**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 

**QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d)**

**OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For theQuarterly Period Ended September 30, 2004**

 

**CommissionFile No. 0-22361**

 

**NETBANK, INC.**

(Exact name of registrant asspecified in its charter)

 
| **Georgia**                                               | ** ** | **58-2224352**                           |
|-----------------------------------------------------------|------------|------------------------------------------|
| (State of  incorporation)                                 |       | (I.R.S.  Employer Identification Number) |
|                                                      |       |                                     |
| **11475  Great Oaks Way**                                 | ** ** | ** **                               |
| **Suite  100**                                            |       |                                     |
| **Alpharetta,  Georgia**                                  | ** ** | **30022**                                |
| (Address of  principal executive offices)                 |       | (Zip Code)                               |
|                                                      |       |                                     |
| **(770) 343-6006**                                        |
| Registrant’s  telephone number, including area code: |

 

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

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Exchange 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 October 31, 2004** |
|-------------------------------|------------|-------------------------------------------------|
| Common Stock,  par value $.01 |       | 46,506,520                                      |

 

 

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

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

 

2

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**NetBank,Inc.**

**Consolidated Balance Sheets**

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

 
| ** **                                                                                                       | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| **Assets**                                                                                                       |       |                         |       |                        |       |
| Cash and  cash equivalents:                                                                                      |       |                         |       |                        |       |
| Cash and due  from banks                                                                                         |       | $                            | 220,300    |                        | $          | 24,211 |   |
| Federal  funds sold                                                                                              |       | 9,110                        |       | 9,416                       |       |
| Total cash  and cash equivalents                                                                                 |       | 229,410                      |       | 33,627                      |       |
| Investment  securities available for sale-at fair value (amortized cost of $310,322 and  $449,972, respectively) |       | 312,602                      |       | 454,348                     |       |
| Stock of  Federal Home Loan Bank of Atlanta - at cost                                                            |       | 61,446                       |       | 54,491                      |       |
| Loans held  for sale                                                                                             |       | 1,291,137                    |       | 1,951,113                   |       |
| Loans and  leases receivable - net of allowance for credit losses of $45,306 and  $43,689, respectively          |       | 2,088,899                    |       | 1,761,372                   |       |
| Mortgage  servicing rights – net                                                                            |       | 171,993                      |       | 165,214                     |       |
| Accrued  interest receivable                                                                                     |       | 11,059                       |       | 14,713                      |       |
| Furniture,  equipment and capitalized software – net                                                        |       | 52,628                       |       | 53,902                      |       |
| Goodwill and  other intangibles – net                                                                       |       | 78,992                       |       | 62,441                      |       |
| Due from  servicers and investors                                                                                |       | 110,112                      |       | 33,187                      |       |
| Receivable  from unsettled trades                                                                                |       | —                       |       | 90,000                      |       |
| Other assets                                                                                                     |       | 79,993                       |       | 60,397                      |       |
| **Total  assets**                                                                                                |       | $                            | 4,488,271  |                        | $          | 4,734,805 |   |
|                                                                                                             |       |                         |       |                        |       |
| **Liabilities,  minority interests and shareholders’ equity**                                               |       |                         |       |                        |       |
| **Liabilities:**                                                                                                 |       |                         |       |                        |       |
| Deposits                                                                                                         |       | $                            | 2,744,709  |                        | $          | 2,539,427 |   |
| Other  borrowed funds                                                                                            |       | 1,065,294                    |       | 1,421,022                   |       |
| Subordinated  debt                                                                                               |       | 11,857                       |       | 11,857                      |       |
| Accrued  interest payable                                                                                        |       | 10,004                       |       | 9,098                       |       |
| Loans in  process                                                                                                |       | 47,562                       |       | 30,756                      |       |
| Unsettled  trades                                                                                                |       | —                       |       | 131,707                     |       |
| Representations  and warranties                                                                                  |       | 22,339                       |       | 17,905                      |       |
| Accounts  payable and accrued liabilities                                                                        |       | 148,699                      |       | 142,683                     |       |
| Total  liabilities                                                                                               |       | 4,050,464                    |       | 4,304,455                   |       |
|                                                                                                             |       |                         |       |                        |       |
| Commitments  and contingencies                                                                                   |       | —                       |       | —                      |       |
| Minority interests in affiliates                                                                                 |       | 450                          |       | —                      |       |
|                                                                                                             |       |                         |       |                        |       |
| **Shareholders’  equity:**                                                                                  |       |                         |       |                        |       |
| Preferred  stock, no par (10,000,000 shares authorized; none outstanding)                                        |       | —                       |       | —                      |       |
| Common  stock, $.01 par (100,000,000 shares authorized, 52,820,308 shares issued)                                |       | 528                          |       | 528                         |       |
| Additional  paid-in capital                                                                                      |       | 431,712                      |       | 432,035                     |       |
| Retained  earnings                                                                                               |       | 62,918                       |       | 44,102                      |       |
| Accumulated  other comprehensive income, net of taxes of $860 and $1,634, respectively                           |       | 1,420                        |       | 2,742                       |       |
| Treasury  stock, at cost (6,073,388 and 5,235,538 shares, respectively)                                          |       | (58,931                      | )          | (48,674                     | )          |
| Unearned  compensation                                                                                           |       | (290                         | )          | (383                        | )          |
| Total  shareholders’ equity                                                                                 |       | 437,357                      |       | 430,350                     |       |
| **Total  liabilities, minority interests and shareholders’ equity**                                         |       | $                            | 4,488,271  |                        | $          | 4,734,805 |   |

 

See notes toconsolidated financial statements.

 

3

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**NetBank,Inc.**

**ConsolidatedStatements of Operations**

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

 
| ** **                                                                                                             | ** ** | **Three months ended September 30,** | ** ** | **Nine months ended September 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2004**                                  | ** ** | **2003**                                 | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Interest  income:**                                                                                                  |       |                                      |       |                                     |       |   |   |   |   |
| Loans and  leases                                                                                                      |       | $                                         | 57,481     |                                     | $          | 55,159 |   | $ | 160,102 |   | $ | 138,323 |   |
| Investment  securities                                                                                                 |       | 5,697                                     |       | 3,702                                    |       | 13,568 |   | 15,662 |   |
| Short-term  investments                                                                                                |       | 314                                       |       | 58                                       |       | 684 |   | 277 |   |
| Total  interest income                                                                                                 |       | 63,492                                    |       | 58,919                                   |       | 174,354 |   | 154,262 |   |
|                                                                                                                   |       |                                      |       |                                     |       |   |   |   |   |
| **Interest  expense:**                                                                                                 |       |                                      |       |                                     |       |   |   |   |   |
| Deposits                                                                                                               |       | 11,862                                    |       | 12,293                                   |       | 34,364 |   | 37,273 |   |
| Other  borrowed funds                                                                                                  |       | 13,513                                    |       | 9,666                                    |       | 33,625 |   | 27,818 |   |
| Total  interest expense                                                                                                |       | 25,375                                    |       | 21,959                                   |       | 67,989 |   | 65,091 |   |
| Net interest  income                                                                                                   |       | 38,117                                    |       | 36,960                                   |       | 106,365 |   | 89,171 |   |
| Provision  for credit losses                                                                                           |       | 469                                       |       | 2,537                                    |       | 3,982 |   | 4,299 |   |
| Net interest  income after provision for credit losses                                                                 |       | 37,648                                    |       | 34,423                                   |       | 102,383 |   | 84,872 |   |
|                                                                                                                   |       |                                      |       |                                     |       |   |   |   |   |
| **Non-interest  income:**                                                                                              |       |                                      |       |                                     |       |   |   |   |   |
| Service  charges and fees                                                                                              |       | 17,440                                    |       | 12,017                                   |       | 51,110 |   | 35,795 |   |
| Gains on  sales of mortgage loans and mortgage servicing rights, net of provision for  estimated losses on repurchases |       | 27,755                                    |       | 75,914                                   |       | 93,968 |   | 184,461 |   |
| Other income                                                                                                           |       | 7,562                                     |       | 8,717                                    |       | 11,821 |   | 14,696 |   |
| Net gain on  sales of investment securities                                                                            |       | 2,248                                     |       | —                                   |       | 5,417 |   | 11,394 |   |
| Gains on  derivatives                                                                                                  |       | 2,914                                     |       | —                                   |       | 2,914 |   | — |   |
| Total  non-interest income                                                                                             |       | 57,919                                    |       | 96,648                                   |       | 165,230 |   | 246,346 |   |
|                                                                                                                   |       |                                      |       |                                     |       |   |   |   |   |
| **Non-interest  expense:**                                                                                             |       |                                      |       |                                     |       |   |   |   |   |
| Salaries and  benefits                                                                                                 |       | 31,730                                    |       | 37,067                                   |       | 94,812 |   | 98,952 |   |
| Customer  service                                                                                                      |       | 3,383                                     |       | 2,684                                    |       | 9,407 |   | 8,282 |   |
| Marketing                                                                                                              |       | 2,551                                     |       | 1,988                                    |       | 6,974 |   | 6,319 |   |
| Data  processing                                                                                                       |       | 4,722                                     |       | 3,638                                    |       | 13,888 |   | 11,659 |   |
| Depreciation  and amortization                                                                                         |       | 5,098                                     |       | 4,063                                    |       | 14,714 |   | 11,254 |   |
| Impairment  and amortization of mortgage servicing rights                                                              |       | 24,530                                    |       | 31,195                                   |       | 38,810 |   | 58,530 |   |
| Office  expenses                                                                                                       |       | 2,938                                     |       | 2,169                                    |       | 8,409 |   | 7,534 |   |
| Occupancy                                                                                                              |       | 5,770                                     |       | 5,578                                    |       | 16,277 |   | 14,131 |   |
| Travel and  entertainment                                                                                              |       | 1,100                                     |       | 1,184                                    |       | 3,662 |   | 3,129 |   |
| Professional  fees                                                                                                     |       | 2,806                                     |       | 5,517                                    |       | 10,719 |   | 12,119 |   |
| Prepaid lost  interest from curtailments                                                                               |       | 906                                       |       | 3,451                                    |       | 4,174 |   | 8,587 |   |
| Other  expenses                                                                                                        |       | 3,340                                     |       | 3,428                                    |       | 10,185 |   | 10,256 |   |
| Prepayment  fees on the early extinguishment of debt                                                                   |       | —                                    |       | 4,316                                    |       | — |   | 16,267 |   |
| Minority  interests in net earnings of consolidated affiliates                                                         |       | 192                                       |       | —                                   |       | 606 |   | — |   |
| Total  non-interest expense                                                                                            |       | 89,066                                    |       | 106,278                                  |       | 232,637 |   | 267,019 |   |
| Income  before income taxes                                                                                            |       | 6,501                                     |       | 24,793                                   |       | 34,976 |   | 64,199 |   |
| Income tax  expense                                                                                                    |       | (2,486                                    | )          | (9,204                                   | )          | (13,100 | ) | (23,695 | ) |
| Net income                                                                                                             |       | $                                         | 4,015      |                                     | $          | 15,589 |   | $ | 21,876 |   | $ | 40,504 |   |
|                                                                                                                   |       |                                      |       |                                     |       |   |   |   |   |
| Net income  per common and potential common shares outstanding:                                                        |       |                                      |       |                                     |       |   |   |   |   |
| Basic                                                                                                                  |       | $                                         | 0.09       |                                     | $          | 0.33 |   | $ | 0.47 |   | $ | 0.84 |   |
| Diluted                                                                                                                |       | $                                         | 0.09       |                                     | $          | 0.32 |   | $ | 0.46 |   | $ | 0.83 |   |
|                                                                                                                   |       |                                      |       |                                     |       |   |   |   |   |
| Weighted  average common and potential common shares outstanding:                                                      |       |                                      |       |                                     |       |   |   |   |   |
| Basic                                                                                                                  |       | 46,846                                    |       | 47,829                                   |       | 46,962 |   | 48,039 |   |
| Diluted                                                                                                                |       | 47,156                                    |       | 48,590                                   |       | 47,431 |   | 48,661 |   |
|                                                                                                                   |       |                                      |       |                                     |       |   |   |   |   |
| Dividends  declared on common stock                                                                                    |       | $                                         | 0.02       |                                     | $          | 0.02 |   | $ | 0.06 |   | $ | 0.06 |   |

 

See notes to consolidated financialstatements.

 

4

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**NetBank, Inc.**

**ConsolidatedStatements of Shareholders’ Equity**

**(Unauditedand in 000’s)**

 
| ** **                                                           | ** ** | **Common  shares** | ** ** | **Common  Stock** | ** ** | **Additional  paid-in capital** | ** ** | **Retained  earnings** | ** ** | **Accumulated  other  comprehensive  income** | ** ** | **Treasury stock** | ** ** | **Unearned  compensation** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|---------------------------------|------------|------------------------|------------|-----------------------------------------------|------------|--------------------|------------|----------------------------|------------|-----------|------------|
| Balance - June 30, 2004                                         |       | 52,820             |       | $                 | 528        |                            | $          | 432,029                |       | $                                             | 59,888     |               | $          | (1,975                     | )          | $         | (59,639    | ) | $ | (321 | ) | $ | 430,510 |   |
| Comprehensive income:                                                |       |               |       |              |       |                            |       |                   |       |                                          |       |               |       |                       |       |      |       |
| Net income for the three months ended September 30,  2004       |       | —             |       | —            |       | —                          |       | 4,015                  |       | —                                        |       | —             |       | —                     |       | 4,015     |       |
| Realized net gain on sale of securities, net of taxes                |       | —             |       | —            |       | —                          |       | —                 |       | (1,416                                        | )          | —             |       | —                     |       | (1,416    | )          |
| Unrealized net gain on securities, net of taxes                      |       | —             |       | —            |       | —                          |       | —                 |       | 4,811                                         |       | —             |       | —                     |       | 4,811     |       |
| Comprehensive income                                                 |       |               |       |              |       |                            |       |                   |       |                                          |       |               |       |                       |       | 7,410     |       |
| Dividends declared on common stock                                   |       | —             |       | —            |       | —                          |       | (939                   | )          | —                                        |       | —             |       | —                     |       | (939      | )          |
| Purchase of shares of common stock for treasury, net  of reissuances |       | —             |       | —            |       | (317                            | )          | (46                    | )          | —                                        |       | 708                |       | —                     |       | 345       |       |
| Amortization of unearned compensation                                |       | —             |       | —            |       | —                          |       | —                 |       | —                                        |       | —             |       | 31                         |       | 31        |       |
|                                                                 |       |               |       |              |       |                            |       |                   |       |                                          |       |               |       |                       |       |      |       |
| Balance – September 30, 2004                               |       | 52,820             |       | $                 | 528        |                            | $          | 431,712                |       | $                                             | 62,918     |               | $          | 1,420                      |       | $         | (58,931    | ) | $ | (290 | ) | $ | 437,357 |   |
|                                                                 |       |               |       |              |       |                            |       |                   |       |                                          |       |               |       |                       |       |      |       |   |   |   |   |   |   |   |
|                                                                 |       | **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 nine months ended September 30,  2004        |       | —             |       | —            |       | —                          |       | 21,876                 |       | —                                        |       | —             |       | —                     |       | 21,876    |       |
| Realized  net gain on sales of securities, net of taxes              |       | —             |       | —            |       | —                          |       | —                 |       | (3,396                                        | )          | —             |       | —                     |       | (3,396    | )          |
| Unrealized net gain on securities, net of taxes                      |       | —             |       | —            |       | —                          |       | —                 |       | 2,074                                         |       | —             |       | —                     |       | 2,074     |       |
| Comprehensive income                                                 |       |               |       |              |       |                            |       |                   |       |                                          |       |               |       |                       |       | 20,554    |       |
| Dividends declared on common stock                                   |       | —             |       | —            |       | —                          |       | (2,818                 | )          | —                                        |       | —             |       | —                     |       | (2,818    | )          |
| Purchase of shares of common stock for treasury, net  of reissuances |       | —             |       | —            |       | (323                            | )          | (242                   | )          | —                                        |       | (10,257            | )          | —                     |       | (10,822   | )          |
| Amortization of unearned compensation                                |       | —             |       | —            |       | —                          |       | —                 |       | —                                        |       | —             |       | 93                         |       | 93        |       |
|                                                                 |       |               |       |              |       |                            |       |                   |       |                                          |       |               |       |                       |       |      |       |
| Balance –  September 30,  2004                        |       | 52,820             |       | $                 | 528        |                            | $          | 431,712                |       | $                                             | 62,918     |               | $          | 1,420                      |       | $         | (58,931    | ) | $ | (290 | ) | $ | 437,357 |   |
|                                                                      |            |                    |            |                   |            |                                 |            |                        |            |                                               |            |                    |            |                            |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See notes to consolidated financial statements.

