** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

** **

**QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period EndedMarch 31, 2005**

** **

**Commission File No. 0-22361**

 

**NETBANK, INC.******(Exact name of registrant as specified in itscharter)

 

| **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 areacode:

 

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

 

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

YES ý  NO o

 

                Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date:

 

| **Class**                    | ** ** | **Shares Outstanding at May 1, 2005** |
|------------------------------|------------|---------------------------------------|
| Common Stock, par value $.01 |       | 46,236,855                            |

 

 

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**NETBANK, INC.****TABLE OF CONTENTS**

 
| **Part  I. FINANCIAL INFORMATION**                                                                            | ** ** |
|---------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                                                                    | ** ** |
| **Item 1. Financial Statements (Unaudited)**                                                                  | ** ** |
| ** **                                                                                                    | ** ** |
| **Consolidated balance sheets  as of March 31, 2005 and December 31, 2004**                                   | ** ** |
| ** **                                                                                                    | ** ** |
| **Consolidated  statements of operations for the three months ended March 31, 2005 and 2004**                 | ** ** |
|                                                                                                          |       |
| **Consolidated  statements of shareholders’ equity for the three months ended March 31, 2005  and 2004** |       |
|                                                                                                          |       |
| **Consolidated  statements of cash flows for the three months ended March 31, 2005 and 2004**                 |       |
|                                                                                                          |       |
| **Notes to  consolidated financial statements**                                                               |       |
|                                                                                                          |       |
| **Item 2. Management’s  Discussion and Analysis of Financial Condition and Results of Operations**       |       |
|                                                                                                          |       |
| **Item 3. Quantitative and  Qualitative Disclosures about Market Risk**                                       |       |
|                                                                                                          |       |
| **Item 4. Controls and  Procedures**                                                                          |       |
|                                                                                                          |       |
| **Part II.  OTHER INFORMATION**                                                                               |       |
|                                                                                                          |       |
| **Item 1. Legal Proceedings**                                                                                 | ** ** |
|                                                                                                          |       |
| **Item 2. Unregistered Sales  of Equity Securities and Use of Proceeds**                                      | ** ** |
|                                                                                                          |       |
| **Item 3. Defaults Upon  Senior Securities**                                                                  | ** ** |
|                                                                                                          |       |
| **Item 4. Submission of  Matters to a Vote of Security Holders**                                              | ** ** |
|                                                                                                          |       |
| **Item 5. Other Information**                                                                                 | ** ** |
|                                                                                                          |       |
| **Item 6. Exhibits**                                                                                          | ** ** |
|                                                                                                          |       |
| **Signature Page**                                                                                            | ** ** |
|                                                                                                          |       |

 

2

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**PART I****—FINANCIAL INFORMATION**

 

**Item 1****. Financial Statements**

 

 

3

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**NetBank,Inc.**

**ConsolidatedBalance Sheets**

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

 
| ** **                                                                                                      | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------|------------|------------------|------------|
| ** **                                                                                                      | ** ** | **2005**      | ** ** | **2004**         | ** ** |
| **Assets**                                                                                                      |       |          |       |             |       |
| Cash and cash equivalents:                                                                                      |       |          |       |             |       |
| Cash and due from banks                                                                                         |       | $             | 144,933    |             | $          | 104,070 |   |
| Federal funds sold                                                                                              |       | 23,695        |       | 46,232           |       |
| Total cash and cash equivalents                                                                                 |       | 168,628       |       | 150,302          |       |
| Investment securities available for sale-at fair value (amortized  cost of $751,955 and $702,127, respectively) |       | 741,108       |       | 700,295          |       |
| Stock of Federal Home Loan Bank of Atlanta - at cost                                                            |       | 71,054        |       | 60,128           |       |
| Loans held for sale                                                                                             |       | 1,119,856     |       | 1,173,779        |       |
| Loan and lease receivables - net of allowance for credit losses of  $25,075 and $24,462, respectively           |       | 2,122,998     |       | 2,095,832        |       |
| Mortgage servicing rights — net                                                                            |       | 210,253       |       | 172,819          |       |
| Accrued interest receivable                                                                                     |       | 12,259        |       | 11,513           |       |
| Furniture, equipment and capitalized software — net                                                        |       | 49,115        |       | 51,438           |       |
| Goodwill and other intangibles — net                                                                       |       | 80,517        |       | 79,195           |       |
| Due from servicers and investors                                                                                |       | 22,683        |       | 52,441           |       |
| Receivable from unsettled trades                                                                                |       | 75,000        |       | —           |       |
| Other assets                                                                                                    |       | 81,544        |       | 74,439           |       |
| **Total assets**                                                                                                |       | $             | 4,755,015  |             | $          | 4,622,181 |   |
|                                                                                                            |       |          |       |             |       |
| **Liabilities, minority interests and  shareholders’ equity**                                              |       |          |       |             |       |
| **Liabilities:**                                                                                                |       |          |       |             |       |
| Deposits                                                                                                        |       | $             | 2,591,488  |             | $          | 2,639,441 |   |
| Other borrowed funds                                                                                            |       | 1,506,858     |       | 1,311,491        |       |
| Subordinated debt                                                                                               |       | 32,477        |       | 11,857           |       |
| Accrued interest payable                                                                                        |       | 9,853         |       | 10,309           |       |
| Loans in process                                                                                                |       | 47,937        |       | 27,820           |       |
| Unsettled trades                                                                                                |       | —        |       | 50,543           |       |
| Representations and warranties                                                                                  |       | 22,031        |       | 22,676           |       |
| Accounts payable and accrued liabilities                                                                        |       | 141,592       |       | 133,562          |       |
| Total liabilities                                                                                               |       | 4,352,236     |       | 4,207,699        |       |
|                                                                                                            |       |          |       |             |       |
| Commitments and contingencies                                                                                   |       | —        |       | —           |       |
| Minority interests in  affiliates                                                                               |       | 519           |       | 455              |       |
|                                                                                                            |       |          |       |             |       |
| **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 and  52,820,308 shares issued, respectively)  |       | 528           |       | 528              |       |
| Additional paid-in capital                                                                                      |       | 432,132       |       | 432,132          |       |
| Retained earnings                                                                                               |       | 40,553        |       | 43,849           |       |
| Accumulated other comprehensive income, net of taxes of $(4,130) and  $(696), respectively                      |       | (6,738        | )          | (1,136           | )          |
| Treasury stock, at cost (6,583,454 and 6,292,082 shares,  respectively)                                         |       | (64,020       | )          | (61,087          | )          |
| Unearned compensation                                                                                           |       | (195          | )          | (259             | )          |
| Total shareholders’ equity                                                                                 |       | 402,260       |       | 414,027          |       |
| **Total liabilities, minority interests and  shareholders’ equity**                                        |       | $             | 4,755,015  |             | $          | 4,622,181 |   |

 

See notes to consolidated financialstatements.

 

 

4

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**NetBank,Inc.**

** **

**ConsolidatedStatements of Operations**

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

** **
| ** **                                                            | ** ** | **Three months ended  March 31,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                            | ** ** | **2005**                          | ** ** | **2004** | ** ** |
|                                                                  |       |                              |       |   |   |
| **Interest income:**                                                  |       |                              |       |   |   |
| Loans and leases                                                      |       | $                                 | 47,853     |   | $ | 48,039 |   |
| Investment securities                                                 |       | 8,788                             |       | 3,966 |   |
| Short-term investments                                                |       | 379                               |       | 180 |   |
| Total interest income                                                 |       | 57,020                            |       | 52,185 |   |
|                                                                  |       |                              |       |   |   |
| **Interest expense:**                                                 |       |                              |       |   |   |
| Deposits                                                              |       | 13,216                            |       | 11,818 |   |
| Other borrowed funds                                                  |       | 13,027                            |       | 8,618 |   |
| Total interest expense                                                |       | 26,243                            |       | 20,436 |   |
| Net interest income                                                   |       | 30,777                            |       | 31,749 |   |
| Provision for credit losses                                           |       | 2,351                             |       | 1,847 |   |
| Net interest income after provision for credit losses                 |       | 28,426                            |       | 29,902 |   |
|                                                                  |       |                              |       |   |   |
| **Non-interest income:**                                              |       |                              |       |   |   |
| Service charges and fees                                              |       | 17,013                            |       | 17,032 |   |
| Gains on sales of mortgage loans and mortgage servicing rights        |       | 24,820                            |       | 32,314 |   |
| Net gain on sales of investment securities                            |       | 2,477                             |       | 3,169 |   |
| Net losses on derivatives                                             |       | (7,121                            | )          | — |   |
| Other income                                                          |       | 7,220                             |       | 4,176 |   |
| Total non-interest income                                             |       | 44,409                            |       | 56,691 |   |
|                                                                  |       |                              |       |   |   |
| **Non-interest expense:**                                             |       |                              |       |   |   |
| Salaries and benefits                                                 |       | 31,723                            |       | 30,927 |   |
| Customer service                                                      |       | 3,124                             |       | 2,913 |   |
| Marketing                                                             |       | 2,855                             |       | 2,259 |   |
| Data processing                                                       |       | 4,375                             |       | 4,491 |   |
| Depreciation and amortization                                         |       | 5,603                             |       | 4,783 |   |
| Impairment and amortization of mortgage servicing rights              |       | 9,948                             |       | 10,246 |   |
| Office expenses                                                       |       | 2,820                             |       | 2,680 |   |
| Occupancy                                                             |       | 5,901                             |       | 5,134 |   |
| Travel and entertainment                                              |       | 1,250                             |       | 1,176 |   |
| Professional fees                                                     |       | 3,990                             |       | 2,910 |   |
| Prepaid lost interest on curtailments                                 |       | 1,024                             |       | 1,372 |   |
| Other expenses                                                        |       | 3,349                             |       | 2,670 |   |
| Total non-interest expense                                            |       | 75,962                            |       | 71,561 |   |
| Income (loss) before income taxes                                     |       | (3,127                            | )          | 15,032 |   |
| Income tax (expense) benefit                                          |       | 1,098                             |       | (5,638 | ) |
| Net income (loss)                                                     |       | $                                 | (2,029     | ) | $ | 9,394 |   |
|                                                                  |       |                              |       |   |   |
| Net income (loss) per common and potential common shares outstanding: |       |                              |       |   |   |
| Basic                                                                 |       | $                                 | (0.04      | ) | $ | 0.20 |   |
| Diluted                                                               |       | $                                 | (0.04      | ) | $ | 0.20 |   |
|                                                                  |       |                              |       |   |   |
| Weighted average common and potential common shares outstanding:      |       |                              |       |   |   |
| Basic                                                                 |       | 46,366                            |       | 47,250 |   |
| Diluted                                                               |       | 46,366                            |       | 47,968 |   |
|                                                                  |       |                              |       |   |   |
| Dividends declared on common stock per share                          |       | $                                 | 0.02       |   | $ | 0.02 |   |

 

See notes to consolidated financialstatements.

 

 

5

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**NetBank,Inc.**

**ConsolidatedStatements of Shareholders’ Equity**

**(unauditedand in 000s)**

** **

 
| ** **                                                           | ** ** | **For the three months ended  March 31,** | ** ** |
|----------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                           | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| **Common shares**                                                    |       |                                      |       |   |   |
| Beginning balance                                                    |       | 52,820                                    |       | 52,820 |   |
| Issuance of common shares                                            |       | —                                    |       | — |   |
| Ending balance                                                       |       | 52,820                                    |       | 52,820 |   |
| **Common stock**                                                     |       |                                      |       |   |   |
| Beginning balance                                                    |       | $                                         | 528        |   | $ | 528 |   |
| Issuance of common stock                                             |       | —                                    |       | — |   |
| Ending balance                                                       |       | $                                         | 528        |   | $ | 528 |   |
| **Paid-in capital**                                                  |       |                                      |       |   |   |
| Beginning balance                                                    |       | $                                         | 432,132    |   | $ | 432,035 |   |
| Re-issuance of shares of common stock                                |       | —                                    |       | (115 | ) |
| Ending balance                                                       |       | $                                         | 432,132    |   | $ | 431,920 |   |
| **Retained earnings**                                                |       |                                      |       |   |   |
| Beginning balance                                                    |       | $                                         | 43,849     |   | $ | 44,102 |   |
| Net income (loss)                                                    |       | (2,029                                    | )          | 9,394 |   |
| Cash dividends declared                                              |       | (926                                      | )          | (941 | ) |
| Loss on re-issuance of shares of common stock                        |       | (341                                      | )          | — |   |
| Ending balance                                                       |       | $                                         | 40,553     |   | $ | 52,555 |   |
| **Accumulated other comprehensive income**                           |       |                                      |       |   |   |
| Beginning balance                                                    |       | $                                         | (1,136     | ) | $ | 2,742 |   |
| Realized gain on sale of securities, net of taxes                    |       | (1,536                                    | )          | (1,980 | ) |
| Unrealized gain (loss) on securities, net of taxes                   |       | (4,066                                    | )          | 4,230 |   |
| Ending balance                                                       |       | $                                         | (6,738     | ) | $ | 4,992 |   |
| **Treasury stock, at cost**                                          |       |                                      |       |   |   |
| Beginning balance                                                    |       | $                                         | (61,087    | ) | $ | (48,674 | ) |
| Purchase of shares of common stock for treasury, net of re-issuances |       | (2,898                                    | )          | (7,382 | ) |
| Employee forfeitures of unearned compensation                        |       | (35                                       | )          | — |   |
| Ending balance                                                       |       | $                                         | (64,020    | ) | $ | (56,056 | ) |
| **Unearned compensation**                                            |       |                                      |       |   |   |
| Beginning balance                                                    |       | $                                         | (259       | ) | $ | (383 | ) |
| Amortization of unearned compensation                                |       | 29                                        |       | 31 |   |
| Employee forfeitures of unearned compensation                        |       | 35                                        |       | — |   |
| Ending balance                                                       |       | $                                         | (195       | ) | $ | (352 | ) |
| **Total stockholders’ equity**                                  |       | $                                         | 402,260    |   | $ | 433,587 |   |
|                                                                 |       |                                      |       |   |   |
| **Comprehensive income**                                             |       |                                      |       |   |   |
| Net income (loss)                                                    |       | $                                         | (2,029     | ) | $ | 9,394 |   |
| Realized gain on sale of securities, net of taxes                    |       | (1,536                                    | )          | (1,980 | ) |
| Change in unrealized gain (loss) on securities, net of taxes         |       | (4,066                                    | )          | 4,230 |   |
| Comprehensive income (loss)                                          |       | $                                         | (7,631     | ) | $ | 11,644 |   |

 

See notes to consolidated financialstatements.

