** **

**UNITEDSTATES SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934.**  |
|------------|------------|------------------------------------------------------------------------------------------------------|
| ** ** | ** ** | ** **                                                                                           |
| ** ** | ** ** | **For  the quarterly period ended: September 30, 2004**                                              |
| ** ** | ** ** | ** **                                                                                           |
| **OR**     |
| ** ** | ** ** | ** **                                                                                           |
| **o**      | ** ** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934.** |
| ** ** | ** ** | ** **                                                                                           |
| ** ** | ** ** | **Commission  File Number:  1-13485**                                                           |

 

**AMNETMORTGAGE, INC.**

(Exact name of registrant as specified in its charter)

 
| **Maryland**                                                                        | ** ** | **33-0741174**                       |
|-------------------------------------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of   incorporation or organization)                    |       | (I.R.S. Employer Identification No.) |
|                                                                                |       |                                 |
| **10421 Wateridge Circle, Suite 250  San Diego, California**                        | ** ** | **92121**                            |
| (Address of principal executive offices)                                            |       | (Zip Code)                           |
|                                                                                |       |                                 |
| **(858) 909-1200**                                                                  |
| (Registrant’s telephone number, including area code)                           |
|                                                                                |       |                                 |
| ** **                                                                          |
| (Former name, former address and former fiscal year, if changed since  last report) |

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15 (d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that the registrantwas required to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

ý  YES    o  NO

 

Indicate by check markwhether the registrant is an accelerated filer (asdefined in Rule 12b-2 of the Act). Yes o No ý

 

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

 
| Common Stock ($0.01) |   | 7,310,194 as of October 29, 2004 |
|----------------------|--------|----------------------------------|

 

----

 
| INDEX                                                                                                                                                                                                                                      |   |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                                                                                       |   |
| PART I.   FINANCIAL INFORMATION                                                                                                                                                                                                       |   |
|                                                                                                                                                                                                                                       |   |
| Item 1. Consolidated Financial Statements                                                                                                                                                                                                  |   |
|                                                                                                                                                                                                                                       |   |
| Consolidated Balance Sheets  at September 30, 2004 and December 31, 2003                                                                                                                                                         |   |
|                                                                                                                                                                                                                                       |   |
| Consolidated  Statements of Operations and Comprehensive Income (Loss) for the three months  ended September 30, 2004 and September 30, 2003 and for the nine  months ended September 30, 2004 and September 30, 2003. |   |
|                                                                                                                                                                                                                                       |   |
| Consolidated  Statements of Cash Flows for the nine months ended September 30, 2004  and September 30, 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.  Unregistered Sales of Equity Securities and Use of Proceeds                                                                                                                                                                       |   |
|                                                                                                                                                                                                                                       |   |
| Item 3.  Defaults Upon Senior Securities                                                                                                                                                                                                   |   |
|                                                                                                                                                                                                                                       |   |
| Item  4. Submission of Matters to a Vote of Security Holders                                                                                                                                                                               |   |
|                                                                                                                                                                                                                                       |   |
| Item 5. Other  Information                                                                                                                                                                                                                 |   |
|                                                                                                                                                                                                                                       |   |
| Item  6. Exhibits                                                                                                                                                                                                                          |   |

 

2

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PARTI.  FINANCIAL INFORMATION

Item1.  Consolidated Financial Statements

 

AmNet Mortgage, Inc. and Subsidiaries

Consolidated BalanceSheets, unaudited

(in thousands,except share and per share data)

 
| ** **                                                                                                                                                                   | ** ** | **September 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|----------------------------|------------|
|                                                                                                                                                                         |       |                        |       |                       |       |
| **ASSETS**                                                                                                                                                                   |       |                        |       |                       |       |
| Cash and cash equivalents                                                                                                                                                    |       | $                           | 46,133     |                       | $          | 44,400 |   |
| Cash and cash equivalents—restricted                                                                                                                                    |       | 2,100                       |       | 2,100                      |       |
| Mortgage loans held for sale, net, pledged (lower of cost or market)                                                                                                         |       | 394,368                     |       | 276,781                    |       |
| Bond collateral, mortgage loans, net                                                                                                                                         |       | 16,526                      |       | 157,872                    |       |
| Bond collateral, real estate owned, net                                                                                                                                      |       | 671                         |       | 3,380                      |       |
| Accounts receivable—mortgage loans sold/funded                                                                                                                          |       | 8,855                       |       | 3,856                      |       |
| Income tax refunds receivable                                                                                                                                                |       | 3,488                       |       | —                     |       |
| Derivative financial instruments                                                                                                                                             |       | 237                         |       | (1,224                     | )          |
| Accrued interest receivable                                                                                                                                                  |       | 898                         |       | 2,593                      |       |
| Deferred taxes                                                                                                                                                               |       | 4,992                       |       | 5,694                      |       |
| Other assets                                                                                                                                                                 |       | 6,183                       |       | 5,520                      |       |
|                                                                                                                                                                         |       | $                           | 484,451    |                       | $          | 500,972 |   |
|                                                                                                                                                                         |       |                        |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                               |       |                        |       |                       |       |
| Liabilities:                                                                                                                                                                 |       |                        |       |                       |       |
| Short-term debt                                                                                                                                                              |       | $                           | 380,791    |                       | $          | 268,619 |   |
| Accrued interest payable                                                                                                                                                     |       | 677                         |       | 494                        |       |
| Accrued expenses and other liabilities                                                                                                                                       |       | 9,904                       |       | 12,950                     |       |
| Long-term debt, net                                                                                                                                                          |       | 15,869                      |       | 130,295                    |       |
| Total liabilities                                                                                                                                                            |       | 407,241                     |       | 412,358                    |       |
| Commitments and contingencies (Note 12)                                                                                                                                 |       |                        |       |                       |       |
| Minority interest                                                                                                                                                            |       | 161                         |       | 129                        |       |
| Stockholders’ Equity:                                                                                                                                                   |       |                        |       |                       |       |
| Preferred stock, par value $.01 per share; 100,000 shares authorized;  no shares issued and outstanding                                                                      |       | —                      |       | —                     |       |
| Common stock, par value $.01 per share; 24,900,000 shares authorized;  7,310,194 shares issued and outstanding in 2004, and 7,873,714 shares issued  and outstanding in 2003 |       | 73                          |       | 79                         |       |
| Additional paid-in-capital                                                                                                                                                   |       | 103,739                     |       | 108,719                    |       |
| Accumulated deficit                                                                                                                                                          |       | (26,763                     | )          | (20,313                    | )          |
| Total stockholders’ equity                                                                                                                                              |       | 77,049                      |       | 88,485                     |       |
|                                                                                                                                                                         |       | $                           | 484,451    |                       | $          | 500,972 |   |
|                                                                                                                                                                              |            |                             |            |                            |            |  |  |  |  |  |

 

See accompanyingnotes to consolidated financial statements.

 

3

----

 

AmNet Mortgage,Inc. and Subsidiaries

ConsolidatedStatements of Operations and Comprehensive Income (Loss), unaudited

(in thousands,except per share data)

 
| ** **                                                                                                                        | ** ** | **For the Three Months Ended September 30, 2004** | ** ** | **For the Three Months Ended September 30, 2003** | ** ** | **For the Nine Months Ended September 30, 2004** | ** ** | **For The Nine Months Ended September 30, 2003** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
|                                                                                                                              |       |                                                   |       |                                                   |       |                                                  |       |                                                  |       |
| **Revenues**                                                                                                                      |       |                                                   |       |                                                   |       |                                                  |       |                                                  |       |
| Gain on sales of loans                                                                                                            |       | $                                                      | 24,198     |                                                   | $          | 9,580                                                 |       | $                                                     | 42,037     |   | $ | 62,760 |   |
| Derivative financial instruments and market adjustments                                                                           |       |                                                   |       |                                                   |       |                                                  |       |                                                  |       |
| Derivative financial instruments—forward sales of mortgage-backed  securities and options to sell mortgage-backed securities |       | (7,793                                                 | )          | 4,194                                                  |       | (2,423                                                | )          | 1,115                                                 |       |
| Market adjustment on interest rate lock commitments                                                                               |       | (3,753                                                 | )          | 10,955                                                 |       | (520                                                  | )          | 2,539                                                 |       |
| Total derivative financial instruments and market adjustments                                                                     |       | (11,546                                                | )          | 15,149                                                 |       | (2,943                                                | )          | 3,654                                                 |       |
| Interest on mortgage assets                                                                                                       |       | 8,227                                                  |       | 13,046                                                 |       | 24,437                                                |       | 32,684                                                |       |
| Other income                                                                                                                      |       | 281                                                    |       | 558                                                    |       | 1,010                                                 |       | 1,021                                                 |       |
| Total revenue, net of derivative financial instruments and  adjustments                                                           |       | 21,160                                                 |       | 38,333                                                 |       | 64,541                                                |       | 100,119                                               |       |
| **Expenses**                                                                                                                      |       |                                                   |       |                                                   |       |                                                  |       |                                                  |       |
| Employee compensation and benefits                                                                                                |       | 12,752                                                 |       | 14,030                                                 |       | 38,994                                                |       | 36,100                                                |       |
| Interest expense                                                                                                                  |       | 4,420                                                  |       | 5,646                                                  |       | 12,414                                                |       | 14,456                                                |       |
| Office and occupancy expense                                                                                                      |       | 1,076                                                  |       | 706                                                    |       | 2,871                                                 |       | 1,894                                                 |       |
| Provision for loan losses (bond collateral)                                                                                       |       | 80                                                     |       | 764                                                    |       | 208                                                   |       | 2,478                                                 |       |
| Gain on sale of real estate owned, net                                                                                            |       | (86                                                    | )          | (236                                                   | )          | (406                                                  | )          | (751                                                  | )          |
| Loss on bond collateral sold                                                                                                      |       | (437                                                   | )          | —                                                 |       | 4,872                                                 |       | —                                                |       |
| Professional fees                                                                                                                 |       | 925                                                    |       | 1,432                                                  |       | 3,329                                                 |       | 4,174                                                 |       |
| Other operating expenses                                                                                                          |       | 4,098                                                  |       | 5,002                                                  |       | 13,038                                                |       | 12,781                                                |       |
| Total expenses                                                                                                                    |       | 22,828                                                 |       | 27,344                                                 |       | 75,320                                                |       | 71,132                                                |       |
| (Loss) income before income taxes                                                                                                 |       | (1,668                                                 | )          | 10,989                                                 |       | (10,779                                               | )          | 28,987                                                |       |
| Income tax (benefit) provision                                                                                                    |       | (683                                                   | )          | 3,221                                                  |       | (4,328                                                | )          | (442                                                  | )          |
| Net (loss) income                                                                                                                 |       | $                                                      | (985       | )                                                      | $          | 7,768                                                 |       | $                                                     | (6,451     | ) | $ | 29,429 |   |
|                                                                                                                              |       |                                                   |       |                                                   |       |                                                  |       |                                                  |       |
| Basic weighted average shares outstanding                                                                                         |       | 7,364,244                                              |       | 7,858,733                                              |       | 7,716,079                                             |       | 7,861,665                                             |       |
| Diluted weighted average shares outstanding                                                                                       |       | 7,364,244                                              |       | 8,521,286                                              |       | 7,716,079                                             |       | 8,524,218                                             |       |
|                                                                                                                              |       |                                                   |       |                                                   |       |                                                  |       |                                                  |       |
| Net (loss) income per share-basic                                                                                                 |       | $                                                      | (0.13      | )                                                      | $          | 0.99                                                  |       | $                                                     | (0.84      | ) | $ | 3.74 |   |
|                                                                                                                              |       |                                                   |       |                                                   |       |                                                  |       |                                                  |       |
| Net (loss) income per share-diluted                                                                                               |       | $                                                      | (0.13      | )                                                      | $          | 0.91                                                  |       | $                                                     | (0.84      | ) | $ | 3.45 |   |

 

See accompanyingnotes to consolidated financial statements.

 

4

----

 

AmNet Mortgage,Inc. and Subsidiaries

Consolidated Statementsof Cash Flows,unaudited

(in thousands)

 
| ** **                                                                            | ** ** | **For the Nine Months Ended September 30, 2004** | ** ** | **For the Nine Months Ended September 30, 2003** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-------------------------------------------------------|------------|
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                 |       |                                                  |       |                                                  |       |
| Net (loss) income                                                                     |       | $                                                     | (6,451     | )                                                     | $          | 29,429 |   |
| Adjustments to reconcile net (loss) income to net cash used in  operating activities: |       |                                                  |       |                                                  |       |
| Loss on bond collateral sold                                                          |       | 4,872                                                 |       | —                                                |       |
| Amortization of mortgage assets premiums                                              |       | 995                                                   |       | 2,663                                                 |       |
| Amortization of CMO capitalized costs                                                 |       | 474                                                   |       | 265                                                   |       |
| Provision for loan losses                                                             |       | 208                                                   |       | 2,477                                                 |       |
| Change in real estate owned provision                                                 |       | 473                                                   |       | 1,573                                                 |       |
| Gain on sale of real estate owned, net                                                |       | (406                                                  | )          | (751                                                  | )          |
| Proceeds from sale of mortgage loans held for sale                                    |       | 6,402,844                                             |       | 8,345,391                                             |       |
| Mortgage loan originations                                                            |       | (6,520,430                                            | )          | (8,322,279                                            | )          |
| Increase in restricted cash                                                           |       | —                                                |       | (975                                                  | )          |
| (Increase)/decrease in accounts receivable—mortgage loans sold/funded            |       | (4,999                                                | )          | 1,653                                                 |       |
| Increase in income tax refunds receivable                                             |       | (3,488                                                | )          | —                                                |       |
| Decrease in accrued interest receivable                                               |       | 1,695                                                 |       | 1,543                                                 |       |
| Decrease/(increase) in deferred taxes                                                 |       | 702                                                   |       | (9,865                                                | )          |
| Increase in other assets                                                              |       | (661                                                  | )          | (2,322                                                | )          |
| (Increase)/decrease in derivative financial instruments                               |       | (1,461                                                | )          | 1,519                                                 |       |
| Increase/(decrease) in accrued interest payable                                       |       | 183                                                   |       | (39                                                   | )          |
| (Decrease)/increase in accrued expenses and other liabilities                         |       | (3,045                                                | )          | 14,312                                                |       |
| Increase in minority interest                                                         |       | 32                                                    |       | 26                                                    |       |
| Net cash (used in)/provided by operating activities                                   |       | (128,463                                              | )          | 64,620                                                |       |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                 |       |                                                  |       |                                                  |       |
| Principal payments on bond collateral, mortgage loans                                 |       | 24,991                                                |       | 68,781                                                |       |
| Proceeds from sale of bond collateral                                                 |       | 111,150                                               |       | —                                                |       |
| Proceeds from sale of real estate owned                                               |       | 1,771                                                 |       | 7,627                                                 |       |
| Net cash provided by investing activities                                             |       | 137,912                                               |       | 76,408                                                |       |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                 |       |                                                  |       |                                                  |       |
| Payments on long-term debt                                                            |       | (29,410                                               | )          | (84,437                                               | )          |
| Payments on long-term debt from sale of bond collateral                               |       | (85,491                                               | )          | —                                                |       |
| Increase/(decrease) in net borrowings from short-term debt                            |       | 112,172                                               |       | (25,776                                               | )          |
| Stock options exercised                                                               |       | 158                                                   |       | 40                                                    |       |
| Purchase of treasury stock                                                            |       | (5,145                                                | )          | (145                                                  | )          |
| Net cash used in financing activities                                                 |       | (7,716                                                | )          | (110,318                                              | )          |
| Net increase in cash and cash equivalents                                             |       | 1,733                                                 |       | 30,710                                                |       |
| Cash and cash equivalents at beginning of year                                        |       | 44,400                                                |       | 13,647                                                |       |
| Cash and cash equivalents at end of period                                            |       | $                                                     | 46,133     |                                                  | $          | 44,357 |   |
| Supplemental information:                                                             |       |                                                  |       |                                                  |       |
| Interest paid                                                                         |       | $                                                     | 12,232     |                                                  | $          | 14,496 |   |
| Taxes paid                                                                            |       | $                                                     | 2,832      |                                                  | $          | 160 |   |
| Transfers from bond collateral, mortgage loans, net to real estate  owned             |       | $                                                     | 1,127      |                                                  | $          | 4,378 |   |

 

See accompanyingnotes to consolidated financial statements.

 

5

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**AMNETMORTGAGE, INC.**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1.  Summary of Significant Accounting Policiesand Practices**

 

*Basis of Financial StatementPresentation*

 

InMay 2004, American Residential Investment Trust, Inc. changed its name to AmNetMortgage, Inc.

 

The consolidatedfinancial statements include the accounts of AmNet Mortgage, Inc., a Marylandcorporation, American Mortgage Network, Inc., a Delaware corporation andwholly-owned subsidiary of AmNet Mortgage, Inc., American ResidentialEagle, Inc., a Delaware special purpose corporation and wholly-ownedsubsidiary of AmNet Mortgage Inc. and American ResidentialEagle 2, Inc., a Delaware limited purpose corporation andwholly-owned subsidiary of American Residential Eagle, Inc. Substantiallyall of the assets of American Residential Eagle, Inc. are pledged to supportlong-term debt in the form of collateralized mortgage bonds and are notavailable for the satisfaction of general claims of AmNet Mortgage, Inc.American Residential Holdings, Inc. is an affiliate of AmNet Mortgage,Inc. that is consolidated in accordance with FASB Interpretation No. 46R “Consolidationof Variable Interest Entities.” All entities are together referred to as the “Company”or “AmNet.” The Company’s exposure to loss on the assets pledged as collateralis limited to its net investment, as the collateralized mortgage bonds arenon-recourse to the Company. All significant intercompany balances andtransactions have been eliminated in the consolidation of AmNet. Certain reclassificationshave been made to prior period amounts to conform to the current presentation.

 

In management’s opinion,all adjustments necessary for a fair statement are reflected in the interimperiods presented. These adjustments are of a normal recurring nature. Theinterim financial data as of September 30, 2004 and for the nine monthsended September 30, 2004 and September 30, 2003 is unaudited;however, in the opinion of the Company, the interim data includes alladjustments, consisting only of normal recurring adjustments, necessary for afair statement of the results for the interim periods.

 

Sales of mortgage loansare accounted for under Statement of Financial Accounting Standards (SFAS)No. 140, “Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities.” Mortgage loans are sold with the mortgageservicing rights released. Gains or losses on sales of mortgage loans arerecognized based on the difference between the selling prices and the carryingvalue of the related mortgage loans sold. Deferred origination fees andexpenses are recognized at the time of sale.

