** **

**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM10-Q**

** **

**QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d)OF THE SECURITIES EXCHANGE ACT OF 1934**

** **

**For the Quarterly Period Ended March 31, 2004**

** **

**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) |
|                                                     |   |                                    |
| **11475 Great Oaks Way**                                 |   |                                    |
| **Suite 100**                                            |   |                                    |
| **Alpharetta, Georgia**                                  |   | **30022**                               |
| (Address of principal executive offices)                 |   | (Zip Code)                              |
|                                                     |   |                                    |
| **(770) 343-6006**                                       |
| Registrant’s telephone number, including area code: |

 

Indicate bycheck mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  YES ý  NO o

 

Indicate by check markwhether the registrant is an accelerated filer (as defined in Exchange Act Rule12b-2):

 

YES ý  NO o

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date:

 
| **Class**                    |   | **Shares Outstanding At April 30, 2004** |
|------------------------------|--------|------------------------------------------|
| Common Stock, par value $.01 |   | 46,335,094                               |

 

 

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**NETBANK, INC.**

**TABLE OF CONTENTS**

 
| **Part I. Financial  Information**                                                                            |   |
|---------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                          |   |
| **Item I. Financial  Statements**                                                                             |   |
|                                                                                                          |   |
| **Consolidated balance sheets  as of March 31, 2004 and December 31, 2003**                                   | 3      |
|                                                                                                          |   |
| **Consolidated  statements of operations for the three months ended March 31, 2004 and 2003**                 | 4      |
|                                                                                                          |   |
| **Consolidated  statements of shareholders’ equity for the three months ended March 31, 2004  and 2003** | 5      |
|                                                                                                          |   |
| **Consolidated  statements of cash flows for the three months ended March 31, 2004 and 2003**                 | 6      |
|                                                                                                          |   |
| **Notes to  consolidated financial statements**                                                               | 7      |
|                                                                                                          |   |
| **Item  2. Management’s Discussion and Analysis of Financial Condition and Results of  Operations**      | 16     |
|                                                                                                          |   |
| **Item  3. Quantitative and Qualitative Disclosures about Market Risk**                                       | 27     |
|                                                                                                          |   |
| **Item 4.  Controls and Procedures**                                                                          | 28     |
|                                                                                                          |   |
| **Part II. OTHER  INFORMATION**                                                                               |   |
|                                                                                                          |   |
| **Item 1. Legal  Proceedings**                                                                                | 28     |
|                                                                                                          |   |
| **Item  2. Changes in Securities and Use of Proceeds**                                                        | 30     |
|                                                                                                          |   |
| **Item  3. Defaults Upon Senior Securities**                                                                  | 30     |
|                                                                                                          |   |
| **Item  4. Submission of Matters to a Vote of Security Holders**                                              | 30     |
|                                                                                                          |   |
| **Item 5. Other  Information**                                                                                | 30     |
|                                                                                                          |   |
| **Item  6. Exhibits and Reports on Form 8-K**                                                                 | 30     |
|                                                                                                          |   |
| **Signature Page**                                                                                            | 31     |

 

2

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**Part I. Item 1. Financial Statements**

 

**NetBank, Inc.**

**ConsolidatedBalance Sheets**

**(unaudited and in 000’s except per share amounts)**

 
|                                                                                                             |   | **March 31,  2004** |      | **December 31,  2003** |   |
|------------------------------------------------------------------------------------------------------------------|--------|---------------------|-----------|------------------------|--------|
| **Assets**                                                                                                       |   |                |      |                   |   |
| Cash  and cash equivalents:                                                                                      |   |                |      |                   |   |
| Cash  and due from banks                                                                                         |   | $                   | 160,919   |                   | $      | 24,211 |   |
| Federal  funds sold                                                                                              |   | 27,664              |      | 9,416                  |   |
| Total  cash and cash equivalents                                                                                 |   | 188,583             |      | 33,627                 |   |
| Investment  securities available for sale-at fair value (amortized cost of $293,913 and  $449,972, respectively) |   | 301,960             |      | 454,348                |   |
| Stock  of Federal Home Loan Bank of Atlanta - at cost                                                            |   | 56,711              |      | 54,491                 |   |
| Loans  held for sale                                                                                             |   | 1,374,553           |      | 1,951,113              |   |
| Loans  and leases receivable – net of allowance for credit losses of $44,591 and  $43,689, respectively     |   | 2,038,582           |      | 1,756,960              |   |
| Mortgage  servicing rights – net                                                                            |   | 156,624             |      | 165,214                |   |
| Accrued  interest receivable                                                                                     |   | 10,767              |      | 14,713                 |   |
| Furniture,  equipment and capitalized software – net                                                        |   | 53,315              |      | 53,902                 |   |
| Goodwill  and other intangibles – net                                                                       |   | 65,330              |      | 62,441                 |   |
| Due  from servicers and investors                                                                                |   | 32,125              |      | 33,187                 |   |
| Receivable  from unsettled trades                                                                                |   | 13,740              |      | 90,000                 |   |
| Other  assets                                                                                                    |   | 79,662              |      | 64,809                 |   |
| **Total assets**                                                                                                 |   | $                   | 4,371,952 |                   | $      | 4,734,805 |   |
|                                                                                                             |   |                |      |                   |   |
| **Liabilities and shareholders’ equity**                                                                    |   |                |      |                   |   |
| **Liabilities:**                                                                                                 |   |                |      |                   |   |   |
| Deposits                                                                                                         |   | $                   | 2,644,171 |                   | $      | 2,539,427 |   |
| Other  borrowed funds                                                                                            |   | 1,071,648           |      | 1,421,022              |   |
| Subordinated  debt                                                                                               |   | 11,857              |      | 11,857                 |   |
| Accrued  interest payable                                                                                        |   | 9,404               |      | 9,098                  |   |
| Loans  in process                                                                                                |   | 53,880              |      | 30,756                 |   |
| Unsettled  trades                                                                                                |   | —              |      | 131,707                |   |
| Representations  and warranties                                                                                  |   | 18,465              |      | 17,905                 |   |
| Accounts  payable and accrued liabilities                                                                        |   | 128,940             |      | 142,683                |   |
| Total  liabilities                                                                                               |   | 3,938,365           |      | 4,304,455              |   |
|                                                                                                             |   |                |      |                   |   |
| Commitments  and contingencies                                                                                   |   | —              |      | —                 |   |
|                                                                                                             |   |                |      |                   |   |
| **Shareholders’  equity:**                                                                                  |   |                |      |                   |   |
| Preferred stock, no par  (10,000,000 shares authorized; none outstanding)                                        |   | —              |      | —                 |   |
| Common stock, $.01 par  (100,000,000 shares authorized,  52,820,308 shares issued)                               |   | 528                 |      | 528                    |   |
| Additional paid-in capital                                                                                       |   | 431,920             |      | 432,035                |   |
| Retained earnings                                                                                                |   | 52,555              |      | 44,102                 |   |
| Accumulated other comprehensive  income, net of taxes of $3,055 and $1,634, respectively                         |   | 4,992               |      | 2,742                  |   |
| Treasury stock, at cost  (5,830,500 and 5,235,538 shares, respectively)                                          |   | (56,056             | )         | (48,674                | )      |
| Unearned compensation                                                                                            |   | (352                | )         | (383                   | )      |
| Total shareholders’ equity                                                                                  |   | 433,587             |      | 430,350                |   |
| **Total  liabilities and shareholders’ equity**                                                             |   | $                   | 4,371,952 |                   | $      | 4,734,805 |   |

 

See notes to consolidated financialstatements.

 

3

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**NetBank,Inc.**

**ConsolidatedStatements of Operations**

**(unauditedand in 000’s except per share amounts)**

 
|                                                              |   | **Three months  ended March 31,** |   |
|-------------------------------------------------------------------|--------|-----------------------------------|--------|
|                                                              |   | **2004**                          |   | **2003** |   |
|                                                              |   |                              |   |   |   |
| **Interest income:**                                              |   |                              |   |   |   |
| Loans and leases                                                  |   | $                                 | 48,039 |   | $ | 38,261 |   |
| Investment securities                                             |   | 3,966                             |   | 6,609 |   |
| Short-term investments                                            |   | 180                               |   | 132 |   |
| Total interest income                                             |   | 52,185                            |   | 45,002 |   |
|                                                              |   |                              |   |   |   |
| **Interest  expense:**                                            |   |                              |   |   |   |
| Deposits                                                          |   | 11,818                            |   | 12,446 |   |
| Other borrowed funds                                              |   | 8,618                             |   | 9,053 |   |
| Total interest expense                                            |   | 20,436                            |   | 21,499 |   |
| Net interest income                                               |   | 31,749                            |   | 23,503 |   |
| Provision for credit losses                                       |   | 1,847                             |   | 868 |   |
| Net interest income after  provision for credit losses            |   | 29,902                            |   | 22,635 |   |
|                                                              |   |                              |   |   |   |
| **Non-interest  income:**                                         |   |                              |   |   |   |
| Service charges and fees                                          |   | 17,032                            |   | 11,326 |   |
| Gains on sales of mortgage loans  and mortgage servicing rights   |   | 32,314                            |   | 48,923 |   |
| Net gain on sales of investment  securities                       |   | 3,169                             |   | 6,332 |   |
| Other income                                                      |   | 4,176                             |   | 2,563 |   |
| Total non-interest income                                         |   | 56,691                            |   | 69,144 |   |
|                                                              |   |                              |   |   |   |
| **Non-interest  expense:**                                        |   |                              |   |   |   |
| Salaries and benefits                                             |   | 30,927                            |   | 29,810 |   |
| Customer service                                                  |   | 2,913                             |   | 2,771 |   |
| Marketing                                                         |   | 2,259                             |   | 2,074 |   |
| Data processing                                                   |   | 4,491                             |   | 4,150 |   |
| Depreciation and amortization                                     |   | 4,783                             |   | 3,536 |   |
| Impairment and amortization of  mortgage servicing rights         |   | 10,246                            |   | 9,801 |   |
| Office expenses                                                   |   | 2,680                             |   | 2,723 |   |
| Occupancy                                                         |   | 5,134                             |   | 4,313 |   |
| Travel and entertainment                                          |   | 1,176                             |   | 852 |   |
| Professional fees                                                 |   | 2,910                             |   | 2,887 |   |
| Other expenses                                                    |   | 4,042                             |   | 5,915 |   |
| Prepayment fees on the early  extinguishment of debt              |   | —                            |   | 5,976 |   |
| Total non-interest expense                                        |   | 71,561                            |   | 74,808 |   |
| Income before income taxes                                        |   | 15,032                            |   | 16,971 |   |
| Income tax expense                                                |   | (5,638                            | )      | (6,269 | ) |
| Net income                                                        |   | $                                 | 9,394  |   | $ | 10,702 |   |
|                                                              |   |                              |   |   |   |
| Net income per common and  potential common shares outstanding:   |   |                              |   |   |   |
| Basic                                                             |   | $                                 | 0.20   |   | $ | 0.22 |   |
| Diluted                                                           |   | $                                 | 0.20   |   | $ | 0.22 |   |
|                                                              |   |                              |   |   |   |
| Weighted average common and  potential common shares outstanding: |   |                              |   |   |   |
| Basic                                                             |   | 47,250                            |   | 48,324 |   |
| Diluted                                                           |   | 47,968                            |   | 48,762 |   |
|                                                              |   |                              |   |   |   |
| Dividends declared on common  stock per share                     |   | $                                 | 0.02   |   | $ | 0 .02 |   |

 

Seenotes to consolidated financial statements.

 

4

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**NetBank, Inc.**

**Consolidated Statements of Shareholders’ Equity**

**(Unaudited and in000’s)**

 
|                                                                 |   | **Common  shares** |   | **Common  stock** |   | **Additional   paid-in capital** |   | **Retained  earnings** |   | **Accumulated  other  comprehensive  income** |   | **Treasury  stock** |   | **Unearned  compensation** |   | **Total** |    |
|----------------------------------------------------------------------|--------|--------------------|--------|-------------------|--------|----------------------------------|--------|------------------------|--------|-----------------------------------------------|--------|---------------------|--------|----------------------------|--------|-----------|---------|
| Balance – December 31, 2003                                     |   | 52,820             |   | $                 | 528    |                             | $      | 432,035                |   | $                                             | 44,102 |                | $      | 2,742                      |   | $         | (48,674 | ) | $ | (383 | ) | $ | 430,350 |   |
| Comprehensive income:                                                |   |               |   |              |   |                             |   |                   |   |                                          |   |                |   |                       |   |      |    |
| Net income                                                           |   | —             |   | —            |   | —                           |   | 9,394                  |   | —                                        |   | —              |   | —                     |   | 9,394     |    |
| Realized gain on sales of  securities, net of taxes                  |   | —             |   | —            |   | —                           |   | —                 |   | (1,980                                        | )      | —              |   | —                     |   | (1,980    | )       |
| Unrealized gain on securities,  net of taxes                         |   | —             |   | —            |   | —                           |   | —                 |   | 4,230                                         |   | —              |   | —                     |   | 4,230     |    |
| Comprehensive income                                                 |   |               |   |              |   |                             |   |                   |   |                                          |   |                |   |                       |   | 11,644    |    |
| Dividends declared on common  stock                                  |   | —             |   | —            |   | —                           |   | (941                   | )      | —                                        |   | —              |   | —                     |   | (941      | )       |
| Purchase of shares of common  stock for treasury, net of reissuances |   | —             |   | —            |   | (115                             | )      | —                 |   | —                                        |   | (7,382              | )      | —                     |   | (7,497    | )       |
| Amortization of unearned  compensation                               |   | —             |   | —            |   | —                           |   | —                 |   | —                                        |   | —              |   | 31                         |   | 31        |    |
| Balance – March 31, 2004                                        |   | 52,820             |   | $                 | 528    |                             | $      | 431,920                |   | $                                             | 52,555 |                | $      | 4,992                      |   | $         | (56,056 | ) | $ | (352 | ) | $ | 433,587 |   |

 
|                                                                 |   | **Common  shares** |   | **Common  stock** |   | **Additional  paid-in capital** |   | **Retained  (deficit)  earnings** |   | **Accumulated  other  comprehensive  income** |   | **Treasury  stock** |   | **Unearned  compensation** |   | **Total** |    |
|----------------------------------------------------------------------|--------|--------------------|--------|-------------------|--------|---------------------------------|--------|-----------------------------------|--------|-----------------------------------------------|--------|---------------------|--------|----------------------------|--------|-----------|---------|
| Balance – December 31, 2002                                     |   | 52,675             |   | $                 | 527    |                            | $      | 426,485                           |   | $                                             | (2,568 | )                   | $      | 11,026                     |   | $         | (33,880 | ) | $ | — |   | $ | 401,590 |   |
| Comprehensive income:                                                |   |               |   |              |   |                            |   |                              |   |                                          |   |                |   |                       |   |      |    |
| Net Income                                                           |   | —             |   | —            |   | —                          |   | 10,702                            |   | —                                        |   | —              |   | —                     |   | 10,702    |    |
| Realized gain on sales of  securities, net of taxes                  |   | —             |   | —            |   | —                          |   | —                            |   | (3,993                                        | )      | —              |   | —                     |   | (3,993    | )       |
| Unrealized gain on sales of  securities, net of taxes                |   | —             |   | —            |   | —                          |   | —                            |   | 1,826                                         |   | —              |   | —                     |   | 1,826     |    |
| Comprehensive income                                                 |   |               |   |              |   |                            |   |                              |   |                                          |   |                |   |                       |   | 8,535     |    |
| Dividends declared on common  stock                                  |   | —             |   | —            |   | —                          |   | (973                              | )      | —                                        |   | —              |   | —                     |   | (973      | )       |
| Purchase of shares of common  stock for treasury, net of reissuances |   | —             |   | —            |   | (3                              | )      | —                            |   | —                                        |   | (7,499              | )      | —                     |   | (7,502    | )       |
| Issuances of common stock                                            |   | 68                 |   | —            |   | 4,575                           |   | —                            |   | —                                        |   | —              |   | —                     |   | 4,575     |    |
| Balance – March 31, 2003                                        |   | 52,743             |   | $                 | 527    |                            | $      | 431,057                           |   | $                                             | 7,161  |                | $      | 8,859                      |   | $         | (41,379 | ) | $ | — |   | $ | 406,225 |   |

 

Seenotes to consolidated financial statements.

