** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

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

 

**For the Quarterly Period Ended June 30, 2004**

 

**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’stelephone number, including area code:

 

Indicate by check mark whether the registrant (1) has filed allreports required to be filed by Section 13 or 15(d) of the Securities ExchangeAct of 1934 during the preceding 12 months (or for such shorter periodthat the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.  YES ý  NO o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inExchange Act Rule 12b-2):

 

YES ý  NO o

 

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

 

| **Class**                    | ** ** | **Shares Outstanding at August 2, 2004** |
|------------------------------|------------|------------------------------------------|
| Common Stock, par value $.01 |       | 46,886,102                               |

 

 

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

 
| **Part I. Financial Information** | ** **                                                                                                         |
|-----------------------------------|--------------------------------------------------------------------------------------------------------------------|
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Item I. Financial Statements**                                                                                   | ** ** |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Consolidated balance sheets as of June 30, 2004 and December 31, 2003**                                          | 3 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Consolidated statements of operations for  the three and six months ended June 30, 2004 and 2003**               | 4 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Consolidated statements of shareholders’ equity for the three and six months ended June 30, 2004 and 2003** | 5 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Consolidated statements of cash flows for  the six months ended June 30, 2004 and 2003**                         | 6 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Notes to consolidated financial statements**                                                                     | 7 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Item 2. Management’s Discussion and  Analysis of Financial Condition and Results of Operations**            | 17 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Item 3. Quantitative and Qualitative  Disclosures about Market Risk**                                            | 32 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Item 4. Controls and Procedures**                                                                                | 33 |
| ** **                        | ** **                                                                                                         |   |
| **Part II. OTHER INFORMATION**    |                                                                                                               |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Item 1. Legal Proceedings**                                                                                      | 33 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Item 2. Changes in Securities and Use of Proceeds**                                                              | 35 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Item 3. Defaults Upon Senior Securities**                                                                        | 35 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Item 4. Submission of Matters to a Vote of Security Holders**                                                    | 35 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Item 5. Other Information**                                                                                      | 36 |
| ** **                        | ** **                                                                                                         |   |
| ** **                        | **Item 6. Exhibits and Reports on Form 8-K**                                                                       | 36 |
| ** **                        | ** **                                                                                                         |   |
| **Signature Page**                | ** **                                                                                                         |

 

2

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**NetBank, Inc.**

**Consolidated Balance Sheets**

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

 
| ** **                                                                                                       | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| **Assets**                                                                                                       |       |               |       |                   |       |
| Cash and cash equivalents:                                                                                       |       |               |       |                   |       |
| Cash and due from banks                                                                                          |       | $                  | 73,937     |                   | $          | 24,211 |   |
| Federal funds sold                                                                                               |       | 23,348             |       | 9,416                  |       |
| Total cash and cash equivalents                                                                                  |       | 97,285             |       | 33,627                 |       |
| Investment securities available for sale-at  fair value (amortized costs of $442,233 and $449,972, respectively) |       | 439,038            |       | 454,348                |       |
| Stock of Federal Home Loan Bank of Atlanta  - at cost                                                            |       | 89,861             |       | 54,491                 |       |
| Loans held for sale                                                                                              |       | 1,786,452          |       | 1,951,113              |       |
| Loans and leases receivable - net of  allowance for credit losses of $46,033 and $43,689, respectively           |       | 2,332,340          |       | 1,761,372              |       |
| Mortgage servicing rights – net                                                                             |       | 200,320            |       | 165,214                |       |
| Accrued interest receivable                                                                                      |       | 13,925             |       | 14,713                 |       |
| Furniture, equipment and capitalized  software – net                                                        |       | 53,796             |       | 53,902                 |       |
| Goodwill and other intangibles – net                                                                        |       | 69,574             |       | 62,441                 |       |
| Due from servicers and investors                                                                                 |       | 37,902             |       | 33,187                 |       |
| Receivable from unsettled trades                                                                                 |       | —             |       | 90,000                 |       |
| Other assets                                                                                                     |       | 55,271             |       | 60,397                 |       |
| **Total assets**                                                                                                 |       | $                  | 5,175,764  |                   | $          | 4,734,805 |   |
|                                                                                                             |       |               |       |                   |       |
| **Liabilities, minority interests in  affiliates and shareholders’ equity**                                 |       |               |       |                   |       |
| **Liabilities:**                                                                                                 |       |               |       |                   |       |
| Deposits                                                                                                         |       | $                  | 2,448,485  |                   | $          | 2,539,427 |   |
| Other borrowed funds                                                                                             |       | 2,058,975          |       | 1,421,022              |       |
| Subordinated debt                                                                                                |       | 11,857             |       | 11,857                 |       |
| Accrued interest payable                                                                                         |       | 9,884              |       | 9,098                  |       |
| Loans in process                                                                                                 |       | 51,968             |       | 30,756                 |       |
| Unsettled trades                                                                                                 |       | —             |       | 131,707                |       |
| Representations and warranties                                                                                   |       | 22,278             |       | 17,905                 |       |
| Accounts payable and accrued liabilities                                                                         |       | 141,418            |       | 142,683                |       |
| Total liabilities                                                                                                |       | 4,744,865          |       | 4,304,455              |       |
|                                                                                                             |       |               |       |                   |       |
| Commitments and contingencies                                                                                    |       | —             |       | —                 |       |
| Minority  interests in affiliates                                                                                |       | 389                |       | —                 |       |
|                                                                                                             |       |               |       |                   |       |
| **Shareholders’ equity:**                                                                                   |       |               |       |                   |       |
| Preferred stock, no par (10,000,000 shares  authorized; none outstanding)                                        |       | —             |       | —                 |       |
| Common stock, $.01 par (100,000,000 shares  authorized, 52,820,308 shares issued)                                |       | 528                |       | 528                    |       |
| Additional paid-in capital                                                                                       |       | 432,029            |       | 432,035                |       |
| Retained earnings                                                                                                |       | 59,888             |       | 44,102                 |       |
| Accumulated other comprehensive income, net  of taxes of $1,220 and $1,634, respectively                         |       | (1,975             | )          | 2,742                  |       |
| Treasury stock, at cost (6,146,893 and  5,235,538 shares, respectively)                                          |       | (59,639            | )          | (48,674                | )          |
| Unearned compensation                                                                                            |       | (321               | )          | (383                   | )          |
| Total shareholders’ equity                                                                                  |       | 430,510            |       | 430,350                |       |
| **Total liabilities, minority interests in  affiliates, and shareholders’ equity**                          |       | $                  | 5,175,764  |                   | $          | 4,734,805 |   |

 

See notes to consolidated financial statements.

 

3

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**NetBank, Inc.**

**ConsolidatedStatements of****Operations**

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

 
| ** **                                                        | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                        | ** ** | **2004**                        | ** ** | **2003**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Interest income:**                                              |       |                            |       |                          |       |   |   |   |   |
| Loans and leases                                                  |       | $                               | 54,582     |                          | $          | 44,903 |   | $ | 102,621 |   | $ | 83,164 |   |
| Investment securities                                             |       | 3,905                           |       | 5,351                         |       | 7,871 |   | 11,960 |   |
| Short-term investments                                            |       | 190                             |       | 87                            |       | 370 |   | 219 |   |
| Total interest income                                             |       | 58,677                          |       | 50,341                        |       | 110,862 |   | 95,343 |   |
|                                                              |       |                            |       |                          |       |   |   |   |   |
| **Interest expense:**                                             |       |                            |       |                          |       |   |   |   |   |
| Deposits                                                          |       | 10,684                          |       | 12,534                        |       | 22,502 |   | 24,980 |   |
| Other borrowed funds                                              |       | 11,494                          |       | 9,099                         |       | 20,112 |   | 18,152 |   |
| Total interest expense                                            |       | 22,178                          |       | 21,633                        |       | 42,614 |   | 43,132 |   |
| Net interest income                                               |       | 36,499                          |       | 28,708                        |       | 68,248 |   | 52,211 |   |
| Provision for credit losses                                       |       | 1,666                           |       | 894                           |       | 3,513 |   | 1,762 |   |
| Net interest income after provision for  credit losses            |       | 34,833                          |       | 27,814                        |       | 64,735 |   | 50,449 |   |
|                                                              |       |                            |       |                          |       |   |   |   |   |
| **Non-interest income:**                                          |       |                            |       |                          |       |   |   |   |   |
| Service charges and fees                                          |       | 16,638                          |       | 12,452                        |       | 33,670 |   | 23,778 |   |
| Gains on sales of mortgage loans and  mortgage servicing rights   |       | 33,899                          |       | 59,624                        |       | 66,213 |   | 108,547 |   |
| Net gain on sales of securities                                   |       | —                          |       | 5,062                         |       | 3,169 |   | 11,394 |   |
| Other income                                                      |       | 83                              |       | 3,416                         |       | 4,259 |   | 5,979 |   |
| Total non-interest income                                         |       | 50,620                          |       | 80,554                        |       | 107,311 |   | 149,698 |   |
|                                                              |       |                            |       |                          |       |   |   |   |   |
| **Non-interest expense:**                                         |       |                            |       |                          |       |   |   |   |   |
| Salaries and benefits                                             |       | 32,155                          |       | 32,075                        |       | 63,082 |   | 61,885 |   |
| Customer service                                                  |       | 3,111                           |       | 2,827                         |       | 6,024 |   | 5,598 |   |
| Marketing                                                         |       | 2,164                           |       | 2,257                         |       | 4,423 |   | 4,331 |   |
| Data processing                                                   |       | 4,675                           |       | 3,871                         |       | 9,166 |   | 8,021 |   |
| Depreciation and amortization                                     |       | 4,833                           |       | 3,655                         |       | 9,616 |   | 7,191 |   |
| Impairment and amortization of mortgage  servicing rights         |       | 4,034                           |       | 17,534                        |       | 14,280 |   | 27,335 |   |
| Office expenses                                                   |       | 2,791                           |       | 2,642                         |       | 5,471 |   | 5,365 |   |
| Occupancy                                                         |       | 5,373                           |       | 4,240                         |       | 10,507 |   | 8,553 |   |
| Travel and entertainment                                          |       | 1,386                           |       | 1,093                         |       | 2,562 |   | 1,945 |   |
| Professional fees                                                 |       | 5,003                           |       | 3,715                         |       | 7,913 |   | 6,602 |   |
| Other expenses                                                    |       | 6,071                           |       | 6,049                         |       | 10,113 |   | 11,964 |   |
| Prepayment penalties on the early  extinguishment of debt         |       | —                          |       | 5,975                         |       | — |   | 11,951 |   |
| Minority interests in net earnings of  consolidated affiliates    |       | 414                             |       | —                        |       | 414 |   | — |   |
| Total non-interest expense                                        |       | 72,010                          |       | 85,933                        |       | 143,571 |   | 160,741 |   |
| Income before income taxes                                        |       | 13,443                          |       | 22,435                        |       | 28,475 |   | 39,406 |   |
| Income tax expense                                                |       | (4,976                          | )          | (8,222                        | )          | (10,614 | ) | (14,491 | ) |
| **Net income**                                                    |       | $                               | 8,467      |                          | $          | 14,213 |   | $ | 17,861 |   | $ | 24,915 |   |
|                                                              |       |                            |       |                          |       |   |   |   |   |
| Net income per common and potential common  shares outstanding:   |       |                            |       |                          |       |   |   |   |   |
| Basic                                                             |       | $                               | 0.18       |                          | $          | 0.30 |   | $ | 0.38 |   | $ | 0.52 |   |
| Diluted                                                           |       | $                               | 0.18       |                          | $          | 0.29 |   | $ | 0.38 |   | $ | 0.51 |   |
|                                                              |       |                            |       |                          |       |   |   |   |   |
| Weighted average common and potential  common shares outstanding: |       |                            |       |                          |       |   |   |   |   |
| Basic                                                             |       | 46,790                          |       | 47,968                        |       | 47,020 |   | 48,146 |   |
| Diluted                                                           |       | 47,169                          |       | 48,639                        |       | 47,568 |   | 48,700 |   |
|                                                              |       |                            |       |                          |       |   |   |   |   |
| Dividends declared on common stock                                |       | $                               | 0.02       |                          | $          | 0.02 |   | $ | 0.04 |   | $ | 0.04 |   |

 

See notes to consolidated financial statements.

 

4

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**NetBank,Inc.**

**Consolidated Statements of Shareholders’Equity**

**(Unaudited and in 000’s)**

** **
| ** **                                                          | ** ** | **Common  shares** | ** ** | **Common  Stock** | ** ** | **Additional  paid-in capital** | ** ** | **Retained  earnings** | ** ** | **Accumulated  other  comprehensive  income** | ** ** | **Treasury  stock** | ** ** | **Unearned  compensation** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|---------------------------------|------------|------------------------|------------|-----------------------------------------------|------------|---------------------|------------|----------------------------|------------|-----------|------------|
| Balance - December 31, 2003                                         |       | 52,820             |       | $                 | 528        |                            | $          | 432,035                |       | $                                             | 44,102     |                | $          | 2,742                      |       | $         | (48,674    | ) | $ | (383 | ) | $ | 430,350 |   |
| Comprehensive income:                                               |       |               |       |              |       |                            |       |                   |       |                                          |       |                |       |                       |       |      |       |
| Net income for the three months ended March 31, 2004                |       | —             |       | —            |       | —                          |       | 9,394                  |       | —                                        |       | —              |       | —                     |       | 9,394     |       |
| Realized gain on sales of  securities, net of taxes                 |       | —             |       | —            |       | —                          |       | —                 |       | (1,980                                        | )          | —              |       | —                     |       | (1,980    | )          |
| Unrealized gain on sales of securities, net of taxes                |       | —             |       | —            |       | —                          |       | —                 |       | 4,230                                         |       | —              |       | —                     |       | 4,230     |       |
| Comprehensive income                                                |       |               |       |              |       |                            |       |                   |       |                                          |       |                |       |                       |       | 11,644    | *          |
| Dividends declared on common stock                                  |       | —             |       | —            |       | —                          |       | (941                   | )          | —                                        |       | —              |       | —                     |       | (941      | )          |
| Purchase of shares of common stock for treasury, net of reissuances |       | —             |       | —            |       | (115                            | )          | —                 |       | —                                        |       | (7,382              | )          | —                     |       | (7,497    | )          |
| Amortization of unearned compensation                               |       | —             |       | —            |       | —                          |       | —                 |       | —                                        |       | —              |       | 31                         |       | 31        |       |
| Balance - March 31, 2004                                            |       | 52,820             |       | $                 | 528        |                            | $          | 431,920                |       | $                                             | 52,555     |                | $          | 4,992                      |       | $         | (56,056    | ) | $ | (352 | ) | $ | 433,587 |   |
| Comprehensive income:                                               |       |               |       |              |       |                            |       |                   |       |                                          |       |                |       |                       |       |      |       |
| Net income for the three months ended June 30, 2004                 |       | —             |       | —            |       | —                          |       | 8,467                  |       | —                                        |       | —              |       | —                     |       | 8,467     |       |
| Unrealized loss on securities, net of taxes                         |       | —             |       | —            |       | —                          |       | —                 |       | (6,967                                        | )          | —              |       | —                     |       | (6,967    | )          |
| Comprehensive income                                                |       |               |       |              |       |                            |       |                   |       |                                          |       |                |       |                       |       | 1,500     | *          |
| Dividends declared on common stock                                  |       | —             |       | —            |       | —                          |       | (938                   | )          | —                                        |       | —              |       | —                     |       | (938      | )          |
| Purchase of shares of common stock for treasury, net of reissuances |       | —             |       | —            |       | 109                             |       | (196                   | )          | —                                        |       | (3,583              | )          | —                     |       | (3,670    | )          |
| Issuances of common stock                                           |       | —             |       | —            |       | —                          |       | —                 |       | —                                        |       | —              |       | 31                         |       | 31        |       |
| Balance - June 30, 2004                                             |       | 52,820             |       | $                 | 528        |                            | $          | 432,029                |       | $                                             | 59,888     |                | $          | (1,975                     | )          | $         | (59,639    | ) | $ | (321 | ) | $ | 430,510 |   |

 
| ** **                                                          | ** ** | **Common  shares** | ** ** | **Common  Stock** | ** ** | **Additional  paid-in capital** | ** ** | **Retained  (deficit)  earnings** | ** ** | **Accumulated  other  comprehensive   income** | ** ** | **Treasury  stock** | ** ** | **Unearned  compensation** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|---------------------------------|------------|-----------------------------------|------------|------------------------------------------------|------------|---------------------|------------|----------------------------|------------|-----------|------------|
| Balance - December 31, 2002                                         |       | 52,675             |       | $                 | 527        |                            | $          | 426,485                           |       | $                                              | (2,568     | )                   | $          | 11,026                     |       | $         | (33,880    | ) | — |   | $ | 401,590 |   |
| Comprehensive income:                                               |       |               |       |              |       |                            |       |                              |       |                                           |       |                |       |                       |       |      |       |
| Net loss for the three months ended March 31, 2003                  |       | —             |       | —            |       | —                          |       | 10,702                            |       | —                                         |       | —              |       | —                     |       | 10,702    |       |
| Unrealized loss on securities, net of taxes                         |       | —             |       | —            |       | —                          |       | —                            |       | (2,167                                         | )          | —              |       | —                     |       | (2,167    | )          |
| Comprehensive income                                                |       |               |       |              |       |                            |       |                              |       |                                           |       |                |       |                       |       | 8,535     | *          |
| Dividends declared on common stock                                  |       | —             |       | —            |       | —                          |       | (973                              | )          | —                                         |       | —              |       | —                     |       | (973      | )          |
| Purchase of shares of common stock for treasury, net of reissuances |       | —             |       | —            |       | (3                              | )          | —                            |       | —                                         |       | (7,499              | )          | —                     |       | (7,502    | )          |
| Issuances of common stock                                           |       | 68                 |       | —            |       | 4,575                           |       | —                            |       | —                                         |       | —              |       | —                     |       | 4,575     |       |
| Balance - March 31, 2003                                            |       | 52,743             |       | $                 | 527        |                            | $          | 431,057                           |       | $                                              | 7,161      |                | $          | 8,859                      |       | $         | (41,379    | ) | — |   | $ | 406,225 |   |
| Comprehensive income:                                               |       |               |       |              |       |                            |       |                              |       |                                           |       |                |       |                       |       |      |       |
| Net loss for the three months ended June 30, 2003                   |       | —             |       | —            |       | —                          |       | 14,213                            |       | —                                         |       | —              |       | —                     |       | 14,213    |       |
| Unrealized gain on securities, net of taxes                         |       | —             |       | —            |       | —                          |       | —                            |       | 2,749                                          |       | —              |       | —                     |       | 2,749     |       |
| Comprehensive income                                                |       |               |       |              |       |                            |       |                              |       |                                           |       |                |       |                       |       | 16,962    | *          |
| Dividends declared on  common stock                                 |       | —             |       | —            |       | —                          |       | (964                              | )          | —                                         |       | —              |       | —                     |       | (964      | )          |
| Purchase of shares of common stock for treasury, net of reissuances |       | —             |       | —            |       | (16                             | )          | —                            |       | —                                         |       | (2,228              | )          | —                     |       | (2,244    | )          |
| Issuances of common stock                                           |       | 19                 |       | 1                 |       | 348                             |       | —                            |       | —                                         |       | —              |       | —                     |       | 349       |       |
| Balance - June 30, 2003                                             |       | 52,762             |       | $                 | 528        |                            | $          | 431,389                           |       | $                                              | 20,410     |                | $          | 11,608                     |       | $         | (43,607    | ) | — |   | $ | 420,328 |   |

 

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* Comprehensive income was$13,144 and $25,497 for the six months ended June 30, 2004 and 2003,respectively.