 

In March 2004, theSEC released Staff Accounting Bulletin (SAB) No. 105, “Application ofAccounting Principles to Loan Commitments.” The Company accounts for itscommitments to extend credit as derivatives and records changes in fair valueof the commitments in the statement of operations. The adoption of SAB No. 105beginning in the second quarter of 2004 did not have a significant effect onthe Company’s financial statements.

 

In December 2003, the Accounting Standards ExecutiveCommittee issued Statement of Position 03-3, “Accounting for Certain Loans orDebt Securities Acquired in a Transfer” (“SOP 03-3”). SOP 03-3 is effective forloans acquired in fiscal years beginning after December 15, 2004. The SOPaddresses accounting for differences between contractual cash flows and cashflows expected to be collected from an investor’s initial investment in loansor debt securities acquired in a transfer if those differences areattributable, at least in part, to credit quality. This SOP does not apply toloans originated by the Company.**The Company isevaluating the applicability of this Statement to the Company’s operations.

 

Please refer to theCompany’s Form 10-K for the year ending December 31, 2003, for a detaileddiscussion of all significant accounting policies.

 

6

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*StockOptions*

 

The Company elected toapply APB Opinion No. 25, “Accounting for Stock Issued to Employees,” inaccounting for its stock-based compensation plans: the 2004 Equity IncentivePlan and 1997 Employee Stock Purchase Plan. Accordingly, no compensation costhas been recognized in the financial statements. SFAS No. 123 “Accountingfor Stock Based Compensation” requires pro forma disclosures of expensecomputed as if the fair value-based method had been applied in the financialstatements of companies that continue to account for such arrangements underOpinion No. 25.

 

In December 2002,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “AccountingFor Stock Based Compensation Transition and Disclosure,” which amends SFASNo. 123. SFAS No. 148 requires more prominent and frequentdisclosures about the effects of stock-based compensation. The Company willcontinue to account for its stock based compensation according to theprovisions of APB Opinion No. 25.

 

The FASB is currentlyconsidering amending SFAS No. 123, “Accounting for Stock-Based Compensation,”which will supercede APB Opinion No. 25, “Accounting for Stock Issued toEmployees.” The proposed standard which is expected to be finalized inDecember, 2004 will require the Company to record compensation expense for allshare-based compensation. If adopted, this proposed standard would have anegative impact on our earnings in future periods since stock options areissued periodically to qualified employees.

 

Had compensation cost forthe Company’s stock options been recognized based upon the estimated fair valueon the grant date under the fair value methodology prescribed by SFASNo. 123, as amended by SFAS No. 148, the Company’s net income (loss)and income per share would have been as follows (in thousands except income pershare) (unaudited):

 
| ** **                                                                                                                | ** ** | **Three Months Ended**      | ** ** | **Nine Months Ended**       | ** ** |
|---------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
|                                                                                                                      |       |                        |       |                        |       |   |   |   |   |
| Net (loss) income as reported                                                                                             |       | $                           | (985       | )                           | $          | 7,768 |   | $ | (6,451 | ) | $ | 29,429 |   |
| Deduct: Total stock-based compensation expense determined under fair  value-based method, net of tax effects (See Note 9) |       | (145                        | )          | (185                        | )          | (564 | ) | (1,208 | ) |
| Pro forma net (loss) income                                                                                               |       | $                           | (1,130     | )                           | $          | 7,583 |   | $ | (7,015 | ) | $ | 28,221 |   |
| (Loss) income per share:                                                                                                  |       |                        |       |                        |       |   |   |   |   |
| Basic as reported                                                                                                         |       | $                           | (0.13      | )                           | $          | 0.99 |   | $ | (0.84 | ) | $ | 3.74 |   |
| Basic pro forma                                                                                                           |       | $                           | (0.15      | )                           | $          | 0.97 |   | $ | (0.91 | ) | $ | 3.59 |   |
| Diluted as reported                                                                                                       |       | $                           | (0.13      | )                           | $          | 0.91 |   | $ | (0.84 | ) | $ | 3.45 |   |
| Diluted pro forma                                                                                                         |       | $                           | (0.15      | )                           | $          | 0.89 |   | $ | (0.91 | ) | $ | 3.31 |   |
|                                                                                                                           |            |                             |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |

 

The assumptions used tocalculate the fair value of options granted are evaluated and revised asnecessary to reflect market conditions and the Company’s experience. Theseassumptions have not changed from prior periods.

 

**Note 2.  Concentration of Mortgage Loan Sales**

 

For the nine monthsending September 30, 2004, the Company sold a majority of the mortgageloans it originated to two of its competitors, Countrywide Home Loans, Inc. (59%) and Wells Fargo Funding, Inc. (16%). TheCompany’s considerations in deciding where to sell loans are price andoperational efficiency.  The Company alsoconsiders speed of execution and loan product guidelines.  The Company believes that all of the loans itsells currently could be sold to a number of other investors.

 

7

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**Note 3.  Income Per Share**

 

The following tableillustrates the computation of basic and diluted income per share (inthousands, except share and per share data) (unaudited):

 
| ** **                                                                                                              | ** ** | **For the Three**

**Months Ended**

**September 30,**

**2004** | ** ** | **For the Three**

**Months Ended**

**September 30,**

**2003** | ** ** | **For the Nine**

**Months Ended**

**September 30,**

**2004** | ** ** | **For the Nine**

**Months Ended**

**September 30,**

**2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|----------------------------------------------------------------------|------------|
| Numerator:                                                                                                              |       |                                                                  |       |                                                                  |       |                                                                 |       |                                                                 |       |
| Numerator for basic (loss) income per share                                                                             |       | $                                                                     | (985       | )                                                                     | $          | 7,768                                                                |       | $                                                                    | (6,451     | ) | $ | 29,429 |   |
| Denominator:                                                                                                            |       |                                                                  |       |                                                                  |       |                                                                 |       |                                                                 |       |
| Denominator for basic (loss) income per share - weighted average  number of common shares outstanding during the period |       | 7,364,244                                                             |       | 7,858,733                                                             |       | 7,716,079                                                            |       | 7,861,665                                                            |       |
| Denominator for diluted (loss) income per share                                                                         |       | 7,364,244                                                             |       | 8,521,286                                                             |       | 7,716,079                                                            |       | 8,524,218                                                            |       |
|                                                                                                                    |       |                                                                  |       |                                                                  |       |                                                                 |       |                                                                 |       |
| (Loss) income per share - basic                                                                                         |       | $                                                                     | (0.13      | )                                                                     | $          | 0.99                                                                 |       | $                                                                    | (0.84      | ) | $ | 3.74 |   |
| (Loss) income per share - diluted                                                                                       |       | $                                                                     | (0.13      | )                                                                     | $          | 0.91                                                                 |       | $                                                                    | (0.84      | ) | $ | 3.45 |   |
|                                                                                                                         |            |                                                                       |            |                                                                       |            |                                                                      |            |                                                                      |            |  |  |  |  |  |  |  |

 

For the nine months endedSeptember 30, 2004 and 2003 there were 1,132,729and 1,119,047 options, respectively, that were antidilutive and,therefore, not included in the calculations above.

 

**Note 4.  Mortgage Loans Held for Sale, net, pledged**

 

AmNet has pledged loansheld for sale totaling approximately $394.4million to secure credit lines (warehouse facilities) from four financial institutions. (See Note 7. “Short-Term Debt.”). Mortgage loansheld for sale at September 30, 2004 consist of loans which have beencommitted for sale of approximately $286.4million and loans available for sale of approximately $108.0 million, all ofwhich are carried at the lower of cost or market value.

 

**Note 5.  Bond Collateral, Mortgage Loans, net**

 

AmNet has pledgedcollateral in order to secure the long-term debt issued in the form of CMOs.Bond Collateral Mortgage Loans consist primarily of subprime credit, 30-yearmortgage loans secured by first liens on one-to-four family residential properties.As of September 30, 2004 and 2003, 0% and17.65%, respectively, of the bond collateral mortgage loans were fixedrate loans. The balance of the bond collateral mortgage loans areadjustable-rate mortgages. All Bond Collateral Mortgage Loans are pledged tosecure repayment of the related long-term debt obligation. All principal andinterest (less servicing and related fees) on the bond collateral is remittedto a trustee and is available for payment of the long-term debt obligation. Theobligations under the long-term debt are payable solely from the bondcollateral and are otherwise non-recourse to AmNet.

 

InMarch of 2004, approximately $113.9 million in Bond Collateral Mortgage Loansand approximately $2.3 million in REO bond collateral were reclassified as heldfor sale.  By September 30, 2004 allof these mortgage loans including real estate owned, had been sold.  One remaining portfolio (CMO/FASIT 1998-1)was not sold.  Bond collateral for thisstructure is shown as Bond collateral, mortgage loans, net and Bond collateral,real estate owned, net.

 

8

----

 

Shown below are thecomponents of bond collateral mortgage loans held for investment atSeptember 30, 2004; compared to the same components at December 31,2003 (dollars in thousands) (unaudited):

 
| ** **                                           | ** ** | **CMO/REMIC  2000-2 Securitization** | ** ** | **CMO/REMIC  1999-A Securitization** | ** ** | **CMO  1999-2 Securitization** | ** ** | **CMO  1999-1 Securitization** | ** ** | **CMO/FASIT  1998-1 Securitization** | ** ** | **TOTAL  Bond Collateral** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|--------------------------------------|------------|--------------------------------|------------|--------------------------------|------------|--------------------------------------|------------|----------------------------|------------|
| **At September 30, 2004**                            | ** ** | ** **                           | ** ** | ** **                           | ** ** | ** **                     | ** ** | ** **                     | ** ** | ** **                           | ** ** | ** **                 | ** ** |
| Mortgage loans                                       |       | $                                    | 0          |                                 | $          | 0                              |       | $                              | 0          |                                 | $          | 0                          |       | $ | 16,648 |   | $ | 16,648 |   |
| Unamortized  premium                                 |       | 0                                    |       | 0                                    |       | 0                              |       | 0                              |       | 42                                   |       | 42                         |       |
| Allowance for  loan losses                           |       | 0                                    |       | 0                                    |       | 0                              |       | 0                              |       | (164                                 | )          | (164                       | )          |
|                                                 |       | $                                    | 0          |                                 | $          | 0                              |       | $                              | 0          |                                 | $          | 0                          |       | $ | 16,526 |   | $ | 16,526 |   |
| ** **                                           | ** ** | ** **                           | ** ** | ** **                           | ** ** | ** **                     | ** ** | ** **                     | ** ** | ** **                           | ** ** | ** **                 | ** ** |
| Weighted average  net coupon                         |       | 0                                    | %          | 0                                    | %          | 0                              | %          | 0                              | %          | 9.43                                 | %          | 9.43                       | %          |
| Unamortized  premiums as a percent of mortgage loans |       | 0                                    | %          | 0                                    | %          | 0                              | %          | 0                              | %          | 0.25                                 | %          | 0.25                       | %          |
| ** **                                           | ** ** | ** **                           | ** ** | ** **                           | ** ** | ** **                     | ** ** | ** **                     | ** ** | ** **                           | ** ** | ** **                 | ** ** |
| **At December 31, 2003**                        | ** ** | ** **                           | ** ** | ** **                           | ** ** | ** **                     | ** ** | ** **                     | ** ** | ** **                           | ** ** | ** **                 | ** ** |
| Mortgage loans                                       |       | $                                    | 7,068      |                                 | $          | 40,435                         |       | $                              | 58,922     |                                 | $          | 27,021                     |       | $ | 22,668 |   | $ | 156,114 |   |
| Unamortized premium                                  |       | 362                                  |       | 809                                  |       | 1,747                          |       | 749                            |       | 102                                  |       | 3,769                      |       |
| Allowance for  loan losses                           |       | (141                                 | )          | (486                                 | )          | (517                           | )          | (311                           | )          | (556                                 | )          | (2,011                     | )          |
|                                                 |       | $                                    | 7,289      |                                 | $          | 40,758                         |       | $                              | 60,152     |                                 | $          | 27,459                     |       | $ | 22,214 |   | $ | 157,872 | ** ** |
| ** **                                           | ** ** | ** **                           | ** ** | ** **                           | ** ** | ** **                     | ** ** | ** **                     | ** ** | ** **                           | ** ** | ** **                 | ** ** |
| Weighted average  net coupon                         |       | 9.15                                 | %          | 9.49                                 | %          | 9.00                           | %          | 8.88                           | %          | 9.40                                 | %          | 9.17                       | %          |
| Unamortized  premiums as a percent of mortgage loans |       | 5.12                                 | %          | 2.00                                 | %          | 2.96                           | %          | 2.77                           | %          | 0.45                                 | %          | 2.41                       | %          |
|                                                      |            |                                      |            |                                      |            |                                |            |                                |            |                                      |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Note 6.  Derivative Financial Instruments**

 

AmNet makes commitmentsto fund mortgages at set interest rates, which are referred to as rate lockcommitments. Additionally, most of the Company’s loans are not yet committedfor sale at the time of funding. Collectively, rate lock commitments and fundedloans not yet committed for sale are the Company’s pipeline.  The value of the rate lock commitments anduncommitted loans will vary depending on changes in market interest ratesbetween the time that a rate lock commitment is made and the time that the loanfunds and is committed for sale to an investor.

 

AmNet estimates thenumber of rate lock commitments in the pipeline that will not close in order tocalculate its interest rate exposure on a daily basis. AmNet then purchaseshedging instruments in order to try to protect profit margins on the pipeline.The hedging instruments typically used are forward sales of mortgage-backedsecurities (“TBA”) and options on forward sales of mortgage-backed securities.Historically, changes in the price of these instruments closely relate tochanges in the value (price) of loans in the pipeline.

 

9

----

 

At September 30,2004 and September 30, 2003 AmNet had the following commitments tooriginate loans and loans not yet committed for sale to investors, andoffsetting hedge coverage; (dollars in thousands) (unaudited) (Note thatinterest rate exposure does not directly correlate to hedge coverage withoutapplying an option adjusted spread and fallout factor [for rate locks]):

 
| ** **                                                                                      | ** ** | **September 30, 2004** | ** ** | **September 30, 2003** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| **Interest rate exposure:**                                                                     |       |                   |       |                   |       |
|                                                                                            |       |                   |       |                   |       |
| Commitments to originate loans at set interest rates (after applying  fallout)                  |       | $                      | 547,094    |                   | $          | 545,758 |   |
|                                                                                            |       |                   |       |                   |       |
| Funded loans not yet committed for sale to investors                                            |       | 107,993                |       | 208,267                |       |
|                                                                                            |       |                   |       |                   |       |
| **Hedge coverage:**                                                                             |       |                   |       |                   |       |
|                                                                                            |       |                   |       |                   |       |
| Forward sales of To Be Announced mortgage-backed securities  (“TBA”)(notional amount) |       | 547,000                |       | 682,000                |       |
|                                                                                            |       |                   |       |                   |       |
| Options on forward sales of mortgage-backed securities (notional  amount)                       |       | 30,000                 |       | 180,000                |       |
|                                                                                                 |            |                        |            |                        |            |  |  |

 

The fair value of forwardsales of mortgage-backed securities and options on forward sales ofmortgage-backed securities are based on quoted market prices for theseinstruments. The rate lock commitments are also considered a derivativeinstrument and are assigned fair values based on the change in the quotedmarket value of the underlying loans due to market movements, less an estimatedfactor for loans that will not close (fallout ratio). The fallout ratio isaffected by the Company’s recent fallout history, interest rate changes andloan characteristics.

 

The following is asummary of the carrying value of AmNet’s derivative instruments as ofSeptember 30, 2004 and December 31, 2003 (dollars in thousands)(unaudited):

 
| **September 30,  2004**                               | ** ** | **Range of  Coupon Rate** | ** ** | **Range of  Notional Amount** | ** ** | **Fair  Value** | ** ** | **Range of  Expiration Dates** | ** ** |
|------------------------------------------------------------|------------|---------------------------|------------|-------------------------------|------------|-----------------|------------|--------------------------------|------------|
| ***Forward  sales of mortgage-backed securities (TBAs):*** |       |                      |       |                          |       |            |       |                           |       |
| Fifteen year  Fannie Mae                                   |       | 4.5-5.5 MBS               |       | $                             | 500-20,000 |            | $          | (525                           | )          | Oct 19-Dec 16, 2004 |   |
| Thirty year  Fannie Mae                                    |       | 5.0-6.0 MBS               |       | 1,000-15,000                  |       | 228             |       | Oct 14-Dec 13, 2004            |       |
| Thirty year  Ginnie Mae                                    |       | 5.0-5.5 MBS               |       | 500-5,000                     |       | (137            | )          | Oct 21-Dec 20, 2004            |       |
| Forward  commitment by investor                            |       | 4.875-5.0                 |       | 15,000                        |       | 327             |       | Nov15-Nov 30, 2004             |       |
| ***Options  on TBAs:***                                    |       |                      |       |                          |       |            |       |                           |       |
| Thirty year  Fannie Mae                                    |       | 5.5 Puts                  |       | 15,000                        |       | 3               |       | Oct 19, 2004                   |       |
| ***Rate  lock commitments***                               |       |                      |       |                          |       | 341             |       |                           |       |
| ***Total  derivative financial instruments***              |       |                      |       |                          |       | $               | 237        |                           |       |   |
|                                                            |            |                           |            |                               |            |                 |            |                                |            |  |  |

 
| **December 31,  2003**                   | ** ** | **Coupon  Rate** | ** ** | **Range of  Notional Amount** | ** **   | **Fair  Value** | ** ** | **Range of  Expiration Dates** | ** ** |
|-----------------------------------------------|------------|------------------|------------|-------------------------------|--------------|-----------------|------------|--------------------------------|------------|
| ***TBA***                                     |       |             |       |                          |         |            |       |                           |       |
| Fifteen year  Fannie Mae                      |       | 4.5-5.5 MBS      |       | $                             | 3,000-25,000 |            | $          | (803                           | )          | Jan 20-Mar 18, 2004 |   |
| Twenty year  Fannie Mae                       |       | 4.5 MBS          |       | 2,000                         |         | 56              |       | Feb 12, 2004                   |       |
| Thirty year  Fannie Mae                       |       | 5.0-6.0 MBS      |       | 4,500-20,000                  |         | (1,388          | )          | Jan 14-Mar 15, 2004            |       |
| Thirty year  Ginnie Mae                       |       | 5.0-6.0 MBS      |       | 1,000-8,000                   |         | (122            | )          | Jan 22-Feb 19, 2004            |       |
| ***Options  on TBAs:***                       |       |             |       |                          |         |            |       |                           |       |
| Thirty year  Fannie Mae                       |       | 5.5 Puts         |       | 50,000                        |         | 172             |       | Mar 15, 2004                   |       |
| ***Rate  lock commitments***                  |       |             |       |                          |         | 861             |       |                           |       |
| ***Total  derivative financial instruments*** |       |             |       |                          |         | $               | (1,224     | )                              |       |   |
|                                               |            |                  |            |                               |              |                 |            |                                |            |  |  |