 

5

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**NetBank,Inc.**

**ConsolidatedStatements of Cash Flows**

**(unauditedand in 000’s)**

 
|                                                                                         |   | **Three months ended March 31,** |    |
|----------------------------------------------------------------------------------------------|--------|----------------------------------|---------|
|                                                                                         |   | **2004**                         |    | **2003** |   |
| Operating activities:                                                                        |   |                             |    |   |   |
| Net income                                                                                   |   | $                                | 9,394   |   | $ | 10,702 |   |
| Adjustments to reconcile net  income to net cash provided by (used in) operating activities: |   |                             |    |   |   |
| Depreciation and amortization                                                                |   | 4,783                            |    | 3,536 |   |
| Amortization of premiums on  investment securities, loan and lease receivables and debt      |   | 3,275                            |    | 2,135 |   |
| Gain on sales of available for  sale investment securities                                   |   | (3,169                           | )       | (6,332 | ) |
| Origination of loans held for  sale                                                          |   | (3,258,766                       | )       | (4,357,423 | ) |
| Proceeds from sales of loans held  for sale                                                  |   | 3,867,126                        |    | 4,252,301 |   |
| Net gain on sales of loans and  servicing rights                                             |   | (32,314                          | )       | (48,923 | ) |
| Capitalization of mortgage servicing  rights                                                 |   | (3,854                           | )       | (50,201 | ) |
| Proceeds from sale of mortgage  servicing rights                                             |   | 1,990                            |    | 22,795 |   |
| Impairment and amortization of  mortgage servicing rights                                    |   | 10,246                           |    | 9,801 |   |
| Provision for credit losses                                                                  |   | 1,847                            |    | 868 |   |
| Amortization of unearned  compensation                                                       |   | 31                               |    | — |   |
| Changes in assets and liabilities  which provide (use) cash:                                 |   |                             |    |   |   |
| Decrease in accrued interest  receivable                                                     |   | 3,946                            |    | 1,369 |   |
| (Increase) decrease in other  assets, due from servicers, and intangibles                    |   | (16,680                          | )       | 5,443 |   |
| Increase (decrease) in accrued  interest payable                                             |   | 306                              |    | (2,079 | ) |
| Decrease in accounts payable and  accrued liabilities                                        |   | (13,743                          | )       | (12,072 | ) |
| Increase in loans in process                                                                 |   | 23,124                           |    | 24,975 |   |
| Net cash provided by (used in)  operating activities                                         |   | 597,542                          |    | (143,105 | ) |
|                                                                                         |   |                             |    |   |   |
| Investing activities:                                                                        |   |                             |    |   |   |
| Purchases of available for sale  investment securities                                       |   | (6,000                           | )       | (50,508 | ) |
| Principal repayments on available  for sale investment securities                            |   | 16,991                           |    | 19,973 |   |
| Sales and maturities of available  for sale investment securities                            |   | 14,216                           |    | 122,149 |   |
| (Purchase) sale of Federal Home  Loan Bank Stock                                             |   | (2,220                           | )       | 3,100 |   |
| Origination and purchases of  loans and leases                                               |   | (415,459                         | )       | (241,872 | ) |
| Principal repayments on loans and  leases                                                    |   | 130,890                          |    | 114,582 |   |
| Purchases of furniture, fixtures,  and equipment                                             |   | (4,196                           | )       | (6,452 | ) |
| Net cash used in investing  activities                                                       |   | (265,778                         | )       | (39,028 | ) |
|                                                                                         |   |                             |    |   |   |
| Financing activities:                                                                        |   |                             |    |   |   |
| Increase in money market and  checking accounts                                              |   | 147,125                          |    | 289,145 |   |
| Decrease in certificates of  deposits                                                        |   | (42,381                          | )       | (54,754 | ) |
| Proceeds from other borrowed  funds                                                          |   | 3,361,608                        |    | 1,642,598 |   |
| Repayments of other borrowed  funds                                                          |   | (3,634,722                       | )       | (1,686,453 | ) |
| Net purchase of treasury stock                                                               |   | (7,497                           | )       | (7,502 | ) |
| Net proceeds from the issuance of  common stock                                              |   | —                           |    | 4,575 |   |
| Dividend payments on common stock                                                            |   | (941                             | )       | (973 | ) |
| Net cash (used in) provided by  financing activities                                         |   | (176,808                         | )       | 186,636 |   |
| Net increase in cash and cash  equivalents                                                   |   | 154,956                          |    | 4,503 |   |
| Cash and cash equivalents:                                                                   |   |                             |    |   |   |
| Cash, beginning of period                                                                    |   | 33,627                           |    | 111,565 |   |
| Cash, end of period                                                                          |   | $                                | 188,583 |   | $ | 116,068 |   |
|                                                                                         |   |                             |    |   |   |
| Supplemental disclosures of cash  flow information:                                          |   |                             |    |   |   |
| Cash paid during the period for  interest                                                    |   | $                                | 20,130  |   | $ | 23,578 |   |
| (Refunds received) cash paid  during the period for income taxes                             |   | $                                | (8,359  | ) | $ | 1,734 |   |

 

Seenotes to consolidated financial statements.

 

6

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**NETBANK,INC.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**March31, 2004**

**(unaudited)**

 

**1.             ORGANIZATIONAND BASIS OF PRESENTATION**

 

NetBank,Inc. is a financial holding company that wholly owns the outstanding stock ofNetBank, (“NetBank, FSB” or the “Bank”), a federal savings bank; MeritageMortgage Corporation (“Meritage”), a wholesale non-conforming mortgageprovider; MG Reinsurance Company (“MG Reinsurance”), a captive reinsurancecompany; NetInsurance, Inc., (“NetInsurance”), a licensed insurance agency; andNB Partners, Inc., a corporation formed to be involved in strategic partneringopportunities.  NetBank, FSB owns all ofthe outstanding stock of Market Street Mortgage Corporation (“Market Street”),a retail mortgage company, NetBank Payment Systems, Inc. (“NPS”), a leadingprovider of ATM services for retail and other non-bank businesses and ResourceBancshares Mortgage Group, Inc. (“Resource”). Resource wholly owns RBMG, Inc.(“RBMG”), a wholesale mortgage banking company, and Republic Leasing Company,Inc. (“Republic Leasing”), a commercial financing company.

 

NetBankacquired NPS on December 1, 2003. Accordingly, the financial impact of NPS is included from the date ofacquisition.  The entire consolidatedcompany is referred to herein as “NetBank” or “the Company”.

 

Inthe opinion of management, the unaudited consolidated financial statementsincluded herein reflect all adjustments, consisting only of normal recurringaccruals, which are necessary for the fair presentation of the financialcondition and results of operations for the interim periods presented. Certaininformation and footnote disclosures normally included in financial statementshave been condensed or omitted pursuant to applicable rules and regulations ofthe Securities and Exchange Commission (“SEC”). The financial statementsincluded herein should be read in conjunction with the financial statements andnotes thereto, included in NetBank’s Form 10-K filed with the SEC for the yearended December 31, 2003. The results of operations for the interim periodsreported herein are not necessarily indicative of results to be expected forthe full year. Certain 2003 amounts have been reclassified for comparabilitywith 2004 amounts.

 

Alldollar figures are presented in thousands (000s) except per share data unlessotherwise noted.

 

**2.             ACQUISITIONS**

 

EffectiveFebruary 1, 2004, the Company acquired certain assets of Electronic CashSystems, Inc., a provider of ATM and merchant processing services, pursuant toan Asset Purchase and Assignment Agreement. The consideration paid, including transaction costs, was $4.7million.  The acquisition was accountedfor as a purchase, and accordingly, all assets were recorded at fairvalue.  As such, $3.0 million ingoodwill, including transaction costs, and $1.5 million in contract intangibleswere recorded.

 

OnDecember 1, 2003, NetBank, Inc. acquired all of the outstanding stock ofFinancial Technologies, Inc., subsequently renamed NetBank Payment Systems,Inc., pursuant to an agreement dated October 5, 2003.  The consideration paid consisted of 77,674 shares of NetBankcommon stock and cash of $16 million. The Company accounted for the acquisition as a purchase and recordedapproximately $12.6 million of goodwill and $4.8 million of contractintangibles. Goodwill was decreased during the three months ended March 31,2004 by $1.4 million related to adjustments to inventories and taxes associatedwith the acquisition.  The Company maypay additional consideration if NPS reaches specific financial goals over thenext five years.

 

EffectiveApril 30, 2003, the Company acquired certain assets of Memorial Park Mortgage,LTD, a mortgage banking business, pursuant to an Asset Purchase and AssignmentAgreement.  The consideration paid,including transaction costs, was $3.2 million. The acquisition was accounted for as a purchase, and accordingly, allassets were recorded at fair value.  Assuch, $2.0 million in goodwill, including transaction costs, was recorded.

 

7

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**3.             ACCOUNTINGPOLICIES**

 

Referenceis made to the accounting policies of NetBank described in the notes toconsolidated financial statements contained in NetBank’s Form 10-K for the yearended December 31, 2003. The Company has followed those policies in preparingthis report.

 

*Significant Estimates.*Thepreparation of the consolidated financial statements in conformity withaccounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the amounts reportedin the consolidated financial statements and accompanying notes.  Such estimates relate to the Company’sallowance for credit losses, the fair values of mortgage loans held for sale,lease receivables, mortgage servicing rights, servicing hedges and theCompany’s other hedging instruments. Because of the inherent uncertainties associated with any estimationprocess and due to possible future changes in market and economic conditionsthat will affect fair values, it is possible that actual future results andrealization of the underlying assets and liabilities could differ significantlyfrom the amounts reflected as of the balance sheet date.

 

*Stock Options.*The Company accounts forstock options issued under the recognition and measurement principles ofAccounting Principles Board 25, *Accountingfor Stock Issued to Employees,*and related Interpretations. No stockoption-based employee compensation cost is reflected in the results ofoperations, as all options granted under those plans had an exercise priceequal to or greater than the market value of the underlying common stock on thedate of grant. The following table illustrates the pro forma effects on theresults of operations and earnings per share if the Company had applied thefair value recognition provisions of FASB Statement 123, *Accounting for Stock-Based Compensation,*tostock option-based employee compensation.

 
|                                                                                                                                         |   | **Three months  ended  March 31,** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                                                                                         |   | **2004**                           |   | **2003** |   |
| Net income, as reported                                                                                                                      |   | $                                  | 9,394  |   | $ | 10,702 |   |
| Deduct:                                                                                                                                      |   |                               |   |   |   |
| Total stock option-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (367                               | )      | (469 | ) |
| Pro forma net income                                                                                                                         |   | $                                  | 9,027  |   | $ | 10,233 |   |
|                                                                                                                                         |   |                               |   |   |   |
| Earnings per share:                                                                                                                          |   |                               |   |   |   |
| Basic – as reported                                                                                                                     |   | $                                  | 0.20   |   | $ | 0.22 |   |
| Basic – pro forma                                                                                                                       |   | $                                  | 0.19   |   | $ | 0.21 |   |
|                                                                                                                                         |   |                               |   |   |   |
| Diluted – as reported                                                                                                                   |   | $                                  | 0.20   |   | $ | 0.22 |   |
| Diluted – pro forma                                                                                                                     |   | $                                  | 0.19   |   | $ | 0.21 |   |

 

Inaddition, for the three months ended March 31, 2004 compensation expense of $31related to restricted stock awards was recognized and included in net income asreported.

 

*New Accounting Pronouncements.*OnMarch 9, 2004, the SEC issued Staff Accounting Bulletin No. 105 (“SAB 105”), *Application of Accounting Principles to LoanCommitments*, which provides guidance regarding loan commitments thatare accounted for as derivatives instruments. In the bulletin, the SEC determined that a loan commitment for which theinterest rate has been locked should be valued at zero at inception.  NetBank will adopt SAB 105 prospectively onApril 1, 2004, and is it not expected to have a material impact on theCompany’s balance sheet or statement of operations.

 

8

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**4.             LOAN ANDLEASE RECEIVABLES**

 

AtMarch 31, 2004 and December 31, 2003 the Company had net unamortized premiumsand deferred cost on its loans and leases of $32,858 and $30,256,respectively.  As of March 31, 2004NetBank had commitments to fund mortgage loans of $1.7 billion, unused homeequity lines of credit of $73,916 and commercial financing commitments of$8,659.  As of March 31, 2003 NetBankhad commitments to fund mortgage loans of $2.4 billion, unused home equitylines of credit of $81,541 and commercial financing commitments of $9,012.