 

See notes to consolidatedfinancial statements.

 

5

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**NetBank, Inc.**

**Consolidated Statements of Cash Flows**

**(unaudited and in 000’s)**

 
| ** **                                                                                   | ** ** | **Six months ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                   | ** ** | **2004**                      | ** ** | **2003** | ** ** |
| Operating activities:                                                                        |       |                          |       |   |   |
| Net income                                                                                   |       | $                             | 17,861     |   | $ | 24,915 |   |
| Adjustments to reconcile net income to net  cash provided by (used in) operating activities: |       |                          |       |   |   |
| Depreciation and amortization                                                                |       | 9,616                         |       | 7,191 |   |
| Amortization of premiums on investment  securities, loan and lease receivables and debt      |       | 5,101                         |       | 4,545 |   |
| Origination of loans held for sale                                                           |       | (7,162,203                    | )          | (9,958,953 | ) |
| Proceeds from sales of loans held for sale                                                   |       | 7,393,276                     |       | 9,053,416 |   |
| Net gain on sales of loans and servicing  rights                                             |       | (66,213                       | )          | (108,547 | ) |
| Capitalization of mortgage servicing rights                                                  |       | (52,802                       | )          | (84,732 | ) |
| Proceeds from sale of mortgage servicing  rights                                             |       | 3,182                         |       | 42,073 |   |
| Impairment and amortization of mortgage  servicing rights                                    |       | 14,280                        |       | 27,335 |   |
| Provision for credit losses                                                                  |       | 3,513                         |       | 1,762 |   |
| Loss on sales of fixed assets                                                                |       | 12                            |       | — |   |
| Changes in assets and liabilities which  provide (use) cash:                                 |       |                          |       |   |   |
| Decrease in accrued interest receivable                                                      |       | 788                           |       | 936 |   |
| Increase in other assets, due from  servicers, and intangibles                               |       | (6,722                        | )          | (4,860 | ) |
| Increase (decrease) in accrued interest  payable                                             |       | 786                           |       | (2,831 | ) |
| Decrease in accounts payable and accrued  liabilities                                        |       | (1,265                        | )          | (1,050 | ) |
| Increase in loans in process                                                                 |       | 21,212                        |       | 74,136 |   |
| Net cash provided by (used in) operating  activities                                         |       | 180,422                       |       | (924,664 | ) |
|                                                                                         |       |                          |       |   |   |
| Investing activities:                                                                        |       |                          |       |   |   |
| Purchases of available for sale securities                                                   |       | (165,156                      | )          | (50,508 | ) |
| Principal repayments on available for sale  investment securities                            |       | 32,102                        |       | 48,040 |   |
| Sales and maturities of available for sale  investment securities                            |       | 14,216                        |       | 318,304 |   |
| Gain on sales of available for sale  investment securities                                   |       | (3,169                        | )          | (11,394 | ) |
| Purchase of Federal Home Loan Bank Stock                                                     |       | (35,370                       | )          | (13,905 | ) |
| Origination and purchases of loans and  leases                                               |       | (816,970                      | )          | (482,148 | ) |
| Principal repayments on loans and leases                                                     |       | 242,690                       |       | 188,576 |   |
| Purchases of furniture, fixtures, and  equipment                                             |       | (9,593                        | )          | (11,990 | ) |
| Proceeds from the disposal of fixed assets                                                   |       | 70                            |       | — |   |
| Other investing activities                                                                   |       | 389                           |       | — |   |
| Net cash used in investing activities                                                        |       | (740,791                      | )          | (15,025 | ) |
|                                                                                         |       |                          |       |   |   |
| Financing activities:                                                                        |       |                          |       |   |   |
| (Decrease) increase in money market and  checking accounts                                   |       | (6,589                        | )          | 512,190 |   |
| Decrease in certificates of deposits                                                         |       | (84,353                       | )          | (92,880 | ) |
| Proceeds from other borrowed funds                                                           |       | 8,689,794                     |       | 5,418,491 |   |
| Repayments of other borrowed funds                                                           |       | (7,961,841                    | )          | (4,948,390 | ) |
| Net proceeds from issuance of trust  preferred securities                                    |       | —                        |       | 4,382 |   |
| Net purchase of treasury stock                                                               |       | (11,167                       | )          | (4,822 | ) |
| Dividend payments on common stock                                                            |       | (1,879                        | )          | (1,937 | ) |
| Amortization of unearned compensation                                                        |       | 62                            |       | — |   |
| Net cash provided by financing activities                                                    |       | 624,027                       |       | 887,034 |   |
| Net increase (decrease) in cash and cash  equivalents                                        |       | 63,658                        |       | (52,655 | ) |
| Cash and cash equivalents:                                                                   |       |                          |       |   |   |
| Cash, beginning of period                                                                    |       | 33,627                        |       | 111,565 |   |
| Cash, end of period                                                                          |       | $                             | 97,285     |   | $ | 58,910 |   |
|                                                                                         |       |                          |       |   |   |
| Supplemental disclosures of cash flow  information:                                          |       |                          |       |   |   |
| Cash paid during the period for interest                                                     |       | $                             | 41,828     |   | $ | 45,963 |   |
| (Refunds received) cash paid during the  period for income taxes                             |       | $                             | (8,362     | ) | $ | 1,824 |   |

 

See notes to consolidated financial statements.

 

6

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**NETBANK, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**June 30, 2004**

**(unaudited)**

 

**1.             ORGANIZATION AND BASIS OFPRESENTATION**

 

NetBank, Inc. is a financialholding company that wholly owns the outstanding stock of NetBank, (“NetBank,FSB” or the “Bank”), a federal savings bank; MG Reinsurance Company (“MGReinsurance”), a captive reinsurance company; NetInsurance, Inc.,(“NetInsurance”), a licensed insurance agency; and NB Partners, Inc., acorporation formed to be involved in strategic partnering opportunities.  NetBank, FSB owns all of the outstandingstock of Market Street Mortgage Corporation (“Market Street”), a retailmortgage company, NetBank Payment Systems, Inc. (“NPS”), a leading provider ofATM services for retail and other non-bank businesses; Meritage MortgageCorporation (“Meritage”), a wholesale non-conforming mortgage provider andRBMG, Inc. (“RBMG”), a wholesale mortgage banking company.  The entire consolidated company is referredto herein as “NetBank” 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 NetBank’s Form 10-Kfiled with the SEC for the year ended December 31, 2003. The results ofoperations for the interim periods reported herein are not necessarilyindicative of results to be expected for the full year. Certain 2003 amountshave been reclassified for comparability with 2004 amounts.

 

All dollar figures arepresented in thousands (000s), except per share data, unless otherwise noted.

 

**Net incomeper share is presented on a diluted basis.**

** **

**2.             ACQUISITIONS**

** **

On June 1, 2004, the Company acquired certain assets of Western StatesATM Systems, Inc., a provider of ATMs and ATM processing services, pursuant toan Asset Purchase and Assignment Agreement. The consideration paid, was $4.0 million.  The acquisition was accounted for as apurchase, and, accordingly, all assets were recorded at fair value.  Its results of operations have been includedfrom the date of acquisition.  As such,$1.8 million in goodwill, including transaction costs, and $2.1 million in contractintangibles were recorded.

 

On February 1, 2004, the Company acquired certain assets of ElectronicCash Systems, Inc., a provider of ATM and merchant processing services,pursuant to an Asset Purchase and Assignment Agreement.  The consideration paid, including transactioncosts, was $4.7 million.  The acquisitionwas accounted for as a purchase, and, accordingly, all assets were recorded atfair value.  Its results of operations have been includedfrom the date of acquisition.  Assuch, $3.0 million in goodwill, including transaction costs, and $1.5 millionin contract intangibles were recorded.

 

On December 1, 2003, NetBank, Inc. acquired all of the outstandingstock of Financial Technologies, Inc., subsequently renamed NetBank PaymentSystems, Inc., pursuant to an agreement dated October 5, 2003.  The consideration paid consisted of 77,674shares of NetBank common stock and cash of $16 million.  The acquisition was accounted for a purchase,and, accordingly, all assets were recorded at fair value. The Company recorded$12.6 million of goodwill and $4.8 million of contract intangibles associatedwith the purchase.  Goodwill wasdecreased during the three months ended March 31, 2004 by $1.4 million relatedto adjustments to inventories and taxes associated with the acquisition.  The Company may pay additional considerationif NPS reaches specific financial goals over the next five years.  NPS’s results of operations have beenincluded from the date of acquisition.

 

On April 30, 2003, the Company acquired certain assets of Memorial ParkMortgage, LTD, a mortgage banking business, pursuant to an Asset Purchase andAssignment Agreement.  The considerationpaid, including transaction costs, was $3.2

 

7

----

 

million.  The acquisition wasaccounted for as a purchase, and accordingly, all assets were recorded at fairvalue.  Its results of operations have been includedfrom the date of acquisition.  Assuch, $2.0 million in goodwill, including transaction costs, was recorded.

 

**3.             ACCOUNTING POLICIES**

** **

Reference is made to theaccounting policies of NetBank described in the notes to consolidated financialstatements contained in NetBank’s Form 10-K for the year endedDecember 31, 2003. The Company has followed those policies in preparingthis report.

 

*SignificantEstimates.*The preparation of the consolidatedfinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the amounts reported in the consolidated financialstatements and accompanying notes.  Certain of these estimates relate to theCompany’s allowance for credit losses; the fair values of loans held for sale,mortgage servicing rights, servicing hedges and the Company’s other hedginginstruments; and reserves for estimated losses on representations andwarranties provided to purchasers of loans or mortgage servicing rights.Because of the inherent uncertainties associated with any estimation processand due to possible future changes in market and economic conditions that willaffect fair values, it is possible that actual future results and realizationof the underlying assets and liabilities could differ significantly from theamounts reflected as of the balance sheet date.

 

*StockOptions.*The Company accounts for stock options issuedunder the recognition and measurement principles of Accounting Principles Board25, *Accounting for Stock Issued to Employees,*andrelated Interpretations. No stock option-based employee compensation cost isreflected in the results of operations, as all options granted under thoseplans had an exercise price equal to or greater than the market value of theunderlying common stock on the date of grant. The following table illustratesthe pro forma effects on the results of operations and earnings per share ifthe Company had applied the fair value recognition provisions of FASB Statement123, *Accounting for Stock-Based Compensation,*tostock option-based employee compensation.

 
| ** **                                                                                                                                   | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                                   | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income, as reported                                                                                                                      |       | $                                | 8,467      |                           | $          | 14,213 |   | $ | 17,861 |   | $ | 24,915 |   |
| Deduct:                                                                                                                                      |       |                             |       |                           |       |   |   |   |   |
|                                                                                                                                         |       |                             |       |                           |       |   |   |   |   |
| Total stock option-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (725                             | )          | (552                           | )          | (1,275 | ) | (1,021 | ) |
| Pro forma net income                                                                                                                         |       | $                                | 7,742      |                           | $          | 13,661 |   | $ | 16,586 |   | $ | 23,894 |   |
|                                                                                                                                         |       |                             |       |                           |       |   |   |   |   |
| Earnings per share:                                                                                                                          |       |                             |       |                           |       |   |   |   |   |
| Basic – as reported                                                                                                                     |       | $                                | 0.18       |                           | $          | 0.30 |   | $ | 0.38 |   | $ | 0.52 |   |
| Basic – pro forma                                                                                                                       |       | $                                | 0.17       |                           | $          | 0.28 |   | $ | 0.35 |   | $ | 0.50 |   |
|                                                                                                                                         |       |                             |       |                           |       |   |   |   |   |
| Diluted – as reported                                                                                                                   |       | $                                | 0.18       |                           | $          | 0.29 |   | $ | 0.38 |   | $ | 0.51 |   |
| Diluted – pro forma                                                                                                                     |       | $                                | 0.16       |                           | $          | 0.28 |   | $ | 0.35 |   | $ | 0.49 |   |

** **

**In addition, for the three and six months ended June30, 2004, pre-tax compensation expense of $31 and $62, respectively, related torestricted stock awards was recognized and included in net income as reported.**

** **

**8**

----

** **

*New Accounting Pronouncements.*On March 9, 2004, the SEC issued Staff Accounting Bulletin No. 105(“SAB 105”), *Application of Accounting Principles to Loan Commitments*, which provides guidance regarding loan commitments that are accountedfor as derivatives instruments.  In thebulletin, the SEC determined that a loan commitment for which the interest ratehas been locked should be valued at zero at inception.  The adoption of SAB 105 prospectively onApril 1, 2004, did not have a material impact on the Company’s balance sheet orstatement of operations.

 

**4.             LOAN AND LEASE RECEIVABLES**

** **

At June 30, 2004 and December 31,2003 the Company had net unamortized premiums and deferred cost on its loansand leases of $35,845 and $30,256, respectively.   As of June 30, 2004, NetBank had commitments to fund mortgageloans of $1.3 billion, open-end consumer lines of credit of $74,915,undisbursed mortgage construction loans of $63,551, undisbursed commercialfinancing loans of $3,732 and commercial financing commitments of $3,821.  As of December 31, 2003, NetBank hadcommitments to fund mortgage loans of $967 million, open-end consumer lines ofcredit of $73,702, undisbursed mortgage construction loans of $53,091,undisbursed commercial financing loans of $4,447 and commercial financingcommitments of $2,379.

 

The following is a summary ofNetBank’s loan and lease portfolio:

 
| ** **                       | ** ** | **As of  June 30, 2004** | ** ** | **As of  December 31, 2003** | ** ** |
|----------------------------------|------------|--------------------------|------------|------------------------------|------------|
| ** **                       | ** ** | **Amount**               | ** ** | **%**                        | ** ** | **Amount** | ** ** | **%** | ** ** |
| Residential mortgages            |       | $                        | 1,650,947  |                         | 69.4       | % | $ | 1,309,689 |   | 72.6 | % |
| Leases                           |       | 375,968                  |       | 15.8                         | %          | 349,952 |   | 19.4 | % |
| Auto                             |       | 276,859                  |       | 11.6                         | %          | 92,724 |   | 5.1 | % |
| Home equity lines                |       | 71,849                   |       | 3.0                          | %          | 50,816 |   | 2.8 | % |
| Consumer                         |       | 2,750                    |       | 0.2                          | %          | 1,880 |   | 0.1 | % |
| Total                            |       | 2,378,373                |       | 100.0                        | %          | 1,805,061 |   | 100.0 | % |
| Less allowance for credit losses |       | (46,033                  | )          |                         |       | (43,689 | ) |   |   |
| Total                            |       | $                        | 2,332,340  |                         |       |   | $ | 1,761,372 |   |   |   |

** **

**5.             ALLOWANCE FOR CREDIT LOSSES**

** **

NetBank considers a loan or lease receivable to be impaired when it isprobable that it will be unable to collect all amounts due according to theoriginal terms of the loan or lease agreement. NetBank measures impairment of a loan or lease on a loan-by-loan orlease-by-lease basis.  Amounts ofimpaired loans that are not probable of collection are charged offimmediately.  NetBank had $85,144 and$87,228 of impaired, non-accrual loan and lease receivables as of June 30, 2004and December 31, 2003, respectively.  Thepurchased CMC lease portfolio represented $82,514 of the $85,144 totalimpaired, non-accrual loan and lease receivables as of June 30, 2004.  Reference is made to Note 11 for additionaldetail regarding the CMC lease portfolio.