 

5

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**NetBank, Inc.**

**ConsolidatedStatements of Shareholders’ Equity**

**(Unauditedand in 000’s)**

 
| ** **                                                           | ** ** | **Common  shares** | ** ** | **Common  Stock** | ** ** | **Additional  paid-in capital** | ** ** | **Retained  earnings** | ** ** | **Accumulated  other  comprehensive  income** | ** ** | **Treasury  stock** | ** ** | **Unearned  compensation** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------------|------------|--------------------|------------|-------------------|------------|---------------------------------|------------|------------------------|------------|-----------------------------------------------|------------|---------------------|------------|----------------------------|------------|-----------|------------|
| Balance - June 30, 2003                                         |       | 52,762             |       | $                 | 528        |                            | $          | 431,389                |       | $                                             | 20,410     |                | $          | 11,608                     |       | $         | (43,607    | ) | $ | — |   | $ | 420,328 |   |
| Comprehensive income:                                                |       |               |       |              |       |                            |       |                   |       |                                          |       |                |       |                       |       |      |       |
| Net income for the three months ended  September 30, 2003       |       | —             |       | —            |       | —                          |       | 15,589                 |       | —                                        |       | —              |       | —                     |       | 15,589    |       |
| Realized net gain on sale of securities                              |       | —             |       | —            |       | —                          |       | —                 |       | —                                        |       | —              |       | —                     |       | —    |       |
| Unrealized net loss on securities, net of taxes                      |       | —             |       | —            |       | —                          |       | —                 |       | (6,665                                        | )          | —              |       | —                     |       | (6,665    | )          |
| Comprehensive income                                                 |       |               |       |              |       |                            |       |                   |       |                                          |       |                |       |                       |       | 8,924     |       |
| Dividends declared on common stock                                   |       | —             |       | —            |       | —                          |       | (951                   | )          | —                                        |       | —              |       | —                     |       | (951      | )          |
| Purchase of shares of common stock for treasury, net of  reissuances |       | —             |       | —            |       | 54                              |       | —                 |       | —                                        |       | (2,214              | )          | —                     |       | (2,160    | )          |
| Issuances of common stock                                            |       | 69                 |       | —            |       | 662                             |       | —                 |       | —                                        |       | —              |       | —                     |       | 662       |       |
|                                                                 |       |               |       |              |       |                            |       |                   |       |                                          |       |                |       |                       |       |      |       |
| Balance – September 30, 2003                               |       | 52,831             |       | $                 | 528        |                            | $          | 432,105                |       | $                                             | 35,048     |                | $          | 4,943                      |       | $         | (45,821    | ) | $ | — |   | $ | 426,803 |   |
|                                                                 |       |               |       |              |       |                            |       |                   |       |                                          |       |                |       |                       |       |      |       |
| ** **                                                           | ** ** | **Common  shares** | ** ** | **Common  Stock** | ** ** | **Additional  paid-in capital** | ** ** | **Retained  earnings** | ** ** | **Accumulated  other  comprehensive  income** | ** ** | **Treasury  stock** | ** ** | **Unearned  compensation** | ** ** | **Total** | ** ** |
| Balance - December 31, 2002                                     |       | 52,675             |       | $                 | 527        |                            | $          | 426,485                |       | $                                             | (2,568     | )                   | $          | 11,026                     |       | $         | (33,880    | ) | $ | — |   | $ | 401,590 |   |
| Comprehensive income:                                                |       |               |       |              |       |                            |       |                   |       |                                          |       |                |       |                       |       |      |       |
| Net income for the nine months ended  September 30, 2003        |       | —             |       | —            |       | —                          |       | 40,504                 |       | —                                        |       | —              |       | —                     |       | 40,504    |       |
| Realized net gain on sale of securities, net of taxes                |       | —             |       | —            |       | —                          |       | —                 |       | (7,178                                        | )          | —              |       | —                     |       | (7,178    | )          |
| Unrealized net gain on securities, net of taxes                      |       | —             |       | —            |       | —                          |       | —                 |       | 1,095                                         |       | —              |       | —                     |       | 1,095     |       |
| Comprehensive income                                                 |       |               |       |              |       |                            |       |                   |       |                                          |       |                |       |                       |       | 34,421    |       |
| Dividends declared on common stock                                   |       | —             |       | —            |       | —                          |       | (2,888                 | )          | —                                        |       | —              |       | —                     |       | (2,888    | )          |
| Purchase of shares of common stock for treasury, net  of reissuances |       | —             |       | —            |       | 35                              |       | —                 |       | —                                        |       | (11,941             | )          | —                     |       | (11,906   | )          |
| Issuances of common stock                                            |       | 156                |       | 1                 |       | 5,585                           |       | —                 |       | —                                        |       | —              |       | —                     |       | 5,586     |       |
|                                                                 |       |               |       |              |       |                            |       |                   |       |                                          |       |                |       |                       |       |      |       |
| Balance – September 30, 2003                               |       | 52,831             |       | $                 | 528        |                            | $          | 432,105                |       | $                                             | 35,048     |                | $          | 4,943                      |       | $         | (45,821    | ) | $ | — |   | $ | 426,803 |   |

 

See notes to consolidated financial statements.

 

6

----

 

**NetBank,Inc.**

**ConsolidatedStatements of Cash Flows**

**(unauditedand in 000’s)**

 
| ** **                                                                                    | ** ** | **Nine months ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2004**                                 | ** ** | **2003** | ** ** |
| Operating  activities:                                                                        |       |                                     |       |   |   |
| Net income                                                                                    |       | $                                        | 21,876     |   | $ | 40,504 |   |
| Adjustments  to reconcile net income to net cash provided by (used in) operating  activities: |       |                                     |       |   |   |
| Depreciation  and amortization                                                                |       | 14,714                                   |       | 11,254 |   |
| Amortization  of premiums on investment securities, loan and lease receivables and debt       |       | 5,101                                    |       | 8,185 |   |
| Origination  of loans held for sale                                                           |       | (9,729,806                               | )          | (14,615,168 | ) |
| Proceeds  from sales of loans held for sale                                                   |       | 10,485,000                               |       | 13,676,118 |   |
| Net gain on  sales of loans and servicing rights                                              |       | (93,968                                  | )          | (184,461 | ) |
| Capitalization  of mortgage servicing rights                                                  |       | (50,114                                  | )          | (169,787 | ) |
| Proceeds  from sales of mortgage servicing rights                                             |       | 4,356                                    |       | 58,436 |   |
| Impairment  and amortization of mortgage servicing rights                                     |       | 38,810                                   |       | 58,530 |   |
| Provision  for credit losses                                                                  |       | 3,982                                    |       | 4,299 |   |
| Gains on  sales of investment securities                                                      |       | (5,417                                   | )          | (11,394 | ) |
| Changes in  assets and liabilities which provide (use) cash:                                  |       |                                     |       |   |   |
| (Decrease)  increase in accrued interest receivable                                           |       | 3,654                                    |       | (4,502 | ) |
| (Decrease)  increase in due from servicers and investors                                      |       | (76,925                                  | )          | 28,425 |   |
| Decrease in  other assets                                                                     |       | (19,596                                  | )          | (9,883 | ) |
| Increase  (decrease) in accrued interest payable                                              |       | 906                                      |       | (3,358 | ) |
| Increase in  loans in process                                                                 |       | 16,806                                   |       | 4,475 |   |
| Increase in  accounts payable and accrued liabilities                                         |       | 6,016                                    |       | 35,426 |   |
| Net cash  provided by (used in) operating activities                                          |       | 625,395                                  |       | (1,072,901 | ) |
|                                                                                          |       |                                     |       |   |   |
| Investing  activities:                                                                        |       |                                     |       |   |   |
| Purchases of  available for sale securities                                                   |       | (315,411                                 | )          | (50,508 | ) |
| Principal  repayments on available for sale securities                                        |       | 37,817                                   |       | 66,096 |   |
| Sales and  maturities of available for sale securities                                        |       | 290,835                                  |       | 318,304 |   |
| Purchase of  Federal Home Loan Bank Stock                                                     |       | (6,955                                   | )          | (31,460 | ) |
| Origination  and purchase of loans and leases receivable                                      |       | (1,215,724                               | )          | (1,128,005 | ) |
| Principal  repayments on loans and leases receivable                                          |       | 537,320                                  |       | 388,496 |   |
| Proceeds  from sales of loans and leases receivable                                           |       | 346,039                                  |       | — |   |
| Purchases of  furniture, equipment and capitalization of software, net of disposals           |       | (11,975                                  | )          | (16,630 | ) |
| Acquisitions,  net of cash acquired                                                           |       | (16,424                                  | )          | (3,209 | ) |
| Other  investing activities                                                                   |       | 450                                      |       | — |   |
| Net cash  used in investing activities                                                        |       | (354,028                                 | )          | (456,916 | ) |
|                                                                                          |       |                                     |       |   |   |
| Financing  activities:                                                                        |       |                                     |       |   |   |
| (Decrease)  increase in money market and checking accounts                                    |       | (1,664                                   | )          | 576,871 |   |
| Increase  (decrease) in certificates of deposits                                              |       | 206,946                                  |       | (97,408 | ) |
| Proceeds  from other borrowed funds                                                           |       | 11,826,643                               |       | 9,865,117 |   |
| Repayments  of other borrowed funds                                                           |       | (12,092,370                              | )          | (8,851,540 | ) |
| Net proceeds  from issuance of Subordinated debt                                              |       | —                                   |       | 4,382 |   |
| Repayment of  convertible subordinated debt                                                   |       | —                                   |       | (26,126 | ) |
| Issuances of  common stock                                                                    |       | —                                   |       | 5,586 |   |
| Net  purchases of treasury stock                                                              |       | (12,321                                  | )          | (11,906 | ) |
| Dividend  payments on common stock                                                            |       | (2,818                                   | )          | (2,888 | ) |
| Net cash  (used in) provided by financing activities                                          |       | (75,584                                  | )          | 1,462,088 |   |
| Net increase  (decrease) in cash and cash equivalents                                         |       | 195,783                                  |       | (67,729 | ) |
| Cash and  cash equivalents:                                                                   |       |                                     |       |   |   |
| Cash,  beginning of period                                                                    |       | 33,627                                   |       | 111,565 |   |
| Cash, end of  period                                                                          |       | $                                        | 229,410    |   | $ | 43,836 |   |
|                                                                                          |       |                                     |       |   |   |
| Supplemental  disclosures of cash flow information:                                           |       |                                     |       |   |   |
| Cash paid  during the period for interest                                                     |       | $                                        | 67,203     |   | $ | 68,449 |   |
| (Refunds  received) cash paid for income taxes                                                |       | $                                        | (8,869     | ) | $ | 12,463 |   |
|                                                                                          |       |                                     |       |   |   |
| Non-cash  investing and financing activities:                                                 |       |                                     |       |   |   |
| Fair value  of assets acquired                                                                |       | $                                        | 326        |   | $ | 1,259 |   |
| Goodwill and  intangible assets                                                               |       | 18,854                                   |       | 1,950 |   |
| Liabilities  assumed                                                                          |       | 39                                       |       | — |   |
| Stock issued  in acquisition                                                                  |       | (1,592                                   | )          | — |   |
| Cash paid  for business                                                                       |       | $                                        | 17,627     |   | $ | 3,209 |   |

 

See notes toconsolidated financial statements.

 

7

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**NETBANK,INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**September 30,2004**

**(unaudited)**

 

**1.**                                      ORGANIZATION AND BASIS OF PRESENTATION

** **

NetBank, Inc. is a financial holding company that wholly owns theoutstanding stock of NetBank, (“NetBank, FSB” or the “Bank”), a federal savingsbank; MG Reinsurance Company (“MG Reinsurance”), a captive reinsurance company;NetInsurance, Inc., (“NetInsurance”), a licensed insurance agency; and NBPartners, Inc., a corporation formed to be involved in strategic partneringopportunities.  NetBank, FSB owns all ofthe outstanding stock of Market Street Mortgage Corporation (“Market Street”),a retail mortgage company, NetBank Payment Systems, Inc. (“NPS”), a leading providerof ATM services for retail and other non-bank businesses and Meritage MortgageCorporation (“Meritage”), a wholesale non-conforming mortgage provider. Theentire consolidated company is referred to herein as “NetBank” or “the Company”.

 

During the third quarter of 2004, Resource Bancshares Mortgage Group,Inc. and Republic Leasing Company, Inc., both of which had been subsidiaries ofNetBank, FSB, were legally consolidated into NetBank, FSB and ceased to existas separate corporations.  Republic Leasingnow operates as the NetBank Business Finance division of NetBank, FSB.  In addition, on October 1, 2004, RBMG,Inc. was legally consolidated into NetBank, FSB and ceased to exist as aseparate corporation.  RBMG, Inc. nowoperates as the NetBank Funding division of NetBank, FSB.

 

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 of operationsfor the interim periods reported herein are not necessarily indicative ofresults to be expected for the full year. Certain 2003 amounts have beenreclassified for comparability with 2004 amounts.

 

All dollar figures are presented in thousands (000s), except per sharedata, unless otherwise noted. Net income per share is presented on a dilutedbasis.

 

**2.**                                      ACQUISITIONS

** **

On July 1, 2004, theCompany acquired the principal operating assets of Beacon Credit Services, LLC,a privately held provider of RV, boat and aircraft financing.  The consideration paid consisted of194,217 shares of NetBank common stock and cash of $5.0 million.  Theacquisition was accounted for as a purchase, and, accordingly, all assets wererecorded at fair value resulting in $6.4 million of goodwill.  Beacon Credit Services, LLC’s resultsof operations have been included from the date of acquisition.

 

During the nine months endedSeptember 30, 2004, NetBank Payment Systems acquired certain assets orprocessing contracts of various smaller ATM and merchant processingbusinesses.  The acquisitions wereaccounted for as purchases, and, as such, $6.2 million of goodwill and $6.1million of amortizable intangibles were recorded.  Consideration for all the businesses totaled$12.7 million. The acquisitions results of operations have been includedfrom the date of acquisition.

 

On December 1,2003, NetBank, Inc. acquired all of the outstanding stock of FinancialTechnologies, Inc., subsequently renamed NetBank Payment Systems, Inc., pursuantto an agreement dated October 5, 2003. The consideration paid consisted of 77,674 shares of NetBank commonstock and cash of $16 million.  Theacquisition was accounted for as a purchase, and, accordingly, all assets wererecorded at fair value. The Company recorded $12.6 million of goodwill and $4.8million of contract intangibles associated with the purchase.  Goodwill was decreased during the threemonths ended March 31, 2004 by $1.4 million related to adjustments toinventories and taxes associated with the acquisition.  The Company may

 

8

----

 

payadditional consideration if NPS reaches specific financial goals over the nextfive years.  NPS’s results of operationshave been included from the date of acquisition.

 

On April 30,2003, the Company acquired certain assets of Memorial Park Mortgage, LTD, amortgage banking business, pursuant to an Asset Purchase and AssignmentAgreement.  The consideration paid,including transaction costs, was $3.2 million. The acquisition was accounted for as a purchase, and accordingly, allassets were recorded at fair value.  Its results of operationshave been included from the date of acquisition.  As such, $2.0 million in goodwill,including transaction costs, was recorded.

 

**3.**                                      ACCOUNTING POLICIES

** **

Reference is made to the accounting policies of NetBank described inthe notes to consolidated financial statements contained in NetBank’sForm 10-K for the year ended December 31, 2003. The Company hasfollowed those policies in preparing this report.

 

*Significant Estimates.*Thepreparation of the consolidated financial statements in conformity withaccounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the amounts reportedin the consolidated financial statements and accompanying notes.  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.

 

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

 
| ** **                                                                                                                                   | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                                                                   | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net income,  as reported                                                                                                                     |       | $                                          | 4,015      |                                      | $          | 15,589 |   | $ | 21,876 |   | $ | 40,504 |   |
| Deduct:                                                                                                                                      |       |                                       |       |                                      |       |   |   |   |   |
| Total stock  option-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | (794                                       | )          | (663                                      | )          | (2,070 | ) | (1,684 | ) |
| Pro forma  net income                                                                                                                        |       | $                                          | 3,221      |                                      | $          | 14,926 |   | $ | 19,806 |   | $ | 38,820 |   |
|                                                                                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Earnings per  share:                                                                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Basic – as  reported                                                                                                                    |       | $                                          | 0.09       |                                      | $          | 0.33 |   | $ | 0.47 |   | $ | 0.84 |   |
| Basic – pro  forma                                                                                                                      |       | $                                          | 0.07       |                                      | $          | 0.31 |   | $ | 0.42 |   | $ | 0.81 |   |
|                                                                                                                                         |       |                                       |       |                                      |       |   |   |   |   |
| Diluted – as  reported                                                                                                                  |       | $                                          | 0.09       |                                      | $          | 0.32 |   | $ | 0.46 |   | $ | 0.83 |   |
| Diluted –  pro forma                                                                                                                    |       | $                                          | 0.07       |                                      | $          | 0.31 |   | $ | 0.42 |   | $ | 0.80 |   |

 

9

----

 

**In addition, for the three and ninemonths ended September 30, 2004, pre-tax compensation expense of $31 and $93,respectively, related to restricted stock awards was recognized and included innet income as reported.**

** **

*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 on April 1,2004, did not have a material impact on the Company’s balance sheet orstatement of operations.

 

In March 2004,the FASB’s Emerging Issues Task Force (“EITF”) supplemented EITF 03-1, “*The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*.” EITF 03-1 provides guidancefor evaluating whether an investment is other-than-temporarily impaired andrequires disclosures about unrealized losses on available for sale debt andequity securities. In September 2004, the FASB issued FSP EITF Issue03-1-1, “Effective Date of Paragraphs 10-20 of EITF Issue 03-1,” which deferredthe effective date of the recognition and measurement provisions of theconsensus until further guidance is issued. A separate proposed FSP was issued in September 2004 to addressEITF 03-1 implementation issues. Comments on this proposal were due on October 29,2004. The additional annual disclosures required by the March 2004consensus are effective for the fiscal year ending December 31, 2004. Theamount of any other-than-temporary impairment that may need to be recognizedupon full implementation of EITF 03-1 will depend on market conditions andother factors and will not be known until the guidance is finalized. NetBank is currently evaluating the impact implementation of thisguidance could have on its consolidated financial position or results ofoperations.

 

**4.**                                      LOAN AND LEASE RECEIVABLES

** **

At September 30, 2004 and December 31, 2003 the Company hadnet unamortized premiums and deferred cost on its loans and leases of $33,272and $30,256, respectively.   As of September 30,2004, NetBank had commitments to fund mortgage loans of $1.1 billion, open-endconsumer lines of credit of $75,345, undisbursed mortgage construction loans of$68,805, undisbursed commercial financing loans of $3,665 and commercialfinancing commitments of $1,814.  As of December 31,2003, NetBank had commitments to fund mortgage loans of $967 million, open-endconsumer lines of credit of $73,702, undisbursed mortgage construction loans of$53,091, undisbursed commercial financing loans of $4,447 and commercialfinancing commitments of $2,379.

 

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

 
| ** **                        | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------------|------------|-----------------------------|------------|----------------------------|------------|
| ** **                        | ** ** | **Amount**                  | ** ** | **%**                      | ** ** | **Amount** | ** ** | **%** | ** ** |
| First  mortgages                  |       | $                           | 1,147,750  |                       | 53.8       | % | $ | 1,186,922 |   | 65.8 | % |
| Second  mortgages                 |       | 157,222                     |       | 7.4                        | %          | 122,767 |   | 6.8 | % |
| Leases                            |       | 390,871                     |       | 18.3                       | %          | 349,952 |   | 19.4 | % |
| Auto                              |       | 341,879                     |       | 16.0                       | %          | 92,724 |   | 5.1 | % |
| Home equity  lines                |       | 92,484                      |       | 4.3                        | %          | 50,816 |   | 2.8 | % |
| Consumer                          |       | 3,999                       |       | 0.2                        | %          | 1,880 |   | 0.1 | % |
| Total                             |       | 2,134,205                   |       | 100.0                      | %          | 1,805,061 |   | 100.0 | % |
| Less  allowance for credit losses |       | (45,306                     | )          |                       |       | (43,689 | ) |   |   |
| Total                             |       | $                           | 2,088,899  |                       |       |   | $ | 1,761,372 |   |   |   |

 

10

----

 

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

** **

NetBank considers a loan orlease receivable to be impaired when it is probable that it will be unable tocollect all amounts due according to the original terms of the loan or leaseagreement.  NetBank measures impairmentof a loan or lease on a loan-by-loan or lease-by-lease basis.  Amounts of impaired loans that are not probableof collection are charged off immediately. NetBank had $86,045 and $87,228 of impaired, non-accrual loan and leasereceivables as of September 30, 2004 and December 31, 2003,respectively.  The purchased CMC leaseportfolio represented $81,993 of the $86,045 total impaired, non-accrual loanand lease receivables as of September 30, 2004, and $82,995 of $87,228 asof December 31, 2003.