 

Thefollowing is a summary of NetBank’s loan and lease portfolio:

 
|                             |   | **As of  March 31, 2004** |      | **As of  December 31, 2003** |   |
|----------------------------------|--------|---------------------------|-----------|------------------------------|--------|
|                             |   | **Amount**                |      | **%**                        |   | **Amount** |   | **%** |   |
| Residential mortgages            |   | $                         | 1,496,798 |                         | 71.9   | % | $ | 1,309,689 |   | 72.7 | % |
| Leases                           |   | 356,384                   |      | 17.1                         | %      | 345,540 |   | 19.2 | % |
| Auto                             |   | 169,326                   |      | 8.1                          | %      | 92,724 |   | 5.2 | % |
| Home equity lines                |   | 58,241                    |      | 2.8                          | %      | 50,816 |   | 2.8 | % |
| Consumer                         |   | 2,424                     |      | 0.1                          | %      | 1,880 |   | 0.1 | % |
| Total                            |   | 2,083,173                 |      | 100.0                        | %      | 1,800,649 |   | 100.0 | % |
| Less allowance for credit losses |   | (44,591                   | )         |                         |   | (43,689 | ) |   |   |
| Total                            |   | $                         | 2,038,582 |                         |   |   | $ | 1,756,960 |   |   |   |

 

9

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**5.             ALLOWANCEFOR CREDIT LOSSES**

 

NetBankconsiders 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.  NetBankmeasures impairment of a loan or lease on a loan-by-loan or lease-by-leasebasis.  Amounts of impaired loans thatare not probable of collection are charged off immediately.  NetBank had $81,418 and $82,816 of impaired,non-accrual loan and lease receivables as of March 31, 2004 and December 31,2003, respectively.  The purchased CMClease portfolio represents $77,835 of the $81,418 total impaired, non-accrualloan and lease receivables as of March 31, 2004.  Reference is made to Note 11 for additional detail regarding theCMC lease portfolio.

 

Thefollowing is a summary of the allowance for credit losses:

 
|                                                                  |   | **Three months  ended  March 31,** |   |
|-----------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                  |   | **2004**                           |   | **2003** |   |
| **Beginning  balance**                                                |   | $                                  | 43,689 |   | $ | 42,576 |   |
| Provision for credit losses                                           |   | 1,847                              |   | 868 |   |
| Charge-offs:                                                          |   |                               |   |   |   |
| Residential mortgages                                                 |   | (153                               | )      | (346 | ) |
| Leases                                                                |   | (973                               | )      | (1,442 | ) |
| Home equity lines                                                     |   | (187                               | )      | (288 | ) |
| Consumer                                                              |   | (48                                | )      | (18 | ) |
| Auto                                                                  |   | (324                               | )      | — |   |
| Total charge-offs                                                     |   | (1,685                             | )      | (2,094 | ) |
| Recoveries:                                                           |   | —                             |   | — |   |
| Residential mortgages                                                 |   | 11                                 |   | 90 |   |
| Leases                                                                |   | 567                                |   | 514 |   |
| Home equity lines                                                     |   | —                             |   | 3 |   |
| Consumer                                                              |   | —                             |   | — |   |
| Auto                                                                  |   | 162                                |   | — |   |
| Total recoveries                                                      |   | 740                                |   | 607 |   |
| Total charge-offs, net                                                |   | (945                               | )      | (1,487 | ) |
| **Ending balance**                                                    |   | $                                  | 44,591 |   | $ | 41,957 |   |
|                                                                  |   |                               |   |   |   |
| Allowance for credit losses as a  percent of average loans and leases |   | 2.4                                | %      | 4.2 | % |

 

**6.             FAIRVALUE AND IMPAIRMENT OF MORTGAGE SERVICING RIGHTS**

 

Forpurposes of evaluating its mortgage servicing rights portfolio for impairment,the Company disaggregates its servicing portfolio into two primary segments:available for sale and held for sale.

 

Thesegment of the portfolio designated as available for sale is composed ofservicing rights that were retained out of production pursuant to individualportfolio retention decisions or purchased in bulk transactions.  As of March 31, 2004, the Company isretaining the majority of its conventional mortgage loan servicing rights.  The available for sale portfolio isdisaggregated for purposes of measuring potential impairments according todefined risk tranches.  The Company hasdefined its risk tranches 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,

 

10

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prepaymentspeeds, default rates and other relevant factors, is compared to amortizedcarrying values of the mortgage servicing rights for purposes of measuringpotential impairment.

 

Thesegment of the portfolio designated as held for sale is composed of recentlyproduced servicing rights that are scheduled for sale and have been allocatedto specific forward servicing sales contracts. The held for sale portfolio is disaggregated for purposes of measuringpossible impairments according to the specific forward sales contracts to whichallocated, which the Company has determined to be the appropriate approach todisaggregation by predominant risk characteristic for this portfoliosegment.  For each such risk tranche,the fair value is based upon the allocated forward committed delivery price,which is compared to amortized carrying value for purposes of measuring potentialimpairment.

 

Thefollowing amounts related to NetBank’s mortgage servicing rights portfolio asof March 31, 2004 and December 31, 2003:

 
|                         |   | **Available for  sale** |       | **Held for sale** |   |
|------------------------------|--------|-------------------------|------------|-------------------|--------|
|                         |   | **2004**                |       | **2003**          |   | **2004** |   | **2003** |   |
| UPB                          |   | $                       | 12,775,835 |              | $      | 12,293,325 |   | $ | 475,284 |   | $ | 250,338 |   |
| Carrying Value               |   | $                       | 150,391    |              | $      | 162,030 |   | $ | 6,233 |   | $ | 3,184 |   |
| Carrying Value / UPB         |   | 1.18                    | %          | 1.32              | %      | 1.31 | % | 1.27 | % |
| Fair value                   |   | $                       | 150,982    |              | $      | 162,656 |   | $ | 6,233 |   | $ | 3,184 |   |
| Fair Value / UPB             |   | 1.18                    | %          | 1.32              | %      | 1.31 | % | 1.27 | % |
| Weighted average note rate   |   | 6.04                    | %          | 6.09              | %      | 5.64 | % | 5.82 | % |
| Weighted average service fee |   | 0.33                    | %          | 0.33              | %      | 0.40 | % | 0.32 | % |
| Net Basis as multiple        |   | 3.57                    |       | 3.99              |   | 3.26 |   | 3.91 |   |

 

Thefollowing table summarizes changes in the impairment reserve for NetBank’savailable for sale mortgage servicing rights:

 
| Balance as of December 31, 2003 |   | $     | 58,253 |   |
|---------------------------------|--------|-------|--------|--------|
| Servicing valuation impairment  |   | 1,170 |   |
| Balance as of March 31, 2004    |   | $     | 59,423 |   |

 

**7.             DEPOSITS**

 

Thefollowing table sets forth the dollar amount of deposits and weighted averageinterest rates in the various types of deposit programs offered by the Company:

 
|                                    |   | **As of March 31,  2004** |      | **As of December  31, 2003** |   |
|-----------------------------------------|--------|---------------------------|-----------|------------------------------|--------|
|                                    |   | **Amount**                |      | **Percentage**               |   | **Weighted  average  interest  rate** |   | **Amount** |   | **Percentage** |   | **Weighted  average  interest  rate** |   |
| Non-interest bearing checking  accounts |   | $                         | 343,538   |                         | 13.0   | % | N/A |   | $ | 198,884 |   | 7.8 | % | N/A |   |
| Interest bearing:                       |   |                      |      |                         |   |   |   |   |   |   |   |   |   |
| Checking accounts                       |   | 244,877                   |      | 9.3                          | %      | 1.1 | % | 228,178 |   | 9.0 | % | 1.4 | % |
| Money market                            |   | 1,349,066                 |      | 51.0                         | %      | 1.7 | % | 1,363,294 |   | 53.7 | % | 1.9 | % |
| Certificate of deposit under $100       |   | 586,770                   |      | 22.2                         | %      | 2.7 | % | 632,602 |   | 24.9 | % | 2.8 | % |
| Certificate of deposit over $100        |   | 119,920                   |      | 4.5                          | %      | 2.7 | % | 116,469 |   | 4.6 | % | 2.8 | % |
| Total deposits                          |   | $                         | 2,644,171 |                         | 100.0  | % |   |   | $ | 2,539,427 |   | 100.0 | % |   |   |

 

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Accruedinterest as of March 31, 2004 related to checking, money market andcertificates of deposit accounts was $82, $820 and $5,058, respectively.  Accrued interest as of December 31, 2003,related to checking, money market, and certificates of deposit accounts was$81, $801 and $5,686, respectively.  AtMarch 31, 2004, and December 31, 2003, $647 and $664 of overdrawn deposits wereclassified as loans, respectively.

 

**8.             BORROWINGS**

 

Asummary of borrowings and available borrowings, grouped by year of maturity, asof March 31, 2004 follows:

 
| **Type of Borrowing**                    |   | **Year of maturity** |   | **Range of stated  interest rates  March 31, 2004** |    | **Principal amount  outstanding  March 31, 2004** |      |
|------------------------------------------|--------|----------------------|--------|-----------------------------------------------------|---------|---------------------------------------------------|-----------|
| $0.5 million line of credit              |   | 2004                 |   | Prime                                               | *  | $                                                 | 37        |   |
| $25 million line of credit               |   | 2004                 |   | Fed Funds                                           | *  | —                                            |      |
| $100 million warehouse line of  credit   |   | 2004                 |   | 2.22%, 2.72                                         | %*      | —                                            |      |
| $250 million master repurchase  facility |   | 2004                 |   | 2.17% to 2.42                                       | %*      | 148,486                                           |      |
| $625 million FHLB warehouse line  **     |   | 2005                 |   | DRC + 0.50                                          | %*      | —                                            |      |
| $200 million master repurchase  facility |   | 2004                 |   | 2.34% to 2.46                                       | %       | 2,325                                             |      |
| FHLB advances                            |   | 2004                 |   | DRC, 4.45                                           | %*      | 125,225                                           |      |
| FHLB advances                            |   | 2005                 |   | 1.77% to 7.41                                       | %       | 166,000                                           |      |
| FHLB advances                            |   | 2006                 |   | 2.04% to 5.63                                       | %       | 60,000                                            |      |
| FHLB advances                            |   | 2007                 |   | 2.57                                                | %       | 40,000                                            |      |
| Notes Payable                            |   | 2007                 |   | 5.95                                                | %       | 259                                               |      |
| FHLB advances                            |   | 2008                 |   | 1.90% to 1.92                                       | %       | 100,000                                           |      |
| Notes Payble                             |   | 2008                 |   | 5.95                                                | %       | 1,304                                             |      |
| FHLB advances                            |   | 2009                 |   | 1.80% to 4.64                                       | %       | 215,000                                           |      |
| FHLB advances                            |   | 2014                 |   | 1.79% to 2.93                                       | %       | 185,000                                           |      |
| Subordinated Debt                        |   | 2032                 |   | LIBOR + 3.35                                        | %*      | 4,382                                             |      |
| Subordinated Debt                        |   | 2033                 |   | LIBOR + 3.25                                        | %*      | 4,382                                             |      |
| Subordinated Debt                        |   | 2034                 |   | LIBOR + 2.85                                        | %*      | 3,093                                             |      |
| $175 million master repurchase  facility |   | N/A                  |   | 1.54                                                | %*      | 28,012                                            |      |
|                                     |   | Total Debt           |   |                                                |    | $                                                 | 1,083,505 |   |

 

----

*   Indicatesa variable rate.

** Lineof credit extends to 40% of assets

 

Sevenof the Federal Home Loan Bank (“FHLB”) advances totaling $226,000 are fixedrate. The remaining advances totaling $590,000 are also fixed, however, theymay be converted at the FHLB’s option to adjustable rate based on the threemonth floating LIBOR.  The FHLBwarehouse line is a $625,000 adjustable line of credit with a floating ratebased on the daily rate credit (“DRC”) plus 50 basis points used to fundmortgages originated by Market Street and RBMG.  An additional warehouse line based upon 40% of assets has afloating rate based on the DRC.  All ofthe FHLB advances and the FHLB warehouse line are secured by investmentsecurities or mortgage loans.  At March31, 2004, NetBank had pledged $262,394 of investment securities and $1.3billion of mortgage loans to the FHLB as collateral for various FHLB advances.

 

InJuly 2003, all the convertible subordinated notes were called at par, and theremaining unamortized discount of $145 was written off.

 

NetBank’ssubordinated debt is supported by trust preferred securities, which were issuedin private pooled transactions through off balance sheet trusts: NBI Trust I,II and III. The subordinated debt, and the associated trust preferredsecurities

 

12

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carrya variable rate and were initially priced at LIBOR plus approximately 3.35%with a cap of 12.5% through January 2008. Interest payments and the resetting of the rates both occur on aquarterly basis.  The debt is scheduledto mature from December 2032 through December 2033 and cannot be redeemed bythe trust for a minimum of five years after issuance.

 

Mostof the revolving lines of credit, warehouse lines of credit (other than theFHLB warehouse line), the master repurchase facilities and commercial paperconduit facility are secured by mortgage loans and are subject to restrictivecovenants.  The covenants includecertain minimum net worth requirements, minimum tangible net worthrequirements, certain minimum financial ratios, maintenance of servicereligibility for various government agencies, a minimum balance in the mortgageservicing rights portfolio and certain minimum liquidity requirements, whichare all defined in the terms of the related debt agreements.  In addition, the covenants restrict thetypes of business activities in which the Company may engage.  NetBank was in compliance with all debtcovenants in place as of March 31, 2004. Although management anticipates complying with all current debtcovenants, there can be no assurance that NetBank or its individualsubsidiaries will be able to comply with all debt covenants in the future.  Failure to comply could result in the lossof the related financing.  Short-termdebt outstanding to third parties reached the highest level for the quarter onMarch 12, 2004 with a daily short-term balance of $1,304 million.

 

**9.             NETINCOME PER COMMON AND COMMON EQUIVALENT SHARE**

 

Basicand diluted net income per common and potential common share has beencalculated based on the weighted average number of shares outstanding.  The following schedule reconciles thenumerator and denominator of the basic and diluted net income per common andpotential common share for the three months ended March 31, 2004 and 2003.  The effect of the retired convertible debtsecurities was not included in the 2003 period because the assumed conversionof such securities was anti-dilutive.

 
|                                                                   |   | **Net Income  (Numerator)** |       | **Shares  (Denominator)** |       | **Per Share  Amount** |       |
|------------------------------------------------------------------------|--------|-----------------------------|------------|---------------------------|------------|-----------------------|------------|
| **Three  months ended March 31, 2004**                                 |   |                        | ** ** |                      | ** ** |                  | ** ** |
| Basic EPS                                                              |   | $                           | 9,394      |                      | 47,250     |                  | $          | 0.20 |   |
| Effect of  dilutive securities – option to purchase common shares |   | —                      |       | 718                       |       | —                |       |
| Diluted EPS                                                            |   | $                           | 9,394      |                      | 47,968     |                  | $          | 0.20 |   |
|                                                                   |   |                        |       |                      |       |                  |       |
| **Three  months ended March 31, 2003**                                 |   |                        | ** ** |                      | ** ** |                  | ** ** |
| Basic EPS                                                              |   | $                           | 10,702     |                      | 48,324     |                  | $          | 0.22 |   |
| Effect of  dilutive securities – option to purchase common shares |   | —                      |       | 438                       |       | —                |       |
| Diluted EPS                                                            |   | $                           | 10,702     |                      | 48,762     |                  | $          | 0.22 |   |

 

**10.          BUSINESSSEGMENTS**

 

Duringthe three months ended March 31, 2004, NetBank realigned its operating segmentsas described in following paragraph. All prior periods amounts have been restated in conformity with thecurrent period presentation.