 

9

----

 

The following is a summary ofthe allowance for credit losses:

 
| ** **                                                            | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                            | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Beginning balance**                                                 |       | $                                | 44,591     |                           | $          | 41,957 |   | $ | 43,689 |   | $ | 42,576 |   |
| Provision for credit losses                                           |       | 1,666                            |       | 894                            |       | 3,513 |   | 1,762 |   |
| Charge-offs:                                                          |       |                             |       |                           |       |   |   |   |   |
| Residential mortgages                                                 |       | (99                              | )          | (78                            | )          | (252 | ) | (424 | ) |
| Leases                                                                |       | (722                             | )          | (1,313                         | )          | (1,695 | ) | (2,755 | ) |
| Home equity lines                                                     |       | (132                             | )          | (145                           | )          | (319 | ) | (433 | ) |
| Consumer                                                              |       | (25                              | )          | —                         |       | (73 | ) | (18 | ) |
| Auto                                                                  |       | (419                             | )          | —                         |       | (743 | ) | — |   |
| Total charge-offs                                                     |       | (1,397                           | )          | (1,536                         | )          | (3,082 | ) | (3,630 | ) |
| Recoveries:                                                           |       |                             |       |                           |       |   |   |   |   |
| Residential mortgages                                                 |       | 104                              |       | 12                             |       | 115 |   | 102 |   |
| Leases                                                                |       | 686                              |       | 473                            |       | 1,253 |   | 987 |   |
| Home equity lines                                                     |       | 116                              |       | 55                             |       | 116 |   | 58 |   |
| Consumer                                                              |       | —                           |       | —                         |       | — |   | — |   |
| Auto                                                                  |       | 267                              |       | —                         |       | 429 |   | — |   |
| Total recoveries                                                      |       | 1,173                            |       | 540                            |       | 1,913 |   | 1,147 |   |
| Total charge-offs, net                                                |       | (224                             | )          | (996                           | )          | (1,169 | ) | (2,483 | ) |
| **Ending balance**                                                    |       | $                                | 46,033     |                           | $          | 41,855 |   | $ | 46,033 |   | $ | 41,855 |   |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Allowance for credit losses as a percent of  average loans and leases |       | 2.1                              | %          | 3.8                            | %          | 2.3 | % | 4.1 | % |

 

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

 

For purposes of evaluatingits mortgage servicing rights portfolio for impairment, the Companydisaggregates its servicing portfolio into two primary segments: available forsale and held for sale.

 

The segment of the portfolio designated asavailable for sale is composed of servicing rights that were retained out ofproduction pursuant to individual portfolio retention decisions or purchased inbulk transactions.  The available forsale portfolio is disaggregated for purposes of measuring potential impairmentsaccording to defined risk tranches.  TheCompany has defined its risk tranches based upon interest rate band and producttype.  With respect to each such risk tranche,the fair value thereof, which is based upon an internal analysis that considerscurrent market conditions, prevailing interest rates, prepayment speeds,default rates and other relevant factors, is compared to amortized carryingvalues of the mortgage servicing rights for purposes of measuring potentialimpairment.

 

The segment of the portfoliodesignated as held for sale is composed of recently produced servicing rightsthat are scheduled for sale and have been allocated to specific forwardservicing sales contracts.  The held forsale portfolio is disaggregated for purposes of measuring possible impairmentsaccording to the specific forward sales contracts to which allocated, which theCompany has determined to be the appropriate approach to disaggregation bypredominant risk characteristic for this portfolio segment.  For each such risk tranche, the fair value isbased upon the allocated forward committed delivery price, which is compared toamortized carrying value for purposes of measuring potential impairment.

 

10

----

 

The following amounts relatedto NetBank’s mortgage servicing rights portfolio as of June 30, 2004 andDecember 31, 2003:

 
| ** **                   | ** ** | **Available for sale** | ** ** | **Held for sale** | ** ** |
|------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                   | ** ** | **2004**               | ** ** | **2003**          | ** ** | **2004** | ** ** | **2003** | ** ** |
| UPB                          |       | $                      | 12,852,809 |              | $          | 12,293,325 |   | $ | 173,670 |   | $ | 250,338 |   |
| Carrying Value               |       | $                      | 197,730    |              | $          | 162,030 |   | $ | 2,590 |   | $ | 3,184 |   |
| Carrying Value / UPB         |       | 1.54                   | %          | 1.32              | %          | 1.49 | % | 1.27 | % |
| Fair value                   |       | $                      | 198,232    |              | $          | 162,656 |   | $ | 2,590 |   | $ | 3,184 |   |
| Fair Carrying Value / UPB    |       | 1.54                   | %          | 1.32              | %          | 1.49 | % | 1.27 | % |
| Weighted average note rate   |       | 5.99                   | %          | 6.09              | %          | 6.32 | % | 5.82 | % |
| Weighted average service fee |       | 0.33                   | %          | 0.33              | %          | 0.32 | % | 0.32 | % |
| Net Basis as multiple        |       | 4.66                   |       | 3.99              |       | 4.66 |   | 3.91 |   |

 

The following table summarizes changes in the impairment reserve forNetBank’s available for sale mortgage servicing rights:

 
| ** **                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
| Balance as of January 1,                  |       | $        | 58,253     |     | $          | 14,429 |   |
| Servicing valuation (recovery) impairment |       | (4,643   | )          | 14,175   |       |
| Balance as of June 30,                    |       | $        | 53,610     |     | $          | 28,604 |   |

 

**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 June 30, 2004** | ** ** | **As of December 31, 2003** | ** ** |
|----------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                             | ** ** | **Amount**              | ** ** | **Percentage**              | ** ** | **Weighted  average  interest  rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest  rate** | ** ** |
| Non-interest bearing checking accounts |       | $                       | 253,317    |                        | 10.4       | % | N/A |   | $ | 198,884 |   | 7.8 | % | N/A |   |
| Interest bearing:                      |       |                    |       |                        |       |   |   |   |   |   |   |   |   |
| Checking accounts                      |       | 240,914                 |       | 9.8                         | %          | 1.1 | % | 228,178 |   | 9.0 | % | 1.4 | % |
| Money market                           |       | 1,289,536               |       | 52.7                        | %          | 1.7 | % | 1,363,294 |   | 53.7 | % | 1.9 | % |
| Certificate of deposit under $100      |       | 548,952                 |       | 22.4                        | %          | 2.8 | % | 632,602 |   | 24.9 | % | 2.8 | % |
| Certificate of deposit over $100       |       | 115,766                 |       | 4.7                         | %          | 2.8 | % | 116,469 |   | 4.6 | % | 2.8 | % |
| Total deposits                         |       | $                       | 2,448,485  |                        | 100.0      | % |   |   | $ | 2,539,427 |   | 100.0 | % |   |   |

 

Accrued interest as of June 30,2004 related to checking, money market and certificates of deposit accounts was$77, $708 and $4,472, respectively. Accrued interest as of December 31, 2003, related to checking, moneymarket, and certificates of deposit accounts was $81, $801 and $5,686,respectively.  At June 30, 2004, andDecember 31, 2003, $714 and $664 of overdrawn deposits were classified asloans, respectively.

 

11

----

 

**8.             BORROWINGS**

 

A summary of borrowings and available borrowings, grouped by year ofmaturity, as of June 30, 2004 follows:

 
| **Type  of Borrowing**                   | ** ** | **Year of maturity** | ** ** | **Range of stated  interest rates** | ** ** | **Principal amount  outstanding** | ** ** |
|------------------------------------------|------------|----------------------|------------|-------------------------------------|------------|-----------------------------------|------------|
| $0.5 million line of credit              |       | 2004                 |       | Prime                               | *          | $                                 | 36         |   |
| $25 million line of credit               |       | 2004                 |       | Fed Funds                           | *          | —                            |       |
| $350 million warehouse line of credit    |       | 2004                 |       | 2.19%, 2.69                         | %*         | 105,333                           |       |
| $300 million master  repurchase facility |       | 2004                 |       | 2.59% to 2.84                       | %*         | 299,770                           |       |
| $625 million FHLB warehouse  line **     |       | 2005                 |       | DRC + 0.50                          | %*         | 170,500                           |       |
| $200 million master  repurchase facility |       | 2004                 |       | 2.62% to 2.74                       | %          | 37,708                            |       |
| FHLB advances                            |       | 2004                 |       | DRC, 4.45                           | %*         | 580,725                           |       |
| FHLB advances                            |       | 2005                 |       | 1.77% to 7.41                       | %          | 166,000                           |       |
| FHLB advances                            |       | 2006                 |       | 2.04% to 5.63                       | %          | 110,000                           |       |
| FHLB advances                            |       | 2007                 |       | 2.57                                | %          | 40,000                            |       |
| Notes Payable                            |       | 2007                 |       | 5.95                                | %          | 240                               |       |
| FHLB advances                            |       | 2008                 |       | 1.90% to 1.92                       | %          | 100,000                           |       |
| Notes Payble                             |       | 2008                 |       | 5.95                                | %          | 1,221                             |       |
| FHLB advances                            |       | 2009                 |       | 1.80% to 4.64                       | %          | 215,000                           |       |
| FHLB advances                            |       | 2014                 |       | 1.79% to 2.93                       | %          | 185,000                           |       |
| Subordinated Debt                        |       | 2032                 |       | LIBOR + 3.35                        | %*         | 4,382                             |       |
| Subordinated Debt                        |       | 2033                 |       | LIBOR + 3.25                        | %*         | 4,382                             |       |
| Subordinated Debt                        |       | 2034                 |       | LIBOR + 2.85                        | %*         | 3,093                             |       |
| $175 million master  repurchase facility |       | N/A                  |       | 1.70                                | %*         | 47,442                            |       |
| Total Debt                               |       |                 |       |                                |       | $                                 | 2,070,832  |   |

 

----

*                      Indicatesa variable rate.

**               Lineof credit extends to 40% of assets

 

Nine of the Federal Home Loan Bank (“FHLB”) advances totaling $276,000are fixed rate. The remaining advances totaling $590,000 are also fixed,however, they may be converted at the FHLB’s option to adjustable rate based onthe three month floating LIBOR.  The FHLB warehouse line is a $625,000adjustable line of credit with a floating rate based on the daily rate credit(“DRC”) plus 50 basis points used to fund mortgages originated by Market Streetand RBMG.  An additional warehouse linebased upon 40% of assets of the savings bank has a floating rate based on theDRC.  All of the FHLB advances and theFHLB warehouse line are secured by investment securities or mortgageloans.  At June 30, 2004, NetBank had pledged $388,813 of investmentsecurities and $1.5 billion of mortgage loans to the FHLB as collateral forvarious FHLB advances.

 

In July 2003, all theconvertible subordinated notes were called at par, and the remainingunamortized discount of $145 was written off.

 

NetBank’s subordinated debt issupported by trust preferred securities, which were issued in private pooledtransactions through off-balance sheet trusts: NBI Trust I, II and III. Thesubordinated debt, and the associated trust preferred securities carry avariable rate and were initially priced at LIBOR plus approximately 3.35% witha 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 maturefrom December 2032 through December 2033 and cannot be redeemed by the trustfor a minimum of five years after issuance.

 

Most of the revolving lines ofcredit, warehouse lines of credit (other than the FHLB warehouse line), themaster repurchase facilities and commercial paper conduit facility are securedby mortgage loans and are subject to restrictive covenants.  The covenants include certain minimum networth requirements, minimum tangible net worth requirements,

 

12

----

 

certain minimum financialratios, maintenance of servicer eligibility for various government agencies, aminimum balance in the mortgage servicing rights portfolio 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.  NetBank was in compliancewith all debt covenants in place as of June 30, 2004.  Although managementanticipates complying with all current debt covenants, there can be noassurance that NetBank or its individual subsidiaries will be able to complywith 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 levelfor the quarter on May 26, 2004 with a daily short-term balance of $2,380million.

 

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

** **

Basic and diluted net income per common and potential common share hasbeen calculated based on the weighted average number of sharesoutstanding.  The following schedulereconciles the numerator and denominator of the basic and diluted net incomeper common and potential common share for the three and six months ended June30, 2004 and 2003.  The effect of theretired convertible debt securities was not included in the 2003 periodsbecause the assumed conversion of such securities was anti-dilutive.

 
| ** **                                                        | ** ** | **Net Income (Numerator)** | ** ** | **Shares (Denominator)** | ** ** | **Per Share Amount** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------|------------|
| **Six months ended June 30, 2004**                                |       |                       |       |                     |       |                 |       |
| Basic EPS                                                         |       | $                          | 17,861     |                     | 47,020     |                 | $          | 0.38 |   |
| Effect of dilutive securities - option to  purchase common shares |       | —                     |       | 548                      |       | —               |       |
| Diluted EPS                                                       |       | $                          | 17,861     |                     | 47,568     |                 | $          | 0.38 |   |
|                                                              |       |                       |       |                     |       |                 |       |
| **Six months ended June 30, 2003**                                |       |                       |       |                     |       |                 |       |
| Basic EPS                                                         |       | $                          | 24,915     |                     | 48,146     |                 | $          | 0.52 |   |
| Effect of dilutive securities - option to  purchase common shares |       | —                     |       | 554                      |       | 0.01                 |       |
| Diluted EPS                                                       |       | $                          | 24,915     |                     | 48,700     |                 | $          | 0.51 |   |

 
| ** **                                                        | ** ** | **Net Income (Numerator)** | ** ** | **Shares (Denominator)** | ** ** | **Per Share Amount** | ** ** |
|-------------------------------------------------------------------|------------|----------------------------|------------|--------------------------|------------|----------------------|------------|
| **Three months ended June 30, 2004**                              |       |                       |       |                     |       |                 |       |
| Basic EPS                                                         |       | $                          | 8,467      |                     | 46,790     |                 | $          | 0.18 |   |
| Effect of dilutive securities - option to  purchase common shares |       | —                     |       | 379                      |       | —               |       |
| Diluted EPS                                                       |       | $                          | 8,467      |                     | 47,169     |                 | $          | 0.18 |   |
|                                                              |       |                       |       |                     |       |                 |       |
| **Three months ended June 30, 2003**                              |       |                       |       |                     |       |                 |       |
| Basic EPS                                                         |       | $                          | 14,213     |                     | 47,968     |                 | $          | 0.30 |   |
| Effect of dilutive securities - option to  purchase common shares |       | —                     |       | 671                      |       | 0.01                 |       |
| Diluted EPS                                                       |       | $                          | 14,213     |                     | 48,639     |                 | $          | 0.29 |   |

 

13

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**10.          BUSINESS SEGMENTS**

 

During 2004, NetBank realigned its operatingsegments as described in following paragraph. All prior periods amounts have been restated in conformity with thecurrent period presentation.

 

NetBank’s principal activities include retailbanking, financial intermediary and transaction processing.  The retailbanking segment primarily consists of offering consumer banking productssuch as checking, money market, and certificates of deposit.  Its investments primarily consist of 1-4family mortgage loans originated by the financial intermediary segment, smallbusiness financing loans and leases originated by its NetBank BusinessFinancing division, auto loans originated by its dealer financial servicesdivision, purchased securities for investment, mortgage servicing assets andvarious other purchased or retained loan products.  The financialintermediary segment originates mortgage loans directly with borrowers andpurchases mortgage loans from correspondents and/or brokers.  The financial intermediary segment packagesor pools such loans either inclusive or exclusive of servicing rights forretention by the retail banking segment or sale into the secondary market.  The transaction processing segment processesmortgages on behalf of community banks on a private label basis; provides ATMand merchant processing services; subservices loans for the retail banksegment, financial intermediary segment and for third-party customers; andsells various insurance products using an Internet-based platform.

 

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 NetBank, Inc. and is not necessarily comparable with similar informationfrom any other financial institution. The information presented is also notnecessarily indicative of the segment’s operations if they were independententities.

 
| ** **                                       | ** ** | **For the three months ended June 30, 2004** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  banking**                          | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Other +  Eliminations** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                            | 29,231     |   | $ | 28,781 |   | $ | 10 |   | $ | 655 |   | $ | 58,677 |   |
| Intersegment interest income                     |       | 9,941                                        |       | 55 |   | — |   | (9,996 | ) | — |   |
| Total interest income                            |       | 39,172                                       |       | 28,836 |   | 10 |   | (9,341 | ) | 58,677 |   |
| Interest expense                                 |       | 19,411                                       |       | 2,601 |   | 21 |   | 145 |   | 22,178 |   |
| Intersegment interest expense                    |       | 90                                           |       | 9,814 |   | — |   | (9,904 | ) | — |   |
| Total interest expense                           |       | 19,501                                       |       | 12,415 |   | 21 |   | (9,759 | ) | 22,178 |   |
| Net interest income                              |       | 19,671                                       |       | 16,421 |   | (11 | ) | 418 |   | 36,499 |   |
| Provision for credit losses                      |       | 1,643                                        |       | 23 |   | — |   | — |   | 1,666 |   |
| Intersegment- servicing and processing fees      |       | —                                       |       | — |   | 3,937 |   | (3,937 | ) | — |   |
| Non-interest income                              |       | 12,041                                       |       | 35,715 |   | 4,405 |   | (1,541 | ) | 50,620 |   |
| Non-interest expense                             |       | 22,790                                       |       | 38,135 |   | 9,473 |   | 1,612 |   | 72,010 |   |
| Intersegment- servicing and processing  expenses |       | 2,495                                        |       | 1,442 |   | — |   | (3,937 | ) | — |   |
| Pre-tax income (loss)                            |       | $                                            | 4,784      |   | $ | 12,536 |   | $ | (1,142 | ) | $ | (2,735 | ) | $ | 13,443 |   |
| Total assets                                     |       | $                                            | 5,261,513  |   | $ | 1,627,285 |   | $ | 34,352 |   | $ | (1,747,386 | ) | $ | 5,175,764 |   |

** **

**14**

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** **
| ** **                                       | ** ** | **For the three months ended June 30, 2003** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  banking**                          | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Other &  Eliminations** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                            | 19,491     |   | $ | 30,832 |   | $ | — |   | $ | 18 |   | $ | 50,341 |   |
| Intersegment interest income                     |       | 11,314                                       |       | 82 |   | — |   | (11,396 | ) | — |   |
| Total interest income                            |       | 30,805                                       |       | 30,914 |   | — |   | (11,378 | ) | 50,341 |   |
| Interest expense                                 |       | 19,207                                       |       | 1,947 |   | — |   | 479 |   | 21,633 |   |
| Intersegment interest expense                    |       | 400                                          |       | 11,060 |   | — |   | (11,460 | ) | — |   |
| Total interest expense                           |       | 19,607                                       |       | 13,007 |   | — |   | (10,981 | ) | 21,633 |   |
| Net interest income                              |       | 11,198                                       |       | 17,907 |   | — |   | (397 | ) | 28,708 |   |
| Provision for credit losses                      |       | 872                                          |       | 22 |   | — |   | — |   | 894 |   |
| Intersegment- servicing and processing fees      |       | —                                       |       | — |   | 3,396 |   | (3,396 | ) | — |   |
| Non-interest income                              |       | 17,177                                       |       | 63,116 |   | 1,526 |   | (1,265 | ) | 80,554 |   |
| Non-interest expense                             |       | 41,375                                       |       | 36,891 |   | 5,967 |   | 1,700 |   | 85,933 |   |
| Intersegment- servicing and processing  expenses |       | 2,493                                        |       | 903 |   | — |   | (3,396 | ) | — |   |
| Pre-tax income (loss)                            |       | $                                            | (16,365    | ) | $ | 43,207 |   | $ | (1,045 | ) | $ | (3,362 | ) | $ | 22,435 |   |
| Total assets                                     |       | $                                            | 3,966,115  |   | $ | 2,680,321 |   | $ | 7,024 |   | $ | (2,143,035 | ) | $ | 4,510,425 |   |

