | $                                | 3,518,743  |                        | $          | 13,155,256 |   | $ | 87,824 |   | $ | 143,515 |   |
| Carrying value                              |       | $                                | 38,266     |                        | $          | 200,371 |   | $ | 810 |   | $ | 1,509 |   |
| Carrying value /  UPB                       |       | 1.09                             | %          | 1.52                        | %          | 0.92 | % | 1.05 | % |
| Fair value                                  |       | $                                | 38,786     |                        | $          | 201,034 |   | $ | 810 |   | $ | 1,509 |   |
| Fair value / UPB                            |       | 1.10                             | %          | 1.53                        | %          | 0.92 | % | 1.05 | % |
| Weighted average  note rate                 |       | 6.20                             | %          | 5.89                        | %          | 6.63 | % | 6.47 | % |
| Weighted average  service fee               |       | 0.28                             | %          | 0.32                        | %          | 0.33 | % | 0.35 | % |
| Net basis as multiple                       |       | 3.95                             |       | 4.76                        |       | 2.76 |   | 3.00 |   |

 

**7.**             DEPOSITS

The following table setsforth the dollar amount of deposits and weighted average interest rates of thevarious types of deposit programs offered by the Company:
|                                         | ** ** | **As of September 30, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amount**                                       | ** ** | **Percentage**                                  | ** ** | **Weighted  average  interest rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest rate** | ** ** |
| Non-interest  bearing checking accounts |       | $                                                | 274,868    |                                            | 10.1       | % | — |   | $ | 284,046 |   | 10.2 | % | — |   |
| Interest  bearing:                      |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Checking accounts                       |       | 207,692                                          |       | 7.6                                             | %          | 0.9 | % | 232,658 |   | 8.3 | % | 0.9 | % |
| Money market                            |       | 702,923                                          |       | 25.8                                            | %          | 3.3 | % | 943,432 |   | 33.8 | % | 3.2 | % |
| Certificate of deposit under $100       |       | 1,441,885                                        |       | 52.8                                            | %          | 4.7 | % | 1,240,784 |   | 44.4 | % | 4.0 | % |
| Certificate of deposit over $100        |       | 100,948                                          |       | 3.7                                             | %          | 4.7 | % | 92,927 |   | 3.3 | % | 4.1 | % |
| Total deposits                          |       | $                                                | 2,728,316  |                                            | 100.0      | % |   |   | $ | 2,793,847 |   | 100.0 | % |   |   |

 

Accrued interest as of September 30, 2006 related to checking, moneymarket and certificates of deposit accounts was $49, $604 and $19,838,respectively.  Accrued interest as ofDecember 31, 2005 related to checking, money market, and certificates ofdeposit

11

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accounts was $55, $777 and $12,620, respectively.  At September 30, 2006 and December 31, 2005,$664 and $696 of overdrawn deposits were classified as loans, respectively.

**8.****            ****BORROWINGS**

A summary of borrowings and available borrowings, grouped by year ofmaturity, as of September 30, 2006 follows:
| Type of borrowing             | ** ** | **Year of   maturity** | ** ** | **Range of stated  interest rates** | ** ** | **Principal amount  outstanding** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|----------------------------------------------------|------------|----------------------------------------|------------|
| $25 million line  of credit             |       | 2006                             |       | Fed Funds + 0.25                                   | %*         | $                                      | —     |   |
| $75 million  master repurchase facility |       | 2006                             |       | LIBOR + 0.70                                       | %*         | —                                 |       |
| $200 million  warehouse line of credit  |       | 2006                             |       | LIBOR + 0.80                                       | %*         | —                                 |       |
| FHLB warehouse  line of credit          |       | 2006                             |       | DRC + 0.50                                         | %*         | —                                 |       |
| FHLB overnight  advances                |       | 2006                             |       | DRC                                                | *          | —                                 |       |
| Repo facility                           |       | 2006                             |       | 5.56                                               | %          | 54,033                                 |       |
| FHLB advances                           |       | 2006                             |       | 3.38% to 5.36                                      | %          | 200,000                                |       |
| FHLB advances                           |       | 2007                             |       | 2.57                                               | %          | 40,000                                 |       |
| FHLB advances                           |       | 2009                             |       | 2.45                                               | %          | 50,000                                 |       |
| FHLB advances                           |       | 2010                             |       | 3.63% to 3.97                                      | %          | 150,000                                |       |
| FHLB advances                           |       | 2011                             |       | 4.29% to 4.43                                      | %          | 50,000                                 |       |
| FHLB advances                           |       | 2014                             |       | 2.36% to 2.93                                      | %          | 110,000                                |       |
| Subordinated  debt                      |       | 2032                             |       | LIBOR + 3.35                                       | %*         | 4,382                                  |       |
| Subordinated  debt                      |       | 2033                             |       | LIBOR + 3.25                                       | %*         | 4,382                                  |       |
| Subordinated  debt                      |       | 2034                             |       | LIBOR + 2.85                                       | %*         | 3,093                                  |       |
| Subordinated  debt                      |       | 2034                             |       | LIBOR + 3.00                                       | %*         | 20,620                                 |       |
|                                    |       |                             |       |                                               |       | $                                      | 686,510    |   |

 

*              Indicates a variablerate.

The totalborrowings available through the Federal Home Loan Bank (“FHLB”) are determinedeach quarter based on a percentage of the total assets of NetBank, FSB subjectto limitations of available collateral. During 2006, the Company’s availableborrowings as a percentage of total assets were reduced from 50% to 30%.  In addition, if the Company’s advances totalgreater than 20% of total assets, eligible securities must be pledged.  The Company accesses the FHLB advancefacility through fixed and convertible term advances, as well as short-termadvances, including thirty day and overnight borrowings. FHLB advances arefixed rate; however, as of September 30, 2006, $535,000 was convertible at theFHLB’s option to an adjustable rate based on LIBOR. The FHLB warehouse line isan adjustable line of credit with a floating rate based on the daily rate credit(“DRC”) plus 50 basis points. This warehouse line can be used to fund mortgagesoriginated by the Company. All of the FHLB advances and the FHLB warehouse lineare secured by investment securities or mortgage loans. At September 30, 2006, approximately$182,181 of investment securities and approximately $828,973 of mortgage loanswere pledged to the FHLB as collateral for the various FHLB advances, the FHLBwarehouse line and the overnight facility.

The $54,033 repofacility was collateralized by approximately $64,648 of investment securitiesat September 30, 2006. This facility matured on October 11, 2006 and wasrenewed at that time.

The Company’ssubordinated debt is supported by trust preferred securities, which were issuedin 2002, 2003 and 2005 in private pooled transactions through off-balance sheettrusts: NBI Trust I, II, III and IV. The subordinated debt and theassociated trust preferred securities carry variable rates and were initiallypriced at LIBOR plus a spread ranging from 2.85% to 3.35% with a cap of 12.5%for five years after their respective date of issuances. Interest payments andthe resetting of the rates both occur on a quarterly basis. The debt isscheduled to mature from December 2032 through December 2034 andcannot be redeemed by the trust for a minimum of five years after issuance.

Most of therevolving lines of credit, warehouse lines of credit (other than the FHLBwarehouse line) and the master repurchase facility are secured by mortgageloans and are subject to restrictive covenants. The covenants include certainminimum net worth requirements, minimum tangible net worth requirements,minimum financial ratios, capital requirements, maintenance of servicereligibility for various government agencies and certain minimum liquidityrequirements, which are all defined in the terms of the related debtagreements. In addition, the covenants restrict the types of businessactivities in which the Company may engage. The Company was in compliance with orhad obtained waivers for all debt covenants in place as of September 30, 2006.Although management anticipates complying with all current debt covenants,there can be no assurance that the Company or its individual subsidiaries willbe able to comply with all debt covenants in the future. Failure to complycould result in the acceleration of the repayment of the related financing.

12

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Short-term debtoutstanding reached the highest month-end level during the nine months endedSeptember 30, 2006 on January 31, 2006 with a short-term balance of $1,002,002.

**9.**             STOCK-BASED COMPENSATION

The Company has adopted the 1996 Stock Incentive Plan (the “StockPlan”), which provides that employees, officers, directors and consultants ofNetBank may be granted nonqualified and incentive stock options to purchaseshares of common stock of NetBank, shares of NetBank common stock, derivativesecurities related to the value of the common stock, or cash awards.  Up to 9,500,000 shares of our common stockmay be issued under the Stock Plan. Generally, the options vest within four years and expire ten years fromthe date of the grant.  Vesting ceasesimmediately upon employee termination and any vested options are forfeited ifnot exercised within 90 days of termination. This exercise grace period is extended to one year in the case of arecipient’s death or disability.

Prior to January 1, 2006, the Company accounted for the Stock Planunder the recognition and measurement provisions of Accounting Principles Board25 (“APB 25”), *Accounting for Stock Issued to Employees,*andrelated Interpretations, as permitted by Statement of Financial AccountingStandards No. 123, (“SFAS 123”), *Accounting for Stock-BasedCompensation.*  No stock-basedemployee compensation cost related to options was recognized in the Company’s Statementof Operations for periods ending prior to January 1, 2006, as all optionsgranted under the Stock Plan had an exercise price equal to the market value ofthe underlying common stock on the date of grant.

Effective January 1, 2006, the Company adopted the fair valuerecognition provisions of Statement of Financial Accounting Standards No. 123(revised 2004) (“SFAS 123(R)”), *Share-Based Payment,*usingthe modified prospective transition method. Under this transition method, compensation cost recognized in 2006includes: (a) compensation cost for all share-based payments granted prior to,but not yet vested as of January 1, 2006, based on the grant-date fair valueestimated in accordance with the original provisions of SFAS 123, and (b)compensation cost for all share-based payments granted subsequent to January 1,2006, based on the grant-date fair value determined in accordance with theprovisions of SFAS 123(R).  The Companyrecognized $269 and $1,809 of expense during the three and nine months ended September30, 2006 related to stock options, respectively.  As permitted under the modified prospectivetransition method, results for prior periods have not been restated.

In addition to providing for the issuance of options, the Stock Planalso provides for the grant of stock awards. Compensation expense related to stock awards was recognized on astraight-line basis over the vesting period and included in the Statement ofOperations before adoption of SFAS 123(R). With the adoption of SFAS 123(R) effective January 1, 2006, the Companymodified the calculation of compensation expense related to stock awards toinclude both a straight-line basis over the vesting period and an estimation offorfeitures.   For the three months endedSeptember 30, 2006 and 2005, the Company recognized $260 and $128 of expenserelated to stock awards, respectively. For the nine months ended September 30,2006 and 2005, the Company recognized $890 and $316 of expense related to stockawards, respectively.

The Company also adopted the Mid-Term Incentive Plan (the “Mid-TermPlan”) which is administered under the Stock Plan.  On January 1, 2004, the CompensationCommittee granted incentive awards to certain executives under the Mid-TermPlan.  The awards are payable only if theCompany achieves specified levels of consolidated earnings per share andearnings per share of its retail banking, financial intermediary andtransaction processing segments during the two- and three-year performanceperiods ending December 31, 2005 and 2006, respectively.  Awards are denominated in cash but payable inshares of restricted stock, with 50 percent of the shares vesting immediatelyafter the last day of the relevant performance period and 25 percent of the sharesvesting at the end of each of the first and second years thereafter.  In the case of a recipient’s death,disability, retirement, or termination of employment without cause, awardswould vest in full prior to the last day of the performance period, based onactual performance to the vesting date. In addition, if the recipient’s employment is constructively terminatedin the 18-month period after a change of control event, awards vest in fullprior to the last day of the performance period, based on actual performance tothe vesting date.  No expense wasrecognized in 2005 with respect to the Mid-Term Plan based upon earnings pershare results.  Based upon the Company’searnings performance through the third quarter 2006, it is not probable thatany performance goals will be met for the Mid-Term Plan.  Therefore in third quarter 2006, $148 ofexpense which had been accrued in the first half of the year was reversedresulting in no expense being recognized for the Mid-Term Plan during the ninemonths ended September 30, 2006.  Duringthe first quarter of 2006, the Compensation Committee adopted and grantedincentive awards to certain executives of the Company under an Amended andRestated Mid-Term Incentive Plan (the “New Mid-Term Plan”).  The New Mid-Term Plan is substantiallyconsistent with the original Mid-Term Plan except that the performance goalsare based upon the pre-tax income for the retail banking, financialintermediary and transaction processing segments and consolidated pre-taxincome for two and three year performance periods ending December 31, 2007 and2008, respectively.  Under SFAS 123(R),the terms of the New Mid-Term Plan are subject to the classification criteriaof Statement of Financial Accounting Standards No. 150 (“SFAS 150”), *Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity,*since the monetary value of the awardis predominately fixed and considered stock-settled debt.  

13

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On July 1, 2002, the Company established the NetBank, Inc. EmployeeStock Purchase Plan (“the Employee Plan”), to allow participants to purchasestock in the Company through payroll deductions.  The Employee Plan purchases shares of NetBankcommon stock from the Company on the last day of each quarter at 85% of the marketvalue on the purchase date.  Employeesare eligible to enroll in the Employee Plan on January 1, April 1, July 1 andOctober 1.  There was no expenserecognized during 2005 related to the Employee Plan.  Under SFAS 123(R), the Employee Plan ischaracterized as stock-settled debt and is subject to the classificationcriteria of SFAS 150.  For the three and ninemonths ended September 30, 2006, the Company recognized $24 and $88,respectively, of expense with an offsetting liability related to the EmployeePlan.

SFAS 123(R) requires that a company disclose proforma information forperiods prior to its adoption of SFAS 123(R). The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofSFAS 123 to options granted under the Company’s stock option plan for the threeand nine months ended September 30, 2005. For purposes of this pro forma disclosure, the value of the options isestimated using a Black-Scholes-Merton option-pricing formula and amortized toexpense over the options’ vesting periods.
|                                                                                                                                                     | ** ** | **Three months  ended Sept. 30,  2005** | ** ** | **Nine months  ended Sept. 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|
| Net loss, as  reported                                                                                                                              |       | $                                                      | (1,371     | )                                                     | $          | (1,075 | ) |
|                                                                                                                                                |       |                                                   |       |                                                  |       |
| Deduct total  stock option-based employee compensation expense determined under fair value  based method for all awards, net of related tax effects |       | (837                                                   | )          | (2,829                                                | )          |
| Pro forma net  loss                                                                                                                                 |       | $                                                      | (2,208     | )                                                     | $          | (3,904 | ) |
|                                                                                                                                                |       |                                                   |       |                                                  |       |
| Earnings per  share:                                                                                                                                |       |                                                   |       |                                                  |       |
| Basic – as reported                                                                                                                            |       | $                                                      | (0.03      | )                                                     | $          | (0.02 | ) |
| Basic – pro forma                                                                                                                              |       | $                                                      | (0.05      | )                                                     | $          | (0.08 | ) |
|                                                                                                                                                |       |                                                   |       |                                                  |       |
| Diluted – as reported                                                                                                                          |       | $                                                      | (0.03      | )                                                     | $          | (0.02 | ) |
| Diluted – pro  forma                                                                                                                           |       | $                                                      | (0.05      | )                                                     | $          | (0.08 | ) |

 

As a result of adopting SFAS 123(R) on January 1, 2006, the Company’sloss before income taxes and net loss for the quarter ended September 30, 2006,were $293 and $190 higher, respectively, than if it had continued to accountfor share-based compensation under APB 25. For the nine months ended September 30, 2006, the Company’s loss beforeincome taxes and net loss were $1,901 and $1,215 higher, respectively, than ifit had continued to account for share-based compensation under APB 25.

No options were granted during the third quarter of 2006.  The fair value of each option granted underthe Stock Plan for the three months ended September 30, 2005 was estimated onthe date of grant using the Black-Scholes-Merton option-pricing formula withthe following weighted average assumptions:
|                          | ** ** | **For the three months ended  September 30, 2005** | ** ** |
|--------------------------|------------|----------------------------------------------------------------------------------|------------|
| Fair value               |       | $                                                                                | 2.59       |   |
| Expected life  (years)   |       | 5                                                                                |       |
| Risk-free interest  rate |       | 3.96                                                                             | %          |
| Dividend rate            |       | 0.70                                                                             | %          |
| Expected volatility      |       | 29.90                                                                            | %          |
|                          |            |                                                                                  |            |  |

 

Expected volatilities are based on the historical volatility of theCompany’s common stock and other factors. For options granted prior to 2006, the expected term of the options isestimated based on historical option exercise activity.  For options granted in 2006, the expectedterm is calculated using the shortcut method based on guidance from SEC StaffAccounting Bulletin No. 107, *Share-Based Payment*(SAB107), for the vesting and original contractual terms.  The risk-free interest rate for the periodswithin the contractual life of the option is based on the U.S. Treasury yieldcurve in effect at the time of grant.

Option activity under the Stock Plan as of September 30, 2006, and changesduring the nine months ended September 30, 2006 follows:

14

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|                                            | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Fair Value** | ** ** |
|--------------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------|------------|
| Options  outstanding at beginning of year  |       | 5,033      |       | $                                      | 10.96      |                                                |       |                           |       |   |
| Granted                                    |       | 496        |       | $                                      | 7.27       |                                                |       |                           |       |   |
| Exercised                                  |       | (25        | )          | $                                      | 4.75       |                                                |       |                           |       |   |
| Forfeited                                  |       | (283       | )          | $                                      | 11.86      |                                                |       |                           |       |   |
| Cancelled                                  |       | (176       | )          | $                                      | 10.10      |                                                |       |                           |       |   |
| Options  outstanding at September 30, 2006 |       | 5,045      |       | $                                      | 10.61      |                                                | 6.2        |                           | $          | 18,524 |   |
| Options vested  at September 30, 2006      |       | 3,761      |       | $                                      | 10.90      |                                                | 6.2        |                           | $          | 13,583 |   |
| Options exercisable at  September 30, 2006 |       | 3,761      |       | $                                      | 10.90      |                                                | 6.2        |                           | $          | 13,583 |   |

 

Option activity under the Stock Plan as of September 30, 2006, andchanges during the quarter ended September 30, 2006 follows:
|                                              | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Fair Value** | ** ** |
|----------------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------|------------|
| Options  outstanding at beginning of quarter |       | 5,349      |       | $                                      | 10.65      |                                                |       |                           |       |   |
| Granted                                      |       | —     |       | $                                      | —     |                                                |       |                           |       |   |
| Exercised                                    |       | (6         | )          | $                                      | 4.20       |                                                |       |                           |       |   |
| Forfeited                                    |       | (230       | )          | $                                      | 11.83      |                                                |       |                           |       |   |
| Cancelled                                    |       | (68        | )          | $                                      | 10.06      |                                                |       |                           |       |   |
| Options  outstanding at September 30, 2006   |       | 5,045      |       | $                                      | 10.61      |                                                | 6.2        |                           | $          | 18,524 |   |
| Options vested  at September 30, 2006        |       | 3,761      |       | $                                      | 10.90      |                                                | 6.2        |                           | $          | 13,583 |   |
| Options exercisable at  September 30, 2006   |       | 3,761      |       | $                                      | 10.90      |                                                | 6.2        |                           | $          | 13,583 |   |

 

The status of the Company’s nonvested options as of September 30, 2006,and changes during the nine-month period ended September 30, 2006 follows:
|                                   | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------|------------|------------|------------|---------------------------------------------------------|------------|
| Nonvested,  January 1, 2006       |       | 1,579      |       | $                                                       | 4.17       |   |
| Granted                           |       | 496        |       | $                                                       | 2.61       |   |
| Vested                            |       | (618       | )          | $                                                       | 3.62       |   |
| Cancelled,  forfeited and expired |       | (173       | )          | $                                                       | 4.06       |   |
| Nonvested, September  30, 2006    |       | 1,284      |       | $                                                       | 3.85       |   |

 

As of September 30, 2006, there was $3,061 of total unrecognizedcompensation cost, net of estimated forfeitures, related to nonvested optionsunder the Stock Plan.  That cost isexpected to be recognized in less than three years.  The total fair value of options vested duringthe quarter ended September 30, 2006 was $96.