 

 

6

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**NetBank,Inc.**

**ConsolidatedStatements of Cash Flows**

**(unauditedand in 000s)**

 
| ** **                                                                                | ** ** | **Three months ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                | ** ** | **March 31,**          | ** ** |
| ** **                                                                                | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Operating activities:                                                                     |       |                   |       |   |   |
| Net income                                                                                |       | $                      | (2,029     | ) | $ | 9,394 |   |
| Adjustments to reconcile net (loss) income to net cash provided by  operating activities: |       |                   |       |   |   |
| Depreciation and amortization                                                             |       | 5,603                  |       | 4,783 |   |
| Amortization of premiums on investment securities, loan and lease  receivables and debt   |       | 4,303                  |       | 3,275 |   |
| Origination of loans held for sale                                                        |       | (2,738,208             | )          | (3,258,766 | ) |
| Repurchase of previously sold mortgages                                                   |       | (31,039                | )          | (8,361 | ) |
| Proceeds from sales of loans held for sale                                                |       | 2,847,354              |       | 3,875,487 |   |
| Net gain on sales of loans and servicing rights                                           |       | (24,820                | )          | (32,314 | ) |
| Capitalization and mark-to-market of mortgage servicing rights                            |       | (11,487                | )          | (3,854 | ) |
| Proceeds from sales of mortgage servicing rights                                          |       | 491                    |       | 1,990 |   |
| Impairment and amortization of mortgage servicing rights                                  |       | 9,948                  |       | 10,246 |   |
| Provision for credit losses                                                               |       | 2,351                  |       | 1,847 |   |
| Amortization of unearned compensation                                                     |       | 29                     |       | 31 |   |
| Gains on sales of investment securities                                                   |       | (2,477                 | )          | (3,169 | ) |
| Changes in assets and liabilities which provide (use) cash:                               |       |                   |       |   |   |
| (Increase) decrease in accrued interest receivable                                        |       | (746                   | )          | 3,946 |   |
| Decrease (increase) in due from servicers and other assets                                |       | 22,653                 |       | (13,791 | ) |
| (Decrease) increase in accrued interest payable                                           |       | (456                   | )          | 306 |   |
| Increase in loans in process                                                              |       | 20,117                 |       | 23,124 |   |
| Increase (decrease) in accounts payable and accrued liabilities                           |       | 11,464                 |       | (13,743 | ) |
| Net cash provided by operating activities                                                 |       | 113,051                |       | 600,431 |   |
|                                                                                      |       |                   |       |   |   |
| Investing activities:                                                                     |       |                   |       |   |   |
| Purchases of available for sale securities                                                |       | (161,965               | )          | (6,000 | ) |
| Principal repayments on available for sale securities                                     |       | 25,773                 |       | 16,991 |   |
| Sales of available for sale securities                                                    |       | 89,044                 |       | 14,216 |   |
| Purchase of mortgage servicing rights                                                     |       | (36,395                | )          | — |   |
| Purchase of Federal Home Loan Bank Stock                                                  |       | (10,926                | )          | (2,220 | ) |
| Origination and purchase of loan and lease receivables                                    |       | (171,676               | )          | (415,459 | ) |
| Principal repayments on loan and lease receivables                                        |       | 137,632                |       | 130,890 |   |
| Purchases of furniture, equipment and capitalization of software, net  of disposals       |       | (2,593                 | )          | (3,796 | ) |
| Acquisitions, net of cash acquired                                                        |       | (2,009                 | )          | (3,289 | ) |
| Change in minority interest                                                               |       | 64                     |       | — |   |
| Net cash used in investing activities                                                     |       | (133,051               | )          | (268,667 | ) |
|                                                                                      |       |                   |       |   |   |
| Financing activities:                                                                     |       |                   |       |   |   |
| (Decrease) increase in money market and checking accounts                                 |       | (27,152                | )          | 147,125 |   |
| Decrease in certificates of deposits                                                      |       | (20,801                | )          | (42,381 | ) |
| Proceeds from other borrowed funds                                                        |       | 2,132,956              |       | 3,361,608 |   |
| Repayments of other borrowed funds                                                        |       | (2,063,132             | )          | (3,634,722 | ) |
| Net proceeds from issuance of subordinated debt                                           |       | 20,620                 |       | — |   |
| Net purchases of treasury stock                                                           |       | (3,239                 | )          | (7,497 | ) |
| Dividend payments on common stock                                                         |       | (926                   | )          | (941 | ) |
| Net cash provided by (used in) financing activities                                       |       | 38,326                 |       | (176,808 | ) |
| Net increase in cash and cash equivalents                                                 |       | 18,326                 |       | 154,956 |   |
| Cash and cash equivalents:                                                                |       |                   |       |   |   |
| Cash, beginning of period                                                                 |       | 150,302                |       | 33,627 |   |
| Cash, end of period                                                                       |       | $                      | 168,628    |   | $ | 188,583 |   |
|                                                                                      |       |                   |       |   |   |
| Supplemental disclosures of cash flow information:                                        |       |                   |       |   |   |
| Cash paid during the period for interest                                                  |       | $                      | 26,699     |   | $ | 20,130 |   |
| Cash paid (refunds received) for income taxes                                             |       | $                      | 527        |   | $ | (8,359 | ) |

 

See notes to consolidated financialstatements.

 

 

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**NETBANK, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**March 31, 2005**

**(unaudited)**

**1.             ORGANIZATION ANDBASIS OF PRESENTATION**

NetBank, Inc. is a financial holding company engaged primarily inretail banking, mortgage banking, business finance and providing ATM andmerchant processing services. NetBank, Inc. wholly owns the outstandingstock of NetBank (“NetBank, FSB” or “the Bank”), a federal savings bank; MGReinsurance Company (“MG Reinsurance”), a captive reinsurance company;NetInsurance, Inc. (“NetInsurance”), a licensed insurance agency; and NBPartners, Inc., a corporation involved in strategic partneringopportunities. NB Partners, Inc. owns all of the outstanding stock of FinancialTechnologies, Inc., a corporation formed in 2004 to market transactionprocessing services to other financial services companies. NetBank, FSB ownsall of the outstanding stock of Market Street Mortgage Corporation (“MarketStreet”), a retail mortgage company, NetBank Payment Systems, Inc. (“NPS”),a provider of ATM and merchant processing services for retail and othernon-bank businesses and Meritage Mortgage Corporation (“Meritage”), a wholesalenon-conforming mortgage provider. Additionally, NetBank, FSB’s wholesalemortgage division operates as NetBank Funding Services and its businessfinancing unit operates as NetBank Business Finance.  The consolidated company is referred toherein as “we,” “our” or “the Company”.

In the opinion of management, the unaudited consolidated financialstatements included herein reflect all adjustments, consisting only of normalrecurring accruals, which are necessary for the fair presentation of thefinancial condition and results of operations for the interim periodspresented. Certain information and footnote disclosures normally included infinancial statements have been condensed or omitted pursuant to applicablerules and regulations of the Securities and Exchange Commission (“SEC”). Thefinancial statements included herein should be read in conjunction with thefinancial statements and notes thereto, included in our Annual Report on Form 10-Kfiled with the SEC for the year ended December 31, 2004 (“2004 Form 10-K”).The results of operations for the interim periods reported herein are notnecessarily indicative of results to be expected for the full year. Certain2004 amounts have been reclassified for comparability with 2005 amounts.

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

**2.             ACQUISITIONS**

During the three months ended March 31, 2005, NPSacquired certain assets or processing contracts of various smaller ATM and merchantprocessing businesses.  The acquisitionswere accounted for as purchases, and, as such, approximately $2 million ofamortizable intangibles were recorded. Consideration for all the businesses totaled $2,175. The results ofoperations for the acquired businesses have been included from the dates ofacquisition.

**3.             ACCOUNTING POLICIES**

Reference is made to the Company’s accountingpolicies as described in the notes to the consolidated financial statementscontained in its 2004 Form 10-K. The Company has followed those policiesin preparing this report.

*SignificantEstimates.*The preparation of the consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States of America (“GAAP”) requires management to make estimates andassumptions that affect the amounts reported in the consolidated financialstatements and accompanying notes. Such estimates relate to the Company’sallowance for credit losses; the fair values of loans held for sale, loan andlease receivables, mortgage servicing rights, servicing hedges and the Company’sother hedging instruments; and reserves for losses on representations andwarranties provided to purchasers of loans or mortgage servicing rights.Because of the inherent 

 

 

8

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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 inrealization of the underlying assets and liabilities could differ significantlyfrom the amounts reflected as of the balance sheet date.

 

*Stock-Based Compensation.*The Companyaccounts for stock options issued under the recognition and measurementprinciples of Accounting Principles Board Opinion No. 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 Company also allowsparticipants to purchase stock under the NetBank, Inc. Employee Stock PurchasePlan (“the Stock Plan”).  The Stock Planpurchases shares of the Company’s common stock from the Company on the last dayof each quarter at 85% of the market value on the purchase date.  No stock-based compensation expense is reflectedin the results of operations related to the Stock Plan.  The following table illustrates the pro formaeffects on the results of operations and net income (loss) per share if theCompany had applied the fair value recognition provisions of Statement ofFinancial Accounting Standard No. 123, *Accounting for Stock-BasedCompensation — Transition and Disclosure,*to stock-based employeecompensation.

 
| ** **                                                                                                                           | ** ** | **Three months ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                           | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| Net income, as reported                                                                                                              |       | $                                 | (2,029     | ) | $ | 9,394 |   |
| Deduct:                                                                                                                              |       |                              |       |   |   |
| Total stock-based employee compensation expense determined under fair  value based method for all awards, net of related tax effects |       | (536                              | )          | (566 | ) |
| Pro forma net income                                                                                                                 |       | $                                 | (2,565     | ) | $ | 8,828 |   |
|                                                                                                                                 |       |                              |       |   |   |
| Net income (loss) per share:                                                                                                         |       |                              |       |   |   |
| Basic — as reported                                                                                                             |       | $                                 | (0.04      | ) | $ | 0.20 |   |
| Basic — pro forma                                                                                                               |       | $                                 | (0.06      | ) | $ | 0.19 |   |
|                                                                                                                                 |       |                              |       |   |   |
| Diluted — as reported                                                                                                           |       | $                                 | (0.04      | ) | $ | 0.20 |   |
| Diluted — pro forma                                                                                                             |       | $                                 | (0.06      | ) | $ | 0.18 |   |

**Inaddition, for the three months ended March 31, 2005 and 2004, pre-taxcompensation expense of $23 and $31, respectively, related to restricted stockawards was recognized and included in our results of operations.**

*New Accounting Pronouncements.  *On December 16, 2004,the Financial Accounting Standards Board issued Statement of FinancialAccounting Standards No. 123 (revised 2004) (“SFAS 123r”), *Share-Based Payment*, which is a revision of SFAS 123.SFAS 123r supersedes APB 25 and amends Statement of FinancialAccounting Standards No. 95, *Statement of Cash flows*.Generally, the approach to accounting for share-based payments inSFAS 123r is similar to the approach described in SFAS 123, exceptthat SFAS 123r requires all share-based payments to employees, includinggrants of stock options, to be recognized in the financial statements based ontheir fair values. SFAS 123r is effective for NetBank at the beginning ofthe first interim period beginning after June 15, 2005; early adoption isencouraged. NetBank intends to adopt SFAS 123r using theModified-Prospective Transition provisions of SFAS 123r, which willrequire financial statement recognition of the fair value of all share-basedpayments that vest subsequent to adoption. Pro forma disclosure will berequired for all prior periods presented. However, effective April 21, 2005, SEC release No. 33-8568delayed the effective date of SFAS 123r to fiscal years beginning on or afterDecember 15, 2005.  Pursuant to thisrelease, the Company will delay its adoption of SFAS 123r until January 1,2006.

 

9

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**4.             LOAN AND LEASE RECEIVABLES**

The Company’s portfolio of loan and lease receivables consistsprimarily of internally originated 1-4 family first and second mortgage loans,home equity loans, automobile loans and business equipment financing loans andleases.

As of March 31, 2005 and December 31, 2004 the Company had netpremiums on its loan and lease receivables of $35,661 and $33,765,respectively.

The following is a summary of the Company’s loan and lease receivables portfolio:

 
| ** **                       | ** ** | **As of**          | ** ** | **As of**             | ** ** |
|----------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
| ** **                       | ** ** | **Amount**         | ** ** | **%**                 | ** ** | **Amount** | ** ** | **%** | ** ** |
| First mortgages                  |       | $                  | 1,028,453  |                  | 47.9       | % | $ | 1,081,676 |   | 51.0 | % |
| Second mortgages                 |       | 156,982            |       | 7.3                   | %          | 170,993 |   | 8.1 | % |
| Leases                           |       | 368,550            |       | 17.2                  | %          | 356,016 |   | 16.8 | % |
| Auto                             |       | 441,852            |       | 20.6                  | %          | 391,934 |   | 18.5 | % |
| Home equity lines                |       | 146,893            |       | 6.8                   | %          | 115,068 |   | 5.4 | % |
| Consumer                         |       | 5,343              |       | 0.2                   | %          | 4,607 |   | 0.2 | % |
| Total                            |       | 2,148,073          |       | 100.0                 | %          | 2,120,294 |   | 100.0 | % |
| Less allowance for credit losses |       | (25,075            | )          |                  |       | (24,462 | )  |   |   |
| Total                            |       | $                  | 2,122,998  |                  |       |   | $ | 2,095,832 |   |   |   |

 

NetBank’s lease receivables consist primarily ofbusiness equipment leases originated and serviced by its NetBank BusinessFinance division. In addition to its originated lease receivables, NetBank, FSBowns a portfolio of purchased lease receivables originated by Commercial MoneyCenter, Inc. (“CMC”). NetBank, FSB is involved in litigation with threeinsurance companies who are sureties on the purchased leases. Since the secondquarter of 2002, the entire portfolio has been on non-accrual status pendingoutcome of the litigation. NetBank, FSB has filed a claim for allprincipal and interest payments that are currently past due, approximately $96million. The Company charged off $50,230 of the unpaid principal balance during2004 resulting in a remaining balance of $31,527 as of December 31, 2004. Theremaining balance as of March 31, 2005 was $31,294.