 

10

----

 

The following is asummary of the components within Total derivative financial instruments andmarket adjustments income (expense) (dollars in thousands) (unaudited):

 
| ** **                                                                       | ** ** | **For the Three  Months Ended  September 30, 2004** | ** ** | **For the Three  Months Ended  September 30, 2003** | ** ** | **For the Nine  Months Ended  September 30, 2004** | ** ** | **For the Nine  Months Ended  September 30, 2003** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|
| Derivative financial instruments - (expense) income:                             |       |                                                     |       |                                                     |       |                                                    |       |                                                    |       |
| TBA (loss)/gain - closed positions                                               |       | $(13,317                                                 | )          | $11,281                                                  |       | $(4,906                                                 | )          | $1,711                                                  |       |
| Options gain - closed positions                                                  |       | —                                                   |       | 8,458                                                    |       | 4,287                                                   |       | 8,457                                                   |       |
| Change in value of TBAs - open positions                                         |       | 6,381                                                    |       | (12,902                                                  | )          | 2,150                                                   |       | (4,535                                                  | )          |
| Change in value of Options - open positions                                      |       | (857                                                     | )          | (2,643                                                   | )          | (3,954                                                  | )          | (4,518                                                  | )          |
| Change in market adjustment on interest rate lock commitments                    |       | (3,753                                                   | )          | 10,955                                                   |       | (520                                                    | )          | 2,539                                                   |       |
|                                                                             |       |                                                     |       |                                                     |       |                                                    |       |                                                    |       |
| Total derivative financial instruments and market adjustments  (expense) income: |       | $(11,546                                                 | )          | $15,149                                                  |       | $(2,943                                                 | )          | $3,654                                                  |       |

 

**Note 7. Short-Term Debt**

 

As of September 30,2004, mortgage loans held for sale totaling $394.4 millionwere pledged as collateral for warehouse facility borrowings of $380.8 million with four financialinstitutions. At September 30, 2004, the Company’s maximum borrowingcapacity combined from these four financial institutions was$1.4 billion.  The table below showsthe age of pledged mortgage loans as of September 30, 2004. (in thousands)(unaudited):

 
| **Aging Range**    | ** ** | **Number of Loans** | ** ** | **Warehouse line usage** | ** ** | **% of Total** | ** ** |
|--------------------|------------|---------------------|------------|--------------------------|------------|----------------|------------|
| ** **         | ** ** | ** **          | ** ** | ** **               | ** ** | ** **     | ** ** |
| Less than 30 days  |       | 1,955               |       | $                        | 334,598    |           | 87.9       | % |
| 30 to 60 days      |       | 336                 |       | 42,389                   |       | 11.1           | %          |
| 61 days to 90 days |       | 35                  |       | 3,804                    |       | 1.0            | %          |
| Total              |       | 2,326               |       | $                        | 380,791    |           | 100.0      | % |

 

Of the $380.8 million ofwarehouse line usage at September 30, 2004,$122.4 million was funded through uncommitted warehouse facilities.

 

Warehouse facilities mature on various dates within two years,generally bearing interest at one-month LIBOR plus spread. The weighted averageborrowing rates were 3.08% and 2.69% for the three month period endingSeptember 30, 2004 and September 30, 2003 respectively. Theweighted-average borrowing rate was 2.74% for the nine months ending September 30,2004 and 2.71% for the nine months ending September 30, 2003. Theweighted-average facility fee was .23% for the nine months endingSeptember 30, 2004 and .25% for the nine months ending September 30,2003 on the aggregate committed amount of the warehouse facilities. Thewarehouse facilities are repaid as principal payments on mortgage loans arereceived, or as the mortgage loans are sold. The agreements governing thesefacilities contain a number of covenants, including covenants based on tangiblenet worth, net income, and liquidity of the Company. As a result of the Company’sthird quarter net loss, the Company was out of compliance with certain of itswarehouse lending agreements at September 30, 2004. The Company was out ofcompliance with earnings covenants in its JPMorgan Chase Bank, CountrywideWarehouse Lending and Residential Funding Corporation agreements. Each of thewarehouse lenders has waived, for the period ending September 30, 2004, thecovenants for which the Company was out of compliance.

 

In 2001, the Company alsoentered into a $5 million senior subordinated secured revolving loanagreement (“Subordinated Loan Agreement”). The Subordinated Loan Agreement borean interest rate of 12%. The $3 million loan balance was paid off in full inApril 2004. The agreement has since expired and the Company has no optionto renew the agreement.

 

In April of 2004,the Company entered into agreements to sell approximately 85% of its mortgageportfolio assets. As a result, approximately $90 million in long-term debt wasreclassified to short-term debt pending sale. During the second quarter of 2004the Company extinguished all of the reclassified short-term debt, usingproceeds from the sale of the related bond collateral mortgage loans and realestate owned bond collateral.  As ofSeptember 30, 2004, all mortgage portfolio assets related to the April 2004sale agreements have been sold.

 

11

----

 

**Note 8.  Long-Term Debt Related to Securitizations,net**

 

The components of thelong-term debt at September 30, 2004 and December 31, 2003, alongwith selected other information are summarized below (dollars in thousands)(unaudited):

 
| ** **                           | ** ** | **CMO/REMIC  2000-2  Securitization** | ** ** | **CMO/REMIC  1999-A**

**Securitization** | ** ** | **CMO  1999-2  Securitization** | ** ** | **CMO  1999-1  Securitization** | ** ** | **CMO/FASIT  1998-1  Securitization** | ** ** | **TOTAL  Long-Term Debt** | ** ** |
|--------------------------------------|------------|---------------------------------------|------------|-------------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|---------------------------------------|------------|---------------------------|------------|
| **At  September 30, 2004**      | ** ** | ** **                            | ** ** | ** **                                | ** ** | ** **                      | ** ** | ** **                      | ** ** | ** **                            | ** ** | ** **                | ** ** |
| Long-term debt                       |       | $                                     | 0          |                                      | $          | 0                               |       | $                               | 0          |                                  | $          | 0                         |       | $ | 15,869 |   | $ | 15,869 |   |
| Capitalized costs  on long-term debt |       | 0                                     |       | 0                                         |       | 0                               |       | 0                               |       | —                                |       | —                    |       |
| Total long-term  debt                |       | $                                     | 0          |                                      | $          | 0                               |       | $                               | 0          |                                  | $          | 0                         |       | $ | 15,869 |   | $ | 15,869 |   |
| ** **                           | ** ** | ** **                            | ** ** | ** **                                | ** ** | ** **                      | ** ** | ** **                      | ** ** | ** **                            | ** ** | ** **                | ** ** |
| Weighted average  financing rates    |       | 0                                     | %          | 0                                         | %          | 0                               | %          | 0                               | %          | 3.03                                  | %          | 3.03                      | %          |
| ** **                           | ** ** | ** **                            | ** ** | ** **                                | ** ** | ** **                      | ** ** | ** **                      | ** ** | ** **                            | ** ** | ** **                | ** ** |
| **At  December 31, 2003**       | ** ** | ** **                            | ** ** | ** **                                | ** ** | ** **                      | ** ** | ** **                      | ** ** | ** **                            | ** ** | ** **                | ** ** |
| Long-term debt                       |       | $                                     | 7,182      |                                      | $          | 33,012                          |       | $                               | 51,594     |                                  | $          | 16,753                    |       | $ | 22,229 |   | $ | 130,770 |   |
| Capitalized costs  on long-term debt |       | (30                                   | )          | (1                                        | )          | (267                            | )          | (177                            | )          | —                                |       | (475                      | )          |
| Total long-term  debt                |       | $                                     | 7,152      |                                      | $          | 33,011                          |       | $                               | 51,327     |                                  | $          | 16,576                    |       | $ | 22,229 |   | $ | 130,295 |   |
| ** **                           | ** ** | ** **                            | ** ** | ** **                                | ** ** | ** **                      | ** ** | ** **                      | ** ** | ** **                            | ** ** | ** **                | ** ** |
| Weighted average  financing rates    |       | 2.24                                  | %          | 1.29                                      | %          | 3.33                            | %          | 1.82                            | %          | 2.14                                  | %          | 2.37                      | %          |

 

**Note 9.  Stock Plans**

 

At the annual meeting ofshareholders held on August 12, 2004 there was majority approval for thecreation of the 2004 Equity Incentive Plan. Approval of this plan authorized an additional 500,000 options to begranted combined with all ungranted options in the 1997 Stock Incentive Plan,1997 Stock Option Plan and the 1997 Outside Director Stock Option Plan.  The 1997 plans will cease to exist except forthe 1997 Employee Stock Purchase Plan. As of September 30, 2004, shares of common stock were reserved forissuance under the Company’s stock option plans as follows (unaudited):

 
| ** **                                                                     | ** ** | **1997  Stock Incentive Plan** | ** ** | **1997  Stock Option Plan** | ** ** | **1997  Employee Stock Purchase Plan** | ** ** | **1997  Outside Director Stock Option Plan** | ** ** | **2004  Equity Incentive Plan** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|----------------------------------------|------------|----------------------------------------------|------------|---------------------------------|------------|-----------|------------|
|                                                                           |       |                           |       |                        |       |                                   |       |                                         |       |                            |       |      |       |
| Total Options  Authorized at 1/1/2004                                          |       | 315,200                        |       | 1,474,800                   |       | 20,000                                 |       | 210,000                                      |       | —                          |       | 2,020,000 |       |
| Total Options  Issued at or by 8/12/04                                         |       | 284,800                        |       | 1,459,393                   |       | —                                 |       | 179,500                                      |       | —                          |       | 1,923,693 |       |
| Options  Authorized at 8/12/04                                                 |       | —                         |       | —                      |       | —                                 |       | —                                       |       | 500,000                         |       | 500,000   |       |
| Balance of  Options Not Granted at 8/12/04                                     |       | 30,400                         |       | 15,407                      |       | 20,000                                 |       | 30,500                                       |       | 500,000                         |       | 596,307   |       |
| Balance of  Options not Granted at 8/12/04 moved to 2004 Equity Incentive Plan |       | (30,400                        | )          | (15,407                     | )          | —                                 |       | (30,500                                      | )          | 76,307                          |       | —    |       |
| Options Reserved  For Issuance at 8/12/04                                      |       | —                         |       | —                      |       | 20,000                                 |       | —                                       |       | 576,307                         |       | 596,307   |       |
| Cancellations  8/12/04 to 9/30/04                                              |       | —                         |       | 20,878                      |       | —                                 |       | —                                       |       | —                          |       | 20,878    |       |
| Cancellations  8/12/04 to 9/30/04 moved to 2004 Equity Incentive Plan          |       | —                         |       | (20,878                     | )          | —                                 |       | —                                       |       | 20,878                          |       | —    |       |
| Options Reserved  For Issuance at 9/30/04                                      |       | —                         |       | —                      |       | 20,000                                 |       | —                                       |       | 597,185                         |       | 617,185   |       |

 

12

----

 

Stock option activityduring the nine months ending September 30, 2004 was as follows(unaudited):

 
| ** **                         | ** ** | **Number of Options** | ** ** | **Weighted-Average Exercise Price** | ** ** |
|------------------------------------|------------|-----------------------|------------|-------------------------------------|------------|
|                               |       |                  |       |                                |       |
| Balance at December 31, 2003  |       | 1,768,100             |       | $                                   | 7.96       |   |
| Granted                            |       | 216,750               |       | 8.62                                |       |
| Forfeited                          |       | (113,259              | )          | 7.54                                |       |
| Exercised                          |       | (29,170               | )          | 5.42                                |       |
| Balance at September 30, 2004 |       | 1,842,421             |       | $                                   | 8.10       |   |

 

At September 30,2004, the range of exercise prices for outstanding options was $1.75 to $15.00and the weighted-average remaining contractual life of outstanding options was 6.26 years. The weighted averageexercise price of exercisable outstanding options was $9.03.  The table belowshows options and prices for all outstanding options at September 30, 2004(unaudited):

 
| **Option Exercise Price Range** | ** ** | **Vested** | ** ** | **Unvested** | ** ** | **Number of Options** | ** ** |
|---------------------------------|------------|------------|------------|--------------|------------|-----------------------|------------|
|                            |       |       |       |         |       |                  |       |
| $1.75 to $3.00                  |       | 110,035    |       | 61,799       |       | 171,834               |       |
| $3.01 to $5.00                  |       | 235,021    |       | 235,041      |       | 470,062               |       |
| $5.01 to $7.50                  |       | 307,136    |       | 43,314       |       | 350,450               |       |
| $7.51 to $10.00                 |       | 131,996    |       | 152,679      |       | 284,675               |       |
| $10.01 to $12.50                |       | 291,820    |       | 17,480       |       | 309,300               |       |
| $12.51 to $15.00                |       | 256,100    |       | —       |       | 256,100               |       |
|                            |       | 1,332,108  |       | 510,313      |       | 1,842,421             |       |

 

The per shareweighted-average fair value of stock options granted between January 1,2004 and September 30, 2004 is computed quarterly.  For the first quarter ending March 31,2004 the value was $2.48.  For the secondquarter ending June 30, 2004 the value was $3.47.  For the third quarter endingSeptember 30, 2004 the value was $3.53. These values were calculated using the Black-Scholes option-pricingmodel, using the following weighted-average assumptions (unaudited):

 
| ** **              | ** ** | **Three Months  Ending  March 31, 2004** | ** ** | **Three Months  Ending   June 30, 2004** | ** ** | **Three Months  Ending  September 30, 2004** | ** ** |
|-------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------------|------------|
| Expected dividend yield |       | 0.00                                          | %          | 0.00                                          | %          | 0.00                                              | %          |
| Risk-free interest rate |       | 2.80                                          | %          | 3.81                                          | %          | 3.38                                              | %          |
| Expected volatility     |       | 27.78                                         | %          | 39.59                                         | %          | 35.19                                             | %          |
| Expected life (years)   |       | 5                                             |       | 5                                             |       | 5                                                 |       |

 

**Note 10.  Business Segments**

 

The Company reports itsfinancial results in two segments: the Mortgage Banking Business and theMortgage Asset Portfolio Business. The Mortgage Banking Business originateshome mortgage loans through a network of mortgage loan brokers. These mortgageloans are subsequently sold to financial institutions. The Mortgage AssetPortfolio Business segment manages a portfolio of mortgage loans pledged ascollateral for CMO debt.

 

The accounting policiesof the segments are the same as described in Note 1, “Summary ofSignificant Accounting Policies and Practices.” The Company evaluates theperformance of its business segments based on revenue and expenses under thedirect control of each business segment. The expense of premises and equipmentincurred to support business operations are allocated accordingly, by segment.

 

13

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The table below reflectsthe total assets at September 30, 2004 and 2003, and the capitalexpenditures for the nine-month periods ending September 30, 2004 and 2003(in thousands) (unaudited):

 
| ** **                                                                     | ** ** | **Mortgage Banking** | ** ** | **Mortgage Asset Portfolio** | ** ** | **Combined Segments** | ** ** |
|--------------------------------------------------------------------------------|------------|----------------------|------------|------------------------------|------------|-----------------------|------------|
|                                                                           |       |                 |       |                         |       |                  |       |
| Total assets as of September 30, 2004                                     |       | $                    | 429,973    |                         | $          | 54,478                | *          | $ | 484,451 |   |
| Total capital expenditures for the nine months ending  September 30, 2004 |       | $                    | 1,700      |                         | $          | —                |       | $ | 1,700 |   |
|                                                                           |       |                 |       |                         |       |                  |       |
| Total assets as of September 30, 2003                                     |       | $                    | 422,888    |                         | $          | 197,614               |       | $ | 620,502 |   |
| Total capital expenditures for the nine months ending  September 30, 2003 |       | $                    | 3,167      |                         | $          | —                |       | $ | 3,167 |   |
|                                                                                |       |                 |       |                         |       |                  |       |
| * Cash composes $32.8 million of these assets.                                 |       |                 |       |                         |       |                  |       |
|                                                                                |            |                      |            |                              |            |                       |            |  |  |  |  |  |  |  |

 

14

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The tables below reflectthe year-to-date income statement activity by segment for the three-month andnine-month periods ending September 30, 2004 and September 30, 2003:

 

AmNet Mortgage, Inc. andSubsidiariesConsolidated Statements of Operations by Business Segment, unaudited