Restricted stock activity under the Stock Plan as of September 30,2006, and changes during the nine months ended September 30, 2006 follows:
|                                   | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------|------------|------------|------------|---------------------------------------------------------|------------|
| Nonvested,  January 1, 2006       |       | 189        |       | $                                                       | 8.50       |   |
| Granted                           |       | 271        |       | $                                                       | 7.39       |   |
| Vested                            |       | (89        | )          | $                                                       | 8.16       |   |
| Cancelled,  forfeited and expired |       | (25        | )          | $                                                       | 7.92       |   |
| Nonvested, September  30, 2006    |       | 346        |       | $                                                       | 7.76       |   |

 

Restrictedstock activity under the Stock Plan as of September 30, 2006, and changesduring the quarter ended September 30, 2006 follows:

15

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|                                   | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------|------------|------------|------------|---------------------------------------------------------|------------|
| Nonvested, June  30, 2006         |       | 355        |       | $                                                       | 7.76       |   |
| Granted                           |       | —     |       | —                                                  |       |
| Vested                            |       | (1         | )          | $                                                       | 7.66       |   |
| Cancelled,  forfeited and expired |       | (8         | )          | $                                                       | 7.65       |   |
| Nonvested, September  30, 2006    |       | 346        |       | $                                                       | 7.76       |   |

 

**10.**          GOODWILL AND INTANGIBLES

**The Company accounts for goodwill in accordance with Statement ofFinancial Accounting Standards No. 142, *Goodwill and OtherIntangible Assets*(“SFAS 142”). SFAS 142 requires that entities assess the fair value of allacquisition-related goodwill on a reporting unit basis.  We review the recorded value of goodwill forimpairment at least annually during the third quarter of each year, or earlierif events or changes in circumstances indicate that the carrying amount mayexceed fair value.  As a result of theCompany’s most recent impairment analyses, performed during the third quarterof 2006, management recorded a goodwill impairment of $19,505 related to our nonconformingmortgage operations. The impairment charge eliminated all of the goodwillrelated to our nonconforming operations and the Company received no tax benefitfrom this charge. In addition, management recorded a goodwill impairment chargeof $3,682 related to our NPS business unit. Measurement of the NPS impairment loss was based on management’sestimate using all currently available information. Future adjustments may benecessary based on new information as it becomes available.  See note 14 for further information regardingour nonconforming mortgage operations.**

**In the second quarter of 2006, management recorded a goodwill impairmentof $6,358 related to our 2004 acquisition of Beacon Credit Services.  The impairment charge eliminated all of thegoodwill related to the Beacon acquisition. See note 14 for further information regarding Beacon Credit Services.**

**Changes in the carrying amount of goodwill and intangible assets for the ninemonths ended September 30, 2006 by reportable segment are as follows:**
|                                | ** ** | **Retail Banking** | ** ** | **Financial  Intermediary** | ** ** | **Transaction  Processing** | ** ** | **Other** | ** ** | **Total** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------|------------|-----------|------------|
| Balance,  December 31, 2005    |       | $                       | 1,311      |                        | $          | 49,512                      |       | $         | 34,009     |      | $          | 265 |   | $ | 85,097 |   |
| Goodwill  acquired             |       | —                  |       | 576                         |       | —                      |       | —    |       | 576       |       |
| Intangible  assets acquired    |       | —                  |       | —                      |       | 397                         |       | —    |       | 397       |       |
| Goodwill  impairment           |       | —                  |       | (25,863                     | )          | (3,682                      | )          | —    |       | (29,545   | )          |
| Intangible asset  amortization |       | (454                    | )          | —                      |       | (2,222                      | )          | —    |       | (2,676    | )          |
| Balance, September 30,  2006   |       | $                       | 857        |                        | $          | 24,225                      |       | $         | 28,502     |      | $          | 265 |   | $ | 53,849 |   |

 

16

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**11.**          NET LOSS PER COMMON AND COMMON EQUIVALENTSHARE

Basic and dilutednet loss per common and potential common share has been calculated based on theweighted average number of shares outstanding. The following table reconciles the numerator and denominator of thebasic and diluted net loss per common and potential common share for the threeand nine months ended September 30, 2006 and 2005.
|                                       | ** ** | **Net Loss** | ** ** | **Shares**        | ** ** | **Per Share  Amount** | ** ** |
|---------------------------------------|------------|-------------------|------------|-------------------|------------|----------------------------|------------|
| ** **                            | ** ** | **(Numerator)**   | ** ** | **(Denominator)** | ** ** | ** **                 | ** ** |
| Nine months  ended September 30, 2006 |       |              |       |              |       |                       |       |
| Basic EPS                             |       | $                 | (115,668   | )                 | 46,316     |                       | $          | (2.50 | ) |
| Effect of  dilutive securities        |       | —            |       | —            |       | —                     |       |
| Diluted EPS                           |       | $                 | (115,668   | )                 | 46,316     |                       | $          | (2.50 | ) |
|                                  |       |              |       |              |       |                       |       |
| Nine months  ended September 30, 2005 |       |              |       |              |       |                       |       |
| Basic EPS                             |       | $                 | (1,075     | )                 | 46,201     |                       | $          | (0.02 | ) |
| Effect of  dilutive securities        |       | —            |       | —            |       | —                     |       |
| Diluted EPS                           |       | $                 | (1,075     | )                 | 46,201     |                       | $          | (0.02 | ) |

 
|                                        | ** ** | **Net Loss** | ** ** | **Shares**        | ** ** | **Per Share  Amount** | ** ** |
|----------------------------------------|------------|-------------------|------------|-------------------|------------|----------------------------|------------|
| ** **                             | ** ** | **(Numerator)**   | ** ** | **(Denominator)** | ** ** | ** **                 | ** ** |
| Three months  ended September 30, 2006 |       |              |       |              |       |                       |       |
| Basic EPS                              |       | $                 | (73,281    | )                 | 46,362     |                       | $          | (1.58 | ) |
| Effect of  dilutive securities         |       | —            |       | —            |       | —                     |       |
| Diluted EPS                            |       | $                 | (73,281    | )                 | 46,362     |                       | $          | (1.58 | ) |
|                                   |       |              |       |              |       |                       |       |
| Three months  ended September 30, 2005 |       |              |       |              |       |                       |       |
| Basic EPS                              |       | $                 | (1,371     | )                 | 46,119     |                       | $          | (0.03 | ) |
| Effect of  dilutive securities         |       | —            |       | —            |       | —                     |       |
| Diluted EPS                            |       | $                 | (1,371     | )                 | 46,119     |                       | $          | (0.03 | ) |

 

**12.**          BUSINESS SEGMENTS

Effective in the first quarter of 2006, the Company revised its segmentreporting format from four to five segments: retail banking, financial intermediary, transaction processing,servicing asset, and other/corporate overhead. We believe the realignment of the segments more closely representsmanagement’s view of the business than the previous method.  The servicing asset segment captures theinvestment results of the hedges related to the servicing asset segment as wellas other costs related to the MSRs. These results were historically reported aspart of the retail banking segment, which, as a result of the new segmentformat, now only captures the operating results of the online bank, the NetBankBusiness Finance division and the Dealer Financial Services division.  Inaddition to the creation of the servicing asset segment, the other/corporateoverhead segment was previously reported as the other/eliminations segment andincluded primarily costs charged to the holding company.  This segment also now includes overhead costswhich were previously recognized throughout all segments.  Historical results below have beenreclassified to conform with current period presentation.  

The retail banking segment’s investments primarily consist of 1-4family mortgage loans originated by the financial intermediary segment, smallbusiness financing loans and leases originated by the NetBank Business Financedivision, auto loans originated by the Dealer Financial Services division,purchased securities for investment, and various other purchased or retainedloan products.  The financial intermediary segment originates mortgageloans directly with borrowers and purchases mortgage loans from correspondentsand/or brokers.  The financialintermediary segment packages or pools such loans either inclusive or exclusiveof servicing rights for retention by the retail banking segment or sale intothe secondary market.  The financialintermediary segment also encompasses the origination of loans for recreationalvehicles (RVs), boats and aircraft which are then sold to the retail bankingsegment for investment purposes or to third party investors.  The transaction processing segmentsubservices loans for the retail bank segment, the financial intermediarysegment, the servicing asset segment, and for third-party customers; and providesATM and merchant processing services. The servicing asset segment manages the mortgage servicing rightsretained by the Company in conjunction with the origination of mortgage loansor obtained through bulk acquisitions. The other/corporate overhead segment contains holding company and overheadexpenses along with the elimination of intersegment gains and losses on loanssold to the retail banking segment, intersegment interest, and intersegmentservicing and processing expenses.

17

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The financialinformation for each business segment reflects specific identifiabletransactions or allocated transactions based on an internal allocationmethod.  The measurement of theperformance of the business segments is based on our management structure andis not necessarily comparable with similar information from any other financialinstitution. The information presented is also not necessarily indicative ofthe segment’s operations if they were independent entities.
|                                                  | ** ** | **For the three months ended September 30, 2006** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  banking**                                                                  | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Servicing  asset** | ** ** | **Other/  corporate  overhead** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                                                                    | 34,676     |   | $ | 23,745 |   | $ | 13 |   | $ | — |   | $ | 217 |   | $ | 58,651 |   |
| Intersegment  interest income                    |       | 23,584                                                                               |       | 71 |   | — |   | 2,875 |   | (26,530 | ) | — |   |
| Total interest  income                           |       | 58,260                                                                               |       | 23,816 |   | 13 |   | 2,875 |   | (26,313 | ) | 58,651 |   |
| Interest expense                                 |       | 35,584                                                                               |       | 1,235 |   | — |   | 61 |   | 698 |   | 37,578 |   |
| Intersegment  interest expense                   |       | 5,801                                                                                |       | 18,318 |   | 94 |   | 2,419 |   | (26,632 | ) | — |   |
| Total interest  expense                          |       | 41,385                                                                               |       | 19,553 |   | 94 |   | 2,480 |   | (25,934 | ) | 37,578 |   |
| Net interest  income                             |       | 16,875                                                                               |       | 4,263 |   | (81 | ) | 395 |   | (379 | ) | 21,073 |   |
| Provision for  credit losses                     |       | 2,410                                                                                |       | (3 | ) | — |   | — |   | — |   | 2,407 |   |
| Intersegment-  servicing and processing fees     |       | —                                                                               |       | — |   | 2,867 |   | — |   | (2,867 | ) | — |   |
| Non-interest  income                             |       | 4,396                                                                                |       | 6,215 |   | 3,966 |   | (48,778 | ) | (396 | ) | (34,597 | ) |
| Non-interest  expense                            |       | 20,473                                                                               |       | 49,609 |   | 9,129 |   | 543 |   | 6,390 |   | 86,144 |   |
| Intersegment-  servicing and processing expenses |       | 111                                                                                  |       | 411 |   | — |   | 2,345 |   | (2,867 | ) | — |   |
| Pre-tax loss                                     |       | $                                                                                    | (1,723     | ) | $ | (39,539 | ) | $ | (2,377 | ) | $ | (51,271 | ) | $ | (7,165 | ) | $ | (102,075 | ) |
| Total assets                                     |       | $                                                                                    | 3,844,870  |   | $ | 431,972 |   | $ | 32,445 |   | $ | (29,702 | ) | $ | (430,177 | ) | $ | 3,849,408 |   |

 
|                                                  | ** ** | **For the three months ended September 30, 2005** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  banking**                                                                  | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Servicing  asset** | ** ** | **Other/  corporate  overhead** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                                                                    | 37,561     |   | $ | 29,347 |   | $ | 8 |   | $ | — |   | $ | 340 |   | $ | 67,256 |   |
| Intersegment  interest income                    |       | 22,426                                                                               |       | 123 |   | (26 | ) | 2,792 |   | (25,315 | ) | — |   |
| Total interest  income                           |       | 59,987                                                                               |       | 29,470 |   | (18 | ) | 2,792 |   | (24,975 | ) | 67,256 |   |
| Interest expense                                 |       | 34,519                                                                               |       | 1,890 |   | 1 |   | 67 |   | 549 |   | 37,026 |   |
| Intersegment  interest expense                   |       | 5,164                                                                                |       | 18,291 |   | — |   | 2,193 |   | (25,648 | ) | — |   |
| Total interest  expense                          |       | 39,683                                                                               |       | 20,181 |   | 1 |   | 2,260 |   | (25,099 | ) | 37,026 |   |
| Net interest  income                             |       | 20,304                                                                               |       | 9,289 |   | (19 | ) | 532 |   | 124 |   | 30,230 |   |
| Provision for  credit losses                     |       | 2,646                                                                                |       | 62 |   | — |   | — |   | — |   | 2,708 |   |
| Intersegment-  servicing and processing fees     |       | —                                                                               |       | — |   | 3,591 |   | — |   | (3,591 | ) | — |   |
| Non-interest  income                             |       | 3,744                                                                                |       | 29,232 |   | 4,522 |   | 3,443 |   | 207 |   | 41,148 |   |
| Non-interest  expense                            |       | 20,796                                                                               |       | 35,805 |   | 6,979 |   | 1,256 |   | 5,864 |   | 70,700 |   |
| Intersegment-  servicing and processing expenses |       | 136                                                                                  |       | 971 |   | — |   | 2,484 |   | (3,591 | ) | — |   |
| Pre-tax income  (loss)                           |       | $                                                                                    | 470        |   | $ | 1,683 |   | $ | 1,115 |   | $ | 235 |   | $ | (5,533 | ) | $ | (2,030 | ) |
| Total assets                                     |       | $                                                                                    | 4,554,156  |   | $ | 1,654,898 |   | $ | 41,343 |   | $ | 239,495 |   | $ | (1,374,579 | ) | $ | 5,115,313 |   |

 
|                                                  | ** ** | **For the nine months ended September 30, 2006** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  banking**                                                                 | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Servicing  asset** | ** ** | **Other/  corporate  overhead** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                                                                   | 113,409    |   | $ | 74,374 |   | $ | 27 |   | $ | — |   | $ | 470 |   | $ | 188,280 |   |
| Intersegment  interest income                    |       | 69,850                                                                              |       | 182 |   | — |   | 8,312 |   | (78,344 | ) | — |   |
| Total interest  income                           |       | 183,259                                                                             |       | 74,556 |   | 27 |   | 8,312 |   | (77,874 | ) | 188,280 |   |
| Interest expense                                 |       | 110,622                                                                             |       | 2,797 |   | — |   | 155 |   | 1,978 |   | 115,552 |   |
| Intersegment  interest expense                   |       | 16,487                                                                              |       | 55,483 |   | 284 |   | 6,549 |   | (78,803 | ) | — |   |
| Total interest  expense                          |       | 127,109                                                                             |       | 58,280 |   | 284 |   | 6,704 |   | (76,825 | ) | 115,552 |   |
| Net interest  income                             |       | 56,150                                                                              |       | 16,276 |   | (257 | ) | 1,608 |   | (1,049 | ) | 72,728 |   |
| Provision for  credit losses                     |       | 6,381                                                                               |       | 102 |   | — |   | — |   | — |   | 6,483 |   |
| Intersegment-  servicing and processing fees     |       | —                                                                              |       | — |   | 9,343 |   | — |   | (9,343 | ) | — |   |
| Non-interest  income                             |       | 12,483                                                                              |       | 44,289 |   | 11,850 |   | (66,219 | ) | (1,061 | ) | 1,342 |   |
| Non-interest  expense                            |       | 61,152                                                                              |       | 125,165 |   | 21,184 |   | 1,882 |   | 25,035 |   | 234,418 |   |
| Intersegment-  servicing and processing expenses |       | 350                                                                                 |       | 1,736 |   | — |   | 7,257 |   | (9,343 | ) | — |   |
| Pre-tax income  (loss)                           |       | $                                                                                   | 750        |   | $ | (66,438 | ) | $ | (248 | ) | $ | (73,750 | ) | $ | (27,145 | ) | $ | (166,831 | ) |
| Total assets                                     |       | $                                                                                   | 3,844,870  |   | $ | 431,972 |   | $ | 32,445 |   | $ | (29,702 | ) | $ | (430,177 | ) | $ | 3,849,408 |   |

 

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|                                                  | ** ** | **For the nine months ended September 30, 2005** | ** ** |
|--------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  banking**                                                                 | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Servicing  asset** | ** ** | **Other/  corporate  overhead** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                                                                   | 110,227    |   | $ | 75,744 |   | $ | 27 |   | $ | — |   | $ | 779 |   | $ | 186,777 |   |
| Intersegment  interest income                    |       | 52,426                                                                              |       | 307 |   | (20 | ) | 6,728 |   | (59,441 | ) | — |   |
| Total interest  income                           |       | 162,653                                                                             |       | 76,051 |   | 7 |   | 6,728 |   | (58,662 | ) | 186,777 |   |
| Interest expense                                 |       | 87,605                                                                              |       | 5,637 |   | 33 |   | 197 |   | 1,356 |   | 94,828 |   |
| Intersegment  interest expense                   |       | 13,319                                                                              |       | 41,157 |   | 6 |   | 5,856 |   | (60,338 | ) | — |   |
| Total interest  expense                          |       | 100,924                                                                             |       | 46,794 |   | 39 |   | 6,053 |   | (58,982 | ) | 94,828 |   |
| Net interest  income                             |       | 61,729                                                                              |       | 29,257 |   | (32 | ) | 675 |   | 320 |   | 91,949 |   |
| Provision for  credit losses                     |       | 7,298                                                                               |       | 91 |   | — |   | — |   | — |   | 7,389 |   |
| Intersegment-  servicing and processing fees     |       | —                                                                              |       | — |   | 10,482 |   | — |   | (10,482 | ) | — |   |
| Non-interest  income                             |       | 11,363                                                                              |       | 86,586 |   | 13,881 |   | 4,703 |   | 317 |   | 116,850 |   |
| Non-interest  expense                            |       | 56,152                                                                              |       | 103,413 |   | 19,633 |   | 3,340 |   | 20,155 |   | 202,693 |   |
| Intersegment-  servicing and processing expenses |       | 434                                                                                 |       | 2,816 |   | — |   | 7,232 |   | (10,482 | ) | — |   |
| Pre-tax income  (loss)                           |       | $                                                                                   | 9,208      |   | $ | 9,523 |   | $ | 4,698 |   | $ | (5,194 | ) | $ | (19,518 | ) | $ | (1,283 | ) |
| Total assets                                     |       | $                                                                                   | 4,554,156  |   | $ | 1,654,898 |   | $ | 41,343 |   | $ | 239,495 |   | $ | (1,374,579 | ) | $ | 5,115,313 |   |

 

**13.****         COMMITMENTS,CONTINGENCIES AND GUARANTEES**

The Company was servicing or subservicing for the benefit of others 95,579and 109,685 residential loans with unpaid principal balances aggregatingapproximately $12.6 billion and $14.2 billion at September 30, 2006 andDecember 31, 2005, respectively. Mortgagors’ taxes and insurance escrowfunds and investors’ principal and interest escrow funds totaled approximately$260 million and $270 million as of September 30, 2006 and December 31,2005, respectively. Loans serviced for others and the related escrow funds arenot owned by the Company; however, the majority of the escrow funds aredeposited in NetBank, FSB.

The Company has issued mortgage-backed securities under programssponsored by Ginnie Mae, Freddie Mac and Fannie Mae. In connection withservicing mortgage-backed securities guaranteed by Ginnie Mae, Freddie Mac orFannie Mae, the Company advances certain principal and interest payments tosecurity holders prior to their collection from specific mortgagors.Additionally, the Company must remit certain payments including property taxesand insurance premiums in advance of collecting them from specific mortgagorsand make certain payments of attorney’s fees and other costs related to loansin foreclosure. These amounts are included in servicing advances under thecaption “due from servicers and investors” in the accompanying consolidatedbalance sheets. Likewise, during the month that a mortgagor pays off his/hermortgage, the Company must accept an interest payment from the borrower that ispro-rated to the date of payoff and pass through a full month’s interest to thesecurity holder. The Company includes its projection of the cost of suchadvances and lost interest on mortgages that prepay, and the expense ofunreimbursed attorney and other costs associated with foreclosure in itsvaluation of its mortgage servicing rights.

In the ordinary course of business, the Company is exposed to liabilityunder representations and warranties made to purchasers and insurers ofmortgage loans and the purchasers of mortgage servicing rights. Under certaincircumstances, the Company may be required to repurchase mortgage loans orindemnify the purchasers of loans or mortgage servicing rights for losses ifthere has been a breach of representations or warranties.  Repurchased loans are carried at the lower ofcost or net realizable value.  As of September30, 2006 and December 31, 2005, loans held for sale included repurchased loanswith a net carrying value of $59.0 million and $63.6 million, respectively.