 

NetBank’sprincipal activities include retail banking, financial intermediary andtransaction processing.  The retailbanking segment primarily consists of offering consumer banking products suchas checking, money market, and certificates of deposit.  Its investments primarily consist of 1-4family mortgage loans originated by the financial intermediary segment, smallbusiness financing leases originated by Republic Leasing, auto loans originatedby its dealer financial services division, purchased securities for investment,mortgage servicing assets and various other purchased or

 

13

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retainedloan products.  The financialintermediary segment originates mortgage loans directly with borrowers andpurchases mortgage loans from correspondents and/or brokers.  The financial intermediary segment packagesor pools such loans either inclusive or exclusive of servicing rights forretention by the retail banking segment or sale into the secondary market.  The transaction processing segment processesmortgages on behalf of community banks on a private label basis; provides ATMand merchant processing services; subservices loans for the retail bank segment,transaction processing segment and for third-party customers; and sells variousinsurance products using an Internet-based platform.

 

Thefinancial information 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 the management structure ofNetBank, Inc. and is not necessarily comparable with similar information fromany other financial institution. The information presented is also notnecessarily indicative of the segment’s operations if they were independententities.

 
|                                                  |   | **For the three  months ended March 31, 2004** |   |
|-------------------------------------------------------|--------|------------------------------------------------|--------|
|                                                  |   | **Retail  banking**                            |   | **Financial  intermediary** |   | **Transaction  processing** |   | **Other /   Eliminations** |   | **Consolidated** |   |
| Interest income                                       |   | $                                              | 25,410 |   | $ | 25,802 |   | $ | 8 |   | $ | 965 |   | $ | 52,185 |   |
| Intersegment interest income                          |   | 10,376                                         |   | 58 |   | — |   | (10,434 | ) | — |   |
| Total interest income                                 |   | 35,786                                         |   | 25,860 |   | 8 |   | (9,469 | ) | 52,185 |   |
| Interest expense                                      |   | 18,726                                         |   | 1,545 |   | 24 |   | 141 |   | 20,436 |   |
| Intersegment interest expense                         |   | 153                                            |   | 10,194 |   | — |   | (10,347 | ) | — |   |
| Total interest expense                                |   | 18,879                                         |   | 11,739 |   | 24 |   | (10,206 | ) | 20,436 |   |
| Net interest income                                   |   | 16,907                                         |   | 14,121 |   | (16 | ) | 737 |   | 31,749 |   |
| Provision for credit losses                           |   | 1,829                                          |   | 18 |   | — |   | — |   | 1,847 |   |
| Intersegment– servicing and  processing fees     |   | —                                         |   | — |   | 3,790 |   | (3,790 | ) | — |   |
| Non-interest income                                   |   | 19,195                                         |   | 34,573 |   | 3,971 |   | (1,048 | ) | 56,691 |   |
| Non-interest expense                                  |   | 27,341                                         |   | 35,383 |   | 7,573 |   | 1,264 |   | 71,561 |   |
| Intersegment– servicing and  processing expenses |   | 2,380                                          |   | 1,410 |   | — |   | (3,790 | ) | — |   |
| Pre-tax income (loss)                                 |   | $                                              | 4,552  |   | $ | 11,883 |   | $ | 172 |   | $ | (1,575 | ) | $ | 15,032 |   |

** **
|                                                  |   | **For the three  months ended March 31, 2003** |    |
|-------------------------------------------------------|--------|------------------------------------------------|---------|
|                                                  |   | **Retail  banking**                            |    | **Financial  intermediary** |   | **Transaction  processing** |   | **Other &   Eliminations** |   | **Consolidated** |   |
| Interest income                                       |   | $                                              | 19,500  |   | $ | 25,495 |   | $ | — |   | $ | 7 |   | $ | 45,002 |   |
| Intersegment interest income                          |   | 8,509                                          |    | — |   | — |   | (8,509 | ) | — |   |
| Total interest income                                 |   | 28,009                                         |    | 25,495 |   | — |   | (8,502 | ) | 45,002 |   |
| Interest expense                                      |   | 19,428                                         |    | 1,659 |   | — |   | 412 |   | 21,499 |   |
| Intersegment interest expense                         |   | 485                                            |    | 8,221 |   | — |   | (8,706 | ) | — |   |
| Total interest expense                                |   | 19,913                                         |    | 9,880 |   | — |   | (8,294 | ) | 21,499 |   |
| Net interest income                                   |   | 8,096                                          |    | 15,615 |   | — |   | (208 | ) | 23,503 |   |
| Provision for credit losses                           |   | 849                                            |    | 19 |   | — |   | — |   | 868 |   |
| Intersegment— servicing and  processing fees     |   | —                                         |    | — |   | 3,004 |   | (3,004 | ) | — |   |
| Non-interest income                                   |   | 17,466                                         |    | 51,384 |   | 1,239 |   | (945 | ) | 69,144 |   |
| Non-interest expense                                  |   | 32,733                                         |    | 34,958 |   | 5,890 |   | 1,227 |   | 74,808 |   |
| Intersegment— servicing and  processing expenses |   | 2,111                                          |    | 893 |   | — |   | (3,004 | ) | — |   |
| Pre-tax income (loss)                                 |   | $                                              | (10,131 | ) | $ | 31,129 |   | $ | (1,647 | ) | $ | (2,380 | ) | $ | 16,971 |   |

 

14

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**11.          LOSSCONTINGENCY**

 

NetBank,FSB is involved in litigation with three insurance companies who are suretieson some of NetBank, FSB’s commercial lease portfolios.  NetBank, FSB has filed a claim for allprincipal and interest payments that are currently past due.  The total unpaid principal and interestbalance of $77.8 million is included in loan and lease receivables.  In accordance with the Office of ThriftSupervision requirements, the Company maintains an allowance for losses againstthis portfolio of $21.2 million.  Forthe three months ended March 31, 2004 and 2003, the Company did not accruescheduled interest of $767 and $1,539, respectively, and incurred $503 and  $151, respectively, in legal expensesrelated to this litigation.  Legalexpenses are included in the professional fees line of the statement ofoperations.  For the three months endedMarch 31, 2004 and 2003, the lost interest and legal expenses associated withthe CMC lease portfolio negatively impacted the company’s results byapproximately $0.02.

 

**12.          COMMITMENTSAND GUARANTEES**

 

TheCompany has issued mortgage-backed securities under programs sponsored byGinnie Mae, Freddie Mac and Fannie Mae. In connection with servicing mortgage-backed securities guaranteed byGinnie Mae, Freddie Mac or Fannie Mae, the Company advances certain principaland interest payments to security holders prior to their collection fromspecific mortgagors.  Additionally, theCompany must remit certain payments of property taxes and insurance premiums inadvance of collecting them from specific mortgagors and make certain paymentsof attorney’s fees and other costs related to loans in foreclosure.  These amounts are included in servicingadvances under the caption due from servicers and investors in the accompanyingconsolidated balance sheets.  Likewise,during the month that a mortgagor pays off his/her mortgage, the Company mustaccept an interest payment from the borrower that is pro-rated to the date ofpayoff and pass through a full month’s interest to the security holder.  The Company includes its projection of thecost of such advances and lost interest on mortgages that prepay, and theexpense of unreimbursed attorney and other costs associated with foreclosure inits valuation of the servicing assets.

 

Inthe ordinary course of business, the Company is exposed to liability underrepresentations and warranties made to purchasers and insurers of mortgageloans and the purchasers of servicing rights. Under certain circumstances, the Company may be required to repurchasemortgage loans or indemnify the purchasers of loans or servicing rights forlosses if there has been a breach of representations or warranties.  Repurchased loans are carried at the lowerof cost or net realizable value.  Therewere $39.8 million and $51.9 million of repurchased loans included in mortgageloans held for sale at March 31, 2004 and December 31, 2003, respectively.  The Company had $10.8 million and $16.8million of reserves resulting from the estimation of the net realizable valueassociated with repurchased loans as of March 31, 2004 and December 31, 2003,respectively.  Additionally, the Companyhad $18.5 million and $17.9 million of reserves for estimated losses on futurerepurchases as of March 31, 2004 and December 31, 2003, respectively.

 

NetBankis unable to determine its maximum exposure under its representations andwarranties.  The maximum exposure underNetBank’s representations and warranties would be the outstanding principalbalance and any premium paid of all loans or mortgage servicing rights eversold by the Company less any loans sold servicing released or any loansunderlying mortgage servicing rights that have already prepaid or defaultedwithout a breach of representations and warranties.  For the three months ended March 31, 2004 and 2003, the Companyrepurchased approximately $8.4 million and $9.8 million of unpaid principalbalances, respectively.

 

Incertain sales of whole loans and sales of servicing, the Company iscontractually obligated to refund to the purchaser, certain premiums paid tothe Company on the sale if the mortgagor prepays the mortgage during aspecified period of time (generally from 60 to 120 days after sale).  At March 31, 2004 and December 31, 2003, theCompany held a reserve for its estimated obligation of $1,856 and $1,104,respectively.

 

15

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Asof March 31, 2004, NetBank had commitments to fund mortgage loans of $1.7billion, open-end consumer lines of credit of $73,916, undisbursed mortgageconstruction loans of $55,715, undisbursed commercial financing loans of $3,889and commercial financing commitments of $4,770.

 

NetBankis involved in certain legal proceedings, excluding the CMC litigationdiscussed in note 11, incidental to its business.  NetBank does not believe that the outcome of these proceedingswill have a material adverse effect upon its financial condition, results ofoperations or cash flows.

 

**ITEM 2: Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

*The following discussion may include forward-lookingstatements. Forward-looking statements regarding the intent, belief or currentexpectations of NetBank, Inc. or its officers and directors can be identifiedby the use of forward-looking terms such as “may,” “will,” “should,” “believe,”“expect,” “anticipate,” “estimate,” “continue,” 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 financialservices generally; 2) the public’s perception of the Internet as a secure,reliable channel for transactions; 3) the success of new products and lines ofbusiness considered critical to the Company’s long-term strategy, such as smallbusiness banking and transaction processing services; 4) potential difficultiesin integrating the Company’s operations across its multiple lines of business;5) the cyclical nature of the mortgage banking industry generally; 6) apossible decline in asset quality; 7) the possible adverse effects ofunexpected changes in the interest rate environment; 8) adverse legal rulings,particularly in the company’s litigation over leases originated by theCommercial Money Center, Inc.; and/or 9) increased competition and regulatorychanges. The Company’s 2003 Form 10-K filed with the Securities and ExchangeCommission, contains additional details on these and other risks that arematerial to operations. All forward-looking statements in this report are basedon information available at the time of filing. The Company has no obligationto update any forward-looking statement included herein.*

 

**General**

 

NetBank,Inc. is a financial holding company that wholly owns the outstanding stock ofNetBank, (“NetBank, FSB” or the “Bank”), a federal savings bank; MeritageMortgage Corporation (“Meritage”), a wholesale non-conforming mortgageprovider; MG Reinsurance Company (“MG Reinsurance”), a captive reinsurancecompany; NetInsurance, Inc., (“NetInsurance”), a licensed insurance agency; andNB Partners, Inc., a corporation formed to be involved in strategic partneringopportunities.  NetBank, FSB owns all ofthe outstanding stock of Market Street Mortgage Corporation (“Market Street”),a retail mortgage company, NetBank Payment Systems, Inc. (“NPS”), a leadingprovider of ATM services for retail and other non-bank businesses and ResourceBancshares Mortgage Group, Inc. (“Resource”). Resource wholly owns RBMG, Inc.(“RBMG”), a wholesale mortgage banking company, and Republic Leasing Company,Inc. (“Republic Leasing”), a commercial financing company.

 

NetBankacquired NPS on December 1, 2003. Accordingly, the financial impact of NPS is included from the date ofacquisition.  The entire consolidatedcompany is referred to herein as “NetBank” or “the Company”.

 

Alldollar figures are presented in thousands (000s) except per share data unlessotherwise noted.

 

*Executive Summary.*

 

Afterits acquisition of Resource at March 31, 2002, NetBank commenced a near-termstrategy of re-positioning its balance sheet to accommodate running a financialintermediary operation while positioning its operations so that, over thelong-term, its income would be generated equally from retail banking, financialintermediary operations, and transaction processing operations.

 

Withrespect to the re-positioning of its balance sheet, NetBank has sold many ofthe loans previously acquired from third parties and replaced those loans withinternally-generated loans with better credit and interest rate riskprofiles.  Likewise, the retail bank hasseen an increase in its warehouse lines to the financial intermediary segmentwhereby the company as a

 

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wholeearns a long-term rate on an asset that is pre-sold into the secondarymarket.  On the liability side, NetBankhas replaced higher-priced, longer-term FHLB borrowings with shorter-term,lower-cost borrowings that better match the duration of the new assets beingput on the books.   Likewise, NetBank isproactively managing its pricing strategy to attract multi-product, profitablerelationships.  Higher rates areextended to customers who sign up for multiple services and actively usetransaction-based accounts, such as checking and money market. The bank haslowered the rates on its certificates of deposit to discourage single-productrelationships.  These relationships aretypically unprofitable for the bank since this type of customer is simply lookingfor the highest rate available and has no intention of using the bank for otherservices. The bank may soon offer a higher-rate CD to customers who hold otherproducts and services.  Theseasset-liability strategies have dramatically increased the net interest marginand core profitability of the retail bank. The bank’s net interest margin increased from 100 bps for the quarterended March 31, 2003 to 163 bps for the quarter ended March 31, 2004.

 

Onthe longer-term strategy of balancing its sources of income, the first quarterresults showed significant progress. During the first quarter of 2003, all of the Company’s profits came fromthe financial intermediary segment.  Theretail bank segment went from a loss of $6,388 for the first quarter of 2003 toan income of $2,845 for the first quarter of 2004.  Likewise, the transaction processing segment went from a loss of$1,039 to an income of $108 comparing the first quarter of 2003 to thecomparable period in 2004.