(in thousands)

 
| ** **                                                                     | ** ** | **For the  Three Months Ended September 30, 2004** | ** ** | **For the  Three Months Ended September 30, 2004** | ** ** | **For the  Three Months Ended September 30, 2004** | ** ** | **For the  Nine Months Ended September 30, 2004** | ** ** | **For the  Nine Months Ended September 30, 2004** | ** ** | **For the  Nine Months Ended September 30, 2004** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **Mortgage  Banking**                                   | ** ** | **Mortgage  Asset Portfolio**                           | ** ** | **Combined  Segments**                                  | ** ** | **Mortgage  Banking**                                  | ** ** | **Mortgage  Asset Portfolio**                          | ** ** | **Combined  Segments**                                 | ** ** |
|                                                                           |       |                                                    |       |                                                    |       |                                                    |       |                                                   |       |                                                   |       |                                                   |       |
| **Revenues**                                                                   |       |                                                    |       |                                                    |       |                                                    |       |                                                   |       |                                                   |       |                                                   |       |
| Gain on sales of  loans                                                        |       | $                                                       | 24,198     |                                                    | $          | —                                                  |       | $                                                      | 24,198     |                                                   | $          | 42,037                                                 |       | $ | — |   | $ | 42,037 |   |
| Derivative  financial instruments and market adjustments                       |       |                                                    |       |                                                    |       |                                                    |       |                                                   |       |                                                   |       |                                                   |       |
| Derivative  financial instruments—forward commitments and options         |       | (7,793                                                  | )          | —                                                  |       | (7,793                                                  | )          | (2,423                                                 | )          | —                                                 |       | (2,423                                                 | )          |
| Market adjustment  on interest rate lock commitments                           |       | (3,753                                                  | )          | —                                                  |       | (3,753                                                  | )          | (520                                                   | )          | —                                                 |       | (520                                                   | )          |
| Total derivative  financial instruments and market adjustments                 |       | (11,546                                                 | )          | —                                                  |       | (11,546                                                 | )          | (2,943                                                 | )          | —                                                 |       | (2,943                                                 | )          |
| Interest on  mortgage assets, net of premium amortization                      |       | 8,201                                                   |       | 26                                                      |       | 8,227                                                   |       | 22,208                                                 |       | 2,229                                                  |       | 24,437                                                 |       |
| Other income                                                                   |       | 157                                                     |       | 124                                                     |       | 281                                                     |       | 303                                                    |       | 707                                                    |       | 1,010                                                  |       |
| Total revenue,  net of derivative financial instruments and market adjustments |       | 21,010                                                  |       | 150                                                     |       | 21,160                                                  |       | 61,605                                                 |       | 2,936                                                  |       | 64,541                                                 |       |
| **Expenses**                                                                   |       |                                                    |       |                                                    |       |                                                    |       |                                                   |       |                                                   |       |                                                   |       |
| Employee compensation  and benefits                                            |       | 12,752                                                  |       | —                                                  |       | 12,752                                                  |       | 38,715                                                 |       | 279                                                    |       | 38,994                                                 |       |
| Interest expense                                                               |       | 4,308                                                   |       | 112                                                     |       | 4,420                                                   |       | 11,075                                                 |       | 1,339                                                  |       | 12,414                                                 |       |
| Office and  occupancy expense                                                  |       | 1,076                                                   |       | —                                                  |       | 1,076                                                   |       | 2,871                                                  |       | —                                                 |       | 2,871                                                  |       |
| Provision for  loan losses                                                     |       | —                                                  |       | 80                                                      |       | 80                                                      |       | —                                                 |       | 208                                                    |       | 208                                                    |       |
| Gain on sale of  real estate owned, net                                        |       | —                                                  |       | (86                                                     | )          | (86                                                     | )          | —                                                 |       | (406                                                   | )          | (406                                                   | )          |
| Loss on bond  collateral sold                                                  |       | —                                                  |       | (437                                                    | )          | (437                                                    | )          | —                                                 |       | 4,872                                                  |       | 4,872                                                  |       |
| Professional fees                                                              |       | 792                                                     |       | 133                                                     |       | 925                                                     |       | 2,793                                                  |       | 536                                                    |       | 3,329                                                  |       |
| Other operating  expenses                                                      |       | 3,913                                                   |       | 185                                                     |       | 4,098                                                   |       | 12,461                                                 |       | 577                                                    |       | 13,038                                                 |       |
| Total expenses                                                                 |       | 22,841                                                  |       | (13                                                     | )          | 22,828                                                  |       | 67,915                                                 |       | 7,405                                                  |       | 75,320                                                 |       |
| (Loss) income  before income taxes                                             |       | (1,831                                                  | )          | 163                                                     |       | (1,668                                                  | )          | (6,310                                                 | )          | (4,469                                                 | )          | (10,779                                                | )          |
| Income tax  (benefit) provision                                                |       | (750                                                    | )          | 67                                                      |       | (683                                                    | )          | (2,477                                                 | )          | (1,851                                                 | )          | (4,328                                                 | )          |
| Net (loss) income                                                              |       | $                                                       | (1,081     | )                                                       | $          | 96                                                      |       | $                                                      | (985       | )                                                      | $          | (3,833                                                 | )          | $ | (2,618 | ) | $ | (6,451 | ) |

 

15

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| ** **                                                                     | ** ** | **For the  Three Months Ended September 30, 2003** | ** ** | **For the  Three Months Ended September 30, 2003** | ** ** | **For the  Three Months Ended September 30, 2003** | ** ** | **For the  Nine Months Ended September 30, 2003** | ** ** | **For the  Nine Months Ended September 30, 2003** | ** ** | **For the  Nine Months Ended September 30, 2003** | ** ** |
|--------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|--------------------------------------------------------|------------|
| ** **                                                                     | ** ** | **Mortgage  Banking**                                   | ** ** | **Mortgage  Asset Portfolio**                           | ** ** | **Combined  Segments**                                  | ** ** | **Mortgage  Banking**                                  | ** ** | **Mortgage  Asset Portfolio**                          | ** ** | **Combined  Segments**                                 | ** ** |
|                                                                           |       |                                                    |       |                                                    |       |                                                    |       |                                                   |       |                                                   |       |                                                   |       |
| **Revenues**                                                                   |       |                                                    |       |                                                    |       |                                                    |       |                                                   |       |                                                   |       |                                                   |       |
| Gain on sales of  loans                                                        |       | $                                                       | 9,580      |                                                    | $          | —                                                  |       | $                                                      | 9,580      |                                                   | $          | 62,760                                                 |       | $ | — |   | $ | 62,760 |   |
| Derivative  financial instruments and market adjustments                       |       |                                                    |       |                                                    |       |                                                    |       |                                                   |       |                                                   |       |                                                   |       |
| Derivative  financial instruments—forward commitments and options         |       | 4,194                                                   |       | —                                                  |       | 4,194                                                   |       | 1,115                                                  |       | —                                                 |       | 1,115                                                  |       |
| Market adjustment  on interest rate lock commitments                           |       | 10,955                                                  |       | —                                                  |       | 10,955                                                  |       | 2,539                                                  |       | —                                                 |       | 2,539                                                  |       |
| Total derivative  financial instruments and market adjustments                 |       | 15,149                                                  |       | —                                                  |       | 15,149                                                  |       | 3,654                                                  |       | —                                                 |       | 3,654                                                  |       |
| Interest on  mortgage assets, net of premium amortization                      |       | 10,381                                                  |       | 2,665                                                   |       | 13,046                                                  |       | 23,843                                                 |       | 8,841                                                  |       | 32,684                                                 |       |
| Other income                                                                   |       | 24                                                      |       | 534                                                     |       | 558                                                     |       | 76                                                     |       | 945                                                    |       | 1,021                                                  |       |
| Total revenue,  net of derivative financial instruments and market adjustments |       | 35,134                                                  |       | 3,199                                                   |       | 38,333                                                  |       | 90,333                                                 |       | 9,786                                                  |       | 100,119                                                |       |
|                                                                           |       |                                                    |       |                                                    |       |                                                    |       |                                                   |       |                                                   |       |                                                   |       |
| **Expenses**                                                                   |       |                                                    |       |                                                    |       |                                                    |       |                                                   |       |                                                   |       |                                                   |       |
| Employee compensation  and benefits                                            |       | 13,893                                                  |       | 137                                                     |       | 14,030                                                  |       | 35,487                                                 |       | 613                                                    |       | 36,100                                                 |       |
| Interest expense                                                               |       | 4,535                                                   |       | 1,111                                                   |       | 5,646                                                   |       | 10,656                                                 |       | 3,800                                                  |       | 14,456                                                 |       |
| Office and  occupancy expense                                                  |       | 706                                                     |       | —                                                  |       | 706                                                     |       | 1,894                                                  |       | —                                                 |       | 1,894                                                  |       |
| Provision for  loan losses                                                     |       | —                                                  |       | 764                                                     |       | 764                                                     |       | —                                                 |       | 2,478                                                  |       | 2,478                                                  |       |
| Gain on sale of  real estate owned, net                                        |       | —                                                  |       | (236                                                    | )          | (236                                                    | )          | —                                                 |       | (751                                                   | )          | (751                                                   | )          |
| Professional fees                                                              |       | 1,455                                                   |       | (23                                                     | )          | 1,432                                                   |       | 3,728                                                  |       | 446                                                    |       | 4,174                                                  |       |
| Other operating  expenses                                                      |       | 4,786                                                   |       | 216                                                     |       | 5,002                                                   |       | 12,107                                                 |       | 674                                                    |       | 12,781                                                 |       |
| Total expenses                                                                 |       | 25,375                                                  |       | 1,969                                                   |       | 27,344                                                  |       | 63,872                                                 |       | 7,260                                                  |       | 71,132                                                 |       |
|                                                                           |       |                                                    |       |                                                    |       |                                                    |       |                                                   |       |                                                   |       |                                                   |       |
| Income before  income taxes                                                    |       | 9,759                                                   |       | 1,230                                                   |       | 10,989                                                  |       | 26,461                                                 |       | 2,526                                                  |       | 28,987                                                 |       |
| Income taxes                                                                   |       | 3,547                                                   |       | 398                                                     |       | 3,945                                                   |       | 8,596                                                  |       | 827                                                    |       | 9,423                                                  |       |
| Income tax  benefit from utilization of REIT net operating losses              |       | —                                                  |       | (724                                                    | )          | (724                                                    | )          | —                                                 |       | (9,865                                                 | )          | (9,865                                                 | )          |
| Net income                                                                     |       | $                                                       | 6,212      |                                                    | $          | 1,556                                                   |       | $                                                      | 7,768      |                                                   | $          | 17,865                                                 |       | $ | 11,564 |   | $ | 29,429 |   |

 

**Note 11.  Income Taxes**

 

During 1997, the Companyelected to be taxed as a real estate investment trust (“REIT”) under theInternal Revenue Code of 1986, as amended. As a result of this election, theCompany was not, with certain exceptions, taxed at the corporate level on thenet income distributed to the Company’s shareholders. On July 19, 2002,the shareholders of the Company approved two proposals that allowed for theconversion of the Company from a REIT to a fully taxable entity. OnFebruary 7, 2003, the Company filed a notice with the Internal RevenueService of its decision to relinquish its REIT status, effective January 1,2003.

 

16

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As a result of theconversion to a fully taxable status, an income tax benefit and relateddeferred tax asset of $6.7 million, was recorded in March of 2003.  As of September 30, 2004, our deferred taxasset is $5.0 million which reflects a reduction from $6.7 million byrealization of income tax provisions over time. This benefit was calculatedbased on an assumed income tax rate of 41% for 2004.

 

As the Company’s net income and its projections of net income vary overtime, the expected realizability of its deferred tax assets may change. If theCompany determines that its ability to realize all of its deferred taxes isunlikely, the Company will set up certain reserves against those assets, whichwould negatively affect its net income. However, currently, we expect to fullyutilize our deferred tax assets.

 

 

**Note 12.  Commitments and Contingencies**

 

*LeaseCommitments*

 

The Company rents certainpremises and equipment under non-cancelable operating leases expiring atvarious dates through the year 2009. Rental expense under such leases isincluded in office and occupancy expense, and other operating expenses. Leasecosts totaled $3.0 million in the ninemonths ending September 30, 2004 and $2.1 million in the ninemonths ending September 30, 2003. Future minimum lease payments underthese leases as of September 30, 2004, are as follows (dollars inthousands) (unaudited):

 
| **Year ending September 30:** | ** ** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|
| 2005                               |       | $          | 4,533      |   |
| 2006                               |       | 3,145      |       |
| 2007                               |       | 2,240      |       |
| 2008                               |       | 1,565      |       |
| 2009                               |       | 866        |       |
| After September 30, 2009           |       | 110        |       |
|                               |       | $          | 12,459     |   |

 

**Note 13. Subsequent Events**

 

On November 1, 2004 the Company begancorrespondent lending activity and intends to purchase mortgage loans fromapproved correspondents.  The Company hasleased office space in Columbia, Maryland and hired experienced professionalsfor this purpose. Expenses incurred for correspondent lending are included inthe Mortgage Banking business segment.

 

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ITEM2.  MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

*Thestatements contained in this Form 10-Q that are not purely historical areforward looking statements, including statements regarding our expectations,hopes, beliefs, intentions, or strategies regarding the future. Such statementsuse words such as “expect,” “will,” “may,” “anticipate,” “goal,” “intend,” “seek,”“believe,” “plan,” “strategy” and derivatives of such words. Forward lookingstatements in this report include those statements regarding:*

•                    *Our future results ofoperations and the factors that could impact our results;*

•                    *The factors that mayimpact our future liquidity;*

•                    *Our strategies;*

•                    *Changes in the mortgagemarket and competitive factors;*

•                    *The estimates we use inpreparing our financial statements and the impact of accounting standards;*

•                    *The risks that mayimpact our business.*

*Theseforward looking statements are based on information available to us on the datehereof, and we assume no obligation to update any such forward lookingstatements. It is important to note that our actual results and timing ofcertain events could differ materially from those in such forward lookingstatements.  Some of the most significantrisks that we face that could harm our future operating results or prevent usfrom meeting our goals and objectives are the following:*

•                    *We are utilizing asmuch of our existing infrastructure as we can while managing our staffinglevels and growing our sales presence in existing and new markets.  Our strategy requires us to capture anincreasing percentage of the market in a highly competitive environment, whichwill put pressure on our gross margins. If we are not able to do this, we would likely experience losses (due toour increased level of expenses or lower gross margins).*

•                    *We have expanded ourbranch system and fixed expenses over the past year in a contractingmarket.  Additionally, our market shareincreases are dependent on retaining and expanding our sales force and brokercustomer base, which is more challenging in a highly competitive marketenvironment.*

•                    *We sell a substantialportion of our loans to two of our competitors. If our competitors stop purchasing our loans on favorable terms, wecould be required to find alternate purchasers and/or accept unfavorable terms.  In either case, this could reduce our revenuesand earnings.*

•                    *We are dependent on ourwarehouse lending facilities to operate our business.  We must maintain, renew or replace ourwarehouse lines of credit in order to continue to fund loans.  We believe we are in good standing with ourwarehouse lenders, however, any future reductions or restrictions in ourwarehouse capacity would reduce the volume of loans that we could fund andwould therefore reduce our revenues and earnings.*

•                    *A large portion of theloans we fund are concentrated in California and therefore our results aresubject to adverse economic conditions in California.*

•                    *Our hedging strategiesmay not be successful in mitigating our risks associated with interest ratechanges.  In particular, for new loanproducts with shorter terms and loan products with adjustable rates, hedgingstrategies may not be effective at certain times.*

*Otherfactors that may impact our results, include but are not limited to, generaleconomic conditions, the world political climate, unexpected expense increases,overall interest rates, volatility in interest rates, the shape of the yieldcurve,  changes in accounting rules ortheir application, changes in the margins for gains on sale of originatedloans, changes in the demand of mortgage brokers for our loan products andservices or of loan purchasers for originated loans, changes in the mortgageindustry regulatory environment, increases in prepayment rates and defaultrates, changes in the requirements of correspondent loan programs or ourability to meet such requirements and changes in our anticipated cashrequirements. These and other risk factors that could cause actual results todiffer materially are set forth in more detail in this item under the heading “BusinessRisk Factors.”*

 

18

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**Introduction**

 

Our Company was foundedin 1997 as an externally managed Real Estate Investment Trust. Until 2001,substantially all of our operations consisted of the acquisition of residentialmortgages for investment purposes. In mid-2001, our Board of Directors and managementdetermined that it was in the best interest of the stockholders tofundamentally shift our strategic direction to mortgage banking. We started thetransition in 2001 by forming a subsidiary to engage in mortgage bankingactivities. Effective January 1, 2002 we began reporting our financialresults in two segments: the Mortgage Banking Business and the Mortgage AssetPortfolio Business. In order to more closely align our name with ouractivities, we changed our name from American Residential Investment Trust,Inc. to AmNet Mortgage, Inc., as of May 5, 2004.

 

Relativeto our Mortgage Asset Portfolio segment, we made a strategic decision to sellthe vast majority of our mortgage assets in the second quarter of 2004 and we completedthe sales in the third quarter of 2004. The remaining mortgage assets ofapproximately $17.2 million are pledged to secure long term debt totalingapproximately $15.9 million, referred to as our CMO/FASIT 1998-1Securitization.  Our Companyover-collateralized the bonds at the time of issuance, by pledging assets inexcess of new liabilities.   These bondcollateral assets are carried at the lower of cost or net realizablevalue.   At September 30, 2004, our bondcollateral assets were carried on our balance sheet at approximately $1.9million more than our remaining long term debt.

 

Ona cash basis, we continue to receive principal and interest payments on thebond collateral assets and these proceeds are used by the bond trustee toservice the long term debt. Any excess cash flow is remitted to us on a monthlybasis. The long term debt is non-recourse to our Company meaning that only theprincipal and interest received from the bond collateral assets, combined withany proceeds from the sale of REO loans can be used to service the bondliabilities.  As such, while we dogenerally receive some net cash flow from the bond collateral assets eachmonth, we will never be required to have any cash outlay associated with theseassets and related long term debt liability.

 

Undergenerally accepting accounting principles (“GAAP”), we record interest incomeon the performing loans in the mortgage asset portfolio, interest expense,sales of REO as they occur and administrative expenses incurred by the bondtrustee and servicers.  We also makenecessary adjustments to various loan valuation reserves for defaulted loans inthe portfolio. Given the size of our remaining portfolio, we expect to havenominal impacts on consolidated GAAP earnings going forward, given the bondcollateral assets perform as expected. However should the remaining bond collateral assets default to a greaterdegree than expected or pre-pay more rapidly than expected, we could have amaximum of $1.9 million in GAAP operating charges over the remaining life ofthe portfolio. In other words, the maximum amount of downside exposure relatedto the remaining mortgage asset portfolio business is $1.9 million of non-cashoperating charges.

 

Our Mortgage Bankingsegment originates mortgage loans predominately to prime quality borrowers (exceptour subprime division) secured by first trust deeds through a network ofindependent mortgage brokers. A concentration of our business is in California(24.4% of loans originated in the nine months ending September 30, 2004);however, we do business on a nationwide basis. We sell the loans that weoriginate to institutional purchasers on a servicing-released basis.

 

We use a dedicated salesforce to offer our loan products to approved wholesale mortgage brokers, whorefer their clients’ loans to us for underwriting and funding. Loans meetingour underwriting criteria are generally approved and funded at our regionalunderwriting loan centers. Our headquarters office performs various functionsthrough multiple departments including establishment of policy, riskmanagement, secondary marketing, and loan delivery to investors, finance,accounting, administration, marketing, human resources, and informationtechnology.

 

Our Mortgage Bankingsegment represented 95.1% of our revenue for thenine months ended September 30, 2004. During the nine months endedSeptember 30, 2004, four branch offices and six regional offices were openedfor a total of thirty-two office locations. The number of employeescompany-wide increased from 648 to 715 employees during the nine monthsended September 30, 2004.

 

We borrow funds under ourwarehouse credit facilities to fund and accumulate loans prior to sale tocorrespondent investors on a servicing-released basis. Currently we have fourwarehouse facilities that enable us to borrow up to an aggregate of$1.4 billion. We are generally allowed to borrow from 96% to 99% of thelesser of par or market value of the loans, and must comply with various lendercovenants restricting, among other things, the absolute level of leverage,requiring minimum levels of cash reserves and requiring certain levels ofprofitability.

 

19

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We generate revenue inour Mortgage Banking Business segment three principal ways:

 

•                                            *Gain on loan sales*. Loan rates, fees and discount pointsare set based on our targeted gain on sale. This is referred to as our pricingmargin. We currently sell the loans that we originate to institutionalpurchasers, on a servicing-released basis, for cash. We record the differencebetween the sale price of loans that we have sold and our cost to originate theloans sold as gain on loan sales. We recognize revenue at the time that wecomplete the loan sale, which is generally when we receive loan sale proceedsfrom the purchaser.  Gain on loan salesalso includes fees we charge for loan origination such as underwriting fees,loan document preparation fees and wiring fees net of premiums we pay tobrokers.