 

NetBank, FSB is involved inlitigation with three insurance companies who are sureties on some of NetBank,FSB’s commercial lease portfolios. NetBank, FSB has filed a claim for all principal and interest paymentsthat are currently past due.  The totalunpaid principal and accrued interest balance of $82.0 million is included inloan and lease receivables.  The Companymaintains an allowance for losses against this portfolio of $21.2 million.  For the nine months ended September 30,2004 and 2003, the Company did not accrue scheduled interest of $1.8 millionand $4.1 million, respectively, and incurred $3.0 million and $0.7 million,respectively, in legal expenses related to this litigation.  Legal expenses are included in theprofessional fees line of the consolidated statements of operations.

 

The following is a summary of the allowance for credit losses:

 
| ** **                                                            | ** ** | **Three months ended  September 30,** | ** ** | **Nine months ended  September 30,** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                            | ** ** | **2004**                                   | ** ** | **2003**                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Beginning  balance**                                                |       | $                                          | 46,033     |                                      | $          | 41,855 |   | $ | 43,689 |   | $ | 42,576 |   |
| Provision  for credit losses                                          |       | 469                                        |       | 2,537                                     |       | 3,982 |   | 4,299 |   |
| Charge-offs:                                                          |       |                                       |       |                                      |       |   |   |   |   |
| Residential  mortgages                                                |       | (409                                       | )          | (817                                      | )          | (661 | ) | (1,241 | ) |
| Leases                                                                |       | (1,048                                     | )          | (1,372                                    | )          | (2,743 | ) | (4,127 | ) |
| Home equity  lines                                                    |       | (100                                       | )          | (56                                       | )          | (419 | ) | (489 | ) |
| Consumer                                                              |       | (28                                        | )          | (27                                       | )          | (101 | ) | (45 | ) |
| Auto                                                                  |       | (688                                       | )          | —                                    |       | (1,431 | ) | — |   |
| Total  charge-offs                                                    |       | (2,273                                     | )          | (2,272                                    | )          | (5,355 | ) | (5,902 | ) |
| Recoveries:                                                           |       |                                       |       |                                      |       |   |   |   |   |
| Residential  mortgages                                                |       | 191                                        |       | 19                                        |       | 306 |   | 121 |   |
| Leases                                                                |       | 573                                        |       | 440                                       |       | 1,826 |   | 1,427 |   |
| Home equity  lines                                                    |       | 8                                          |       | 89                                        |       | 124 |   | 147 |   |
| Consumer                                                              |       | —                                     |       | 3                                         |       | — |   | 3 |   |
| Auto                                                                  |       | 305                                        |       | —                                    |       | 734 |   | — |   |
| Total  recoveries                                                     |       | 1,077                                      |       | 551                                       |       | 2,990 |   | 1,698 |   |
| Total charge-offs,  net                                               |       | (1,196                                     | )          | (1,721                                    | )          | (2,365 | ) | (4,204 | ) |
| **Ending  balance**                                                   |       | $                                          | 45,306     |                                      | $          | 42,671 |   | $ | 45,306 |   | $ | 42,671 |   |
|                                                                  |       |                                       |       |                                      |       |   |   |   |   |
| Allowance  for credit losses as a percent of average loans and leases |       | 2.0                                        | %          | 3.1                                       | %          | 2.2 | % | 3.8 | % |

 

The following tables detail NetBank’s loan and lease receivables, theassociated allowance for credit losses and non-performing assets:

 

11

----

 
| **As of September 30, 2004** | ** ** | **Gross UPB** | ** ** | **Allocated  Allowance** | ** ** | **Non-  performing** | ** ** |
|-----------------------------------|------------|---------------|------------|--------------------------|------------|----------------------|------------|
| **Loans  and leases receivable**  | ** ** | ** **    | ** ** | ** **               | ** ** | ** **           | ** ** |
| First  mortgages                  |       | $             | 1,147,750  |                     | $          | 3,631                |       | $ | 2,394 |   |
| Second  mortgages                 |       | 157,222       |       | 4,646                    |       | 226                  |       |
| Leases                            |       | 308,878       |       | 12,713                   |       | 1,006                |       |
| Auto                              |       | 341,879       |       | 2,025                    |       | 412                  |       |
| Home equity  lines                |       | 92,484        |       | 953                      |       | 14                   |       |
| Consumer                          |       | 3,999         |       | 108                      |       | —               |       |
| Loan and  lease receivables       |       | 2,052,212     |       | 24,076                   |       | 4,052                |       |
| CMC leases                        |       | 81,993        |       | 21,230                   |       | 81,993               |       |
| Loan and  lease receivables       |       | $             | 2,134,205  |                     | $          | 45,306               |       | $ | 86,045 |   |

 
| **As of December 31, 2003**  | ** ** | **Gross UPB** | ** ** | **Allocated  Allowance** | ** ** | **Non-  performing** | ** ** |
|-----------------------------------|------------|---------------|------------|--------------------------|------------|----------------------|------------|
| **Loans  and leases receivable**  | ** ** | ** **    | ** ** | ** **               | ** ** | ** **           | ** ** |
| First  mortgages                  |       | $             | 1,186,922  |                     | $          | 3,935                |       | $ | 1,843 |   |
| Second  mortgages                 |       | 122,767       |       | 6,152                    |       | 593                  |       |
| Leases                            |       | 266,957       |       | 10,427                   |       | 1,430                |       |
| Auto                              |       | 92,724        |       | 1,054                    |       | 27                   |       |
| Home equity  lines                |       | 50,816        |       | 829                      |       | 339                  |       |
| Consumer                          |       | 1,880         |       | 62                       |       | 1                    |       |
| Loan and lease  receivables       |       | 1,722,066     |       | 22,459                   |       | 4,233                |       |
| CMC leases                        |       | 82,995        |       | 21,230                   |       | 82,995               |       |
| Total loan  and lease receivables |       | $             | 1,805,061  |                     | $          | 43,689               |       | $ | 87,228 |   |

 

----

 

As more fully described in Note 3 in NetBank’sForm 10-K for the year ended December 31, 2003, its loans held for saleare carried at the lower of aggregate cost or market (“LOCOM”).  The company establishes a reserve until theloans can be sold, which is typically about 30 to 90 days after origination orpurchase.  The majority of NetBank’snon-performing loans held for sale consist of loans which the Company has beenrequired to repurchase.  Once a loan hasbeen repurchased, it is generally resold in a “scratch-and-dent” sale.

 
| ** **                | ** ** | **As of September 30, 2004** | ** ** |
|---------------------------|------------|-----------------------------------|------------|
| **Loans held for sale**   | ** ** | **Gross UPB**                     | ** ** | **Reserve** | ** ** | **Non-  performing** | ** ** |
| Conforming  mortgages     |       | $                                 | 963,593    |   | $ | 5,118 |   | $ | 27,302 |   |
| Non-conforming  mortgages |       | 272,484                           |       | 5,071 |   | 16,587 |   |
| Construction              |       | 59,065                            |       | 140 |   | — |   |
| Commercial  mortgages     |       | 7,243                             |       | 919 |   | — |   |
| Total                     |       | $                                 | 1,302,385  |   | $ | 11,248 |   | $ | 43,889 |   |

 
| ** **                | ** ** | **As of December 31, 2003** | ** ** |
|---------------------------|------------|----------------------------------|------------|
| **Loans held for sale**   | ** ** | **Gross UPB**                    | ** ** | **Reserve** | ** ** | **Non-  performing** | ** ** |
| Conforming  mortgages     |       | $                                | 1,477,616  |   | $ | 9,602 |   | $ | 25,422 |   |
| Non-conforming  mortgages |       | 435,188                          |       | 7,821 |   | 20,566 |   |
| Construction              |       | 44,377                           |       | 63 |   | 421 |   |
| Commercial  mortgages     |       | 12,912                           |       | 1,494 |   | — |   |
| Total                     |       | $                                | 1,970,093  |   | $ | 18,980 |   | $ | 46,409 |   |

 

12

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

** **

As described in note 3 of NetBank’s Annual Report filed on Form 10-Kfor the year ended December 31, 2003, the Company accounts for allmortgage servicing rights per the guidance in SFAS No. 140.  For purposes of evaluating NetBank’s mortgageservicing rights portfolio for impairment, the Company disaggregates itsservicing portfolio into two primary groupings: available for sale and held forsale.

 

The segment ofthe portfolio designated as available for sale is composed of servicing rightsthat were retained out of production pursuant to individual portfolio retentiondecisions or purchased in bulk transactions. The available for sale portfolio is disaggregated for purposes ofmeasuring potential impairments according to defined risk tranches.  The Company has defined these risk tranchesbased upon interest rate band and product type. With respect to each such risk tranche, the fair value thereof, which isbased upon an internal analysis that considers current market conditions,prevailing interest rates, prepayment speeds, default rates and other relevantfactors, is compared to amortized carrying values of the mortgage servicingrights for purposes of measuring potential impairment.

 

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

 

The following amounts related to NetBank’s mortgage servicing rightsportfolio as of September 30, 2004 and December 31, 2003:

 
| ** **                    | ** ** | **Available for sale** | ** ** | **Held for sale** | ** ** |
|-------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                    | ** ** | **2004**               | ** ** | **2003**          | ** ** | **2004** | ** ** | **2003** | ** ** |
| UPB                           |       | $                      | 13,071,921 |              | $          | 12,293,325 |   | $ | 275,756 |   | $ | 250,338 |   |
| Carrying  Value               |       | $                      | 168,991    |              | $          | 162,030 |   | $ | 3,002 |   | $ | 3,184 |   |
| Carrying  Value / UPB         |       | 1.29                   | %          | 1.32              | %          | 1.09 | % | 1.27 | % |
| Fair value                    |       | $                      | 169,260    |              | $          | 162,656 |   | $ | 3,002 |   | $ | 3,184 |   |
| Fair  Carrying Value / UPB    |       | 1.29                   | %          | 1.32              | %          | 1.09 | % | 1.27 | % |
| Weighted  average note rate   |       | 5.95                   | %          | 6.09              | %          | 6.30 | % | 5.82 | % |
| Weighted  average service fee |       | 0.33                   | %          | 0.33              | %          | 0.34 | % | 0.32 | % |
| Net Basis as  multiple        |       | 3.98                   |       | 3.99              |       | 3.18 |   | 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 impairment  |   | 10,387   |       | 38,434   |   |   |   |   |   |
| Balance as  of September 30 |   | $        | 68,640     |     | $      | 52,863 |   |   |   |   |   |

 

13

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**7.**                                      DEPOSITS

** **

The following table sets forth the dollar amount of deposits andweighted average interest rates in the various types of deposit programsoffered by the Company:

 
| ** **                             | ** ** | **As of September 30, 2004** | ** ** | **As of December 31, 2003** | ** ** |
|----------------------------------------|------------|-----------------------------------|------------|----------------------------------|------------|
| ** **                             | ** ** | **Amount**                        | ** ** | **Percentage**                   | ** ** | **Weighted  average  interest  rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest  rate** | ** ** |
| Non-interest bearing checking accounts |       | $                                 | 324,414    |                             | 11.8       | % | N/A |   | $ | 198,884 |   | 7.8 | % | N/A |   |
| Interest  bearing:                     |       |                              |       |                             |       |   |   |   |   |   |   |   |   |
| Checking  accounts                     |       | 245,952                           |       | 9.0                              | %          | 1.1 | % | 228,178 |   | 9.0 | % | 1.4 | % |
| Money market                           |       | 1,218,326                         |       | 44.4                             | %          | 1.7 | % | 1,363,294 |   | 53.7 | % | 1.9 | % |
| Certificate  of deposit under $100     |       | 848,018                           |       | 30.9                             | %          | 2.8 | % | 632,602 |   | 24.9 | % | 2.8 | % |
| Certificate  of deposit over $100      |       | 107,999                           |       | 3.9                              | %          | 2.8 | % | 116,469 |   | 4.6 | % | 2.8 | % |
| Total  deposits                        |       | $                                 | 2,744,709  |                             | 100.0      | % |   |   | $ | 2,539,427 |   | 100.0 | % |   |   |

 

Accrued interest as of September 30, 2004 related to checking,money market and certificates of deposit accounts was $77, $659 and $5,209,respectively.  Accrued interest as of December 31,2003, related to checking, money market, and certificates of deposit accountswas $81, $801 and $5,686, respectively. At September 30, 2004, and December 31, 2003, $677 and $664 ofoverdrawn deposits were classified as loans, respectively.

 

**8.**                                      BORROWINGS

** **

A summary of borrowings andavailable borrowings, grouped by year of maturity, as of September 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                               | *          | $                                 | 32         |   |
| $25 million  line of credit              |       | 2004                 |       | Fed Funds                           | *          | —                            |       |
| $350 million  warehouse line of credit   |       | 2004                 |       | 2.69%, 3.19                         | %*         | 40,958                            |       |
| $300 million master  repurchase facility |       | 2004                 |       | 2.93% to 3.18                       | %*         | —                            |       |
| $625 million FHLB warehouse  line **     |       | 2005                 |       | DRC + 0.50                          | %*         | —                            |       |
| $200 million master  repurchase facility |       | 2004                 |       | 3.09% to 3.21                       | %          | —                            |       |
| FHLB  advances                           |       | 2004                 |       | DRC, 4.45                           | %*         | 50,000                            |       |
| FHLB  advances                           |       | 2005                 |       | 1.73% to 7.41                       | %          | 266,000                           |       |
| FHLB  advances                           |       | 2006                 |       | 2.04% to 5.63                       | %          | 110,000                           |       |
| FHLB  advances                           |       | 2007                 |       | 2.57                                | %          | 40,000                            |       |
| Notes  Payable                           |       | 2007                 |       | 5.95                                | %          | 221                               |       |
| FHLB  advances                           |       | 2008                 |       | 1.90% to 1.92                       | %          | 100,000                           |       |
| Notes Payble                             |       | 2008                 |       | 5.95                                | %          | 1,137                             |       |
| 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                             |       |
| Repurchase agreement                     |       | 2004                 |       | 1.74                                | %          | 56,946                            |       |
| Total Debt                               |       |                 |       |                                |       | $                                 | 1,077,151  |   |

 

14

----

 

----

*Indicates a variable rate.

** Line of credit can extended up to 40% ofNetBank, FSB’s assets

 

Ten of the Federal Home LoanBank (“FHLB”) advances totaling $376,000 are fixed rate. The remaining advancestotaling $590,000 are also fixed, however, they may be converted at the FHLB’soption to adjustable rate based on the three month floating LIBOR.  TheFHLB warehouse line is a $625,000 adjustable line of credit with a floatingrate based on the daily rate credit (“DRC”) plus 50 basis points used to fundmortgages originated by Market Street and NetBank Funding.  An additional warehouse line based upon 40%of assets of the savings bank has a floating rate based on the DRC.  All of the FHLB advances and the FHLBwarehouse line are secured by investment securities or mortgage loans.  AtSeptember 30, 2004, NetBank had pledged $205,404 of investment securitiesand $1.1 billion of mortgage loans to the FHLB as collateral for various FHLBadvances.  During the third quarter of2004, the savings bank entered into a repurchase agreement.  At September 30, 2004, $55,609 ofinvestment securities were pledged as collateral for the related borrowings.

 

In July 2003, all the convertible subordinated notes were calledat par, and the remaining unamortized discount of $145 was written off.

 

NetBank’s subordinated debt is supported by trust preferred securities,which were issued in private pooled transactions through off-balance sheettrusts: NBI Trust I, II and III. The subordinated debt, and the associatedtrust preferred securities carry a variable rate and were initially priced atLIBOR plus 2.85% to 3.35% with a cap of 12.5% through January 2008.  Interest payments and the resetting of therates both occur on a quarterly basis. The debt is scheduled to mature from December 2032 through December 2034and cannot be redeemed by the trust for a minimum of five years after issuance.

 

Most of the revolving lines of credit, warehouse lines of credit (otherthan the FHLB warehouse line) and the master repurchase facilities are securedby mortgage loans and are subject to restrictive covenants.  The covenants include certain minimum networth requirements, minimum tangible net worth requirements, minimum financialratios, capital requirements, maintenance of servicer eligibility for variousgovernment agencies, a minimum balance in the mortgage servicing rightsportfolio and certain minimum liquidity requirements, which are all defined inthe terms of the related debt agreements.  In addition, the covenantsrestrict the types of business activities in which the Company mayengage.  NetBank was in compliance with all debt covenants in place as of September 30,2004.  Although management anticipates complying with all current debtcovenants, there can be no assurance that NetBank or its individualsubsidiaries will be able to comply with all debt covenants in thefuture.  Failure to comply could result in the loss of the relatedfinancing.  Short-term debt outstandingto third parties reached the highest month end level for the quarter on July 31,2004 with a daily short-term balance of $2.2 billion.

 

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

** **

Basic and diluted net incomeper common and potential common share has been calculated based on the weightedaverage number of shares outstanding. The following schedule reconciles the numerator and denominator ofthe basic and diluted net income per common and potential common share for thethree and nine months ended September 30, 2004 and 2003.  The effect of the retired convertible debtsecurities was not included in the 2003 periods because the assumed conversionof such securities was anti-dilutive.

 
| ** **                                                         | ** ** | **Net Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------|------------|-----------------------|------------|
| **Nine  months ended September 30, 2004**                     | ** ** | ** **                  | ** ** | ** **                | ** ** | ** **            | ** ** |
| Basic EPS                                                          |       | $                           | 21,876     |                      | 46,962     |                  | $          | 0.47 |   |
| Effect of  dilutive securities - options to purchase common shares |       | —                      |       | 469                       |       | (0.01                 | )          |
| Diluted EPS                                                        |       | $                           | 21,876     |                      | 47,431     |                  | $          | 0.46 |   |
|                                                               |       |                        |       |                      |       |                  |       |
| **Nine  months ended September 30, 2003**                     | ** ** | ** **                  | ** ** | ** **                | ** ** | ** **            | ** ** |
| Basic EPS                                                          |       | $                           | 40,504     |                      | 48,039     |                  | $          | 0.84 |   |
| Effect of  dilutive securities - options to purchase common shares |       | —                      |       | 622                       |       | (0.01                 | )          |
| Diluted EPS                                                        |       | $                           | 40,504     |                      | 48,661     |                  | $          | 0.83 |   |

 

15

----

 
| ** **                                                         | ** ** | **Net Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------|------------|-----------------------|------------|
| **Three  months ended September 30, 2004**                    | ** ** | ** **                  | ** ** | ** **                | ** ** | ** **            | ** ** |
| Basic EPS                                                          |       | $                           | 4,015      |                      | 46,846     |                  | $          | 0.09 |   |
| Effect of  dilutive securities - options to purchase common shares |       | —                      |       | 310                       |       | —                |       |
| Diluted EPS                                                        |       | $                           | 4,015      |                      | 47,156     |                  | $          | 0.09 |   |
|                                                               |       |                        |       |                      |       |                  |       |
| **Three  months ended September 30, 2003**                    | ** ** | ** **                  | ** ** | ** **                | ** ** | ** **            | ** ** |
| Basic EPS                                                          |       | $                           | 15,589     |                      | 47,829     |                  | $          | 0.33 |   |
| Effect of  dilutive securities - options to purchase common shares |       | —                      |       | 761                       |       | (0.01                 | )          |
| Diluted EPS                                                        |       | $                           | 15,589     |                      | 48,590     |                  | $          | 0.32 |   |

 

**10.**                               BUSINESS SEGMENTS

** **

During2004, NetBank realigned its operating segments as described in the followingparagraph.  Prior period amounts havebeen restated in conformity with the current period presentation.