** **
| ** **                                       | ** ** | **For the six months ended June 30, 2004** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  banking**                        | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Other &  Eliminations** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                          | 54,641     |   | $ | 54,583 |   | $ | 18 |   | $ | 1,620 |   | $ | 110,862 |   |
| Intersegment interest income                     |       | 20,317                                     |       | 113 |   | — |   | (20,430 | ) | — |   |
| Total interest income                            |       | 74,958                                     |       | 54,696 |   | 18 |   | (18,810 | ) | 110,862 |   |
| Interest expense                                 |       | 38,137                                     |       | 4,146 |   | 45 |   | 286 |   | 42,614 |   |
| Intersegment interest expense                    |       | 243                                        |       | 20,008 |   | — |   | (20,251 | ) | — |   |
| Total interest expense                           |       | 38,380                                     |       | 24,154 |   | 45 |   | (19,965 | ) | 42,614 |   |
| Net interest income                              |       | 36,578                                     |       | 30,542 |   | (27 | ) | 1,155 |   | 68,248 |   |
| Provision for credit losses                      |       | 3,472                                      |       | 41 |   | — |   | — |   | 3,513 |   |
| Intersegment- servicing and processing fees      |       | —                                     |       | — |   | 7,727 |   | (7,727 | ) | — |   |
| Non-interest income                              |       | 31,236                                     |       | 70,288 |   | 8,376 |   | (2,589 | ) | 107,311 |   |
| Non-interest expense                             |       | 50,131                                     |       | 73,518 |   | 17,046 |   | 2,876 |   | 143,571 |   |
| Intersegment- servicing and processing  expenses |       | 4,875                                      |       | 2,852 |   | — |   | (7,727 | ) | — |   |
| Pre-tax income (loss)                            |       | $                                          | 9,336      |   | $ | 24,419 |   | $ | (970 | ) | $ | (4,310 | ) | $ | 28,475 |   |
| Total assets                                     |       | $                                          | 5,261,513  |   | $ | 1,627,285 |   | $ | 34,352 |   | $ | (1,747,386 | ) | $ | 5,175,764 |   |

** **

**15**

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** **
| ** **                                       | ** ** | **For the six months ended June 30, 2003** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  banking**                        | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Other &  Eliminations** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                          | 38,991     |   | $ | 56,327 |   | $ | — |   | $ | 25 |   | $ | 95,343 |   |
| Intersegment interest income                     |       | 19,823                                     |       | 82 |   | — |   | (19,905 | ) | — |   |
| Total interest income                            |       | 58,814                                     |       | 56,409 |   | — |   | (19,880 | ) | 95,343 |   |
| Interest expense                                 |       | 38,635                                     |       | 3,606 |   | — |   | 891 |   | 43,132 |   |
| Intersegment interest expense                    |       | 885                                        |       | 19,281 |   | — |   | (20,166 | ) | — |   |
| Total interest expense                           |       | 39,520                                     |       | 22,887 |   | — |   | (19,275 | ) | 43,132 |   |
| Net interest income                              |       | 19,294                                     |       | 33,522 |   | — |   | (605 | ) | 52,211 |   |
| Provision for credit losses                      |       | 1,721                                      |       | 41 |   | — |   | — |   | 1,762 |   |
| Intersegment- servicing and processing fees      |       | —                                     |       | — |   | 6,400 |   | (6,400 | ) | — |   |
| Non-interest income                              |       | 34,643                                     |       | 114,500 |   | 2,765 |   | (2,210 | ) | 149,698 |   |
| Non-interest expense                             |       | 74,108                                     |       | 71,849 |   | 11,857 |   | 2,927 |   | 160,741 |   |
| Intersegment- servicing and processing  expenses |       | 4,604                                      |       | 1,796 |   | — |   | (6,400 | ) | — |   |
| Pre-tax income (loss)                            |       | $                                          | (26,496    | ) | $ | 74,336 |   | $ | (2,692 | ) | $ | (5,742 | ) | $ | 39,406 |   |
| Total assets                                     |       | $                                          | 3,966,115  |   | $ | 2,680,321 |   | $ | 7,024 |   | $ | (2,143,035 | ) | $ | 4,510,425 |   |

** **

**11.          LOSS CONTINGENCY**

** **

NetBank, FSB is involved in litigation with three insurance companieswho are sureties on some of NetBank, FSB’s commercial lease portfolios.  NetBank, FSB has filed a claim for allprincipal and interest payments that are currently past due.  The total unpaid principal and accruedinterest balance of $82.5 million is included in loan and leasereceivables.  In accordance with theOffice of Thrift Supervision requirements, the Company maintains an allowancefor losses against this portfolio of $21.2 million.  For the six months ended June 30, 2004 and2003, the Company did not accrue scheduled interest of $1,342 and $2,892,respectively, and incurred $2,626 and $472, respectively, in legal expensesrelated to this litigation.  Legalexpenses are included in the professional fees line of the consolidatedstatements of operations.

 

# **12.          COMMITMENTSAND GUARANTEES**

# ** **

The Company has issued mortgage-backed securities under programssponsored by Ginnie Mae, Freddie Mac and Fannie Mae.  In connection with servicing mortgage-backedsecurities guaranteed by Ginnie Mae, Freddie Mac or Fannie Mae, the Companyadvances certain principal and interest payments to security holders prior totheir collection from specific mortgagors. Additionally, the Company must remit certain payments of property taxesand insurance premiums in advance of collecting them from specific mortgagorsand make certain payments of attorney’s fees and other costs related to loansin foreclosure.  These amounts areincluded in servicing advances under the caption due from servicers andinvestors in the accompanying consolidated balance sheets.  Likewise, during the month that a mortgagorpays off his/her mortgage, the Company must accept an interest payment from theborrower that is pro-rated to the date of payoff and pass through a full monthof interest to the security holder.  TheCompany includes its projection of the cost of such advances and lost intereston mortgages that prepay, and the expense of unreimbursed attorney and othercosts associated with foreclosure in its valuation of the servicing assets.

 

In the ordinary course ofbusiness, the Company is exposed to liability under representations andwarranties made to purchasers and insurers of mortgage loans and the purchasersof servicing rights.  Under certaincircumstances, the Company may be required to repurchase mortgage loans orindemnify the purchasers of loans or servicing rights for losses if there hasbeen a breach of representations or warranties. Repurchased loans are carried at the lower of cost or net realizablevalue.  There were $45.1 million and$51.9 million of repurchased loans included in mortgage loans held for

 

16

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sale at June 30, 2004 andDecember 31, 2003, respectively.  TheCompany had $12.3 million and $16.8 million of reserves resulting from theestimation of the net realizable value associated with repurchased loans as ofJune 30, 2004 and December 31, 2003, respectively.  Additionally, the Company had $22.3 millionand $17.9 million of reserves for estimated losses on future repurchases as ofJune 30, 2004 and December 31, 2003, respectively.

 

NetBank is unable to determineits maximum exposure under its representations and warranties.  The maximum exposure under NetBank’srepresentations and warranties would be the outstanding principal balance andany premium paid of all loans or mortgage servicing rights ever sold by theCompany less any loans sold servicing released or any loans underlying mortgageservicing rights that have already prepaid or defaulted without a breach ofrepresentations and warranties.  For thesix months ended June 30, 2004 and 2003 the Company repurchased approximately$29.0 million and $18.4 million of unpaid principal balances, respectively.

 

**NetBank is involved in certain legal proceedings, excludingthe CMC litigation discussed in note 11, incidental to its business.  NetBank does not believe that the outcome ofthese proceedings will have a material adverse effect upon its financialcondition, results of operations or cash flows.**

** **

**ITEM2:  **                                              Management’sDiscussion andAnalysis of Financial Condition and Results of Operations

** **

*The following discussion may include forward-looking statements.Forward-looking statements regarding the intent, belief or current expectationsof NetBank, Inc. or its officers and directors can be identified by the use offorward-looking terms such as “may,” “will,” “should,” “believe,” “expect,”“anticipate,” “estimate,” “continue,” or other comparable terminology. Variousinternal and external factors could cause the Company’s actual results todiffer materially from those anticipated by the forward-looking statements.These factors include, but are in no way limited to, 1) the evolving nature ofthe market for Internet banking and financial services generally; 2) thepublic’s perception of the Internet as a secure, reliable channel for transactions;3) the success of new products and lines of business considered critical to theCompany’s long-term strategy, such as small business banking and transactionprocessing services; 4) potential difficulties in integrating the Company’soperations across its multiple lines of business; 5) the cyclical nature of themortgage banking industry generally; 6) a possible decline in asset quality; 7)the possible adverse effects of unexpected changes in the interest rateenvironment; 8) adverse legal rulings, particularly in the company’s litigationover leases originated by the Commercial Money Center, Inc.; and/or 9)increased competition and regulatory changes. The Company’s 2003 Form 10-Kfiled with the Securities and Exchange Commission, contains additional detailson these and other risks that are material to operations. All forward-lookingstatements in this report are based on information available at the time offiling. The Company has no obligation to update any forward-looking statementincluded herein.*

 

**General**

 

NetBank, Inc. is a financialholding company that wholly owns the outstanding stock of NetBank, (“NetBank,FSB” or the “Bank”), a federal savings bank; MG Reinsurance Company (“MGReinsurance”), a captive reinsurance company; NetInsurance, Inc.,(“NetInsurance”), a licensed insurance agency; and NB Partners, Inc., acorporation formed to be involved in strategic partnering opportunities.  NetBank, FSB owns all of the outstandingstock of Market Street Mortgage Corporation (“Market Street”), a retailmortgage company, NetBank Payment Systems, Inc. (“NPS”), a leading provider ofATM services for retail and other non-bank businesses; Meritage MortgageCorporation (“Meritage”), a wholesale non-conforming mortgage provider andRBMG, Inc. (“RBMG”), a wholesale mortgage banking company.  The entire consolidated company is referredto herein as “NetBank” or “the Company”.

 

The results of operations ofall acquisitions are included in the consolidated results of operations fromtheir respective dates of acquisition. All dollar figures are presented in thousands (000s), except per sharedata, unless otherwise noted.  Net incomeper share is presented on a dilutive basis.

 

*Executive Summary.*

 

Net income for the three monthsended June 30, 2004 was $8,467 or $0.18 per share compared to $14,213 or $0.29per share for the same period of 2003. The decline in earnings was primarily due to a decline of $19.3 millionin the financial

 

17

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intermediary segment.  This sharp decline is related to the $1.3billion or 28% decline in sales of mortgage loans period over period coupledwith compressed margins due to increased competition, especially in thecorrespondent channel.  The financialintermediary segment’s drop in earnings was offset, in part, by a $13.3 millionincrease in the retail banking segment. This increase was driven primarily by improved net servicing results of$14.4 million pre-tax, and higher net interest income at the Bank.  The net servicing results improved asmortgage rates increased allowing for a recapture of market value that had beentemporarily impaired.  The retail bank’snet interest margin improved by 65 basis points period over period primarilydue to the retention of higher yielding assets, such as internally originatedauto loans, coupled with a reduction in its cost of funds.  The Bank lowered its cost of funds byprepaying higher fixed-rate FHLB advances during 2003 and replacing singlerelationship CD customers with transactional accounts and short-termborrowings.  While this strategy hastemporarily caused a slight decline in total deposits, NetBank believestransactional- or multi- account customers will provide a more stable lowercost of funds over the long-term.

 

# **Financial Condition**

# ** **

*General. *NetBank’s assets totaled $5.2 billion atJune 30, 2004, an increase of $441 million or 9% from December 31, 2003.  This increase is primarily the result of a$64 million increase in the amount of cash and cash equivalents, and a $571million increase in loan and lease receivables related to the retention ofcertain internally originated assets. Additionally, the value of its mortgage servicing rights portfolioincreased $35 million, as discussed in the following mortgage servicing rightssection.  These increases were partiallyoffset by a decrease of $165 million in loans held for sale due to the velocityof sales outpacing production in the financial intermediary segment and a $90million decline in receivables from unsettled trades.

 

*InvestmentSecurities.*  For the six months ended June 30,2004, the investment security portfolio decreased by $15 million. The securityportfolio decreased due to the sale of $146 million of its mortgage poolsecurities available for sale at gains of $3.2 million, a $5 million decline inmarket value, and the receipt of $4.8 million of payments on mortgage backedsecurities. These decreases were offset, in part, by the purchase of $159million of new investment securities, primarily collateralized mortgage obligationsor U.S. government securities. The Company will continue to buy and sellinvestment securities on a selected basis as part of its overallasset-liability management strategy.

 

The following tables set forth certain information relating to theCompany’s available for sale securities:

 
| **As of  June 30, 2004**            | ** ** | **Amortized  cost** | ** ** | **Unrealized  gains** | ** ** | **Unrealized  losses** | ** ** | **Estimated  fair value** | ** ** |
|-------------------------------------|------------|---------------------|------------|-----------------------|------------|------------------------|------------|---------------------------|------------|
| Mortgage pool securities            |       | $                   | 83,004     |                  | $          | 76                     |       | $                         | 874        |   | $ | 82,206 |   |
| Collateralized mortgage obligations |       | 63,456              |       | 25                    |       | 1,237                  |       | 62,244                    |       |
| U.S. government agencies            |       | 252,957             |       | 105                   |       | 2,167                  |       | 250,895                   |       |
| Corporate bonds                     |       | 39,138              |       | 754                   |       | —                 |       | 39,892                    |       |
| Habitat bonds and other             |       | 3,678               |       | 123                   |       | —                 |       | 3,801                     |       |
| Total                               |       | $                   | 442,233    |                  | $          | 1,083                  |       | $                         | 4,278      |   | $ | 439,038 |   |

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

 

18

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*Loan andLease Receivables.*  For the six months ended June30, 2004, the loan and lease receivables portfolio increased $571 million, a32% increase.  The Company achieved thisgrowth by selectively retaining $643 million in mortgage and home equity loansoriginated through its mortgage subsidiaries, $210 million of auto loansoriginated through its indirect auto lending unit and $82 million of smallbusiness financing leases originated through its NetBank Business Financingdivision.  The retention of theseinternally originated assets was offset, in part, by $364 million of principalreductions and prepayments.  NetBank isactively replacing its purchased loan and lease receivables portfolio withinternally originated loans and leases so it can capitalize on cross-sellingopportunities, internally service the assets and more effectively control itscredit and interest rate risk.  As ofJune 30, 2004, third-party purchased loans and leases represented only 10% ofthe held for investment portfolio. NetBank intends to continue retaining its originated auto loans untilthe percentage of auto and other consumer loans to total interest-earningassets reaches approximately 15%. At that time, the Company will begin sellingany excess originations into the secondary markets.

 

*AssetQuality and Non-performing Assets.* The Companyperiodically reviews the performance of its loan and lease receivablesportfolio by reviewing charge-offs, delinquency statistics, and various otherindustry statistics.  Largenon-homogeneous credits are reviewed on a loan-by-loan or lease-by-lease basis,whereas relatively small credits with similar risk characteristic are reviewedon a pool-by-pool basis.  If a decline incredit quality for a specific pool or individual loan or lease is noted, theCompany records additional allowance through a charge to the provision forcredit losses.  The allowance for creditlosses is maintained at a level estimated to be adequate to provide forprobable losses in the loan and lease receivables portfolio.  The Company determines the adequacy of theallowance based upon reviews of individual loans and leases, recent lossexperience, current economic conditions, the risk characteristics of thevarious categories of loans and leases and other pertinent factors.  NetBank’s non-performing assets as apercentage of gross unpaid principal balance (UPB) improved from 4.8% atDecember 31, 2003, to 3.6% at June 30, 2004, as the level of non-performingassets held fairly constant relative to an increase of $573 million or 32% ingross UPB.  As gross UPB continues to increasefrom the retention of high-quality loans and leases, the Company expects theseratios may continue to improve.