•                                            *Hedging and market adjustments.*Hedging instruments are used to helpmitigate exposure to interest rate fluctuations and protect our pricingmargins. The gains or losses from this activity will be highly negativelycorrelated to revenue derived from loan sales. Typically higher than expectedgains from the sale of loans will be offset by hedging losses and marketadjustments, while lower than expected gains from the sale of loans will beoffset by hedging gains. The value of our rate lock loan pipeline is measuredat the end of each accounting period. The change from the prior period isrecorded as a market adjustment. Hedging gains or losses and market adjustmentsare included in the consolidated statements of operation and comprehensiveincome as derivative financial instruments and market adjustments.

•                                            *Interest income**and market adjustments*. We earn interest on a loan from thetime we fund it until the time we sell it. The interest that we earn ispartially offset by the interest we pay under our warehouse credit facilitiesused to finance our mortgage originations.

 

The expenses in ourMortgage Banking segment include variable costs such as commissions, loanexpenses and contract labor, as well as fixed overhead expenses such aspersonnel, rent, supplies and utilities.

 

We have continued togenerate revenues and expenses from our Mortgage Asset Portfolio Business.Revenues and expenses from this segment of our business have declined in thirdquarter of 2004 due to the sale of the majority of the portfolio assets in May2004. We sold approximately 85% of our portfolio prior to September 30,2004. Net proceeds totaled approximately $26.4 million.

 

***Our 3rdQuarter 2004 Highlights (Executive Overview)***

Our operatingresults for the third quarter of 2004 were dominated by the following:

 

•                    Our Mortgage Banking segment funded approximately$2.1 billion in loan volume for the period while funding for the sameperiod in 2003 was $3.0 billion.  Thisrepresents a decline of approximately 31.5% from the third quarter of 2003 tothe third quarter of 2004 related to a significant decline in theoverall mortgage market, partially offset by market share growth by our Companyover the past year. According to the Mortgage Bankers Association, the mortgageorigination market was $1.199 trillion for the quarter ending September30, 2003, while for the same period in 2004 the approximate market was $.652trillion, a decrease of 46%.  The graph below shows monthly loanproduction comparisons between the third quarters of 2004 and 2003.

 

20

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| ** ** | ** ** | **(in millions)** | ** ** |
|------------|------------|-------------------|------------|
| ** ** | ** ** | **2004**          | ** ** | **2003** | ** ** |
| July       |       | $                 | 623        |   | $ | 1,432 |   |
| August     |       | 741               |       | 935 |   |
| September  |       | 711               |       | 667 |   |
|            |            |                   |            |  |  |  |  |

 

•                                           Mortgage Banking segment revenues, net ofderivative financial instruments and market adjustments, totaled $21.0 million.This revenue was insufficient to cover variable and fixed expenses totaling$22.8 million for the Mortgage Banking segment.

•                                            Unrestricted cash and cash equivalentsdecreased by $4.8 million during the third quarter of 2004 from $50.9 millionat June 30, 2004, to $46.1 million at September 30, 2004. The key factors in this decrease were a $3.6 millionincrease in mortgage loans funded with our own cash, repurchases of our owncommon stock and operating expenses in excess of revenue.

•                                            We repurchased81,200 shares of our outstanding common stock during the third quarter of 2004.The average purchase price was $7.87 per share resulting in a total cash outlayof $639 thousand.

Other Items:

•                                            On September 29, 2004 our Company’s stockbegan trading on the NASDAQ National Market System under the trading symbolAMNT.  Previously we were listed on theAmerican Stock Exchange under the trading symbol INV.

 

**CriticalAccounting Policies**

The followinganalysis of financial condition and results of operations are based upon ourconsolidated financial statements and the notes thereto, which have beenprepared in accordance with accounting principles generally accepted in theUnited States of America (“GAAP”). The preparation of these consolidatedfinancial statements requires us to make a number of estimates and assumptionsthat affect the reported amounts and disclosures in the consolidated financialstatements. On an ongoing basis, we evaluate our estimates and assumptionsbased upon historical experience and various other factors and circumstances.We believe that our estimates and assumptions are reasonable in thecircumstances; however, actual results may differ significantly from theseestimates and assumptions, which could have a material impact on the carryingvalue of assets and liabilities at the balance sheet dates and our results ofoperations for the reporting periods.

We believe that estimates and assumptions are important factors in theportrayal of our financial condition and results of operations. Our criticalaccounting policies that require management’s most subjective judgments includethe following:

• Derivativehedging activities/determination of fair values

• Fair value ofloans held for sale

• Income taxes andbenefits

• Allowance for loanlosses — bond collateral mortgage loans

 

21

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• Amortization ofpremiums on bond collateral loans

• Loan loss reserves —mortgage loans held for sale

Please refer to theCompany’s Form 10-K for the year ending December 31, 2003, for a detaileddiscussion of these policies.

**Management’sFinancial Analysis**

We present non-GAAP financial measures inthis report. We believe that these measures are helpful in understanding ourbusiness and operating results. You should not consider our non-GAAP financialmeasures as a replacement for any GAAP financial measures. The non-GAAPfinancial measures that we present are as follows:

*Gross Margins -*The Mortgage Banking segment generates gainon the sale of loans.  These gains are afunction of the volume of loans sold in the period, and the value of the loansat the time these loans are committed for sale to an investor.  We also generate gains and losses on the derivativefinancial instruments that we acquire to hedge our targeted gain on sale of theloans.  We consider our gross margin tobe the sum of our (i) gain on sale of loans and (ii) total derivative financialinstruments and market adjustments.  Thissum expressed as a percentage of our loan sales volume is our gross marginpercentage.

When we develop the pricing of our loans, we incorporate a target grossmargin percentage that we expect to obtain. We then provide rate lock commitments to borrowers based on that pricingand the related target gross margin percentage. However, if interest rates increase between the time we make a rate lockcommitment and commit a loan for sale, then the market value of the loan wouldbe reduced and we would not achieve our target margin percentage.  If interest rates decrease, then the oppositewould be true. Accordingly, we acquire derivative financial instruments tohedge, or protect, our target margins from interest rate movements.  We hedge our loans from the time of a ratelock commitment to the time the loan is committed for sale to an investor.

If our hedging is effective, as the value of our pipeline decreases andwe record a lower gain on sale, our hedge instruments increase in value tooffset the reduced gain.  Alternatively,as the value of our pipeline increases, we record a larger gain on sale but thelarger gain is offset by a loss on our hedges. Accordingly, if we successfully hedge our pipeline, the gross marginpercentage that we ultimately earn will be close to our target gross marginpercentage and we will not be significantly impacted by interest ratechanges.  In order to evaluate theeffectiveness of our hedging program, management believes that it is importantto evaluate our gross margins and then compare our actual gross marginpercentage against our target gross margin percentage.

*Net Interest Income* - We earn interest income and incurinterest expense in both segments of our operations. In the Mortgage BankingBusiness, we earn interest on a loan from the date the loan is funded untilsale of the loan to an investor. Accordingly, interest income is a function ofthe volume of loans funded, the interest rate on the loans and the length oftime the loans are held. To the extent we fund loans with borrowings under ourwarehouse facilities, we record interest expense based on the same factors.Similarly, in the Mortgage Asset Portfolio Business, we generate revenue fromthe interest we

receive on the mortgageloans we hold for investment and we incur interest expense on the borrowingsused to finance our loan portfolio.

 

Because the interestincome and interest expense in each segment of our business are closely relatedand dependant on many of the same factors, in particular the volume of loans weoriginate or hold for investment, management believes that it is helpful inunderstanding our operations to analyze the impact of interest income andexpense together within each segment of our operations. For this reason, thediscussion below provides information regarding the net interest income(interest income less interest expense) generated by each segment. Managementbelieves that this is consistent with how financial analysts typically considerinterest in analyzing mortgage banking operations.

 

*Fixed andVariable Operating Expenses*— For the same reasons described in “Net InterestIncome” above, the explanation of expenses includes a discussion of ouroperating expenses, which excludes interest expense. Because certain otherexpenses we incur in the Mortgage Banking Business, such as commissions andcontract labor, also vary with the volume of our loan originations, managementbelieves that it is important in understanding this business to consider thevariable and the fixed expenses separately. Accordingly, we have included anestimated breakdown between variable and fixed amounts for each category of ouroperating expenses. Management believes that this will enable a betterunderstanding of our results and the likely impact of future changes in ourorigination volumes.

 

**Relationship Between Our Hedging Instruments AndThe Market Adjustments And Gain On Sale That We May Record For A Period**

* *

Our Mortgage Banking Business is subject to the riskof  changing interest rates between thetime we commit to extend credit at a set interest rate (rate lock) and the timewe sell the mortgage loans.  Our pipelineconsists of loans for which we have provided a rate lock but have not yetclosed (rate locked loans) and closed loans that have not yet been committedfor sale (closed loans).  Generally, asmarket interest rates rise, our pipeline, which then has lower interest ratesthan the market, is not as attractive to investors and therefore we lose valuein the pipeline.  Conversely, as market 

 

22

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interest rates fall, our pipeline is more attractive to investors andwe gain value in the pipeline.  However,some of this gain in value may be offset by an increase in the fallout of ourrate locked loans as borrowers seek alternative loans with the new, lowerinterest rates.

 

To mitigate the risk of rising interest rates andprotect our pricing margins, we purchase hedge instruments.  The gains or losses from this activity willgenerally correlate to losses or gains derived from market adjustments on ourrate locked loans and losses or gains that we record on sales of our closedloans. Typically higher than expected market adjustments and gains from thesale of loans will be offset by hedging losses, while lower than expectedmarket adjustments and gains from the sale of loans will be offset by hedginggains.  However, we will at times havetiming differences between the time we recognize hedge losses and the time weare able to recognize corresponding increases in the value of our closed loans.  These timing differences may impact some ofour quarterly operating results and are therefore explained in detail in thissection.

 

The aggregate gains or losses that we ultimately recognizeon our rate locked loans, closed loans and hedge instruments, is our gross margin. We record gains orlosses on the three components of our gross margin as follows:

 

•                  **Rate locked loans. **Any change in the value of our loanssubject to rate commitments, from value of the loan at the time the rate lock commitmentwas made, to the end of the period is measured at the end of each accountingperiod. The change from the prior period is recorded as a marketadjustment.  Both increases and decreasesin value are recorded at the end of a period. These changes are recorded as a “market adjustment on interest rate lockcommitments” in our Statement of Operations.

•                  **Closed loans. **We do not recognize any increase in valuefrom sales of our closed loan sales until a true sale has taken place.However, if the cost basisof the loan is more than could be obtained by sale in the marketplace, a marketadjustment is recorded (referred to as the lower of cost or market “LOCOM”).  Accordingly, increases in value are notrecorded at the end of a period, but decreases are.  Any changes in value are recorded in ourStatement of Operations as “gain on sale of loans” revenue at the time they arerecognized.

•                  **Hedge instruments. **Our hedging instruments (forward sales ofmortgage backed securities) are marked to market at the end of each period andboth increases and decreases in value are recorded at the end of a period.  These changes in value are recorded as “derivativefinancial instruments” in our Statement of Operations.

 

With respect to these three related components of ourrevenue, the only change in value that is not recorded at the end ofeach period is an increase in value of our closed loans.  A drop in market interest rates will generatean increase in the value of these loans, but this increase is not recognized inour operating income until the loan sales have settled.  Accordingly, we may have increased value attributable to our closedloans at the end of a period which may not be recognized until the nextperiod.  Nevertheless, the relateddecrease in value of any hedge instruments we purchased to hedge these closed loanswill be recorded at the end of the period. As a result, we may recognize hedge loss in one quarter while we may notrecognize the corresponding increase in the value of loans until the nextquarter.

 

In each instance, a timing difference will impact twoquarters.  It will impact the firstquarter negatively, as gains on the closed loans are not reported but the hedgecosts are.  The subsequent quarter willthen have the benefit of recording the gains without the related hedgecosts.  A timing difference may alsooccur at both the beginning and end of the same quarter, with a partialbalancing effect.

 

Timing differences occurred at every quarter-end.  With respect to the third quarter of 2004 ourgain on sale included approximately a $2.2 million that resulted from the timing differencecarryover from the second quarter which was offset by the negative effect ofapproximately $2.3 million that was not recognized at  the end of the third quarter. For the ninemonth period ending September 30, 2004, our gain on sale includedapproximately a $1.7 million timing difference carryover fromDecember 31, 2003. The net amount negatively impacted our gross margins foreach period in additionto the other factors described below.

 

We have provided a more detailed description of themethods and estimates we use to calculate the value of our derivativeinstruments and gain on sale in our Annual Report on form 10-K under theheading “*Derivative and Hedging Activities / Determinationof Fair Values”*.

 

23

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** **

**Results of Operations**

 

***ThreeMonth Results***

 

Mortgage Banking Business

 

Our Mortgage BankingBusiness recorded a net loss of $1.1 million for the three-month period endingSeptember 30, 2004 as compared to net income of $6.2 million in 2003 forthe same period. These results were due in large part to (i) a 33%decrease in loan sales volume and revenues reflecting a contracted overallmortgage loan origination marketplace from 2003; (ii) decreased gross marginson loan sales reflecting competitive pricing pressure; and (iii) increasedoverhead expenses reflecting the expansion of regional and branch offices overthe past year.

 

**($ amounts in 000’s) (unaudited)**

 
| **Loans funded** | **$** | **2,076,279** | ** ** | **$** | **3,033,157** | ** ** |
|------------------|-------|---------------|------------|-------|---------------|------------|

 
| ** **                                                                                                             | ** ** | **Three  Months Ended September 30, 2004** | ** ** | **Three  Months Ended September 30, 2003** | ** ** | **2004  Increase (Decrease)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                             | ** ** | **Amount  Income (Expense)**                    | ** ** | **Basis  Points**                               | ** ** | **Amount  Income (Expense)**  | ** ** | **Basis  Points** | ** ** | **Amount** | ** ** | **Basis  Points** | ** ** |
|                                                                                                                   |       |                                            |       |                                            |       |                          |       |   |   |   |   |   |   |
| Revenues:                                                                                                              |       |                                            |       |                                            |       |                          |       |   |   |   |   |   |   |
| Premiums                                                                                                               |       | $                                               | 50,327     |                                            | 242.39     |                          | $          | 45,852 |   | 151.17 |   | $ | 4,475 |   | 91.22 |   |
| Broker fees                                                                                                            |       | 5,335                                           |       | 25.70                                           |       | 11,465                        |       | 37.80 |   | (6,130 | ) | (12.10 | ) |
| Mortgage broker  premiums                                                                                              |       | (27,265                                         | )          | (131.33                                         | )          | (41,049                       | )          | (135.34 | ) | 13,784 |   | 4.01 |   |
| Premium  recapture and loan loss provisions                                                                            |       | (1,420                                          | )          | (6.84                                           | )          | (2,708                        | )          | (8.93 | ) | 1,288 |   | 2.09 |   |
| Deferred  origination costs                                                                                            |       | (2,779                                          | )          | (13.38                                          | )          | (3,980                        | )          | (13.12 | ) | 1,201 |   | (.26 | ) |
| **Gain on  sales of loans**                                                                                            | ** ** | **$**                                           | **24,198** | ** **                                      | **116.54** | ** **                    | **$**      | **9,580** | ** ** | **31.58** | ** ** | **$** | **14,618** | ** ** | **84.96** | ** ** |
| Derivative  financial instruments and market adjustments                                                               |       | (11,546                                         | )          | (55.61                                          | )          | 15,149                        |       | 49.94 |   | (26,695 | ) | (105.55 | ) |
| **Gain on  sales of loans, after derivative financial instruments and market adjustments  (“gross margin”)** | ** ** | **$**                                           | **12,652** | ** **                                      | **60.93**  | ** **                    | **$**      | **24,729** | ** ** | **81.52** | ** ** | **$** | **(12,077** | **)** | **(20.59** | **)** |
| Interest on  mortgage assets                                                                                           |       | 8,201                                           |       | 39.50                                           |       | 10,381                        |       | 34.23 |   | (2,180 | ) | 5.27 |   |
| Other income                                                                                                           |       | 157                                             |       | .76                                             |       | 24                            |       | .08 |   | 133 |   | .68 |   |
| **Total  revenue (Mortgage Banking segment)**                                                                          | ** ** | **$**                                           | **21,010** | ** **                                      | **101.19** | ** **                    | **$**      | **35,134** | ** ** | **115.83** | ** ** | **$** | **(14,124** | **)** | **(14.64** | **)** |

 

We expect the trend ofreduced loan production from 2003 levels to continue for the remainder of 2004.The overall mortgagee loan production market is expected to contract from $3.8trillion in 2003 to $2.7 trillion in 2004 according to the MBA.

 

Gain on the sales of loansincreased for the quarter ended September 30, 2004 over the quarter endedSeptember 30, 2003. Note that decreasing interest rates for the quarter endedSeptember 30, 2004 increased the gain on sale and decreased the value of ourderivative financial instruments. For the quarter ended September 30, 2003increasing interest rates during the quarter reduced the gain on sale butincreased the value of derivative financial instruments.  Our gain on the sale of loans was made up of acombination of various account categories which are summarized in the chartabove, and quantified in basis points of loan sales volume. Premiums representthe price at which we sell the loans to investors in excess of the principalbalance of loans sold. Broker fees represent various charges to brokers forservices rendered by us which are deferred and recognized as part of the gainon the sales of the loans. Premiums and broker fees are offset by capitalized(deferred) loan origination costs. The largest deferred cost associated withloan production is mortgage broker premiums, or yield spread premiums. Otheroffsets to gain on sale include (i) loan premiums repaid to investors (“premiumrecapture”) and loan loss provisions and (ii) deferred origination costs,which are recognized at the time of loan sale. Premium recapture expensesrepresent repayment of a portion of certain loan sale premiums to investors onpreviously sold loans which subsequently payoff within six months of loan sale.We sell a substantial portion of our loans to two of our competitors.  If our competitors stop purchasing our loanson favorable terms, we could be required to find alternate purchasers and/oraccept unfavorable terms.  In eithercase, this could reduce our revenues and earnings.

 

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Ourloan loss provision decreased by $1.3 million for the third quarter of 2004versus the same period in 2003. Premium recapture expense decreased by $12thousand. The decrease in loan loss provision in the third quarter of 2004 wasthe result of a one time adjustment (due to a change in methodology) to theprovision in the third quarter 2003 which was not required in the same periodin 2004. Going forward we generally expect premium recapture expense to declinedue to the overall decline in refinance loans. Conversely while we believe thatour underwriting process is sound and effective, loan loss provisions mayincrease in the future due to a higher mix of Alt-A and sub-prime loans whichhave more complex underwriting and are more likely to be rejected by investorsif we sell loans which do not meet the investors’ underwriting criteria. Thedecrease in deferred origination costs was a result of decreased loan volume.