**5.             NON-PERFORMING ASSETS AND ALLOWANCEFOR CREDIT LOSSES**

The Company considers a loanor lease receivable to be impaired when it is probable that it will be unableto collect all amounts due according to the original terms of the loan or leaseagreement.  The Company measuresimpairment of a loan or lease on a loan-by-loan or lease-by-lease basis.  Amounts of impaired loans or leases that arenot probable of collection are charged off immediately.

The following table details the Company’s non-accrual and troubled debtrestructurings:

 

| ** **                       | ** ** | **As of**          | ** ** | **As of**             | ** ** |
|----------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
| Loan and lease receivables (1)   |       | $                  | 37,083     |                  | $          | 37,045 |   |
| Loans held for sale (1)          |       | $                  | 36,889     |                  | $          | 36,633 |   |
| Troubled debt restructurings (2) |       | $                  | 356        |                  | $          | 210 |   |

 

10

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

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

Non-performing loan and lease receivables asof March 31, 2005 and December 31, 2004 included $31,294 and $31,527,respectively, of non-performing lease receivables related to the CMC leaseportfolio.

On average the Company held approximately $73,412 and $105,879 ofrestructured and non-accrual loans during the three months ended March 31, 2005and 2004, respectively. Foregone interest for the three months ended March 31,2005 and 2004 was approximately $3.9 and $5.3 million, respectively.  The Company had $6,330 and $5,799 in otherreal estate owned resulting primarily from residential mortgage loanforeclosures at March 31, 2005 and December 31, 2004, respectively.

The following is a summary of the allowancefor credit losses:

 
| ** **                                                           | ** ** | **Three months ended  March 31,** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                           | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| **Beginning balance**                                                |       | $                                 | 24,462     |   | $ | 43,689 |   |
| Provision for credit losses                                          |       | 2,351                             |       | 1,847 |   |
| Charge-offs:                                                         |       |                              |       |   |   |
| First mortgages                                                      |       | —                            |       | (18 | ) |
| Second mortgages                                                     |       | (1                                | )          | (135 | ) |
| Leases                                                               |       | (1,550                            | )          | (973 | ) |
| Auto                                                                 |       | (901                              | )          | (324 | ) |
| Home equity lines                                                    |       | (22                               | )          | (187 | ) |
| Consumer                                                             |       | (27                               | )          | (48 | ) |
| Total charge-offs                                                    |       | (2,501                            | )          | (1,685 | ) |
| Recoveries:                                                          |       |                              |       |   |   |
| First mortgages                                                      |       | 1                                 |       | — |   |
| Second mortgages                                                     |       | 42                                |       | 11 |   |
| Leases                                                               |       | 448                               |       | 567 |   |
| Auto                                                                 |       | 249                               |       | 162 |   |
| Home equity lines                                                    |       | 23                                |       | — |   |
| Consumer                                                             |       | —                            |       | — |   |
| Total recoveries                                                     |       | 763                               |       | 740 |   |
| Total charge-offs, net                                               |       | (1,738                            | )          | (945 | ) |
| **Ending balance**                                                   |       | $                                 | 25,075     |   | $ | 44,591 |   |
| Allowance for credit losses as a percent of average loans and leases |       | 1.2                               | %          | 2.4 | % |

 

**6.             FAIR VALUE AND IMPAIRMENT OFMORTGAGE SERVICING RIGHTS**

The Company accounts for its entire mortgageservicing rights (“MSR”) portfolio at the aggregate of the lower of cost ormarket (“LOCOM”). For purposes of evaluating the MSR portfolio for impairment,the Company disaggregates its MSR portfolio into two primary groupings:available for sale and held for sale.

Thesegment of the portfolio designated as available for sale is composed of MSRsthat were retained out of production pursuant to individual portfolio retentiondecisions or purchased in bulk transactions. The available for sale portfoliois disaggregated for purposes of measuring potential impairments according todefined risk tranches. The Company has defined these risk tranches based uponinterest rate band and product type. With respect to each such risk tranche, the fair 

 

11

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valuethereof, which is based upon an internal analysis that considers current marketconditions, prevailing interest rates, prepayment speeds, default rates andother relevant factors, is compared to amortized carrying values of the MSRsfor purposes of measuring potential impairment.

The segment of the portfolio designated asheld for sale is composed of recently produced MSRs that are scheduled for saleand have been allocated to specific forward servicing sales contracts.  The held for sale portfolio is disaggregatedfor purposes of measuring possible impairments according to the specificforward sales contracts to which allocated, which the Company has determined tobe the appropriate approach to disaggregation by predominant riskcharacteristic for this portfolio segment. For each such risk tranche, the fair value is based upon the allocatedforward committed delivery price, which is compared to amortized carrying valuefor purposes of measuring potential impairment.

The following amounts relateto the Company’s MSR portfolio:

 
| ** **                   | ** ** | **Available for sale** | ** ** | **Held for sale** | ** ** |
|------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                   | ** ** | **March 31,**          | ** ** | **December 31,**  | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
| ** **                   | ** ** | **2005**               | ** ** | **2004**          | ** ** | **2005** | ** ** | **2004** | ** ** |
| UPB                          |       | $                      | 14,819,452 |              | $          | 12,699,935 |   | $ | 201,652 |   | $ | 193,877 |   |
| Carrying Value               |       | $                      | 208,129    |              | $          | 170,651 |   | $ | 2,124 |   | $ | 2,168 |   |
| Carrying Value / UPB         |       | 1.40                   | %          | 1.34              | %          | 1.05 | % | 1.12 | % |
| Fair value                   |       | $                      | 208,810    |              | $          | 171,075 |   | $ | 2,124 |   | $ | 2,168 |   |
| Fair value / UPB             |       | 1.41                   | %          | 1.35              | %          | 1.05 | % | 1.12 | % |
| Weighted average note rate   |       | 5.89                   | %          | 5.95              | %          | 5.94 | % | 6.32 | % |
| Weighted average service fee |       | 0.32                   | %          | 0.33              | %          | 0.29 | % | 0.33 | % |
| Net Basis as multiple        |       | 4.40                   |       | 4.13              |       | 3.66 |   | 3.36 |   |

 

The following table summarizes changes in the impairment reserve for theCompany’s MSRs for the three months ended March 31, 2005 and 2004:

| ** **                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------|------------|----------|------------|----------|------------|
| Balance as of January 1,                   |       | $        | 65,557     |     | $          | 58,253 |   |
| Servicing valuation impairment (recapture) |       | (680     | )          | 1,170    |       |
| Balance as of March 31,                    |       | $        | 64,877     |     | $          | 59,423 |   |

 

**7.             DEPOSITS**

The following table setsforth the dollar amount of deposits and weighted average interest rates in thevarious types of deposit programs offered by the Company:
| ** **                             | ** ** | **As of March 31, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|----------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                             | ** ** | **Amount**               | ** ** | **Percentage**              | ** ** | **Weighted  average  interest rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest rate** | ** ** |
| Non-interest bearing checking accounts |       | $                        | 314,085    |                        | 12.1       | % | — |   | $ | 285,218 |   | 10.8 | % | — |   |
| Interest bearing:                      |       |                     |       |                        |       |   |   |   |   |   |   | — |   |
| Checking accounts                      |       | 246,680                  |       | 9.5                         | %          | 1.0 | % | 261,588 |   | 9.9 | % | 1.0 | % |
| Money market                           |       | 1,117,419                |       | 43.1                        | %          | 2.4 | % | 1,158,529 |   | 43.9 | % | 1.9 | % |
| Certificate of deposit under $100      |       | 829,428                  |       | 32.1                        | %          | 3.2 | % | 830,996 |   | 31.5 | % | 2.9 | % |
| Certificate of deposit over $100       |       | 83,876                   |       | 3.2                         | %          | 3.5 | % | 103,110 |   | 3.9 | % | 3.3 | % |
| Total deposits                         |       | $                        | 2,591,488  |                        | 100.0      | % |   |   | $ | 2,639,441 |   | 100.0 | % |   |   |

 

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Accrued interest as of March 31, 2005 related to checking, money marketand certificates of deposit accounts was $84, $877 and $3,867, respectively.  Accrued interest as of December 31, 2004,related to checking, money market, and certificate of deposit accounts was $66,$607 and $5,426, respectively.  At March31, 2005 and December 31, 2004 $509 and $764 of overdrawn deposits were classifiedas loans, respectively.

**8.             BORROWINGS**

Asummary of borrowings and available borrowings, grouped by year of maturity, asof March 31, 2005 follows:
| **Type of Borrowing**          | ** ** | **Year of  maturity** | ** ** | **Range of stated  interest rates** | ** ** | **Principal amount outstanding** | ** ** |
|------------------------------------------|------------|----------------------------|------------|----------------------------------------------------|------------|---------------------------------------|------------|
| $25 million line of credit               |       | 2005                       |       | Fed Funds                                          | *          | $                                     | —     |   |
| $200 million master  repurchase facility |       | 2005                       |       | 4.12 to 4.24                                       | %          | —                                |       |
| $300 million warehouse line of credit    |       | 2005                       |       | 3.70, 4.20                                         | %*         | 70,765                                |       |
| FHLB thirty-day advances                 |       | 2005                       |       | DRC + 0.50                                         | %*         | 209,000                               |       |
| FHLB overnight advances                  |       | 2005                       |       | DRC                                                | *          | 194,500                               |       |
| FHLB advances                            |       | 2005                       |       | 1.77 to 7.41                                       | %          | 146,000                               |       |
| FHLB advances                            |       | 2006                       |       | 2.04 to 5.63                                       | %          | 260,000                               |       |
| FHLB advances                            |       | 2007                       |       | 2.57                                               | %          | 40,000                                |       |
| Note payable                             |       | 2007                       |       | 5.00                                               | %          | 20                                    |       |
| FHLB advances                            |       | 2008                       |       | 1.90 to 1.92                                       | %          | 100,000                               |       |
| FHLB advances                            |       | 2009                       |       | 1.80 to 4.64                                       | %          | 215,000                               |       |
| FHLB advances                            |       | 2010                       |       | 3.63                                               | %          | 25,000                                |       |
| 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                                 |       |
| Subordinated debt                        |       | 2034                       |       | LIBOR + 3.00                                       | %*         | 20,620                                |       |
| Repurchase agreement                     |       | 2005                       |       | 2.66                                               | %          | 61,573                                |       |
| Total debt                               |       |                       |       |                                               |       | $                                     | 1,539,335  |   |

----

*        Indicatesa variable rate.

The total borrowings available through the Federal Home Loan Bank (“FHLB”)are determined each quarter as 50% of total assets of NetBank, FSB subject to limitationsof available collateral. The Company utilizes this line through fixed andconvertible term advances, as well as short term advances including thirty day andovernight borrowings. Eight of the FHLB advances totaling $356,000 are fixedrate. The remaining advances totaling $615,000 are also fixed, however, theymay be converted at the FHLB’s option to adjustable rate based on the threemonth floating LIBOR. The FHLB 

 

13

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warehouse line is an adjustable line of credit with a floating ratebased on the daily rate credit (“DRC”) plus 50 basis points. This warehouseline can be used to fund mortgages originated by the Company. All of the FHLBadvances and the FHLB warehouse line are secured by investment securities ormortgage loans. At March 31, 2005, NetBank had pledged $609,406 ofinvestment securities and $1.3 billion of mortgage loans to the FHLB ascollateral for the various FHLB advances.

The $61,573 repurchase agreement was collateralized by $65,360 ofinvestment securities. The current agreement is scheduled to mature inApril 2005.

The Company’s subordinated debt is supported by trust preferredsecurities, which were issued in 2002, 2003 and 2005 in private pooledtransactions through off-balance sheet trusts: NBI Trust I, II, III andIV. The subordinated debt, and the associated trust preferred securities forNBI Trust I, II and III, carry variable rates and were initially priced atLIBOR plus 2.85% to 3.35% with a cap of 12.5% through January 2008.Interest payments and the resetting of the rates both occur on a quarterlybasis. The debt is scheduled to mature from December 2032 through December 2034and cannot be redeemed by the trust for a minimum of five years afterissuance.  On February 7, 2005 NBI TrustIV, was established to support $20,620 of additional subordinated debt.  This issuance was priced at LIBOR plus 3.00% andis scheduled to mature in December 2034. NBI Trust IV cannot be redeemed by the trust for a minimum of five yearsafter issuance.  Other terms of NBI TrustIV are similar to NBI Trust I, II and III.

Most of the revolving lines of credit, warehouse lines of credit (otherthan the FHLB warehouse line) and the master repurchase facilities are securedby mortgage loans and are subject to restrictive covenants. The covenantsinclude certain minimum net worth requirements, minimum tangible net worthrequirements, minimum financial ratios, capital requirements, maintenance ofservicer eligibility for various government agencies and certain minimumliquidity requirements, which are all defined in the terms of the related debtagreements. In addition, the covenants restrict the types of businessactivities in which the Company may engage. The Company was in compliance withall debt covenants in place as of March 31, 2005. Although managementanticipates complying with all current debt covenants, there can be noassurance that the Company or its individual subsidiaries will be able tocomply with all debt covenants in the future. Failure to comply could result inthe loss of the related financing.

Short-term debt outstanding to third parties reached the highest monthend level during the current quarter on January 31, 2005 with a short-termbalance of $904 million.