 

NetBank’sprincipal activities include retail banking, financial intermediary andtransaction processing.  The retail banking segment primarilyconsists of offering consumer banking products such as checking, moneymarket, and certificates of deposit.  Itsinvestments primarily consist of 1-4 family mortgage loans originated by thefinancial intermediary segment, small business financing loans and leasesoriginated by its NetBank Business Financing division, auto loans originated byits dealer financial services division, purchased securities for investment,mortgage servicing assets and various other purchased or retained loanproducts.  The financial intermediary segment originates mortgage loansdirectly with borrowers and through brokers and purchases mortgage loans fromcorrespondents.  The financialintermediary segment packages or pools such loans either inclusive or exclusiveof servicing rights for retention by the retail banking segment or sale intothe secondary market.  The transactionprocessing segment provides ATM and merchant processing services; subservicesloans for the retail bank segment, financial intermediary segment and forthird-party customers; and sells various insurance products using anInternet-based platform.

 

The financial informationfor each business segment reflects specific identifiable transactions orallocated transactions based on an internal allocation method.  The measurement of the performance of thebusiness segments is based on the management structure of NetBank, Inc. and isnot necessarily comparable with similar information from any other financialinstitution. The information presented is also not necessarily indicative ofthe segment’s operations if they were independent entities.

 

16

----

 
| ** **                                        | ** ** | **For the three months ended September 30,  2004** | ** ** |
|---------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                        | ** ** | **Retail  banking**                                     | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Other &  Eliminations** | ** ** | **Consolidated** | ** ** |
| Interest  income                                  |       | $                                                       | 33,639     |   | $ | 29,420 |   | $ | 12 |   | $ | 421 |   | $ | 63,492 |   |
| Intersegment  interest income                     |       | 11,597                                                  |       | 549 |   | — |   | (12,146 | ) | — |   |
| Total  interest income                            |       | 45,236                                                  |       | 29,969 |   | 12 |   | (11,725 | ) | 63,492 |   |
| Interest  expense                                 |       | 22,685                                                  |       | 2,476 |   | 20 |   | 194 |   | 25,375 |   |
| Intersegment  interest expense                    |       | 138                                                     |       | 11,814 |   | — |   | (11,952 | ) | — |   |
| Total  interest expense                           |       | 22,823                                                  |       | 14,290 |   | 20 |   | (11,758 | ) | 25,375 |   |
| Net interest  income                              |       | 22,413                                                  |       | 15,679 |   | (8 | ) | 33 |   | 38,117 |   |
| Provision  for credit losses                      |       | 466                                                     |       | 3 |   | — |   | — |   | 469 |   |
| Intersegment  - servicing and processing fees     |       | —                                                  |       | 1,145 |   | 3,721 |   | (4,866 | ) | — |   |
| Non-interest  income                              |       | 25,114                                                  |       | 28,701 |   | 4,616 |   | (512 | ) | 57,919 |   |
| Non-interest  expense                             |       | 42,301                                                  |       | 38,222 |   | 7,300 |   | 1,243 |   | 89,066 |   |
| Intersegment  - servicing and processing expenses |       | 2,560                                                   |       | 2,306 |   | — |   | (4,866 | ) | — |   |
| Pre-tax  income (loss)                            |       | 2,200                                                   |       | 4,994 |   | 1,029 |   | (1,722 | ) | 6,501 |   |
| Income tax  (expense) benefit                     |       | (841                                                    | )          | (1,913 | ) | (385 | ) | 653 |   | (2,486 | ) |
| Net income  (loss)                                |       | $                                                       | 1,359      |   | $ | 3,081 |   | $ | 644 |   | $ | (1,069 | ) | $ | 4,015 |   |
|                                              |       |                                                    |       |   |   |   |   |   |   |   |   |
| Total assets                                      |       | $                                                       | 4,148,062  |   | $ | 1,494,300 |   | $ | 36,436 |   | $ | (1,190,527 | ) | $ | 4,488,271 |   |

 
|                                              |   | **For the three months ended September 30,  2003** |       |
|---------------------------------------------------|--------|---------------------------------------------------------|------------|
|                                              |   | **Retail  banking**                                     | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Other &  Eliminations** | ** ** | **Consolidated** |   |
| Interest  income                                  |   | $                                                       | 22,481     |   | $ | 36,402 |   | $ | — |   | $ | 36 |   | $ | 58,919 |   |
| Intersegment  interest income                     |   | 13,287                                                  |       | 53 |   | — |   | (13,340 | ) | — |   |
| Total  interest income                            |   | 35,768                                                  |       | 36,455 |   | — |   | (13,304 | ) | 58,919 |   |
| Interest  expense                                 |   | 19,345                                                  |       | 2,331 |   | — |   | 283 |   | 21,959 |   |
| Intersegment  interest expense                    |   | 92                                                      |       | 13,049 |   | — |   | (13,141 | ) | — |   |
| Total  interest expense                           |   | 19,437                                                  |       | 15,380 |   | — |   | (12,858 | ) | 21,959 |   |
| Net interest  income                              |   | 16,331                                                  |       | 21,075 |   | — |   | (446 | ) | 36,960 |   |
| Provision  for credit losses                      |   | 2,542                                                   |       | (5 | ) | — |   | — |   | 2,537 |   |
| Intersegment  - servicing and processing fees     |   | —                                                  |       | — |   | 3,329 |   | (3,329 | ) | — |   |
| Non-interest  income                              |   | 17,808                                                  |       | 79,592 |   | 1,614 |   | (2,366 | ) | 96,648 |   |
| Non-interest  expense                             |   | 54,627                                                  |       | 43,336 |   | 6,101 |   | 2,214 |   | 106,278 |   |
| Intersegment  - servicing and processing expenses |   | 2,909                                                   |       | 420 |   | — |   | (3,329 | ) | — |   |
| Pre-tax  income (loss)                            |   | (25,939                                                 | )          | 56,916 |   | (1,158 | ) | (5,026 | ) | 24,793 |   |
| Income tax  (expense) benefit                     |   | 16,082                                                  |       | (35,288 | ) | 718 |   | 9,284 |   | (9,204 | ) |
| Net income  (loss)                                |   | $                                                       | (9,857     | ) | $ | 21,628 |   | $ | (440 | ) | $ | 4,258 |   | $ | 15,589 |   |

 

17

----

 
|                                              |   | **For the nine months ended September 30,  2004** |       |
|---------------------------------------------------|--------|--------------------------------------------------------|------------|
|                                              |   | **Retail  banking**                                    | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Other &  Eliminations** | ** ** | **Consolidated** |   |
| Interest  income                                  |   | $                                                      | 88,280     |   | $ | 84,003 |   | $ | 30 |   | $ | 2,041 |   | $ | 174,354 |   |
| Intersegment  interest income                     |   | 31,914                                                 |       | 662 |   | — |   | (32,576 | ) | — |   |
| Total  interest income                            |   | 120,194                                                |       | 84,665 |   | 30 |   | (30,535 | ) | 174,354 |   |
| Interest  expense                                 |   | 60,822                                                 |       | 6,622 |   | 65 |   | 480 |   | 67,989 |   |
| Intersegment  interest expense                    |   | 381                                                    |       | 31,822 |   | — |   | (32,203 | ) | — |   |
| Total  interest expense                           |   | 61,203                                                 |       | 38,444 |   | 65 |   | (31,723 | ) | 67,989 |   |
| Net interest  income                              |   | 58,991                                                 |       | 46,221 |   | (35 | ) | 1,188 |   | 106,365 |   |
| Provision  for credit losses                      |   | 3,938                                                  |       | 44 |   | — |   | — |   | 3,982 |   |
| Intersegment  - servicing and processing fees     |   | —                                                 |       | 1,145 |   | 10,775 |   | (11,920 | ) | — |   |
| Non-interest  income                              |   | 56,350                                                 |       | 98,989 |   | 12,992 |   | (3,101 | ) | 165,230 |   |
| Non-interest  expense                             |   | 92,432                                                 |       | 113,118 |   | 22,968 |   | 4,119 |   | 232,637 |   |
| Intersegment  - servicing and processing expenses |   | 7,435                                                  |       | 4,485 |   | — |   | (11,920 | ) | — |   |
| Pre-tax  income (loss)                            |   | 11,536                                                 |       | 28,708 |   | 764 |   | (6,032 | ) | 34,976 |   |
| Income tax  (expense) benefit                     |   | (4,321                                                 | )          | (11,015 | ) | (23 | ) | 2,259 |   | (13,100 | ) |
| Net income  (loss)                                |   | $                                                      | 7,215      |   | $ | 17,693 |   | $ | 741 |   | $ | (3,773 | ) | $ | 21,876 |   |

 
|                                              |   | **For the nine months ended September 30,  2003** |       |
|---------------------------------------------------|--------|--------------------------------------------------------|------------|
|                                              |   | **Retail  banking**                                    | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Other &  Eliminations** | ** ** | **Consolidated** |   |
| Interest  income                                  |   | $                                                      | 61,472     |   | $ | 92,729 |   | $ | — |   | $ | 61 |   | $ | 154,262 |   |
| Intersegment  interest income                     |   | 33,110                                                 |       | 135 |   | — |   | (33,245 | ) | — |   |
| Total  interest income                            |   | 94,582                                                 |       | 92,864 |   | — |   | (33,184 | ) | 154,262 |   |
| Interest  expense                                 |   | 57,980                                                 |       | 5,937 |   | — |   | 1,174 |   | 65,091 |   |
| Intersegment  interest expense                    |   | 977                                                    |       | 32,330 |   | — |   | (33,307 | ) | — |   |
| Total  interest expense                           |   | 58,957                                                 |       | 38,267 |   | — |   | (32,133 | ) | 65,091 |   |
| Net interest  income                              |   | 35,625                                                 |       | 54,597 |   | — |   | (1,051 | ) | 89,171 |   |
| Provision  for credit losses                      |   | 4,263                                                  |       | 36 |   | — |   | — |   | 4,299 |   |
| Intersegment  - servicing and processing fees     |   | —                                                 |       | — |   | 8,685 |   | (8,685 | ) | — |   |
| Non-interest  income                              |   | 52,451                                                 |       | 194,092 |   | 4,379 |   | (4,576 | ) | 246,346 |   |
| Non-interest  expense                             |   | 128,735                                                |       | 116,276 |   | 16,867 |   | 5,141 |   | 267,019 |   |
| Intersegment  - servicing and processing expenses |   | 7,513                                                  |       | 1,172 |   | — |   | (8,685 | ) | — |   |
| Pre-tax  income (loss)                            |   | (52,435                                                | )          | 131,205 |   | (3,803 | ) | (10,768 | ) | 64,199 |   |
| Income tax  (expense) benefit                     |   | 32,510                                                 |       | (81,347 | ) | 2,358 |   | 22,784 |   | (23,695 | ) |
| Net income                                        |   | $                                                      | (19,925    | ) | $ | 49,858 |   | $ | (1,445 | ) | $ | 12,016 |   | $ | 40,504 |   |

 

# **11.**                               COMMITMENTS AND GUARANTEES

# ** **

The Company has issuedmortgage-backed securities under programs sponsored by Ginnie Mae, Freddie Macand Fannie Mae.  In connection withservicing mortgage-backed securities guaranteed by Ginnie Mae, Freddie Mac orFannie Mae, the Company advances certain principal and interest payments tosecurity holders prior to their collection from specific mortgagors.  Additionally, the Company must remit certainpayments of property taxes and insurance premiums in advance of collecting themfrom specific mortgagors and make certain payments of attorney’s fees and othercosts related to loans in foreclosure. These amounts are included in servicing advances under the caption duefrom servicers and investors in the accompanying consolidated balancesheets.  Likewise, during the month thata mortgagor prepays in full his/her mortgage, the Company must accept aninterest payment from the borrower that is pro-rated to the date of

 

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prepayment and pass througha full month of interest to the security holder.  The Company includes its projection of thecost of such advances and lost interest on mortgages that prepay, and theexpense of unreimbursed attorney and other costs associated with foreclosure inits valuation of the servicing assets.

 

In the ordinary course of business, the Company is exposed to liabilityunder representations and warranties made to purchasers and insurers ofmortgage loans and the purchasers of servicing rights.  Under certain circumstances, the Company maybe required to repurchase mortgage loans or indemnify the purchasers of loansor servicing rights for losses if there has been a breach of representations orwarranties.  Repurchased loans arecarried at the lower of cost or net realizable value.  There were $53.2 million and $51.9 million ofrepurchased loans included in mortgage loans held for sale at September 30,2004 and December 31, 2003, respectively. The Company had $10.3 million and $16.8 million of reserves, recorded inloans held for sale, resulting from the estimation of the net realizable valueassociated with repurchased loans as of September 30, 2004 and December 31,2003, respectively.  Additionally, theCompany had $22.3 million and $17.9 million of reserves for estimated losses onfuture repurchases as of September 30, 2004 and December 31, 2003,respectively.

 

NetBank is unable to determine its maximum exposure under itsrepresentations and warranties.  Themaximum exposure under NetBank’s representations and warranties would be theoutstanding principal balance and any premium paid on all loans or mortgageservicing rights ever sold by the Company less any loans sold servicingreleased or any loans underlying mortgage servicing rights that have alreadyprepaid or defaulted without a breach of representations and warranties.  For the nine months ended September 30,2004 and 2003 the Company repurchased approximately $70.5 million and $32.1million of unpaid principal balances, respectively.

 

**NetBank is involved in certain legal proceedings, excludingthe CMC litigation discussed in note 5, 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.**

** **

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

 

*The following discussion may includeforward-looking statements. Forward-looking statements regarding the intent,belief or current expectations of NetBank, Inc. or its officers and directorscan be identified by the use of forward-looking terms such as “may,” “will,” “should,”“believe,” “expect,” “anticipate,” “estimate,” “continue,” or other comparableterminology. Various internal and external factors could cause the Company’sactual results to differ materially from those anticipated by theforward-looking statements. These factors include, but are in no way limitedto, 1) the evolving nature of the market for Internet banking and financialservices generally; 2) the public’s perception of the Internet as a secure,reliable channel for transactions; 3) the success of new products and lines ofbusiness considered critical to the Company’s long-term strategy, such as smallbusiness banking and transaction processing services; 4) potential difficultiesin integrating the Company’s operations across its multiple lines of business;5) the cyclical nature of the mortgage banking industry generally; 6) apossible decline in asset quality; 7) the possible adverse effects ofunexpected changes in the interest rate environment; 8) adverse legal rulings,particularly in the company’s litigation over leases originated by theCommercial Money Center, Inc.; and/or 9) increased competition and regulatorychanges. The Company’s 2003 Form 10-K filed with the Securities and ExchangeCommission, contains additional details on these and other risks that arematerial to operations. All forward-looking statements in this report are basedon information available at the time of filing. The Company has no obligationto update any forward-looking statement included herein.*

 

**General**

 

NetBank, Inc. is a financial holding company that wholly owns theoutstanding stock of NetBank, (“NetBank, FSB” or the “Bank”), a federal savingsbank; MG Reinsurance Company (“MG Reinsurance”), a captive reinsurance company;NetInsurance, Inc., (“NetInsurance”), a licensed insurance agency; and NBPartners, Inc., a corporation formed to be involved in strategic partneringopportunities.  NetBank, FSB owns all ofthe outstanding stock of Market Street Mortgage Corporation (“Market Street”),a retail mortgage company, NetBank Payment Systems, Inc. (“NPS”), a leadingprovider of ATM services for retail and other non-bank businesses and MeritageMortgage Corporation (“Meritage”), a wholesale non-conforming mortgageprovider. The entire consolidated company is referred to herein as “NetBank” or“the Company”.

 

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During the third quarter of 2004, Resource Bancshares Mortgage Group,Inc. and Republic Leasing Company, Inc., both of which had been subsidiaries ofNetBank, FSB, were legally consolidated into NetBank, FSB and ceased to existas separate corporations.  RepublicLeasing now operates as the NetBank Business Finance division of NetBank,FSB.  In addition, on October 1, 2004,RBMG, Inc. was legally consolidated into NetBank, FSB and ceased to exist as aseparate corporation.  RBMG, Inc. nowoperates as the NetBank Funding division of NetBank, FSB.

 

The results of operations of all acquisitions are included in theconsolidated results of operations from their respective dates ofacquisition.  All dollar figures arepresented in thousands (000s), except per share data, unless otherwisenoted.  Net income per share is presentedon a dilutive basis.

 

*Executive Summary.*

 

Net income for the three months ended September 30, 2004 was $4,015 or$0.09 per share compared to $15,589 or $0.32 per share for the same period of2003.  The decline in earnings wasprimarily due to a decline of $32.7 million in the financial intermediarysegment.  This sharp decline is relatedto the $1.3 billion or 26% decline in sales of mortgage loans period overperiod coupled with compressed margins due to increased competition, especiallyin the correspondent channel.

 

The financial intermediary segment’s drop in earnings was offset, inpart, by a $17.7 million increase in the retail banking segment.  This increase was driven primarily by improvednet servicing results of $13.1 million pre-tax, higher net interest income atthe Bank of $6.1 million, gain on sale of loans of $2 million, and animprovement in net gain on sale of securities and prepaid debt of $6.6 million.  Net servicing results improved as a result oflower actual and projected prepayments in the third quarter of 2004 comparedwith the third quarter 2003.  The retailbank’s net interest margin improved by 27 basis points period over periodprimarily due to the retention of higher yielding assets, such as internallyoriginated auto 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.  NetBank believestransactional- or multi- account customers will provide a more stable lowercost of funds over the long-term.  Theimprovement in the net gain on sale of securities and prepaid debt relates to1) a net loss during the three months ended September 30, 2003 of $4.3 millionrelated to prepayment fees incurred in the payoff of certain higher cost termFHLB borrowings and 2) gains realized on the sale of certain mortgage-backedsecurities that were being used as an on-balance sheet, economic hedge of aportion of the interest rate risk inherent in the servicing assets.  During the third quarter NetBank acquired the principal operating assets of BeaconCredit Services, LLC, a privately held provider of RV, boat and aircraftfinancing.  Through Beacon, NetBank willoriginate RV, boat and aircraft loans for sale into the secondary markets.