 

The use of hedges(recorded as derivative financial instruments) is key to protecting our profitmargins between the time of the interest rate lock and when the loan iscommitted for sale to an investor. We use forward sales ofmortgage-backed securities (TBA) and options on forward sales ofmortgage-backed securities as our primary hedging instruments. Due to decreasesin mortgage interest rates and investor yield requirements during most of thethird quarter of 2004 and increases in interest rates in the third quarter of2003, we recorded net losses on derivative financial instruments of$11.5 million and net gains of $15.1 million, respectively.  During the third quarter of 2004, we continuedwith the same strategy of using forward sales of mortgage-backed securities andoptions on mortgage-backed securities.

 

Ourgross margins were $12.7 million for the three months ended September 30,2004 or 59 basis points on $2.2 billion in loan sales volume representing adecline of $12 million from $24.7 million on $3.2 billion in loan sales volumefor the comparable period in 2003. Loan sales volume declined $1.0 billion.This decline was a major contributor in our reduction in the dollar amount of grossmargins. The remaining decline was due to the lower overall basis point grossmargins that resulted from lower pricing reflecting competitive pressures (partiallyoffset by higher margin loan product sales) and higher than expected rate lockcommitment fall out and broker rate lock renegotiations.  The higher fallout and rate lockrenegotiations occurred due to significant price movement during the threemonths ended September 30, 2004 which occurred when interest rates dipped andinvestor yield requirements dropped. This type of market movement makes it more difficult to estimate loanfallout, and thus determine hedge coverage ratios, and when rates dropsignificantly, brokers request rate lock exceptions at a greater level. Weaccommodate these exceptions to the extent necessary to meet competitivepressure. Looking forward, in October, we decreased our pricing targets on someloan products to respond to competitive pressure.  The overall impact is expected to be a fiveto ten basis point decline in our gross margin in the fourth quarter. There canbe no assurances that the competitive pressures will subside, and accordinglyour gross margins are expected to be adversely impacted until more historical pricingmargins return to the market.

 

Duringthe third quarter of 2004 we had the benefit in our gain of sale of loans ofapproximately a $2.1 million timing difference carryover from the secondquarter offset by the negative effect of an approximately $2.3 million carryoverat the end of the third quarter. With the exception of the impact of higherthan expected rate lock commitment fallout and broker rate lock renegotiationsin the quarter ended September 30, 2004, our actual gross margin percentages ineach quarter were close to our target gross margin percentages and accordingly,we believe that our hedging program was generally successful in protectingprofit margins on our loan originations. However, our hedging strategies maynot be successful in mitigating our risks associated with interest rate changesin future periods. In particular, for new loan products with large loanbalances, short terms, and loan products with adjustable rates, our hedgingprocess may not be effective at certain times.

 

We recorded interestincome of $8.2 million for the three months ended September 30, 2004.We earn interest on a loan from the date the loan is funded until finaldisposition. Accordingly, interest income is a function of the volume of loansfunded, the interest rate on the loans and the length of time the loans areheld prior to sale. To the extent we fund loans with borrowings under ourwarehouse facilities, we record interest expense based on the same factors.Interest expense for the period was $4.3 million. The resulting netinterest income earned on loan inventories was $3.9 million, representing19 basis points on third quarter 2004 loan production of $2.1 billion. Forthe comparable period ended September 30, 2003 interest income was$10.4 million and interest expense was $4.5 million. This resulted innet interest earned of $5.8 million, representing 19 basis points on thirdquarter 2003 loan production of $3.0 billion.

 

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The table below providesthe relationship between estimated fixed, variable and total expenses for thethree months ended September 30, 2004 and 2003 (dollars in thousands)(unaudited):

 
| **Loans funded — three months ending September 30,  2004** | ** ** | **$** | **2,076,279** | ** ** |
|-----------------------------------------------------------------|------------|-------|---------------|------------|

 
| **2004  Mortgage Banking Expenses** | ** ** | **Estimated  Variable Expenses** | ** ** | **Estimated  Variable Expenses Bpts.** | ** ** | **Estimated  Fixed Expenses** | ** ** | **Estimated  Fixed Expenses Bpts.** | ** ** | **Total  Expenses** | ** ** | **Total  Expenses Bpts.** | ** ** |
|-------------------------------------|------------|----------------------------------|------------|----------------------------------------|------------|-------------------------------|------------|-------------------------------------|------------|---------------------|------------|---------------------------|------------|
|                                |       |                             |       |                                   |       |                          |       |                                |       |                |       |                      |       |
| Employee  compensation and benefits |       | $                                | 4,639      |                                   | 22.34      |                          | $          | 8,113                               |       | 39.07               |       | $                         | 12,752     |   | 61.41 |   |
| Office and  occupancy expense       |       | —                           |       | —                                 |       | 1,076                         |       | 5.18                                |       | 1,076               |       | 5.18                      |       |
| Professional  fees                  |       | 171                              |       | .82                                    |       | 621                           |       | 2.99                                |       | 792                 |       | 3.81                      |       |
| Other operating  expense            |       | 1,218                            |       | 5.87                                   |       | 2,695                         |       | 12.98                               |       | 3,913               |       | 18.85                     |       |
| **Total  operating expenses**       | ** ** | **6,028**                        | ** ** | **29.03**                              | ** ** | **12,505**                    | ** ** | **60.22**                           | ** ** | **18,533**          | ** ** | **89.25**                 | ** ** |
| Interest expense                    |       | 4,308                            |       | 20.75                                  |       | —                        |       | —                              |       | 4,308               |       | 20.75                     |       |
| **Total  expenses**                 | ** ** | **$**                            | **10,336** | ** **                             | **49.78**  | ** **                    | **$**      | **12,505**                          | ** ** | **60.22**           | ** ** | **$**                     | **22,841** | ** ** | **110.00** | ** ** |

 
| **Loans funded —three months  ending September 30, 2003** | ** ** | **$** | **3,033,157** | ** ** |
|----------------------------------------------------------------|------------|-------|---------------|------------|

 
| **2003  Mortgage Banking Expenses** | ** ** | **Estimated Variable Expenses** | ** ** | **Estimated Variable Expenses Bpts.** | ** ** | **Estimated Fixed Expenses** | ** ** | **Estimated Fixed Expenses Bpts.** | ** ** | **Total Expenses** | ** ** | **Total Expenses Bpts.** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|---------------------------------------|------------|------------------------------|------------|------------------------------------|------------|--------------------|------------|--------------------------|------------|
|                                |       |                            |       |                                  |       |                         |       |                               |       |               |       |                     |       |
| Employee compensation and benefits  |       | $                               | 7,010      |                                  | 23.11      |                         | $          | 6,883                              |       | 22.69              |       | $                        | 13,893     |   | 45.80 |   |
| Office and occupancy expense        |       | —                          |       | —                                |       | 706                          |       | 2.33                               |       | 706                |       | 2.33                     |       |
| Professional fees                   |       | 380                             |       | 1.25                                  |       | 1,075                        |       | 3.54                               |       | 1,455              |       | 4.79                     |       |
| Other operating expense             |       | 1,776                           |       | 5.86                                  |       | 3,010                        |       | 9.92                               |       | 4,786              |       | 15.78                    |       |
| **Total operating expenses**        | ** ** | **9,166**                       | ** ** | **30.22**                             | ** ** | **11,674**                   | ** ** | **38.48**                          | ** ** | **20,840**         | ** ** | **68.70**                | ** ** |
| Interest expense                    |       | 4,535                           |       | 14.95                                 |       | —                       |       | —                             |       | 4,535              |       | 14.95                    |       |
| **Total expenses**                  | ** ** | **$**                           | **13,701** | ** **                            | **45.17**  | ** **                   | **$**      | **11,674**                         | ** ** | **38.48**          | ** ** | **$**                    | **25,375** | ** ** | **83.65** | ** ** |
|                                     |            |                                 |            |                                       |            |                              |            |                                    |            |                    |            |                          |            |  |  |  |  |

 

Total expenses incurredin the Mortgage Banking Business for the three months ended September 30,2004 were approximately $22.8 million. Operating expenses, which included allexpenses except interest expense (employee compensation and benefits, officeand occupancy expense and other operating expenses), were approximately$18.5 million for the three months ended September 30, 2004. For thecomparable period ended September 30, 2003, there were approximately$25.4 million of total expenses, of which approximately $20.8 millionwere operating expenses. The decrease in operating expenses in 2004 wasprimarily due to the decline in loan volume and loan volume-related expenses.For the three months ended September 30, 2004, expenses includedapproximately $4.8 million in sales commissions, which vary in proportionof the volume of funded loans, or approximately 23 basis points (.23%) on$2.1 billion in funded loans. Operating expenses totaled $18.5 million orapproximately 89 basis points (.89%), on $2.1 billion in funded loans inthe third quarter of 2004. Total expenses in basis points of loans sold (whichis a measurement of the cost per loan) increased for the three months endedSeptember 30, 2004 compared to the same period in 2003 (from 79 basispoints in 2003 to 106 basis points in 2004). The operating cost per loanincreased from $1,211 in the third quarter of 2003 to $1,523 per loan in thethird quarter of 2004. The increased cost per loan reflects reduced loanproduction in the third quarter of 2004 causing less efficiency due to a largerbranch system (new branches which are not fully developed) and higherheadquarters overhead.

 

We expect to continue to incuroperating expenses in excess of revenue associated with our new correspondentlending channel until at least the quarter ending June 30, 2005.

 

The effective federal andstate tax rate for this segment was estimated to be 41%.  In 2003, we had a combined federal and stateeffective tax rate of approximately 30% primarily due to the realization of ouroperating loss carry forwards associated with start-up operating losses. Duringthe quarter ended September 30, 2004, we recorded an income tax benefit of $683thousand, against a pretax loss of $1.7 million.  This benefit is expected to be realized infuture periods through the utilization of net operating loss carryforwards;however should the Company not generate sufficient operating profits, ourdeferred tax benefits may have to be reversed. There can be no assurances that all of the Company’s deferred taxassets, 

 

26

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totaling $5.0 millionwill be realized.

 

Interest rate movementsare difficult to predict, but it is recognized that interest rates on residentialmortgages were historically low, and refinance demand was very strong duringthe latter part of the first quarter of 2004 and April of 2004. Revisedprojections by the MBA (April 2004) for mortgage loan originations for theremainder of 2004 indicate an increase in interest rates and a reduction ofrefinance demand. Wherever possible we are managing staffing levels and utilizing asmuch of our existing infrastructure to process our loan production (adjuststaffing size to an optimal level of efficiency) while growing our salespresence in existing and new markets. In summary, we have been expanding and will continueto expand our business operations, primarily in sales areas, while we focus oncontrolling our fixed expenses in a contracting market.  Our strategy requires us to capture anincreasing percentage of the market in a highly competitive environment, whichwill put pressure on our gross margins. If we are not able to do this, we would likely experience losses due toour current level of operating expenses.

 

MortgageAsset Portfolio Business 

 

OurMortgage Asset Portfolio Business recorded net income of $95.3 thousand for thethree month period ending September 30, 2004 as compared to net income of$1.6 million in 2003 for the same period. This decline was due in large part tothe sale of approximately 85% of our portfolio assets.

 

We held mortgage assetsof approximately $185.9 million as of September 30, 2003. As ofSeptember 30, 2004 mortgage assets were approximately $17.2 million.  This reduction was based on a decision toliquidate the majority of our remaining portfolio in May 2004. As ofSeptember 30, 2004, we have received approximately $26.4 million incash from the sales of portfolio assets, net of repayment of related long-termdebt (bonds). We recorded approximately a $437 thousand reduction to thevaluation allowance on bond collateral sold in the third quarter of 2004. As ofSeptember 30, 2004 all loans intended for sale in May 2004 have been sold.

 

As a result of theportfolio sale, the Mortgage Asset Portfolio Business has become a minor partof both revenue and expense on a consolidated basis. For the third quarter of2004, total revenue was approximately $150 thousand while in the third quarterof 2003, total revenue was $3.2 million. As a result of a reduction of $437thousand in valuation expense related to the portfolio sale, total expensesresulted in a gain of approximately $13 thousand while expenses for thethird quarter of 2003 were $2.0 million.

 

***NineMonth Results***

 

Mortgage Banking Business

 

Our Mortgage BankingBusiness recorded a net loss of $3.8 million for the nine-month periodending September 30, 2004 as compared to net income of $17.9 million in2003 for the same period. These results were due in large part to (i) a23% decrease in loan sales volume and revenues reflecting a contracted overallmortgage loan origination marketplace from 2003; (ii) a decreased gross marginon loan sales due to competitive pricing pressure partially offset by animproved mix of loan products with higher margins; and (iii) increasedexpenses reflecting the expansion of regional and branch offices over the pastyear.

 

The table below providesa nine month comparative view of loan production for 2004 and 2003 (unaudited):

 

27

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| ** **          | ** ** | **(in millions)** | ** ** |
|---------------------|------------|-------------------|------------|
| ** **          | ** ** | **2004**          | ** ** | **2003** | ** ** |
| January             |       | $                 | 436        |   | $ | 598 |   |
| February            |       | 558               |       | 618 |   |
| March               |       | 877               |       | 862 |   |
| April               |       | 1,147             |       | 1,030 |   |
| May                 |       | 751               |       | 876 |   |
| June                |       | 668               |       | 1,301 |   |
| July                |       | 623               |       | 1,432 |   |
| August              |       | 741               |       | 935 |   |
| September           |       | 711               |       | 667 |   |
| Year to date totals |       | $                 | 6,512      |   | $ | 8,319 |   |

 

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Thecomponents of our revenues are summarized below ($ amounts in 000’s)(unaudited):

 
| **Loans funded** | ** ** | **$** | **6,512,087** | ** ** | **$** | **8,318,549** |
|------------------|------------|-------|---------------|------------|-------|---------------|

 
| ** **                                                                                                             | ** ** | **Nine  Months Ended September 30, 2004** | ** ** | **Nine  Months Ended September 30, 2003** | ** ** | **2004  Increase (Decrease)** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                                             | ** ** | **Amount  Income (Expense)**                   | ** ** | **Basis  Points**                              | ** ** | **Amount  Income (Expense)**  | ** ** | **Basis  Points** | ** ** | **Amount** | ** ** | **Basis  Points** | ** ** |
|                                                                                                                   |       |                                           |       |                                           |       |                          |       |   |   |   |   |   |   |
| Revenues:                                                                                                              |       |                                           |       |                                           |       |                          |       |   |   |   |   |   |   |
| Premiums                                                                                                               |       | $                                              | 122,269    |                                           | 187.76     |                          | $          | 162,684 |   | 195.57 |   | $ | (40,415 | ) | (7.81 | ) |
| Broker fees                                                                                                            |       | 15,503                                         |       | 23.81                                          |       | 27,748                        |       | 33.36 |   | (12,245 | ) | (9.55 | ) |
| Mortgage broker  premiums                                                                                              |       | (82,704                                        | )          | (127.00                                        | )          | (112,265                      | )          | (134.96 | ) | 29,561 |   | 7.96 |   |
| Premium  recapture and loan loss provisions                                                                            |       | (4,615                                         | )          | (7.09                                          | )          | (5,855                        | )          | (7.04 | ) | 1,240 |   | (.05 | ) |
| Deferred  origination costs                                                                                            |       | (8,416                                         | )          | (12.92                                         | )          | (9,552                        | )          | (11.48 | ) | 1,136 |   | (1.44 | )  |
| **Gain on  sales of loans**                                                                                            | ** ** | **$**                                          | **42,037** | ** **                                     | **64.56**  | ** **                    | **$**      | **62,760** | ** ** | **75.45** | ** ** | **$** | **(20,723** | **)** | **(10.89** | **)** |
| Derivative  financial instruments and market adjustments                                                               |       | (2,943                                         | )          | (4.52                                          | )          | 3,654                         |       | 4.39 |   | (6,597 | ) | (8.91 | ) |
| **Gain on  sales of loans, after derivative financial instruments and market adjustments  (“gross margin”)** | ** ** | **$**                                          | **39,094** | ** **                                     | **60.04**  | ** **                    | **$**      | **66,414** | ** ** | **79.84** | ** ** | **$** | **(27,320** | **)** | **(19.80** | **)** |
| Interest on  mortgage assets                                                                                           |       | 22,208                                         |       | 34.10                                          |       | 23,843                        |       | 28.66 |   | (1,635 | ) | 5.44 |   |
| Other income                                                                                                           |       | 303                                            |       | .46                                            |       | 76                            |       | .09 |   | 227 |   | .37 |   |
| **Total  revenue (Mortgage Banking segment)**                                                                          | ** ** | **$**                                          | **61,605** | ** **                                     | **94.60**  | ** **                    | **$**      | **90,333** | ** ** | **108.59** | ** ** | **$** | **(28,728** | **)** | **(13.99** | **)** |
|                                                                                                                        |            |                                                |            |                                                |            |                               |            |  |  |  |  |  |  |  |  |  |  |  |  |

 

Gain on the sales ofloans decreased for the nine months ended September 30, 2004, primarilydue to our decrease in volume of loan sales and narrower margins particularlyin the first three months of 2004. Our gain on the sale of loans was made up ofa combination of various account categories which are summarized in the chartabove, and quantified in basis points of loan sales volume.

 

The use of derivativefinancial instruments is a key to protecting our profit margins between thetime of the interest rate lock to when the loan is sold to an investor. Interest ratesat September 30, 2004 and 2003 were nearly equal. However during the nine monthperiod ended September 30, 2003, interest rates fluctuated during the twoperiods. Due to decreases in mortgage interest rates during the last half ofthe nine month period ending September 30, 2004 and increases in interestrates for the same period of 2003, we recorded net losses on derivativefinancial instruments of $2.9 million and net gains of $3.7 million,respectively.

 

Ourgross margins were $39.1 million for the nine months ended September 30,2004 or 61 basis points on $6.4 billion in loan sales volume, a decline of$27.3 million from $66.4 million, or 80 basis points on $8.3 billion in loansales volume for the comparable period in 2003. Loan sales volume declined $1.9 billion. This decline was a major contributorin our reduction in the dollar amount of gross margins. The remaining declinewas due to the lower overall gross margins that resulted from lower pricingreflecting competitive pressures. In total, premiumrecapture expense and loss provisions declined $1.2 million between the ninemonths ending September 30, 2004 and 2003. The loan loss provisionincreased by $93 thousand for the third quarter of 2004 versus the same periodin 2003, while premium recapture expense declined by $1.3 million. Goingforward we generally expect premium recapture expense to decline due to theoverall decline in refinance loans. Conversely, while we believe that ourunderwriting process is sound and effective, loan repurchase obligations mayincrease in the future due to a higher mix of Alt-A loans, which have morecomplex underwriting and are more likely to be rejected by investors if we sellloans which do not meet the investors’ underwriting criteria.