 

The following tables detailNetBank’s held for investment loan and lease portfolio, the associatedallowance for credit losses and non-performing assets:

 
| ** **                     | ** ** | **June 30, 2004** | ** ** |
|--------------------------------|------------|-------------------|------------|
| ** **                     | ** ** | **Gross UPB**     | ** ** | **Allocated  Allowance** | ** ** | **(1) Non-  performing** | ** ** | **Allowance /  NPA** | ** ** | **NPA /  Gross  UPB** | ** ** |
| **Held for investment assets** |       |              |       |   |   |   |   |   |   |   |   |
| Residential mortgages          |       | $                 | 1,650,947  |   | $ | 9,376 |   | $ | 1,036 |   | 905.0 | % | 0.1 | % |
| Leases                         |       | 293,454           |       | 12,188 |   | 1,308 |   | 931.8 | % | 0.4 | % |
| Home equity lines              |       | 71,849            |       | 1,196 |   | 123 |   | 972.4 | % | 0.2 | % |
| Consumer                       |       | 2,750             |       | 112 |   | — |   | 0.0 | % | 0.0 | % |
| Auto                           |       | 276,859           |       | 1,931 |   | 163 |   | 1184.7 | % | 0.1 | % |
| Loan and lease receivables     |       | 2,295,859         |       | 24,803 |   | 2,630 |   | 943.1 | % | 0.1 | % |
| CMC leases (2)                 |       | 82,514            |       | 21,230 |   | 82,514 |   | 25.7 | % | 100.0 | % |
| Loan and lease receivables     |       | $                 | 2,378,373  |   | $ | 46,033 |   | $ | 85,144 |   | 54.1 | % | 3.6 | % |

 

19

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| ** **                       | ** ** | **December 31, 2003** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **Gross UPB**         | ** ** | **Allocated  Allowance** | ** ** | **(1) Non-  performing** | ** ** | **Allowance /  NPA** | ** ** | **NPA /  Gross  UPB** | ** ** |
| **Held for investment assets**   |       |                  |       |   |   |   |   |   |   |   |   |
| Residential mortgages            |       | $                     | 1,309,689  |   | $ | 10,087 |   | $ | 2,436 |   | 414.1 | % | 0.2 | % |
| Leases                           |       | 266,957               |       | 10,427 |   | 1,430 |   | 729.2 | % | 0.5 | % |
| Home equity lines                |       | 50,816                |       | 829 |   | 339 |   | 244.5 | % | 0.7 | % |
| Consumer                         |       | 1,880                 |       | 62 |   | 1 |   | 6200.0 | % | 0.1 | % |
| Auto                             |       | 92,724                |       | 1,054 |   | 27 |   | 3903.7 | % | 0.0 | % |
| Loan and lease receivables       |       | 1,722,066             |       | 22,459 |   | 4,233 |   | 530.6 | % | 0.2 | % |
| CMC leases (2)                   |       | 82,995                |       | 21,230 |   | 82,995 |   | 25.6 | % | 100.0 | % |
| Total loan and lease receivables |       | $                     | 1,805,061  |   | $ | 43,689 |   | $ | 87,228 |   | 50.1 | % | 4.8 | % |

 

----

(1)            Non-performingassets (“NPA”) include all loans and leases that are 90 days or more delinquentor on non-accrual status.  The tablesabove do not include $32,081 and $46,409 of non-performing loans classified asheld for sale as of June 30, 2004 and December 31, 2003, respectively.  Since loans classified as held for sale arecarried at the lower of cost or market, the estimated losses that may occurhave already been recorded in both the balance sheet and statement ofoperations.

 

(2)            Thereader is directed to Part II. Item 1.Legal Proceedings contained within this report for additional detail regardingthe CMC litigation.

 

*MortgageServicing Rights.*  Beginning in late 2002, NetBankadopted a long-term strategy of retaining primarily all of its originatedconventional MSRs in order to achieve the necessary critical mass for theservicing division to become operationally profitable.  During the second quarter of 2004, however,based on market conditions, the Company chose to sell approximately 50% of itsmortgage loan production servicing released. For the six months ended June 30, 2004, the value of NetBank’s MSRsincreased $35 million or 21%.  The $35million increase in value was primarily driven by the capitalization of $34million of retained servicing coupled with the recovery of $20 million of inmarket value.  These increases wereoffset, in part, by $19 million of amortization.

 

*Derivatives.*The fairvalue of hedges covering the available for sale servicing portfolio decreasedin value by $11,541 during the six months ended June 30, 2004.  The fair value of hedges covering thepipeline of servicing also decreased in value by $1,453 during the six monthsended June 30, 2004.  As discussed in thepreceding section, the decline in value of the Company’s servicing hedges wereoffset by an increase in value in the portfolio of available for sale mortgageservicing rights.  The fair value of theCompany’s loan commitments for which the interest rate is locked (“rate locks”)declined in value by $749 during the six months ended June 30, 2004; however,the portfolio of mandatory delivery commitments hedging the Company’s ratelocks increased in value by $735 during the same period.  The value of the mandatory deliverycommitments hedging the Company’s inventory of closed loans also increased invalue by $3,999 during the same period.

 

*Liabilities.* Totalliabilities increased $440 million during the six months ended June 30,2004.  The increase was primarily relatedto a $638 million increase in other borrowed funds, which were used to supportthe higher level of loans held for investment. These increases were partially offset by a $91 million or 4% decline indeposits, and $132 million decline in unsettled trades.

 

*Deposits.*  Deposits were $2.4 billion at June 30, 2004,a 4% decrease compared to $2.5 billion at December 31, 2003.  As of June 30, 2004, deposits represented 54%of total interest-bearing liabilities (including deposits, other borrowed fundsand subordinated debt) outstanding.  FHLBadvances, warehouse lines of credit and repurchase agreements representedapproximately 46%, and subordinated debt represented less than 1%.  During the six months ended June 30, 2004,NetBank was able to achieve a lower cost of funds on deposits by replacing highrate single relationship accounts, generally CDs or money market accounts, withlower rate multiple relationship customers that are not as rate sensitive.

 

20

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NetBank will continue workingto deepen its relationships with new and existing customers.  The following table summarizes NetBank’sdeposits:

 
| ** **                             | ** ** | **As of June 30, 2004** | ** ** | **As of December 31, 2003** | ** ** |
|----------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                             | ** ** | **Amount**              | ** ** | **Percentage**              | ** ** | **Weighted  average  interest  rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest  rate** | ** ** |
| Non-interest bearing checking accounts |       | $                       | 253,317    |                        | 10.4       | % | N/A |   | $ | 198,884 |   | 7.8 | % | N/A |   |
|                                   |       |                    |       |                        |       |   |   |   |   |   |   |   |   |
| Interest bearing:                      |       |                    |       |                        |       |   |   |   |   |   |   |   |   |
| Checking accounts                      |       | 240,914                 |       | 9.8                         | %          | 1.1 | % | 228,178 |   | 9.0 | % | 1.4 | % |
| Money market                           |       | 1,289,536               |       | 52.7                        | %          | 1.7 | % | 1,363,294 |   | 53.7 | % | 1.9 | % |
| Certificate of deposit under $100      |       | 548,952                 |       | 22.4                        | %          | 2.7 | % | 632,602 |   | 24.9 | % | 2.8 | % |
| Certificate of deposit over $100       |       | 115,766                 |       | 4.7                         | %          | 2.7 | % | 116,469 |   | 4.6 | % | 2.8 | % |
| Total deposits                         |       | $                       | 2,448,485  |                        | 100.0      | % |   |   | $ | 2,539,427 |   | 100.0 | % |   |   |

* *

*Shareholders’Equity.*  Totalshareholders’ equity increased $160 for the six months ended June 30,2004.  The increase is primarily due to a$15,786 increase in retained earnings resulting from $17,861 of net income,offset by $1,879 of dividends and $196 of losses on the reissuance of treasurystock.  The increase in retained earningswas offset by a decrease of $4,717 in accumulated other comprehensive income(OCI), and an increase in treasury stock of $10,695 due to the repurchase of1,041,036 shares of common stock at a weighted average cost of $11.81 per shareoffset, in part, by the reissuance of 129,681 shares under the employee stockpurchase plan and exercise of employee stock options.  NetBank will continue to repurchase sharesperiodically in the public market or through private transactions.  In April 2004 the Board of Directorsincreased the number of shares available for repurchase by one million.  Including this increase, there areapproximately 1.1 million shares remaining available for repurchase undercurrent Board authority.

 

**Results ofOperations – Three months ended June 30, 2004 compared to the three monthsended June 30, 2003**

 

*General.* Net income for the three months ended June 30, 2004 was $8,467 or $0.18 pershare, compared to net income of $14,213 or $0.29 per share, for the sameperiod in 2003. NetBank’s management capitalized on the favorable interest rateenvironment in the second quarter of 2003 to post strong revenues from itsfinancial intermediary segment.  Incontrast, rising interest rates and interest rate volatility during the secondquarter of 2004 adversely impacted the results reported from the financialintermediary segment.  Mortgageproduction dropped from $5.6 billion to $3.9 billion, while sales of mortgagesdropped from $4.7 billion to $3.4 billion comparing the second quarter of 2003to 2004, respectively.  NetBank alsoexperienced pressure on its margins in the financial intermediary segment fromincreasing competition, especially in the correspondent channel.  The financial intermediary segment’s netincome was down by $19.3 million as a result. This was offset, in part, by improved results in the retail bank segmentwhich posted income of $3,011 during the second quarter of 2004 compared with aloss of $10,310 for the second quarter of 2003.

 

*InterestIncome*.  NetBank’s interest income for the threemonths ended June 30, 2004 was $58,677 compared to $50,341 for the same periodin 2003.  As detailed in the followingrate volume variance table, NetBank lowered the average balance of itsinvestment securities available for sale and loans held for sale by $93,465 and$134,708, respectively, and increased the average balance of loan and leasereceivables by $1,063,181.  This repositioningresulted in a positive volume variance of $10,295 due to the increase inaverage interest-earning assets.  Thiswas partially offset by a $1,959 negative variance due to lower yields.  The increase in loan and lease receivables isprincipally the result of the bank retaining primarily adjustable ratemortgages originated by the financial intermediary segment.  During the current quarter NetBank retained$350 million of internally originated mortgage loans, approximately $124million of internally originated auto loans and $42 million of originatedbusiness finance loans and leases.  Asdiscussed in note 11 of the consolidated financial statements included withinthis report, the Company has not accrued and did not receive approximately $575and $1,354 of interest related to the CMC lease portfolio during the threemonths ended June 30,

 

21

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2004 and 2003,respectively.  See Part II. Item 1. LegalProceedings within this report for a more in depth discussion of the CMC leaseportfolio and associated litigation.

 

*InterestExpense*. Total interest expense for the three monthsended June 30, 2004 was $22,178 compared to $21,633 for the same period of2003.  The $545 increase is due to anincrease of $633,543 in interest-bearing liabilities, offset, in part, by theimpact of a 33 basis-point reduction in the average cost of funds.  For the three months ended June 30, 2004there was $10,684 of interest expense on deposits (including checking, moneymarket and certificates of deposits) as compared to $12,534 for the threemonths ended June 30, 2003.  The $1,850 net decrease in interest expenseon deposits was the result of a 25 basis-point decline in the average rate paidon deposits resulting in a positive $439 rate variance, coupled with a volumevariance of $1,411 due to a decrease in average interest-bearing depositbalances of $82,429.  For the threemonths ended June 30, 2004 interest expense on other borrowed funds (includingshort-term debt, FHLB advances, and convertible subordinated debt) was $11,494compared to $9,099 for the same period of 2003. The $2,395 increase in interest expense related to other borrowed fundsis the result of an increase of $715,972 in the average outstanding balance,offset, in part, by a 69 basis-point decline in the average cost of funds.  The 69 basis-point reduction in the averagecost of other borrowed funds is primarily due to higher fixed-rate term FHLBadvances being prepaid during the second half of 2003.

 

*NetInterest Income. *Netinterest income is determined by interest rate spread, which is the differencebetween the yields earned on interest-earning assets and the rates paid oninterest-bearing liabilities, and the relative amounts of interest-earningassets and interest-bearing liabilities. Net interest income was $36,499, or 3.20% of average interest-earningassets for the three months ended June 30, 2004, compared to $28,708, or 3.12%,of average interest-earning assets for the three months ended June 30, 2003.

 

The following table details the relative interest rates and averagebalances of NetBank’s interest-earning assets and interest-bearing liabilitiesfor the three months ended June 30, 2004, and 2003:

 
| **Average Balance** | ** ** | **Average Yield /  Rate** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** **                          | ** **             | **Variance attributable to**                   | ** ** |
|---------------------|------------|---------------------------|------------|------------|------------|--------------|------------|-------------------------------------|------------------------|------------------------------------------------|------------|
| **2004**            | ** ** | **2003**                  | ** ** | **2004**   | ** ** | **2003**     | ** ** | ** **                          | ** **             | **2004**                                       | ** ** | **2003** | ** ** | **Variance** | ** ** | **Rate** | ** ** | **Volume (3****)** | ** ** |
| ** **          |       |                      |       |       |       |         |       | **Interest-earning  assets:**       |                   |                                           |       |   |   |   |   |   |   |   |   |
| $                   | 76,187     |                      | 34,956     |       | 1.00       | %            | 1.00       | %                                   | Short-term investments |                                           | $          | 190 |   | $ | 87 |   | $ | 103 |   | $ | — |   | $ | 103 |   |
| 445,432             |       | 538,897                   |       | 3.51       | %          | 3.97         | %          | Investment securities (1)           |                   | 3,905                                          |       | 5,351 |   | (1,446 | ) | (627 | ) | (819 | ) |
| 1,869,731           |       | 2,004,439                 |       | 6.00       | %          | 6.27         | %          | Loans held for sale (2)             |                   | 28,051                                         |       | 31,417 |   | (3,366 | ) | (1,345 | ) | (2,021 | ) |
| 2,164,506           |       | 1,101,325                 |       | 4.90       | %          | 4.90         | %          | Loans and leases receivable  (2)    |                   | 26,531                                         |       | 13,486 |   | 13,045 |   | 13 |   | 13,032 |   |
| 4,555,856           |       | 3,679,617                 |       | 5.15       | %          | 5.47         | %          | Total interest-earning  assets      |                   | 58,677                                         |       | 50,341 |   | 8,336 |   | (1,959 | ) | 10,295 |   |
|                |       |                      |       |       |       |         |       |                                |                   |                                           |       |   |   |   |   |   |   |   |   |
| ** **          |       |                      |       |       |       |         |       | **Interest-bearing  liabilities:**  |                   |                                           |       |   |   |   |   |   |   |   |   |
| 238,923             |       | 183,766                   |       | 1.12       | %          | 1.55         | %          | Checking accounts                   |                   | 669                                            |       | 711 |   | (42 | ) | (196 | ) | 154 |   |
| 1,315,623           |       | 1,079,564                 |       | 1.65       | %          | 2.14         | %          | Money market                        |                   | 5,428                                          |       | 5,786 |   | (358 | ) | (1,332 | ) | 974 |   |
| 675,051             |       | 1,048,696                 |       | 2.72       | %          | 2.30         | %          | Certificates of deposit             |                   | 4,587                                          |       | 6,037 |   | (1,450 | ) | 1,089 |   | (2,539 | ) |
| 1,023,186           |       | 595,846                   |       | 1.89       | %          | 2.08         | %          | Short-term debt                     |                   | 4,837                                          |       | 3,099 |   | 1,738 |   | (282 | ) | 2,020 |   |
| 840,196             |       | 528,737                   |       | 3.10       | %          | 4.23         | %          | FHLB advances                       |                   | 6,512                                          |       | 5,590 |   | 922 |   | (1,492 | ) | 2,414 |   |
| 11,857              |       | 8,326                     |       | 4.89       | %          | 4.66         | %          | Subordinated debt                   |                   | 145                                            |       | 97 |   | 48 |   | 5 |   | 43 |   |
| —              |       | 26,358                    |       | 0.00       | %          | 4.75         | %          | Convertible subordinated  debt      |                   | —                                         |       | 313 |   | (313 | ) | — |   | (313 | ) |
| 4,104,836           |       | 3,471,293                 |       | 2.16       | %          | 2.49         | %          | Total interest-bearing  liabilities |                   | 22,178                                         |       | 21,633 |   | 545 |   | (2,208 | ) | 2,753 |   |
|                |       |                      |       |       |       |         |       |                                |                   |                                           |       |   |   |   |   |   |   |   |   |
| —              |       | —                    |       | 2.99       | %          | 2.98         | %          | Net interest margin                 |                   | 36,499                                         |       | 28,708 |   | 7,791 |   | 249 |   | 7,542 |   |
| 451,020             |       | 208,324                   |       | 0.21       | %          | 0.14         | %          | Interest free sources               |                   | —                                         |       | — |   | — |   | — |   | — |   |
| $                   | 4,555,856  |                      | $          | 3,679,617  |       | 3.20         | %          | 3.12                                | %                      | Net interest income to interest-earning assets |       | $ | 36,499 |   | $ | 28,708 |   | $ | 7,791 |   | $ | 249 |   | $ | 7,542 |   |
|                     |            |                           |            |            |            |              |            |                                     |                        |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

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

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

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

 

22

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*Provisionfor Credit Losses.*  The provision for creditlosses was $1,666 for the three months ended June 30, 2004, compared to $894for the same period of 2003.  Theincrease in provision relates to the increase in loans retained during thequarter.  During the three months endedJune 30, 2004, NetBank retained its originated auto loans of $124 million,originated mortgage loans of $350 million, and originated leases of $42million.  During the three months endedJune 30, 2003, NetBank retained originated mortgage loans of $204 million andoriginated leases of $36 million. Reference is made to the asset quality and non-performing assets sectionin the financial condition section contained within this report for additionaldetail concerning the determination of provision expense related to maintainingthe proper level of allowance for credit losses.

 

*Non-interestIncome.* Non-interest income declined $29,934 forthe three months ended June 30, 2004 compared to the same period of 2003.  This decline was primarily driven by the$25,725 decline in gain on sales of loans due to the $1.4 billion or 31%decline in sales of mortgage loans.  Thedecline in sales was compounded by the decline in margins on sales due toincreased competitive pressures.  Otherincome declined by $3,333 primarily due to lower servicing hedge results as aresult of generally increasing mortgage interest rates compared to the same periodof 2003.  Additionally, the currentquarter was absent the $5,062 of gains on sales of investment securitiesrecognized in the second quarter of 2003. These declines were offset, in part, by an increase of $4,186 in servicecharges and fees.  The increase inservice charges and fees was driven primarily by the addition of NPS in thetransaction processing segment and higher fees in the retail bank segment.