 

The transaction processing segment’s net income improved by $1.4million comparing the third quarter of 2004 to the same period in 2003.  This improvement relates to the acquisitionof NetBank Payment Systems late in 2003 and improved expense control in theservicing operation.

 

**FinancialCondition**

 

*General. *NetBank’s assets totaled $4.5 billion at September30, 2004, a decrease of $247 million or 5% from December 31, 2003.  This decrease is primarily the result of a $660million decline in loans held for sale, a $142 million decline in investmentsecurities available for sale and a $90 million decline in receivables fromunsettled trades.  These declines wereoffset, in part, by increases of $328 million in loans and leases receivable,$196 million in cash and cash equivalents and $77 million in due from servicersand investors.  The $660 million declinein loans held for sale was primarily due to the financial intermediary segmentproducing $10.5 billion of mortgage loans compared to selling $10.2 billion tothird-parties and retaining $781 million at the retail bank.  Investment securities declined during theperiod as a result of purchasing only $315 million new securities to offsetsales of $363 million, calls of $60 million and approximately $35 million inpayments and amortization.  The $90million decline in receivables from unsettled trades is due to NetBank nothaving any unsettled trades at September 30, 2004.  The $328 million increase in loans and leasesreceivable is primarily due to the retention of approximately $781 million inmortgage loans, $306 million of auto loans and $129 million of leases, offset,in part, by the sale of $350 million in mortgage loans and payments andamortization of approximately $538 million. The $196 million increase in cashand cash equivalents is due primarily to receiving approximately $60 millionfor the settlement of loan sales on the last day of the period coupled with achange in the funding / borrowing

 

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methodology. Beginning in early 2004, NetBank began placing a percentage of theestimated next day loan funding amount in overnight accounts to facilitate themovement of funds on the next day.  Duefrom servicers and investors increased primarily from establishment of newreceivables associated with sales of mortgage loans on or near the last day ofthe period.

 

*Investment Securities.*  For the ninemonths ended September 30, 2004, the investment security portfolio decreased by$142 million. The securities portfolio decreased due to the sale of $363million, calls of $60 million and approximately $35 million in payments andamortization. These decreases were offset, in part, by the purchase of $315million of new securities, primarily mortgage backed securities and U.S.government securities.

 

The following tables set forthcertain information relating to the Company’s available for sale securities:

 
| **As of September 30, 2004**        | ** ** | **Amortized  cost** | ** ** | **Unrealized  gains** | ** ** | **Unrealized  losses** | ** ** | **Estimated  fair value** | ** ** |
|-------------------------------------|------------|---------------------|------------|-----------------------|------------|------------------------|------------|---------------------------|------------|
| Mortgage pool securities            |       | $                   | 73,141     |                  | $          | —                 |       | $                         | 300        |   | $ | 72,841 |   |
| Collateralized mortgage obligations |       | 33,648              |       | 76                    |       | 410                    |       | 33,314                    |       |
| U.S. government agencies            |       | 160,683             |       | 2,089                 |       | —                 |       | 162,772                   |       |
| Corporate bonds                     |       | 39,144              |       | 727                   |       | 96                     |       | 39,775                    |       |
| Habitat bonds and other             |       | 3,706               |       | 194                   |       | —                 |       | 3,900                     |       |
| Total                               |       | $                   | 310,322    |                  | $          | 3,086                  |       | $                         | 806        |   | $ | 312,602 |   |
|                                     |            |                     |            |                       |            |                        |            |                           |            |  |  |  |  |  |

 
| **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 |   |
|                                     |            |                     |            |                       |            |                        |            |                           |            |  |  |  |  |  |  |  |  |

 

*Loans and Leases Receivable.*  For the ninemonths ended September 30, 2004, the loans and leases receivable portfolioincreased $328 million, a 19% increase. The Company achieved this growth by selectively retaining $781 millionin mortgage and home equity loans originated through its mortgage subsidiaries,$306 million of auto loans originated through its indirect auto lending unitand $129 million of business financing leases originated through its NetBankBusiness Financing division.  Theretention of these internally originated assets was offset, in part, by thesale of $350 million of mortgage loans and approximately $537 million ofprincipal reductions and prepayments.  Asof September 30, 2004, third-party purchased loans and leases, excluding theCMC lease portfolio, represented approximately 11% of the loan and leasereceivable portfolio.

 

*Asset Quality and Non-performing Assets.* TheCompany periodically reviews the performance of its loans and leases receivableportfolio 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 characteristics 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 loans and leases receivable 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

 

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loans and leases and other pertinent factors.  NetBank’s non-performing loans and leasesreceivable as a percentage of gross unpaid principal balance (UPB) improvedfrom 4.8% at December 31, 2003, to 4.0% at September 30, 2004, as the level ofnon-performing assets held fairly constant relative to an increase of $329million or 18% in gross UPB.

 

The following tables detail NetBank’s held for investment loan andlease portfolio, the associated allowance for credit losses and non-performingassets:

 
| ** **                      | ** ** | **September 30, 2004** | ** ** |
|---------------------------------|------------|------------------------|------------|
| ** **                      | ** ** | **Gross UPB**          | ** ** | **Allocated  Allowance** | ** ** | **Non-  performing** | ** ** | **Allowance  / NPA** | ** ** | **NPA /  Gross  UPB** | ** ** |
| **Loans and leases receivable** | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| First mortgages                 |       | $                      | 1,147,750  |   | $ | 3,631 |   | $ | 2,394 |   | 151.7 | % | 0.2 | % |
| Second mortgages                |       | 157,222                |       | 4,646 |   | 226 |   | 2055.8 | % | 0.1 | % |
| Leases                          |       | 308,878                |       | 12,713 |   | 1,006 |   | 1263.7 | % | 0.3 | % |
| Auto                            |       | 341,879                |       | 2,025 |   | 412 |   | 491.5 | % | 0.1 | % |
| Home equity lines               |       | 92,484                 |       | 953 |   | 14 |   | 6807.1 | % | 0.0 | % |
| Consumer                        |       | 3,999                  |       | 108 |   | — |   | — |   | — |   |
| Loan and lease receivables      |       | 2,052,212              |       | 24,076 |   | 4,052 |   | 594.2 | % | 0.2 | % |
| CMC leases                      |       | 81,993                 |       | 21,230 |   | 81,993 |   | 25.9 | % | 100.0 | % |
| Loan and lease receivables      |       | $                      | 2,134,205  |   | $ | 45,306 |   | $ | 86,045 |   | 52.7 | % | 4.0 | % |

 
| ** **                       | ** ** | **December 31, 2003** | ** ** |
|----------------------------------|------------|-----------------------|------------|
| ** **                       | ** ** | **Gross UPB**         | ** ** | **Allocated  Allowance** | ** ** | **Non-  performing** | ** ** | **Allowance  / NPA** | ** ** | **NPA /  Gross  UPB** | ** ** |
| **Loans and leases receivable**  | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| First mortgages                  |       | $                     | 1,186,922  |   | $ | 3,935 |   | $ | 1,843 |   | 213.5 | % | 0.2 | % |
| Second mortgages                 |       | 122,767               |       | 6,152 |   | 593 |   | 1037.4 | % | 0.5 | % |
| Leases                           |       | 266,957               |       | 10,427 |   | 1,430 |   | 729.2 | % | 0.5 | % |
| Auto                             |       | 92,724                |       | 1,054 |   | 27 |   | 3903.7 | % | 0.0 | % |
| Home equity lines                |       | 50,816                |       | 829 |   | 339 |   | 244.5 | % | 0.7 | % |
| Consumer                         |       | 1,880                 |       | 62 |   | 1 |   | 6200.0 | % | 0.1 | % |
| Loan and lease receivables       |       | 1,722,066             |       | 22,459 |   | 4,233 |   | 530.6 | % | 0.2 | % |
| CMC leases                       |       | 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 | % |

 

As more fully described in note 3 in NetBank’sForm 10-K for the year ended December 31, 2003, its loans held for sale arecarried at the lower of aggregate cost or market (“LOCOM”).  The company establishes a reserve until theloans can be sold, which is typically about 30 to 90 days after origination orpurchase.  The majority of NetBank’snon-performing loans held for sale consist of loans which the Company has beenrequired to repurchase.  Once a loan hasbeen repurchased, it is generally resold in a “scratch-and-dent” sale.

 

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| ** **               | ** ** | **As of September 30, 2004** | ** ** | ** **  | ** ** | **NPA /**            | ** ** |
|--------------------------|------------|------------------------------|------------|-------------|------------|----------------------|------------|
| **Loans held for sale**  | ** ** | **Gross UPB**                | ** ** | **Reserve** | ** ** | **Non-  performing** | ** ** | **reserve  / NPA** | ** ** | **Gross  UPB** | ** ** |
| Conforming mortgages     |       | $                            | 963,593    |        | $          | 5,118                |       | $ | 27,302 |   | 18.7 | % | 2.8 | % |
| Non-conforming mortgages |       | 272,484                      |       | 5,071       |       | 16,587               |       | 30.6 | % | 6.1 | % |
| Construction             |       | 59,065                       |       | 140         |       | —               |       | n/a |   | n/a |   |
| Commercial mortgages     |       | 7,243                        |       | 919         |       | —               |       | n/a |   | n/a |   |
| Total                    |       | $                            | 1,302,385  |        | $          | 11,248               |       | $ | 43,889 |   | 25.6 | % | 3.4 | % |
|                     |       |                         |       |        |       |                 |       |   |   |   |   |
| ** **               | ** ** | **As of December 31, 2003**  | ** ** | ** **  | ** ** | **NPA /**            | ** ** |
| **Loans held for sale**  | ** ** | **Gross UPB**                | ** ** | **Reserve** | ** ** | **Non-  performing** | ** ** | **reserve  / NPA** | ** ** | **Gross  UPB** | ** ** |
| Conforming mortgages     |       | $                            | 1,477,616  |        | $          | 9,602                |       | $ | 25,422 |   | 37.8 | % | 1.7 | % |
| Non-conforming mortgages |       | 435,188                      |       | 7,821       |       | 20,566               |       | 38.0 | % | 4.7 | % |
| Construction             |       | 44,377                       |       | 63          |       | 421                  |       | 15.0 | % | 0.9 | % |
| Commercial mortgages     |       | 12,912                       |       | 1,494       |       | —               |       | n/a |   | n/a |   |
| Total                    |       | $                            | 1,970,093  |        | $          | 18,980               |       | $ | 46,409 |   | 40.9 | % | 2.4 | % |
|                          |            |                              |            |             |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

* *

*Mortgage Servicing Rights.*  NetBankhas adopted a long-term strategy of retaining primarily all its conventional originatedmortgage servicing rights.  However, dueto market conditions during the second and third quarters of 2004, the Companychose to sell approximately 60% of loans servicing released.  The Company capitalized $50.1 million inmortgage servicing rights, $3.7 billion of unpaid principal balance, during thenine months ended September 30, 2004 compared to capitalizing $169.8 million,$10.1 billion of unpaid principal balance, for the nine months ended September30, 2003.  For the nine months ended September30, 2004, the net carrying value of NetBank’s MSRs increased $6.8 million or 4%.  The $6.8 million increase in value wasprimarily driven by the capitalization of $50.1 million of retained servicing offset,in part, by $28.4 million of amortization, $4.4 million of sales and recognitionof a lower of cost or market adjustment of approximately $10.5 million.

 

*Derivatives.*The fair value of derivatives hedging the servicing rights portfolioand qualifying for special hedge accounting, increased in value by $3,728during the nine months ended September 30, 2004.  The fair value of the derivatives hedging theservicing rights portfolio, for which NetBank does not elect special hedgeaccounting, primarily TBA mortgage backed securities, increased in value by$2,914 during the period.  As discussedin the preceding section, the increases in value of the Company’s servicinghedges were offset, in part, by a decline in value in the portfolio of mortgageservicing rights.

 

*Goodwill and intangible assets. *During the three months ended September 30,2004, NetBank tested its goodwill and intangible assets for any potentialimpairment as required by SFAS No. 142. The testing indicated that no impairment existed as of September 30,2004.

 

*Liabilities.* Total liabilities declined $254 million duringthe nine months ended September 30, 2004. The decrease was primarily related to a $356 million decrease in otherborrowed funds and a $132 million decline in unsettled trades.  These decreases were partially offset by a $205million or 8% increase in deposits.  Thedecline in other borrowed funds relates to the decline in loans held for saleand investment securities available for sale.

 

*Deposits.*  Deposits were $2.7 billion at September 30,2004, an 8% increase compared to $2.5 billion at December 31, 2003.  As of September 30, 2004, depositsrepresented 72% of total interest-bearing liabilities (including deposits,other borrowed funds and subordinated debt) outstanding.  FHLB advances, warehouse lines of credit,repurchase agreements

 

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and subordinated debt represented 28%. During the nine months ended September 30, 2004, NetBank was able toachieve a lower cost of funds on deposits by replacing high rate singlerelationship accounts, generally CDs or money market accounts, with lower ratemultiple relationship customers that are not as rate sensitive. NetBank willcontinue working to deepen its relationships with new and existingcustomers.  The following tablesummarizes NetBank’s deposits:

 
| ** **                             | ** ** | **As of September 30, 2004** | ** ** | **As of December 31, 2003** | ** ** |
|----------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
| ** **                             | ** ** | **Amount**                   | ** ** | **Percentage**              | ** ** | **Weighted  average  interest  rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest  rate** | ** ** |
| Non-interest bearing checking accounts |       | $                            | 324,414    |                        | 11.8       | % | N/A |   | $ | 198,884 |   | 7.8 | % | N/A |   |
| Interest bearing:                      |       |                         |       |                        |       |   |   |   |   |   |   |   |   |
| Checking accounts                      |       | 245,952                      |       | 9.0                         | %          | 1.1 | % | 228,178 |   | 9.0 | % | 1.4 | % |
| Money market                           |       | 1,218,326                    |       | 44.4                        | %          | 1.7 | % | 1,363,294 |   | 53.7 | % | 1.9 | % |
| Certificate of deposit under $100      |       | 848,018                      |       | 30.9                        | %          | 2.8 | % | 632,602 |   | 24.9 | % | 2.8 | % |
| Certificate of deposit over $100       |       | 107,999                      |       | 3.9                         | %          | 2.8 | % | 116,469 |   | 4.6 | % | 2.8 | % |
| Total deposits                         |       | $                            | 2,744,709  |                        | 100.0      | % |   |   | $ | 2,539,427 |   | 100.0 | % |   |   |

* *

*Shareholders’ Equity.*  Total shareholders’ equity increased $7,007 forthe nine months ended September 30, 2004. The increase is primarily due to an $18,816 increase in retainedearnings resulting from $21,876 of net income, offset by $2,818 ofdividends.  The increase in retainedearnings was offset by a decrease of $1,322 in accumulated other comprehensiveincome (OCI), and an increase in treasury stock of $10,257 due to therepurchase of 1,232,736 shares of common stock at a weighted average cost of$11.55 per share offset, in part, by the reissuance of 394,886 shares for itsacquisition of certain assets of Beacon Credit Services, sales under theemployee stock purchase plan, and the 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 887 thousand shares remaining available for repurchase undercurrent Board authority.

 

**Results of Operations – Three months ended September 30, 2004 comparedto the three months ended September 30, 2003**

 

*General.*  Net income for the three monthsended September 30, 2004 was $4,015 or $0.09 per share, compared to net incomeof $15,589 or $0.32 per share, for the same period in 2003.  The favorable interest rate environment in thethird quarter of 2003 aiding in posting strong revenues the financialintermediary segment.  In contrast, generallyhigher and more volatile interest rates during the third quarter of 2004adversely impacted the results reported from the financial intermediarysegment.  Mortgage production droppedfrom $5.7 billion to $3.3 billion, while sales of mortgages dropped from $4.9 billionto $3.6 billion comparing the third quarter of 2003 to 2004, respectively.  NetBank also experienced pressure on itsmargins in the financial intermediary segment from increasing competition,especially in the correspondent channel. The financial intermediary segment’s net income was down by $32.7million as a result.   This was offset,in part, by improved results in the retail bank segment which posted income of$1,359 during the third quarter of 2004 compared with a loss of $16,310 for thethird quarter of 2003.

 

*Interest Income*.  NetBank’s interestincome for the three months ended September 30, 2004 was $63,492 compared to$58,919 for the same period in 2003.  Asdetailed in the following rate volume variance table, the average balance ofloans held for sale declined by $529,827. The average balance of investmentsecurities available for sale and loans and leases receivable increased by$188,667 and $887,226, respectively. This repositioning resulted in a positive volume variance of $5,463 due tothe increase in average interest-earning assets.  This was partially offset by a $890 negative

 

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variance due to lower yields. The increase in loans and leases receivable is principally the result ofthe bank retaining primarily adjustable rate mortgages originated by thefinancial intermediary segment.  Duringthe current quarter NetBank retained $138 million of internally originatedmortgage loans, approximately $95.3 million of internally originated auto loansand $46.9 million of originated business finance loans and leases.  As discussed in note 5 of the consolidatedfinancial statements included within this report, the Company has not accruedand did not receive approximately $423 and $1,163 of interest related to theCMC lease portfolio during the three months ended September 30, 2004 and 2003,respectively.  See note 5 and Part II.Item 1. Legal Proceedings within this report for a more in depth discussion ofthe CMC lease portfolio and associated litigation.

 

*Interest Expense*. Total interest expense forthe three months ended September 30, 2004 was $25,375 compared to $21,959 forthe same period of 2003.  The $3,416increase is due to an increase of $721,193 in average interest-bearingliabilities, offset, in part, by the impact of a 8 basis-point reduction in theaverage cost of funds.  For the threemonths ended September 30, 2004 there was $11,862 of interest expense ondeposits (including checking, money market and certificates of deposits) as comparedto $12,293 for the three months ended September 30, 2003.  The $431 netdecrease in interest expense on deposits was the result of a 27 basis-pointdecline in the average rate paid on deposits resulting in a positive $1,553rate variance, offset in part by a volume variance of $1,122 due to an increasein average interest-bearing deposit balances of $204,994.  For the three months ended September 30, 2004interest expense on other borrowed funds (including short-term debt, FHLBadvances, and convertible subordinated debt) was $13,513 compared to $9,666 forthe same period of 2003.  The $3,847increase in interest expense related to other borrowed funds is the result ofan increase of $516,199 in the average outstanding balance, offset, in part, bya 11 basis-point decline in the average cost of funds.  The 11 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.

 

*Net Interest 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 $38,117, or 3.16% of average interest-earningassets for the three months ended September 30, 2004, compared to $36,960, or3.49%, of average interest-earning assets for the three months ended September30, 2003.