 

Duringthe first nine months of 2004 we had the benefit of approximately a $1.7million timing difference carryover from the prior year that partially offsetthe negative effect of approximately $2.3 million carryover of the end of theperiod. The effect of the net negative impact was minor compared to the otherfactors that impacted margins.

 

Comparisonbetween the first nine months of 2003 and 2004 shows a decline in our grossmargin rate from 80 basis points to 61 basis points.  Market conditions remain extremelycompetitive as interest rates increased during much of the nine month periodending September 30, 2004 and the overall mortgage market contracted.  Competitive pricing pressures remained a keyfactor in our reduced margins. Our actual gross margin percentages in each ninemonth period were close to our target margin percentages and accordingly, webelieve that our hedging program was successful (with the exception of higherthan expected rate lock commitment fallout in the third quarter of 2004),  in protecting profit margins on our loanoriginations in both periods.

 

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We recorded interestincome of $22.2 million for the nine months ended September 30, 2004and interest expense for the period was $11.1 million. The resulting netinterest income earned on loan inventories was $11.1 million, representing17 basis points on the nine months ending September 30, 2004 loan production of$6.5 billion. For the comparable period ended September 30, 2003interest income was $23.8 million and interest expense was10.7 million. This resulted in net interest earned of $13.2 million, representing16 basis points on the nine months ending September 30, 2003 loanproduction of $8.3 billion.

 

Total expenses incurredin the Mortgage Banking Business for the nine months ended September 30,2004 were approximately $67.9 million. Operating expenses, which included allexpenses except interest expense (employee compensation and benefits, officeand occupancy expense and other operating expenses), were approximately$56.8 million for the nine months ended September 30, 2004. For the comparableperiod ended September 30, 2003, there were approximately$63.9 million of total expenses of which approximately $53.2 millionwere operating expenses. The increase in operating expenses in 2004 was due tothe ongoing expansion of our mortgage banking operations, which are comprisedof regional and branch loan production offices and headquarters operations. Forthe nine months ended September 30, 2004, expenses included approximately$13.0 million in sales commissions, which vary in proportion with thevolume of funded loans, or approximately 20 basis points (.20%) on$6.5 billion in funded loans. Operating expenses totaled $56.8 million, orapproximately 87 basis points (.87%), on $6.5 billion in funded loans.Total expenses in basis points of loans sold (which is a measurement of thecost per loan) increased from 77 basis points for nine month period endingSeptember 30, 2003 to 106 basis points for the nine months endedSeptember 30, 2004. The operating cost per loan increased from $1,366 in2003 to $1,816 per loan for the nine months ended September 30, 2004. Theincreased cost per loan in 2004 compared to the cost in  2003 shows that the reduced loan productionin the first nine months of 2004 also reduced efficiency due to a larger branchsystem (new branches which are not fully developed) and higher headquartersoverhead.

 

The table below providesthe relationship between estimated fixed, variable and total expenses for thenine months ended September 30, 2004 and 2003 (dollars in thousands)(unaudited):

 
| **Loans funded — nine months ending September 30,  2004** | ** ** | **$** | **6,512,087** | ** ** |
|----------------------------------------------------------------|------------|-------|---------------|------------|

 
| **2004  Mortgage Banking Expenses** | ** ** | **Estimated Variable Expenses** | ** ** | **Estimated Variable Expenses Bpts.** | ** ** | **Estimated Fixed Expenses** | ** ** | **Estimated Fixed Expenses Bpts.** | ** ** | **Total Expenses** | ** ** | **Total Expenses Bpts.** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|---------------------------------------|------------|------------------------------|------------|------------------------------------|------------|--------------------|------------|--------------------------|------------|
|                                |       |                            |       |                                  |       |                         |       |                               |       |               |       |                     |       |
| Employee compensation and benefits  |       | $                               | 14,508     |                                  | 22.28      |                         | $          | 24,207                             |       | 37.17              |       | $                        | 38,715     |   | 59.45 |   |
| Office and occupancy expense.       |       | —                          |       | —                                |       | 2,871                        |       | 4.41                               |       | 2,871              |       | 4.41                     |       |
| Professional fees                   |       | 492                             |       | .76                                   |       | 2,301                        |       | 3.53                               |       | 2,793              |       | 4.29                     |       |
| Other operating expense             |       | 3,815                           |       | 5.86                                  |       | 8,646                        |       | 13.28                              |       | 12,461             |       | 19.14                    |       |
| **Total operating expenses**        | ** ** | **18,815**                      | ** ** | **28.90**                             | ** ** | **38,025**                   | ** ** | **58.39**                          | ** ** | **56,840**         | ** ** | **87.29**                | ** ** |
| Interest expense                    |       | 11,075                          |       | 17.01                                 |       | —                       |       | —                             |       | 11,075             |       | 17.01                    |       |
| **Total expenses**                  | ** ** | **$**                           | **29,890** | ** **                            | **45.91**  | ** **                   | **$**      | **38,025**                         | ** ** | **58.39**          | ** ** | **$**                    | **67,915** | ** ** | **104.30** | ** ** |

 

 
| **Loans funded — nine months ending September 30,  2003** | ** ** | **$** | **8,318,549** | ** ** |
|----------------------------------------------------------------|------------|-------|---------------|------------|

 
| **2003  Mortgage Banking Expenses** | ** ** | **Estimated Variable Expenses** | ** ** | **Estimated Variable Expenses Bpts.** | ** ** | **Estimated Fixed Expenses** | ** ** | **Estimated Fixed Expenses Bpts.** | ** ** | **Total Expenses** | ** ** | **Total Expenses Bpts.** | ** ** |
|-------------------------------------|------------|---------------------------------|------------|---------------------------------------|------------|------------------------------|------------|------------------------------------|------------|--------------------|------------|--------------------------|------------|
|                                |       |                            |       |                                  |       |                         |       |                               |       |               |       |                     |       |
| Employee compensation and benefits  |       | $                               | 18,351     |                                  | 22.06      |                         | $          | 17,136                             |       | 20.60              |       | $                        | 35,487     |   | 42.66 |   |
| Office and occupancy expense        |       | —                          |       | —                                |       | 1,894                        |       | 2.28                               |       | 1,894              |       | 2.28                     |       |
| Professional fees                   |       | 927                             |       | 1.12                                  |       | 2,801                        |       | 3.37                               |       | 3,728              |       | 4.49                     |       |
| Other operating expense             |       | 4,577                           |       | 5.50                                  |       | 7,530                        |       | 9.05                               |       | 12,107             |       | 14.55                    |       |
| **Total operating expenses**        | ** ** | **23,855**                      | ** ** | **28.68**                             | ** ** | **29,361**                   | ** ** | **35.30**                          | ** ** | **53,216**         | ** ** | **63.98**                | ** ** |
| Interest expense                    |       | 10,656                          |       | 12.81                                 |       | —                       |       | —                             |       | 10,656             |       | 12.81                    |       |
| **Total expenses**                  | ** ** | **$**                           | **34,511** | ** **                            | **41.49**  | ** **                   | **$**      | **29,361**                         | ** ** | **35.30**          | ** ** | **$**                    | **63,872** | ** ** | **76.79** | ** ** |

 

 

 

 

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MortgageAsset Portfolio Business

 

OurMortgage Asset Portfolio Business recorded a net loss of $2.6 million for thenine month period ending September 30, 2004 as compared to net income of$11.6 million in 2003 for the same period. This decline was due in large partto the expenses recorded in 2004 upon the sale of approximately 85% of ourportfolio assets.

 

Weheld mortgage assets of approximately $161.3 million as of December 31,2003.  As of September 30, 2004mortgage assets were approximately $17.2 million. This reduction was based on adecision to liquidate the majority of our portfolio previously explained insection titled “Three Month Results”.

 

Forthe nine months ended September 30, 2004, total revenue was approximately$2.9 million while for the same period in 2003 total revenue was $9.8 million.Expenses for the first nine months of 2004 were approximately $7.4 million,while expenses for the same period of 2003 were $7.3 million. Included in thetotal Mortgage Asset Portfolio Business expense of approximately $7.4 millionfor the nine months ended September 30, 2004, is $4.9 million of valuationadjustment expense related to the sale of portfolio assets.

 

 

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*** ***

***Liquidity and Capital Resources***

*General*

Our sources of liquidity during the nine months endedSeptember 30, 2004 primarily consisted of the following:

•                                            borrowingsunder our warehouse facilities;

•                                            revenuesgenerated by our mortgage banking operating activities including interestincome, broker fees, loan sale proceeds and hedge proceeds;

•                                            sale of the majority of our MortgageAsset Portfolio;

•                                            excess interestspread in the Mortgage Asset Portfolio Business, net of repayments to servicersfor past principal and interest advances on completed real estate owneddispositions.

Our primary cash requirements included:

•                                            funding ourmortgage loan originations;

•                                            hedging losses;

•                                            interestexpense under our warehouse facilities;

•                                            operatingexpenses, including commissions;

•                                            repayment ofour borrowings;

•                                            repurchase of stock; and

•                                            maintaining a “restrictedcash” account, which includes amounts required to be held by certain warehouseline providers that may not be used in our operations or as equity for otherwarehouse lines of credit.

As our mortgage banking operations have grown and our mortgage assetportfolio has declined through portfolio sales and borrower payoffs, our cashflow from investment activities has continued to decline in amount andmateriality.

*Cash Generated By and Used In Our Operations*

During the nine months ended September 30, 2004, on a consolidatedbasis we had net positive cash flow of $1.7 million. The principal factorsimpacting our positive cash flow are:

•                    Net increases in our cashinvestment in loan inventories totaled cash usage of approximately $6.1million.  Our warehouse line lendingagreements allow us to borrow from 96% to 99% of the lesser of par or marketvalue for each mortgage loan. We pay an additional 1% to 2% of the loanprincipal amount in fees or yield spread premium to the mortgage brokers.Lastly, a small portion of our loan inventory is funded with equity capital. Wetypically have cash invested totaling between 2% to 4% of the principal amountof loans held for sale, which is recouped when the loans are purchased byinvestors. Mortgage loans held for sale increased from approximately $276.8million at December 31, 2003 to approximately $394.4 million atSeptember 30, 2004. An increase in the amount of loan inventory, either byholding loans for longer periods, or due to increased loan funding volume, willcause cash utilization to carry loan inventories to increase in direct proportionto the inventory held.

•                    Sale of portfolio assets provided net cash proceeds of$26.4 million.

•                    Stock repurchase of 592,690shares utilized $5.1 million in cash.

•                    Pay off of subordinated short-term debt facility used$3.0 million of cash.

•                    Consolidated cash disbursements for operating expensesexceeded cash receipts from revenues by approximately $4.8 million.

•                    Cash usage for capitalexpenditures totaled approximately $1.7 million.

•                    Increase in accrued expensesand other liabilities resulting in a use of $3.0 million and an increase inderivative financial instruments resulting in a use of $1.5 million.

We anticipate that our future liquidity will bepredominantly impacted by our mortgage banking activities. For the remainder of2004, wherever possible, we are managing staffing levels and utilizing ourexisting infrastructure to balance our loan production while growing our salespresence in existing and new markets. Our market share growth strategy isdesigned to generate loan volumes from new customers and increased businesswith existing customers in order to sustain,

 

 

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and potentially increase loan production,despite a continued contraction in the overall loan origination market. We willattempt to increase the proportion of variable costs while controlling fixedcosts to minimize total expenses and maximize capacity utilization as weexecute our market share growth strategy. For the remainder of 2004, we expectto originate $750 million to $850 million per month of new mortgage loans andfund these originations with equity capital and warehouse facility borrowings.We expect our loan inventories to remain relatively flat during the remainderof 2004.  We also expect to continue to engage inhedging transactions that may require cash investment to maintain or adjusthedged positions. If our funding volumes do not generate sufficient revenues,we may utilize cash to fund operating losses. We intend to use cash reserves,borrowings under the warehouse facilities as well as cash flow generated fromthe origination and sale of mortgage loans, to fund our operations. We aretherefore dependent on significant levels of warehouse financing to helpexecute our mortgage banking strategy. Furthermore, absent furtherdeterioration in pricing margins due to competitive pressures, we mustoriginate a minimum level of loans ($750 million to $850 million) withoutextraordinary charges to avoid negative operating cash flow.  During the nine months ending September 30,2004 we averaged $724 million per month in loan production.  We lost $10.8 million prior to income taxwhich included a $4.9 million one time pretax expense on the sale of bondcollateral. See Business Risk Factors in this Item 2 below. Managementbelieves that our Company has sufficient sources of liquidity atSeptember 30, 2004 to meet anticipated business requirements for theforeseeable future.

*Short-TermDebt*

* *

Asof September 30, 2004, short-term debt consists of $381 million ofrevolving credit lines (warehouse facilities) used to fund our lendingactivities. As of September 30, 2004, mortgage loans held for saletotaling $394 million were pledged as collateral for the warehousefacilities. We are dependent on our warehouse lending facilities to operate ourbusiness.  We must maintain, renew orreplace our warehouse lines of credit in order to continue to fund loans.  Our warehouse facilities consist ofborrowings of $381 million with four financial institutions. AtSeptember 30, 2004, our maximum available borrowings combined from thesefour financial institutions is $1.4 billion. These facilities typicallyadvance 96% to 99% of the lesser of par or market value of the loans pledged ascollateral. Such financing is currently provided primarily under (i) a 364-daysecured mortgage warehousing revolving credit agreement, dated as ofNovember 26, 2001, (the “Bank Credit Agreement”) with JPMorgan/Chase Bank;(ii) secured mortgage warehousing revolving credit agreement, originallydated March 28, 2002, (the “UBS Warburg Agreement”) with UBS Warburg RealEstate Securities Inc.; (iii) secured mortgage warehousing revolvingcredit agreement, originally dated October 11, 2002, (the “CountrywideAgreement”) with Countrywide Warehouse Lending; and (iv) a 729-day securedmortgage warehousing revolving credit agreement, dated as of September 15,2003, (the “RFC Agreement”) with Residential Funding Corporation. Thesewarehouse facilities are repaid as principal payments on mortgage loans arereceived, or as the mortgage loans are sold. The agreements governing thesefacilities contain a number of covenants, including covenants based on tangiblenet worth, cash flows, net income, and liquidity of our Company. As aresult of the Company’s third quarter net loss, the Company was out ofcompliance with certain of its warehouse lending agreements at September 30,2004. The Company was out of compliance with earnings covenants in itsJPMorgan/Chase Bank, Countrywide Warehouse Lending and Residential FundingCorporation agreements. Each of the warehouse lenders has waived for the periodending September 30, 2004, the covenants for which the Company was out ofcompliance. We believe we are ingood standing with our warehouse lenders. We have obtained modifications ofwarehouse lending covenants and will continue to negotiate for additionalmodifications to alleviate loan covenant violation concerns for the nearfuture. Any future reductions or restrictions in our warehouse capacity couldreduce the volume of loans that we are able to fund and could therefore reduceour revenues and earnings.

In 2001, we alsoentered into a $5 million senior subordinated secured revolving loanagreement (Subordinated Loan Agreement). The Subordinated Loan Agreement boreinterest at 12% and as of March 31, 2004, there was $3 million inborrowings outstanding. The loan was paid off in April 2004 and theSubordinated Loan Agreement was terminated. We therefore have no further accessto this borrowing facility.

In April of2004, we entered into agreements to sell 85% of our mortgage portfolio assets.As a result, at March 31, 2004, we reclassified approximately $90 millionof our long-term debt to short-term debt. Net proceeds from the portfolio salestotaled approximately $26.4 million for the nine months ending September30, 2004.  All loans sold in April of2004 have been sold as of September 30, 2004.

*Long-TermDebt—Non Recourse Mortgage-Backed Notes*

Our long-term debtconsists of CMO/FASIT 1998-1 mortgage-backed notes, which are collateralized bybond collateral mortgage loans and bond collateral real estate owned.Obligations under the mortgage-backed notes are payable solely from theproceeds from the bond collateral and are otherwise non-recourse to theCompany.

*RateLock Commitments to Borrowers and Commitments to Sell Loans*

In the ordinarycourse of business, we make rate lock commitments to borrowers which obligateus to fund mortgages at set interest rates. The values of the underlying loans,and thus our expected gain on the subsequent funding and sale of these loans,may be impacted by subsequent changes in market interest rates. Accordingly,we attempt to protect (or hedge) our pricing margins by utilizing forward salesof TBAs and options on TBAs. The hedges typically increase or 

 

33

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decreasein value in correlation to offsetting decreases or increases in the value ofthe loans. As loans fund, we typically sell or assign our hedges and enter intomandatory loan sale commitments with our correspondent investors.

 

The following table summarizes our rate lockcommitments and our commitments to sell mortgage-backed securities and mortgageloans (dollars in thousands) (unaudited):
| ** **                                                            | ** ** | **September 30,  2004** | ** ** | **September 30,  2003** | ** ** |
|-----------------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| Commitments to originate loans at set interest rates                  |       | $                       | 919,822    |                    | $          | 937,493 |   |
| Forward sales of mortgage-backed securities (TBA and options on TBAs) |       | 577,000                 |       | 862,000                 |       |
| Mandatory commitments to sell mortgage loans held for sale            |       | 286,375                 |       | 158,746                 |       |
|                                                                       |            |                         |            |                         |            |  |  |

For the purposes of hedging our interest rate exposure on our pipeline,we make various assumptions in order to estimate the rate lock commitmentswhich will not close (fallout ratio). The fallout ratio is applied to the totalrate lock commitments to arrive at the net exposure to interest rate changes inthe market. The pipeline, after applying the fallout ratio to the rate lockcommitments, amounted to $547.1 million and $545.8 million atSeptember 30, 2004 and 2003, respectively. Included in our pipeline areuncommitted loans held for sale of $108.0 million and $208.3 million atSeptember 30, 2004 and September 30, 2003 respectively. Our pipelineis hedged utilizing forward sales of mortgage-backed securities and options onmortgage-backed securities. Some of these commitments may ultimately be deniedby our Company or declined by the borrower, and therefore, the commitmentamounts do not necessarily represent future cash requirements.