NetBank is currently unable to determine its maximum exposure under itsrepresentations and warranties.  Themaximum exposure would be the current unpaid principal balance of any loan wehave ever sold, excluding loans sold which specifically excluded ourrepresentations and warranties, plus any fee or premium we received for thesale.  Additionally, we potentially couldhave to refund any fees or premiums we received for the sale of mortgageservicing rights that are still on the purchasers’ books.  Since we are not the current servicer for themajority of the loans and mortgage servicing rights as described above, wecannot determine our maximum exposure.

As of September 30, 2006, the Company had commitments to fund mortgageloans of $622,438, open-end consumer lines of credit of $52,391, undisbursedmortgage construction loans of $172,208, undisbursed leasing commitments of $3,633and commercial financing commitments of $8,512. 

NetBank, FSB is involved in litigation with three insurance companieswho are sureties on the purchased CMC leases. Since the second quarter of 2002, the entire portfolio has been onnon-accrual status pending outcome of the litigation.  NetBank, FSB has filed a claim for allpayments that are currently past due, approximately $90 million at September30, 2006.  The Company has charged off $50,230of the unpaid principal balances to date. At September 30, 2006, the remaining recorded value of the leases is $25,505.

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The Company isinvolved in certain legal proceedings, excluding the CMC litigation, incidentalto its business.  The Company does notbelieve that the outcome of these proceedings will have a material adverse effectupon its financial condition, results of operations or cash flows.

**14.**          SUBSEQUENT EVENTS

On October 3,2006, the Company announced that Douglas K. Freeman, its Chairman and ChiefExecutive Officer, would step down from those roles and from the Board of Directorson October 5, 2006. In conjunction with Mr. Freeman’s separation from theCompany, the Board approved a one-time termination benefit of $2.9 million,which was paid concurrently with Mr. Freeman’s separation.  The Company expects to record the effect ofthe termination benefit in its consolidated results of operations during thefourth quarter of 2006.  Additionally,the Company announced that Steven F. Herbert, the Company’s former ChiefFinance Executive, would succeed Mr. Freeman as Chief Executive Officer and wasalso elected to the Board of Directors. Furthermore, James P. Gross waspromoted from Corporate Controller to Chief Finance Executive.  

On November 6,2006, the Company announced that it had decided to exit its nonconformingmortgage operations.  As part of theexit, the Company executed a personnel placement agreement with Lime FinancialServices (“Lime”) whereby Lime will extend employment offers to certainpersonnel of Meritage.  We will receive nomaterial financial or other consideration as a result of the aforementionedagreement. The Company expects to incur expenses of approximately $7.2 millionin the fourth quarter of 2006 associated with this exit.  

Additionally, the Companyalso announced that it had entered into an agreement to sell, and has sold,select assets of Beacon Credit Services to senior members of that managementteam.  We will receive no materialfinancial or other consideration as a result of the aforementionedagreement.  The Company does not expectto incur any material expenses related to this exit. 

 

Effective November6, 2006, NetBank, FSB, acting through its Board of Directors, and the Office ofThrift Supervision (“OTS”), entered into a Supervisory Agreement (the“Agreement”) primarily to proactively address concerns over the Bank’sfinancial performance and the impact that losses have had on our capitalposition over the past several quarters. Under the terms of the Agreement, any material modifications to the Bank’sbusiness plan, as submitted to the OTS, as well as any new activity, operationor line of business must be approved by the OTS prior to implementation.  Additionally, the Board must monitor andreport to the OTS on NetBank, FSB’s adherence to its submitted business planwithin a set procedural framework each quarter.

 

On November 7, 2006, the Company announced its decision to close theoperations of its subsidiary, Financial Technologies, Inc. (“FTI”).  The Company expects FTI to cease operationsbefore December 31, 2006.  The Companydoes not expect to incur material expenses related to this exit.

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**Item2: Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

*The following discussion may include forward-looking statements.Forward-looking statements regarding the intent, belief or current expectationsof NetBank, Inc. or its officers and directors can be identified by the use offorward-looking terms such as “believe”, “anticipate”, “estimate”, “expect”,“may”, “will”, “should”, “plan”, “intend”, “project”, or other comparableterminology. Various internal and external factors could cause the Company’sactual results to differ materially from those anticipated by theforward-looking statements. These factors include, but are in no way limitedto, 1) the evolving nature of the market for Internet banking and financial servicesgenerally; 2) the public’s perception of the Internet as a secure, reliablechannel for transactions; 3) the success of new products and lines of businessconsidered critical to the Company’s long-term strategy, such as small businessbanking; 4) potential difficulties in integrating the Company’s operationsacross its multiple lines of business; 5) the cyclical nature of the mortgagebanking industry generally; 6) a possible decline in asset quality; 7) changesin general economic or operating conditions which could adversely affectmortgage loan production and sales, mortgage servicing rights, loan delinquencyrates and/or loan defaults; 8) the possible adverse effects of unexpectedchanges in the interest rate environment; 9) adverse legal rulings, particularlyin the Company’s litigation over leases originated by Commercial Money Center,Inc.; and/or 10) increased competition and regulatory changes. The Company’s2005 Form 10-K, Part II of this Quarterly Report on Form 10-Q,the Quarterly Report on Form 10-Q for the three and six months endedJune 30, 2006 and Item 1A “Risk Factors” contains additional detailson these and other risks that are material to our operations. Allforward-looking statements in this report are based on information available atthe time of filing. Except as required by the federal securities laws, theCompany has no obligation to update any forward-looking statement includedherein.  Forward-looking statements aremade in reliance on the safe harbor provisions of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934, as amended.*

**General**

NetBank, Inc. is a financial holding company engaged primarily inretail banking, mortgage banking, business finance and providing ATM andmerchant processing services. NetBank, Inc. wholly owns the outstanding stockof:  NetBank (“NetBank, FSB” or the“Bank”), a federal savings bank; MG Reinsurance Company (“MG Reinsurance”), acaptive reinsurance company; NetInsurance, Inc. (“NetInsurance”), a licensedinsurance agency; and NB Partners, Inc., a corporation involved in strategicpartnering opportunities. NetBank, FSB owns all of the outstanding stockof:  Market Street Mortgage Corporation(“Market Street”), a retail mortgage company; NetBank Payment Systems, Inc.(“NPS”), a provider of ATM and merchant processing services for retail andother non-bank businesses; Meritage Mortgage Corporation (“Meritage”), awholesale non-conforming mortgage provider; and Financial Technologies, Inc.(“FTI”), a provider of transaction processing services to other financialservices companies. NetBank, FSB’s wholesale mortgage division operates asNetBank Funding Services (“NetBank Funding”); its business financing divisionoperates as “NetBank Business Finance”; its automobile financing divisionoperates as “Dealer Financial Services”; and its recreational vehicle financingdivision operates as “Beacon Credit Services”. The consolidated company is referred to herein as “we,” “us,”  “our,” “NetBank,” or “the Company”.

In the opinion ofmanagement, the unaudited consolidated financial statements included hereinreflect all adjustments, consisting only of normal recurring accruals, whichare necessary for the fair presentation of the financial condition and resultsof operations for the interim periods presented. Certain information andfootnote disclosures normally included in financial statements have beencondensed or omitted pursuant to applicable rules and regulations of the SEC.The financial statements included herein should be read in conjunction with thefinancial statements and notes thereto included in our 2005 Form 10-K. Theresults of operations for the interim periods reported herein are notnecessarily indicative of results to be expected for the full year. Certain2005 amounts have been reclassified for comparability with 2006 amounts.

Unless otherwise noted, alldollar figures are presented in thousands (000s), except per share data.  All of the Company’s operations and assetsare located within the United States of America.

**ExecutiveSummary**

For the threemonths ended September 30, 2006, we incurred a net loss of $73,281, or $1.58per share, compared to a net loss of $1,371 or $0.03 per share for the threemonths ended September 30, 2005, a change of $71,910.  NetBank’s results were adversely impacted by1) one-time charges related to a bulk sale of a substantial portion of theCompany’s MSRs during the third quarter, 2) expenses related to the impairmentof goodwill of our non-conforming operations, 3) a continued high volume ofrepurchase losses related to representations and warranties on loans sold, 4)the flattening of the yield curve which reduces net interest earned oninterest-earning assets held for sale and held for investment, and 5) continueddepressed gain on sales margins within the financial intermediary segment dueto competitive conditions and reduced sales volumes.  

*Retail Banking.*The retail banking segment includes operations of the online bank, the NetBankBusiness Finance division as well as the Dealer Financial Servicesdivision.   The retail bankingsegment incurred a pre-tax loss of $1,723 during the third quarter of 2006

21

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compared topre-tax net income of $470 during the third quarter of 2005, a $2,193decline.  The online bank’s resultsdeclined by $670 primarily as a result of a decrease in net interest income of$3,799 offset by a decrease in non-interest expense of $2,985.  QuickPost, PowerPost and Net Serv contributedto the segment’s decline with decreased results of  $1,800.  NetBank Business Finance reported pre-tax income of $3,218, a slightdecline of $32 over the comparable period in 2005.  The decrease was primarily driven byincreased provision expense of $325 offset by improvements in net interestincome of $285.  Dealer FinancialServices reported improved results of $309 period over period primarily due toimprovements in net interest income of $90 and a reduction in provision expenseof $186.

The Companyannounced on November 7, 2006, that it would be closing the operations of FTI,which includes QuickPost, PowerPost and NetServ products.  See note 14 of the notes to the consolidatedfinancial statements included in this report for further information.

*FinancialIntermediary*.  Thefinancial intermediary segment originates both conforming and non-conformingproducts through our network of brokers and correspondents as well as directlywith consumers through our 73 branch offices. This segment also includes Beacon Credit Services and MG Reinsurance.The financial intermediary segment recorded a pre-tax loss of $39,539 for thethird quarter of 2006, a $41,222 pre-tax decline period over period.  This decline was primarily driven by a$19,505 goodwill impairment charge related to the our non-conformingoperations.  Additionally, gain on salesof loans declined $22,876 period over period primarily as a result of severecompetitive pressures within the mortgage industry coupled with decreased salesvolumes in excess of 30%.   Net interestincome also declined by $5,146 as a result of the flattening of the yield curveand reduced production volumes of 35%. However, this segment has seen an improvement in salary and benefitexpenses of $4,239 as we have been proactive in our efforts to reduce thisvariable expense.

The conforming mortgage operations within the financial intermediarysegment recorded a pre-tax loss of $14,754 for the third quarter of 2006compared to a pre-tax loss of $1,531 during the same quarter in 2005.  This decline was primarily the result of a37-basis point decline in the revenue margins and a 31-basis point increase inexpenses. Margins continue to be severely depressed resulting in a decrease innet interest income of $3,351 as the yield curve continues to remain flat.Generally, we earn long-term interest rates on loans held for sale and financethose loans with short-term borrowings. As the yield curve flattens, net interest margin compresses.  If the yield curve continues to remain flat,we will continue to have declines in net interest margins.  Furthermore, gain on sales of loans declined$10,651 due in part to a 30% decrease in the volume of sales coupled with thecontinued severe competitive pressures.

 The nonconforming operationswithin the financial intermediary segment recorded a pre-tax loss of $25,580during the third quarter of 2006 compared to a pre-tax income of $2,703 duringthe same quarter in 2005, a $28,283 change. The decline is primarily attributable to an impairment of goodwillexpense of $19,505 that the Company recognized this quarter.   Additionally, the nonconforming operationsexperienced a decline in gain on sales of loans of $12,225 primarily as aresult of a 49% decline in sales coupled with the continuation of extremecompetitive market pressures.  

The Companyannounced on November 6, 2006 that it would be exiting both the nonconformingoperations and Beacon Credit Services. See note 14 on the notes to the consolidated financial statementsincluded in this report for further information. 

*TransactionProcessing.* The transaction processing segment houses ourservicing factory and NPS.  This segmentrecorded a pre-tax loss of $2,377 duringthe third quarter of 2006 compared to pre-tax income of $1,115 during the same quarter in 2005. Thedecrease relates primarily to an impairment of goodwill charge of $3,682recognized during the third quarter of 2006 with respect to NPS.  

*ServicingAsset.* The servicing asset segment manages the MSRs we retainin conjunction with the origination of mortgage loans or obtain through bulkacquisition.  The servicing asset segmentreported a pre-tax loss of $51,271 for the three months ended September 30,2006 compared to pre-tax income of $235 for the same period in 2005, a changeof $51,506.  This change was primarily attributableto loss on sales of MSRs of $29,702 and loss on sales of investment securitiesof $13,461.  These securities served asan on balance sheet economic hedge of MSRs. Additionally, servicing fee income declined $3,957.  We believe the losses associated with thissegment should begin to subside due to the completion of the sale during thequarter. 

*Other/CorporateOverhead.* The other/corporate overhead segment includesholding company and overhead expenses along with the elimination ofinter-segment gains and losses on loans sold to the retail banking segment fromthe financial intermediary segment. The other/corporate overhead segmentincurred a $7,165 pre-tax loss for the three months ended September 30, 2006compared to a pre-tax loss of $5,533 for the comparable period of 2005.  The $1,632 change was primarily related toincreased salaries and benefits costs which may be  attributed to the adoption of SFAS 123(R).

*CapitalManagement Program. *Notwithstandingthe fact that NetBank met all of the regulatory capital requirements placed uponit and its subsidiaries at September 30, 2006 and was “well capitalized” underapplicable OTS guidelines at such date, the Company has a proactive capitalmanagement program in order to ensure that NetBank, FSB remains “wellcapitalized.”  As part of this program,the Company reviews capital allocations to lines of business that have beenperforming below target or that may require greater investment to reach theright scale.  The goal is to deploycapital into strategic areas with greater or more stable long-termprofitability prospects.  Given NetBank,FSB’s current capital levels, management has voluntarily

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moderated itspursuit of additional asset growth and other growth initiatives until thecurrent capital pressures ease.  For moreinformation regarding our regulatory capital requirements, see “Liquidity andCapital Resources – Capital Resources” below.

*Risk andContingencies*. Reference is made to the discussions underItem 1A. “Risk Factors” and “Future Outlook” in Item 7. Management’s Discussionand Analysis of Financial Condition and Results of Operations in the 2005 Form10-K for further information regarding the risks and challenges of ourbusiness. Reference is made to note 13 of the notes to consolidated financialstatements included in this report and to Item 1. Legal Proceedings and Item1A. Risk Factors in Part II of this report for additional discussion of certainrisk and contingencies that may affect us.

*ExecutiveLeadership Changes.*  OnOctober 3, 2006, we announced that Douglas K. Freeman, Chairman and ChiefExecutive Officer, would step down from those roles and from the Board ofDirectors on October 5, 2006.  Inconjunction with Mr. Freeman’s separation from the Company, the Board approved aone-time termination benefit of $2.9 million, which was paid concurrently withMr. Freeman’s separation.  The Companywill record the effect of the termination benefit in its consolidated resultsof operations during the fourth quarter of 2006.  Additionally, the Company announced thatSteven F. Herbert, the Company’s former Chief Finance Executive, would succeedMr. Freeman as Chief Executive Officer and was also elected to the Board ofDirectors. Furthermore, James P. Gross was promoted from Corporate Controllerto Chief Finance Executive.  

**FutureOutlook**

Our objective is tobe a premier provider of financial products and services to our targetedmarketing segments.  However, inconjunction with recent changes in executive management, our current strategyand primary focus is as follows: 

*RetailBanking.*NetBank, FSB operates as an FDIC-insured, federallychartered thrift instituition that currently serves over 268 thousand customersthrough a branchless model.  NetBank, FSBoffers services to its customers 24 hours per day, seven days a week, 365 daysyear.  The retail bank also consists ofthe operations of NetBank Business Finance, our business financing division,and Dealer Financial Services, our automobile financing division.  Furthermore, the retail bank previouslyoffered services including QuickPost, PowerPost and NetServ.  In conjunction with efforts to streamline ouroperations and reduce costs, management plans to phase out the QuickPost,PowerPost and NetServ products during the fourth quarter of 2006.  In addition, we are currently evaluating our futureplans for the Dealer Financial Services division.  However, we do not expect significant changesto our NetBank Business Finance division. 

*FinancialIntermediary. *Throughour mortgage banking operations, we serve as an intermediary between consumersand instiutional investors.  We obtainmortgage loans by originating directly with consumers, through brokers or bybuying closed loans from a network of correspondent banks, thrifts andindependent mortgage companies.  Themajority of these loans are held for sale on the Company’s balance sheet priorto delivery into the secondary market. We thus earn a long-term yield, on an asset held short-term, and alsoearn origination and servicing revenues and gains on the sale of the mortgagesor resulting mortgage backed securities. Although we are exiting the nonconforming mortgage operations, we planto continue operating both our indirect and retail conforming operations. 

*TransactionProcessing.*  Ourtransaction processing segment primarily consists of the results of operationsof our servicing factory and NetBank Payment Systems.  The servicing factory currently services over106,000 loans for internal and external customers .  With the completion of the sale of asubstantial portion of our MSRs during the third quarter of 2006, the servicingfactory has seen a shift from primarily internal to external customerservicing.   Late in 2003, we expandedour transaction processing capabilities by acquiring NPS which includes 8,427ATM machines and 1,956 merchant processing terminals. Durng the third quarterof 2006, we recognized an impairment of goodwill expense related to NPS of $3.7million.  Management continues toevaluate the future prospects of NPS. 

The Company has beenoperating in an adverse economic and market environment.  The flat yield curve has reduced net interestmargin on bank assets and the normal warehouse spread on loans held for sale inits mortgage banking operation. Likewise, competitive pressures have reduced gain on sale of loansmargins in our mortgage banking operations. Further, unusually high repurchases of loans have resulted in highreserve provisions for seller representation and warranty liabilities.  NetBank has sold most of its servicing assetsand downsized its operations as described above.  Restructuring activities will be continuingfor at least the next quarter.  AlthoughNetBank believes that it has taken and is taking appropriate steps to returnthe company to profitability, there is no assurance that results of operationswill return the Company to profitability or that additional economic and marketsituations will not manifest themselves that could adversely affect the Company’sresults of operations, financial condition and cash flows.

23

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# **Financial Condition**

*General. *Our assets totaled $3,849,408 at September 30, 2006, a decrease of$922,211 or 19% from December 31, 2005. This is primarily the result of decreases of $373,531 in investmentsecurities available for sale, $287,443 in loans held for sale, $313,593 in loanand lease receivables, and $162,804 in MSRs. These decreases enabled us to pay down other borrowed funds by $694,207and retain additional cash of $219,719 during the nine months ended September30, 2006.

*InvestmentSecurities.*  For the nine months ended September 30,2006, the investment security portfolio decreased by $373,531. This decreasewas primarily due the sale of $336,023 of investment securities during thethird quarter, which served as an economic hedge of MSRs sold during theperiod, resulting in a net loss of $13,461. The decrease is also due toprincipal repayments on mortgage-backed securities of $61,434. The decrease waspartially offset by the purchase of $16,402 of new investment securities andchange in net unrealized losses of $5,687.

The followingtables set forth certain information relating to our available for salesecurities:
| As of September 30, 2006 | ** ** | **Amortized  cost** | ** ** | **Unrealized  gains** | ** ** | **Unrealized  losses** | ** ** | **Estimated  fair value** | ** ** |
|----------------------------------------------|------------|---------------------|------------|-----------------------|------------|------------------------|------------|--------------------------------|------------|
| U.S. Government  agencies – MBS         |       | $                   | 169,394    |                  | $          | 24                     |       | $                              | 3,421      |   | $ | 165,997 |   |
| Collateralized  mortgage obligations         |       | 57,118              |       | 16                    |       | 1,259                  |       | 55,875                         |       |
| U.S. treasury  securities                    |       | —              |       | —                |       | —                 |       | —                         |       |
| Agency bonds                                 |       | 27,126              |       | —                |       | 516                    |       | 26,610                         |       |
| Other                                        |       | 3,976               |       | 88                    |       | —                 |       | 4,064                          |       |
| Total                                        |       | $                   | 257,614    |                  | $          | 128                    |       | $                              | 5,196      |   | $ | 252,546 |   |

 
| As of December 31, 2005 | ** ** | **Amortized  cost** | ** ** | **Unrealized  gains** | ** ** | **Unrealized  losses** | ** ** | **Estimated  fair value** | ** ** |
|---------------------------------------------|------------|---------------------|------------|-----------------------|------------|------------------------|------------|--------------------------------|------------|
| U.S. Government  agencies – MBS        |       | $                   | 535,369    |                  | $          | 24                     |       | $                              | 10,680     |   | $ | 524,713 |   |
| Collateralized  mortgage obligations        |       | 59,049              |       | 3                     |       | 1,450                  |       | 57,602                         |       |
| U.S. treasury  securities                   |       | 13,131              |       | —                |       | 351                    |       | 12,780                         |       |
| Agency bonds                                |       | 27,512              |       | —                |       | 504                    |       | 27,008                         |       |
| Other                                       |       | 3,858               |       | 116                   |       | —                 |       | 3,974                          |       |
| Total                                       |       | $                   | 638,919    |                  | $          | 143                    |       | $                              | 12,985     |   | $ | 626,077 |   |

 

*Loans held for sale.* As more fullydescribed in note 3 of the notes to the consolidated financial statements included in our 2005 Form 10-K, loans held for sale are carried at theaggregate of the lower of cost or market until sold, typically 30 to 90 daysafter origination or purchase. The majority of the non-performing loans heldfor sale consists of loans which have been repurchased under representationsand warranties provided to purchasers. Once a loan has been repurchased, it isgenerally resold at a price less than the repurchase price. Upon repurchase,reserves are transferred from the reserve for representations and warranties toa valuation reserve for repurchased loans to record such loans at estimated netrealizable value.  At September 30, 2006and December 31, 2005, the aggregate fair value of loans held for sale exceededthe aggregate cost.