 

The following table details the relativeinterest rates and average balances of NetBank’s interest-earning assets andinterest-bearing liabilities for the three months ended September 30, 2004, and2003:

 
| **Average Balance** | ** ** | **Average Yield /  Rate** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** **                         | ** ** | **Variance  attributable to**                   | ** ** |
|---------------------|------------|---------------------------|------------|------------|------------|--------------|------------|------------------------------------|------------|-------------------------------------------------|------------|
| **2004**            | ** ** | **2003**                  | ** ** | **2004**   | ** ** | **2003**     | ** ** | ** **                         | ** ** | **2004**                                        | ** ** | **2003** | ** ** | **Variance** | ** ** | **Rate** | ** ** | **Volume  (3)** | ** ** |
|                |       |                      |       |       |       |         |       | **Interest-earning assets:**       |       |                                            |       |   |   |   |   |   |   |   |   |
| $                   | 75,108     |                      | $          | 25,251     |       | 1.67         | %          | 0.92                               | %          | Short-term investments                          |       | $ | 314 |   | $ | 58 |   | $ | 256 |   | $ | 48 |   | $ | 208 |   |
| 583,017             |       | 394,350                   |       | 3.91       | %          | 3.76         | %          | Investment securities (1)          |       | 5,697                                           |       | 3,702 |   | 1,995 |   | 151 |   | 1,844 |   |
| 1,920,128           |       | 2,449,955                 |       | 5.98       | %          | 6.08         | %          | Loans held for sale (2)            |       | 28,721                                          |       | 37,235 |   | (8,514 | ) | (589 | ) | (7,925 | ) |
| 2,251,019           |       | 1,363,793                 |       | 5.11       | %          | 5.26         | %          | Loans and leases receivable (2)    |       | 28,760                                          |       | 17,924 |   | 10,836 |   | (500 | ) | 11,336 |   |
| 4,829,272           |       | 4,233,349                 |       | 5.26       | %          | 5.57         | %          | Total interest-earning assets      |       | 63,492                                          |       | 58,919 |   | 4,573 |   | (890 | ) | 5,463 |   |
|                |       |                      |       |       |       |         |       |                               |       |                                            |       |   |   |   |   |   |   |   |   |
|                |       |                      |       |       |       |         |       | **Interest-bearing liabilities:**  |       |                                            |       |   |   |   |   |   |   |   |   |
| 236,228             |       | 191,016                   |       | 1.20       | %          | 1.50         | %          | Checking accounts                  |       | 710                                             |       | 715 |   | (5 | ) | (141 | ) | 136 |   |
| 1,254,827           |       | 1,213,121                 |       | 1.65       | %          | 1.98         | %          | Money market                       |       | 5,183                                           |       | 6,018 |   | (835 | ) | (1,007 | ) | 172 |   |
| 865,435             |       | 747,359                   |       | 2.76       | %          | 2.98         | %          | Certificates of deposit            |       | 5,969                                           |       | 5,560 |   | 409 |   | (405 | ) | 814 |   |
| 1,270,014           |       | 1,114,973                 |       | 2.07       | %          | 1.78         | %          | Short-term debt                    |       | 6,582                                           |       | 4,969 |   | 1,613 |   | 809 |   | 804 |   |
| 751,402             |       | 391,233                   |       | 3.62       | %          | 4.51         | %          | FHLB advances                      |       | 6,799                                           |       | 4,414 |   | 2,385 |   | (874 | ) | 3,259 |   |
| 11,857              |       | 8,764                     |       | 4.45       | %          | 5.61         | %          | Subordinated debt                  |       | 132                                             |       | 123 |   | 9 |   | (25 | ) | 34 |   |
| —              |       | 2,104                     |       | 0.00       | %          | 30.42        | %          | Convertible subordinated debt      |       | —                                          |       | 160 |   | (160 | ) | — |   | (160 | ) |
| 4,389,763           |       | 3,668,570                 |       | 2.31       | %          | 2.39         | %          | Total interest-bearing liabilities |       | 25,375                                          |       | 21,959 |   | 3,416 |   | (1,643 | ) | 5,059 |   |
|                |       |                      |       |       |       |         |       |                               |       |                                            |       |   |   |   |   |   |   |   |   |
| —              |       | —                    |       | 2.95       | %          | 3.18         | %          | Net interest margin                |       | 38,117                                          |       | 36,960 |   | 1,157 |   | 753 |   | 404 |   |
| 439,509             |       | 564,779                   |       | 0.21       | %          | 0.31         | %          | Interest free sources              |       | —                                          |       | — |   | — |   | — |   | — |   |
| $                   | 4,829,272  |                      | $          | 4,233,349  |       | 3.16         | %          | 3.49                               | %          | Net interest income to interest-earning  assets |       | $ | 38,117 |   | $ | 36,960 |   | $ | 1,157 |   | $ | 753 |   | $ | 404 |   |

 

25

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----

(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 in thevolume variances.

 

*Provision for Credit Losses.*  Theprovision for credit losses was $469 for the three months ended September 30,2004, compared to $2,537 for the same period of 2003.  The decrease in provision relates in part tothe sale of $350 million of conforming ARMs during the quarter.  The remaining difference relates to feweroriginated loans that were retained during the third quarter of 2004 comparedwith the same quarter in 2003.   Duringthe three months ended September 30, 2004, NetBank retained its originated autoloans of $95 million, originated mortgage loans of $138 million and originatedleases of $47 million.  During the threemonths ended September 30, 2003, NetBank retained originated auto loans of $39million, originated mortgage loans of $544 million and originated leases of $36million.  Reference is made to the assetquality and non-performing assets section in the financial condition sectioncontained within this report for additional detail concerning the determinationof provision expense related to maintaining the proper level of allowance forcredit losses.

 

*Non-interest Income.* Non-interest incomedeclined $38,729 for the three months ended September 30, 2004 compared to the sameperiod of 2003.  This decline wasprimarily driven by the $48,159 decline in gain on sales of loans due to the$1.3 billion or 26% decline in sales of mortgage loans.  The decline in sales was compounded by thedecline in margins on sales due to increased competitive pressures.  Other income declined by $1,155 primarily dueto lower hedge results due generally to increasing mortgage interest rates andinterest rate volatility compared to the same period of 2003.  During the quarter ended September 30, 2004, certainderivatives positions, for which the Company did not elect special hedgeaccounting, resulted in gains of $2.9 million. Likewise, the Company monetized a portion of its gain on selectedmortgage backed securities giving rise to realized gains of $2.2 million.  During the same quarter in 2003, the Companyhad no gains on sales on securities or free-standing derivates.  The increase in service charges and fees wasdriven primarily by the addition of NPS in the transaction processing segment,higher servicing revenues related to an increase in loans serviced, and higherfees in the retail bank segment.

 

*Non-interest Expense.*  Non-interestexpense includes all operating expenses such as salaries and benefits,marketing and general and administrative expenses.  Non-interest expense decreased $17,212, or16%, for the three months ended September 30, 2004 compared to the same periodof 2003.  The decline was primarilydriven by a net decline of $6,665 in amortization and impairment of mortgageservicing rights due to the reduction in actual and projected prepayments,$6,665 reduced salaries and benefits expense of $5.3 million related primarilyto reduced production volume in the financial intermediary segment, $4,316reduced prepayment fees on the early extinguishment of debt related to theextinguishment of term FHLB borrowings in 2003, $2,711 reduction inprofessional fees related to a reduction in legal expenses associated with theCMC litigation and the settlement of certain claims involving Market StreetMortgage Corporation, and a reduction in prepaid lost interest on curtailmentsrelated to reduced actual prepayments on loans serviced in 2004 compared with2003.  Amortization and impairment ofmortgage servicing rights declined due lower projected prepayments resulting ina $9,228 decline in impairment off set, in part, by an increase of $2,563 inamortization due to the increase in UPB underlying the portfolio of mortgageservicing rights.  These decreases wereoffset, in part, by depreciation and amortization, occupancy and other expensecategories that were generally higher as the Company’s operations expandedperiod-over-period with the additions of NetBank Dealer Financial Services, (“DFS”),NPS and NetInsurance.

 

# ***Retail Bank Operations***

 

The table below provides an overview of the results of operations forthe retail bank segment:

 

26

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| ** **                                                                     | ** ** | **2004  3rd Qtr** | ** **     | **2003  3rd Qtr** | ** ** | **change** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------|----------------|-------------------|------------|------------|------------|
| Net interest income                                                            |       | **$**             | **22,499**     | ** **        | $          | 16,420     |       | $ | 6,079 |   |
| Provision for credit losses                                                    |       | **466**           | ** **     | 2,542             |       | (2,076     | )          |
| Net interest income after provision                                            |       | **22,033**        | ** **     | 13,878            |       | 8,155      |       |
| Gain on sale of loans                                                          |       | **2,011**         | ** **     | 30                |       | 1,981      |       |
| Fees, charges and other income                                                 |       | **3,307**         | ** **     | 2,742             |       | 565        |       |
| Total revenues                                                                 |       | **27,351**        | ** **     | 16,650            |       | 10,701     |       |
| Total expenses                                                                 |       | **17,232**        | ** **     | 14,960            |       | 2,272      |       |
| Pre-tax income before net gains on  securities, debt and net servicing results |       | **10,119**        | ** **     | 1,690             |       | 8,429      |       |
| Net gain on securities and prepaid debt                                        |       | **2,248**         | ** **     | (4,316            | )          | 6,564      |       |
| Net servicing results                                                          |       | **(10,167**       | **)**          | (23,313           | )          | 13,146     |       |
| Pre-tax income (loss)                                                          |       | **$**             | **2,200**      | ** **        | $          | (25,939    | )          | $ | 28,139 |   |
|                                                                           |       | ** **        | ** **     |              |       |       |       |
| Average earning assets                                                         |       | **$**             | **4,609,700**  | ** **        | $          | 3,914,352  |       | $ | 695,348 |   |
|                                                                           |       | ** **        | ** **     | ** **        |       |       |       |   |   |   |
| UPB underlying MSRs at the retail bank                                         |       | **$**             | **13,154,634** | ** **        | $          | 11,088,788 |       | $ | 2,065,846 |   |
|                                                                           |       | ** **        | ** **     |              |       |       |       |
| Operations to average earning assets                                           |       | ** **        | ** **     |              |       |       |       |
| Net interest income                                                            |       | **1.95**          | **%**          | 1.68              | %          | 0.27       | %          |
| Provision                                                                      |       | **0.04**          | **%**          | 0.26              | %          | (0.22      | )%         |
| Net interest income after provision                                            |       | **1.91**          | **%**          | 1.42              | %          | 0.49       | %          |
| Fees, charges and other income                                                 |       | **0.29**          | **%**          | 0.28              | %          | 0.01       | %          |
| Banking revenues                                                               |       | **2.20**          | **%**          | 1.70              | %          | 0.50       | %          |
| Total expenses                                                                 |       | **1.50**          | **%**          | 1.53              | %          | (0.03      | )%         |
| Pre-tax income before net gains on  securities, debt and net servicing results |       | **0.70**          | **%**          | 0.17              | %          | 0.53       | %          |
|                                                                           |       | ** **        | ** **     |              |       |       |       |
| Net servicing results to UPB underlying  MSRs                                  |       | **(0.31**         | **)%**         | (0.84             | )%         | 0.53       | %          |

 

Pre-tax income improved by$28,139 to $2,200 for the three months ended September 30, 2004, compared witha pre-tax loss of $25,939 for the same period in 2003.

 

Improvements in net interestincome of $6,079, improvements in net servicing results of $13,146, net gain onsecurities and prepayment of debt of $6,564, reduction in provision for creditlosses of $2,076, and increases in fees, charges and other income of $565resulted in the improvement period-over-period. Net interest income improved primarily because of the retention over thepast year of originated assets 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 by0.27% to 1.95% for the three months ended September 30, 2004 compared with1.68% for the same period in 2003.  Netservicing results improved as a result of lower actual and projectedprepayments in the third quarter of 2004 compared with the third quarter2003.  The reduction in the provision forcredit losses relates to the sale of approximately $350 million ARM loansduring the third quarter of 2004 coupled with a slowdown in mortgages, leasesand auto loans retained during the third quarter of 2004 compared with thecomparable quarter during 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 earningswere offset, in part, by increases in operating expenses of $2,272.  The increase in operating expenses relatesprimarily to the growth in the Company’s auto lending operation.

 

*Financial Intermediary*

 

The following table highlights the financialintermediary segment production and sales activities:

 

27

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| ** **                           | ** ** | **For the three months ended  September 30,** | ** **    | ** ** | ** ** |
|--------------------------------------|------------|-----------------------------------------------|---------------|------------|------------|
| **Pre-tax results**                  | ** ** | **2004**                                      | ** **    | **2003**   | ** ** | **change** | ** ** |
| Net interest income                  |       | **$**                                         | **15,651**    |       | $          | 21,060 |   | $ | (5,409 | ) |
| Gain on sales of loans               |       | **25,489**                                    | ** **    | 78,107     |       | (52,618 | ) |
| Other income                         |       | **3,316**                                     | ** **    | 1,167      |       | 2,149 |   |
| Net Beacon Credit Services results   |       | **(189**                                      | **)**         | —     |       | (189 | ) |
| Net MG Reinsurance results           |       | **557**                                       | ** **    | 299        |       | 258 |   |
| Total revenues                       |       | **44,824**                                    | ** **    | 100,633    |       | (55,809 | ) |
| Salary and employee benefits         |       | **23,531**                                    | ** **    | 29,835     |       | (6,304 | ) |
| Occupancy & Depreciation expense |       | **7,155**                                     | ** **    | 6,384      |       | 771 |   |
| Other expenses                       |       | **9,144**                                     | ** **    | 7,498      |       | 1,646 |   |
| Total expenses                       |       | **39,830**                                    | ** **    | 43,717     |       | (3,887 | ) |
| Pre-tax income                       |       | **$**                                         | **4,994**     | ** ** | $          | 56,916 |   | $ | (51,922 | ) |
|                                 |       | ** **                                    | ** **    |       |       |   |   |
| Production                           |       | **$**                                         | **3,348,876** | ** ** | $          | 5,681,523 |   | $ | (2,332,647 | ) |
| Sales                                |       | **$**                                         | **3,777,305** | ** ** | $          | 5,464,508 |   | $ | (1,687,203 | ) |
|                                 |       | ** **                                    | ** **    |       |       |   |   |
| Total revenues to sales              |       | **1.19**                                      | **%**         | 1.84       | %          | (0.65 | )% |
| Total expenses to production         |       | **1.19**                                      | **%**         | 0.77       | %          | 0.42 | % |
| Pre-tax margin                       |       | **0.00**                                      | **%**         | 1.07       | %          | (1.07 | )% |

 

Note: The ratio of revenues to sales is based onmortgage banking sales, which includes inter-segment sales to the retail banksegment.

 

The interest rate environment during the third quarter of 2003 was muchmore favorable to mortgage production than the environment during thecomparable 2004 quarter.  In 2003,mortgage rates were hitting historic lows. The loan pipelines of originators throughout the mortgage bankingindustry were filled, resulting in less pressure on margins.  During the latter part of 2003 and continuingthrough the third quarter of 2004, mortgage rates generally rose, andcompetitive pressures heated up as pipeline volumes decreased.  This margin pressure was especially true inthe correspondent channel.  This resultedin a decrease in mortgage production of $2.3 billion and a decrease in sales of$1.7 billion.  The competitive pressuresreduced revenue margins from 184 bps for the quarter ended September 30, 2003to 119 bps for the comparable quarter in 2004. As a result, revenues decreased $56 million.  Expenses decreased $3,887.  Expenses in bps of production increased from77 bps to 119 bps from the quarter ended September 30, 2003 to the comparablequarter in 2004.  This was the result ofless leverage of fixed expenses during the quarter ended September 30, 2004.

 

*Transaction Processing Segment*

 

Thetransaction processing segment provides ATM and merchant processing services;subservices loans for the retail bank segment, financial intermediary segmentand for third party customers; and sells various insurance products using anInternet-based platform.

 

The following table highlights the results of operations for thetransaction processing segment:

 
| ** **            | ** ** | **For the three months ended  September 30,** | ** ** | ** ** | ** ** |
|-----------------------|------------|-----------------------------------------------|------------|------------|------------|
| ** **            | ** ** | **2004**                                      | ** ** | **2003**   | ** ** | **change** | ** ** |
| Total revenue         |       | **$**                                         | **7,066**  |       | $          | 4,943 |   | $ | 2,123 |   |
| Total expenses        |       | **6,037**                                     |       | 6,101      |       | (64 | ) |
| Pre-tax income (loss) |       | **$**                                         | **1,029**  |       | $          | (1,158 | ) | $ | 2,187 |   |

 

28

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The transaction processing segment reported an improvement in pre-taxoperating results of $2.2 million.  Theservicing factory showed improved results of $1,527 related primarily toimproved expense control.  NetBankPayment Systems, acquired during the fourth quarter of 2003, added $722thousand of pre-tax profit to the transaction processing segment’s resultsduring the third quarter of 2004.

 

**Results of Operations – Nine months ended September 30, 2004, comparedto the nine months ended September 30, 2003**

 

*General.*  Net income for the nine monthsended September 30, 2004 was $21,876 or $0.46 per share, compared to net incomeof $40,504 or $0.83 per share, for the same period in 2003. NetBank’smanagement capitalized on the favorable interest rate environment during thefirst nine months of 2003 to post strong revenues from its financialintermediary segment.  In contrast,rising interest rates and interest rate volatility during the first nine monthsof 2004 adversely impacted the results reported from the financial intermediarysegment.  Mortgage production droppedfrom $15.6 billion to $10.5 billion, while sales of mortgages dropped from$13.3 billion to $10.2 billion comparing the first nine months of 2003 to 2004,respectively.  NetBank also experiencedpressure on its margins in the financial intermediary segment from increasingcompetition, especially in the correspondent channel.  The financial intermediary segment’s netincome was down by $64,823 as a result. This was offset, in part, by improved results in the retail bank segmentwhich posted net income of $7,215 during the first nine months of 2004 comparedwith a net loss of $33,082 for the first nine months of 2003.

 

*Interest Income*.  NetBank’s interestincome for the nine months ended September 30, 2004 was $174,354 compared to$154,262 for the same period in 2003.  Asdetailed in the following rate volume variance table, the average balance ofloans held for sale declined by $173,710 and the average balance of loan andlease receivables increased by $957,028, resulting in a $27,649 positivevariance due to the increase in average interest-earning assets, partiallyoffset by a $7,557 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 nine months ended September 30,2004, NetBank retained $781 million of internally originated mortgage loans,approximately $306 million of internally originated auto loans and $129 millionof originated business finance loans and leases.  As discussed in note 5 of the consolidatedfinancial statements included within this report, the Company has not accruedand has not received approximately $1.8 million and $4.1 million of scheduled interestrelated to the CMC lease portfolio during the nine months ended September 30,2004 and 2003, respectively.  See PartII. Item 1. Legal Proceedings within this report for a more in depth discussionof the CMC lease portfolio and associated litigation.