 

*Non-interestExpense.*  Non-interest expense includes alloperating expenses such as salaries and benefits, marketing and general and administrativeexpenses.  Non-interest expense decreased$13,923, or 16%, for the three months ended June 30, 2004 compared to the sameperiod of 2003.  This decline wasprimarily driven by the $13,500 decline in impairment and amortization ofmortgage servicing rights due to the leveling off of long-term mortgagerates.  Reference is made to the mortgageservicing rights sub-section of the financial condition section containedwithin this report for a more in-depth analysis of this change.  Additionally, the three months ended June 30,2004 did not include the $5,975 of prepayment fees incurred due to the earlyextinguishment of fixed rate FHLB advances during the same period of 2003.  These declines in expenses were partiallyoffset by increases in professional fees of $1,288, depreciation andamortization of $1,178 and occupancy expense of $1,133.  The increase in professional fees wasassociated with higher legal fees as the Company ramped-up its discoveryprocess related to the CMC litigation. Depreciation and amortization and occupancy were generally higher as theCompany’s operations expanded period-over-period with the additions of NetBankDealer Financial Services, (“DFS”), NPS and NetInsurance.

 

# ***Retail Bank Operations***

 

The table below provides an overviewof the results of operations for the retail bank segment:

 

 
| ** **                                                                            | ** ** | **2004  2nd Qtr** | ** **     | **2003  2nd Qtr** | ** ** | **Change** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------|----------------|-------------------|------------|------------|------------|
| Net interest income                                                                   |       | **$**             | **19,750**     | ** **        | $          | 11,281     |       | $ | 8,469 |   |
| Provision for credit losses                                                           |       | **1,643**         | ** **     | 872               |       | 771        |       |
| Net interest income after provision                                                   |       | **18,107**        | ** **     | 10,409            |       | 7,698      |       |
| Fees, charges and other income                                                        |       | **3,262**         | ** **     | 2,822             |       | 440        |       |
| Total revenues                                                                        |       | **21,369**        | ** **     | 13,231            |       | 8,138      |       |
| Total expenses                                                                        |       | **17,344**        | ** **     | 15,045            |       | 2,299      |       |
| Pre-tax income before gains on securities,  debt and net servicing results            |       | **4,025**         | ** **     | (1,814            | )          | 5,839      |       |
| Net gain on securities and prepaid debt                                               |       | **—**        | ** **     | (913              | )          | 913        |       |
| Net servicing results                                                                 |       | **759**           | ** **     | (13,638           | )          | 14,397     |       |
| Pre-tax income (loss)                                                                 |       | **$**             | **4,784**      | ** **        | $          | (16,365    | )          | $ | 21,149 |   |
|                                                                                  |       | ** **        | ** **     |              |       |       |       |
| Earning assets                                                                        |       | **$**             | **4,289,058**  | ** **        | $          | 3,776,594  |       | $ | 512,464 |   |
| UPB underlying MSRs                                                                   |       | **$**             | **12,889,546** | ** **        | $          | 9,268,773  |       | $ | 3,620,773 |   |
|                                                                                  |       | ** **        | ** **     |              |       |       |       |
| **Efficiencies to earning assets**                                                    |       | ** **        | ** **     |              |       |       |       |
| Net interest income                                                                   |       | **1.84**          | **%**          | 1.19              | %          | 0.65       | %          |
| Provision                                                                             |       | **0.15**          | **%**          | 0.09              | %          | 0.06       | %          |
| Net interest income after provision                                                   |       | **1.69**          | **%**          | 1.10              | %          | 0.59       | %          |
| Fees, charges and other income                                                        |       | **0.30**          | **%**          | 0.30              | %          | 0.00       | %          |
| Banking revenues                                                                      |       | **1.99**          | **%**          | 1.40              | %          | 0.59       | %          |
| Total expenses                                                                        |       | **1.62**          | **%**          | 1.59              | %          | 0.03       | %          |
| Pre-tax income (loss) before net gains on  securities, debt and net servicing results |       | **0.37**          | **%**          | (0.19             | )%         | 0.56       | %          |
|                                                                                  |       | ** **        | ** **     |              |       |       |       |
| Net servicing results to UPB underlying  MSRs                                         |       | **0.02**          | **%**          | (0.59             | )%         | 0.61       | %          |

 

23

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Pre-tax income improved by $21,149 to $4,784 for the three months endedJune 30, 2004, compared with a pre-tax loss of $16,365 for the same period in2003.

 

Improvements in net interest income of $8,469, net servicing results of$14,397, net gain on securities and prepayment of debt of $913, and fees,charges and other income of $440 resulted in the improvementperiod-over-period.  Net interest incomeimproved primarily because of the retention over the past year of originatedassets including mortgages, leases and auto loans.  Likewise, during 2003, the retail bankingsegment prepaid a large number of higher-priced term FHLB advances and, throughpricing, moved the mix of deposits from higher cost certificates of deposit tolower cost money market and checking accounts. These asset-liability strategies have improved net interest income by0.65% to 1.84% for the three months ended June 30, 2004 compared with 1.19% forthe same period in 2003.  Net servicingresults improved primarily as the result of a $15 million increase in marketvalue due to a stabilization of long-term mortgage rates compared with thecomparable period in 2003.  Theimprovement in fees, charges and other income relates to the increase intransactional accounts (i.e. checking and money market) period over period.

 

These improvements in earnings were offset, in part, by increases of$771 in provision for credit losses and increases in operating expenses of$2,299.  The provision for credit lossesincreased as the result of the increase in retention of originated mortgages,business finance loans and leases, and auto loans during the three months endedJune 30, 2004 compared with the comparable period of 2003.  The increase in operating expenses relatesprimarily to higher legal fees as the Company ramped-up its discovery processrelated to the CMC litigation.

 

*Financial Intermediary*

 

The following table highlights the financial intermediary segmentproduction and sales activities:

 
| ** **                           | ** ** | **2004  2nd Qtr** | ** **    | **2003  2nd Qtr** | ** ** | **change** | ** ** |
|--------------------------------------|------------|-------------------|---------------|-------------------|------------|------------|------------|
| Net interest income                  |       | **$**             | **16,403**    | ** **        | $          | 17,887     |       | $ | (1,484 | ) |
| Gain on sales of loans               |       | **35,442**        | ** **    | 61,095            |       | (25,653    | )          |
| Other income                         |       | **(590**          | **)**         | 1,417             |       | (2,007     | )          |
| Net MG Reinsurance results           |       | **535**           | ** **    | 554               |       | (19        | )          |
| Total revenues                       |       | **51,790**        | ** **    | 80,953            |       | (29,163    | )          |
| Salary and employee benefits         |       | **23,900**        | ** **    | 24,684            |       | (784       | )          |
| Occupancy & Depreciation expense |       | **7,002**         | ** **    | 4,969             |       | 2,033      |       |
| Other expenses                       |       | **8,352**         | ** **    | 8,093             |       | 259        |       |
| Total expenses                       |       | **39,254**        | ** **    | 37,746            |       | 1,508      |       |
| Pre-tax income                       |       | **$**             | **12,536**    | ** **        | $          | 43,207     |       | $ | (30,671 | ) |
|                                 |       | ** **        | ** **    |              |       |       |       |
| Production                           |       | **$**             | **3,903,437** | ** **        | $          | 5,601,530  |       | $ | (1,698,093 | ) |
| Sales                                |       | **$**             | **3,433,347** | ** **        | $          | 4,749,440  |       | $ | (1,316,093 | ) |
|                                 |       | ** **        | ** **    |              |       |       |       |
| **Efficiencies**                     |       | ** **        | ** **    |              |       |       |       |
| Total revenues to sales              |       | **1.51**          | **%**         | 1.70              | %          | (0.19      | )%         |
| Total expenses to production         |       | **1.01**          | **%**         | 0.67              | %          | 0.34       | %          |
| Pre-tax margin                       |       | **0.50**          | **%**         | 1.03              | %          | (0.53      | )%         |

 

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

 

24

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The interest rate environmentduring the second quarter of 2003 was much more favorable to mortgageproduction than the environment during the comparable 2004 quarter.  In 2003, mortgage rates were hitting historiclows.  The loan pipelines of originatorsthroughout the mortgage banking industry were filled, resulting in lesspressure on margins.  During the latterpart of 2003 and continuing into the first quarter of 2004, mortgage ratesrose, and competitive pressures heated up as pipeline volumes decreased.  This margin pressure was especially true inthe correspondent channel.  This resultedin a decrease in mortgage production of $1.7 billion and a decrease in sales of$1.3 billion.  The competitive pressuresreduced revenue margins from 170 bps for the quarter ended June 30, 2003 to 151bps for the comparable quarter in 2004. As a result, revenues decreased $29.2 million.  Expenses increased $1,508.  Expenses in bps of production increased from67 bps to 101 bps from the quarter ended June 30, 2003 to the comparablequarter in 2004.  This was the result ofless leverage of fixed expenses during the quarter ended June 30, 2004.

 

*TransactionProcessing Segment*

 

The transaction processing segment processesmortgages on behalf of community banks on a private label basis; provides ATMand merchant processing services; subservices loans for the retail banksegment, financial intermediary segment and for third party customers; andsells various insurance products using an Internet-based platform.

 

The following table highlightsthe results of operations for the transaction processing segment:

 
| ** **     | ** ** | **2004  2nd Qtr** | ** ** | **2003  2nd Qtr** | ** ** | **change** | ** ** |
|----------------|------------|-------------------|------------|-------------------|------------|------------|------------|
| Total revenue  |       | **$**             | **6,928**  | ** **        | $          | 4,922      |       | $ | 2,006 |   |
| Total expenses |       | **8,070**         | ** ** | 5,967             |       | 2,103      |       |
|           |       | **$**             | **(1,142** | **)**             | $          | (1,045     | )          | $ | (97 | ) |

 

The transaction processingsegment remained flat comparing the quarter ended June 30, 2004 to June 30,2003.  NPS added $605 of pre-tax incometo the segment’s results; however, this was offset, in part, by weaker resultsin the RMS processing unit, related to lower volumes of loans processed, and inthe NetInsurance division.

 

**Results ofOperations – Six months ended June 30, 2004, compared to the six months endedJune 30, 2003**

 

*General.* Net income for the six months ended June 30, 2004 was $17,861 or $0.38 pershare, compared to net income of $24,915 or $0.51 per share, for the sameperiod in 2003. NetBank’s management capitalized on the favorable interest rateenvironment during the first six months of 2003 to post strong revenues fromits financial intermediary segment.  In

 

25

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contrast, rising interest ratesand interest rate volatility during the first six months of 2004 adverselyimpacted the results reported from the financial intermediary segment.  Mortgage production dropped from $10.0billion to $7.2 billion, while sales of mortgages dropped from $8.4 billion to$6.6 billion comparing the first six months of 2003 to 2004, respectively.  NetBank also experienced pressure on its marginsin the financial intermediary segment from increasing competition, especiallyin the correspondent channel.  Thefinancial intermediary segment’s net income was down by $31,515 as a result.  This was offset, in part, by improved resultsin the retail bank segment which posted income of $5,856 during the first sixmonths of 2004 compared with a loss of $16,692 for the first six months of2003.

 

*InterestIncome*.  NetBank’s interest income for the sixmonths ended June 30, 2004 was $110,862 compared to $95,343 for the same periodin 2003.  As detailed in the followingrate volume variance table, NetBank lowered the average balance of itsinvestment securities available for sale by $155,385 and increased the averagebalance of loan and lease receivables by $991,930.  This repositioning resulted in a $22,284positive variance due to the increase in average interest-earning assets,partially offset by a $6,765 negative variance due to lower yields.  The increase in loan and lease receivables isprincipally the result of the bank retaining primarily adjustable ratemortgages originated by the financial intermediary segment.  During the six months ended June 30, 2004,NetBank retained $643 million of internally originated mortgage loans,approximately $210 million of internally originated auto loans and $82 millionof originated business finance loans and leases.  As discussed in note 11 of the consolidatedfinancial statements included within this report, the Company has not accruedand has not received approximately $1,342 and $2,892 of interest related to theCMC lease portfolio during the six months ended June 30, 2004 and 2003,respectively.  See Part II. Item 1. LegalProceedings within this report for a more in depth discussion of the CMC leaseportfolio and associated litigation.

 

*InterestExpense*. Total interest expense remained flat for thesix months ended June 30, 2004, at $42,614 compared to $43,132 for the sameperiod of 2003.  The $518 decline is dueto an increase of $701,873 in interest-bearing liabilities, offset, in part, bythe impact of a 49 basis-point reduction in the average cost of funds.  For the six months ended June 30, 2004 therewas $22,502 of interest expense on deposits (including checking, money marketand certificates of deposits) as compared to $24,980 for the six months endedJune 30, 2003.  The $2,478 net decrease in interest expense on depositswas the result of a 30 basis-point decline in the average rate paid ondeposits, offset, in part, by an increase in the average interest-bearingdeposit balances of $83,692.  For the sixmonths ended June 30, 2004, interest expense on other borrowed funds (includingshort-term debt, FHLB advances, and convertible subordinated debt) was $20,112compared to $18,152 for the same period of 2003.  The $1,960 increase in interest expenserelated to other borrowed funds is the result of an increase of $618,181 in theaverage outstanding balance, offset, in part, by a 102 basis-point decline inthe average cost of funds.  The 102basis-point reduction in the average cost of other borrowed funds is primarilydue to higher fixed-rate term FHLB advances being prepaid during 2003.

 

*NetInterest Income. *Netinterest income is determined by interest rate spread, which is the differencebetween the yields earned on interest-earning assets and the rates paid oninterest-bearing liabilities, and the relative amounts of interest-earningassets and interest-bearing liabilities. Net interest income was $68,248, or 3.14% of average interest-earningassets for the six months ended June 30, 2004, compared to $52,211, or 3.01% ofaverage interest-earning assets for the six months ended June 30, 2003.

 

26

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The following table details the relative interest rates and averagebalances of NetBank’s interest-earning assets and interest-bearing liabilitiesfor the six months ended June 30, 2004, and 2003:

 
| **Average Balance** | ** ** | **Average Yield /  Rate** | ** ** | ** ** | ** ** | **Interest** | ** **        | ** **                          | ** ** | **Variance  attributable to**                  | ** ** |
|---------------------|------------|---------------------------|------------|------------|------------|--------------|-------------------|-------------------------------------|------------|------------------------------------------------|------------|
| ** **          | ** ** | ** **                | ** ** | ** ** | ** ** | ** **   | **Volume(3****)** | ** **                          |
| **2004**            | ** ** | **2003**                  | ** ** | **2004**   | ** ** | **2003**     | ** **        | ** **                          | ** ** | **2004**                                       | ** ** | **2003** | ** ** | **Variance** | ** ** | **Rate** | ** ** | ** ** |
| ** **          |       |                      |       |       |       |         |              | **Interest-earning  assets:**       |       |                                           |       |   |   |   |   |   |   |   |   |
| $                   | 73,852     |                      | $          | 36,315     |       | 1.00         | %                 | 1.21                                | %          | Short-term investments                         |       | $ | 370 |   | $ | 219 |   | $ | 151 |   | $ | (38 | ) | $ | 189 |   |
| 449,405             |       | 604,790                   |       | 3.50       | %          | 3.96         | %                 | Investment securities (1)           |       | 7,871                                          |       | 11,960 |   | (4,089 | ) | (1,391 | ) | (2,698 | ) |
| 1,813,295           |       | 1,808,947                 |       | 5.80       | %          | 6.39         | %                 | Loans held for sale (2)             |       | 52,569                                         |       | 57,785 |   | (5,216 | ) | (5,336 | ) | 120 |   |
| 2,013,898           |       | 1,021,968                 |       | 4.97       | %          | 4.97         | %                 | Loans and leases receivable  (2)    |       | 50,052                                         |       | 25,379 |   | 24,673 |   | — |   | 24,673 |   |
| 4,350,450           |       | 3,472,020                 |       | 5.10       | %          | 5.49         | %                 | Total interest-earning  assets      |       | 110,862                                        |       | 95,343 |   | 15,519 |   | (6,765 | ) | 22,284 |   |
|                |       |                      |       |       |       |         |              |                                |       |                                           |       |   |   |   |   |   |   |   |   |
| ** **          |       |                      |       |       |       |         |              | **Interest-bearing  liabilities:**  |       |                                           |       |   |   |   |   |   |   |   |   |
| 233,020             |       | 175,946                   |       | 1.18       | %          | 1.55         | %                 | Checking accounts                   |       | 1,373                                          |       | 1,361 |   | 12 |   | (326 | ) | 338 |   |
| 1,336,270           |       | 992,384                   |       | 1.70       | %          | 2.19         | %                 | Money market                        |       | 11,326                                         |       | 10,885 |   | 441 |   | (2,431 | ) | 2,872 |   |
| 713,578             |       | 1,030,846                 |       | 2.75       | %          | 2.47         | %                 | Certificates of deposit             |       | 9,803                                          |       | 12,734 |   | (2,931 | ) | 1,443 |   | (4,374 | ) |
| 821,343             |       | 465,763                   |       | 1.95       | %          | 2.16         | %                 | Short-term debt                     |       | 7,994                                          |       | 5,019 |   | 2,975 |   | (489 | ) | 3,464 |   |
| 849,547             |       | 564,958                   |       | 2.79       | %          | 4.36         | %                 | FHLB advances                       |       | 11,832                                         |       | 12,311 |   | (479 | ) | (4,435 | ) | 3,956 |   |
| 11,857              |       | 6,354                     |       | 4.82       | %          | 4.69         | %                 | Subordinated debt                   |       | 286                                            |       | 149 |   | 137 |   | 4 |   | 133 |   |
| —              |       | 27,491                    |       | 0.00       | %          | 4.90         | %                 | Convertible subordinated  debt      |       | —                                         |       | 673 |   | (673 | ) | (674 | ) | 1 |   |
| 3,965,615           |       | 3,263,742                 |       | 2.15       | %          | 2.64         | %                 | Total interest-bearing  liabilities |       | 42,614                                         |       | 43,132 |   | (518 | ) | (6,908 | ) | 6,390 |   |
|                |       |                      |       |       |       |         |              |                                |       |                                           |       |   |   |   |   |   |   |   |   |
| —              |       | —                    |       | 2.95       | %          | 2.85         | %                 | Net interest margin                 |       | 68,248                                         |       | 52,211 |   | 16,037 |   | 143 |   | 15,894 |   |
| 384,835             |       | 208,278                   |       | 0.19       | %          | 0.16         | %                 | Interest free sources               |       | —                                         |       | — |   | — |   | — |   | — |   |
| $                   | 4,350,450  |                      | $          | 3,472,020  |       | 3.14         | %                 | 3.01                                | %          | Net interest income to interest-earning assets |       | $ | 68,248 |   | $ | 52,211 |   | $ | 16,037 |   | $ | 143 |   | $ | 15,894 |   |
|                     |            |                           |            |            |            |              |                   |                                     |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

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

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

 

*Provision forCredit Losses.*  The provision for credit losseswas $3,513 for the six months ended June 30, 2004, compared to $1,762 for thesame period of 2003.  The increase inprovision relates to the increase in loans and leases retained during theperiods.  During the six months endedJune 30, 2004, NetBank retained its originated auto loans of $210 million,originated mortgage loans of $643 million, and originated business financeloans or leases of $82 million; compared to retentions of originated mortgageloans of $480 million, originated auto loans of $5 million and originatedbusiness finance loans or leases of $67 million during 2003.  Reference is made to the asset quality andnon-performing assets section in the financial condition section containedwithin this report for additional detail concerning the determination ofprovision expense related to maintaining the proper level of allowance forcredit losses.