 

Thefinancial intermediary segment in 2003 enjoyed the benefits of a historicallylow interest rate environment.  Late in2003 and continuing into 2004, mortgage rates increased and production andsales volumes declined.  Productiondropped from $4.4 billion for the first quarter of 2003 to $3.3 billion for thefirst quarter of  2004.  Sales of mortgages, likewise, dropped from$4.1 billion for the first quarter of 2003 to $3.8 billion for the firstquarter of 2004.  Margins in thefinancial intermediary segment dropped from 161 bps during the first quarter of2003 to 129 bps for the first quarter of 2004 as competitive pressures heatedup related to excess capacity particularly in the correspondent channel.  This resulted in a reduction in net incomeof $12,203 comparing the first quarter of 2003 with the comparable quarter of2004.  In spite of this drop in incomefrom the financial intermediary segment, the aforementioned strategies enabledNetBank to post consolidated earnings of $9,394 or $0.20 per share for thequarter ended March 31, 2004 compared with income of $10,702 or $0.22 per sharefor the same period in 2003.

 

**Financial Condition**

 

*General. *NetBank’sassets totaled $4.4 billion at March 31, 2004, a decrease of $363 million or 8%from December 31, 2003.  This decline isprimarily the result of three factors: first, the velocity of sales into thesecondary market by the financial intermediary segment surpassed its productionby $513 million during the period; second, the retail banking segment sold $146million of investment securities available for sale; and third, receivablesfrom unsettled trades declined by $76 million. These declines were partially offset by increases of $282 million inloan and lease receivables and $155 million in cash and cash equivalents.

 

*Investment Securities.*  During the three months ended March 31,2004, the Company sold $146 million of its investment securities available forsale at gains of $3.2 million.  Asreflected in the following tables, the majority of the securities sold weremortgage pool securities.  The Companywill continue to buy and sell investment securities on a selected basis as partof its overall asset-liability management strategy.

 

17

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Thefollowing tables set forth certain information relating to the Company’savailable for sale securities:

 
| **As of March 31, 2004**             |   | **Amortized  cost** |    | **Unrealized  gains** |   | **Unrealized  losses** |   | **Estimated  fair value** |   |
|--------------------------------------|--------|---------------------|---------|-----------------------|--------|------------------------|--------|---------------------------|--------|
| Mortgage pool securities             |   | $                   | 91,405  |                  | $      | 1,165                  |   | $                         | — |   | $ | 92,570 |   |
| Collateralized mortgage  obligations |   | 1,239               |    | 86                    |   | —                 |   | 1,325                     |   |
| U.S. government agencies             |   | 162,285             |    | 5,948                 |   | —                 |   | 168,233                   |   |
| Corporate bonds                      |   | 35,101              |    | 848                   |   | —                 |   | 35,949                    |   |
| Habitat bonds and other              |   | 3,883               |    | —                |   | —                 |   | 3,883                     |   |
| Total                                |   | $                   | 293,913 |                  | $      | 8,047                  |   | $                         | — |   | $ | 301,960 |   |

 
| **As of December 31, 2003**          |   | **Amortized  cost** |    | **Unrealized  gains** |   | **Unrealized  losses** |   | **Estimated  fair value** |   |
|--------------------------------------|--------|---------------------|---------|-----------------------|--------|------------------------|--------|---------------------------|--------|
| Mortgage pool securities             |   | $                   | 191,492 |                  | $      | 1,243                  |   | $                         | 114    |   | $ | 192,621 |   |
| Collateralized mortgage  obligations |   | 1,356               |    | 108                   |   | —                 |   | 1,464                     |   |
| U.S. government agencies             |   | 224,435             |    | 2,743                 |   | —                 |   | 227,178                   |   |
| Corporate bonds                      |   | 29,094              |    | 411                   |   | 187                    |   | 29,318                    |   |
| Habitat bonds and other              |   | 3,595               |    | 172                   |   | —                 |   | 3,767                     |   |
| Total                                |   | $                   | 449,972 |                  | $      | 4,677                  |   | $                         | 301    |   | $ | 454,348 |   |

* *

*Loan and Lease Receivables.*  For the three months ended March 31, 2004,the loan and lease receivables portfolio increased $283 million, a 16%increase.  The Company achieved thisgrowth by selectively retaining $294 million in mortgage and home equity loansoriginated through its mortgage subsidiaries, $87 million of auto loansoriginated through its indirect auto lending unit and $39 million of smallbusiness financing leases originated through Republic leasing.  The retention of these internally originatedassets was offset, in part, by $138 million of principal reductions andprepayments.  NetBank is activelyreplacing its purchased loan and lease receivables portfolio with internallyoriginated loans and leases so it can capitalize on cross-sellingopportunities, internally service the assets and more effectively control itscredit and interest rate risk. Third-party purchased loans represent only 13% of the held forinvestment portfolio.  NetBank intendsto continue retaining its originated auto loans until the percentage of autoand other consumer loans to total interest-earning assets reaches approximately15%.  At that time, the Company willbegin selling any excess originations into the secondary markets.

 

*Asset Quality and Non-performing Assets.*The Company periodically reviews the performance of its loan and leasereceivables portfolio by reviewing charge-offs, delinquency statistics, andvarious other industry statistics. Large non-homogeneous credits are reviewed on a loan-by-loan orlease-by-lease basis, whereas relatively small credits with similar riskcharacteristic are reviewed on a pool-by-pool basis.  If a decline in credit quality for a specific pool or individualloan or lease is noted, the Company records additional allowance through acharge to the provision for credit losses. The allowance for credit losses is maintained at a level estimated to beadequate to provide for probable losses in the loan and lease receivablesportfolio.  The Company determines theadequacy of the allowance based upon reviews of individual loans and leases,recent loss experience, current economic conditions, the risk characteristics ofthe various categories of loans and leases and other pertinent factors.  NetBank’s non-performing assets as apercentage of gross unpaid principal balance (UPB) improved from 4.6% atDecember 31, 2003, to 3.9% at March 31, 2004, as the level of non-performingassets held fairly constant relative to an increase of $283 million or 16% ingross UPB.  As gross UPB continues toincrease from the retention of high-quality loans and leases, the Companyexpects these ratios may continue to improve.

 

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Thefollowing tables detail NetBank’s held for investment loan and lease portfolio,the associated allowance for credit losses and non-performing assets:

 
|                            |   | **March 31, 2004** |       |
|---------------------------------|--------|--------------------|------------|
|                            |   | **Gross UPB**      |       | **Allocated  Allowance** |   | **(1) Non-  performing** |   | **Allowance /   NPA** |   | **NPA /   Gross  UPB** |   |
| **Held for  investment assets** |   |               | ** ** |   | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Residential mortgages           |   | $                  | 1,496,798  |   | $ | 9,872 |   | $ | 1,978 |   |   |   |   |   |
| Leases                          |   | 278,549            |       | 11,224 |   | 1,264 |   |   |   |   |   |
| Auto                            |   | 169,326            |       | 1,326 |   | 54 |   |   |   |   |   |
| Home equity lines               |   | 58,241             |       | 859 |   | 287 |   |   |   |   |   |
| Consumer                        |   | 2,424              |       | 80 |   | — |   |   |   |   |   |
| Loan and lease receivables      |   | 2,005,338          |       | 23,361 |   | 3,583 |   | 652.0 | % | 0.2 | % |
| CMC leases (2)                  |   | 77,835             |       | 21,230 |   | 77,835 |   | 27.3 | % | 100.0 | % |
| Total                           |   | $                  | 2,083,173  |   | $ | 44,591 |   | $ | 81,418 |   | 54.8 | % | 3.9 | % |

 
|                       |   | **December 31,  2003** |      |
|----------------------------|--------|------------------------|-----------|
|                       |   | **Gross UPB**          |      | **Allocated  Allowance** |   | **(1) Non-  performing** |   | **Allowance /   NPA** |   | **NPA /   Gross UPB** |   |
| Residential mortgages      |   | $                      | 1,309,689 |   | $ | 10,087 |   | $ | 2,436 |   |   |   |   |   |
| Leases                     |   | 266,957                |      | 10,427 |   | 1,430 |   |   |   |   |   |
| Auto                       |   | 92,724                 |      | 1,054 |   | 27 |   |   |   |   |   |
| Home equity lines          |   | 50,816                 |      | 829 |   | 339 |   |   |   |   |   |
| Consumer                   |   | 1,880                  |      | 62 |   | 1 |   |   |   |   |   |
| Loan and lease receivables |   | 1,722,066              |      | 22,459 |   | 4,233 |   | 530.6 | % | 0.2 | % |
| CMC leases (2)             |   | 78,583                 |      | 21,230 |   | 78,583 |   | 27.0 | % | 100.0 | % |
| Total                      |   | $                      | 1,800,649 |   | $ | 43,689 |   | $ | 82,816 |   | 52.8 | % | 4.6 | % |

 

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(1)            Non-performingassets (“NPA”) include all loans and leases that are 90 days or more delinquentor on non-accrual status.  The tablesabove do not include $45,553 and $46,409 of non-performing loans classified asheld for sale as of March 31, 2004 and December 31, 2003, respectively.  Since loans classified as held for sale arecarried at the lower of cost or market, the estimated losses that may occurhave already been recorded in both the balance sheet and statement ofoperations.

 

(2)            Thereader is directed to Part II. Item 1. Legal Proceedings contained within thisreport for additional detail regarding the CMC litigation.

 

*Mortgage Servicing Rights.*  Beginning in late 2002, NetBank adopted astrategy of retaining primarily all of its originated conventional MSRs inorder to achieve the necessary critical mass the servicing division requires toeventually become operationally profitable. NetBank will continue to retain the majority of its originated MSRs forthe foreseeable future.  For the threemonths ended March 31, 2004, the value of NetBank’s MSRs declined $9 million or5%.  The $9 million decline in value wasprimarily driven by the $10 million of amortization and impairment and the fallof long-term interest rates, which resulted in a loss of $18 million in themarket value during the quarter.  Thesedeclines in value were offset in part by the capitalization of $19 million innew servicing rights.  Should long-termrates rise during the next quarter, the Company could see a reversal of theloss in market value.

 

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*Derivatives.*The fair value of hedgescovering the available for sale servicing portfolio increased in value by$9,956 during the three months ended March 31, 2004.  The fair value of hedges covering the pipeline of servicing alsoincreased in value by $2,361 during the three months ended March 31, 2004.  The fair value of the Company’s loancommitments for which the interest rate is locked (“rate locks”) declined invalue by $2,229 during the three months ended March 31, 2004; however, theportfolio of mandatory delivery commitments hedging the Company’s rate locksincreased in value by $3,859 during the same period.  The value of the mandatory delivery commitments hedging the Company’sinventory of closed loans also increased in value by $1,111 during the sameperiod.

 

*Liabilities.* Total liabilities declined $366 million during the three monthsended March 31, 2004 compared to December 31, 2003.  The decline was primarily related a $349 million decline in otherborrowed funds, which were used to support the higher level of loans held forsale, and a $132 million decline in unsettled trades.  These declines were partially offset by a $105 million or 4%increase in deposits.

 

*Deposits.*  Deposits were $2.6 billion at March 31, 2004, a 4% increasecompared to $2.5 billion at December 31, 2003. As of March 31, 2004, deposits represented 71% of total interest-bearingliabilities (including deposits, other borrowed funds and subordinated debt)outstanding.  FHLB advances, warehouselines of credit and repurchase agreements represented approximately 28%, andsubordinated debt represented less than 1%. During the three months ended March 31, 2004, NetBank was able toachieve both increased deposits and lower cost of funds by replacing $42,381 ofhigher cost certificates of deposits with $147,125 of money market andinterest-bearing checking accounts. NetBank will continue to emphasize transactional accounts as its primarylong-term funding source.  The followingtable summarizes NetBank’s deposits:

 
|                                    |   | **As of March 31,  2004** |      | **As of December  31, 2003** |   |
|-----------------------------------------|--------|---------------------------|-----------|------------------------------|--------|
|                                    |   | **Amount**                |      | **Percentage**               |   | **Weighted  average  interest  rate** |   | **Amount** |   | **Percentage** |   | **Weighted  average  interest  rate** |   |
| Non-interest bearing checking  accounts |   | $                         | 343,538   |                         | 13.0   | % | N/A |   | $ | 198,884 |   | 7.8 | % | N/A |   |
| Interest bearing:                       |   |                      |      |                         |   |   |   |   |   |   |   |   |   |
| Checking accounts                       |   | 244,877                   |      | 9.3                          | %      | 1.1 | % | 228,178 |   | 9.0 | % | 1.4 | % |
| Money market                            |   | 1,349,066                 |      | 51.0                         | %      | 1.7 | % | 1,363,294 |   | 53.7 | % | 1.9 | % |
| Certificate of deposit under $100       |   | 586,770                   |      | 22.2                         | %      | 2.7 | % | 632,602 |   | 24.9 | % | 2.8 | % |
| Certificate of deposit over $100        |   | 119,920                   |      | 4.5                          | %      | 2.7 | % | 116,469 |   | 4.6 | % | 2.8 | % |
| Total deposits                          |   | $                         | 2,644,171 |                         | 100.0  | % |   |   | $ | 2,539,427 |   | 100.0 | % |   |   |

* *

*Shareholders’ Equity.*  Total shareholders’ equity increased $3,237for the three months ended March 31, 2004. The increase is primarily due to an $8,453 increase in retained earningsresulting from $9,394 of net income, offset in part by $941 of dividends, andan increase of $2,250 in accumulated other comprehensive income (OCI).  These increases were offset by an increasein treasury stock of $7,382 due to the repurchase of 672,100 shares of commonstock at a weighted average cost of $12.26 per share offset, in part, by the reissuanceof 77,138 shares under the employee stock purchase plan and exercise ofemployee stock options.  NetBank willcontinue to repurchase shares periodically in the public market or throughprivate transactions.  In April 2004 theBoard of Directors increased the number of shares available for repurchase byone million.  Including this increase,there are approximately 1.3 million shares remaining available for repurchaseunder current Board authority.

 

 

**Results of Operations - Three months ended March 31, 2004,compared to the three months ended March 31, 2003**

 

*General.*  Net income for the three months ended March 31, 2004, was $9,394or $0.20 per share, compared to net income of $10,702 or $0.22 per share, forthe same period in 2003. NetBank’s management capitalized on the favorableinterest rate environment in the first quarter of 2003 to post strong revenuesfrom its financial intermediary segment. In contrast,

 

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interestrate volatility during the first quarter of 2004 adversely impacted the resultsreported from the financial intermediary segment.  Mortgage production dropped from $4.4 billion to $3.3 billion,while sales of mortgages dropped from $4.1 billion to $3.8 billion comparingthe first quarter of 2003 to 2004, respectively.  NetBank also experienced pressure on its margins in the financialintermediary segment from increasing competition, especially in thecorrespondent channel.  The financialintermediary segment’s net income was down by $12.2 million as a result.   This was offset, in part, by improvedresults in the retail bank segment which posted income of $2,845 during thefirst quarter of 2004 compared with a loss of $6,388 for the first quarter of2003.