**9.             NET INCOME PER COMMON AND COMMONEQUIVALENT SHARE**

Basic and diluted net income (loss) per common and potential commonshare has been calculated based on the weighted average number of sharesoutstanding.  The following schedulereconciles the numerator and denominator of the basic and diluted net income(loss) per common and potential common share for the three months ended March31, 2005 and 2004. For the three months ended March 31, 2005, there is nodifference in basic and diluted shares as the effect of options outstanding topurchase shares of common stock would be anti-dilutive to the net loss for theperiod.

 
| ** **                                                        | ** ** | **Net income (loss) (Numerator)** | ** ** | **Weighted Average Shares Outstanding (Denominator)** | ** ** | **Per Share Amount** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------|------------|-------------------------------------------------------|------------|----------------------|------------|
| **Three months ended March 31, 2005**                             | ** ** | ** **                        | ** ** | ** **                                            | ** ** | ** **           | ** ** |
| Basic                                                             |       | $                                 | (2,029     | )                                                     | 46,366     |                 | $          | (0.04 | ) |
| Effect of dilutive securities - options to purchase common shares |       | —                            |       | —                                                |       | —               |       |
| Diluted                                                           |       | $                                 | (2,029     | )                                                     | 46,366     |                 | $          | (0.04 | ) |
|                                                              |       |                              |       |                                                  |       |                 |       |
| **Three months ended March 31, 2004**                             | ** ** | ** **                        | ** ** | ** **                                            | ** ** | ** **           | ** ** |
| Basic                                                             |       | $                                 | 9,394      |                                                  | 47,250     |                 | $          | 0.20 |   |
| Effect of dilutive securities - options to purchase common shares |       | —                            |       | 718                                                   |       | —               |       |
| Diluted                                                           |       | $                                 | 9,394      |                                                  | 47,968     |                 | $          | 0.20 |   |

 

14

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**10.          BUSINESS SEGMENTS**

The Company’s principal activities include retail banking, financialintermediary and transaction processing.  The retail banking segmentprimarily consists of offering consumer banking products such as checking,money market, and certificates of deposit. Its investments primarily consist of1-4 family mortgage loans originated by the financial intermediary segment,business financing loans and leases originated by its NetBank Business Financedivision, auto loans originated by its Dealer Financial Services division,purchased securities for investment, MSRs and various other purchased orretained loan products. The financial intermediary segment primarilyoriginates mortgage loans via a network of retail branches or acquires mortgageloans from correspondents and/or brokers and packages pools of such loanseither inclusive of or exclusive of MSRs for sale to the retail banking segmentor into the secondary market. The transaction processing segment provides ATMand merchant processing services; subservices loans for the retail bankingsegment, financial intermediary segment and for third-party customers; andsells various insurance products using an Internet-based platform.

During the fourth quarter of 2004, the Company acquired the principaloperating assets of Guaranty Residential Lending, Inc., a retail mortgageorigination business. Additionally, during the third quarter of 2004, theCompany acquired the principal operating assets of Beacon Credit Services,LLC., a provider of boat, aircraft and recreational vehicle financing.  The results of operations for both businessesare included from their respective dates of acquisition.  At varying times throughout 2004, NPSacquired certain assets or servicing contracts from various smaller ATM andmerchant processing businesses.  Theresults of operations for these purchases are included in the transactionprocessing segment from their respective dates of acquisition.

The financial information for each business segment reflects specificidentifiable transactions or allocated transactions based on an internalallocation method.  The measurement ofthe performance of the business segments is based on the management structureof the Company and is not necessarily comparable with similar information fromany other financial institution. The information presented is also notnecessarily indicative of the segments’ operations if they were independententities. None of the Company’s segments have a significant exposure to anyindividual customer or vendor.
| ** **                                       | ** ** | **For the three months ended March 31, 2005** | ** ** |
|--------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                       | ** ** | **Retail banking**                            | ** ** | **Financial intermediary** | ** ** | **Transaction processing** | ** ** | **Other / Eliminations** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                             | 35,823     |   | $ | 21,057 |   | $ | 10 |   | $ | 130 |   | $ | 57,020 |   |
| Inter-segment interest income                    |       | 13,066                                        |       | 2,278 |   | 7 |   | (15,351 | ) | — |   |
| Total interest income                            |       | 48,889                                        |       | 23,335 |   | 17 |   | (15,221 | ) | 57,020 |   |
| Interest expense                                 |       | 24,440                                        |       | 1,480 |   | 20 |   | 303 |   | 26,243 |   |
| Inter-segment interest expense                   |       | 1,974                                         |       | 13,606 |   | — |   | (15,580 | ) | — |   |
| Total interest expense                           |       | 26,414                                        |       | 15,086 |   | 20 |   | (15,277 | ) | 26,243 |   |
| Net interest income                              |       | 22,475                                        |       | 8,249 |   | (3 | ) | 56 |   | 30,777 |   |
| Provision for credit losses                      |       | 2,336                                         |       | 15 |   | — |   | — |   | 2,351 |   |
| Inter-segment- servicing and processing fees     |       | —                                        |       | — |   | 3,456 |   | (3,456 | ) | — |   |
| Non-interest income                              |       | 13,691                                        |       | 25,475 |   | 4,820 |   | 423 |   | 44,409 |   |
| Non-interest expense                             |       | 28,647                                        |       | 38,297 |   | 7,259 |   | 1,759 |   | 75,962 |   |
| Inter-segment- servicing and processing expenses |       | 2,566                                         |       | 890 |   | — |   | (3,456 | ) | — |   |
| Pre-tax income (loss)                            |       | $                                             | 2,617      |   | $ | (5,478 | ) | $ | 1,014 |   | $ | (1,280 | ) | $ | (3,127 | ) |

 

15

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| ** **                                       | ** ** | **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 |   |
| Inter-segment 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 |   |
| Inter-segment 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 |   |
| Inter-segment- servicing and processing fees     |       | —                                        |       | — |   | 3,527 |   | (3,527 | ) | — |   |
| Non-interest income                              |       | 19,195                                        |       | 34,573 |   | 3,971 |   | (1,048 | ) | 56,691 |   |
| Non-interest expense                             |       | 27,341                                        |       | 35,978 |   | 6,978 |   | 1,264 |   | 71,561 |   |
| Inter-segment- servicing and processing expenses |       | 2,380                                         |       | 1,147 |   | — |   | (3,527 | ) | — |   |
| Pre-tax income (loss)                            |       | $                                             | 4,552      |   | $ | 11,551 |   | $ | 504 |   | $ | (1,575 | ) | $ | 15,032 |   |

 

# **11.          COMMITMENTS,CONTINGENCIES AND GUARANTEES**

The Company was servicing or subservicing for the benefit of others 120,253and 106,781 residential loans, with unpaid principal balances aggregatingapproximately $16.1 billion and $14.0 billion at March 31, 2005 andDecember 31, 2004, respectively. Mortgagor’s taxes and insurance escrowfunds and investors principal and interest escrow funds totaled approximately $308million and $288 million as of March 31, 2005 and December 31, 2004,respectively. Loans serviced for others and the related escrow funds are notowned by the Company; however, the majority of the escrow funds are depositedin NetBank, FSB.

The Company has issued mortgage-backed securities under programs sponsoredby Ginnie Mae, Freddie Mac and Fannie Mae. In connection with servicingmortgage-backed securities guaranteed by Ginnie Mae, Freddie Mac or Fannie Mae,the Company advances certain principal and interest payments to securityholders prior to their collection from specific 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. Theseamounts are included in servicing advances under the caption “due fromservicers and investors” in the accompanying consolidated balance sheets.Likewise, during the month that a mortgagor pays off his/her mortgage, theCompany must accept an interest payment from the borrower that is pro-rated tothe date of payoff and pass through a full month’s interest to the securityholder. The Company includes its projection of the cost of such advances andlost interest on mortgages that prepay, and the expense of unreimbursedattorney and other costs associated with foreclosure in its valuation of its MSRs.

In the ordinary course of business, the Company is exposed to liabilityunder representations and warranties made to purchasers and insurers ofmortgage loans and the purchasers of MSRs. Under certain circumstances, theCompany may be required to repurchase mortgage loans or indemnify thepurchasers of loans or MSRs for losses if there has been a breach ofrepresentations or warranties. Repurchased loans are carried at the lower of cost or net realizablevalue.  As of March 31, 2005 and December31, 2004, loans held for sale included repurchased loans with a net carryingvalue of $50.9 million and $48.9 million, respectively.

The Company is unable to determine its maximum exposure under itsrepresentations and warranties.  Themaximum exposure under the Company’s representations and warranties would bethe outstanding principal balance and any premium paid for all loans ormortgage servicing rights ever sold by the Company less any loans soldservicing released or any loans underlying MSRs that have already prepaid ordefaulted without a breach of representations and warranties. The Companyrepurchased approximately $31 million and $8.4 million of unpaid principalbalances during the three months ended March 31, 2005 and 2004, respectively.The Company had $22.0 million and

 

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$22.7 million of reserves for estimated losses on future repurchases asof March 31, 2005 and December 31, 2004, respectively.

As of March 31, 2005, the Company had commitments to fund mortgageloans of $1.0 billion, open-end consumer lines of credit of $83,118,undisbursed mortgage construction loans of $70,108 and undisbursed leasingcommitments of $7,298.

**The Company is involved incertain legal proceedings, excluding the CMC litigation, incidental to itsbusiness.  The Company does not believethat the outcome of these proceedings will have a material adverse effect uponits financial condition, results of operations 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 2004 Form 10-K,contains additional details on these and other risks that are material tooperations. All forward-looking statements in this report are based oninformation available at the time of filing. The Company has no obligation toupdate any forward-looking statement included herein. Forward-lookingstatements are made in reliance on the safe harbor provisions of Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended.*

**General**

NetBank, Inc. is a financial holding company engaged primarily inretail banking, mortgage banking, business finance and providing ATM andmerchant processing services. NetBank, Inc. wholly owns the outstandingstock of NetBank (“NetBank, FSB” or “the Bank”), a federal savings bank; MGReinsurance Company (“MG Reinsurance”), a captive reinsurance company;NetInsurance, Inc. (“NetInsurance”), a licensed insurance agency; and NBPartners, Inc., a corporation involved in strategic partneringopportunities. NB Partners, Inc. owns all of the outstanding stock ofFinancial Technologies, Inc., a corporation formed in 2004 to markettransaction processing services to other financial services companies. NetBank,FSB owns all of the outstanding stock of Market Street Mortgage Corporation (“MarketStreet”), a retail mortgage company, NetBank Payment Systems, Inc. (“NPS”),a provider of ATM and merchant processing services for retail and othernon-bank businesses and Meritage Mortgage Corporation (“Meritage”), a wholesalenon-conforming mortgage provider.  Additionally, NetBank, FSB’s wholesalemortgage division operates as NetBank Funding Services and its businessfinancing unit operates as NetBank Business Finance.  The consolidated company is referred toherein as “we,” “our” or “the Company”.

In the opinion of management, the unaudited consolidated financialstatements included herein reflect all adjustments, consisting only of normalrecurring accruals, which are necessary for the fair presentation of thefinancial condition and results of operations for the interim periodspresented. Certain information and footnote disclosures normally included infinancial statements have been condensed or omitted pursuant to applicablerules and regulations of the Securities and Exchange Commission (“SEC”). Thefinancial statements included herein should be read in conjunction with thefinancial statements and notes thereto, included in our 2004 Form 10-K.The results of operations for the interim periods reported 

 

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herein are not necessarily indicative of results to be expected for thefull year. Certain 2004 amounts have been reclassified for comparability with2005 amounts.

All figures are presented in thousands (000s), except share and pershare data, unless otherwise noted. All of our operations and assets arelocated within the United States.

**Executive Summary and Future Outlook**

For the three months ended March 31, 2005, we recorded a net loss of $2,029or $0.04 per share compared to net income of $9,394 or $0.20 per share duringthe comparable period of 2004.

*Retail Banking.* The retail banking segment had pre-taxincome during the period of $2,617, a $1,935 or 43% decline period over period.The Internet-only banking, leasing and auto operations collectively increasedtheir period over period pre-tax income by $2,699. This increase was primarilydriven by a 42-basis point increase in net interest income after provisioncoupled with a $149 million increase in the average balance of interest earningassets. Management believes the Internet-only banking, leasing and autooperations will continue to expand and increase their contribution to theCompany’s bottom-line in future periods by continuing to retain high-quality,higher yielding assets. This improvement was offset by a $4,634 pre-tax declinein the net servicing results, which was primarily due to the 2004 periodbenefiting from a $3,200 pre-tax increase in the value of mortgage servicingrights (“MSRs”), net of hedge results. As part of our strategy to grow theservicing asset, on March 31, 2005 we acquired the MSRs related to a portfolioof $2.5 billion in conventional, fixed rate mortgages. We believe the portfoliocan, for the most part, be absorbed by current excess servicing capacitydriving down per loan servicing cost. This additional operational leverageshould aid in moving this operation closer to our goal of break-even.

*Financial Intermediary*. The financial intermediarysegment recorded a pre-tax loss of $5,478, a $17,029 pre-tax decline periodover period.  This decline was driven bya $1.0 billion decline in mortgage sales coupled with severely compressedmargins, especially in the non-conforming mortgage operations. Thenon-conforming operations contributed $4,813 of the segment’s pre-tax loss dueto its margin on sale of loans falling to a record low 136 basis points, a 52%year over year decline. Management believes the decline in margins in its non-conformingmortgage operations will abate, if not reverse, and return to more normallevels at some point during 2005. Management also believes that margins in itsthird-party conforming mortgage operations will continue to decompress infuture quarters. The locked conforming mortgage pipeline increased to $917million at March 31, 2005 compared to only $755 million at December 31, 2004.The Mortgage Bankers Association of America’s April 2005 forecast for mortgageoriginations has been revised down to $2.498 trillion compared to $2.542 trillionat December 31, 2004. Based on this and other factors, management cautions thatthere remains a heightened risk that increased competitive pressures couldpersist resulting in continued losses within the mortgage banking operations.Additionally, during recent quarters, we have seen an increase in thefrequency, but not the severity, of mortgage loan repurchases. This trend hasresulted in increased provision in order to increase our current reserve level.It is still uncertain whether this trend will continue or abate. If the trendcontinues to increase in future periods, it would require us to continue toincrease our reserves to cover future losses on the disposition of repurchasedloans.