Thefollowing tables set forth information regarding our portfolio of loans heldfor sale:
| As of September 30, 2006 | ** ** | **Gross UPB** | ** ** | **Reserve** | ** ** | **Non-  performing** | ** ** |
|----------------------------------------------|------------|--------------------|------------|-------------|------------|----------------------|------------|
| Conforming  mortgages                        |       | $                  | 584,638    |        | $          | 3,010                |       | $ | 15,815 |   |
| Non-conforming  mortgages                    |       | 195,742            |       | 10,765      |       | 34,588               |       |
| Construction                                 |       | 173,677            |       | 382         |       | —               |       |
| Commercial /  recreational                   |       | 6,690              |       | 115         |       | —               |       |
| Total loans held  for sale                   |       | $                  | 960,747    |        | $          | 14,272               |       | $ | 50,403 |   |

 
| As of December 31, 2005 | ** ** | **Gross UPB** | ** ** | **Reserve** | ** ** | **Non-  performing** | ** ** |
|---------------------------------------------|------------|--------------------|------------|-------------|------------|----------------------|------------|
| Conforming  mortgages                       |       | $                  | 811,602    |        | $          | 3,266                |       | $ | 25,630 |   |
| Non-conforming  mortgages                   |       | 346,940            |       | 9,283       |       | 24,005               |       |
| Construction                                |       | 84,429             |       | 191         |       | —               |       |
| Commercial /  recreational                  |       | 3,734              |       | 47          |       | —               |       |
| Total loans held  for sale                  |       | $                  | 1,246,705  |        | $          | 12,787               |       | $ | 49,635 |   |

 

The Company, whenrequired to repurchase mortgage loans, bundles such loans in pools and re-sellsthem.  The $768 increase innon-performing loans held for sale is primarily related to such re-sales ofmortgage loans during the nine months ended September 30, 2006 versus the ninemonths ended September 30, 2005.

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The size of therepurchase inventory, which is primarily comprised of non-performing loans,will vary depending on the timing of the repurchases and the subsequentdispositions.

*Loan andLease Receivables.*  For the nine months ended September30, 2006, the loan and lease receivables portfolio decreased $313,593.  Thedecrease in loan and lease receivables was primarily due to principalreductions and prepayments of $535,712 and sales of HELOCs of $131,243.  These decreases were partially offset by theretention of $209,787 of auto loans and $148,954 of business equipment financeleases.

*AssetQuality and Non-performing Assets.* We periodically review theperformance of our loan and lease receivables portfolio by reviewingcharge-offs, delinquency statistics, and various other industrystatistics.  Large non-homogeneouscredits are reviewed on a loan-by-loan or lease-by-lease basis, whereasrelatively small credits with similar risk characteristics are reviewed on apool-by-pool basis.  If a decline incredit quality for a specific pool or individual loan or lease is noted, werecord additional allowance through a charge to the provision for creditlosses.  The allowance for credit lossesis maintained at a level estimated to be adequate to provide for probablelosses in the loan and lease receivables portfolio. We determine the adequacyof the allowance based upon reviews of individual loans and leases or pools asapplicable, recent loss experience, current economic conditions, the riskcharacteristics of the various categories of loans and leases and otherpertinent factors. Our non-performing assets as a percentage of gross UPBincreased slightly from 1.47% at December 31, 2005, to 1.69% at September 30,2006, as the level of non-performing assets declined by $244 while total loansand leases receivable declined $314,717.

NetBank, FSB is involved in litigation with three insurance companieswho are sureties on purchased lease receivables originated by Commercial MoneyCenter, Inc. (“CMC”). Reference is made to Item 1. “LegalProceedings” in Part II of this report for detailed information related to theCompany’s ongoing CMC litigation. In July 2006, in the CMC litigation, theCourt in the multi-district litigation (“MDL” Court) issued a Revised CaseManagement Plan. In that plan, the MDL Court lifted the stay on expertdiscovery and ordered that the parties disclose experts supporting their claimsand exchange expert reports. The MDL Court also ordered that dispositivemotions, such as NetBank, FSB’s planned new motion for summary judgment againstthe sureties, must be filed between January 15, 2007 and January 31, 2007.Based upon the revised plan issued by the MDL Court, the Company does notexpect any resolution of NetBank, FSB’s claims against the sureties prior tospring 2007.

The following tablesdetail our held for investment loan and lease receivables portfolio, theassociated allowance for credit losses, and non-performing assets:
| As of September 30, 2006 | ** ** | **Gross UPB** | ** ** | **Allocated  Allowance** | ** ** | **(1) Non-  performing** | ** ** |
|----------------------------------------------|------------|--------------------|------------|--------------------------|------------|-------------------------------|------------|
| First mortgages                              |       | $                  | 690,044    |                     | $          | 2,001                         |       | $ | 2,735 |   |
| Second mortgages                             |       | 92,078             |       | 2,796                    |       | 573                           |       |
| Leases                                       |       | 410,968            |       | 16,095                   |       | 2,196                         |       |
| Auto                                         |       | 601,856            |       | 3,475                    |       | 434                           |       |
| Home equity  lines                           |       | 71,887             |       | 1,810                    |       | 1,362                         |       |
| Consumer                                     |       | 44,909             |       | 300                      |       | —                        |       |
| Loan and lease  receivables                  |       | 1,911,742          |       | 26,477                   |       | 7,300                         |       |
| CMC leases (2)                               |       | 25,505             |       | —                   |       | 25,505                        |       |
| Total loan and  lease receivables            |       | $                  | 1,937,247  |                     | $          | 26,477                        |       | $ | 32,805 |   |

 
| As of December 31, 2005 | ** ** | **Gross UPB** | ** ** | **Allocated  Allowance** | ** ** | **(1) Non-  performing** | ** ** |
|---------------------------------------------|------------|--------------------|------------|--------------------------|------------|-------------------------------|------------|
| First mortgages                             |       | $                  | 824,431    |                     | $          | 2,463                         |       | $ | 2,836 |   |
| Second mortgages                            |       | 115,188            |       | 2,973                    |       | 498                           |       |
| Leases                                      |       | 379,999            |       | 14,771                   |       | 2,737                         |       |
| Auto                                        |       | 610,924            |       | 2,948                    |       | 471                           |       |
| Home equity  lines                          |       | 257,991            |       | 4,244                    |       | 452                           |       |
| Consumer                                    |       | 37,377             |       | 202                      |       | 1                             |       |
| Loan and lease  receivables                 |       | 2,225,910          |       | 27,601                   |       | 6,995                         |       |
| CMC leases (2)                              |       | 26,054             |       | —                   |       | 26,054                        |       |
| Total loan and  lease receivables           |       | $                  | 2,251,964  |                     | $          | 27,601                        |       | $ | 33,049 |   |

 

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(1)  Non-performingincludes all loans that are 90 days or more contractually past due includingloans which have been restructured.  TheCompany also held $7,827 and $6,782 of restructured loans which were performingin accordance with the restructured terms as of September 30, 2006 and December31, 2005, respectively.

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(2)  Referenceis made to note 5 and 13 of the notes to the consolidated financial statementsincluded in this report for additional details regarding the CMC leaseportfolio.

*MortgageServicing Rights.*  For the nine months ended September 30, 2006,the MSR portfolio decreased $162,804 compared to the prior year period.  The decrease was primarily driven by the saleof $141,755 of MSRs, transaction costs of $6,622 associated with such sale, the$27,512 of amortization, the $6,063 net impact of other sales of MSRs and the impaimentof $7,380 in the value of MSRs.  Thesedecreases were partially offset by capitalization of MSRs during theperiod.

During the nine months ended September 30, 2006, NetBank recorded adecrease of $15,819 in the market value of the derivatives portfolio hedgingthe MSRs.  The fair value of thederivative portfolio hedging the MSRs is recorded in other assets.   

Thefollowing table provides a sensitivity analysis of the fair value of theavailable for sale MSRs portfolio:
|                                             | ** ** | **As of  Sept. 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|---------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Fair value                                  |       | $                                        | 38,786     |                                        | $          | 201,034 |   |
| Weighted average life  in years             |       | 5.4                                      |       | 5.2                                         |       |
|                                        |       |                                     |       |                                        |       |
| Prepayment speed  assumption (annual rate)  |       | 13.40                                    | %          | 13.70                                       | %          |
| Impact on fair value of  10% adverse change |       | $                                        | (2,326     | )                                           | $          | (9,442 | ) |
| Impact on fair value of  20% adverse change |       | $                                        | (4,199     | )                                           | $          | (18,579 | ) |
|                                        |       |                                     |       |                                        |       |
| Discount rate                               |       | 10.76                                    | %          | 10.83                                       | %          |
| Impact on fair value of  10% adverse change |       | $                                        | (1,454     | )                                           | $          | (9,177 | ) |
| Impact on fair value of  20% adverse change |       | $                                        | (2,796     | )                                           | $          | (16,194 | ) |

 

The sensitivities above are hypothetical and should be used withcaution.  As the figures indicate,changes in fair value based on a 10% variation in assumptions generally cannotbe extrapolated because the relationship of the change in assumption to thechange in fair value may not be linear. Also, in the table above, the effect of a variation in a particularassumption on the fair value of the available for sale servicing rights iscalculated without changing any other assumption; in reality, changes in onefactor may result in changes in another, which might magnify or counteract thesensitivities.  The analysis aboveexcludes the impact of our hedging activities related to the available for saleservicing rights.

*Derivatives.*The value ofderivatives hedging the MSR portfolio was $4,350 at September 30, 2006 comparedto $23,558 at December 31, 2005, a decrease of $19,208. The derivatives consistprimarily of commitments to purchase mortgage pool securities, options, floors,swaps, swaptions, caps, and floors.  Thevalue of the derivatives hedging the pipeline of MSRs was $1 at September 30,2006 compared to a loss of $993 at December 31, 2005.  The value of our loan commitments for whichthe interest rate is locked (“rate locks”) decreased in value to a gain of $1,167at September 30, 2006 compared to a gain of $1,592 at December 31, 2005, adecrease of $425. Our portfolio of mandatory delivery commitments hedging ourrate locks reflected a loss of $1,612 at September 30, 2006 compared to a lossof $1,081 at December 31, 2005. Both the rate locks and corresponding mandatorydelivery commitments are marked-to-market and reflected in our consolidatedstatement of operations. The value of the mandatory delivery commitmentshedging our inventory of closed loans reflected a loss of $1,991 at September30, 2006 compared to a loss of $2,852 at December 31, 2005, an improvement of$861. Since a portion of the mandatory delivery commitments qualify for hedgeaccounting, a basis adjustment was recorded to our inventory of mortgage loansheld for sale for the effective hedges.

*Liabilities.* Our total liabilitiesdecreased $812,863 during the nine months ended September 30, 2006.  The decrease was primarily related todecreases of $694,207 in other borrowed funds, $58,244 in accounts payable andaccrued liabilities, and $65,531 in deposits. These decreases were partiallyoffset by increases of $6,454 in accrued interest payable and $882 inrepresentations and warranties.  We wereable to reduce other borrowed funds as a result of the decreases in investmentsecurities available for sale, loans held for sale and loans and leasesreceivable during the nine months ended September 30, 2006.

*Deposits.*  Deposits were $2,728,316 at September 30,2006 compared to $2,793,847 at December 31, 2005.  As of September 30, 2006, depositsrepresented 80% of total interest-bearing liabilities (including deposits,other borrowed funds, and subordinated debt) outstanding; Federal Home LoanBank (“FHLB”) advances, warehouse lines of credit, and repurchase agreementsrepresented approximately 19% in the aggregate of total interest bearingliabilities; and subordinated debt was only 1%. We will continue working to expand our relationships with new andexisting customers to increase our deposit base.

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The following tablesummarizes our deposits:
|                                         | ** ** | **As of September 30, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------|------------|--------------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amount**                                       | ** ** | **Percentage**                                  | ** ** | **Weighted  average  interest  rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest rate** | ** ** |
| Non-interest bearing  checking accounts |       | $                                                | 274,868    |                                            | 10.1       | % | — |   | $ | 284,046 |   | 10.2 | % | — |   |
| Interest bearing:                       |       |                                             |       |                                            |       |   |   |   |   |   |   |   |   |
| Checking  accounts                      |       | 207,692                                          |       | 7.6                                             | %          | 0.9 | % | 232,658 |   | 8.3 | % | 0.9 | % |
| Money market                            |       | 702,923                                          |       | 25.8                                            | %          | 3.3 | % | 943,432 |   | 33.8 | % | 3.2 | % |
| Certificate of  deposit under $100      |       | 1,441,885                                        |       | 52.8                                            | %          | 4.7 | % | 1,240,784 |   | 44.4 | % | 4.0 | % |
| Certificate of  deposit over $100       |       | 100,948                                          |       | 3.7                                             | %          | 4.7 | % | 92,927 |   | 3.3 | % | 4.1 | % |
| Total deposits                          |       | $                                                | 2,728,316  |                                            | 100.0      | % |   |   | $ | 2,793,847 |   | 100.0 | % |   |   |

 

*Reservefor Representations and Warranties.*The reserve forrepresentations and warranties is maintained at a level estimated to beadequate to cover future losses on loans which we may be required to repurchaseunder representations and warranties provided to purchasers and insurers ofmortgage loans. We establish the reserve for future losses by reducing currentperiod gain on sale of loans.  Thereserve increased $882 during the nine months ended September 30, 2006.  This increase is primarily attributable to anincrease in provision, partially offset by charges to the reserve relating toprepayments that trigger early prepayment claims by buyers of loans and netcharges on loans repurchased or indemnified under seller representations andwarranties.  The majority of repurchasesoccur during the first 24 months following the date of sale.  We have experienced an increase in thefrequency and severity related to repurchases; however, it is still uncertainwhether this trend will continue or abate. If the trend continues to increase in future periods, it would requireus to continue to provide for losses at higher levels to cover future losses onthe disposition of repurchased loans. 

The Company repurchased approximately $108,307 and $98,031 of unpaidprincipal balances during the nine months ended September 30, 2006 and 2005,respectively. These repurchases were a result of the following: 
|                               | ** ** | **For the nine months ended** | ** ** |
|-------------------------------|------------|---------------------------------------------------|------------|
| ** **                    | ** ** | **Sept. 30, 2006**                      | ** ** | **Sept. 30, 2005** | ** ** |
| Documentation                 |       | $                                                 | 20,317     |   | $ | 42,505 |   |
| Fraudulent  misrepresentation |       | 21,410                                            |       | 22,117 |   |
| Early payment default         |       | 66,580                                            |       | 33,409 |   |
| Total                         |       | $                                                 | 108,307    |   | $ | 98,031 |   |

 

*Documentation.*  Repurchases related to documentation haveincreased in recent years. During the last three years, NetBank producedand sold a large volume of affordable housing program loans to FNMA.  The underwriting and documentationrequirements under such programs are different than with traditionalagency-eligible products in which the Company regularly deals and have resultedin a greater number of documentation deficiencies and consequently an increasein the volume of repurchases. 

*Fraudulentmisrepresentation.* There has been an industry-wide increasein borrower fraud, including borrower misrepresentation of income and assets,and of intent to occupy the real property as a principal residence.  There has, likewise, been a rise in the levelof fraud on the part of other parties to a mortgage transaction includingappraisers, broker and correspondent customers, and real estate agents.  

*Earlypayment default.* As iscustomary in whole loan sales, NetBank provides early payment defaultprotection to the buyers.  All of oursales from our non-conforming channel are whole loan sales.  The increased production in this channel inrecent years has given rise to an increase in repurchase volumes for earlypayment default.  Likewise, commencing in2004 and continuing in 2005 and 2006, our third party conforming channel soldlarger percentages of loans in whole loan sales as opposed to agency mortgagebacked securities, resulting in increases in repurchase volume related to earlypayment default because whole loan buyers are more likely to require sellers torepurchase loans in the case of early payment default.

We are currently in the process of exiting our nonconforming mortgageoperations, which should resolve the issues for this channel goingforward.  We are continuing to enhanceour conforming underwriting processes in an effort to reduce repurchasefrequencies including centralizing our third party conforming channel’sunderwriting functions into one location.  We believe this will allow close monitoringand management of our underwriters and processors.  In addition, we are implementing new softwarepackages to identify potential fraud issues. One software package analyzes the specific borrower informationand compares it to various external databases for validation.  Another software package compares theappraisal value of the property to external sources for comparable values. Additionally, we have

27

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eliminated certain mortgage products with the greatest repurchasefrequency.

The Company had $21.5 million and $20.7 million of reserves forestimated losses on future repurchases as of September 30, 2006 andDecember 31, 2005, respectively. 

*Shareholders’Equity.*  Totalshareholders’ equity decreased $109,581 for the nine months ended September 30,2006.  The decline is primarily due tothe current period’s retained deficit of $117,666.  These changes were partially offset by a$2,163 increase in additional paid in capital, a decline in unearnedcompensation of $1,253, a decrease of $4,655 in accumulated other comprehensiveloss, and a change of $14 in treasury stock. The $117,666 change in retained deficit is primarily the result of thenet loss of $115,668 for the nine months ended September 30, 2006, the paymentof $1,853 of dividends, and $410 of losses on the reissuance of treasury stock,partially offset by a $265 reclassification of unearned compensation uponadoption of SFAS 123(R).  The change intreasury stock is the result of the repurchase of 6,000 shares of common stockoffset by the reissuance of 87,922 shares under the employee stock purchaseplan and 25,515 shares related to option exercises. Further, upon adoption ofSFAS 123(R), we reclassified 107,348 shares of restricted stock granted totreasury stock, net of vested shares.  

**Results of Operations – Threemonths ended September 30, 2006 compared to the three months ended September30, 2005**

*General.* Net loss for the three months ended September 30, 2006 was $73,281 or $1.58 pershare, compared to a net loss of $1,371 or $0.03 per share for the same periodin 2005.  The current quarter wasnegatively impacted by loss on sales of MSRs, loss on sales of investmentsecurities, expenses related to the impairment of goodwill and continueddeclines in gain on sales of mortgage loans. The increase in loss on sales ofMSRs stems from the completion of a bulk sale of our MSRs which was finalizedduring the third quarter.  The bulk saleof MSRs also resulted in increased loss on sales of investment securities thathad been utilized as an on-balance sheet hedge of our MSRs.  Impairment of goodwill expenses increasedrelated to the write down of the goodwill associated with our nonconformingmortgage operations and a partial write down of the goodwill associated withNPS.  Gains on sales of mortgage loansdeclined due to continued high repurchase levels as well as competitivepressures on margins.  

*InterestIncome*.  Our interest income for the three months endedSeptember 30, 2006 was $58,651 compared to $67,256 for the same period in2005.  This decrease is attributed to a$1,111,815 decline in the average balance of interest-earning assets partiallyoffset by a 72-basis point increase in the average yield of interest-earningassets. Reference is made to the rate volume variance table set forth below foradditional detail regarding the changes in interest income.