 

*Interest Income*.  NetBank’s interest income for the three months ended March 31,2004, was $52,185 compared to $45,002 for the same period in 2003.  As detailed in the following rate volumevariance table, NetBank lowered the average balance of its short-terminvestments and investment securities available for sale by $166,153 andincreased the average balance of its loans held for sale by $199,787 and loanand lease receivables by $866,578.  Theincrease in loan and lease receivables is principally the result of the bankretaining primarily adjustable rate mortgages originated by the financialintermediary segment.  During thecurrent quarter NetBank retained $293 million of internally originated mortgageloans and approximately $87 million of internally originated auto loans.  As the Company continues to selectively retaininternally originated loans, the average balance of loan and lease receivableswill increase as a percentage of total interest-earning assets.  The expected increase in loan and leasereceivables as a percentage of total interest-earning assets will be compoundedby the expected decline in the average balance of loans held for sale.  This decline is based on the April 2004,Mortgage Bankers Association’s forecast of residential mortgage originationsbeing 33% lower in 2004 than in 2003. As discussed in note 11 of the consolidated financial statementsincluded within this report, the Company has not accrued and has not receivedapproximately $767 of interest related to the CMC lease portfolio during thethree months ended March 31, 2004.  SeePart II. Item 1. Legal Proceedings within this report for a more in depthdiscussion of the CMC lease portfolio and associated litigation.

 

*Interest Expense*. Total interest expense forthe three months ended March 31, 2004, was $20,436 compared to $21,499 for thesame period of 2003.  The $1,063 declineis primarily due to the 67 basis-point reduction in the average cost of funds,offset in part by the impact of an increase of $770,814 in the average balanceof interest-bearing liabilities.  Forthe three months ended March 31, 2004 there was $11,818 of interest expense ondeposits (including checking, money market and certificates of deposits) ascompared to $12,446 for the three months ended March 31, 2003.  The $628 net decrease in interest expense ondeposits was the result of a 37 basis-point decline in the average rate paid ondeposits resulting in a positive $969 rate variance, partially offset by anegative volume variance of $341 due to increased average interest-bearingdeposit balances of $249,813.  For thethree months ended March 31, 2004, interest expense on other borrowed funds(including short-term debt, FHLB advances, and convertible subordinated debt)was $8,618 compared to $9,053 for the same period of 2003.  The $435 decline in interest expense relatedto other borrowed funds is the result of a 143 basis-point decline in theaverage cost of funds, partially offset by an increase of $521,001 in theaverage outstanding balance.  The 143basis-point reduction in the average cost of other borrowed funds is primarilydue to fixed-rate term FHLB advances being prepaid and replaced with variablerate advances.

 

*Net Interest Income. *Net interest income is determined by interest rate spread,which is the difference between the yields earned on interest-earning assetsand the rates paid on interest-bearing liabilities, and the relative amounts ofinterest-earning assets and interest-bearing liabilities.  Net interest income was $31,749, or 3.06% ofaverage interest-earning assets for the three months ended March 31, 2004,compared to $23,503, or 2.90% of average interest-earning assets for the threemonths ended March 31, 2003.

 

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Thefollowing table details the relative interest rates and average balances ofNetBank’s interest-earning assets and interest-bearing liabilities for thethree months ended March 31, 2004, and 2003:

 
| **Average  Balance** |      | **Average  Yield /  Rate** |   |      |   | **Interest** |   |                                |                   | **Variance  attributable to**                   |   |
|----------------------|-----------|----------------------------|--------|-----------|--------|--------------|--------|-------------------------------------|------------------------|-------------------------------------------------|--------|
| **2004**             |      | **2003**                   |   | **2004**  |   | **2003**     |   |                                |                   | **2004**                                        |   | **2003** |   | **Variance** |   | **Rate** |   | **Volume  (3)** |   |
|                 |      |                       |   |      |   |         |   | **Interest-earning  assets:**       |                   |                                            |   |   |   |   |   |   |   |   |   |
| $                    | 71,516    |                       | 37,674 |      | 1.01   | %            | 1.40   | %                                   | Short-term investments |                                            | $      | 180 |   | $ | 132 |   | $ | 48 |   | $ | (37 | ) | $ | 85 |   |
| 453,377              |      | 653,372                    |   | 3.50      | %      | 4.05         | %      | Investment securities  (1)          |                   | 3,966                                           |   | 6,609 |   | (2,643 | ) | (893 | ) | (1,750 | ) |
| 1,756,858            |      | 1,557,071                  |   | 5.58      | %      | 6.54         | %      | Loans held for sale (2)             |                   | 24,518                                          |   | 25,477 |   | (959 | ) | (3,747 | ) | 2,788 |   |
| 1,863,290            |      | 996,712                    |   | 5.05      | %      | 5.13         | %      | Loans and leases  receivable (2)    |                   | 23,521                                          |   | 12,784 |   | 10,737 |   | (202 | ) | 10,939 |   |
| 4,145,041            |      | 3,244,829                  |   | 5.04      | %      | 5.55         | %      | Total interest-earning  assets      |                   | 52,185                                          |   | 45,002 |   | 7,183 |   | (4,879 | ) | 12,062 |   |
|                 |      |                       |   |      |   |         |   |                                |                   |                                            |   |   |   |   |   |   |   |   |   |
|                 |      |                       |   |      |   |         |   | **Interest-bearing  liabilities:**  |                   |                                            |   |   |   |   |   |   |   |   |   |
| 227,117              |      | 168,126                    |   | 1.24      | %      | 1.55         | %      | Checking accounts                   |                   | 704                                             |   | 650 |   | 54 |   | (129 | ) | 183 |   |
| 1,356,917            |      | 906,564                    |   | 1.74      | %      | 2.25         | %      | Money market accounts               |                   | 5,898                                           |   | 5,099 |   | 799 |   | (1,159 | ) | 1,958 |   |
| 752,105              |      | 1,011,636                  |   | 2.77      | %      | 2.65         | %      | Certificates of deposit             |                   | 5,216                                           |   | 6,697 |   | (1,481 | ) | 319 |   | (1,800 | ) |
| 619,499              |      | 335,069                    |   | 2.04      | %      | 2.29         | %      | Short-term debt                     |                   | 3,157                                           |   | 1,921 |   | 1,236 |   | (213 | ) | 1,449 |   |
| 858,898              |      | 601,178                    |   | 2.48      | %      | 4.47         | %      | FHLB advances                       |                   | 5,320                                           |   | 6,720 |   | (1,400 | ) | (2,996 | ) | 1,596 |   |
| 11,857               |      | 4,382                      |   | 4.76      | %      | 4.75         | %      | Subordinated debt                   |                   | 141                                             |   | 52 |   | 89 |   | — |   | 89 |   |
| —               |      | 28,624                     |   | —    |   | 5.03         | %      | Convertible subordinated  debt      |                   | —                                          |   | 360 |   | (360 | ) | — |   | (360 | ) |
| 3,826,393            |      | 3,055,579                  |   | 2.14      | %      | 2.81         | %      | Total interest-bearing  liabilities |                   | 20,436                                          |   | 21,499 |   | (1,063 | ) | (4,178 | ) | 3,115 |   |
|                 |      |                       |   |      |   |         |   |                                |                   |                                            |   |   |   |   |   |   |   |   |   |
| —               |      | —                     |   | 2.90      | %      | 2.74         | %      | Net interest margin                 |                   | 31,749                                          |   | 23,503 |   | 8,246 |   | (701 | ) | 8,947 |   |
| 318,648              |      | 189,250                    |   | 0.16      | %      | 0.16         | %      | Interest free sources               |                   | —                                          |   | — |   | — |   | — |   | — |   |
| $                    | 4,145,041 |                       | $      | 3,244,829 |   | 3.06         | %      | 2.90                                | %                      | Net  interest income to interest-earning assets |   | $ | 31,749 |   | $ | 23,503 |   | $ | 8,246 |   | $ | (701 | ) | $ | 8,947 |   |
|                      |           |                            |        |           |        |              |        |                                     |                        |                                                 |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

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

(2) No separate treatment has beenmade for non-accrual loans.

(3) Variances attributable to therate and volume mix are included in the volume variances.

 

*Provision for Credit Losses.*  The provision for credit losses was $1,847for the three months ended March 31, 2004, compared to $868 for the same periodof 2003.  The increase in provisionrelates to the increase in loans retained during the quarter.  During the three months ended March 31,2004, NetBank retained its originated auto loans of $87 million, originatedmortgage loans of $293 million, and originated leases of $39 million.  During the three months ended March 31,2003, NetBank retained originated mortgage loans of $215 million and originatedleases of $31 million.  Reference ismade to the asset quality and non-performing assets section in the financialcondition section contained within this report for additional detail concerningthe determination of provision expense related to maintaining the proper levelof allowance for credit losses.

 

*Non-interest Income.*  Non-interest income decreased $12,453 to$56,691 for the three months ended March 31, 2004, compared to $69,144 for thesame period of 2003.  Gain on sales ofmortgage loans and mortgage servicing rights accounted for $16,609 of theperiod-over-period decrease, which was primarily due to the $374,013 decreasein sales of mortgage loans period over period coupled with a compression in themargin on sales related primarily to correspondent operations.  This decrease was partially offset by anincrease of $5,706 in service charges and fees related to the growth in the servicingportfolio and the growth in deposits. For the three months ended March 31, 2004, other income increased $1,613compared to the same period of 2003. Other income for the three months ended March 31, 2004, consisted of$1,201 of gains associated with fair value adjustments for assets accounted forunder SFAS No. 133, $545 of revenues from MG Reinsurance, $382 of revenues fromRepublic Leasing, $472 of revenue from NetBank Payment Systems, and $1,576 ofancillary fees and income.

 

*Non-interest Expense.*  Non-interest expense includes all operatingexpenses such as salaries and benefits, marketing and general andadministrative expenses.  Non-interestexpense decreased by $3,247 to $71,561 for the three months ended March 31,2004, from $74,808 for the three months ended March 31, 2003.  The decrease is primarily related to thereduction in prepayment penalties on the early extinguishment of debt of $5,976during the quarter ended March 31, 2004

 

22

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comparedwith the same period in 2003.  Duringthe quarter ended March 31, 2004, NetBank did not prepay any of its term FHLBadvances, while during the quarter ended March 31, 2003, NetBank prepaid $100million of term, fixed-rate advances. This decrease in non-interest expense was offset, in part, by increasesin depreciation and amortization of $1,247 related to the deployment of newtechnology late in 2003, salaries and benefits of $1,117 (a 4% increase), andoccupancy expense of $821.

 

*Retail Bank Operations*

 

Thetable below provides an overview of the results of operations for the retailbank segment:

 
|                                                                                  |   | **2004  1st Qtr** |           | **2003  1st Qtr** |   | **Change** |   |
|---------------------------------------------------------------------------------------|--------|-------------------|----------------|-------------------|--------|------------|--------|
| Net interest income                                                                   |   | **$**             | **16,989**     | ** **        | $      | 8,097      |   | $ | 8,892 |   |
| Provision for credit losses                                                           |   | **1,829**         | ** **     | 849               |   | 980        |   |
| Net interest income after provision                                                   |   | **15,160**        | ** **     | 7,248             |   | 7,912      |   |
| Fees, charges and other income                                                        |   | **4,220**         | ** **     | 3,225             |   | 995        |   |
| Total revenues                                                                        |   | **19,380**        | ** **     | 10,473            |   | 8,907      |   |
| Total expenses                                                                        |   | **15,890**        | ** **     | 15,209            |   | 681        |   |
| Pre-tax income (loss) before gains on securities, debt and net servicing  results     |   | **3,490**         | ** **     | (4,736            | )      | 8,226      |   |
| Net gain on securities and prepaid debt                                               |   | **3,169**         | ** **     | 356               |   | 2,813      |   |
| Net servicing results                                                                 |   | **(2,107**        | **)**          | (5,751            | )      | 3,644      |   |
| Pre-tax income (loss)                                                                 |   | **$**             | **4,552**      | ** **        | $      | (10,131    | )      | $ | 14,683 |   |
|                                                                                  |   |              | ** **     |              |   |       |   |
| Earning assets                                                                        |   | **$**             | **4,156,361**  | ** **        | $      | 3,248,201  |   | $ | 908,160 |   |
| UPB underlying MSRs                                                                   |   | **$**             | **13,086,946** | ** **        | $      | 7,811,076  |   | $ | 5,275,870 |   |
|                                                                                  |   |              | ** **     |              |   |       |   |
| **Efficiencies to earning assets**                                                    |   |              | ** **     |              |   |       |   |
| Net interest income                                                                   |   | **1.63**          | **%**          | 1.00              | %      | 0.63       | %      |
| Provision                                                                             |   | **0.18**          | **%**          | 0.10              | %      | 0.08       | %      |
| Net interest income after provision                                                   |   | **1.45**          | **%**          | 0.90              | %      | 0.55       | %      |
| Fees, charges and other income                                                        |   | **0.41**          | **%**          | 0.40              | %      | 0.01       | %      |
| Banking revenues                                                                      |   | **1.86**          | **%**          | 1.30              | %      | 0.56       | %      |
| Total expenses                                                                        |   | **1.53**          | **%**          | 1.87              | %      | (0.34      | )%     |
| Pre-tax income (loss) before net gains on securities, debt and net  servicing results |   | **0.33**          | **%**          | (0.57             | )%     | 0.90       | %      |
|                                                                                  |   |              | ** **     |              |   |       |   |
| Net servicing results to UPB underlying MSRs                                          |   | **(0.06**         | **)%**         | (0.29             | )%     | 0.23       | %      |

 

Pre-taxincome improved by $14,683 to $4,552 for the quarter ended March 31, 2004,compared with a pre-tax loss of $10,131 for the same period in 2003.

 

Improvementsin net interest income of $8,892, net gain on securities and prepayment of debtof $2,813, net servicing results of $3,644, and fees, charges and other incomeof $995 resulted in the improvement quarter over quarter.  Net interest income improved primarilybecause of the retention over the past year of originated assets includingmortgages, leases and auto loans. Likewise, during 2003, the retail banking segment prepaid a large numberof higher-priced term FHLB advances and, through pricing, moved the mix ofdeposits from higher cost certificates of deposit to lower cost money marketand checking accounts.  Theseasset-liability strategies have improved the net interest income by 0.63% to1.63% for the quarter ended March 31, 2004 compared with 1.00% for the sameperiod in 2003.  The improvement in the

 

23

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gainon securities and prepayment of debt relates to the gain of $3.2 million on thesale of certain securities in the bank’s investment portfolio as part of thebank’s proactive asset-liability management strategy whereby assets were soldto mitigate inherent risks.  Netservicing results improved as the result of a reduction in actual prepaymentsand improved net hedge results during the quarter ended March 31, 2004 comparedwith the comparable quarter in 2003. The improvement in fees, charges and other income relates to theincrease in transactional accounts (i.e. checking and money market) period overperiod.