*Transaction Processing.* The transaction processingsegment increased its pre-tax income by $510 to $1,014 year over year. Theincrease was primarily driven by strict cost controls at NetInsurance, expansionof the ATM and merchant processing operation and an increase in loans servicedwithin the servicing factory. We believe the transaction processing segmentwill continue its trend of increasing its contribution to the Company’sresults. NPS continues to expand its operations by purchasing smaller ATM andmerchant processing business and processing contracts. NPS’s credit/debit cardtransaction volume increased by 55% year over year and by 2% sequential quarterover quarter. The servicing factory, which services loans on behalf of theretail banking and financial intermediary segments, should also see continuedimprovement as the number of loans serviced increases pushing up its revenuesand driving down its cost to service per loan.

 

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*Other/Eliminations.* The other/eliminationssegment recorded a pre-tax loss of $1,280, which is a $295 improvement over the2004 period.  The improvement isprimarily due to overhead cost controls and a reduction of inter-segmentrevenue eliminations related to the $255 million decline in loans sold to theretail banking segment from the financial intermediary segment.

*Risk and Contingencies*. Reference is made to the discussionunder the heading “Risks Relating to NetBank’s Business” in Item 1. Businessand to the heading “Future Outlook” in Item 7. Management’s Discussion andAnalysis of Financial Condition and Results of operations in the Company’s 2004Form 10-K for further information regarding the risks and challenges of ourbusiness. Reference is made to note 11 of the notes to consolidated financial statementsincluded in this report and to Item 1. “Legal Proceeding” in Part II of thisreport for additional discussion of certain risk and contingencies that mayaffect us.

 

# **Financial Condition**

*General. *Total assetsincreased $132,834 or 3% during the three months ended March 31, 2005.  This slight increase in assets is primarilydue to increases in unsettled trades of $75,000, investment securitiesavailable for sale of $40,813; loan and lease receivables of $27,166 and MSRsof $37,434.  These increases were offset,in part, by declines of $53,923 in loans held for sale and $29,758 in due fromservicers and investors.

Total liabilities increased $145 million or 3% during the three monthsended March 31, 2005.  This was primarilydriven by a $195 million increase in other borrowed funds, a $21 millionincrease in subordinated debt and a $20 million increase in loans inprocess.  These increases were offset, inpart, by a $48 million decline in deposits and a $51 million decline inunsettled trades.  The increase in otherborrowed funds was primarily used to support the higher levels of investmentsecurities, loan and lease receivables, MSRs and to offset the decline indeposits.

*Investment Securities.*  For the three monthsended March 31, 2005, the investment security portfolio increased by $41million primarily as a result of $162 million of purchases offset, in part, by$89 million of sales, $24 million of principal payments and a $6.5 milliondecline in fair value.

The following tables set forth certain information relating to theCompany’s available for sale securities:
| **As of March 31, 2005**               | ** ** | **Amortized cost** | ** ** | **Unrealized gains** | ** ** | **Unrealized losses** | ** ** | **Estimated fair value** | ** ** |
|----------------------------------------|------------|--------------------|------------|----------------------|------------|-----------------------|------------|--------------------------|------------|
| U.S. agency - mortgage pool securities |       | $                  | 599,790    |                 | $          | —                |       | $                        | 10,471     |   | $ | 589,319 |   |
| Collateralized mortgage obligations    |       | 28,835             |       | 25                   |       | 429                   |       | 28,431                   |       |
| U.S. treasury securities               |       | 30,108             |       | 212                  |       | 59                    |       | 30,261                   |       |
| U.S. agency bonds                      |       | 50,303             |       | —               |       | 519                   |       | 49,784                   |       |
| Corporate bonds                        |       | 39,156             |       | 616                  |       | 354                   |       | 39,418                   |       |
| Habitat bonds and other                |       | 3,763              |       | 132                  |       | —                |       | 3,895                    |       |
| Total                                  |       | $                  | 751,955    |                 | $          | 985                   |       | $                        | 11,832     |   | $ | 741,108 |   |

 
| **As of December 31, 2004**            | ** ** | **Amortized cost** | ** ** | **Unrealized gains** | ** ** | **Unrealized losses** | ** ** | **Estimated fair value** | ** ** |
|----------------------------------------|------------|--------------------|------------|----------------------|------------|-----------------------|------------|--------------------------|------------|
| U.S. agency - mortgage pool securities |       | $                  | 574,495    |                 | $          | —                |       | $                        | 3,205      |   | $ | 571,290 |   |
| Collateralized mortgage obligations    |       | 31,572             |       | 108                  |       | 87                    |       | 31,593                   |       |
| U.S. treasury securities               |       | 53,177             |       | 865                  |       | 87                    |       | 53,955                   |       |
| Corporate bonds                        |       | 39,150             |       | 609                  |       | 218                   |       | 39,541                   |       |
| Habitat bonds and other                |       | 3,733              |       | 183                  |       | —                |       | 3,916                    |       |
| Total                                  |       | $                  | 702,127    |                 | $          | 1,765                 |       | $                        | 3,597      |   | $ | 700,295 |   |

Management has reviewed the investment security portfolio and hasdetermined that no security with an unrealized loss is other than temporarilyimpaired.

 

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*Loans and Leases Receivable.*  For the three monthsended March 31, 2005, the loans and leases receivable portfolio increased $27,166million or 1%.  The increase was theresult of originating and retaining mortgage loans of $38,401, auto loans of $87,378and lease receivables of $45,897, which was offset by approximately $145million in principal payments.

*Loans Held for Sale.* For the three months endedMarch 31, 2005, loans held for sale declined by $53,923 or 5% to $1.11 billion.This decline was primarily driven by sales of mortgage loans outpacingseasonally lower levels of production.

*Asset Quality and Non-performing Assets.* Management periodicallyreviews the performance of the loans and leases receivable portfolio byreviewing charge-offs, delinquency statistics, and various other industry statistics.  Large non-homogeneous credits are reviewed ona loan-by-loan or lease-by-lease basis, whereas relatively small credits withsimilar risk characteristics are reviewed on a pool-by-pool basis.  If a decline in credit quality for a specificpool or individual loan or lease is noted, we record additional allowancethrough a charge to the provision for credit losses.  The allowance for credit losses is maintainedat a level estimated to be adequate to provide for probable losses in the loanand lease receivables portfolio.  Wedetermine the adequacy of the allowance based upon reviews of individual loansand leases, recent loss experience, current economic conditions, the riskcharacteristics of the various categories of loans and leases and other pertinentfactors.  Non-performing loan and leasereceivables as a percentage of gross unpaid principal balance (“UPB”) heldsteady at 1.7% comparing March 31, 2005 to December 31, 2004.  The following tables detail the loan andlease receivables portfolio, the associated allowance for credit losses andnon-performing assets:

 
| **As of March 31, 2005**   | ** ** | **Gross UPB** | ** ** | **Allocated Allowance** | ** ** | **(1) Non-performing** | ** ** |
|----------------------------|------------|---------------|------------|-------------------------|------------|------------------------|------------|
| First mortgages            |       | $             | 1,028,453  |                    | $          | 3,654                  |       | $ | 3,443 |   |
| Second mortgages           |       | 156,982       |       | 4,169                   |       | 267                    |       |
| Leases                     |       | 337,256       |       | 13,131                  |       | 1,920                  |       |
| Auto                       |       | 441,852       |       | 1,737                   |       | 83                     |       |
| Home equity lines          |       | 146,893       |       | 2,273                   |       | 76                     |       |
| Consumer                   |       | 5,343         |       | 111                     |       | —                 |       |
| Loan and lease receivables |       | 2,116,779     |       | 25,075                  |       | 5,789                  |       |
| CMC leases (2)             |       | 31,294        |       | —                  |       | 31,294                 |       |
| Loan and lease receivables |       | $             | 2,148,073  |                    | $          | 25,075                 |       | $ | 37,083 |   |

 
| **As of December 31, 2004**      | ** ** | **Gross UPB** | ** ** | **Allocated Allowance** | ** ** | **(1) Non-performing** | ** ** |
|----------------------------------|------------|---------------|------------|-------------------------|------------|------------------------|------------|
| First mortgages                  |       | $             | 1,081,676  |                    | $          | 3,842                  |       | $ | 3,232 |   |
| Second mortgages                 |       | 170,993       |       | 4,451                   |       | 183                    |       |
| Leases                           |       | 324,489       |       | 13,146                  |       | 1,532                  |       |
| Auto                             |       | 391,934       |       | 1,593                   |       | 278                    |       |
| Home equity lines                |       | 115,068       |       | 1,334                   |       | 291                    |       |
| Consumer                         |       | 4,607         |       | 96                      |       | 2                      |       |
| Loan and lease receivables       |       | 2,088,767     |       | 24,462                  |       | 5,518                  |       |
| CMC leases (2)                   |       | 31,527        |       | —                  |       | 31,527                 |       |
| Total loan and lease receivables |       | $             | 2,120,294  |                    | $          | 24,462                 |       | $ | 37,045 |   |

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(1) Non-performingincludes all loans that are 90 days or more contractually past due includingloans which have been restructured.  TheCompany also held $356 and $210 of restructured loans which were performing asof March 31, 2005 and December 31, 2004, respectively.

(2) Reference ismade to note 4 of the notes to the consolidated financial statements includedin this report for additional details regarding the CMC lease portfolio.

 

As more fullydescribed in note 3 of the notes to the consolidated financial statements included in theCompany’s 2004 Form 10-K, loans heldfor sale are carried at the aggregate of the lower of cost or market untilbeing sold, typically 30 to 90 days after origination or purchase. The majorityof the non-performing loans held for sale consist of loans which have beenrepurchased under representations and warranties provided to purchasers.  Once a loan has been repurchased, it isgenerally resold at a loss. Upon repurchase, reserves are transferred from thereserve for representations and warranties to a valuation reserve forrepurchased loans to record such loans at estimated net realizable value.  At 

 

 

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March 31, 2005 and December31, 2004 the aggregate market value of loans held for sale exceeded theaggregate cost.  The followingtables set forth information regarding the Company’s loans held for sale:

 

| **As of March 31, 2005**   | ** ** | **Gross UPB** | ** ** | **Non-performing** | ** ** | **Reserve** | ** ** |
|----------------------------|------------|---------------|------------|--------------------|------------|-------------|------------|
| Conforming mortgages       |       | $             | 828,247    |               | $          | 21,476      |       | $ | 4,646 |   |
| Non-conforming mortgages   |       | 228,797       |       | 15,361             |       | 5,199       |       |
| Construction               |       | 64,963        |       | 52                 |       | 278         |       |
| Commercial / recreational  |       | 8,371         |       | —             |       | 399         |       |
| Total held for sale assets |       | $             | 1,130,378  |               | $          | 36,889      |       | $ | 10,522 |   |

 

| **As of December 31, 2004** | ** ** | **Gross UPB** | ** ** | **Non-performing** | ** ** | **Reserve** | ** ** |
|-----------------------------|------------|---------------|------------|--------------------|------------|-------------|------------|
| Conforming mortgages        |       | $             | 821,422    |               | $          | 23,488      |       | $ | 4,179 |   |
| Non-conforming mortgages    |       | 300,406       |       | 12,810             |       | 5,293       |       |
| Construction                |       | 54,564        |       | 335                |       | 140         |       |
| Commercial / recreational   |       | 7,893         |       | —             |       | 894         |       |
| Total held for sale assets  |       | $             | 1,184,285  |               | $          | 36,633      |       | $ | 10,506 |   |

 

*Mortgage Servicing Rights.*  During the three months ended March 31, 2005,the net carrying value of the MSR portfolio increased $37,434 or 22%.  This increase was primarily the result ofpurchasing a $2.5 billion bulk portfolio, $36.4 million in capitalized value,coupled with the capitalization of $5.9 million related to retained servicingand $5.3 million of mark-to-market adjustments. These increases were offset, inpart, by amortization of $10.6 million during the period.

*Deposits.*  Depositswere $2.59 billion at March 31, 2005, a 2% decrease compared to $2.64 billionat December 31, 2004.  The $48 milliondecline was primarily centered in brokered CDs and money market accounts, whichis primarily the result of a change in pricing as part of management’s overallinterest rate management strategy. The following table summarizes our deposits:

 
| ** **                        | ** ** | **As of March 31, 2005** | ** ** | **As of December 31, 2004** | ** ** |
|-----------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                        | ** ** | **Amount**               | ** ** | **Percentage**              | ** ** | **Weighted  average  interest rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest rate** | ** ** |
| Non-interest bearing:             |       |                     |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Checking accounts                 |       | $                        | 314,085    |                        | 12.1       | % | — |   | $ | 285,218 |   | 10.8 | % | — |   |
| Interest bearing:                 |       |                     |       |                        |       |   |   |   |   |   |   | — |   |
| Checking accounts                 |       | 246,680                  |       | 9.5                         | %          | 1.0 | % | 261,588 |   | 9.9 | % | 1.0 | % |
| Money market                      |       | 1,117,419                |       | 43.1                        | %          | 2.4 | % | 1,158,529 |   | 43.9 | % | 1.9 | % |
| Certificate of deposit under $100 |       | 829,428                  |       | 32.1                        | %          | 3.2 | % | 830,996 |   | 31.5 | % | 2.9 | % |
| Certificate of deposit over $100  |       | 83,876                   |       | 3.2                         | %          | 3.5 | % | 103,110 |   | 3.9 | % | 3.3 | % |
| Total deposits                    |       | $                        | 2,591,488  |                        | 100.0      | % |   |   | $ | 2,639,441 |   | 100.0 | % |   |   |

*Shareholders’ Equity.*  Total shareholders’ equity declined by $11,767for the three months ended March 31, 2005. The decrease is primarily due to a $5,602 decline in the othercomprehensive income related to the decline in the fair value of available forsale investment securities, a $3,296 decline in retained earnings primarily dueto the quarterly net loss of $2,029 and the payment of $926 in dividends andthe $2,933 increase in treasury stock primarily related to the repurchase of423,726 shares of the Company’s common stock at a weighted average cost of$9.29 per share.