 

*Non-interestIncome.* Non-interest income declined $42,387 forthe six months ended June 30, 2004 compared to the same period of 2003.  This decline was primarily driven by the$42,334 decline in gain on sales of loans due to the $1.9 billion, or 19%,decline in sales of mortgage loans.  Thedecline in sales was compounded by the decline in margins on sales due toincreased competitive pressures. Additionally, gains on sales of investment securities were lower by$8,225 for the six months ended June 30, 2004 compared to the same period of2003.  These declines were offset, inpart, by an increase of $9,892 in service charges and fees.  The increase in service charges and fees wasdriven primarily by the addition of NPS in the transaction processing segmentand higher fees in the retail banking segment.

 

*Non-interestExpense.*  Non-interest expense includes alloperating expenses such as salaries and benefits, marketing and general andadministrative expenses.  Non-interestexpense decreased $17,170, or 11%, for the six months ended June 30, 2004compared to the same period of 2003. This decline was primarily driven by the $13,055 decline in impairmentand amortization of mortgage servicing rights due to the leveling off oflong-term mortgage rates.  Reference ismade to the mortgage servicing rights sub-section of the financial conditionsection contained within this report for a more in-depth

 

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analysis of this change.  Additionally, the six months ended June 30,2004 did not include the $11,951 of prepayment fees incurred with the earlypayoff of fixed rate FHLB advances during the same period of 2003.  These declines in expenses were partiallyoffset by increases in depreciation and amortization of $2,425, professionalfees of $1,311 and occupancy expense of $1,954. The increase in professional fees was associated with higher legal feesas the Company ramped-up its discovery process related to the CMClitigation.  Depreciation andamortization and occupancy were generally higher as the Company’s operationsexpanded period over period with the additions of DFS, NPS and NetInsurance.

 

# ***Retail Bank Operations***

 

The table below provides anoverview of the results of operations for the retail bank segment:

 
| ** **                                                                           | ** ** | **Six Months  Ended June 30,** | ** **     |
|--------------------------------------------------------------------------------------|------------|--------------------------------|----------------|
| ** **                                                                           | ** ** | **2004**                       | ** **     | **2003** | ** ** | **Change** | ** ** |
| Net interest income                                                                  |       | **$**                          | **36,739**     | ** ** | $ | 19,378 |   | $ | 17,361 |   |
| Provision for credit losses                                                          | ** ** | **3,472**                      | ** **     | 1,721 |   | 1,751 |   |
| Net interest income after provision                                                  | ** ** | **33,267**                     | ** **     | 17,657 |   | 15,610 |   |
| Fees, charges and other income                                                       | ** ** | **7,247**                      | ** **     | 6,047 |   | 1,200 |   |
| Total revenues                                                                       | ** ** | **40,514**                     | ** **     | 23,704 |   | 16,810 |   |
| Total expenses                                                                       | ** ** | **32,999**                     | ** **     | 30,254 |   | 2,745 |   |
| Pre-tax income before gains on securities,  debt and net servicing results           | ** ** | **7,515**                      | ** **     | (6,550 | ) | 14,065 |   |
| Net gain on securities and prepaid debt                                              | ** ** | **3,169**                      | ** **     | (557 | ) | 3,726 |   |
| Net servicing results                                                                | ** ** | **(1,348**                     | **)**          | (19,389 | ) | 18,041 |   |
| Pre-tax income (loss)                                                                | ** ** | **$**                          | **9,336**      | ** ** | $ | (26,496 | ) | $ | 35,832 |   |
|                                                                                 |       |                           | ** **     |   |   |   |   |
| Earning assets                                                                       | ** ** | **$**                          | **4,222,710**  | ** ** | $ | 3,623,366 |   | $ | 599,344 |   |
| UPB underlying MSRs                                                                  | ** ** | **$**                          | **12,889,546** | ** ** | $ | 9,268,773 |   | $ | 3,620,773 |   |
|                                                                                 |       |                           | ** **     |   |   |   |   |
| **Efficiencies to earning assets**                                                   |       |                           | ** **     |   |   |   |   |
| Net interest income                                                                  | ** ** | **1.74**                       | **%**          | 1.07 | % | 0.67 | % |
| Provision                                                                            | ** ** | **0.16**                       | **%**          | 0.09 | % | 0.07 | % |
| Net interest income after provision                                                  | ** ** | **1.58**                       | **%**          | 0.98 | % | 0.60 | % |
| Fees, charges and other income                                                       | ** ** | **0.34**                       | **%**          | 0.33 | % | 0.01 | % |
| Banking revenues                                                                     | ** ** | **1.92**                       | **%**          | 1.31 | % | 0.61 | % |
| Total expenses                                                                       | ** ** | **1.56**                       | **%**          | 1.67 | % | (0.11 | )% |
| Pre-tax income(loss) before net gains on  securities, debt and net servicing results | ** ** | **0.36**                       | **%**          | (0.36 | )% | 0.72 | % |
|                                                                                 |       |                           | ** **     |   |   |   |   |
| Net servicing results to UPB underlying  MSRs                                        | ** ** | **(0.02**                      | **)%**         | (0.42 | )% | 0.40 | % |

 

Pre-tax income improved by $35,832 to $9,336 for the six months endedJune 30, 2004, compared with a pre-tax loss of $26,496 for the same period in2003.

 

Improvements in net interest income of $17,361, net gain on securitiesand prepayment of debt of $3,726, net servicing results of $18,041, and fees,charges and other income of $1,200 resulted in the improvement period overperiod.  Net interest income improvedprimarily because of the retention over the past year of originated assetsincluding mortgages, leases and auto loans. Likewise, during 2003, the retail banking segment prepaid a large numberof higher-priced term FHLB advances and, through pricing, moved the mix ofdeposits from higher cost certificates of deposit to lower cost money marketand checking accounts.  Theseasset-liability strategies have improved the net interest income by 0.67% to

 

28

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1.74% for the six months ended June 30, 2004 compared with 1.07% forthe same period in 2003.  The improvementin the gain on securities and prepayment of debt relates to the gain of $3.2 millionon the sale of certain securities in the bank’s investment portfolio as part ofthe bank’s proactive asset-liability management strategy whereby assets weresold to mitigate inherent risks.  Netservicing results improved as the result of a $15 million increase in themarket value of its mortgage servicing rights, a reduction in actualprepayments and improved net hedge results during the six months ended June 30,2004 compared with the comparable period in 2003.  The improvement in fees, charges and otherincome relates to the increase in transactional accounts (i.e. checking andmoney market) period over period.

 

These improvements in earnings were offset, in part, by increases of$1,751 in provision for credit losses and increases in operating expenses of$2,745.  The provision for credit lossesincreased as the result of the increase in retention of originated mortgages,business finance loans and leases, and auto loans during the six months endedJune 30, 2004 compared with the comparable period of 2003.  The increase in operating expenses relatesprimarily to higher legal fees as the Company ramped-up its discovery processrelated to the CMC litigation.

 

*Financial Intermediary*

 

The following table highlights the financial intermediary segment productionand sales activities:

 
| ** **                           | ** ** | **Six Months  Ended June 30,** | ** **    |
|--------------------------------------|------------|--------------------------------|---------------|
| ** **                           | ** ** | **2004**                       | ** **    | **2003** | ** ** | **Change** | ** ** |
| Net interest income                  | ** ** | **$**                          | **30,508**    |   | $ | 33,483 |   | $ | (2,975 | ) |
| Gain on sales of loans               | ** ** | **67,741**                     |          | 110,803 |   | (43,062 | ) |
| Other income                         | ** ** | **1,121**                      |          | 2,475 |   | (1,354 | ) |
| Net MG Reinsurance results           | ** ** | **1,042**                      |          | 1,110 |   | (68 | ) |
| Total revenues                       | ** ** | **100,412**                    |          | 147,871 |   | (47,459 | ) |
| Salary and employee benefits         | ** ** | **46,346**                     |          | 48,255 |   | (1,909 | ) |
| Occupancy & Depreciation expense | ** ** | **13,738**                     |          | 9,972 |   | 3,766 |   |
| Other expenses                       | ** ** | **15,909**                     |          | 15,308 |   | 601 |   |
| Total expenses                       | ** ** | **75,993**                     |          | 73,535 |   | 2,458 |   |
| Pre-tax income                       | ** ** | **$**                          | **24,419**    |   | $ | 74,336 |   | $ | (49,917 | ) |
|                                 |       |                           |          |   |   |   |   |
| Production                           | ** ** | **$**                          | **7,162,203** |   | $ | 9,958,953 |   | $ | (2,796,750 | ) |
| Sales                                | ** ** | **$**                          | **7,204,850** |   | $ | 8,894,956 |   | $ | (1,690,106 | ) |
|                                 | ** ** | ** **                     |          |   |   |   |   |
| **Efficiencies**                     | ** ** | ** **                     |          |   |   |   |   |
| Total revenues to sales              | ** ** | **1.39**                       | **%**         | 1.66 | % | (0.27 | )% |
| Total expenses to production         | ** ** | **1.06**                       | **%**         | 0.74 | % | 0.32 | % |
| Pre-tax margin                       | ** ** | **0.33**                       | **%**         | 0.92 | % | (0.59 | )% |

 

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

 

The interest rate environmentduring the six months ended June 30, 2003 was much more favorable to mortgageproduction than the environment during the comparable 2004 quarter.  In 2003, mortgage rates were hitting historiclows.  The loan pipelines of originatorsthroughout the mortgage banking industry were filled, resulting in lesspressure on margins.  During the latterpart of 2003 and continuing into the first quarter of 2004, mortgage ratesrose, and competitive pressures heated up as pipeline volumes decreased.  This margin pressure was especially true inthe correspondent channel.  This resultedin a decrease in mortgage production of $2.8 billion and a decrease in sales of$1.7 billion.  The competitive pressuresreduced revenue margins from 166 bps for the six months ended June 30, 2003 to139 bps for the comparable period in 2004. As a result, revenues decreased $47,459. Expenses increased by $2,458. Expenses in bps of production increased from 74 bps to 106 bps from thesix months ended June 30, 2003 to the comparable period in 2004.

 

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This was the result of lessleverage of fixed expenses during the six months ended June 30, 2004 andexpenses incurred to obtain trailing documents needed to sell or securitize thebuildup of loans in inventory.

 

*TransactionProcessing Segment*

 

The transaction processing segment processesmortgages on behalf of community banks on a private label basis; provides ATMand merchant processing services; subservices loans for the retail banksegment, financial intermediary segment and for third party customers; andsells various insurance products using an Internet-based platform.

 

The following table highlightsthe results of operations for the transaction processing segment for the sixmonths ended June 30, 2004 and 2003: 

 
| ** **     | ** ** | **2004**   | ** ** | **2003**   | ** ** | **change** | ** ** |
|----------------|------------|------------|------------|------------|------------|------------|------------|
| Total revenue  | ** ** | **$**      | **13,597** | ** ** | $          | 9,165      |       | $ | 4,432 |   |
| Total expenses | ** ** | **14,567** | ** ** | 11,857     |       | 2,710      |       |
| ** **     |       | **$**      | **(970**   | **)**      | $          | (2,692     | )          | $ | 1,722 |   |

 

The transaction processingsegment improved its pre-tax contribution by $1,722.  This is primarily due to the addition of NPSin December of 2003, which added $980 of pre-tax income, and a $1,761improvement in the servicing factory related to higher loan counts.  These improvements were offset, in part, byweaker results in the RMS processing unit and the NetInsurance division.

 

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

###### ** **

As indicated in NetBank’sAnnual Report on Form 10-K for the year ended December 31, 2003, NetBank hasidentified its policies for the valuation of its mortgage servicing rights, themaintenance of its allowance for credit losses, maintenance of reserves relatedto the liabilities for representations and warranties on sales of loans andservicing rights, and accounting for derivative instruments as its mostcritical accounting policies. These policies require management to makejudgments, estimates and assumptions concerning future events, which materiallyunderpin the current period accounting for these items. Given the effect suchjudgments, estimates and assumptions can have on NetBank’s balance sheet andstatement of operations these policies are regularly reviewed bymanagement.  Management believes thatgiven current information, its judgments, estimates and assumptions used inthese policies are appropriate.  Forfurther information regarding NetBank’s critical accounting policies, refer toits Annual Report on Form 10-K for the year ended December 31, 2003.

 

# **Contractual Obligations and Off-Balance SheetArrangements**

# ** **

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

# ** **

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

# ** **

# **Liquidity and Capital Resources**

# ** **

*Liquidity. *NetBank’s liquidity,represented by cash and cash equivalents, is a product of its operating, investing,and financing activities.  NetBank’sprimary sources of funds are deposits, borrowings, prepayments and maturitiesof outstanding loans, sales of loans, sales or maturities of investmentsecurities and other short-term investments, and funds

 

30

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provided from operations.  While scheduled loan payments and maturinginvestment securities and short-term investments are relatively predictablesources of funds, deposit flows and loan prepayments are greatly influenced bygeneral interest rates, economic conditions, and competition.  NetBank can use cash generated through theretail deposit market, its traditional funding source, to offset the cashutilized in investing activities. NetBank’s available for sale securities and short-term interest-earningassets can also be used to provide liquidity for lending and other operationalrequirements.  For the six months endedJune 30, 2004, NetBank had positive cash flow of $63,658 compared to negativecash flow of $52,655 for the same period of 2003.  The net cash inflow primarily related to a$637,953 increase in other borrowed funds, a $164,661 decrease in loans heldfor sale and a $15,310 decline in investment securities available forsale.  These cash in flows were partiallyoffset by a $570,968 increase in loan and lease receivables and a $90,942decrease in deposits.  Cash flows for thesix months ended June 30, 2003, were negative related to the Company’s $10billion level of production in the financial intermediary segment outpacing the$8.4 billion level of sales into the secondary market.  As an additional source of funds, NetBank hadavailable under existing lines of credit agreements $1 billion at June 30, 2004(see Note 8 of the consolidated financial statements included as part of thisreport for additional details of the available lines of credit).

 

TheCompany uses deposits as its principal source of funds.  For the six months ended June 30, 2004,deposits decreased by $90,942 to $2.4 billion from $2.5 billion as of December31, 2003.  NetBank’s deposit productsinclude checking, money market and certificates of deposit accounts.  Deposit account terms vary, with the principaldifferences being the minimum balance required, the time periods the funds mustremain on deposit and the interest rate. NetBank is competitive in the types of accounts, services and ranges ofinterest rates offered on deposit products. Although market demand generally dictates which deposit maturities andrates will be accepted by the public, NetBank intends to continue to promotechecking, money market and certificates of deposit to the extent possibleconsistent with asset and liability management goals.  NetBank increased its other borrowed funds,which include FHLB advances, repurchase agreements and warehouse lines ofcredit, by $637,953 during the six months ended June 30, 2004.  This increase was primarily related to the$570,504 increase in loan and lease receivables.

 

*CapitalResources.* NetBank and NetBank, FSB are subject to various regulatory capitalrequirements administered by the federal banking agencies. Failure of eithercompany to meet minimum capital requirements can initiate certain mandatory andpossibly additional discretionary actions by regulators that, if undertaken,could have a direct material effect on NetBank’s consolidated financialstatements.  Under capital adequacyguidelines and the regulatory framework for prompt corrective action, NetBank,FSB must meet specific capital guidelines that involve quantitative measures ofNetBank, FSB’s assets, liabilities, and certain off-balance sheet items ascalculated under regulatory accounting practices. NetBank, FSB’s capitalamounts and classifications are also subject to qualitative judgments by theregulators about components, risk weightings and other factors. In addition,under regulatory guidelines, NetBank, FSB may not pay a dividend to NetBank,Inc. if doing so would cause NetBank, FSB to be less than adequatelycapitalized, as defined below. During the six months ended June 30, 2004,NetBank repurchased 1,041,036 shares at a weighted average cost of $11.81, andmanagement had authorization to repurchase up to an additional 1.1 millionshares of its common stock through open market or private transactions.