*InterestExpense*. Total interest expense for the three months endedSeptember 30, 2006 was $37,578 compared to $37,026 for the same period of2005.  The $552 increase is due to an89-basis point increase in the average cost of funds partially offset by a$846,347 decrease in the average balance of interest-bearing liabilities.  For the three months ended September 30,2006, interest expense on deposits increased $4,376 versus the same period in2005 as a result of increases in the average interest rate paid.  For the three months ended September 30,2006, interest expense on other borrowed funds (including short-term debt, FHLBadvances, and convertible subordinated debt) was $13,024 compared to $16,848for the same period of 2005.  The $3,824decrease in interest expense related to other borrowed funds is a result ofdecreases in the average outstanding balance of debt of $629,830.  Reference is made to the rate volume variancetable set forth below for additional detail regarding the changes in interestincome.

*NetInterest Income. *Netinterest income is determined by interest rate spread, which is the differencebetween the yields earned on interest-earning assets and the rates paid oninterest-bearing liabilities, and the relative amounts of interest-earningassets and interest-bearing liabilities. Net interest income was $21,073 or 1.95% of net average interest-earningassets for the three months ended September 30, 2006 compared to $30,230 or2.12% of net average interest-earning assets for the three months endedSeptember 30, 2005.  The 17-basis pointdecline in net interest margin is primarily due to a flattening of the yieldcurve as increases in short-term rates have not carried through to the long endof the yield curve. The rates we pay on our deposits and short-term borrowingsis generally related to the short end of the yield curve; the yield we earn onour mortgage loans held for sale is based primarily on the long end of thecurve.

The following tabledetails the relative interest rates and average balances of our interest-earningassets and interest-bearing liabilities for the three months ended September30, 2006 and 2005:

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| ** **                                  | ** ** | ** **                    | ** ** | ** ** | ** ** | ** **   | ** ** | ** **                          | ** **                                      | ** **               | ** ** | ** ** | ** ** | **Variance** | ** ** |
|---------------------------------------------|------------|-------------------------------|------------|------------|------------|--------------|------------|-------------------------------------|-------------------------------------------------|--------------------------|------------|------------|------------|--------------|------------|
| ** **                                  | ** ** | **Average Yield /** | ** ** | ** ** | ** ** | ** **   | ** ** | ** **                          | ** **                                      | **attributable to** | ** ** |
| **Average Balance**                    | ** ** | **Rate**                      | ** ** | ** ** | ** ** | **Interest** | ** ** | ** **                          | ** **                                      | ** **               | ** ** | **Volume** | ** ** |
| **2006**                                    | ** ** | **2005**                      | ** ** | **2006**   | ** ** | **2005**     | ** ** | ** **                          | ** **                                      | **2006**                 | ** ** | **2005**   | ** ** | **Variance** | ** ** | **Rate** | ** ** | **(3)** | ** ** |
|                                        | ** ** | ** **                    | ** ** | ** ** | ** ** | ** **   | ** ** | **Interest-earning assets:**        | ** **                                      | ** **               | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| $      29,152 |       | $                             | 73,577     |       | 4.94       | %            | 3.60       | %                                   | Short-term investments                          |                     | $          | 360        |       | $            | 662        |   | $ | (302 | ) | $ | 246 |   | $ | (548 | ) |
| 517,654                                     |       | 773,550                       |       | 4.73       | %          | 4.40         | %          | Investment securities  (1)          |                                            | 6,121                    |       | 8,502      |       | (2,381       | )          | 638 |   | (3,019 | ) |
| 1,255,740                                   |       | 1,829,233                     |       | 7.23       | %          | 6.20         | %          | Loans held for sale (2)             |                                            | 22,708                   |       | 28,368     |       | (5,660       | )          | 4,726 |   | (10,386 | ) |
| 1,952,371                                   |       | 2,190,372                     |       | 6.04       | %          | 5.43         | %          | Loans and leases  receivable (2)    |                                            | 29,462                   |       | 29,724     |       | (262         | )          | 3,319 |   | (3,581 | ) |
| 3,754,917                                   |       | 4,866,732                     |       | 6.25       | %          | 5.53         | %          | Total interest-earning  assets      |                                            | 58,651                   |       | 67,256     |       | (8,605       | )          | 8,929 |   | (17,534 | ) |
|                                        |       |                          |       |       |       |         |       |                                |                                            |                     |       |       |       |         |       |   |   |   |   |
|                                        | ** ** | ** **                    | ** ** | ** ** | ** ** | ** **   | ** ** | **Interest-bearing liabilities:**   | ** **                                      | ** **               | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| 206,326                                     |       | 222,697                       |       | 1.49       | %          | 1.44         | %          | Checking accounts                   |                                            | 766                      |       | 804        |       | (38          | )          | 25 |   | (63 | ) |
| 744,251                                     |       | 1,000,906                     |       | 3.14       | %          | 2.65         | %          | Money market                        |                                            | 5,841                    |       | 6,636      |       | (795         | )          | 1,224 |   | (2,019 | ) |
| 1,457,402                                   |       | 1,400,893                     |       | 4.93       | %          | 3.64         | %          | Certificates of deposit             |                                            | 17,947                   |       | 12,738     |       | 5,209        |       | 4,503 |   | 706 |   |
| 629,845                                     |       | 652,829                       |       | 5.61       | %          | 3.78         | %          | Short-term debt                     |                                            | 8,840                    |       | 6,167      |       | 2,673        |       | 2,993 |   | (320 | ) |
| 425,000                                     |       | 1,031,846                     |       | 3.30       | %          | 3.94         | %          | FHLB advances                       |                                            | 3,508                    |       | 10,154     |       | (6,646       | )          | (1,647 | ) | (4,999 | ) |
| 32,477                                      |       | 32,477                        |       | 8.33       | %          | 6.49         | %          | Subordinated debt                   |                                            | 676                      |       | 527        |       | 149          |       | 149 |   | — |   |
| 3,495,301                                   |       | 4,341,648                     |       | 4.30       | %          | 3.41         | %          | Total interest-bearing  liabilities |                                            | 37,578                   |       | 37,026     |       | 552          |       | 7,247 |   | (6,695 | ) |
| —                                      |       | —                        |       | 1.95       | %          | 2.12         | %          | Net interest margin                 |                                            | 21,073                   |       | 30,230     |       | (9,157       | )          | 1,682 |   | (10,839 | ) |
| 259,616                                     |       | 525,084                       |       | 0.29       | %          | 0.36         | %          | Interest free sources               |                                            | —                   |       | —     |       | —       |       | — |   | — |   |
| $ 3,754,917                            |       | $                             | 4,866,732  |       | 2.24       | %            | 2.48       | %                                   | Net interest income to  interest-earning assets |                     | $          | 21,073     |       | $            | 30,230     |   | $ | (9,157 | ) | $ | 1,682 |   | $ | (10,839 | ) |

 

----

(1)           Based on amortizedcost; changes in fair value are not considered.

(2)           Noseparate treatment has been made for non-accrual loans.

(3)           Variances attributableto the rate and volume mix are included in the volume variances.

*Provisionfor Credit Losses.*  The provision for credit losses was$2,407 for the three months ended September 30, 2006 compared to $2,708 for thesame period of 2005.  The decrease inprovision for credit losses relates primarily to the sale of $27,352 of HELOCsduring the third quarter as well as a decrease in the average loans and leasesreceivable balance. Reference is made to the heading “Financial Condition -Asset Quality and Non-performing Assets” above for additional detail concerningthe determination of provision expense related to maintaining the proper levelof allowance for credit losses.

*Non-interestIncome.* Non-interest income declined by $75,745 to aloss of $34,597 for the three months ended September 30, 2006 compared to thesame period of 2005.  We experienced anincrease in losses on sales of MSRs of $29,559 as well as increases in losseson sales of investment securities of $13,461. These increased losses are primarily a result of the bulk sale of$141,755 in MSRs which we completed during the third quarter.  Additionally, gain on sales of loans declined$23,118 during the three months ended September 30, 2006 as compared to thesame period in 2005 primarily due to continued competitive pressures within thesecondary  market and higher repurchasevolumes. 

*Non-interestExpense.*  Non-interest expense includes all operatingexpenses such as salaries and benefits, marketing, and general andadministrative expenses.  Non-interestexpense increased $15,444 for the three months ended September 30, 2006compared to the same period in 2005. This increase was primarily driven by an increase in goodwill impairmentexpenses of $23,187.  The impairmentcharge was partially offset by a decrease of $3,054 in salaries and benefits expensesand a decrease of $2,025 in marketing costs as we strive to tighten expenses.

* Adoption of SFAS 123(R)*.  On January 1, 2006, we adopted SFAS 123(R)using the modified prospective transition method.  Unlike the modified retrospective transitionmethod, the modified prospective transition method has no impact on priorperiod financial statements.  Prior tothe adoption of SFAS 123(R), we accounted for stock based compensation underthe provisions of APB Opinion No. 25, *Accounting for StockIssued to Employees*.  As such,no compensation cost was recognized in the consolidated statement of operationsrelated to the Employee Stock Purchase Plan or options as all options grantedhad an exercise price equal to the market value of the underlying common stockon the grant date.  Compensation expensewas previously recognized related to the Mid-Term Incentive Plan and stockawards.

As a result of theadoption, loss before income taxes for the three months ended September 30,2006 includes $405 of stock based compensation costs.  As of September 30, 2006, there was $5,033 ofunrecognized compensation cost, net of estimated forfeitures, related to stockbased compensation.  This cost isexpected to be recognized over a weighted average period of less than 4 yearson a straight line basis.  TheBlack-Scholes-Merton pricing model was used to calculate the fair value ofstock options and stock grants, and no cumulative effect of accountingadjustment was required.  During 2005, inanticipation of the adoption of SFAS 123(R), we began granting certainemployees a combination of stock options and stock awards as opposed to allstock options, and accelerated the vesting of all options which had a strikeprice in excess of $14.00.  We have noimmediate plans to modify share-based payment arrangements.  See note 9 of the notes to the consolidatedfinancial statements included herein for further information regarding share-based payments, including assigned assumptions.

29

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*RetailBanking Segment.*

The table below providesan overview of the pre-tax results of operations for the retail bankingsegment:
|                                                                                                | ** ** | **For the three months ended September 30,** | ** **    |
|------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------|---------------|
| ** **                                                                                     | ** ** | **2006**                                                                   | ** **    | **2005** | ** ** | **Change** | ** ** |
| Net interest income                                                                            | ** ** | **$**                                                                      | **16,878**    |   | $ | 20,302 |   | $ | (3,424 | ) |
| Provision for credit  losses                                                                   | ** ** | **2,410**                                                                  |          | 2,646 |   | (236 | ) |
| Net interest  income after provision                                                           | ** ** | **14,468**                                                                 |          | 17,656 |   | (3,188 | ) |
| Gains (losses) on sales  of loans                                                              | ** ** | **(33**                                                                    | **)**         | — |   | (33 | ) |
| Fees, charges and other  income                                                                | ** ** | **3,477**                                                                  |          | 3,742 |   | (265 | ) |
| Total banking  revenues                                                                        | ** ** | **17,912**                                                                 |          | 21,398 |   | (3,486 | ) |
| Total banking  expenses                                                                        | ** ** | **16,334**                                                                 |          | 19,427 |   | (3,093 | ) |
| Pre-tax banking  results                                                                       | ** ** | **1,578**                                                                  |          | 1,971 |   | (393 | ) |
| Net QuickPost,  PowerPost and NetServ results                                                  | ** ** | **(3,301**                                                                 | **)**         | (1,501 | ) | (1,800 | ) |
| Pre-tax (loss) income                                                                          | ** ** | **$**                                                                      | **(1,723**    | **)** | $ | 470 |   | $ | (2,193 | ) |
|                                                                                           | ** ** | ** **                                                                 |          |   |   |   |   |
| Average earning assets                                                                         | ** ** | **$**                                                                      | **3,975,800** |   | $ | 4,832,728 |   | $ | (856,928 | ) |
| QuickPost transactions                                                                         | ** ** | **420,381**                                                                |          | 44,136 |   | 376,245 |   |
|                                                                                           |       |                                                                       |          |   |   |   |   |
| **Operations to average earning  assets (excluding QuickPost, PowerPost and NetServ results)** | ** ** | ** **                                                                 | ** **    | ** ** | ** ** | ** ** | ** ** |
| Net interest income  after provision                                                           | ** ** | **1.46**                                                                   | **%**         | 1.46 | % | 0.00 | % |
| Gain on sale, fees,  charges and other income                                                  | ** ** | **0.35**                                                                   | **%**         | 0.31 | % | 0.04 | % |
| Total banking revenues                                                                         | ** ** | **1.81**                                                                   | **%**         | 1.77 | % | 0.04 | % |
| Total banking expenses                                                                         | ** ** | **1.64**                                                                   | **%**         | 1.61 | % | 0.03 | % |
| Pre-tax banking  results                                                                       | ** ** | **0.17**                                                                   | **%**         | 0.16 | % | 0.01 | % |

 

Note: The above tabledisaggregates the results of our QuickPost, PowerPost and NetServ initiatives.

The retail bankingsegment recorded a pre-tax loss of $1,723 in the third quarter of 2006, a$2,193 decrease over the comparable period in 2005. The majority of the declinerelates to several start-up initiatives the company was developing. The companyrecorded a pre-tax loss of $3,301 on these particular services, which includeQuickPost, PowerPost and NetServ.  Asdiscussed within the “Future Outlook” section herein, the Company plans tocease providing these services during the fourth quarter.

The online bank’s resultsdeclined by $670 primarily as a result of a decrease in net interest income of$3,799 offset by a decrease in non-interest expense of $2,985. The decrease innet interest income is attributed to a flattening of the yield curve as adecline in the average balance of interest-earning assets.  QuickPost, PowerPost and NetServ contributedto the segment’s decline with decreased results of $1,800.   

*FinancialIntermediary Segment.*

The followingtable highlights the financial intermediary segment’s pre-tax results andproduction and sales activities:

30

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|                                      | ** ** | **For the three months ended September 30,** | ** **    |
|--------------------------------------|------------|----------------------------------------------------------------------------|---------------|
| ** **                           | ** ** | **2006**                                                                   | ** **    | **2005** | ** ** | **Change** | ** ** |
| Net interest income                  | ** ** | **$**                                                                      | **3,948**     |   | $ | 9,094 |   | $ | (5,146 | ) |
| Gain on sales of loans               | ** ** | **4,396**                                                                  |          | 27,272 |   | (22,876 | ) |
| Loss on sale of MSRs                 | ** ** | **(96**                                                                    | **)**         | (238 | ) | 142 |   |
| Other income                         | ** ** | **272**                                                                    |          | 683 |   | (411 | ) |
| Net Beacon Credit  Services results  | ** ** | **(103**                                                                   | **)**         | (309 | ) | 206 |   |
| Net MG Reinsurance  results          | ** ** | **898**                                                                    |          | 820 |   | 78 |   |
| Total revenues                       | ** ** | **9,315**                                                                  |          | 37,322 |   | (28,007 | ) |
| Salary and employee  benefits        | ** ** | **14,061**                                                                 |          | 18,300 |   | (4,239 | ) |
| Occupancy and  depreciation expense  | ** ** | **6,464**                                                                  |          | 6,830 |   | (366 | ) |
| Other expenses                       | ** ** | **8,824**                                                                  |          | 10,509 |   | (1,685 | ) |
| Impairment of goodwill               | ** ** | **19,505**                                                                 |          | — |   | 19,505 |   |
| Total expenses                       | ** ** | **48,854**                                                                 |          | 35,639 |   | 13,215 |   |
| Pre-tax (loss)  income               | ** ** | **$**                                                                      | **(39,539**   | **)** | $ | 1,683 |   | $ | (41,222 | ) |
|                                 |       |                                                                       |          |   |   |   |   |
| Production                           | ** ** | **$**                                                                      | **2,439,654** |   | $ | 3,764,981 |   | $ | (1,325,327 | ) |
| Sales (includes  intersegment sales) | ** ** | **$**                                                                      | **2,427,891** |   | $ | 3,688,402 |   | $ | (1,260,511 | ) |
|                                 |       |                                                                       |          |   |   |   |   |
| Total revenues to sales              | ** ** | **0.38**                                                                   | **%**         | 1.01 | % | (0.63 | )% |
| Total expenses to  production        | ** ** | **2.00**                                                                   | **%**         | 0.95 | % | 1.05 | % |
| Pre-tax margin                       | ** ** | **(1.62**                                                                  | **)%**        | 0.06 | % | (1.68 | )% |

 

Note: The ratio of revenues to sales is based onmortgage banking sales, which includes intersegment sales to the retail banksegment. The above table disaggregates the results of Beacon Credit Servicesand MG Reinsurance.

For the threemonths ended September 30, 2006, the financial intermediary segment recorded apre-tax loss of $39,539 versus pre-tax income of $1,683 for the same period in2005.  The decline was primarily drivenby the $19,505 expense recorded in the current period for impairment ofgoodwill at our nonconforming operations division.  Gain on the sales of loans decreased by$22,876 due to higher provision levels of $5,280 related to our representationsand warranties on sold loans and a significant decline in sales and relatedmargins.  The remaining decrease isattributable to a decline of $5,146 in net interest income.  Generally, NetBank earns a long-term interestrate on loans held for sale and finances those loans with short-termborrowings.  As the yield curve flattens,the net interest margin compresses.

*Transaction Processing Segment.*

The transaction processing segment provides ATM and merchant processingservices and subservices loans for the retail banking segment, the financialintermediary segment, the servicing asset segment and third-party customers.

The followingtable highlights the results of operations for the transaction processingsegment: 
|                       | ** ** | **For the three months ended Sept. 30,** | ** ** |
|-----------------------|------------|------------------------------------------------------------------------|------------|
| ** **            | ** ** | **2006**                                                               | ** ** | **2005** | ** ** | **Change** | ** ** |
| Total revenue         | ** ** | **$**                                                                  | **5,517**  |   | $ | 6,555 |   | $ | (1,038 | ) |
| Total expenses        | ** ** | **7,894**                                                              |       | 5,440 |   | 2,454 |   |
| Pre-tax (loss) income | ** ** | **$**                                                                  | **(2,377** | **)** | $ | 1,115 |   | $ | (3,492 | ) |

 

For the threemonths ended September 30, 2006, the transaction processing segment recorded apre-tax loss of $2,377 versus pre-tax income of $1,115 for the same period in2005.  The decline was primarily due tothe $3,682 expense related to the partial impairment of goodwill at NPSpartially offset by an increase of $524 in pre-tax income within the servicingfactory.  Although the number of loansserviced or subserviced within the servicing factory declined period overperiod, the pre-tax margin per loan improved by 26 dollars for the three monthsending September 30, 2006.

*Servicing Asset Segment.*

The servicingasset segment manages the MSRs retained by the Company in conjunction with theorigination of mortgage loans or obtained through bulk transactions.  The servicing asset segment recorded apre-tax loss of $51,271 for the three months ended September 30, 2006, a changeof $51,506 from the same period in 2005. The changes were primarily attributable to the loss of

31

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$29,702 recordedon the bulk sale of $141,755 of MSRs during the quarter as well as a $13,461loss on sales of investment securities. The investment securities sold had been utilized as an on-balance sheethedge of the $141,755 of MSRs sold during the period.
|                                | ** ** | **For the three months ended Sept. 30,** | ** **  |
|--------------------------------|------------|------------------------------------------------------------------------|-------------|
| ** **                     | ** ** | **2006**                                                               | ** **  | **2005** | ** ** | **Change** | ** ** |
| Net interest income            | ** ** | **$**                                                                  | **395**     |   | $ | 532 |   | $ | (137 | ) |
| Servicing fees                 | ** ** | **7,095**                                                              |        | 11,052 |   | (3,957 | ) |
| Loss on the sale of  MSRs      | ** ** | **(29,702**                                                            | **)**       | — |   | (29,702 | ) |
| Other income                   | ** ** | **102**                                                                |        | — |   | 102 |   |
| Total revenue                  | ** ** | **(22,110**                                                            | **)**       | 11,584 |   | (33,694 | ) |
| Amortization of MSRs           | ** ** | **6,981**                                                              |        | 12,608 |   | (5,627 | ) |
| Subservicing fees paid         | ** ** | **2,345**                                                              |        | 2,484 |   | (139 | ) |
| Other expenses                 | ** ** | **543**                                                                |        | 1,256 |   | (713 | ) |
| Total expenses                 | ** ** | **9,869**                                                              |        | 16,348 |   | (6,479 | ) |
| Pre-tax  servicing margin      | ** ** | **(31,979**                                                            | **)**       | (4,764 | ) | (27,215 | ) |
| (Loss) gain on  hedges         | ** ** | **(4,357**                                                             | **)**       | 755 |   | (5,112 | ) |
| Loss on sale of  securities    | ** ** | **(13,461**                                                            | **)**       | — |   | (13,461 | ) |
| (Impairment)  recovery of MSRs | ** ** | **(1,474**                                                             | **)**       | 4,244 |   | (5,718 | ) |
| Net hedge  results             | ** ** | **(19,292**                                                            | **)**       | 4,999 |   | (24,291 | ) |
| Net pre-tax  (loss) income     | ** ** | **$**                                                                  | **(51,271** | **)** | $ | 235 |   | $ | (51,506 | ) |

 

*Other/Corporate Overhead Segment.*

Theother/corporate overhead segment contains holding company and overhead expensesalong with the elimination of intersegment gains and losses on loans sold tothe retail banking segment from the financial intermediary segment. Overheadexpenses that are wholly attributable to a line of business are recognizedwithin that business, while overhead expenses that relate to multiple lines ofbusiness are pooled and reported within the other/corporate overheadsegment.  The other/corporate overheadsegment incurred a $7,165 pre-tax loss for the three months ended September 30,2006 compared to a pre-tax loss of $5,533 for the comparable period of2005.  The increased expenses areattributed to the adoption of SFAS 123(R).