 

Theseimprovements in earnings were offset, in part, by increases of $980 inprovision for credit losses and increases in operating expenses of $681.  The provision for credit losses increased asthe result of the increase in retention of originated mortgages, leases, andauto loans during the quarter ended March 31, 2004 compared with the comparablequarter for the prior year.  Theincrease in operating expenses relates primarily to the increase intransactional accounts period to period.

 

*Financial Intermediary*

 

Thefollowing table highlights the financial intermediary segment production andsales activities:

 
|                                 |   | **2004  1st Qtr** |          | **2003  1st Qtr** |   | **Change** |   |
|--------------------------------------|--------|-------------------|---------------|-------------------|--------|------------|--------|
| Pre-tax results                      |   |              |          |              |   |       |   |
| Net interest income                  |   | **$**             | **14,105**    | ** **        | $      | 15,596     |   | $ | (1,491 | ) |
| Gain on sales of loans               |   | **32,299**        | ** **    | 49,708            |   | (17,409    | )      |
| Other income                         |   | **1,711**         | ** **    | 1,058             |   | 653        |   |
| Net MG Reinsurance results           |   | **507**           | ** **    | 556               |   | (49        | )      |
| Total revenues                       |   | **48,622**        | ** **    | 66,918            |   | (18,296    | )      |
| Salary and employee benefits         |   | **22,446**        | ** **    | 23,571            |   | (1,125     | )      |
| Occupancy & depreciation expense |   | **6,278**         | ** **    | 5,003             |   | 1,275      |   |
| Other expenses                       |   | **8,015**         | ** **    | 7,215             |   | 800        |   |
| Total expenses                       |   | **36,739**        | ** **    | 35,789            |   | 950        |   |
| Pre-tax income                       |   | **$**             | **11,883**    | ** **        | $      | 31,129     |   | $ | (19,246 | ) |
|                                 |   |              | ** **    |              |   |       |   |
| Production                           |   | **$**             | **3,258,766** | ** **        | $      | 4,357,423  |   | $ | (1,098,657 | ) |
| Sales                                |   | **$**             | **3,771,503** | ** **        | $      | 4,145,516  |   | $ | (374,013 | ) |
|                                 |   |              | ** **    |              |   |       |   |
| **Efficiencies**                     |   |              | ** **    |              |   |       |   |
| Total revenues to sales              |   | **1.29**          | **%**         | 1.61              | %      | (0.32      | )%     |
| Total expenses to production         |   | **1.13**          | **%**         | 0.82              | %      | 0.31       | %      |
| Pre-tax margin                       |   | **0.16**          | **%**         | 0.79              | %      | (0.63      | )%     |

 

Note:The ratio of production revenues in bps to sales is based on mortgage bankingsales, which includes inter-segment sales to the retail bank segment.

 

Theinterest rate environment during the first quarter of 2003 was much morefavorable to mortgage production than the environment during the comparable2004 quarter.  In 2003, mortgage rateswere hitting historic lows.  The loanpipelines of originators throughout the mortgage banking industry were filled,resulting in less pressure on margins. During the latter part of 2003 and continuing into the first quarter of2004, mortgage rates rose, and competitive pressures heated up as pipelinevolumes decreased.  This margin pressurewas especially true in the correspondent channel.  This resulted in a decrease in mortgage production of $1.1billion and a decrease in sales of $374 million.  The competitive pressures reduced revenue margins from 161 bpsfor the quarter ended March 31, 2003 to 129 bps for the comparable quarter in2004.  As a result, revenues decreased$18.3 million.  Expenses increased$950.  Expenses in bps of productionincreased from 82 bps to 113 bps from the quarter ended March 31, 2003 to thecomparable quarter in 2004.  This wasthe result of less leverage of fixed expenses during the quarter ended March31, 2004 and expenses incurred during the quarter ended March 31, 2004 toobtain trailing documents needed to sell or securitize the buildup of loans ininventory at December 31, 2003.

 

24

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*Transaction Processing Segment*

 

Thetransaction processing segment processes mortgages on behalf of community bankson a private label basis; provides ATM and merchant processing services;subservices loans for the retail bank segment, financial intermediary segmentand for third party customers; and sells various insurance products using anInternet-based platform.

 

Thefollowing table highlights the results of operations for the transactionprocessing segment:

 
|                  |   | **2004  1st Qtr** |       | **2003  1st Qtr** |   | **Change** |   |
|-----------------------|--------|-------------------|------------|-------------------|--------|------------|--------|
| Total revenue         |   | **$**             | **7,661**  | ** **        | $      | 4,243      |   | $ | 3,418 |   |
| Total expenses        |   | **7,489**         | ** ** | 5,890             |   | 1,599      |   |
| Pre-tax income (loss) |   | **$**             | **172**    | ** **        | $      | (1,647     | )      | $ | 1,819 |   |

 

Theimprovement in the transaction processing segment for the quarter ended 2004compared with the comparable quarter for 2003 relates primarily to theimprovement in servicing factory results and the acquisition of NPS.  NPS added $375 of pre-tax income to thesegment’s results.  Improved expensecontrol and leveraging the expense base over more loans allowed the servicingfactory to improve its results by $1.9 million.  These improvements were offset, in part, by weaker results in theRMS processing unit related to lower volumes of loans processed.

 

**Critical Accounting Policies**

 

Asindicated in NetBank’s Annual Report on Form 10-K for the year ended December31, 2003, NetBank has identified its policies for the valuation of its mortgageservicing rights, the maintenance of its allowance for credit losses,maintenance of reserves related to the liabilities for representations andwarranties on sales of loans and servicing rights, and accounting forderivative instruments as its most critical accounting policies. These policiesrequire management to make judgments, estimates and assumptions concerningfuture events, which materially underpin the current period accounting forthese items. Given the effect such judgments, estimates and assumptions canhave on NetBank’s balance sheet and statement of operations these policies areregularly reviewed by management. Management believes that given current information, its judgments,estimates and assumptions used in these policies are appropriate.  For further information regarding NetBank’scritical accounting policies, refer to its Annual Report on Form 10-K for theyear ended December 31, 2003.

 

**Contractual Obligations and Off-Balance Sheet Arrangements**

 

TheCompany, in the normal course of business, is party to various off-balancesheet arrangements.  These arrangementsinclude the Company’s obligation to make scheduled payments for its operatingleases; its liability to repurchase loans under representations and warrantiesprovided to purchasers of its mortgage loans and mortgage servicing rights; andits obligation to make scheduled principal and interest payments on borrowedfunds.

 

Referenceis made to the contractual obligations and off-balance sheet arrangementssection on page 48 of NetBank’s 2003 Annual Report filed on Form 10-K foradditional details regarding the schedule of amounts contractually due.

 

**Liquidity and Capital Resources**

 

*Liquidity. *NetBank’sliquidity, represented by cash and cash equivalents, is a product of its operating,investing, and financing activities. NetBank’s primary sources of funds are deposits, borrowings, prepaymentsand maturities of outstanding loans, sales of loans, sales or maturities ofinvestment securities and other short-term investments, and funds provided fromoperations.  While scheduled loanpayments and maturing investment securities and short-term investments arerelatively predictable sources of funds, deposit flows and loan prepayments aregreatly influenced by general interest rates, economic conditions, andcompetition.  NetBank can use cashgenerated through the retail deposit market, its traditional funding source, tooffset the cash utilized in investing activities.  NetBank’s available for sale securities and short-

 

25

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terminterest-earning assets can also be used to provide liquidity for lending andother operational requirements.  For thethree months ended March 31, 2004, NetBank had positive cash flow of $154,956compared to positive cash flow of $4,503 for the same period of 2003.  The net cash inflow primarily related to a$152,388 decrease in investment securities available for sale, a $576,560decrease in loans held for sale and a $104,744 increase in deposits.  These cash in flows were partially offset bya $281,622 increase in loan and lease receivables and a $349,374 decrease inother borrowed funds.  Cash flows forthe three months ended March 31, 2003, were unusually low related to theCompany’s $4.4 billion level of production in the financial intermediarysegment outpacing the $4.1 billion level of sales into the secondary market.

 

Asan additional source of funds, NetBank had available under existing lines ofcredit agreements $1.2 billion at March 31, 2004, (see Note 8 of theconsolidated financial statements included as part of this report foradditional details of the available lines of credit).  As of March 31, 2004, NetBank had commitments to fund mortgageloans of $1.7 billion, open-end consumer lines of credit of $73,916,undisbursed mortgage construction loans of $55,715, undisbursed commercialfinancing loans of $3,889 and commercial financing commitments of $4,770.

 

TheCompany uses deposits as its principal source of funds.  For the three months ended March 31, 2004,deposits increased by $104,744 to $2.6 billion from $2.5 billion as of December31, 2003.  NetBank’s deposit productsinclude checking, money market and certificates of deposit accounts.  Deposit account terms vary, with theprincipal differences being the minimum balance required, the time periods thefunds must remain on deposit and the interest rate.  NetBank is competitive in the types of accounts, services andranges of interest rates offered on deposit products.  Although market demand generally dictates which depositmaturities and rates will be accepted by the public, NetBank intends tocontinue to promote checking, money market and certificates of deposit to theextent possible consistent with asset and liability management goals.  Additionally, NetBank decreased its otherborrowed funds, which include FHLB advances, repurchase agreements andwarehouse lines of credit, by $0.3 billion during the three months ended March31, 2004.  This decrease was primarilyrelated to the $0.6 billion decrease in loans held for sale.

 

*Capital Resources.*  NetBank and NetBank, FSB are subject to various regulatorycapital requirements administered by the federal banking agencies. Failure ofeither company to meet minimum capital requirements can initiate certain mandatoryand possibly additional discretionary actions by regulators that, ifundertaken, could have a direct material effect on NetBank’s consolidatedfinancial statements.  Under capitaladequacy guidelines and the regulatory framework for prompt corrective action,NetBank, FSB must meet specific capital guidelines that involve quantitativemeasures of NetBank, FSB’s assets, liabilities, and certain off-balance sheetitems as calculated under regulatory accounting practices. NetBank, FSB’scapital amounts and classifications are also subject to qualitative judgmentsby the regulators about components, risk weightings and other factors. Inaddition, under regulatory guidelines, NetBank, FSB may not pay a dividend toNetBank, Inc. if doing so would cause NetBank, FSB to be less than adequatelycapitalized, as defined below. During the quarter ended March 31, 2004,NetBank’s Board of Directors declared a dividend in the amount of $.02 pershare to shareholders of record on February 15, 2004. The dividend was paid onMarch 15, 2004.  During the three monthsended March 31, 2004, NetBank repurchased 672,100 shares at a weighted averagecost of $12.26, and management had authorization to repurchase up to anadditional 1.3 million shares of its common stock through open market orprivate transactions.

 

Quantitativemeasures established by regulation to ensure capital adequacy require NetBank,FSB to maintain minimum amounts and ratios as set forth in the followingtable.  NetBank, FSB’s regulatoryagency, the Office of Thrift Supervision (“OTS”), requires NetBank, FSB tomaintain minimum ratios of tangible capital to tangible assets of 1.5%, corecapital to tangible assets of 4.0% and total capital to risk-weighted assets of8.0%.  Additionally, NetBank, Inc. issubject to a side letter agreement with the OTS, which was put in place inconnection with NetBank’s acquisition of Resource in 2002.  The side letter requires NetBank, Inc. tomaintain minimum capital held against forward sold conforming mortgages to bethe greater of 5% or $50,000 and in no event allow the total capital to totalassets to fall below 8% and NetBank, FSB to maintain 6% core capital and 12%total risk-based capital ratios.  As ofMarch 31, 2004, NetBank, FSB was in compliance with all capital requirements.  The following table presents informationrelated to NetBank, FSB along with capital requirements mandated by the OTS:

 

26

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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** |   |
| **March 31, 2004**                          |   |       | ** ** |                               | ** ** |                                                                             | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Total capital (to risk-weighted assets)     |   | $          | 302,106    |                               | 12.23      | %                                                                                | $          | 197,668 |   | 8.00 | % | $ | 247,020 |   | 10.00 | % |
| Core capital (to adjusted total assets)     |   | $          | 267,325    |                               | 6.63       | %                                                                                | $          | 161,273 |   | 4.00 | % | $ | 201,603 |   | 5.00 | % |
| Tangible capital (to adjusted total assets) |   | $          | 267,325    |                               | 6.63       | %                                                                                | $          | 60,481 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital (to risk-weighted assets)    |   | $          | 267,325    |                               | 10.82      | %                                                                                | N/A        |   | N/A |   | $ | 148,239 |   | 6.00 | % |
| **December 31, 2003**                       |   |       | ** ** |                               | ** ** |                                                                             | ** ** |   | ** ** |   | ** ** |   | ** ** |
| Total capital (to risk-weighted assets)     |   | $          | 296,359    |                               | 11.79      | %                                                                                | $          | 201,122 |   | 8.00 | % | $ | 251,365 |   | 10.00 | % |
| Core capital (to adjusted total assets)     |   | $          | 262,792    |                               | 6.42       | %                                                                                | $          | 163,712 |   | 4.00 | % | $ | 204,667 |   | 5.00 | % |
| Tangible capital (to adjusted total assets) |   | $          | 262,792    |                               | 6.42       | %                                                                                | $          | 61,400 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital (to risk-weighted assets)    |   | $          | 262,792    |                               | 10.45      | %                                                                                | N/A        |   | N/A |   | $ | 150,885 |   | 6.00 | % |

 

Inaddition, NetBank’s subsidiaries engaged in mortgage banking must adhere tovarious HUD regulatory guidelines including required minimum net worth tomaintain their FHA approved lending status. Failure to comply with the HUD guidelines could result in withdrawal ofthis certification.  As of March 31,2004, Market Street, RBMG and Meritage were in compliance with HUDguidelines.  NetBank and itssubsidiaries are subject to various other capital requirements by secondarymarket investors and states.  None ofthese capital requirements 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.  At March 31,2004, all ofthe capital requirements placed upon NetBank and its subsidiaries were met, andthere have been no subsequent events that would lead management to believe thatcontinued compliance would not be met in the future.

 

**Part I.Item 3: Quantitative and Qualitative Market Risk**

 

NetBank’sprincipal businesses are retail banking and the origination and purchase ofmortgage loans.  These businesses arefunded by customer deposits and, to the extent necessary, other borrowed funds.Consequently, a significant portion of NetBank’s assets and liabilities aremonetary in nature and fluctuations in interest rates will affect NetBank’sfuture net interest income and cash flows. This interest rate risk is NetBank’sprimary market risk exposure. For the three months ended March 31, 2004, theonly derivative financial instruments that NetBank entered into were associatedwith hedging activities related to the portfolio of mortgage loans held forsale, the pipeline of mortgage loans for which the interest rate has beenlocked, the owned mortgage servicing rights portfolio and the mortgageservicing rights which NetBank intends to retain associated with the pipelineof mortgage loans for which the interest rate has already been locked. NetBankhas no market risk-sensitive instruments held for trading purposes. NetBank’sexposure to market risk is reviewed on a regular basis by NetBank’s management.