 

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 Office of Thrift Supervision (“OTS”), requiresNetBank, FSB to maintain minimum ratios of tangible capital to tangible assetsof 1.5%, core capital to tangible assets of 4.0% and total capital torisk-weighted assets of 8.0%. Additionally, NetBank, Inc. is subject to a side letter agreement withthe OTS, which was put in place in connection with NetBank’s acquisition ofResource in 2002.  The side letterrequires NetBank, FSB to maintain 6% core capital and 12% total risk-basedcapital ratios.  As of June 30, 2004,NetBank, FSB was classified as well capitalized with a total risk-based capitalratio of 12.43%.  Additionally, the sideletter agreement requires NetBank, Inc. to maintain a minimum of 10% totalcapital to assets, adjusted for capital held against forward sold conformingmortgages to be the greater of 5% or $50,000, and in no event allow the totalcapital ratio to fall below 8.0%. NetBank, Inc.’s requirement at June 30, 2004 under this provision was8.95%.  NetBank, Inc.’s total capitalratio at June 30, 2004 was 8.55%. Management has notified the OTS of this deficiency and intends to cureit as soon as possible.  The followingtable presents information related to NetBank, FSB along with capitalrequirements mandated by the OTS:

 

31

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| ** **                                  | ** ** | **Actual** | ** ** | **For capital adequacy  purposes** | ** ** | **To be categorized as Well  Capitalized under prompt  corrective action plan** | ** ** |
|---------------------------------------------|------------|------------|------------|------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **Amount** | ** ** | **Ratio**                          | ** ** | **Amount**                                                                      | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **June 30, 2004**                           |       |       |       |                               |       |                                                                            |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)     |       | $          | 363,570    |                               | 12.43      | %                                                                               | $          | 234,048 |   | 8.00 | % | $ | 292,494 |   | 10.00 | % |
| Core capital (to adjusted total assets)     |       | $          | 326,883    |                               | 6.86       | %                                                                               | $          | 190,509 |   | 4.00 | % | $ | 238,253 |   | 5.00 | % |
| Tangible capital (to adjusted total assets) |       | $          | 326,883    |                               | 6.86       | %                                                                               | $          | 71,476 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital (to risk-weighted assets)    |       | $          | 326,883    |                               | 11.17      | %                                                                               | N/A        |   | N/A |   | $ | 175,586 |   | 6.00 | % |
| **December 31, 2003**                       |       |       |       |                               |       |                                                                            |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)     |       | $          | 296,359    |                               | 11.79      | %                                                                               | $          | 201,122 |   | 8.00 | % | $ | 251,365 |   | 10.00 | % |
| Core capital (to adjusted total assets)     |       | $          | 262,792    |                               | 6.42       | %                                                                               | $          | 163,712 |   | 4.00 | % | $ | 204,667 |   | 5.00 | % |
| Tangible capital (to adjusted total assets) |       | $          | 262,792    |                               | 6.42       | %                                                                               | $          | 61,400 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital (to risk-weighted assets)    |       | $          | 262,792    |                               | 10.45      | %                                                                               | N/A        |   | N/A |   | $ | 150,885 |   | 6.00 | % |

 

In addition, NetBank’ssubsidiaries engaged in mortgage banking must adhere to various HUD regulatoryguidelines including required minimum net worth to maintain their FHA approvedlending status.  Failure to comply withthe HUD guidelines could result in withdrawal of this certification.  As of June 30, 2004, Market Street, RBMG andMeritage were in compliance with HUD guidelines.  NetBank and its subsidiaries are subject tovarious other capital requirements by secondary market investors andstates.  None of these capitalrequirements are more stringent than the OTS capital requirements.  Failure to comply with these restrictionscould have a material adverse impact on the Company’s results of operations.  At June 30,2004, all of the capitalrequirements placed upon NetBank and its subsidiaries were met, and there havebeen no subsequent events that would lead management to believe that continuedcompliance would not be met in the future.

 

# **Part I**. Item 3: Quantitativeand Qualitative Market Risk

 

NetBank’s principal businesses are retail banking and the originationand purchase of mortgage loans.  Thesebusinesses are funded by customer deposits and, to the extent necessary, otherborrowed funds. Consequently, a significant portion of NetBank’s assets andliabilities are monetary in nature and fluctuations in interest rates willaffect NetBank’s future net interest income and cash flows. This interest raterisk is NetBank’s primary market risk exposure. For the six months ended June30, 2004, the only derivative financial instruments that NetBank entered intowere associated with hedging activities related to the portfolio of mortgageloans held for sale, the pipeline of mortgage loans for which the interest ratehas been locked, the owned mortgage servicing rights portfolio and the mortgageservicing rights which NetBank intends to retain associated with the pipelineof mortgage loans for which the interest rate has already been locked. NetBankhas no market risk-sensitive instruments held for trading purposes. NetBank’sexposure to market risk is reviewed on a regular basis by NetBank’s management.

 

NetBank, FSB, like other banks,measures interest rate risk based on Net Portfolio Value (“NPV”) analysis.  NPV equals the present value of expected netcash flows from existing assets minus the present value of expected net cashflows from existing liabilities.  A NPVratio is determined by dividing NPV by the present value of assets.  The following table sets forth the estimatedpercentage change in NetBank, FSB’s NPV ratios as of June 30, 2004, December31, 2003, and June 30, 2003, assuming rate shocks of +300 to -100 basis points:

 

##### **Limits and current NPVratios for NetBank, FSB**

 

| **Rate  shock   (in basis points)** | ** ** | **As of  6/30/2004** | ** ** | **As of  12/31/2003** | ** ** | **As of  6/30/2003** | ** ** | **Minimum as  of 6/30/2004** | ** ** |
|-------------------------------------|------------|----------------------|------------|-----------------------|------------|----------------------|------------|------------------------------|------------|
| **+300**                            |       | 7.66                 | %          | 6.54                  | %          | 7.54                 | %          | 4.00                         | %          |
| **+200**                            |       | 8.19                 | %          | 7.37                  | %          | 7.76                 | %          | 6.00                         | %          |
| **+100**                            |       | 8.80                 | %          | 8.17                  | %          | 8.00                 | %          | 6.00                         | %          |
| **Flat**                            |       | 9.14                 | %          | 8.66                  | %          | 7.91                 | %          | 6.00                         | %          |
| **-100**                            |       | 9.31                 | %          | 9.07                  | %          | 7.82                 | %          | 6.00                         | %          |

 

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Computation of prospectiveeffects of hypothetical rate changes is based on many assumptions, includingrelative levels of market interest rates, loan prepayments and depositdecay.  They should not be relied upon asindicative of actual results. Further, the computations do not contemplatecertain actions management could undertake in response to changes in interestrates.

 

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

 

As of the end of the periodcovered by this report, the Company carried out an evaluation, under the supervisionand with the participation of the Company’s management, including the Company’sChief Executive Officer and Chief Financial Executive, of the effectiveness ofthe design and operation of the Company’s disclosure controls and procedurespursuant to the Exchange Act Rule 13a-15. Based upon that evaluation, the Company’s Chief Executive Officer andChief Financial Executive concluded that the Company’s disclosure controls andprocedures are effective in timely alerting them to material information relatingto the Company (including its consolidated subsidiaries) that is required to bein the Company’s periodic filings with the Securities and ExchangeCommission.  There have been nosignificant changes in the Company’s internal controls or, to the Company’sknowledge, in other factors that could significantly affect those internalcontrols subsequent to the date the Company carried out its evaluation, andthere have been no corrective actions with respect to significant deficienciesand material weaknesses.

 

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

# ** **

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

 

As reported in previousfilings, NetBank, FSB, filed a complaint in January 2002 against CommercialMoney Center, Inc. (“CMC”), the originator, seller, and subservicer ofequipment leases purchased by NetBank, FSB, and against Illinois UnionInsurance Company (“Illinois Union”), Safeco Insurance Company of America(“Safeco”), and Royal Indemnity Company (“Royal,” with Illinois Union, Safeco andRoyal, collectively, referred to as the “Sureties”), the insurance companiesthat issued surety bonds and insurance policies guaranteeing payment of theincome stream from the leases and that also served as master servicers of theleases.  The NetBank, FSB action allegesseveral claims, including claims for breach of contract, fraud, and bad faith,and seeks, among other things, payment under and enforcement of surety bondsand insurance policies issued by the insurance and surety companies.  TheJudicial Panel on Multi-District Litigation has consolidated the actionsinvolving NetBank, FSB with more than 35 other cases pending around the countryinvolving other banks and financial institutions that were seeking to enforcesurety bonds and insurance policies relating to 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 previousfilings, NetBank, FSB had joined with the other claimants in a motion forjudgment on the pleadings, which motion was filed on January 31, 2003, and isstill pending before the MDL Court. Meanwhile, discovery in the case has been proceeding and fact discoveryis scheduled to close on August 3, 2004. 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 now intends to filea motion for summary judgment based in part on such discovery.  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.

 

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Also, as reported in previousfilings, on May 30, 2002, CMC filed for bankruptcy protection.  The bankruptcy proceeding is not a part ofthe consolidation of cases in Ohio.  On June11, 2003, the California Bankruptcy Court approved an amended settlementagreement (the “NetBank Agreement”) among NetBank, FSB, Lakeland Bank and theTrustee.  The NetBank Agreement resolvesall claims of the Trustee with respect to the lease payments that wereguaranteed by surety bonds and insurance policies issued by Safeco and IllinoisUnion, as well as all claims related to the surety bonds and insurancepolicies.  In addition to approving the NetBank Agreement, the California BankruptcyCourt approved a settlement agreement between the Trustee and Royal (the “RoyalAgreement’).  Under the Royal Agreement,Royal has agreed, among other things, to fund litigation by the Trustee againstNetBank, FSB to avoid its interests in the leases that were guaranteed bysurety bonds issued by Royal, as well as NetBank, FSB’s interests in the suretybonds themselves.  On September 4, 2003,the Trustee filed a Complaint against NetBank, FSB as contemplated by the RoyalAgreement, seeking to avoid NetBank, FSB’s interest in the leases and suretybonds relating to the Royal guaranteed lease pools.  On May 6, 2004, NetBank, FSB filed a motionfor summary judgment against the Trustee. A hearing on the motion had been scheduled for August 31, 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.  The Bankruptcy Court did not reschedule ahearing on the motion for summary judgment but set another status conferencefor October 1, 2004.

 

NetBank, FSB intends tovigorously pursue its claims against all the Sureties, including claims for anyloss associated with the claims brought by the Trustee against NetBank,FSB.  At this time, we are unable toexpress an opinion as to the likelihood of loss, or the amount or range ofpotential loss, with regard to this matter.

 

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

 

On June 27, 2001, severallessees of equipment leased from CMC filed suit in Los Angeles Superior Courtagainst CMC and several John Doe defendants alleging that the leases violatedCalifornia usury laws, the California Financial Code, and the California UnfairBusiness Practices Act.  The plaintiffswere seeking to rescind or reform their obligations under the leases and wereseeking to recover statutory damages and attorney’s fees.  The plaintiffs subsequently amended theircomplaint to name NetBank, FSB, several other investor banks, and severalsurety companies as co-defendants in the action.  After CMC filed for bankruptcy, the actionwas removed to the bankruptcy court in the Central District of California, butthe plaintiffs subsequently agreed to withdraw their claims against CMC andwere successful in their motion to remand the case back to state court.

 

On March 15, 2004, the SuperiorCourt sustained demurrers and motions to quash filed by NetBank, FSB andvarious other defendants on certain of the plaintiffs’ claims.  The Superior Court sustained the demurrersunder the California Financial Code, without leave to amend.  The Superior Court also sustained demurrerson the Unfair Business Practices Act, with leave to amend the claims to addgreater specificity to the claims, but without leave to amend as to unnamedrepresentatives 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, theplaintiffs served an amended complaint against NetBank, FSB alleging claimsfor, among other things, violations of another section of the CaliforniaFinancial Code, unfair competition under Section 17200 of the CaliforniaBusiness and Professions Code and usury. NetBank intends to vigorously defend the amended claims and to pursuerecovery against Safeco Insurance Company, Royal Indemnity Company, andIllinois Union Insurance Company for any damages and costs incurred in thiscase.

 

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

 

On June 27, 2001, the Company was served with a complaint for adeclaratory judgment filed by interState NetBank in the District of New Jerseychallenging the “NETBANK®” service mark.  The Company answered andcounterclaimed for trademark infringement on July 13, 2001.  Discovery wasstayed pending a ruling on interState NetBank’s November 19, 2001 motionfor summary judgment, which claimed that “NETBANK” is generic for all bankingservices delivered over the Internet.  OnSeptember 22, 2002, the District Court ruled that “NETBANK” is generic but didnot cancel the Company’s existing service mark registration.  The Company filed a motion forreconsideration of the District Court’s decision.  On June 23, 2003, the District Court deniedthe Company’s motion for reconsideration but clarified that two of

 

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the Company’s counterclaims remained in the case: (1) a claim forinfringement of the Company’s “NETBANK®” service mark to the extent that itcovers online bill-payment services (as opposed to online banking services ingeneral) and (2) a claim for unfair competition under New Jersey and commonlaw.  The parties completed factdiscovery on February 27, 2004.  On April30, 2004, interState NetBank filed a second motion for summary judgment,seeking the dismissal of the remaining two claims brought by NetBank, as wellas an award of attorneys’ fees.

 

The Company intends tovigorously defend against interState NetBank’s challenge of the “NETBANK®”service mark and will continue to pursue its counterclaims for trademarkinfringement and unfair competition, as well as later appeal the dismissal onsummary judgment of its remaining counterclaims based on the District Court’sruling that “NETBANK” is generic for banking services delivered over theInternet.  While there is a possibilityof a final, adverse outcome for the Company, at this stage of the matter, wecannot fairly determine the likelihood of such outcome.  However, in theevent of a final, adverse outcome, it is unlikely that there would be amonetary loss aside from the loss in value of the intellectual property rightsin the NETBANK® registration, unless the court awards interState NetBank itsattorneys’ fees as requested in its April 30, 2004 motion for summary judgment.

 

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

 
| **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 March 31, 2004   |       | —                                 |       | —                            |       | —                                                                                                   |       | 448,200                                                                                                                            |       |
| April 1 through April 30, 2004 |       | 178,600                                |       | $                                 | 11.51      |                                                                                                     | 178,600    |                                                                                                                               | 1,269,600  |   |
| May 1 through May 31, 2004     |       | 163,536                                |       | $                                 | 10.49      |                                                                                                     | 163,536    |                                                                                                                               | 1,106,064  |   |
| June 1 through June 30, 2004   |       | 26,800                                 |       | $                                 | 10.39      |                                                                                                     | 26,800     |                                                                                                                               | 1,079,264  |   |
|                           |       |                                   |       |                              |       |                                                                                                     |       |                                                                                                                               |       |
| Total                          |       | 368,936                                |       | $                                 | 10.98      |                                                                                                     | 368,936    |                                                                                                                               | 1,079,264  |   |

 

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Note 1: In August2002, the Board of Directors approved a plan to repurchase up to 1 millionshares of the Company’s common stock. The plan was subsequently increased by 1 million shares in October 2002,2 million shares in January 2003 and 1 million shares in April2004.

 

**PartII. Item 3:  DefaultsUpon Senior Securities**

 

**None**

 

**PartII. Item 4:  Submissionof Matters to a Vote of Security Holders**

** **

On April 29, 2004, NetBank held its Annual Meeting of Shareholders at which the following actions were taken:

 

Approved the proposal to elect the director nominees named below:

 
| T. Stephen Johnson: |   | For:  40,516,762 |   | Withheld: 1,679,826 |
|---------------------|--------|-----------------------|--------|---------------------|
|                |   |                  |   |                |
| Stuart Cable:       |   | For:  40,656,838 |   | Withheld: 1,539,750 |

 

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| Joel A. Smith III: |   | For:  40,655,746 |   | Withheld: 1,540,842 |
|--------------------|--------|-----------------------|--------|---------------------|
|               |   |                  |   |                |
| Eula L. Adams:     |   | For:  40,261,622 |   | Withheld: 1,934,966 |

 

Approved a proposal to approve the 4th amendment to the 1996 NetBank, Inc. Stock Incentive Plan:

 
| For: 18,064,476 |   | Against: 13,419,825 |   | Abstain:  338,134 |
|-----------------|--------|---------------------|--------|------------------------|

 

Approved a proposal to ratify Ernst & Young LLP as NetBank’s independent auditors:

 
| For: 41,461,704 |   | Against: 716,784 |   | Abstain:  18,101 |
|-----------------|--------|------------------|--------|-----------------------|

 

**PartII. Item 5:  OtherInformation**

 

**None**

** **

**Part II. Item 6: Exhibits and Reports on Form 8-K**

 
|   | (a)    | Exhibits             |
|--------|--------|----------------------|
|   |   |                 |   |
|   |   | 10                   | Amendment  No. 2 to Employment Agreement between NetBank, Inc. and Douglas K. Freeman  dated April 30, 2004. |
|   |   |                 |   |
|   |   | 31.1                 | Chief  Executive Officer’s certification under Section 302 of the Sarbanes-Oxley Act  of 2002. |
|   |   |                 |   |
|   |   | 31.2                 | Chief Financial  Executive’s certification under Section 302 of the Sarbanes-Oxley Act of  2002. |
|   |   |                 |   |
|   |   | 32                   | Certifications  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
|   |   |                 |   |
|   | (b)    | Reports on  Form 8-K |
|   |   |                 |   |
|   |   | i.                   |   | NetBank  filed a Current Report on Form 8-K on April 16, 2004 furnishing its monthly  operating statistics as posted to its Web site. |
|   |   |                 |   |   |
|   |   | ii.                  |   | NetBank  filed a Current Report on Form 8-K on April 28, 2004, furnishing the  Company’s press release detailing the Company’s results for the first quarter  of 2004. |
|   |   |                 |   |   |
|   |   | iii.                 |   | NetBank  filed a Current Report on Form 8-K on May 17, 2004, furnishing its monthly  operating statistics as posted to its Web site. |
|   |   |                 |   |   |
|   |   | iv.                  |   | NetBank  filed a Current Report on Form 8-K on June 10, 2004, announcing it had reached  a definitive agreement to acquire principal operating assets of Beacon Credit  Services, LLC. |
|   |   |                 |   |   |
|   |   | v.                   |   | NetBank  filed a Current Report on Form 8-K on June 16, 2004, furnishing its monthly  operating statistics as posted to its Web site. |

 

 

#### **SIGNATURE**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                  | NETBANK, INC. |
|-----------------------|---------------|
|                  |          |
|                  | By:           | /s/ Steven F. Herbert |   |
|                  |          | Steven F. Herbert |
|                  |          |   |
| Dated: August 9, 2004 |          | *Chief Financial Executive and Chief Accounting Officer* |

** **

**36**

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