 

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**Results of Operations — Threemonths ended March 31, 2005 compared to three months ended March 31, 2004**

*General.*  Net loss for the three months ended March 31,2005 was $2,029 or $0.04 per share, compared to net income of $9,394 or $0.20per share for the same period in 2004.  Thecurrent period net loss was primarily driven by the $7,494 decline in gain onsales of loans, centered in the non-conforming mortgage operation due to margincompression, coupled with a $2,853 period over period decline in theperformance of the MSRs net of hedge results. The three months ended March 31,2004 included a $3,200 recapture of MSR value net of hedge results.

*Interest Income*.  Interest income for the three monthsended March 31, 2005 was $57,020 compared to $52,185 for the same period in 2004.As detailed in the following rate volume variance table, the average balance ofinvestment securities available for sale and loans and leases receivableincreased by $322,257 and $237,152, respectively. The increase in the averagebalance of loan and lease receivables is the result of the continuedorigination and retention of various mortgage products, home equity loans, autoloans and business equipment leases. These increases were offset, in part, by adecline of $470,637 in the average balance of loans held for sale. This declinewas primarily related to December through February typically being the lowestproduction months of the year.  A generalincrease in market rates resulted in a positive rate variance of $5,524.  This increase was partially offset by a $689negative volume/mix variance due to the largest increase in yield beingcentered in loans held for sale which also experienced a large decline inaverage balance.

*Interest Expense*. Total interest expense for the three monthsended March 31, 2005 was $26,243 compared to $20,436 for the same period of 2004.  The $5,807 increase is primarily due to a54-basis point increase in the average cost of funds coupled with an increaseof $85,678 in the average balance of total interest-bearing liabilities periodover period. The average balance of total deposits declined by $112,174, whichresulted in a positive volume/mix variance of $271.  This was offset by an increase of 36 basispoints in the average rate paid on deposits, which resulted in a negative$1,669 rate variance.  The averagebalance of the remaining interest-bearing liabilities increased by $197,852 or13%, and the average interest rate paid increased by 78 basis points.  These two increases resulted in a $4,409increase in interest expense period over period.

*Net Interest Income. *Net interestincome is determined by interest rate spread, which is the difference betweenthe yields earned on interest-earning assets and the rates paid oninterest-bearing liabilities, and the relative amounts of interest-earningassets and interest-bearing liabilities. Net interest income was $30,777, or 2.89%of average interest-earning assets for the three months ended March 31, 2005,compared to $31,749, or 3.06%, of average interest-earning assets for the threemonths ended March 31, 2004.

The following table detailsthe relative interest rates and average balances of interest-earning assets andinterest-bearing liabilities for the three months ended March 31, 2005 and 2004:
| **Average Balance** | ** ** | **Average Yield / Rate** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** **                          | ** ** | **Variance attributable to**                    | ** ** |
|---------------------|------------|--------------------------|------------|------------|------------|--------------|------------|-------------------------------------|------------|-------------------------------------------------|------------|
| **2005**            | ** ** | **2004**                 | ** ** | **2005**   | ** ** | **2004**     | ** ** | ** **                          | ** ** | **2005**                                        | ** ** | **2004** | ** ** | **Variance** | ** ** | **Rate** | ** ** | **Volume (3)** | ** ** |
| ** **          | ** ** | ** **               | ** ** | ** ** | ** ** | ** **   | ** ** | **Interest-earning assets:**        | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                   | 101,569    |                     | $          | 71,516     |       | 1.49         | %          | 1.01                                | %          | Short-term investments                          |       | $ | 379 |   | $ | 180 |   | $ | 199 |   | $ | 87 |   | $ | 112 |   |
| 775,634             |       | 453,377                  |       | 4.53       | %          | 3.50         | %          | Investment securities (1)           |       | 8,788                                           |       | 3,966 |   | 4,822 |   | 1,171 |   | 3,651 |   |
| 1,286,221           |       | 1,756,858                |       | 6.40       | %          | 5.58         | %          | Loans held for sale (2)             |       | 20,583                                          |       | 24,518 |   | (3,935 | ) | 3,596 |   | (7,531 | ) |
| 2,100,442           |       | 1,863,290                |       | 5.19       | %          | 5.05         | %          | Loan and lease receivables  (2)     |       | 27,270                                          |       | 23,521 |   | 3,749 |   | 670 |   | 3,079 |   |
| 4,263,866           |       | 4,145,041                |       | 5.35       | %          | 5.04         | %          | Total interest-earning assets       |       | 57,020                                          |       | 52,185 |   | 4,835 |   | 5,524 |   | (689 | ) |
|                |       |                     |       |       |       |         |       |                                |       |                                            |       |   |   |   |   |   |   |   |   |
| ** **          | ** ** | ** **               | ** ** | ** ** | ** ** | ** **   | ** ** | **Interest-bearing liabilities:**   | ** ** | ** **                                      | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 231,310             |       | 227,117                  |       | 1.29       | %          | 1.24         | %          | Checking accounts                   |       | 744                                             |       | 704 |   | 40 |   | 27 |   | 13 |   |
| 1,134,272           |       | 1,356,917                |       | 2.01       | %          | 1.74         | %          | Money market                        |       | 5,713                                           |       | 5,898 |   | (185 | ) | 936 |   | (1,121 | ) |
| 858,383             |       | 752,105                  |       | 3.15       | %          | 2.77         | %          | Certificates of deposit             |       | 6,759                                           |       | 5,216 |   | 1,543 |   | 706 |   | 837 |   |
| 897,615             |       | 619,499                  |       | 2.91       | %          | 2.04         | %          | Short-term debt                     |       | 6,525                                           |       | 3,157 |   | 3,368 |   | 1,346 |   | 2,022 |   |
| 766,950             |       | 858,898                  |       | 3.21       | %          | 2.48         | %          | FHLB advances                       |       | 6,162                                           |       | 5,320 |   | 842 |   | 1,581 |   | (739 | ) |
| 23,541              |       | 11,857                   |       | 5.78       | %          | 4.76         | %          | Subordinated debt                   |       | 340                                             |       | 141 |   | 199 |   | 30 |   | 169 |   |
| 3,912,071           |       | 3,826,393                |       | 2.68       | %          | 2.14         | %          | Total interest-bearing  liabilities |       | 26,243                                          |       | 20,436 |   | 5,807 |   | 4,626 |   | 1,181 |   |
|                |       |                     |       |       |       |         |       |                                |       |                                            |       |   |   |   |   |   |   |   |   |
| —              |       | —                   |       | 2.67       | %          | 2.90         | %          | Net interest margin                 |       | 30,777                                          |       | 31,749 |   | (972 | ) | 898 |   | (1,870 | ) |
| 351,795             |       | 318,648                  |       | 0.22       | %          | 0.16         | %          | Interest free sources               |       | —                                          |       | — |   | — |   | — |   | — |   |
| $                   | 4,263,866  |                     | $          | 4,145,041  |       | 2.89         | %          | 3.06                                | %          | Net interest income to  interest-earning assets |       | $ | 30,777 |   | $ | 31,749 |   | $ | (972 | ) | $ | 898 |   | $ | (1,870 | ) |

 

22

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(1)      Based on amortized cost; changes in fair value are notconsidered.

 

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

 

(3)      Variances attributable to the rate and volume mix are includedin the volume variances.

 

*Provision for Credit Losses.*  The provision forcredit losses was $2,351 for the three months ended March 31, 2005 compared to$1,847 for the same period of 2004. The $504 increase in provision primarily relatesto the growth and seasoning of the auto portfolio. During the three monthsended March 31, 2005, we originated and retained mortgage loans of $38 million,auto loans of $87 million and lease receivables of $46 million.  During the three months ended March 31, 2004, weretained originated mortgage loans of $293 million, auto loans of $87 million,and originated leases of $39 million. During the three months ended March 31,2005, the Company had net charge-offs of $1,738, or 0.08% of average loan andlease receivables, compared to $945 of net charge-offs, or 0.05% of averageloan and lease receivables for the same period of 2004.  Reference is made to the heading “FinancialCondition - Asset Quality and Non-performing Assets” above for additionaldetail concerning the determination of provision expense related to maintainingthe proper level of allowance for credit losses.

*Non-interest Income.*  Non-interest incomedeclined $12,282 for the three months ended March 31, 2005 compared to the sameperiod of 2004.  This decline wasprimarily driven by the $7,494 decline in gain on sales of loans due to the $756million or 22% decline in sales of mortgage loans.  The decline in sales was compounded by thedecline in margins on sales due to increased competitive pressures, especiallyin the non-conforming operation. Other income increased by $3,044 primarilyrelated to mark-to-market adjustments on the MSR hedges, which was offset by adecline of $7,121 in loss on derivatives. Loss on derivatives is comprised primarily of TBA mortgage-backsecurities for which we do not elect special hedge accounting but do use toeconomically hedge the MRS portfolio.

*Non-interest Expense.*  Non-interest expenseincludes all operating expenses such as salaries and benefits, marketing andgeneral and administrative expenses. Non-interest expense increased $4,401, or 6%, for the three months endedMarch 31, 2005 compared to the same period of 2004. The increase was primarilydriven by a $1 million increase in professional fees related to the increasedcost of compliance with section 404 of the Sarbanes-Oxley Act.  This increase is coupled with increases indepreciation and amortization, occupancy and other expense categories that weregenerally higher as our operations expanded period over period with theaddition of Beacon Credit Services and the expansion of the retail mortgageoperations.

# ***Segment results for the three months ended March 31, 2005 compared tothe three months ended March 31, 2004. All comparisons are on a pre-tax basis.***

# ***Retail Bank Operations***

The table below provides an overview of theresults of operations for the retail bank segment:

 
| ** **                                   | ** ** | **For the three months ended March 31,** | ** **     |
|----------------------------------------------|------------|------------------------------------------|----------------|
| ** **                                   | ** ** | **2005**                                 | ** **     | **2004** | ** ** | **change** | ** ** |
| Net interest income                          | ** ** | **$**                                    | **22,542**     |   | $ | 16,989 |   | $ | 5,553 |   |
| Provision for credit losses                  | ** ** | **2,336**                                |           | 1,829 |   | 507 |   |
| Net interest income after provision          | ** ** | **20,206**                               |           | 15,160 |   | 5,046 |   |
| Gains on sales of loans                      | ** ** | **501**                                  |           | 1,063 |   | (562 | ) |
| Fees, charges and other income               | ** ** | **3,327**                                |           | 2,922 |   | 405 |   |
| Total revenues                               | ** ** | **24,034**                               |           | 19,145 |   | 4,889 |   |
| Total expenses                               | ** ** | **17,845**                               |           | 15,655 |   | 2,190 |   |
| Pre-tax income before net servicing results  | ** ** | **6,189**                                |           | 3,490 |   | 2,699 |   |
| Net servicing results                        | ** ** | **(3,572**                               | )              | 1,062 |   | (4,634 | ) |
| Pre-tax income                               | ** ** | **$**                                    | **2,617**      |   | $ | 4,552 |   | $ | (1,935 | ) |
|                                         |       |                                     |           |   |   |   |   |
| Average earning assets                       | ** ** | **$**                                    | **4,305,234**  |   | $ | 4,156,361 |   | $ | 148,873 |   |
| Average UPB underlying MSRs                  | ** ** | **$**                                    | **13,175,247** |   | $ | 13,086,946 |   | $ | 88,301 |   |
|                                         |       |                                     |           |   |   |   |   |
| **Operations to earning assets**             |       |                                     |           |   |   |   |   |
| Net interest income after provision          | ** ** | **1.88**                                 | **%**          | 1.46 | % | 0.42 | % |
| Gain on sale, fees, charges and other income | ** ** | **0.36**                                 | **%**          | 0.38 | % | (0.02 | )% |
| Banking revenues                             | ** ** | **2.24**                                 | **%**          | 1.84 | % | 0.40 | % |
| Total expenses                               | ** ** | **1.66**                                 | **%**          | 1.51 | % | 0.15 | % |
| Pre-tax income before net servicing results  | ** ** | **0.58**                                 | **%**          | 0.33 | % | 0.25 | % |
|                                         |       |                                     |           |   |   |   |   |
| Net servicing results to UPB underlying MSRs | ** ** | **(0.11**                                | )**%**         | 0.03 | % | (0.14 | )% |

 

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The retail banking segmentearned $2,617 for three months ended March 31, 2005, a decline of $1,935compared to the same period of 2004.  Theretail banking segment is comprised of four main operating units: Internet-basedretail banking, indirect automobile lending, business financing and ourlonger-term investment in MSRs.  Thethree lending operations improved period over period by $2,699. Thisimprovement was the result of a $149 million increase in the average balance ofinterest-earning assets coupled with a 42-basis point improvement in netinterest income after provision.  Thisincrease was more than offset by a $4,634 decline in the net servicing results.  The decline in net servicing results wasprimarily related to the 2004 period containing a recapture of previousimpairment, net of hedge results, of $3,200, coupled with an increase inamortization expense period over period. Management expects the $2.5 billion bulk MSR purchase made on March 31,2005 to improve the net servicing results in future periods as we begin to takeadvantage of greater economies of scale.