**Results of Operations – Ninemonths ended September 30, 2006 compared to the nine months ended September 30,2005**

*General.* Net loss for the nine months ended September 30, 2006 was $115,668 or $2.50 pershare, compared to a net loss of $1,075 or $0.02 per share for the same periodin 2005.  The current period wasnegatively impacted by loss on sales of MSRs, loss on sales of investmentsecurities, expenses related to the impairment of goodwill and continueddeclines in gain on sales of mortgage loans. The increase in loss on sales ofMSRs stems from the completion of a bulk sale of our MSRs which was finalizedduring the third quarter.  The bulk saleof the MSRs also resulted in increased loss on sales of investment securitiesthat had been utilized as an on-balance sheet economic hedge of our MSRs.  Goodwill impairment expenses incurred duringthe period in relation to the goodwill associated with Beacon Credit Services,our nonconforming mortgage operations and NPS. Gain on sales of mortgage loans declined due to continued high repurchaselevels as well as competitive pressures on margins.  

*InterestIncome*.  Our interest income for the nine months endedSeptember 30, 2006 was $188,280 compared to $186,777 for the same period in2005.  This increase was the result ofthe average yield increasing by 66 basis points to 6.13% of interest-earningassets coupled with a decrease of $455,685 in the average balance ofinterest-earning assets.  Reference ismade to the rate volume variance table set forth below for additional detailregarding the changes in interest income.

*InterestExpense*. Total interest expense for the nine months endedSeptember 30, 2006 was $115,552 compared to $94,828 for the same period of2005.  The $20,724 increase is due to a 97-basispoint increase in the average cost of funds partially offset by a decline inthe average balance of interest-bearing liabilities of $312,709.  For the nine months ended September 30, 2006compared to same period of 2005, interest expense on deposits increased $20,575as a result of increases in the average interest rate paid coupled with a$76,512 increase in the average outstanding balance of deposits.  For the nine months ended September 30, 2006,interest expense on other borrowed funds (including short-term debt, FHLBadvances, and convertible subordinated debt) was $45,985 compared to $45,836for the same period of 2005.  The $149increase in interest expense related to other borrowed funds is a result ofincreases in the average cost of funds offset by a decline in the averagebalance of borrowings during the current period.  Reference is made to the rate volume variancetable set forth below for additional detail regarding the changes in interestincome.

*NetInterest Income. *Netinterest income is determined by interest rate spread, which is the differencebetween the yields earned on interest-earning assets and the rates paid oninterest-bearing liabilities, and the relative amounts of interest-earningassets and interest-bearing liabilities. Net interest income was $72,728 or 2.37% of average interest-earningassets for the nine months ended

32

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September 30, 2006compared to $91,949 or 2.69% of average interest-earning assets for the ninemonths ended September 30, 2005.  The32-basis point decline is primarily due to the persistent flattening andinversion of the yield curve during the current period, as recent increases inshort-term rates have not carried through to the long end of the yield curve.The rates we pay on our deposits and short-term borrowings is generally relatedto the short end of the yield curve; whereas the yield we earn on our mortgageloans held for sale is based primarily on the long end of the curve.

The followingtable details the relative interest rates and average balances of ourinterest-earning assets and interest-bearing liabilities for the nine monthsended September 30, 2006 and 2005:
| ** **                                  | ** ** | ** **                   | ** ** | ** ** | ** ** | ** **   | ** ** | ** **                         | ** **                                     | ** **               | ** ** | ** ** | ** ** | **Variance** | ** ** |
|---------------------------------------------|------------|------------------------------|------------|------------|------------|--------------|------------|------------------------------------|------------------------------------------------|--------------------------|------------|------------|------------|--------------|------------|
| ** **                                  | ** ** | **Average Yield ** | ** ** | ** ** | ** ** | ** **   | ** ** | ** **                         | ** **                                     | **attributable to** | ** ** |
| **Average Balance**                    | ** ** | **/ Rate**                   | ** ** | ** ** | ** ** | **Interest** | ** ** | ** **                         | ** **                                     | ** **               | ** ** | **Volume** | ** ** |
| **2006**                                    | ** ** | **2005**                     | ** ** | **2006**   | ** ** | **2005**     | ** ** | ** **                         | ** **                                     | **2006**                 | ** ** | **2005**   | ** ** | **Variance** | ** ** | **Rate** | ** ** | **(3)** | ** ** |
|                                        | ** ** | ** **                   | ** ** | ** ** | ** ** | ** **   | ** ** | Interest-earning assets:           | ** **                                     | ** **               | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| $      34,913 |       | $                            | 64,388     |       | 4.62       | %            | 3.22       | %                                  | Short-term investments                         |                     | $          | 1,209      |       | $            | 1,557      |   | $ | (348 | ) | $ | 451 |   | $ | (799 | ) |
| 636,911                                     |       | 774,585                      |       | 4.74       | %          | 4.50         | %          | Investment securities (1)          |                                           | 22,628                   |       | 26,169     |       | (3,541       | )          | 930 |   | (4,471 | ) |
| 1,325,247                                   |       | 1,567,744                    |       | 7.17       | %          | 6.27         | %          | Loans held for sale (2)            |                                           | 71,289                   |       | 73,746     |       | (2,457       | )          | 7,055 |   | (9,512 | ) |
| 2,098,591                                   |       | 2,144,630                    |       | 5.92       | %          | 5.30         | %          | Loans and leases receivable (2)    |                                           | 93,154                   |       | 85,305     |       | 7,849        |       | 6,648 |   | 1,201 |   |
| 4,095,662                                   |       | 4,551,347                    |       | 6.13       | %          | 5.47         | %          | Total interest-earning assets      |                                           | 188,280                  |       | 186,777    |       | 1,503        |       | 15,084 |   | (13,581 | ) |
|                                        |       |                         |       |       |       |         |       |                               |                                           |                     |       |       |       |         |       |   |   |   |   |
|                                        | ** ** | ** **                   | ** ** | ** ** | ** ** | ** **   | ** ** | **Interest-bearing  liabilities:** | ** **                                     | ** **               | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
| 216,683                                     |       | 229,055                      |       | 1.43       | %          | 1.36         | %          | Checking accounts                  |                                           | 2,320                    |       | 2,331      |       | (11          | )          | 80 |   | (91 | ) |
| 841,833                                     |       | 1,067,639                    |       | 3.12       | %          | 2.33         | %          | Money market                       |                                           | 19,698                   |       | 18,634     |       | 1,064        |       | 4,217 |   | (3,153 | ) |
| 1,403,673                                   |       | 1,088,983                    |       | 4.52       | %          | 3.43         | %          | Certificates of deposit            |                                           | 47,549                   |       | 28,027     |       | 19,522       |       | 5,935 |   | 13,587 |   |
| 858,441                                     |       | 862,439                      |       | 5.07       | %          | 3.36         | %          | Short-term debt                    |                                           | 32,646                   |       | 21,723     |       | 10,923       |       | 7,374 |   | 3,549 |   |
| 470,289                                     |       | 858,491                      |       | 3.24       | %          | 3.53         | %          | FHLB advances                      |                                           | 11,428                   |       | 22,753     |       | (11,325      | )          | (1,245 | ) | (10,080 | ) |
| 32,477                                      |       | 29,498                       |       | 7.85       | %          | 6.15         | %          | Subordinated debt                  |                                           | 1,911                    |       | 1,360      |       | 551          |       | 251 |   | 300 |   |
| 3,823,396                                   |       | 4,136,105                    |       | 4.03       | %          | 3.06         | %          | Total interest-bearing liabilities |                                           | 115,552                  |       | 94,828     |       | 20,724       |       | 16,612 |   | 4,112 |   |
|                                        |       |                         |       |       |       |         |       |                               |                                           |                     |       |       |       |         |       |   |   |   |   |
| —                                      |       | —                       |       | 2.10       | %          | 2.41         | %          | Net interest margin                |                                           | 72,728                   |       | 91,949     |       | (9,221       | )          | (1,528 | ) | (17,693 | ) |
| 272,266                                     |       | 415,242                      |       | 0.27       | %          | 0.28         | %          | Interest free sources              |                                           | —                   |       | —     |       | —       |       | — |   | — |   |
| $ 4,095,662                            |       | $                            | 4,551,347  |       | 2.37       | %            | 2.69       | %                                  | Net interest income to interest-earning assets |                     | $          | 72,728     |       | $            | 91,949     |   | $ | (19,221 | ) | $ | (1,528 | ) | $ | (17,693 | ) |

 

 

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(1)           Based on amortizedcost; changes in fair value are not considered.

(2)           Noseparate treatment has been made for non-accrual loans.

(3)           Variances attributableto the rate and volume mix are included in the volume variances.

*Provisionfor Credit Losses.*  The provision for credit losses was$6,483 for the nine months ended September 30, 2006 compared to $7,389 for thesame period of 2005.  The decrease inprovision for credit losses relates primarily to HELOC sales during the currentperiod, partially offset by continued retention of auto loans and businessfinancing leases compared to the 2005 period. Reference is made to the heading“Financial Condition - Asset Quality and Non-performing Assets” above foradditional detail concerning the determination of provision expense related tomaintaining the proper level of allowance for credit losses.

*Non-interestIncome.* Non-interest income declined by $115,508 to$1,342 for the nine months ended September 30, 2006 compared to the same periodof 2005.  During the current period, weexperienced increased losses on derivatives of $15,670, a decline in gains onsales of loans of $42,437, and an increase in loss on sales of MSRs of $29,648,which includes the loss of $29,702 on the bulk sale of MSRs during the thirdquarter of 2006. The decline in gains on sales of loans primarily reflectsincreased provision levels related to representations and warranties on loanssold.  Additionally, we experiencedincreased impairment charges to our of MSRs of $10,604 as well as a decline ingains on sales of investment securities of $17,643, both of which contributedto the decline in non-interest income. The decline in gains on sales of investment securities for the currentperiod includes a $13,461 loss incurred on the sales of certain investmentsecurities that had been used as an on-balance sheet economic hedge against theMSRs that were sold.

*Non-interest Expense.* Non-interest expense includes all operating expenses such as salaries and benefits,marketing, and general and administrative expenses.  Non-interest expense increased $31,725 forthe nine months ended September 30, 2006, which is primarily attributable toincreases in impairment of goodwill of $29,545 during the current period, aswell as the adoption of SFAS 123(R).  

*Adoptionof SFAS 123(R)*.  OnJanuary 1, 2006, we adopted SFAS 123(R) using the modified prospectivetransition method.  Unlike the modifiedretrospective transition method, the modified prospective transition method hasno impact on prior period financial statements. Prior to the adoption of SFAS 123(R), we accounted for stock basedcompensation under the provisions of APB Opinion

33

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No. 25, *Accounting for Stock Issued to Employees*.  As such, no compensation cost was recognizedin the consolidated statement of operations related to the Employee StockPurchase Plan or options as all options granted had an exercise price equal tothe market value of the underlying common stock on the grant date.  Compensation expense was previouslyrecognized related to the Mid-Term Incentive Plan and stock awards.

As a result of theadoption, loss before income taxes for the nine months ended September 30, 2006includes $2,787 of stock based compensation costs.  As of September 30, 2006, there was $5,033 ofunrecognized compensation cost, net of estimated forfeitures, related to stockbased compensation.  This cost isexpected to be recognized over a weighted average period of less than 4 yearson a straight line basis.  TheBlack-Scholes-Merton pricing model was used to calculate the fair value ofstock options and stock grants, and no cumulative effect of accountingadjustment was required.  In anticipationof the adoption of SFAS123(R), we began granting certain employees a combinationof stock options and stock awards as opposed to all stock options, andaccelerated the vesting of all options which had a strike price in excess of$14.00.  We have no immediate plans tomodify share based payment arrangements. See note 9 of the notes to the consolidated financial statementsincluded herein for further information regarding share based paymentsincluding assigned assumptions.

*RetailBanking Segment.*

The table below providesan overview of the pre-tax results of operations for the retail bankingsegment:
|                                                                                                | ** ** | **For the nine months ended September 30,** | ** **    |
|------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------|---------------|
| ** **                                                                                     | ** ** | **2006**                                                                  | ** **    | **2005** | ** ** | **Change** | ** ** |
| Net interest income                                                                            | ** ** | **$**                                                                     | **56,153**    |   | $ | 61,728 |   | $ | (5,575 | ) |
| Provision for credit  losses                                                                   | ** ** | **6,381**                                                                 |          | 7,298 |   | (917 | ) |
| Net interest  income after provision                                                           | ** ** | **49,772**                                                                |          | 54,430 |   | (4,658 | ) |
| Gain on sales of loans                                                                         | ** ** | **275**                                                                   |          | 501 |   | (226 | ) |
| Fees, charges and other  income                                                                | ** ** | **10,499**                                                                |          | 10,860 |   | (361 | ) |
| Total banking  revenues                                                                        | ** ** | **60,546**                                                                |          | 65,791 |   | (5,245 | ) |
| Total banking  expenses                                                                        | ** ** | **51,414**                                                                |          | 55,082 |   | (3,668 | ) |
| Pre-tax banking  results                                                                       | ** ** | **9,132**                                                                 |          | 10,709 |   | (1,577 | ) |
| Net QuickPost,  PowerPost and NetServ results                                                  | ** ** | **(8,382**                                                                | **)**         | (1,501 | ) | (6,881 | ) |
| Pre-tax income                                                                                 | ** ** | **$**                                                                     | **750**       |   | $ | 9,208 |   | $ | (8,458 | ) |
|                                                                                           |       |                                                                      |          |   |   |   |   |
| Average earning assets                                                                         | ** ** | **$**                                                                     | **4,307,633** |   | $ | 4,544,792 |   | $ | (237,159 | ) |
|                                                                                           |       |                                                                      |          |   |   |   |   |
| **Operations to average earning  assets (excluding QuickPost, PowerPost and NetServ results)** | ** ** | ** **                                                                | ** **    | ** ** | ** ** | ** ** | ** ** |
| Net interest income  after provision                                                           | ** ** | **1.54**                                                                  | **%**         | 1.60 | % | (0.06 | )% |
| Gain on sale, fees,  charges and other income                                                  | ** ** | **0.33**                                                                  | **%**         | 0.33 | % | 0.00 | % |
| Total banking revenues                                                                         | ** ** | **1.87**                                                                  | **%**         | 1.93 | % | (0.06 | )% |
| Total banking expenses                                                                         | ** ** | **1.59**                                                                  | **%**         | 1.62 | % | 0.03 | % |
| Pre-tax banking  results                                                                       | ** ** | **0.28**                                                                  | **%**         | 0.31 | % | (0.03 | )% |

 

Note: The above tabledisaggregates the results of our QuickPost, PowerPost and NetServ initiatives.

The retail bankingsegment recorded pre-tax income of $750 for the nine months ended September 30,2006, a $8,458 decrease over the comparable period in 2005. The majority of thedecline relates to several start-up transaction processing initiatives thecompany was developing. The company recorded a pre-tax loss of $8,382 on theseparticular services, which include QuickPost, PowerPost and NetServ. Asdiscussed within the “Future Outlook” section herein, the Company plans tocease providing these services during the fourth quarter.

Also contributing to thedecrease in pre-tax income for the segment was a decline in net interest incomethat is attributed to a continued flattening and inversion of the yield curveduring the current period.

*FinancialIntermediary Segment.*

The followingtable highlights the financial intermediary segment’s pre-tax results andproduction and sales activities:

34

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|                                      | ** ** | **For the nine months ended September 30,** | ** **    |
|--------------------------------------|------------|---------------------------------------------------------------------------|---------------|
| ** **                           | ** ** | **2006**                                                                  | ** **    | **2005** | ** ** | **Change** | ** ** |
| Net interest income                  | ** ** | **$**                                                                     | **15,422**    |   | $ | 28,887 |   | $ | (13,465 | ) |
| Gain on sales of loans               | ** ** | **38,019**                                                                |          | 79,593 |   | (41,574 | ) |
| Loss on sales of MSRs                | ** ** | **(395**                                                                  | **)**         | (448 | ) | 53 |   |
| Other income                         | ** ** | **1,691**                                                                 |          | 2,478 |   | (787 | ) |
| Net Beacon Credit  Services results  | ** ** | **(6,721**                                                                | **)**         | (1,106 | ) | (5,615 | ) |
| Net MG Reinsurance  results          | ** ** | **2,376**                                                                 |          | 2,543 |   | (167 | ) |
| Total revenues                       | ** ** | **50,392**                                                                |          | 111,947 |   | (61,555 | ) |
| Salary and employee  benefits        | ** ** | **50,377**                                                                |          | 53,770 |   | (3,393 | ) |
| Occupancy and  depreciation expense  | ** ** | **18,807**                                                                |          | 19,556 |   | (749 | ) |
| Impairment of goodwill               | ** ** | **19,505**                                                                |          | — |   | 19,505 |   |
| Other expenses                       | ** ** | **28,141**                                                                |          | 29,098 |   | (957 | ) |
| Total expenses                       | ** ** | **116,830**                                                               |          | 102,424 |   | 14,406 |   |
| Pre-tax (loss)  income               | ** ** | **$**                                                                     | **(66,438**   | **)** | $ | 9,523 |   | $ | (75,961 | ) |
|                                 |       |                                                                      |          |   |   |   |   |
| Production                           | ** ** | **$**                                                                     | **7,837,643** |   | $ | 9,997,089 |   | $ | (2,159,446 | ) |
| Sales (includes  intersegment sales) | ** ** | **$**                                                                     | **7,816,941** |   | $ | 9,587,167 |   | $ | (1,770,226 | ) |
|                                 |       |                                                                      |          |   |   |   |   |
| Total revenues to sales              | ** ** | **0.64**                                                                  | **%**         | 1.17 | % | (0.53 | )% |
| Total expenses to  production        | ** ** | **1.49**                                                                  | **%**         | 1.02 | % | 0.47 | % |
| Pre-tax margin                       | ** ** | **(0.85**                                                                 | **)%**        | 0.15 | % | (1.00 | )% |

 

Note: The ratio of revenues to sales is based onmortgage banking sales, which includes intersegment sales to the retail banksegment. The above table disaggregates the results of Beacon Credit Servicesand MG Reinsurance.

For the ninemonths ended September 30, 2006, the financial intermediary segment had apre-tax loss of $66,438 versus pre-tax income of $9,523 for the same period in2005.  A decrease in net interest incomeof $13,465 contributed to the decline. Generally, NetBank earns a long-term interest rate on loans held forsale and finances those loans with short-term borrowings.  As the yield curve flattens, the net interestmargin compresses.  The financialintermediary segment was also subject to decreased gain on sales of loans of$41,574, which also contributed to the decline. This decrease in gain on sales is primarily the results of increasedprovisions during the current period, which resulted from repurchaseobligations related to our representations and warranties on sold loans.  Additionally, gains on sales of loans wereimpacted by the $1,770 decline in sales period over period.  Furthermore, segment results were impacted byimpairment of goodwill expenses of $6,358 related to Beacon Credit Services and$19,505 related to our nonconforming mortgage operations recorded during thecurrent period. 

*TransactionProcessing Segment.*

The transaction processing segment provides ATM and merchant processingservices and subservices loans for the retail banking segment, the financialintermediary segment, the servicing asset segment and third party customers.