 

*Interest Expense*. Total interest expense forthe nine months ended September 30, 2004 was $67,989 compared to $65,091 forthe same period of 2003.  The $2,898 increaseis due to an increase of $708,313 in average interest-bearing liabilities,offset, in part, by the impact of a 34 basis-point reduction in the averagecost of funds.  For the nine months endedSeptember 30, 2004 there was $34,364 of interest expense on deposits (includingchecking, money market and certificates of deposits) as compared to $37,273 forthe nine months ended September 30, 2003.  The $2,909 net decrease ininterest expense on deposits was the result of a 29 basis-point decline in theaverage rate paid on deposits, offset, in part, by an increase in the averageinterest-bearing deposit balances of $124,126. For the nine months ended September 30, 2004, interest expense on otherborrowed funds (including short-term debt, FHLB advances, and convertiblesubordinated debt) was $33,625 compared to $27,818 for the same period of2003.  The $5,807 increase in interestexpense related to other borrowed funds is the result of an increase of$584,187 in the average outstanding balance, offset, in part, by a 56basis-point decline in the average cost of funds.  The 56 basis-point reduction in the averagecost of other borrowed funds is primarily due to higher fixed-rate term FHLBadvances being prepaid during 2003.

 

*Net Interest 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 $106,365, or 3.14% of average interest-earningassets for the nine months ended September 30, 2004, compared to $89,171, or3.19% of average interest-earning assets for the nine months ended September30, 2003.

 

The following table details therelative interest rates and average balances of NetBank’s interest-earningassets and interest-bearing liabilities for the nine months ended September 30,2004, and 2003:

 

29

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| **Average Balance** | ** ** | **Average Yield  / Rate** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** **                         | ** **             | **Variance  attributable to**                   | ** ** |
|---------------------|------------|---------------------------|------------|------------|------------|--------------|------------|------------------------------------|------------------------|-------------------------------------------------|------------|
| **2004**            | ** ** | **2003**                  | ** ** | **2004**   | ** ** | **2003**     | ** ** | ** **                         | ** **             | **2004**                                        | ** ** | **2003** | ** ** | **Variance** | ** ** | **Rate** | ** ** | **Volume  (3)** | ** ** |
| ** **          |       |                      |       |       |       |         |       | **Interest-earning assets:**       |                   |                                            |       |   |   |   |   |   |   |   |   |
| $                   | 74,270     |                      | 32,627     |       | 1.23       | %            | 1.13       | %                                  | Short-term investments |                                            | $          | 684 |   | $ | 277 |   | $ | 407 |   | $ | 24 |   | $ | 383 |   |
| 493,942             |       | 534,644                   |       | 3.66       | %          | 3.91         | %          | Investment securities (1)          |                   | 13,568                                          |       | 15,662 |   | (2,094 | ) | (1,002 | ) | (1,092 | ) |
| 1,848,906           |       | 2,022,616                 |       | 5.86       | %          | 6.26         | %          | Loans held for sale (2)            |                   | 81,290                                          |       | 95,020 |   | (13,730 | ) | (6,068 | ) | (7,662 | ) |
| 2,092,938           |       | 1,135,910                 |       | 5.02       | %          | 5.08         | %          | Loans and leases receivable (2)    |                   | 78,812                                          |       | 43,303 |   | 35,509 |   | (511 | ) | 36,020 |   |
| 4,510,056           |       | 3,725,797                 |       | 5.15       | %          | 5.52         | %          | Total interest-earning assets      |                   | 174,354                                         |       | 154,262 |   | 20,092 |   | (7,557 | ) | 27,649 |   |
|                |       |                      |       |       |       |         |       |                               |                   |                                            |       |   |   |   |   |   |   |   |   |
|                |       |                      |       |       |       |         |       | **Interest-bearing liabilities:**  |                   |                                            |       |   |   |   |   |   |   |   |   |
| 234,089             |       | 180,969                   |       | 1.19       | %          | 1.53         | %          | Checking accounts                  |                   | 2,083                                           |       | 2,076 |   | 7 |   | (461 | ) | 468 |   |
| 1,309,122           |       | 1,065,963                 |       | 1.68       | %          | 2.11         | %          | Money market                       |                   | 16,509                                          |       | 16,903 |   | (394 | ) | (3,438 | ) | 3,044 |   |
| 764,197             |       | 936,350                   |       | 2.75       | %          | 2.61         | %          | Certificates of deposit            |                   | 15,772                                          |       | 18,294 |   | (2,522 | ) | 983 |   | (3,505 | ) |
| 970,900             |       | 682,166                   |       | 2.00       | %          | 1.95         | %          | Short-term debt                    |                   | 14,576                                          |       | 9,988 |   | 4,588 |   | 256 |   | 4,332 |   |
| 816,832             |       | 507,050                   |       | 3.04       | %          | 4.40         | %          | FHLB advances                      |                   | 18,631                                          |       | 16,725 |   | 1,906 |   | (5,172 | ) | 7,078 |   |
| 11,857              |       | 7,157                     |       | 4.70       | %          | 5.07         | %          | Subordinated debt                  |                   | 418                                             |       | 272 |   | 146 |   | (20 | ) | 166 |   |
| —              |       | 19,029                    |       | 0.00       | %          | 5.84         | %          | Convertible subordinated debt      |                   | —                                          |       | 833 |   | (833 | ) | (833 | ) | — |   |
| 4,106,997           |       | 3,398,684                 |       | 2.21       | %          | 2.55         | %          | Total interest-bearing liabilities |                   | 67,989                                          |       | 65,091 |   | 2,898 |   | (8,685 | ) | 11,583 |   |
|                |       |                      |       |       |       |         |       |                               |                   |                                            |       |   |   |   |   |   |   |   |   |
| —              |       | —                    |       | 2.94       | %          | 2.97         | %          | Net interest margin                |                   | 106,365                                         |       | 89,171 |   | 17,194 |   | 1,128 |   | 16,066 |   |
| 403,059             |       | 327,113                   |       | 0.20       | %          | 0.22         | %          | Interest free sources              |                   | —                                          |       | — |   | — |   | — |   | — |   |
| $                   | 4,510,056  |                      | $          | 3,725,797  |       | 3.14         | %          | 3.19                               | %                      | Net interest income to interest-earning  assets |       | $ | 106,365 |   | $ | 89,171 |   | $ | 17,194 |   | $ | 1,128 |   | $ | 16,066 |   |
|                     |            |                           |            |            |            |              |            |                                    |                        |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

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

(3)          Variancesattributable to the rate and volume mix are included in the volume variances

 

*Provision for Credit Losses.*  Theprovision for credit losses was $3,982 for the nine months ended September 30,2004, compared to $4,299 for the same period of 2003.  During the nine months ended September 30,2004, NetBank retained its originated auto loans of $306 million, originatedmortgage loans of $781 million, and originated business finance loans or leasesof $129 million.  This was off set bysales of approximately $350 million of loans. This compares to retentions of originated mortgage loans of $1,024million, originated auto loans of $44 million and originated business financeloans or leases of $103 million during 2003. 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-interest Income.* Non-interest incomedeclined $81,116 for the nine months ended September 30, 2004 compared to thesame period of 2003.  This decline wasprimarily driven by the $90,493 decline in gain on sales of loans due to the $3.1billion, or 24%, decline in sales of mortgage loans.  The decline in sales was compounded by thedecline in margins on sales due to increased competitive pressures.  Additionally, gains on sales of investmentsecurities were lower by $5,977 for the nine months ended September 30, 2004compared to the same period of 2003. These declines were offset, in part, by an increase of $15,315 inservice charges and fees.  The increasein service charges and fees was driven primarily by the increase in loansserviced, the addition of NPS in the transaction processing segment and higherfees in the retail bank segment.

 

*Non-interest Expense.*  Non-interestexpense includes all operating expenses such as salaries and benefits,marketing and general and administrative expenses.  Non-interest expense decreased $34,382, or13%, for the nine months ended September 30, 2004 compared to the same periodof 2003.  This decline was primarilydriven by the $19,720 net decline in impairment and amortization of mortgageservicing rights due to a higher interest rate environment and resultingdecrease in actual and forecast prepayments. Amortization and impairment ofmortgage servicing rights declined due lower projected prepayments resulting ina $28,046 decline in impairment off set, in part, by an increase of $8,326 inamortization due to the increase in UPB underlying the portfolio of mortgageservicing rights.   Reference is made to the

 

30

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mortgage servicing rights sub-section of the financial conditionsection contained within this report for a more in-depth analysis of thischange.  Additionally, the nine monthsended September 30, 2004 did not include the $16,267 of prepayment feesincurred with the early payoff of fixed rate FHLB advances during the same periodof 2003.  Prepaid lost interest oncurtailments were down $4,413 due to the decrease in actual prepayments ofloans during the nine months ended September 30, 2004 compared to the sameperiod of 2003.  Likewise, salaries andbenefits expenses are down $4,140 primarily as a result of reduced productionvolumes in the financial intermediary segment. Professional fees are down by $1,400 due in part to the settlement ofcertain claims involving Market Street Mortgage Corporation. These declines inexpenses were partially offset by increases in depreciation and amortization of$3,460, data processing of $2,229 and occupancy expense of $2,146.  Depreciation and amortization and occupancywere generally higher as the Company’s operations expanded period over periodwith the additions of DFS, NPS and NetInsurance.

 

# ***Retail Bank Operations***

 

The table below provides an overview of the results of operations forthe retail bank segment:

 
| ** **                                                                     | ** ** | **For the nine months ended  September 30,** | ** **     | ** ** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------------------------------|----------------|------------|------------|
| ** **                                                                     | ** ** | **2004**                                     | ** **     | **2003**   | ** ** | **change** | ** ** |
| Net interest income                                                            | ** ** | **$**                                        | **59,238**     | ** ** | $          | 35,798 |   | $ | 23,440 |   |
| Provision for credit losses                                                    | ** ** | **3,938**                                    | ** **     | 4,263      |       | (325 | ) |
| Net interest income after provision                                            | ** ** | **55,300**                                   | ** **     | 31,535     |       | 23,765 |   |
| Gain on sale of loans                                                          | ** ** | **3,072**                                    | ** **     | 30         |       | 3,042 |   |
| Fees, charges and other income                                                 | ** ** | **9,493**                                    | ** **     | 8,789      |       | 704 |   |
| Total revenues                                                                 | ** ** | **67,865**                                   | ** **     | 40,354     |       | 27,511 |   |
| Total expenses                                                                 | ** ** | **50,231**                                   | ** **     | 45,214     |       | 5,017 |   |
| Pre-tax income before net gains on  securities, debt and net servicing results | ** ** | **17,634**                                   | ** **     | (4,860     | )          | 22,494 |   |
| Net gain on securities and prepaid debt                                        | ** ** | **5,417**                                    | ** **     | (4,873     | )          | 10,290 |   |
| Net servicing results                                                          | ** ** | **(11,515**                                  | **)**          | (42,702    | )          | 31,187 |   |
| Pre-tax income (loss)                                                          | ** ** | **$**                                        | **11,536**     | ** ** | $          | (52,435 | ) | $ | 63,971 |   |
|                                                                           |       |                                         | ** **     |       |       |   |   |
| Average earning assets                                                         | ** ** | **$**                                        | **4,351,706**  | ** ** | $          | 3,720,361 |   | $ | 631,345 |   |
|                                                                           | ** ** | ** **                                   | ** **     | ** ** |       |   |   |   |   |   |
| UPB underlying MSRs at the retail bank                                         | ** ** | **$**                                        | **13,154,634** | ** ** | $          | 11,088,788 |   | $ | 2,065,846 |   |
|                                                                           |       |                                         | ** **     |       |       |   |   |
| **Operations to average earning assets**                                       |       |                                         | ** **     |       |       |   |   |
| Net interest income                                                            | ** ** | **1.82**                                     | **%**          | 1.28       | %          | 0.54 | % |
| Provision                                                                      | ** ** | **0.12**                                     | **%**          | 0.15       | %          | (0.03 | )% |
| Net interest income after provision                                            | ** ** | **1.70**                                     | **%**          | 1.13       | %          | 0.57 | % |
| Fees, charges and other income                                                 | ** ** | **0.29**                                     | **%**          | 0.31       | %          | (0.02 | )% |
| Banking revenues                                                               | ** ** | **1.99**                                     | **%**          | 1.44       | %          | 0.55 | % |
| Total expenses                                                                 | ** ** | **1.54**                                     | **%**          | 1.62       | %          | (0.08 | )% |
| Pre-tax income before net gains on  securities, debt and net servicing results | ** ** | **0.45**                                     | **%**          | (0.18      | )%         | 0.63 | % |
|                                                                           |       |                                         | ** **     |       |       |   |   |
| Net servicing results to UPB underlying  MSRs                                  | ** ** | **(0.12**                                    | **)%**         | (0.51      | )%         | 0.39 | % |

 

Pre-tax income improved by $63,971 to $11,536for the nine months ended September 30, 2004, compared with a pre-tax loss of$52,435 for the same period in 2003.

 

Improvements in net interest income of $23,440,net gain on securities and prepayment of debt of $10,290, net servicing resultsof $31,187, provision for credit losses of $325 and fees, charges and otherincome of $704 resulted in the improvement period-over-period.  Net interest income improved primarilybecause of the retention over the past year of originated assets includingmortgages, leases and auto loans. Likewise, during 2003, the retail banking segment prepaid a large numberof higher-priced term FHLB advances and, through pricing, moved the mix ofdeposits from higher cost certificates of deposit to lower cost money marketand checking accounts.  Theseasset-liability strategies have improved

 

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the net interest income by 0.54% to 1.82% forthe nine months ended September 30, 2004 compared with 1.28% for the sameperiod in 2003.  The improvement in thegain on securities and prepayment of debt relates to the gain in 2004 of $5.4million on the sale of certain securities in the bank’s investment portfolio aspart of the bank’s proactive asset-liability management strategy whereby assetswere sold to mitigate inherent risks as well as a reduction in fees on theprepayment of debt coupled with net losses in 2003 associated with theaforementioned prepayment of FHLB advances. Net servicing results improved as the result of an increase in themarket value of its mortgage servicing rights, a reduction in actualprepayments and improved net hedge results during the nine months endedSeptember 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 in operating expenses of $5,017.  Operating expenses increased primarily as theresult of the growth of the auto lending division and increased legal expensesassociated with discovery proceedings in the CMC litigation.

 

*Financial Intermediary*

 

The following table highlights the financialintermediary segment production and sales activities:

 
| ** **                           | ** ** | **For the nine months ended September 30,** | ** **     | ** ** | ** ** |
|--------------------------------------|------------|---------------------------------------------|----------------|------------|------------|
| **Pre-tax results**                  | ** ** | **2004**                                    | ** **     | **2003**   | ** ** | **change** | ** ** |
| Net interest income                  |       | **$**                                       | **46,159**     | ** ** | $          | 54,543 |   | $ | (8,384 | ) |
| Gain on sales of loans               |       | **93,230**                                  | ** **     | 188,910    |       | (95,680 | ) |
| Other income                         |       | **4,437**                                   | ** **     | 3,642      |       | 795 |   |
| Net Beacon Credit Services results   |       | **(189**                                    | **)**          | —     |       | (189 | ) |
| Net MG Reinsurance results           |       | **1,599**                                   | ** **     | 1,409      |       | 190 |   |
| Total revenues                       |       | **145,236**                                 | ** **     | 248,504    |       | (103,268 | ) |
| Salary and employee benefits         |       | **70,642**                                  | ** **     | 78,709     |       | (8,067 | ) |
| Occupancy & Depreciation expense |       | **21,022**                                  | ** **     | 16,476     |       | 4,546 |   |
| Other expenses                       |       | **24,864**                                  | ** **     | 22,114     |       | 2,750 |   |
| Total expenses                       |       | **116,528**                                 | ** **     | 117,299    |       | (771 | ) |
| Pre-tax income                       |       | **$**                                       | **28,708**     | ** ** | $          | 131,205 |   | $ | (102,497 | ) |
|                                 |       | ** **                                  | ** **     |       |       |   |   |
| Production                           |       | **$**                                       | **10,511,079** | ** ** | $          | 15,640,476 |   | $ | (5,129,397 | ) |
| Sales                                |       | **$**                                       | **10,982,155** | ** ** | $          | 14,359,464 |   | $ | (3,377,309 | ) |
|                                 |       | ** **                                  | ** **     |       |       |   |   |
| Total revenues to sales              |       | **1.32**                                    | **%**          | 1.73       | %          | (0.41 | )% |
| Total expenses to production         |       | **1.11**                                    | **%**          | 0.75       | %          | 0.36 | % |
| Pre-tax margin                       |       | **0.21**                                    | **%**          | 0.98       | %          | (0.77 | )% |

 

Note: The ratio of revenues to sales is based onmortgage banking sales, which includes inter-segment sales to the retail banksegment.

 

The interest rate environment during the nine months ended September30, 2003 was much more favorable to mortgage production than the environmentduring the comparable 2004 quarter.  In2003, mortgage rates were hitting historic lows.  The loan pipelines of originators throughoutthe mortgage banking industry were filled, resulting in less pressure onmargins.  During the latter part of 2003and continuing through 2004, mortgage rates generally rose, and competitivepressures heated up as pipeline volumes decreased.  This margin pressure was especially true inthe correspondent channel.  This resultedin a decrease in mortgage production of $5.1 billion and a decrease in sales of$3.4 billion.  The competitive pressuresreduced revenue margins from 173 bps for the nine months ended September 30,2003 to 132 bps for the comparable period in 2004.  As a result, revenues decreased$103,268.  Expenses decreased by$771.  Expenses in bps of productionincreased from 75 bps to 111 bps from the nine months ended September 30, 2003to the comparable period in 2004.  Thiswas the result of less leverage of fixed expenses during the nine months endedSeptember 30, 2004 and expenses incurred to obtain trailing documents needed tosell or securitize the buildup of loans in inventory.

 

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*Transaction Processing Segment*

 

Thetransaction processing segment provides ATM and merchant processing services;subservices loans for the retail bank segment, financial intermediary segmentand for third party customers; and sells various insurance products using anInternet-based platform.

 

The following table highlights the results of operations for thetransaction processing segment for the nine months ended September 30, 2004 and2003:

 
| ** **            | ** ** | **For the nine months ended  September 30,** | ** ** | ** ** | ** ** |
|-----------------------|------------|----------------------------------------------|------------|------------|------------|
| ** **            | ** ** | **2004**                                     | ** ** | **2003**   | ** ** | **change** | ** ** |
| Total revenue         |       | **$**                                        | **19,990** |       | $          | 13,064 |   | $ | 6,926 |   |
| Total expenses        |       | **19,226**                                   |       | 16,867     |       | 2,359 |   |
| Pre-tax income (loss) |       | **$**                                        | **764**    |       | $          | (3,803 | ) | $ | 4,567 |   |

 

The transaction processing segment improved its pre-tax contribution by$4,567.  This is primarily due to theaddition of NPS in December of 2003, which added $1,702 of pre-tax income, andan improvement in the servicing factory related to higher loan counts andbetter expense leverage.