*Financial Intermediary*

The table below provides an overview of theresults of operations for the financial intermediary segment:
| ** **                           | ** ** | **For the three months ended March 31,** | ** **    |
|--------------------------------------|------------|------------------------------------------|---------------|
| ** **                           | ** ** | **2005**                                 | ** **    | **2004** | ** ** | **change** | ** ** |
| Pre-tax results                      | ** ** | ** **                               | ** **    | ** ** | ** ** | ** ** | ** ** |
| Net interest income                  | ** ** | **$**                                    | **8,185**     |   | $ | 14,105 |   | $ | (5,920 | ) |
| Gain on sales of loans               | ** ** | **22,885**                               | ** **    | 32,299 |   | (9,414 | ) |
| Other income                         | ** ** | **887**                                  | ** **    | 1,711 |   | (824 | ) |
| Net Beacon Credit Services results   | ** ** | **(663**                                 | **)**         | — |   | (663 | ) |
| Net MG Reinsurance results           | ** ** | **864**                                  | ** **    | 507 |   | 357 |   |
| Total revenues                       | ** ** | **32,158**                               | ** **    | 48,622 |   | (16,464 | ) |
| Salary and employee benefits         | ** ** | **22,534**                               | ** **    | 22,791 |   | (257 | ) |
| Occupancy & depreciation expense | ** ** | **7,056**                                | ** **    | 6,804 |   | 252 |   |
| Other expenses                       | ** ** | **8,046**                                | ** **    | 7,476 |   | 570 |   |
| Total expenses                       | ** ** | **37,636**                               | ** **    | 37,071 |   | 565 |   |
| Pre-tax income (loss)                | ** ** | **$**                                    | **(5,478**    | **)** | $ | 11,551 |   | $ | (17,029 | ) |
|                                 |       |                                     | ** **    |   |   |   |   |
| Production                           | ** ** | **$**                                    | **2,776,609** | ** ** | $ | 3,258,766 |   | $ | (482,157 | ) |
| Sales                                | ** ** | **$**                                    | **2,760,463** | ** ** | $ | 3,771,503 |   | $ | (1,011,040 | ) |
|                                 |       |                                     | ** **    |   |   |   |   |
| Total revenues to sales              | ** ** | **1.16**                                 | **%**         | 1.29 | % | (0.13 | )% |
| Total expenses to production         | ** ** | **1.36**                                 | **%**         | 1.14 | % | 0.22 | % |
| Pre-tax margin                       | ** ** | **(0.20**                                | **)%**        | 0.15 | % | (0.35 | )% |

----

Note: The ratio ofrevenues to sales is based on financial intermediary sales, which includesinter-segment sales to the retail banking segment of $38,401 and $293,370 forthe three months ended March 31, 2005 and 2004, respectively.

 

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The financial intermediary segment lost $5,478 for the three monthsended March 31, 2005, a decline of $17,029 compared to the same period of2004.  Sale of mortgage loans declined by$1.0 billion, or 27%, period over period. As mortgage pipelines compressed during the latter half of 2004,competitive pressures rose causing a 13-basis point decline in margins onsales.  The net result was a $16,464decline in revenues.  The biggest declinewas seen in the non-conforming mortgage operation which saw its margin hit arecord low of 136 basis points, a 149-basis point decline period over period.

*Transaction Processing*

The transaction processing segment provides ATM and merchant processingservices; subservices loans for the retail banking segment, financialintermediary segment and for third party customers; and sells various insuranceproducts using an Internet-based platform.

The following table highlights the results ofoperations for the transaction processing segment:

 

| ** **     | ** ** | **For the three months ended March 31,** | ** ** |
|----------------|------------|------------------------------------------|------------|
| ** **     | ** ** | **2005**                                 | ** ** | **2004** | ** ** | **change** | ** ** |
| Total revenue  | ** ** | **$**                                    | **6,742**  |   | $ | 6,406 |   | $ | 336 |   |
| Total expenses | ** ** | **5,728**                                |       | 5,902 |   | (174 | ) |
| Pre-tax income | ** ** | **$**                                    | **1,014**  |   | $ | 504 |   | $ | 510 |   |

The transaction processing segment reported an improvement in pre-taxoperating results of $510.  All threedivisions of the segment showed period over period improvement.  The servicing factory results increased $133related to improved expense control and an increase in the volume of loansserviced.  NPS improved $80 as itexpanded the number of ATMs and merchant processing terminals under contractand NetInsurance improved by $297 primarily related to strict expense control.

*Other/Elimination*

The other/elimination segment contains the holding company expensesalong with the elimination of inter-segment gains and losses on loans sold tothe retail banking segment from the financial intermediary segment. The other /elimination segment lost $1,280 for the three months ended March 31, 2005compared to losing $1,575 for the comparable period of 2004.  The $295 improvement was primarily related tostrict expense control at the holding company coupled with a reduction ofdeferred gains related to a decline in inter-segment loan sales.

###### **Critical Accounting Policies**

In response to the Securities and ExchangeCommission’s proposed rule “Disclosure in Management’s Discussion andAnalysis about the Application of Critical Accounting Policies”, seniormanagement, in conjunction with the Audit Committee of the Board of Directors,has identified valuation of the MSR portfolio, determination of the allowancefor credit losses, liabilities for representations and warranties on loans and MSRssold and accounting for derivative financial instruments as being the mostcritical accounting policies. These policies were identified as being the mostcritical based on the SEC’s guidance in identifying them based on whether 1)the accounting estimate required management to make assumptions about mattersthat were highly uncertain at the time the accounting estimate was made and 2)different estimates reasonably could have been used in the current period, orchanges in the accounting estimate that are reasonably likely to occur fromperiod to period, would have a material impact on the presentation of thefinancial condition or results of operations. Management believes that givencurrent information, its judgments, estimates and assumptions used in thesepolicies are appropriate.  For furtherinformation regarding our critical accounting policies, refer to the heading “CriticalAccounting Policies” on page 55 of our 2004 Form 10-K.

 

25

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

The Company, in the normal course of business, had contractualobligations to make scheduled payments for its operating leases; its liabilityto repurchase loans under representations and warranties provided to purchasersof its mortgage loans and MSRs; and its obligation to make scheduled principaland interest payments on borrowed funds. The Company is not a party to anyoff-balance sheet financing arrangements nor does it hold unconsolidatedinterests in any variable interest entities that could rise to futurecontractual obligations. For information as of December 31, 2004 regarding theschedule of amounts contractually due, please refer to the discussion under theheading “Contractual Obligations and Off-Balance Sheet Arrangements” on page 57of our 2004 Form 10-K.

# **Liquidityand Capital Resources**

*Liquidity*.   Liquidity, represented by cash and cashequivalents, is a product of our operating, investing and financing activities.The primary sources of funds are deposits, borrowings, prepayments andmaturities of outstanding loans, sales of loans, sales or maturities ofinvestment securities and other short-term investments, and funds provided fromoperations. While scheduled loan payments and maturing investment securitiesand short-term investments are relatively predictable sources of funds, depositflows and loan prepayments are greatly influenced by general interest rates,economic conditions, and competition. We can use cash generated through theretail deposit market, our traditional funding source, to offset cash utilizedin our investing activities. Available for sale securities and short-terminterest-earning assets can also be used to provide liquidity for lending andother operational requirements. Net cash inflow for the three months endedMarch 31, 2005 was $18,326 compared to $154,956 for the same period of 2004.  The $136,630 decline in net cash flow periodover period is primarily related to loan production of $2.78 billion outpacingloan sales of $2.72 billion during the three months ended March 31, 2005compared to production of $3.26 billion and sales of $3.48 billion for thethree months ended March 31, 2004.

As an additional source of funds, we had available under existing linesof credit agreements $1.4 billion at March 31, 2005 (see note 8 of thenotes to the consolidated financial statements included in this report foradditional details of the available lines of credit).

We use deposits as our principal source of funds.  During the three months ended March 31, 2005,deposits declined by $47,953. Non-interest bearing transactional depositaccounts increased by $28,867 during the three months ended March 31, 2005, butthis increase was offset by a decline of $76,820 in money market and CDaccounts. Deposit account terms vary, with the principal differences being theminimum balance required, the time periods the funds must remain on deposit andthe interest rate. We are competitive in the types of accounts, services andranges of interest rates offered on deposit products. Although market demandgenerally dictates which deposit maturities and rates will be accepted by thepublic, we intend to continue to promote checking, money market andcertificates of deposit to the extent possible consistent with asset andliability management goals. There is the risk that a dramatic increase ininterest rates could cause maturing certificates of deposits to bedisintermediated; and therefore, we would be unable or unwilling to replacethose certificates of deposit at the then higher interest rates. The decreasein deposits was offset by a $195 million increase in other borrowed funds,which primarily include Federal Home Loan Bank advances, repurchase agreementsand warehouse lines of credit.

*Capital Resources.  *The Company and NetBank, FSBare subject to various regulatory capital requirements administered by thefederal banking agencies. Failure of either company to meet minimum capitalrequirements can initiate certain mandatory and possibly additional discretionaryactions by regulators that, if undertaken, could have a direct material effecton the consolidated financial statements. Under capital adequacy guidelines andthe regulatory framework for prompt corrective action, NetBank, FSB must meetspecific capital guidelines that involve quantitative measures of NetBank, FSB’sassets, liabilities, and certain off-balance sheet items as calculated underregulatory accounting practices. NetBank, FSB’s capital amounts andclassifications are also subject to qualitative judgments by the regulatorsabout components, risk weightings and other factors. Under current regulatoryguidelines, NetBank, FSB may not make a capital distribution to the Companywithout prior approval of the Office of Thrift Supervision (“OTS”), thegovernmental agency that regulates NetBank, FSB. Current guidelines require,among other things, that NetBank, FSB not make an unapproved capitaldistribution in excess of its current period year-to-date undistributedearnings plus the preceding two 

 

26

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years undistributed earnings and in no event make a distribution whichwould cause NetBank, FSB to be less than adequately capitalized as definedbelow.

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

 
| ** **                                  | ** ** | **Actual** | ** ** | **For capital adequacy purposes** | ** ** | **To be categorized as Well Capitalized under prompt corrective action  plan** | ** ** |
|---------------------------------------------|------------|------------|------------|-----------------------------------|------------|--------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **Amount** | ** ** | **Ratio**                         | ** ** | **Amount**                                                                     | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **March  31, 2005**                         |       |       |       |                              |       |                                                                           |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)     |       | $          | 323,247    |                              | 10.93      | %                                                                              | $          | 236,556 |   | 8.00 | % | $ | 295,743 |   | 10.00 | % |
| Core capital (to adjusted total assets)     |       | $          | 298,172    |                              | 6.42       | %                                                                              | $          | 185,692 |   | 4.00 | % | $ | 232,221 |   | 5.00 | % |
| Tangible capital (to adjusted total assets) |       | $          | 298,172    |                              | 6.42       | %                                                                              | $          | 69,666 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital (to risk-weighted assets)    |       | $          | 298,172    |                              | 10.08      | %                                                                              | N/A        |   | N/A |   | $ | 177,483 |   | 6.00 | % |
| **December 31, 2004**                       |       |       |       |                              |       |                                                                           |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)     |       | $          | 327,829    |                              | 11.30      | %                                                                              | $          | 232,091 |   | 8.00 | % | $ | 290,114 |   | 10.00 | % |
| Core capital (to adjusted total assets)     |       | $          | 303,368    |                              | 6.73       | %                                                                              | $          | 180,308 |   | 4.00 | % | $ | 225,385 |   | 5.00 | % |
| Tangible capital (to adjusted total assets) |       | $          | 303,368    |                              | 6.73       | %                                                                              | $          | 67,615 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital (to risk-weighted assets)    |       | $          | 303,368    |                              | 10.46      | %                                                                              | N/A        |   | N/A |   | $ | 174,016 |   | 6.00 | % |
|                                             |            |            |            |                                   |            |                                                                                |            |  |  |  |  |  |  |  |  |  |  |

In addition, 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, 2005,Market Street and Meritage were in compliance with HUD guidelines.

The Company and its subsidiaries are subject to various other capitalrequirements by secondary market investors and states.  None of these capital requirements are morestringent than the OTS capital requirements. Failure to comply with these restrictions could have a material adverseimpact on the Company’s results of operations. At March 31, 2005, all of the capital requirements placed upon theCompany and its subsidiaries were met.

# **Item 3**: Quantitative and Qualitative Market Risk

Our principal businesses are retail banking and the origination andpurchase of loans and business equipment financing. These businesses are fundedby customer deposits and, to the extent necessary, other borrowed funds.Consequently, a significant portion of our assets and liabilities are monetaryin nature and fluctuations in interest rates will affect future net interestincome and cash flows. This interest rate risk is our primary market riskexposure. For the three months ended March 31, 2005, the only derivativefinancial instruments that we entered into were associated with hedgingactivities related to (1) the portfolio of mortgage loans held for sale,(2) the pipeline rate locks, (3) hedging the securitization and saleof loans, (4) the current MSR portfolio and (5) the MSRs that will becreated as a byproduct of securitization activities associated with loans heldfor sale and pipeline of rate locks.  Exposureto market risk is reviewed on a regular basis by management. Reference is madeto Item 7A. Quantitative and Qualitative Disclosures About Market Risk on page71 of the Company’s 2004 Form 10-K for additional details regarding the Company’sexposure to and management of market risks.

One of the ways NetBank, FSB, like other savings banks, measuresinterest rate risk is based on a Net Portfolio Value (“NPV”) analysis. NPVequals the present value of expected net cash flows from existing assets minusthe present value of expected net cash flows from existing liabilities. An NPVratio is determined by dividing NPV by the present value of 

 

27

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assets. The following table sets forth the estimated NetBank, FSB NPVratios as of March 31, 2005 and December 31, 2004 assuming rateshocks of +300 to -100 basis points:

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

| **Rate shock  (in basis points)** | ** ** | **As of  March 31, 2005** | ** ** | **As of  December 31, 2004** | ** ** | **Minimum as of  March 31, 2005** | ** ** |
|-----------------------------------|------------|---------------------------|------------|------------------------------|------------|-----------------------------------|------------|
| +300                              |       | 8.40%                     |       | 7.75%                        |       | 4.00%                             |       |
| +200                              |       | 8.69%                     |       | 8.03%                        |       | 6.00%                             |       |
| +100                              |       | 9.25%                     |       | 8.63%                        |       | 6.00%                             |       |
| Flat                              |       | 9.72%                     |       | 8.96%                        |       | 6.00%                             |       |
| -100                              |       | 10.06%                    |       | 9.19%                        |       | 6.00%                             |       |

** **

Minimum ratios for NPV risk are established by the Board of Directorsas prudent levels for the respective interest rate scenarios. Lower NPV ratiosdenote more market rate sensitivity for a given rate scenario.  As of March 31, 2005 the analysisindicates sensitivity to rising market interest rates.  The sensitivities presented in the tableabove are well within the Board approved limits for these scenarios.  Computation of prospective effects ofhypothetical rate changes is based on many assumptions, including relativelevels of market interest rates, loan prepayments and deposit decay. Theyshould not be relied upon as indicative of actual results. Further, the computationsdo not contemplate certain actions management could undertake in response tochanges in interest rates.