The followingtable highlights the results of operations for the transaction processingsegment: 
|                       | ** ** | **For the nine months ended Sept. 30,** | ** ** |
|-----------------------|------------|-----------------------------------------------------------------------|------------|
| ** **            | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **Change** | ** ** |
| Total revenues        | ** ** | **$**                                                                 | **16,915** |   | $ | 19,783 |   | $ | (2,868 | ) |
| Total expenses        | ** ** | **17,163**                                                            |       | 15,085 |   | (2,078 | ) |
| Pre-tax (loss) income | ** ** | **$**                                                                 | **(248**   | **)** | $ | 4,698 |   | $ | (4,946 | ) |

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For the nine months endedSeptember 30, 2006, the transaction processing segment recorded a pre-tax lossof $248 versus pre-tax income of $4,698 in the prior period. The reduction inpre-tax income was primarily due to the decline in pre-tax results at NPS of$5,600 partially offset by an increase in results of $654 within the servicingfactory.  The current period resultsinclude an impairment of goodwill expense of $3,682 at NPS.  Although the number of loans serviced withinthe servicing factory has declined, the pre-tax margin per loan has improved by44 dollars for the nine months ending September 30, 2006.

*ServicingAsset Segment.*

The servicingasset segment manages the MSRs retained by the Company in conjunction with theorigination of mortgage loans or obtained through bulk transactions.  The servicing asset segment recorded apre-tax loss of $73,750 for the nine months ended September 30, 2006, a declineof $68,556 from the same period in 2005. The changes were primarily attributable to the loss of $29,702 sustainedon the bulk sale of $141,755 of MSRs during the current period, as well as the$43,956 decline in net hedge results period over period. The net hedge resultsfor the current period include a $13,461 loss incurred on the sales of certaininvestment securities that had been used as an on-balance sheet economic hedgeagainst the MSRs that were sold.
|                                | ** ** | **For the nine months ended Sept. 30,** | ** ** |
|--------------------------------|------------|-----------------------------------------------------------------------|------------|
| ** **                     | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **Change** | ** ** |
| Net interest income            |       | $                                                                     | 1,608      |   | $ | 675 |   | $ | 933 |   |
| Servicing fees                 |       | 27,396                                                                |       | 31,737 |   | (4,341 | ) |
| Loss on sale of MSRs           |       | (29,702                                                               | )          | — |   | (29,702 | ) |
| Other income                   |       | 165                                                                   |       | 150 |   | 15 |   |
| Total revenue                  |       | (533                                                                  | )          | 32,562 |   | (33,095 | ) |
| Amortization of MSRs           |       | 27,418                                                                |       | 34,480 |   | (7,062 | ) |
| Subservicing fees paid         |       | 7,257                                                                 |       | 7,232 |   | 25 |   |
| Other expenses                 |       | 1,882                                                                 |       | 3,340 |   | (1,458 | ) |
| Total expenses                 |       | 36,557                                                                |       | 45,052 |   | (8,495 | ) |
| Pre-tax  servicing margin      |       | (37,090                                                               | )          | (12,490 | ) | (24,600 | ) |
| (Loss) gain on  hedges         |       | (15,819                                                               | )          | 4,072 |   | (19,891 | ) |
| Loss on sale of  securities    |       | (13,461                                                               | )          | — |   | (13,461 | ) |
| (Impairment) recovery  of MSRs |       | (7,380                                                                | )          | 3,224 |   | (10,604 | ) |
| Net hedge  results             |       | (36,660                                                               | )          | 7,296 |   | (43,956 | ) |
| Net pre-tax loss               |       | $                                                                     | (73,750    | ) | $ | (5,194 | ) | $ | (68,556 | ) |

 

*Other/CorporateOverhead Segment.*

Theother/corporate overhead segment contains holding company and overhead expensesalong with the elimination of inter-segment gains and losses on loans sold tothe retail banking segment from the financial intermediary segment. Overheadexpenses that are wholly attributable to a line of business are recognizedwithin that business, while overhead expenses that relate to multiple lines ofbusiness are pooled and reported within the other/corporate overheadsegment.  The other/corporate overheadsegment incurred a $27,145 pre-tax loss for the nine months ended September 30,2006 compared to a pre-tax loss of $19,518 for the comparable period of2005.  The $7,627 change reflectsincreased amortization expenses as well as increased salaries and benefitscosts.  Salaries and benefits costs haveincreased primarily due to the adoption of SFAS 123(R). 

# **Critical Accounting Policies**

Senior management, in conjunction with the Audit Committee of the Boardof Directors, has identified valuation of the MSR portfolio, determination ofthe allowance for credit losses, liabilities for representations and warrantieson loans and MSRs sold and accounting for derivative financial instruments asour most critical accounting policies. These policies were identified asbeing the most critical based on the SEC’s guidance in identifying them basedon whether 1) the accounting estimate required management to make assumptionsabout matters that were highly uncertain at the time the accounting estimatewas made and 2) different estimates reasonably could have been used in thecurrent period, or changes in the accounting estimate that are reasonablylikely to occur from period to period, would have a material impact on thepresentation of the financial condition or results of operations. Managementbelieves that given current information, its judgments, estimates andassumptions used in these policies are appropriate.  For further information regarding ourcritical accounting policies, refer to the heading “Critical AccountingPolicies” on page 60 of our 2005 Form 10-K.

36

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**ContractualObligations and Off-Balance Sheet Arrangements**

In the normal course of business, we have contractual obligations tomake scheduled payments for our operating leases; our liability to repurchaseloans under representations and warranties provided to purchasers of ourmortgage loans and MSRs; and principal and interest payments on borrowed funds.We are not a party to any off-balance sheet financing arrangements and do nothold unconsolidated interests in any variable interest entities that could giverise to future contractual obligations. For information as of December 31, 2005regarding the schedule of amounts contractually due, please refer to thediscussion under the heading “Contractual Obligations and Off-Balance SheetArrangements” on page 62 of our 2005 Form 10-K.

# **Liquidity and Capital Resources**

*Liquidity. *NetBank’s liquidity, represented by cash and cashequivalents, is a product of its operating, investing, and financingactivities.  Our primary sources of fundsare deposits, borrowings, prepayments and maturities of outstanding loans,sales of loans, sales or maturities of investment securities and othershort-term investments, and funds provided from operations.  While scheduled loan payments and maturinginvestment securities and short-term investments are relatively predictablesources of funds, deposit flows and loan prepayments are greatly influenced bygeneral interest rates, economic conditions, and competition. We can use cashgenerated through the retail deposit market, our traditional funding source, tooffset the cash utilized in investing activities.  Our available for sale securities andshort-term interest-earning assets can also be used to provide liquidity forlending and other operational requirements. Net cash inflows for the nine months ended September 30, 2006 were$219,719 compared to net cash inflows of $152,018 for the same period in2005.  The change in the 2006 periodprimarily related to a $131,243 increase in proceeds from sales of loan andlease receivables, a $212,428 decrease in originations and purchases of loanand lease receivables, and a $2,222,580 decrease in originations of loans heldfor sale during the period. Our cash inflows were partially offset by increasesin net repayments of other borrowed funds of $826,734.

As an additional source of funds, NetBank, Inc. had available underexisting line of credit agreements $1 billion at September 30, 2006.  Reference is made to note 8 of the notes toconsolidated financial statements included in this report for additionaldetails regarding the available lines of credit.

We use deposits as our principal source offunds.  For the nine months endedSeptember 30, 2006, deposits decreased by $66 to $2.728 billion from $2.794billion as of December 31, 2005.  Ourdeposit products include checking, money market and certificates of depositaccounts.  Deposit account terms vary,with the principal differences being the minimum balance required, the timeperiods the funds must remain on deposit, and the interest rate.  We are competitive in the types of accounts,services and ranges of interest rates offered on deposit products.  Although market demand generally dictateswhich deposit maturities and rates will be accepted by the public, we intend tocontinue to promote checking, money market and certificates of deposit to theextent possible consistent with asset and liability management goals.

*Capital Resources.*NetBank and NetBank, FSB are subject to various regulatory capitalrequirements administered by the federal banking agencies, including theOTS.   Failure of either company to meetminimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on our consolidated financial statements. Undercapital adequacy guidelines and the regulatory framework for prompt correctiveaction, NetBank, FSB must meet specific capital guidelines that involvequantitative measures of NetBank, FSB’s assets, liabilities, and certainoff-balance sheet items as calculated under regulatory accounting practices.NetBank, FSB’s capital amounts and classifications are also subject toqualitative judgments by the regulators about components, risk weightings andother factors. Under current regulatory guidelines, NetBank, FSB may not make acapital distribution to the Company without prior approval of the OTS. Currentguidelines require, among other things, that NetBank, FSB not make anunapproved capital distribution in excess of its current period year-to-dateundistributed earnings plus the preceding two years undistributed earnings andin no event make a distribution which would cause NetBank, FSB to be less thanadequately capitalized as defined below.

Quantitative measures established by regulation to ensure capitaladequacy require NetBank, FSB to maintain minimum amounts and ratios as setforth in the following table. The OTS requires NetBank, FSB to maintain minimumratios of tangible capital to tangible assets of 1.5%, core capital to tangibleassets of 4.0% and total capital to risk-weighted assets of 8.0%.  The following table presents informationrelated to NetBank, FSB along with capital requirements mandated by the OTS:

37

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|                                              | ** ** | **Actual** | ** ** | **For capital adequacy  purposes** | ** ** | **To be categorized as Well  Capitalized under prompt  corrective action plan** | ** ** |
|----------------------------------------------|------------|------------|------------|----------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                   | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                                              | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **September  30, 2006**                      | ** ** | ** ** | ** ** | ** **                                   | ** ** | ** **                                                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total capital  (to risk-weighted assets)     |       | $          | 270,688    |                                         | 10.13      | %                                                                                                                       | $          | 225,181 |   | 8.00 | % | $ | 267,227 |   | 10.00 | % |
| Core capital (to  adjusted total assets)     |       | $          | 244,211    |                                         | 6.38       | %                                                                                                                       | $          | 153,108 |   | 4.00 | % | $ | 191,385 |   | 5.00 | % |
| Tangible capital  (to adjusted total assets) |       | $          | 244,211    |                                         | 6.38       | %                                                                                                                       | $          | 57,416 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital  (to risk-weighted assets)    |       | $          | 244,211    |                                         | 9.14       | %                                                                                                                       | N/A        |   | N/A |   | $ | 160,336 |   | 6.00 | % |
| **December  31, 2005**                       | ** ** | ** ** | ** ** | ** **                                   | ** ** | ** **                                                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total capital  (to risk-weighted assets)     |       | $          | 330,510    |                                         | 10.32      | %                                                                                                                       | $          | 256,277 |   | 8.00 | % | $ | 320,346 |   | 10.00 | % |
| Core capital (to  adjusted total assets)     |       | $          | 302,909    |                                         | 6.51       | %                                                                                                                       | $          | 186,257 |   | 4.00 | % | $ | 232,821 |   | 5.00 | % |
| Tangible capital  (to adjusted total assets) |       | $          | 302,909    |                                         | 6.51       | %                                                                                                                       | $          | 69,846 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital (to  risk-weighted assets)    |       | $          | 302,909    |                                         | 9.46       | %                                                                                                                       | N/A        |   | N/A |   | $ | 192,208 |   | 6.00 | % |

 

# In addition,NetBank’s subsidiaries engaged in mortgage banking must adhere to various U.S.Department of Housing and Urban Development (“HUD”) regulatory guidelinesincluding required minimum net worth to maintain their FHA approved lendingstatus.  Failure to comply with the HUDguidelines could result in withdrawal of this certification.  As of September 30, 2006, Market Street andMeritage were in compliance with HUD guidelines.  NetBank and its subsidiaries are subject tovarious other capital requirements by secondary market investors andstates.  None of these capitalrequirements are more stringent than the OTS capital requirements.  Failure to comply with these restrictionscould have a material adverse impact on the Company’s results ofoperations.  All of the capitalrequirements placed upon NetBank and its subsidiaries were met as of September30, 2006.

# **Item 3. Quantitative andQualitative Disclosures about Market Risk**

Our principal businessesare retail banking and the origination and purchase of loans as well providingbusiness equipment financing leases. These businesses are funded by customerdeposits and, to the extent necessary, other borrowed funds. Consequently, asignificant portion of our assets and liabilities are monetary in nature andfluctuations in interest rates will affect future net interest income and cashflows. Interest rate risk is our primary market risk exposure. For the ninemonths ended September 30, 2006, the only derivative financial instruments thatwe entered into were associated with hedging activities related to theportfolio of mortgage loans held for sale, the pipeline of mortgage loans forwhich the interest rate has been locked, the owned MSRs portfolio and the MSRsassociated with the pipeline of mortgage loans for which the interest rate hasalready been locked. Our exposure to market risk is reviewed on a regular basisby management.

 

Reference is made to Item7A. Quantative and Qualitative Disclosures About Market Risk on page 75 of our2005 Form 10-K for additional details regarding the Company’s exposure tomanagement of market risk.  

 

NetBank, FSB, like othersavings banks, measures interest rate risk based on a Net Portfolio Value(“NPV”) analysis. NPV equals the present value of expected net cash flows fromexisting assets minus the present value of expected net cash flows fromexisting liabilities. An NPV ratio is determined by dividing NPV by the presentvalue of assets. The following table sets forth the estimated NetBank, FSB NPVratios as of September 30, 2006, December 31, 2005, and September 30, 2005assuming rate shocks of +300 to -100 basis points:

##### **Limits and currentNPV ratios for NetBank, FSB**

| Rate shock  (in basis points) | ** ** | **As of  Sept. 30, 2006** | ** ** | **As of  Dec. 31, 2005** | ** ** | **As of  Sept. 30, 2005** | ** ** | **Minimum as of  Sept. 30, 2006** | ** ** |
|----------------------------------------------|------------|------------------------------------------|------------|-----------------------------------------|------------|------------------------------------------|------------|-------------------------------------------------------|------------|
| **+300**                                     |       | 8.68                                     | %          | 7.35                                    | %          | 7.02                                     | %          | 4.00                                                  | %          |
| **+200**                                     |       | 8.76                                     | %          | 7.93                                    | %          | 7.55                                     | %          | 6.00                                                  | %          |
| **+100**                                     |       | 8.85                                     | %          | 8.51                                    | %          | 8.03                                     | %          | 6.00                                                  | %          |
| **Flat**                                     |       | 8.94                                     | %          | 9.01                                    | %          | 8.39                                     | %          | 6.00                                                  | %          |
| **-100**                                     |       | 8.98                                     | %          | 9.55                                    | %          | 8.77                                     | %          | 6.00                                                  | %          |

 

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Minimum ratios for NPV risk are established by the Board of Directorsas prudent levels for the respective interest rate scenarios. Lower NPV ratiosdenote more market rate sensitivity for a given rate scenario.  As of September 30, 2006, the analysisindicates sensitivity to rising market interest rates.  This sensitivity is, however, well within theBoard approved limits for these scenarios. Computation of prospective effects of hypothetical rate changes is basedon many assumptions, including relative levels of market interest rates, loanprepayments and deposit decay. They should not be relied upon as indicative ofactual results. Further, the computations do not contemplate certain actionsmanagement could undertake in response to changes in interest rates.

**Item 4. Controls and Procedures**

**Management’s Conclusion on the Effectiveness of Disclosure Controls andProcedures**

*Evaluation of Disclosure Controls and Procedures*. We evaluated the effectiveness of thedesign and operation of our “disclosure controls and procedures,” as defined inRule 13a-15(e) under the Securities Exchange Act of 1934, as amended (the“Exchange Act”), as of the end of the period covered by this report. Thisevaluation (the “controls evaluation”) was done under the supervision and withthe participation of management, including our chief executive officer (“CEO”)and chief financial executive (“CFO”).

*Objectives of Controls*. Disclosure controls and procedures are designed so that informationrequired to be disclosed in our reports filed under the Exchange Act, such asthis quarterly report on Form 10-Q, is recorded, processed, summarized andreported within the time periods specified in the SEC’s rules and forms.Disclosure controls and procedures are also intended to ensure that suchinformation is accumulated and communicated to our management, including theCEO and CFO, as appropriate to allow timely decisions regarding requireddisclosure. In designing and evaluating disclosure controls and procedures,management recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving thedesired control objectives, and management is required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.

*Conclusions*.Based upon the controls evaluation, our CEO and CFO have concluded that as ofSeptember 30, 2006, our disclosure controls and procedures are effective toprovide reasonable assurance that the foregoing objectives are achieved.

*Changes in Internal Control over Financial Reporting*.  Therewere no changes in our internal control over financial reporting, as defined inRule 13a-15(f) under the Exchange Act, during the period covered by this reportthat have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

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# **PART II.  Other Information**

# **Item 1.  Legal Proceedings**

*Illinois Union Insurance Co. v. Commercial Money Center, Inc., etal., Case No. CV-01-0685-KJD-RJJ (District Court ofNevada)*and relatedcases now pending in *In re Commercial MoneyCenter, Inc. Equipment Lease Litigation in the United States DistrictCourt for the Northern District of Ohio, Eastern Division, MDL CaseNo. 1:02-CV-16000*; the pending bankruptcy cases ofCommercial Money Center, Inc. and Commercial Servicing Corporation titled *In re: Commercial Money Center, Inc. and Commercial ServicingCorporation*, Bankruptcy No. 02-09721-H7 (JointlyAdministered), United States Bankruptcy Court For The Southern District ofCalifornia; and *In re Commercial Money Center, Inc.,Debtor (Kipperman v. NetBank, FSB)*, Adversary Proceeding No. 03-90331-JH,In the United States Bankruptcy Court for the Southern District of California, *appeal**pending**NetBank, F.S.B. v. Richard M. Kipperman, Chapter 7 Trustee for theBankruptcy Estates of Commercial Money Centers, Inc. and CommercialServicing Corporation v. NetBank, F.S.B*, United States BankruptcyAppellate Panel of the Ninth Circuit; BAP No. SC-05-1238

As reported in previous filings, NetBank, FSB, fileda complaint in January 2002 against Commercial Money Center, Inc.(“CMC”), Illinois Union Insurance Company (“Illinois Union”), Safeco InsuranceCompany of America (“Safeco”), and Royal Indemnity Company (“Royal,” andtogether with Illinois Union, Safeco and Royal, collectively referred to as the“Sureties”). CMC was the originator and subservicer of various equipment leases(the “Leases”). NetBank, FSB purchased most of the payment streams generated bythe subject Leases from CMC (the “Payment Streams”). The Sureties are insurancecompanies that issued surety bonds and insurance policies guaranteeing paymentof the Payment Streams (the “Bonds”) and that also served as master servicersof the leases. The NetBank, FSB action alleges several claims, including claimsfor breach of contract, fraud, and bad faith, and seeks, among other things,payment under and enforcement of the Bonds. The Judicial Panel onMulti-District Litigation (the “MDL Judicial Panel”) consolidated the actionsinvolving NetBank, FSB with more than 35 other cases pending around the countryinvolving other banks and financial institutions that were seeking to enforcesurety bonds and insurance policies relating to payment streams sold by CMC.All pre-trial activity is currently being held in the United States DistrictCourt for the Northern District of Ohio (the “MDL Court”).

As reported in previous filings, NetBank, FSB hadjoined with the other claimants (the “Claimants”) in a motion for judgment onthe pleadings (“Consolidated Motion for Judgment on the Pleadings” or“Consolidated Motion”), which motion was filed on January 31, 2003.NetBank, FSB later withdrew its motion for judgment on the pleadings and onMarch 25, 2005 filed a Motion for Partial Summary Judgment (the “SummaryJudgment Motion”) or, in the alternative, a Motion for Suggestion of Remand(the “Remand Motion”). The Summary Judgment Motion seeks judgment as a matterof law on NetBank, FSB’s breach of contract claims. The Remand Motion requestedthat, in lieu of deciding the Summary Judgment Motion, the MDL Court insteadsuggest to the MDL Judicial Panel that the claims of NetBank, FSB be remandedto the United States District Court for the District of Nevada. The Suretiesfiled oppositions to the Remand Motion, and they have argued that they do notneed to respond to the Summary Judgment Motion until an unspecified date in thefuture after the MDL Court rules on the pending Consolidated Motion forJudgment on the Pleadings. The MDL Court denied the Remand Motion, and, as aresult of subsequent rulings described below, the MDL Court deemed the SummaryJudgment Motion withdrawn without prejudice to the filing of a new SummaryJudgment Motion in early 2007, following the close of expert discovery.