 

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

 

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

 

**ContractualObligations and Off-Balance Sheet Arrangements**

 

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

 

# **Reference is made to thecontractual obligations and off-balance sheet arrangements section on page 48of NetBank’s 2003 Annual Report filed on Form 10-K for additional detailsregarding the schedule of amounts contractually due.**

# ** **

# **Liquidityand Capital Resources**

 

*Liquidity. *NetBank’sliquidity, represented by cash and cash equivalents, is a product of itsoperating, investing, and financing activities. NetBank’s primary sources of funds are deposits, borrowings, prepaymentsand maturities of outstanding loans, sales of loans, sales or maturities ofinvestment securities and other short-term investments, and funds provided fromoperations.  While scheduled loanpayments and maturing investment securities and short-term investments arerelatively predictable sources of funds, deposit flows and loan prepayments aregreatly influenced by general interest

 

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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. The increase in NetBank’s cash flow was primarily related tosales, maturities and repayments of $11.4 billion of loans compared topurchasing or originating $10.9 billion during the nine months ended September30, 2004.  Cash flows for the nine monthsended September 30, 2003, were negative related to the purchase or originationof $15.7 billion in loans outpacing the $14.1 billion level of sales,maturities and repayments.

 

As an additional source of funds, NetBank had available under existinglines of credit agreements $1.5 billion at September 30, 2004 (see Note 8 ofthe consolidated financial statements included as part of this report foradditional details of the available lines of credit).

 

The Company uses deposits as its principalsource of funds.  For the nine monthsended September 30, 2004, deposits increased by $205 million to $2.7 billionfrom $2.5 billion as of December 31, 2003. NetBank’s deposit products include checking, money market andcertificates of deposit accounts. Deposit account terms vary, with the principal differences being theminimum balance required, the time periods the funds must remain on deposit andthe interest rate.  NetBank iscompetitive in the types of accounts, services and ranges of interest ratesoffered on deposit products.  Althoughmarket demand generally dictates which deposit maturities and rates will beaccepted by the public, NetBank intends to continue to promote checking, moneymarket and certificates of deposit to the extent possible consistent with assetand liability management goals.  NetBank decreasedits other borrowed funds, which include FHLB advances, repurchase agreementsand warehouse lines of credit, by $356 million during the nine months ended September30, 2004.  This decrease was primarilyrelated to the $660 million decrease in loan and lease receivables.

 

*Capital Resources.*  NetBank and NetBank, FSB are subject tovarious regulatory capital requirements administered by the federal bankingagencies. Failure of either company to meet minimum capital requirements caninitiate certain mandatory and possibly additional discretionary actions byregulators that, if undertaken, could have a direct material effect on NetBank’sconsolidated financial statements.  Undercapital adequacy guidelines and the regulatory framework for prompt correctiveaction, NetBank, FSB must meet specific capital guidelines that involvequantitative measures of NetBank, FSB’s assets, liabilities, and certainoff-balance sheet items as calculated under regulatory accounting practices.NetBank, FSB’s capital amounts and classifications are also subject toqualitative judgments by the regulators about components, risk weightings andother factors. In addition, under regulatory guidelines, NetBank, FSB may notpay a dividend to NetBank, Inc. if doing so would cause NetBank, FSB to be lessthan adequately capitalized, as defined below. During the nine months ended September30, 2004, NetBank repurchased 1,232,736 shares of common stock at a weightedaverage cost of $11.55, and management had authorization to repurchase up to anadditional 887 thousand shares of its common stock through open market orprivate transactions.

 

Quantitative measures established byregulation to ensure capital adequacy require NetBank, FSB to maintain minimumamounts and ratios as set forth in the following table.  NetBank, FSB’s regulatory agency, the Officeof Thrift Supervision (“OTS”), requires NetBank, FSB to maintain minimum ratiosof tangible capital to tangible assets of 1.5%, core capital to tangible assetsof 4.0% and total capital to risk-weighted assets of 8.0%.  Additionally, NetBank, Inc. is subject to aside letter agreement with the OTS, which was put in place in connection withNetBank’s acquisition of Resource in 2002. The side letter requires NetBank, FSB to maintain 6% core capital and12% total risk-based capital ratios.  Asof September 30, 2004, NetBank, FSB was classified as well capitalized with atotal risk-based capital ratio of 12.12%. Additionally, the side letter agreement requires NetBank, Inc. tomaintain a minimum of 10% total capital to assets, adjusted for capital heldagainst forward sold conforming mortgages to be the greater of 5% or $50,000,and in no event allow the total capital ratio to fall below 8.0%.  NetBank, FSB and NetBank, Inc. were incompliance with these agreements as of September 30, 2004.  The following table presents informationrelated to NetBank, FSB along with capital requirements mandated by the OTS:

 

34

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| ** **                                  | ** ** | **Actual** | ** ** | **For capital adequacy purposes** | ** ** | **To be categorized as Well  Capitalized under prompt  corrective action plan** | ** ** |
|---------------------------------------------|------------|------------|------------|-----------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **Amount** | ** ** | **Ratio**                         | ** ** | **Amount**                                                                      | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **September 30, 2004**                      |       |       |       |                              |       |                                                                            |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)     |       | $          | 359,745    |                              | 12.12      | %                                                                               | $          | 237,470 |   | 8.00 | % | $ | 296,838 |   | 10.00 | % |
| Core capital (to adjusted total assets)     |       | $          | 321,119    |                              | 7.34       | %                                                                               | $          | 174,936 |   | 4.00 | % | $ | 218,670 |   | 5.00 | % |
| Tangible capital (to adjusted total assets) |       | $          | 321,119    |                              | 7.34       | %                                                                               | $          | 65,601 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital (to risk-weighted assets)    |       | $          | 321,119    |                              | 10.82      | %                                                                               | N/A        |   | N/A |   | $ | 178,103 |   | 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’s subsidiaries engaged in mortgage banking mustadhere to various HUD regulatory guidelines including required minimum networth to maintain their FHA approved lending status.  Failure to comply with the HUD guidelinescould result in withdrawal of this certification.  As of September 30, 2004, Market Street andMeritage were in compliance with HUD guidelines.  NetBank and its subsidiaries are subject tovarious other capital requirements by secondary market investors and states.  None of these capital requirements are morestringent than the OTS capital requirements. Failure to comply with these restrictions could have a material adverseimpact on the Company’s results of operations. At September 30, 2004, all of the capital requirements placed uponNetBank and its subsidiaries were met, and there have been no subsequent eventsthat would lead management to believe that continued compliance would not bemet in the future.

 

# **PartI. Item 3: Quantitative and Qualitative MarketRisk**

 

NetBank’s principal businesses are retailbanking and the origination and purchase of mortgage loans.  These businesses are funded by customerdeposits and, to the extent necessary, other borrowed funds. Consequently, asignificant portion of NetBank’s assets and liabilities are monetary in natureand fluctuations in interest rates will affect NetBank’s future net interestincome and cash flows. This interest rate risk is NetBank’s primary market riskexposure. For the nine months ended September 30, 2004, the only derivativefinancial instruments that NetBank entered into were associated with hedgingactivities related to the portfolio of mortgage loans held for sale, thepipeline of mortgage loans for which the interest rate has been locked, hedging thesecuritization and sale of portfolio loans, the owned mortgageservicing rights portfolio and the mortgage servicing rights which NetBankintends to retain associated with the pipeline of mortgage loans for which theinterest rate has already been locked. NetBank has no market risk-sensitiveinstruments held for trading purposes. NetBank’s exposure to market risk isreviewed on a regular basis by NetBank’s management.

 

NetBank, FSB, like other savings banks, measures interest rate riskbased on Net Portfolio Value (“NPV”) analysis. NPV equals the present value of expected net cash flows from existingassets minus the present value of expected net cash flows from existingliabilities.  A NPV ratio is determinedby dividing NPV by the present value of assets. The following table sets forth the estimated NetBank, FSB NPV ratios asof September 30, 2004, December 31, 2003, and September 30, 2003, assuming rateshocks of +300 to -100 basis points:

 

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

 

| **Rate shock  (in basis points)** | ** ** | **As of  September 30,  2004** | ** ** | **As of  December 31,  2003** | ** ** | **As of  September 30,  2003** | ** ** | **Minimum as of  September 30,  2004** | ** ** |
|-----------------------------------|------------|--------------------------------|------------|-------------------------------|------------|--------------------------------|------------|----------------------------------------|------------|
| **+300**                          |       | 9.40                           | %          | 6.54                          | %          | 6.59                           | %          | 4.00                                   | %          |
| **+200**                          |       | 9.53                           | %          | 7.37                          | %          | 7.06                           | %          | 6.00                                   | %          |
| **+100**                          |       | 9.71                           | %          | 8.17                          | %          | 7.55                           | %          | 6.00                                   | %          |
| **Flat**                          |       | 9.67                           | %          | 8.66                          | %          | 7.80                           | %          | 6.00                                   | %          |
| **-100**                          |       | 9.87                           | %          | 9.07                          | %          | 8.23                           | %          | 6.00                                   | %          |

 

Minimum ratios for NPV risk areestabilished by the board of directors as prudent levels for the respectiveinterest scenarios. Lower NPV ratios denote more market rate sensitivity for agiven rate scenario.  As of September 30,2003 the

 

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analysis indicates sensitivityto rising market interest rates.  Thissensitivity is, however, well within the board approved limits for thesescenarios.  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 period covered by this report, the Company carriedout an evaluation, under the supervision and with the participation of theCompany’s management, including the Company’s Chief Executive Officer and ChiefFinancial Executive, of the effectiveness of the design and operation of theCompany’s disclosure controls and procedures pursuant to the Exchange Act Rule13a-15.  Based upon that evaluation, theCompany’s Chief Executive Officer and Chief Financial Executive concluded thatthe Company’s disclosure controls and procedures are effective in timelyalerting them to material information relating to the Company (including itsconsolidated subsidiaries) that is required to be in the Company’s periodicfilings with the Securities and Exchange Commission.  There have been no significant changes in theCompany’s internal controls or, to the Company’s knowledge, in other factorsthat could significantly affect those internal controls subsequent to the datethe Company carried out its evaluation, and there have been no correctiveactions with respect to significant deficiencies and material weaknesses.

 

# **Part II**. Item 1:  LegalProceedings

 

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

 

Asreported in previous filings, NetBank, FSB, filed a complaint in January 2002against Commercial Money Center, Inc. (“CMC”), the originator, seller, andsubservicer of equipment leases purchased by NetBank, FSB, and against IllinoisUnion Insurance Company (“Illinois Union”), Safeco Insurance Company of America(“Safeco”), and Royal Indemnity Company (“Royal,” with Illinois Union, Safecoand Royal, collectively, referred to as the “Sureties”), the insurancecompanies that issued surety bonds and insurance policies guaranteeing paymentof the income stream from the leases and that also served as master servicersof the leases.  The NetBank, FSB actionalleges several claims, including claims for breach of contract, fraud, and badfaith, and seeks, among other things, payment under and enforcement of suretybonds and insurance policies issued by the insurance and suretycompanies.  The Judicial Panel on Multi-District Litigation has consolidatedthe actions involving NetBank, FSB with more than 35 other cases pending aroundthe country involving other banks and financial institutions that were seekingto enforce surety 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”).

 

Asreported in previous filings, NetBank, FSB had joined with the other claimantsin a motion for judgment on the pleadings, which motion was filed on January31, 2003, and is still pending before the MDL Court.  Meanwhile, discovery in the case has beenproceeding and, with a few exceptions, fact discovery is now complete.  Amendments to the pleadings are currently due14 days after the MDL Court rules on the motions for judgment on thepleadings.  NetBank, FSB has prepared anamendment and supplement to its complaint to include additional claims againstthe Sureties based on discovery adduced and events that have occurred to dateand plans to file the amendment prior to the final date fixed by the MDL Courtfor filing amendments.  Furthermore,NetBank, FSB has withdrawn its motion for judgment on the pleadings and nowintends to file a 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.

 

Also,as reported in previous filings, on May 30, 2002, CMC filed for bankruptcyprotection.  The bankruptcy proceeding isnot a part of the consolidation of cases in Ohio.  On June 11, 2003, the California BankruptcyCourt approved an amended settlement agreement (the “NetBank Agreement”) amongNetBank, FSB, Lakeland Bank and the Trustee. The

 

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NetBankAgreement resolves all claims of the Trustee with respect to the lease paymentsthat were guaranteed by surety bonds and insurance policies issued by Safecoand Illinois Union, as well as all claims related to the surety bonds andinsurance policies.  In addition to approving the NetBank Agreement,the California Bankruptcy Court approved a settlement agreement between theTrustee and Royal (the “Royal Agreement’). Under the Royal Agreement, Royal has agreed, among other things, to fundlitigation by the Trustee against NetBank, FSB to avoid its interests in theleases that were guaranteed by surety bonds issued by Royal, as well asNetBank, FSB’s interests in the surety bonds themselves.  On September 4, 2003, the Trustee filed aComplaint against NetBank, FSB as contemplated by the Royal Agreement, seekingto avoid NetBank, FSB’s interest in the leases and surety bonds relating to theRoyal guaranteed lease pools.  On May 6,2004, NetBank, FSB filed a motion for summary judgment against theTrustee.  The Trustee filed a motion forsummary judgment against NetBank, FSB on June 18, 2004.  A hearing on the motions had been scheduledfor August 31, 2004.  At a statusconference on July 15, 2004, the Bankruptcy Court ordered a stay in thebankruptcy proceedings pending a hearing on July 30, 2004.  At that hearing the Bankruptcy Courtcontinued the stay as to all adversary proceedings and requested the parties toattempt to mediate their disputes.   At asubsequent status conference on October 1, 2004, the Bankruptcy Court scheduleda hearing on the progress of the bankruptcy action mediation for December 7,2004.  At that time, the Bankruptcy Courtwould review and consider for approval any properly noticed settlementproposal.  Also at the October 1,2004, status conference, the Bankruptcy Court lifted the stay of the adversaryproceeding against NetBank, FSB.  A hearing on NetBank, FSB’s and the Trustee’smotions for summary judgment has been scheduled by the Bankruptcy Court forDecember 14, 2004.

 

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

 

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

 

OnJune 27, 2001, several lessees of equipment leased from CMC filed suit in LosAngeles Superior Court against CMC and several John Doe defendants allegingthat the leases violated California usury laws, the California Financial Code,and the California Unfair Business Practices Act.  The plaintiffs were seeking to rescind orreform their obligations under the leases and were seeking to recover statutorydamages and attorney’s fees.  Theplaintiffs subsequently amended their complaint to name NetBank, FSB, severalother investor banks, and several surety companies as co-defendants in theaction.  After CMC filed for bankruptcy,the action was removed to the bankruptcy court in the Central District ofCalifornia, but the plaintiffs subsequently agreed to withdraw their claimsagainst CMC and were successful in their motion to remand the case back tostate court.

 

OnMarch 15, 2004, the Superior Court sustained demurrers and motions to quashfiled by NetBank, FSB and various  otherdefendants 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.

 

OnApril 29, 2004, the plaintiffs served an amended complaint against NetBank, FSBalleging claims for, among other things, violations of another section of theCalifornia Financial Code, unfair competition under Section 17200 of theCalifornia Business and Professions Code and usury.  On October 26, 2004, the court overruled thedefendants’ demurrers to the third amended complaint, so the case willproceed.  NetBank intends to vigorouslydefend the amended claims and to pursue recovery against Safeco InsuranceCompany, Royal Indemnity Company, and Illinois Union Insurance Company for any damagesand costs incurred in this case.

 

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

 

OnJune 27, 2001, the Company was served with a complaint for a declaratoryjudgment filed by interState NetBank in the District of New Jersey challengingthe “NETBANK®” service mark.  The Company answered and counterclaimed fortrademark infringement on July 13, 2001.  Discovery was stayed pending aruling on interState NetBank’s November 19, 2001 motion for summaryjudgment, which claimed that “NETBANK” is generic for all banking servicesdelivered over

 

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theInternet.  On September 22, 2002, theDistrict Court ruled that “NETBANK” is generic but did not cancel the Company’sexisting service mark registration.  TheCompany filed a motion for reconsideration of the District Court’sdecision.  On June 23, 2003, the DistrictCourt denied the Company’s motion for reconsideration but clarified that two ofthe Company’s counterclaims remained in the case: (1) a claim for infringementof the Company’s “NETBANK®” service mark to the extent that it covers onlinebill-payment services (as opposed to online banking services in general) and(2) a claim for unfair competition under New Jersey and common law.  The parties completed fact discovery onFebruary 27, 2004.  On April 30, 2004,interState NetBank filed a second motion for summary judgment, seeking thedismissal of the remaining two claims brought by NetBank, as well as an awardof attorneys’ fees.

 

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

 

**Part II. Item2:  Unregistered Sales of EquitySecurities and Use of Proceeds**

 

On July 1, 2004, the Company issued 194,217 shares of common stock and$5.0 million in cash to the members of Beacon Credit Services, LLC in theCompany’s acquisition of its principal operating assets.  The shares were issued in a privateplacement, exempt from registration under Rule 506 of the Securities Act, asamended.

 
| **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 June 30, 2004            |       | —                                 |       | —                            |       | —                                                                                                       |       | 1,079,264                                                                                                                         |       |
| July 1 through July 31, 2004           |       | 15,600                                 |       | $                                 | 10.49      |                                                                                                         | 15,600     |                                                                                                                              | 1,063,664  |   |
| August 1 through August 31, 2004       |       | 53,200                                 |       | $                                 | 10.23      |                                                                                                         | 53,200     |                                                                                                                              | 1,010,464  |   |
| September 1 through September 30, 2004 |       | 122,900                                |       | $                                 | 10.14      |                                                                                                         | 122,900    |                                                                                                                              | 887,564    |   |
| Total                                  |       | 191,700                                |       | $                                 | 10.19      |                                                                                                         | 191,700    |                                                                                                                              | 887,564    |   |

 

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Note1: In August 2002, the Board of Directors approved a plan to repurchase up to 1million shares of the Company’s common stock. The plan was subsequently increased by 1 million shares in October 2002,2 million shares in January 2003 and 1 million shares in April2004.

 

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

 

**None**

 

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

 

**None**

 

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

 

**None**

 

**Part II. Item 6:  Exhibits**

 

31.1                           ChiefExecutive Officer’s certification under Section 302 of the Sarbanes-Oxley Actof 2002.

31.2                           ChiefFinancial Executive’s certification under Section 302 of the Sarbanes-Oxley Actof 2002.

32                                    Certificationspursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

**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: November 9, 2004 |          | *Chief Financial Executive and  Chief Accounting Officer* |

 

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