**Item 4****: Controls and Procedures**

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

The Company’s Chief Executive Officer and Chief Financial Officer,along with other management of the Company, reviewed and evaluated the Company’sdisclosure controls and procedures (as defined in Rule 13a-15(e) under theSecurities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the endof the period covered by this report. Based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer of the Company concluded that, as of the end of the periodcovered by this report, the disclosure controls and procedures in place at theCompany were effective.

**Other Control Matters**

In response to the material control weakness identified in the Company’s2004 Form 10-K related to the estimation of the change in fair value of theCompany’s portfolio of mortgage loan funding commitments for which the interestrate is locked (“rate locks”), managementhas implemented the following changes to its internal control structure:

•                  The necessary data andinformation for estimating the initial and ending fair values of rate locks arenow accumulated within a single department;

•                  Analytics arenow prepared which compare these changes in fair value to changes in the fairvalue of offsetting hedges and general changes in interest rates to ensureresults are reasonable; and

•                  The Company’scorporate controller is now required to review the process and associatedanalysis.

The changes to management’s internal control over financial reportingas described above were tested by management during the three months endedMarch 31, 2005 and were found to be effective.

 

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Except for the changes discussed above, there were no other changes inthe Company’s internal control over financial reporting that have materiallyeffected, or are reasonably likely to materially effect, its internal controlover financial reporting.

 

# **PART II**- OTHERINFORMATION

 

# **Item1**:  Legal Proceedings

IllinoisUnion Insurance Co. v. Commercial Money Center, Inc., et al., Case No.CV-01-0685-KJD-RJJ (District Court of Nevada) and related cases nowpending in *In re Commercial Money Center, Inc. Equipment LeaseLitigation in the United States District Court for the Northern District ofOhio, Eastern Division, MDL Case No. 1:02-CV-16000*, the pendingbankruptcy proceedings of Commercial Money Center, Inc. and In re CommercialMoney Center, Inc., Debtor (Kipperman v. NetBank, FSB), Bankruptcy No.02-09721; In the United States Bankruptcy Court for the Southern District ofCalifornia

As reported in previous filings, NetBank, FSB, filed a complaint inJanuary 2002 against Commercial Money Center, Inc. (“CMC”), the originator,seller, and subservicer of equipment leases purchased by NetBank, FSB, andagainst Illinois Union Insurance Company (“Illinois Union”), Safeco InsuranceCompany of America (“Safeco”), and Royal Indemnity Company (“Royal,” withIllinois Union, Safeco and Royal, collectively, referred to as the “Sureties”),the insurance companies that issued surety bonds and insurance policiesguaranteeing payment of the income stream from the leases and that also servedas master servicers of the leases.  TheNetBank, FSB action alleges several claims, including claims for breach ofcontract, fraud, and bad faith, and seeks, among other things, payment underand enforcement of surety bonds and insurance policies issued by the insuranceand surety companies.  The Judicial Panel on Multi-District Litigation (the “MDLJudicial Panel”) has consolidated the actions involving NetBank, FSBwith more than 35 other cases pending around the country involving other banksand financial institutions that were seeking to enforce surety bonds andinsurance policies relating to leases sold by CMC.  All pre-trial activity is currently beingheld in the United States District Court for the Northern District of Ohio (the“MDL Court”).

As reported in previous filings, NetBank, FSB had joined with the otherclaimants in a motion for judgment on the pleadings, which motion was filed onJanuary 31, 2003, and is still pending before the MDL Court.  Meanwhile, discovery in the case has beenproceeding and fact discovery is now complete. Amendments to the pleadings are currently due 14 days after the MDLCourt rules on the motions for judgment on the pleadings.  NetBank, FSB has prepared an amendment andsupplement to its complaint to include additional claims against the Suretiesbased on discovery adduced and events that have occurred to date and plans tofile the amendment prior to the final date fixed by the MDL Court for filingamendments.  Furthermore, NetBank, FSBhas withdrawn its motion for judgment on the pleadings and  on March 25, 2005 filed a Motion for PartialSummary Judgment (the “Summary Judgment Motion”) or, in the alternative, aMotion for Suggestion of Remand (the “Remand Motion”).  The Summary Judgment Motion seeks judgment asa matter of law on NetBank, FSB’s breach of contract claims.  The Remand Motion requests that, in lieu ofdeciding the Summary Judgment Motion, the MDL Court instead suggest to the MDLJudicial Panel that the claims of NetBank, FSB be remanded tothe United States District Court for the District of Nevada.  If the Remand Motion isgranted, the Nevada court would then decide the Summary Judgment Motion and, ifnecessary, proceed to trial on any remaining issues of fact. The Suretieshave filed oppositions to the Remand Motion, and they have argued that they don’tneed to respond to the Summary Judgment Motion until an unspecified date in thefuture after the MDL Court rules on the pending Consolidated Motion forJudgment on the Pleadings.  NetBank, FSBhas filed a motion, currently pending with the MDL Court, to enforce or clarifythe briefing schedule so that, if the Remand Motion isdenied, the sureties will be required to respond promptly to the SummaryJudgment Motion.    The Company believes that based on theoverall facts and circumstances, the defenses asserted by the Sureties willfail and that NetBank, FSB will ultimately prevail on its claims.

Also, as reported in previous filings, on May 30, 2002, CMC filed forbankruptcy protection.  The bankruptcyproceeding is not a part of the consolidation of cases in Ohio.  On June 11, 2003, the Bankruptcy Court inCalifornia approved an amended settlement agreement (the “NetBank Agreement”)among NetBank, FSB, Lakeland Bank and the Trustee.   The 

 

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NetBank Agreement resolves all claims of the Trustee with respect tothe lease payments that were guaranteed by surety bonds and insurance policiesissued by Safeco and Illinois Union, as well as all claims related to thesurety bonds and insurance policies.  In addition to approving the NetBank Agreement,the Bankruptcy Court approved a settlement agreement between the Trustee andRoyal (the “Royal Agreement’).  Under theRoyal Agreement, Royal has agreed, among other things, to fund litigation bythe Trustee against NetBank, FSB to avoid its interests in the leases that wereguaranteed by surety bonds issued by Royal, as well as NetBank, FSB’s interestsin the surety bonds themselves.  OnSeptember 4, 2003, the Trustee filed a Complaint against NetBank, FSB ascontemplated by the Royal Agreement, seeking to avoid NetBank, FSB’s interestin the leases and surety bonds relating to the Royal guaranteed leasepools.  On May 6, 2004, NetBank, FSBfiled a motion for partial summary judgment against the Trustee.  The Trustee filed a motion for partialsummary judgment against NetBank, FSB on June 18, 2004.

At a status conference on July 15, 2004, theBankruptcy Court ordered a stay in the bankruptcy proceedings pending a hearingon July 30, 2004.  At that hearing theBankruptcy Court continued the stay as to all adversary proceedings andrequested the parties to attempt to mediate their disputes.  At a status conference on October 1,2004, the Bankruptcy Court lifted the stay of the adversary proceeding againstNetBank, FSB.  A hearing on NetBank, FSB’s and the Trustee’smotions for partial summary judgment was held on December 14, 2004.  On January 27, 2005, the Bankruptcy Courtentered its Memorandum Decision granting the Trustee’s motion for partialsummary judgment and denying NetBank, FSB’s motion for partial summaryjudgment.  An order to that effect wasentered by the Bankruptcy Court on February 28, 2005.    On April 27, 2005, the Bankruptcy Courtentered a judgment conforming to the Memorandum Decision.   The Bankruptcy Court held in the MemorandumDecision that NetBank, FSB was required, but failed, to perfect its securityinterest in the payment streams that were transferred to it from CMC in thesubject transactions and that the subject transactions were loans rather thansales.  NetBank, FSB intends to appealthe decision of the Bankruptcy Court on the motions for partial summaryjudgment.  In the meantime, the partiesto the bankruptcy action have continued to attempt to resolve their disputesand have entered into a Global Settlement Agreement, which is subject toapproval by the Bankruptcy Court.  TheGlobal Settlement Agreement would not affect the decision entered by theBankruptcy Court regarding the motions for partial summary judgment.

NetBank, FSB intends to vigorously pursue its claims against all theSureties, including claims for any loss associated with the claims brought bythe Trustee against NetBank, FSB.  Atthis time, the Company is unable to express an opinion as to the likelihood ofloss, or the amount or range of potential loss, with regard to this matter.

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

On June 27, 2001, several lessees of equipment leased from CMC filedsuit in Los Angeles Superior Court against CMC and several John Doe defendantsalleging that the leases violated California usury laws, the CaliforniaFinancial Code, and the California Unfair Business Practices Act.  The plaintiff lessees were seeking to rescindor reform their obligations under the leases and were seeking to recoverstatutory damages and attorney’s fees. The plaintiffs subsequently amended their complaint to name NetBank,FSB, several other investor banks, and several surety companies asco-defendants in the action.  After CMCfiled for bankruptcy, the action was removed to the bankruptcy court in theCentral District of California, but the plaintiffs subsequently agreed towithdraw their claims against CMC and were successful in their motion to remandthe case back to state court.

On March 15, 2004, the Superior Court sustained demurrers and motionsto quash filed 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 also sustaineddemurrers on the Unfair Business Practices Act, with leave to amend the claimsto add greater specificity to the claims, but without leave to amend as tounnamed 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.

On April 29, 2004, the plaintiffs served an amended complaint againstNetBank, FSB alleging claims for, among other things, violations of anothersection of the California Financial Code, unfair competition under Section17200 of the California Business and Professions Code and usury.  On October 26, 2004, the court overruled thedefendants’ demurrers 

 

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to the third amended complaint. However, on December 13, 2004, the court issued a stay in the actionpending a decision by the appeals court on the plaintiffs’ claims that weredismissed without leave to amend.  Nodiscovery has been taken in this case and there will be no other movement onthese surviving claims pending the outcome of plaintiffs’ appeal.    The Company intends to vigorously defendthe amended claims in the Clayton action and to pursue recovery against Safeco InsuranceCompany, Royal Indemnity Company, and Illinois Union Insurance Company in theCompany’s existing action against them for any damages and costs incurred inthis case.

**Item 2****:  Unregistered Sales of Equity Securities andUse of Proceeds**

In August 2002, the Board of Directors approved a plan torepurchase up to 1 million shares of the Company’s common stock. The plan wassubsequently increased by 1 million shares in October 2002, 2 millionshares in January 2003, 1 million shares in April 2004 and 1 millionshares in May 2005. As summarized below, repurchase activity for the threemonths ended March 31, 2005 included 423,726 shares repurchased at a weightedaverage cost of $9.29 per share.

The table below sets forth information regarding the repurchase ofshares of our common stock during the three months ended March 31, 2005.
| **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** | ** ** |
|---------------------------------|------------|----------------------------------------|------------|------------------------------------|------------|------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------|------------|
| Balance as of December 31, 2004 |       | —                                 |       | —                             |       | —                                                                                               |       | 663,964                                                                                                                      |       |
| January 1 to January 31, 2005   |       | 221,600                                |       | $9.62                              |       | 221,600                                                                                              |       | 442,364                                                                                                                      |       |
| February 1 to February 28, 2005 |       | 80,100                                 |       | $9.20                              |       | 80,100                                                                                               |       | 362,264                                                                                                                      |       |
| March 1 to March 31, 2005       |       | 122,026                                |       | $8.75                              |       | 122,026                                                                                              |       | 240,238                                                                                                                      |       |
| Total                           |       | 423,726                                |       | $9.29                              |       | 423,726                                                                                              |       |                                                                                                                         |       |

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(1)   As of May 1, 2005, 1,180,738shares remained available for repurchase under current Board authority.

** **

**Item 3**:  DefaultsUpon Senior Securities

**                None**

**Item 4**:  Submission ofMatters to a Vote of Security Holders

**None**

**Item 5**:  OtherInformation

**                None**

**Item 6****:  Exhibits**

The exhibits listed in the accompanyingindex to exhibits are filed or incorporated by reference as part of thisreport.

 

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#### **SIGNATURE**

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                | NETBANK, INC. |
|---------------------|---------------|
|                |          |
|                | By:           | /s/ Steven F. Herbert |
|                |          | Steven F. Herbert |
| Dated: May 10, 2005 |          | *Chief Financial Executive and  Chief Accounting Officer* |

** **

 

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**INDEX TO EXHIBITS**

** **
| ** **          | ** ** | ** **                                                                                                                                       | ** ** | **Incorporated by Reference** | ** ** | ** **      | ** ** |
|---------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|-----------------|------------|
| **Exhibit  Number** | ** ** | **Exhibit Description**                                                                                                                          | ** ** | **Form**                      | ** ** | **File Number** | ** ** | **Exhibit** | ** ** | **Filing**** Date** | ** ** | **Filed Herewith** | ** ** |
| 10.1                | *          | Management  Incentive Plan, 2005 Plan Year                                                                                                       |       | 8-K                           |       | 000-22361       |       | 10.1 |   | 5/4/05 |   |   |   |
|                |       |                                                                                                                                             |       |                          |       |            |       |   |   |   |   |   |   |
| 31.1                |       | Certification  Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act  of 1934, as amended — Chief Executive Officer   |       |                          |       |            |       |   |   |   |   | X |   |
|                |       |                                                                                                                                             |       |                          |       |            |       |   |   |   |   |   |   |
| 31.2                |       | Certification  Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities Exchange Act  of 1934, as amended — Chief Financial Executive |       |                          |       |            |       |   |   |   |   | X |   |
|                |       |                                                                                                                                             |       |                          |       |            |       |   |   |   |   |   |   |
| 32.1                | †     | Certification Pursuant to  18 U.S.C. Section 1350 — Chief Executive  Officer and Chief Financial Executive                                  |       |                          |       |            |       |   |   |   |   | X |   |
|                     |            |                                                                                                                                                  |            |                               |            |                 |            |  |  |  |  |  |  |  |  |  |

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*****         This exhibit is a managementcontract, compensatory plan or arrangement.

**†**          The certification attachedas Exhibit 32.1 that accompanies this report is not deemed filed with theSecurities and Exchange Commission and is not to be incorporated by referenceinto any filing of NetBank, Inc. under the Securities Act of 1934, as amemded,or the Securities Exchange Act of 1934, as amended, whether made before orafter the date of this report, irrespective of any general incorporation languagecontained in such filing.

 

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