 

NetBank,FSB, like other banks, measures interest rate risk based on Net Portfolio Value(“NPV”) analysis.  NPV equals thepresent value of expected net cash flows from existing assets minus the presentvalue of expected net cash flows from existing liabilities.  A NPV ratio is determined by dividing NPV bythe present value of assets.  Thefollowing table sets forth the estimated percentage change in NetBank, FSB’sNPV ratios as of March 31, 2004, December 31, 2003 and March 31, 2003, assumingrate shocks of +300 to -100 basis points:

 

**Limitsand current NPV ratios for NetBank, FSB**

** **

| **Rate shock   (in basis points)** |   | **As of  3/31/2004** |   | **As of  12/31/2003** |   | **As of  3/31/2003** |   | **Minimum as  of 3/31/2004** |   |
|------------------------------------|--------|----------------------|--------|-----------------------|--------|----------------------|--------|------------------------------|--------|
| **+300**                           |   | 8.12%                |   | 6.54%                 |   | 9.13%                |   | 4.00%                        |   |
| **+200**                           |   | 8.55%                |   | 7.37%                 |   | 9.40%                |   | 6.00%                        |   |
| **+100**                           |   | 9.03%                |   | 8.17%                 |   | 9.50%                |   | 6.00%                        |   |
| **Flat**                           |   | 9.13%                |   | 8.66%                 |   | 9.44%                |   | 6.00%                        |   |
| **-100**                           |   | 9.25%                |   | 9.07%                 |   | 9.15%                |   | 6.00%                        |   |

 

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Computationof prospective effects of hypothetical rate changes is based on manyassumptions, including relative levels of market interest rates, loanprepayments and deposit decay.  Theyshould not be relied upon as indicative of actual results. Further, thecomputations do not contemplate certain actions management could undertake inresponse to changes in interest rates.

 

**Part I.Item 4:  Controls and Procedures**

 

Asof the end of the period covered by this report, the Company carried out anevaluation, under the supervision and with the participation of the Company’smanagement, including the Company’s Chief Executive Officer and Chief FinancialExecutive, of the effectiveness of the design and operation of the Company’sdisclosure controls and procedures pursuant to the Exchange Act Rule 13a-15.  Based upon that evaluation, the Company’sChief Executive Officer and Chief Financial Executive concluded that theCompany’s disclosure controls and procedures are effective in timely alertingthem to material information relating to the Company (including itsconsolidated subsidiaries) that is required to be in the Company’s periodicfilings with the Securities and Exchange Commission.  There have been no significant changes in the Company’s internalcontrols or, to the Company’s knowledge, in other factors that couldsignificantly affect those internal controls subsequent to the date the Companycarried out its evaluation, and there have been no corrective actions withrespect to significant deficiencies and material weaknesses.

 

**Part II.Item 1:  Legal Proceedings**

 

IllinoisUnion Insurance Co. v. Commercial Money Center, Inc., et al., Case No.CV-01-0685-KJD-RJJ (District Court of Nevada) andrelated cases now pending in *In reCommercial Money Center, Inc. Equipment Lease Litigation in the United StatesDistrict Court for the Northern District of Ohio, Eastern Division, MDL CaseNo. 1:02-CV-16000*, the pending bankruptcy proceedings of CommercialMoney Center, Inc. and In re Commercial Money Center, Inc., Debtor(Kipperman v. NetBank, FSB), Bankruptcy No. 02-09721; In the United States BankruptcyCourt for the Southern District of California

 

Asreported in previous filings, NetBank, FSB, filed a complaint in January 2002against Commercial Money Center, Inc. (“CMC”), the originator, seller, andsubservicer of equipment leases purchased by NetBank, FSB, and against IllinoisUnion Insurance Company (“Illinois Union”), Safeco Insurance Company of America(“Safeco”), and Royal Indemnity Company (“Royal,” with Illinois Union, Safecoand Royal, collectively, referred to as the “Sureties”), the insurancecompanies that issued surety bonds and insurance policies guaranteeing paymentof the income stream from the leases and that also served as master servicersof the leases.  The NetBank, FSB actionalleges several claims, including claims for breach of contract, fraud, and badfaith, and seeks, among other things, payment under and enforcement of suretybonds and insurance policies issued by the insurance and surety companies.  The Judicial Panel on Multi-DistrictLitigation has consolidated the actions involving NetBank, FSB with more than35 other cases pending around the country involving other banks and financialinstitutions that were seeking to enforce surety bonds and insurance policiesrelating to leases sold by CMC.  Allpre-trial activity is currently being held in the United States District Courtfor the Northern District of Ohio (the “MDL Court”).

 

Asreported in previous filings, NetBank, FSB had joined with the other claimantsin a motion for judgment on the pleadings, which motion was filed on January31, 2003, and is still pending before the MDL Court.  Meanwhile, discovery in the case has been proceeding and factdiscovery is scheduled to close on August 3, 2004.  Amendments to the pleadings are due on June 4, 2004.  The Company plans to amend and supplementits complaint to include additional claims against the Sureties based ondiscovery adduced and events that have occurred to date.  Furthermore, NetBank, FSB has withdrawn itsmotion for judgment on the pleadings and now intends to file a motion forsummary judgment based in part on such discovery.  The Company believes that based on the overall facts andcircumstances, the defenses asserted by the Sureties will fail and thatNetBank, FSB will ultimately prevail on its claims.

 

Also,as reported in previous filings, on May 30, 2002, CMC filed for bankruptcyprotection.  The bankruptcy proceedingis not a part of the consolidation of cases in Ohio.  On June 11, 2003, the California Bankruptcy Court approved anamended settlement agreement (the “NetBank Agreement”) among NetBank, FSB,Lakeland Bank and the Trustee.   TheNetBank Agreement resolves all claims of the Trustee with respect to the leasepayments that were guaranteed by surety bonds and insurance policies issued bySafeco and Illinois Union, as well as all claims related to the surety bondsand insurance policies.  In addition toapproving the NetBank Agreement, the California Bankruptcy Court approved asettlement agreement between the Trustee and Royal (the “Royal Agreement’).  Under the Royal Agreement, Royal has

 

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agreed,among other things, to fund litigation by the Trustee against NetBank, FSB toavoid its interests in the leases that were guaranteed by surety bonds issuedby Royal, as well as NetBank, FSB’s interests in the surety bondsthemselves.  On September 4, 2003, theTrustee filed a Complaint against NetBank, FSB as contemplated by the RoyalAgreement, seeking to avoid NetBank, FSB’s interest in the leases and suretybonds relating to the Royal guaranteed lease pools.  On May 6, 2004, NetBank, FSB filed a motion for summary judgmentagainst the Trustee.  A hearing on themotion is currently set for August 31, 2004.

 

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

 

Claytonv. Commercial Money Center, Inc., Case No. BC 253169 (CA Sup, Ct., Los AngelesCounty)

 

OnJune 27, 2001, several lessees of equipment leased from CMC filed suit in LosAngeles Superior Court against CMC and several John Doe defendants allegingthat the leases violated California usury laws, the California Financial Code,and the California Unfair Business Practices Act.  The plaintiffs were seeking to rescind or reform their obligationsunder the leases and were seeking to recover statutory damages and attorney’sfees.  The plaintiffs subsequentlyamended their complaint to name NetBank, FSB, several other investor banks, andseveral surety companies as co-defendants in the action.  After CMC filed for bankruptcy, the actionwas removed to the bankruptcy court in the Central District of California, butthe plaintiffs subsequently agreed to withdraw their claims against CMC andwere successful in their motion to remand the case back to state court.

 

OnMarch 15, 2004, the Superior Court sustained demurrers and motions to quashfiled by NetBank, FSB and various other defendants on certain of theplaintiffs’ claims.  The Superior Courtsustained the demurrers under the California Financial Code, without leave toamend.  The Superior Court alsosustained demurrers on the Unfair Business Practices Act, with leave to amendthe claims to add greater specificity to the claims, but without leave to amendas to unnamed representatives of the alleged class of plaintiffs harmed.  The Superior Court also granted motions tostrike: (1) plaintiffs’ claims under the California Unfair Business PracticesAct as to unnamed representative plaintiffs; (2) plaintiffs’ request forrestitution (the named plaintiffs may amend to establish individual entitlementto restitution); (3) plaintiffs’ request for disgorgement; (4) plaintiffs’request for punitive damages; (5) plaintiffs’ request for compensatory damagesunder the California Unfair Business Practices Act; and (6) plaintiffs’ requestfor attorneys’ fees.

 

OnApril 29, 2004, the plaintiffs served an amended complaint against NetBank, FSBalleging claims for, among other things, violations of another section of theCalifornia Financial Code, unfair competition under Section 17200 of theCalifornia Business and Professions Code and usury.  NetBank intends to vigorously defend the amended claims and topursue recovery against Safeco Insurance Company, Royal Indemnity Company, andIllinois Union Insurance Company for any damages and costs incurred in thiscase.

 

*inter*state NetBank v. NetBank,Inc. and NetBank, Case No. 1:01-CV-1324(JBS) (District of New Jersey)

 

OnJune 27, 2001, the Company was served with a complaint for a declaratoryjudgment filed by interState NetBank in the District of New Jersey challengingthe “NETBANK®” service mark.  TheCompany answered and counterclaimed for trademark infringement on July 13,2001.  Discovery was stayed pending aruling on interState NetBank’s November 19, 2001 motion for summary judgment,which claimed that “NETBANK” is generic for all banking services delivered overthe Internet.  On September 22, 2002,the District Court ruled that “NETBANK” is generic but did not cancel theCompany’s existing service mark registration. The Company filed a motion for reconsideration of the District Court’sdecision.  On June 23, 2003, theDistrict Court denied the Company’s motion for reconsideration but clarifiedthat two of the Company’s counterclaims remained in the case: (1) a claim forinfringement of the Company’s “NETBANK®” service mark to the extent that itcovers online bill-payment services (as opposed to online banking services ingeneral) and (2) a claim for unfair competition under New Jersey and commonlaw.  The parties completed factdiscovery on February 27, 2004. On April 30, 2004, interState NetBank filed asecond motion for summary judgment, seeking the dismissal of the remaining twoclaims brought by NetBank, as well as an award of attorneys' fees.

 

TheCompany intends to vigorously defend against interState NetBank’s challenge ofthe “NETBANK®” service mark and will continue to pursue its counterclaims fortrademark infringement and unfair competition, as well as later appeal thedismissal on summary judgment of its remaining counterclaims based on the DistrictCourt’s ruling that  “NETBANK” isgeneric for banking services delivered over the Internet.  While there is a possibility of a final,adverse outcome for the Company, at this stage of the matter, we cannot fairlydetermine the likelihood of such outcome. However, in the event of a final, adverse outcome, it is unlikely thatthere would be a monetary loss aside from the loss in value of the intellectualproperty rights in the NETBANK® registration, unless the court awardsinterState NetBank its attorneys' fees as requested in its April 30, 2004motion for summary judgment..

 

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**Part II.Item 2:  Changes in Securities, Use ofProceeds and Issuer Purchases of Equity Securities**

** **
| **Period**                           |   | **Total Number of  Shares  Purchased** |   | **Average Price  Paid Per Share** |   | **Total Number of  Shares (or Units)  Purchased as Part of  Publicly Announced  Plans or Programs (1)** |    | **Maximum Number  (or Appropriate  Dollar Value) of  Shares (or Units)  that May Yet Be  Purchased Under  the Plans or  Programs (2)** |    |
|--------------------------------------|--------|----------------------------------------|--------|-----------------------------------|--------|---------------------------------------------------------------------------------------------------------|---------|----------------------------------------------------------------------------------------------------------------------------------------|---------|
| Balance as of December 31, 2003      |   | —                                 |   | —                            |   | —                                                                                                  |    | 1,120,300                                                                                                                              |    |
| January 1 through January 31, 2004   |   | 372,600                                |   | $                                 | 12.45  |                                                                                                    | 372,600 |                                                                                                                                   | 747,700 |   |
| February 1 through February 29, 2004 |   | 134,000                                |   | $                                 | 11.79  |                                                                                                    | 134,000 |                                                                                                                                   | 613,700 |   |
| March 1 through March 31, 2004       |   | 165,500                                |   | $                                 | 12.22  |                                                                                                    | 165,500 |                                                                                                                                   | 448,200 |   |
| Total                                |   | 672,100                                |   | $                                 | 12.26  |                                                                                                    | 672,100 |                                                                                                                                   |    |   |

 

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Note1: In August 2002, the Board of Directors approved a plan to repurchase up to 1million shares of the Company’s common stock. The plan was subsequently increased by 1 million shares in October 2002and by an additional 2 million shares in January 2003.

 

Note2: Subsequent to this report, the Board of Directors increased the repurchaseauthorization by 1 million shares on April 26, 2004.

 

 

**Part II.Item 3:  Defaults Upon Senior Securities**

 

**None**

 

**Part II.Item 4:  Submission of Matters to a Voteof Security Holders**

 

**None**

 

**Part II.Item 5:  Other Information**

 

**None**

 

**Part II.Item 6:  Exhibits and Reports on Form8-K**

 

(a)          Exhibits

 

31.1                           ChiefExecutive Officer’s certification under Section 302 of the Sarbanes-Oxley Act

 

31.2                           ChiefFinancial Executive’s certification under Section 302 of the Sarbanes-Oxley Act

 

32           Certifications pursuant toSection 906 of the Sarbanes-Oxley Act of 2002

 

(b)         Reports on Form 8-K

 

i.                                          NetBankfiled a Current Report on Form 8-K on January 16, 2004, furnishing its monthlyoperating statistics as posted to its Web site.

 

ii.                                       NetBankfiled a Current Report on Form 8-K on January 28, 2004, furnishing theCompany’s press release detailing the Company’s results for the fourth quarterand year ended 2003.

 

iii.                                    NetBankfiled a Current Report on Form 8-K on February 18, 2004 furnishing its monthlyoperating statistics as posted to its Web site.

 

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iv.                                   NetBankfiled a Current Report on Form 8-K on March 16, 2004, furnishing its monthlyoperating statistics as posted to its Web site.

 

v.                                      NetBankfiled a Current Report on Form 8-K on March 29, 2004, furnishing information tobe provided by management to various interested parties.

 

**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/ Steven F. Herbert |   |
|                |          | Steven F. Herbert |
| Dated: May 10, 2004 |          | *Chief Financial Executive and  Chief Accounting Officer* |

 

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