OnAugust 19, 2005, the MDL Court entered two orders on the Claimants’Consolidated Motion for Judgment on the Pleadings. The Court granted theClaimants’ motion with respect to Illinois Union Insurance Company (the“Illinois Union Order”), finding that Illinois Union was liable as a matter oflaw under the bonds that it issued and could not assert fraud of CMC as adefense. Because NetBank, FSB had previously withdrawn from the ConsolidatedMotion in order to file the Summary Judgment Motion, the MDL Court held thatNetBank could file a motion to renew its interest in the Consolidated Motion sothat the Illinois Union Order could apply to NetBank, FSB. NetBank filed itsmotion to renew its interest, and Illinois Union has filed an opposition. Inthe second order on the Claimants’ Consolidated Motion, the MDL Court deniedthe Motion with respect to all the remaining sureties, including Royal andSafeco. The MDL Court held that it could not determine, based on the pleadingsalone, whether the Claimants were the intended obligees under the Bonds and,therefore, whether fraud of CMC could constitute a defense to the Sureties’obligation to pay under the terms of the Bonds. The MDL Court went on to hold, however, that if the Claimantsare ultimately determined to be the obligees under the Bonds, the Sureties willbe precluded from raising a defense of fraudulent inducement by CMC.

On October 31, 2005, the MDL Court ordered thatthe parties mediate their respective claims with a retired federal court judgein Cleveland, Ohio. NetBank, FSB participated in separate mediation sessionswith each of the Sureties, but none of NetBank, FSB’s claims were settledthrough this court-ordered mediation process, which concluded on March 15,2006.

On May 9, 2006, the MDLCourt ruled on whether the Illinois Union order applies to NetBank, FSB.  The MDL Court held that NetBank, FSB would beentitled to the benefit of the Illinois Union rulings, which barred IllinoisUnion from raising fraud by CMC and insurance related defenses as defenses topayment.  The MDL Court also suggestedthat NetBank, FSB would be entitled to

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judgment as a matter of law with respect to theBonds issued by Illinois Union prior to December 2000, but declined to enterjudgment at that time because of allegations of fraud on the part of NetBank,FSB with respect to certain Bonds, so-called replacement bonds, issued inDecember 2000.  The MDL Court held thatIllinois Union’s allegations of fraud on the part of NetBank, FSB in connectionwith the issuance of the replacement bonds were sufficient to get past thepleading stage of the litigation. However, the court noted that NetBank, FSB had previously moved forsummary judgment against Illinois Union and suggested that now, in light of theMDL Court ruling, NetBank, FSB could re-file its motion for summary judgment todispose of all remaining breach of contract issues, including the alleged fraudby NetBank, FSB in respect of the replacement bonds, pursuant to a schedulingorder to be issued by the MDL Court at a later date.  The MDL Court left open the issue of whether IllinoisUnion would be permitted to amend its pleadings to allege new defenses orclaims not expressly covered by the Illinois Union Order and stated that thisissue would be decided when the MDL Court rules on Illinois Union’s pendingmotion for leave to amend its pleadings. The MDL Court made it clear, however, that Illinois Union would not bepermitted to amend to avoid the impact of the Illinois Union Order.  On October 3, 2006, the MDL Court issued anOrder granting Royal’s motion for leave to amend its answer and grantingIllinois Union’s motion for leave to amend its answer as to the replacementbonds but not as to the Bonds issued by Illinois Union prior to December 2000.

On July 19, 2006, the MDL Court issued a RevisedCase Management Plan.  In that plan, theMDL Court lifted the stay on expert discovery that it had entered in andordered that the parties commence expert discovery. The MDL Court also issuedan Amended Revised Case Management Plan on September 12, 2006 providing for theend of expert discovery on April 25, 2007. The MDL Court also ordered that any party wishing to file a dispositivemotion, such as NetBank, FSB’s planned new motion for summary judgment againstthe Sureties, must first file a Notice of Intent to and Request for Leave toFile Summary Judgment Motion by November 14, 2006.  The MDL Court has instructed the parties notto file such Notifications with respect to reformation of the contracts, intentof the parties or fraud.  The MDL Courtwill then issue an order delineating the scope of summary judgment motions thatwill be permitted and set a briefing schedule. Based upon the Amended Revised Plan issued by the MDL Court, the Companydoes not expect any resolution of NetBank, FSB’s claims against the Suretiesprior to the Fall of 2007.

The Company believes that based on the overall factsand circumstances, the defenses asserted by the Sureties will fail and thatNetBank, FSB will ultimately prevail on its claims.

Also, as reported in previous filings, onMay 30, 2002, CMC filed for bankruptcy protection. Shortly thereafter,Commercial Servicing Corporation (“CSC”), an affiliate of CMC, also filedbankruptcy. The bankruptcy cases and related proceedings are not a part of theconsolidated action in the MDL Court. OnSeptember 4, 2003, the Trustee in bankruptcy for CMC and CSC initiated anadversary proceeding in the bankruptcy cases by filing a Complaint againstNetBank, FSB seeking to avoid NetBank, FSB’s interest in the Payment Streamsand their supporting Bonds relating to the Royal guaranteed pools of Leases (the“Adversary Proceeding”). On May 6, 2004, NetBank, FSB filed a motion forpartial summary judgment against the Trustee. The Trustee filed a cross-motionfor partial summary judgment against NetBank, FSB on June 18, 2004. OnJanuary 27, 2005, the Bankruptcy Court entered its Memorandum Decisiongranting the Trustee’s motion for partial summary judgment and denying NetBank,FSB’s motion for partial summary judgment. On February 28, 2005, theBankruptcy Court entered an order denying NetBank, FSB’s Motion for PartialSummary Judgment and granting the Trustee’s Cross-Motion for Summary Judgment.On April 27, 2005, the Bankruptcy Court entered a judgment conforming tothe Memorandum Decision.  On May 20,2005, the Bankruptcy Court entered an amended judgment conforming to theMemorandum Decision. The Bankruptcy Court held in the Memorandum Decision thatNetBank, FSB was required, but failed, to perfect its interest in the PaymentStreams that were transferred to it from CMC in the subject transactions andthat the subject transactions were loans rather than sales. Also onMay 20, 2005, NetBank, FSB appealed the amended judgment to the BankruptcyAppellate Panel for the Ninth Circuit Court of Appeals. On May 25, 2005,NetBank, FSB sought a stay pending appeal of the turnover provisions of theamended judgment from the Bankruptcy Court. The Bankruptcy Court denied therequest for stay on August 1, 2005. Instead of seeking appellate review ofthe denial of the motion to stay, NetBank, FSB entered into an agreement withthe Trustee whereby the Trustee agreed to safely hold the disputed Bondspending conclusion of the appellate process. The Bankruptcy Appellate Panelheard oral argument in the case on March 23, 2006.  

OnAugust 2, 2006, the Bankruptcy Appellate Panel issued its Opinion (the “BAPOpinion’’). In the BAP Opinion, the Bankruptcy Appellate Panel reversed theBankruptcy Court’s decision that the Payment Streams on the Royal Bonds werechattel paper rather than payment intangibles under the Uniform Commercial Code.Therefore, perfection would have been automatic if the transactions involvingthe Payment Streams were “sales” rather than “loans.” However, the Panelaffirmed the Bankruptcy Court’s decision that the transactions were moreproperly characterized as loans rather than sales. Nevertheless, the Panelfound that NetBank, FSB raised genuine issues of fact as to whether itsinterests were perfected by possession through an agent such as Royal, and thatthe Trustee did not meet his burden on this issue by submitting uncontestedevidence regarding who held the leases at the relevant times. The panel heldthat this genuine issue of material fact precludes summary judgment for theTrustee. Accordingly, the Panel remanded the case back to the Bankruptcy Courtfor a determination as to who had possession of the Royal Leases.  On August 11, 2006, the Trustee filed aMotion for Limited Rehearing with the Bankruptcy Appellate Panel asking thecourt to reconsider its August 2, 2006 ruling. On August 21, 2006, NetBank filed a Response to the Motion for LimitedRehearing opposing the Trustee’s Motion. The Bankruptcy Appellate Panel issued and Order on the Motion forLimited Rehearing on August 25, 2006 denying the Trustee’s Motion and stating

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that the legal issue of the effectof possession on the underlying leases should be addressed by the BankruptcyCourt.  That same day, the BankruptcyAppellate Panel issued an Amended Opinion reflecting its Order on the Motionfor Limited Rehearing.  The remandedadversary proceeding is set for a status conference before the Bankruptcy Courton November 17, 2006.  

In the meantime, many of theparties to the CMC and CSC bankruptcy cases resolved their disputes and enteredinto a Global Settlement Agreement, which was approved by the Bankruptcy Courton May 31, 2005. The Global Settlement Agreement resolved all issuesregarding ownership of the Payment Streams that were at issue in the AdversaryProceeding, however ownership of the Royal issued Bonds remains an issue in theAdversary Proceeding, as discussed above. Pursuant to the Global SettlementAgreement, NetBank, FSB received a settlement payment during the second quarterof 2005 of approximately $4 million. In addition, the Global SettlementAgreement provided that NetBank, FSB receive, retroactive to October 1,2004, 100% of all leasepayments made by lessees of Payment Streams transferred to NetBank, FSB. Also,NetBank, FSB was relieved of any obligation to share with the Trustee anyfuture payments made to NetBank, FSB by anyof the Sureties.

NetBank, FSB intends to vigorously pursue its claimsagainst all the Sureties, including claims for any loss associated with theclaims brought by the Trustee against NetBank, FSB. At this time, the Companyis unable to express an opinion as to the likelihood of loss, or the amount orrange of potential loss, with regard to this matter.

*Clayton v. Commercial Money Center, Inc., Case No. BC 253169(CA Sup. Ct., Los Angeles County)*

On June 27, 2001, several lessees of equipmentleased from CMC filed suit in Los Angeles Superior Court against CMC andseveral John Doe defendants alleging that the Leases violated California usurylaws, the California Financial Code, and the California Unfair BusinessPractices Act. The plaintiff lessees were seeking to rescind or reform theirobligations under the Leases and were seeking to recover statutory damages andattorney’s fees. The plaintiffs subsequently amended their complaint to nameNetBank, FSB, several other investor banks, and several surety companies asco-defendants in the action. After CMC filed for bankruptcy, the action wasremoved to the bankruptcy court in the Central District of California, but theplaintiffs subsequently agreed to withdraw their claims against CMC and weresuccessful in their motion to remand the case back to state court.

On March 15, 2004, the Superior Court sustaineddemurrers and motions to quash filed by NetBank, FSB and various otherdefendants on certain of the plaintiffs’ claims. The Superior Court sustainedthe demurrers under the California Financial Code, without leave to amend. TheSuperior Court also sustained demurrers on the Unfair Business Practices Act,with leave to amend the claims to add greater specificity to the claims, butwithout leave to amend as to unnamed representatives of the alleged class ofplaintiffs harmed. The Superior Court also granted motions to strike:(1) plaintiffs’ claims under the California Unfair Business Practices Actclaims as to unnamed representative plaintiffs; (2) plaintiffs’ requestfor restitution (the named plaintiffs may amend to establish individualentitlement to restitution); (3) plaintiffs’ request for disgorgement;(4) plaintiffs’ request for punitive damages; (5) plaintiffs’ requestfor compensatory damages under the California Unfair Business Practices Act;and (6) plaintiffs’ request for attorneys’ fees.

On April 29, 2004, the plaintiffs served anamended complaint against NetBank, FSB alleging claims for, among other things,violations of another section of the California Financial Code, unfaircompetition under Section 17200 of the California Business and ProfessionsCode and usury. On October 26, 2004, the court overruled the defendants’demurrers to the third amended complaint. However, on December 13, 2004,the court issued a stay in the action pending a decision by the appeals courton the plaintiffs’ claims that were dismissed without leave to amend. Nodiscovery has been taken in this case and we expect no resolution of thesesurviving claims prior to the outcome of plaintiffs’ appeal.   The Company intends to vigorously defend theamended claims in the Clayton action and to pursue recovery against Safeco,Royal, and Illinois Union in the Company’s existing action against them for anydamages and costs incurred in this case.

**Item 1A.  Risk Factors**

Inaddition to those risk factors previously described in Item 1A. “Risk Factors”of Part I to our 2005 Form 10-K, Part II of Quarterly Report on Form 10-Q forthree and six months ended June 30, 2006, and in the first paragraph ofItem 2 “Management’s Discussion and Analysis of Financial Condition andResults of Operations’’ in Part I of this Quarterly Report on Form 10-Q,investors should carefully consider the following risks:

***Exitingthe nonconforming mortgage and other businesses may adversely impact ourearnings***

As announced onNovember 6, 2006, we entered into a personnel placement agreement pursuant towhich a third party will extend offers of employment to a majority of theemployees of our nonconforming mortgage operations  and we have sold selected assets of ourrecreational vehicle, boat and aircraft financing operation.  Because these transactions do not cover thefull scope of these operations, we still have personnel and other commitmentsto address to fully exit both lines of business.  Management currently

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expects to recognizeapproximately $7.2 million in expenses associated with this exit. However, wecan give no assurance that the exit-related charges will not be higher thanexpected.  In addition, we can give noassurance that exit-related activities, when completed, will be successful inimproving our operating results.

***Ourcapital management strategies may not be successful***

Based on a number ofmarket and economic factors, including, but not limited to, a continuedflattened yield curve and pricing pressures on our mortgage business, we haveimplemented a disciplined approach to optimizing capital allocations toredirect scarce capital from underperforming businesses to better performingones that carry the greatest long-term strategic significance to the Company,which we believe primarily include our core banking and conforming mortgagebusinesses. Our intention to complete exiting the nonconforming mortgageportion of our business and the exit from our recreational vehicle, boat andaircraft financing operation, as well as potentially other areas of ourbusiness, are part of this ongoing capital strategy.  In addition, we suspended the payment of ourquarterly dividend. While our capital management strategy includes theobjectives of returning the Company to profitability as quickly as possible andimproving our operating profile, we can give no assurance that our capitalmanagement strategy will be successful in improving our results of operations,financial condition or cash flows.

Intangible assets andgoodwill comprise a significant portion of our total assets. Intangible assetsinclude trademarks, customer relationships, software and certain contractualrelationships.  Intangible assets aretested for recoverability whenever events or changes in circumstances indicatethat their carrying value may not be recoverable. Such events include adverse changesin the business climate, current period operating or cash flow losses,forecasted continuing losses or a current expectation that an asset group willbe disposed of before the end of its useful life. An impairment review ofgoodwill and intangible assets is conducted at least once a year or earlier ifevents or changes in circumstances indicate that their carrying value may notbe recoverable. In implementing our capital management strategy, we haverecently exited some of our businesses. As a result of such actions, we have recognized impairment chargesrelating to these activities. Similar events may require us to recognizeincreased levels of future intangible amortization, or incur charges torecognize the impairment of certain other assets.

***We couldbe adversely affected if transitions in senior management are not successful***

Our operations depend toa large extent on the efforts of our senior management. Effective October 5,2006, our Board of Directors appointed Steven F. Herbert as Chief ExecutiveOfficer and James P. Gross as Chief Finance Executive.  We seek to develop and retain an effectivemanagement team through the proper positioning of existing key employees andthe addition of new management personnel where necessary. Our results ofoperations, financial conditions and cash flows could be adversely affected iftransitions in senior management are not successful or if the Company is unableto sustain an effective management team.

***We have a formal supervisory agreement with the Office of ThriftSupervision (“OTS”)***

** **

On November 6, 2006, weentered into a formal written supervisory agreement with the OTS providing fora comprehensive action plan to proactively address concerns over the Bank’sfinancial performance and the impact that losses have had on our capitalposition over the past several quarters. Under the terms of the Agreement, any material modifications to the Bank’sbusiness plan, as submitted to the OTS, as well as any new activity, operationor line of business must be approved by the OTS prior to implementation.  There can be no assurance that the OTS willultimately approve any action taken by the Company to improve our financialperformance and our capital position, or that, if approved, such actions can befavorably executed according to our business plan.

 

There were anumber of areas identified in the Bank’s periodic regulatory examination asneeding improvement.  Although the OTSdetermined that there were no significant regulatory violations in any of thoseor other areas, there can be no assurance that OTS will not determine thatregulatory violations have occurred during future examinations.  Additionally, although management expectsthat the areas identified by the OTS as needing improvement will be remediated,there can be no assurance that the OTS will ultimately approve our strategiesfor improving identified concerns.  

**Item2.  Unregistered Sales of Equity Securitiesand Use of Proceeds**

In August 2002, the Board of Directors approved a plan torepurchase up to 1 million shares of the Company’s common stock. The plan wassubsequently increased by 1 million shares in October 2002, 2 millionshares in January 2003, 1 million shares in April 2004 and 1 millionshares in April 2005. There were no repurchases during the three and nine monthsended September 30, 2006. As of November 1, 2006, 1,086,573 shares remainedavailable for repurchase under current Board authority.

Reference is made to the discussion under the heading “Dividends” underItem 5. Market for Registrant’s Common Equity, Related Shareholder Matters andIssuer Purchases of Equity Securities of our 2005 Form 10-K for a descriptionof current OTS regulations applicable to the ability of NetBank, FSB to paydividends and make other capital distributions to the Company.

**Item3.  Defaults Upon Senior Securities**

None.

**Item4.  Submission of Matters to a Vote ofSecurity Holders**

**None.**

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**Item 5.  Other Information**

**None.**

**Item6.  Exhibits**

The exhibits listed inthe accompanying index to exhibits are filed or incorporated by reference aspart of this report, unless otherwise provided in the index to exhibits.

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**SIGNATURE**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.
|                         | NETBANK, INC. |
|-------------------------|---------------|
|                    |          |   |
|                    | By:           | /s/ James P.  Gross |   |
|                    |          | James P. Gross |
| Dated: November 9, 2006 | * *      | *Chief  Finance Executive  (principal accounting officer and  duly authorized officer)* |

 

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**INDEX TOEXHIBITS**
| **Exhibit**    | ** ** | ** **                                                                                                                                             | ** ** | **Incorporated  by Reference** | ** ** | **Filed**       |
|----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|-----------------|
| **Number**     | ** ** | **Exhibit Description**                                                                                                                           | ** ** | **Form**                       | ** ** | **File Number** | ** ** | **Exhibit** | ** ** | **Filing Date** | ** ** | **Herewith** |
|           |       |                                                                                                                                                   |       |                           |       |            |   |   |   |   |   |   |
| 10.1           |       | Separation  Agreement and General Release between NetBank, Inc. and Douglas K. Freeman  dated October 3, 2006 (effective October 5, 2006)              |       | 8-K                            |       | 000-22361       |   | 10.1 |   | 10/05/06 |   |   |
|           |       |                                                                                                                                                   |       |                           |       |            |   |   |   |   |   |   |
| 10.2           |       | Change of  Control Agreement between NetBank, Inc. and James P. Gross dated as of April  1, 2003                                                       |       | 8-K                            |       | 000-22361       |   | 10.2 |   | 10/05/06 |   |   |
|           |       |                                                                                                                                                   |       |                           |       |            |   |   |   |   |   |   |
| 31.1           |       | Certification  Pursuant to Rules 13a-14(a) and 15d-14(a) under the  Securities Exchange Act of 1934, as amended—Chief Executive Officer |       |                           |       |            |   |   |   |   |   | ý |
|           |       |                                                                                                                                                   |       |                           |       |            |   |   |   |   |   |   |
| 31.2           |       | Certification  Pursuant to Rules 13a-14(a) and 15d-14(a) under the  Securities Exchange Act of 1934, as amended—Chief Financial Officer |       |                           |       |            |   |   |   |   |   | ý |
|           |       |                                                                                                                                                   |       |                           |       |            |   |   |   |   |   |   |
| 32.1**†** | ** ** | Certification  Pursuant to 18 U.S.C. Section 1350—Chief Executive Officer and Chief  Finance Executive                                       |       |                           |       |            |   |   |   |   |   | ý |

 

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**† Thecertification attached as Exhibit 32.1 that accompanies this report is notdeemed filed with the Securities and Exchange Commission and is not to beincorporated by reference into any filing of NetBank, Inc. under the SecuritiesAct of 1934, as amemded, or the Securities Exchange Act of 1934, as amended,whether made before or after the date of this report, irrespective of anygeneral incorporation language contained in such filing.**

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