*Lease and Long-Term Debt Commitments*

Inorder to better understand our future obligations under our leases andlong-term debt agreements, the table below shows our expected future paymentsfor these debt instruments.
| ** **                                                 | ** ** | **Payments Due by Period  (dollars in thousands) (unaudited)** | ** ** |
|------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| **Contractual Obligations as of  September 30, 2004** | ** ** | **Total**                                                      | ** ** | **Less than 1 Year** | ** ** | **1-3 Years** | ** ** | **3-5 Years** | ** ** | **More Than 5 Years** | ** ** |
|                                                       |       |                                                           |       |   |   |   |   |   |   |   |   |
| Long-Term Debt                                             |       | $                                                              | 15,869     |   | $ | 8,192 |   | $ | 5,449 |   | $ | 2,228 |   | $ | 0 |   |
| Operating Leases                                           |       | 12,459                                                         |       | 4,533 |   | 5,385 |   | 2,431 |   | 110 |   |
| Total                                                      |       | $                                                              | 28,328     |   | $ | 12,725 |   | $ | 10,834 |   | $ | 4,659 |   | $ | 110 |   |

Long-term debt is in the form of bonds whichare directly tied to bond collateral (assets) in the form of mortgage loans.

**Business Risk Factors**

**RisksAssociated with Our Mortgage Banking Business**

*We Havea Limited Operating History in the Mortgage Origination Industry, Which Makesit Difficult to Evaluate Our Current Business Performance and Future Prospects*

Our Company wasformed in 1997 and operated as a mortgage REIT (mortgage portfolio investment)until the fourth quarter of 2001, at which time we began originating andselling residential mortgages (mortgage banking). As a result, comparisonsbetween financial performance in current quarters and past quarters may not behelpful in evaluating our current performance or our future prospects. Themarket for mortgage originations has been dominated by unprecedented levels ofrefinances in 2002 and 2003 due to historically low interest rates. While ourexecutive officers have extensive mortgage origination and mortgage bankingexperience, and we have hired experienced personnel in our mortgage bankingsubsidiary, the Company does not have a significant history as a mortgagebanking company and many uncertainties exist as competitors address thesignificant contraction of the mortgage origination market. This may limit ourability to evaluate our current performance and project our future performance.

*WeExpect Our Fixed Operating Expenses to Continue to Increase, Which MayAdversely Affect Our Results of Operations*

Our MortgageBanking Business had a net loss of approximately$3.8 million (after income tax benefits)for the nine month period ended September 30, 2004. These losses wereprimarily attributable to a decline in loan funding volumes and revenues andhigher overhead expenses as compared to the same period in 2003. Weexpect to incur additional costs and expenses related to the expansion of oursales force and regional underwriting centers. If this expansion does notresult in adequate revenues, our financial performance will suffer. We mustgenerate approximately $750 million to $850 million in sales volume per month, absentfurther deterioration in pricing margins due to competitive pressures, to meetour expense obligations. We are expanding our business operations andincreasing our fixed expenses in a contracting market.  Our strategy requires us to capture anincreasing percentage of the market in a highly competitive environment whichwill put pressure on our gross margins. If we are not able to do this, we would likely experience losses due toour increased level of expenses. In addition, we expect to utilize income taxbenefits against future profits and taxes. Some of the tax benefits may have tobe reversed (valuation account established) in the future if significantoperating losses occur, or if we determine at a future date that forecasted 

 

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operating profits may notbe sufficient to fully utilize deferred tax assets. See “Overhead Expenses MayNot Be Covered by Sufficient Revenues to Sustain Profitable Operations.”

 

*We MayNot Be Able to Effectively Manage the Growth of Our Business*

 

Over the past threeyears, we have experienced rapid growth. In the beginning of 2001, we hadapproximately 20 employees. As of September 30, 2004, we hadapproximately 715 employees. Many of these employees have very limitedexperience with us and a limited understanding of our systems. Many of ourfinancial, operational and managerial systems were designed for a smallbusiness and have only recently been upgraded or replaced to support largerscale operations. If we fail to manage our growth effectively, our expensescould increase, negatively affecting our financial results.

 

*ExpandingOur Market Presence and Market Share in the Face of a Contracting Market MayNot Be Successful*

 

Theorigination market was an estimated $3.8 trillion in 2003 due to low interestrates which spurred both strong home sales and refinance demand. In 2004, theorigination market is expected to contract to $2.7 trillion. Competitivenesswill increase in this shrinking mortgage market, putting pressure on the marketcompetitors to reduce revenues to sustain origination volumes and market share.Wherever possible we are managing staffing levels and utilizing our existinginfrastructure to load balance our loan production while growing our salespresence in existing and new markets. Our expansion is based upon increasing aproportion of variable costs while reducing the fixed cost per loan. There canbe no assurance that this strategy will be successful in the face of stiffeningcompetition and a contracting marketplace.

 

*Competitionin the Mortgage Banking Industry and Demand for Mortgages May Hinder OurAbility to Achieve or Sustain Profitable Origination Levels*

 

Our success in theMortgage Banking Business depends, in large part, on our ability to originateloans in sufficient quantity such that the gain on sales of loans net of hedgesare in excess of both fixed and variable overhead costs. There can be noassurance that we will be able to originate sufficient levels of mortgages toachieve and sustain profitability. In originating and selling loans, we competewith investment banking firms, savings and loan associations, banks, mortgagebankers and other entities originating residential 1-4 unit mortgages, many ofwhich have greater financial resources than us. We also face competition fromcompanies already established in these markets. In addition to the level ofhome purchase activity, the origination market is directly tied to the generallevel of interest rates and refinance activity. The origination market was anestimated $3.8 trillion in 2003, due to strong home sales, low interest ratesand strong refinance demand. In 2004 the origination market is expected tocontract to $2.7 trillion. Competitiveness has increased in this shrinkingmortgage market, putting pressure on the market competitors to reduce revenuesto sustain origination volumes and market share. We believe that the varietyand the price competitiveness of our loan products and customer service levelswill allow us to gain market share over the next several years, even as theoverall market for mortgages declines; however, there can be no assurance thatwe will be able to successfully and profitably compete.

 

*OverheadExpenses May Not Be Covered By Sufficient Revenues To Generate ProfitableOperations*

 

We have made a number of fixed overhead commitments toestablish the operational and administrative infrastructure necessary tosupport our loan origination business. At September 30, 2004, lease commitmentsfor headquarter and regional offices totaled approximately 176,300 square feet.There were 715 employees which include 145 which are paid solely bycommissions. The balance of employees is salaried or hourly employees. In orderto achieve profitability at this staffing level, our monthly loan sales volumemust be approximately $750 to $850 million, absent further deteriorationin pricing margins due to competitive pressures, but there can be no assurancethis can be accomplished. Since our revenues are tied directly to the level ofloan production and subsequent sale, it is imperative that we achieve aprofitable level of originations, and the level of future profitability frommortgage banking will be in direct correlation to the level of loan originationvolume. Furthermore, should competitive pressures require us to reduce targetedgains on the sale of loans, the volume required to sustain profitability wouldincrease. There can be no assurances that we will be able to maintain loanorigination volumes sufficient to cover our fixed overhead costs, and should weincur significant operating losses, our capital base and cash reserves could bematerially adversely impacted.

 

*MortgageBanking Revenues Can Fluctuate From Period to Period Based on a Number ofFactors*

 

Our operating resultshave and may in the future fluctuate significantly from period to period as aresult of a number of factors, including the volume of loan origination,interest rates and the level of unrealized gains/losses in unsold loans, thevalue of funded loans not yet committed for sale or positions in derivativesecurities. Accordingly, the consolidated net income of our Company mayfluctuate from period to period.

 

*OurFinancial Results Fluctuate As a Result of Seasonality and Other TimingFactors, Which Makes It Difficult To Predict Our Future Performance and MayAffect the Price of Our Common Stock*

 

Although the refinanceportion of our Mortgage Banking Business is not seasonal, our purchase businessis generally subject to seasonal trends. During 2003, our refinance businessgrew to 90% of our activity. In 2004, as we return to more normal markets andpurchase and refinance activity become more equal, seasonality will againbecome a significant factor in our business. Seasonality trends reflect thegeneral pattern of housing sales, which typically peak during the spring

 

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and summer seasons. Our quarterly operating resultshave fluctuated in the past and are expected to fluctuate in the future,reflecting the seasonality of the industry.

 

Further, if the closingof a sale of loans is postponed, the recognition of gain from the sale is alsopostponed. If such a delay causes us to recognize income in the subsequentquarter, our results of operations for the previous quarter could besignificantly depressed. If our results of operations do not meet theexpectations of our stockholders and potential stockholders, the price of ourcommon stock may decrease.

 

*OurHedging Strategies May Not Be Successful in Mitigating Our Risks AssociatedWith Interest Rate Changes*

 

We use forward sales ofmortgage-backed securities (TBA) and options on mortgage-backed securities(MBS) which are classified as derivative financial instruments, to provide a levelof protection against interest rate risk. When rates change we expect to recorda gain or loss on derivatives which would be offset by an inverse change in thevalue of our rate lock commitments and loans not yet committed for sale. Wecannot assure you, however, that our use of derivatives will offset all of ourrisk related to changes in interest rates. There have been periods, and it ispossible that there will be periods in the future, during which we will incurlosses after accounting for our derivative financial instruments. Thederivative financial instruments we select may not have the desired effect ofreducing our interest rate risk. In addition, the nature and timing of hedgingtransactions may influence the effectiveness of these strategies. If we poorlydesign strategies or improperly execute transactions we could actually increaseour exposure to interest rate risk and potential losses. In addition, hedgingstrategies involve transaction and other costs. We cannot assure you that ourhedging strategy and the derivatives that we use will adequately offset therisk of interest rate volatility or that our hedging transactions will notresult in losses.

 

We offer loan programs ofmany terms, from thirty year fixed interest rate loans to one year adjustablerate loans. The hedging instruments used, on balance, correlate satisfactorilywith the thirty and fifteen year loan programs. The hedging instruments usedfor our shorter term loan programs and adjustable interest rate loans have asomewhat lower correlation to changes in market interest rates than do thirtyyear term programs. Consequently, the design of our hedge strategy may not beeffective at certain times and this occurrence could be amplified for theseshorter term loan programs.

 

*Volatilityin Interest Rates May Adversely Affect Our Results of Operations and OurFinancial Position*

 

Our primary source ofrevenue is from gains on sales of loans, net of gains or losses on derivativefinancial instruments. We set rates and pay broker premiums for loans we fundbased on a pricing process designed to create a targeted profit margin on eachloan. Appropriately pricing these loans can be complex, and we may not alwayssuccessfully price our loans with adequate margin to compensate us for the riskof interest rate volatility.

 

The value of the mortgageloans that we originate is at risk due to fluctuations in interest rates duringtwo time periods: (1) the period beginning when we have committed tofunding the loan (rate lock commitments) and ending when the loan closes, orfunds; and (2) the time period beginning when the loan closes and endingwhen we commit to sell, or sell the loans to third-party purchasers(uncommitted loans). These rate lock commitments and uncommitted loans held forsale are collectively referred to as our pipeline. To manage the interest raterisk of our pipeline, we continuously project the percentage of rate lockcommitments on loans we expect to close. Because projecting a percentage ofrate lock commitment loans that will close is especially difficult duringperiods of volatile interest rates, we cannot assure that our projections willbe accurate. On the basis of such projections, we use forward sales ofmortgage-backed securities (TBA) and options on MBS, which are classified asderivative instruments. These “hedges” are designed to mitigate the adverseimpact interest rate fluctuations may have on the value of the pipeline. Ouruse of hedges is based in part on our estimates as to the percentage of loansthat will close, and therefore we cannot assure you that our use of derivativeinstruments will offset the risk of changes in interest rates.

 

If interest rates change,the actual percentage of rate lock commitment loans that close may differ fromthe projected percentage. A sudden significant increase in interest rates cancause a higher percentage of rate lock commitment loans to close thanprojected. We may not have made forward sales commitments to sell theseadditional loans and consequently may incur significant losses upon their saleat current market prices, which may not be offset by gains in the value ofderivative instruments, adversely affecting results of operations. Likewise, ifa lower percentage of rate lock commitment loans close than was projected, dueto a sudden decrease in interest rates or otherwise, we have and may in thefuture adjust our hedge positions or mandatory sales commitments at asignificant cost, adversely affecting our results of operations. This risk isgreater during times of interest rate volatility.

 

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*We Are Subject to Counterparty Riskson Loan Sale Commitments and Hedging Transactions*

 

In connection with ourmortgage loan sales, which involve the sale of mortgage loans and mortgage-backedsecurities on a forward or other deferred delivery and payment basis, we mayenter into forward sales of mortgage-backed securities (TBA) and options on MBSin connection with our hedging activities. We have credit risk exposure to theextent purchasers/sellers are unable to meet the terms of their forwardpurchase/sale contracts. As is customary in the marketplace, none of theforward payment obligations of any of our counterparties is currently securedor subject to margin requirements. We attempt to limit our credit exposure onforward sales arrangements on mortgage loans and mortgage-backed securities byentering into forward contracts only with institutions that we believe areacceptable credit risks, and which have substantial capital and an establishedtrack record in correspondent lending. We further attempt to limit our creditexposure on hedging transactions by dealing with a wide variety of firms. Ifcounterparties do not perform, our results of operations may be adverselyaffected.

 

*Failureto Renew and Obtain Adequate Financing May Adversely Affect Results OfOperations*

 

We currently have revolving warehouse borrowing facilities in placetotaling $1.4 billion. These facilities enable AmNet to fund up toapproximately $1.6 billion on a monthly basis. In order to continue ouroperations, we must maintain, renew or replace warehouse lines of credit. Thereare a number of financial institutions which specialize in lending to mortgagebanking companies and these types of secured borrowings. We expect to renew ourcurrent warehouse facilities with JP Morgan/Chase Bank, UBS Warburg Real EstateSecurities, Countrywide Warehouse Lending, Inc. and Residential FundingCorporation. Failure to renew facilities would limit our potential to fundloans and may adversely affect our financial results. Among the factors thatwill affect our ability to renew and expand our warehouse line borrowings arefinancial market conditions and the value and performance of our Company priorto the time of such financing. There can be no assurance that any suchfinancing can be successfully completed at advantageous rates or at all. Ourwarehouse credit facilities contain extensive restrictions and covenants that,among other things, require us to satisfy specified financial, asset qualityand loan performance tests. If we fail to meet or satisfy any of thesecovenants, we would be in default under these agreements and our lenders couldelect to declare all amounts outstanding under the agreements to be immediatelydue and payable, enforce their interests against collateral pledged under suchagreements and restrict our ability to make additional borrowings. Theseagreements also contain cross-default provisions, so that if a default occurs,under one agreement, the lenders under our other agreements could also declarea default. Any default under our credit facilities could have an adverse effecton our financial results. As a result of the Company’s third quarter net loss,the Company was out of compliance with certain of its warehouse lendingagreements at September 30, 2004. The Company was out of compliance withearnings covenants in its JPMorgan Chase Bank, Countrywide Warehouse Lendingand Residential Funding Corporation agreements. Each of the warehouse lendershas waived, for the period ending September 30, 2004, the covenants for whichthe Company was out of compliance. We believe we are in good standingwith our warehouse lenders. We have obtained modifications of warehouse lendingcovenants and will continue to negotiate for additional modifications toalleviate loan covenant violation concerns for the near future.

 

The covenants andrestrictions in our warehouse credit facilities may restrict our ability to,among other things:

•               incur additional debt by virtueof having warehouse loan covenants;

•               make certain investments oracquisitions;

•               repurchase or redeem capitalstock;

•               engage in mergers orconsolidations;

•               finance loans with certainattributes;

•               reduce liquidity below certainlevels; and

•               hold loans for longer thanestablished time periods.

 

These restrictions mayinterfere with our ability to obtain financing or to engage in other businessactivities, which may significantly harm our business financial condition,liquidity and results of operations.

 

*We Sella Substantial Portion of Loans We Originate to Competitors*

 

We have warehouse linefacilities with Countrywide. We also sell a portion of our loans to two of ourcompetitors. For the nine months ending September, 30, 2004 we sold toCountrywide Home Loans, Inc., 59% of all loan sales and to Wells Fargo we sold16% all loan sales. If either Countrywide or Wells Fargo changes itscorrespondent lending strategy or procedures, or stops purchasing our loans onfavorable terms, we could be required to find alternate purchasers and/oraccept unfavorable terms. We could also be forced to find other sources ofwarehouse line lending. Any of these results may have an adverse effect on ourresults of operations.

 

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*Dependencyon Correspondent Investors, Secondary Markets*

 

Our ability to generategains on the sales of mortgages is largely dependent upon the continuation ofcorrespondent lending programs offered by large correspondent lenders, as wellas our continued eligibility to participate in such programs. Although we arein good standing with a number of large correspondent lenders and are not awareof any proposed discontinuation of, or significant reduction in, the operationof such programs, any such changes could have a material adverse effect on ouroperations. We anticipate that we will continue to remain eligible toparticipate in such programs, but any significant impairment of sucheligibility would materially adversely affect our operations.

 

*OurOrigination Activity Is Concentrated In California, Making Our Results Subjectto Adverse Economic Conditions In California.*

 

A large proportion of loans we fund are concentrated in California (24.4% of all loans closed for the nine monthperiod ended September 30, 2004). Although we have expanded our operationson the East Coast of the United States, a significant portion of our loanorigination volume is likely to be based in California for the foreseeablefuture. Consequently, our results of operations and financial condition aredependent upon general trends in the California economy and its residentialreal estate market. Residential real estate market declines may adverselyaffect the levels of new mortgages in California or the value paid bycorrespondent investors for loans in California, potentially adverselyaffecting our results of operations and financial condition.

 

*Repurchasedor Non-saleable Loans May Adversely Impact Results of Operations and OurFinancial Position*

 

In connection with thesale of loans to correspondent investors, we make a variety of representationsand warranties regarding the loans, including those that are customary in theindustry relating to, among other things, compliance with laws, regulations andinvestor program standards and the accuracy of information on the loandocuments and in the loan file. In the event that an investor finds that a loanor group of loans violates our representations, the investor may require us torepurchase the loan or loan group and bear any potential related loss on thedisposition of the loans, or provide an indemnification for any lossessustained by the investor on the loans. Additionally, we may originate a loanthat does not meet investor underwriting criteria or has some other defect,requiring us to sell the loans at a significant discount. We have hiredexperienced personnel at all levels and have established significant controlsto ensure that all loans are originated to our underwriting standards, and aremaintained in compliance with all of the representations made by us inconnection with our loan sale agreements. However, there can be no assurancesthat mistakes will not be made or that certain employees will not deliberatelyviolate our lending policies and, accordingly, we are subject to repurchaserisk and losses on unsaleable loans. Typically, with respect to any loan thatmight be repurchased or unsaleable, we would correct the flaws if possible andre-sell the loan in the market. We have created repurchase reserves to providefor this contingency on our financial statements, but there can be noassurances that loan losses associated with repurchased or unsaleable loanswill not adversely impact results of operations or the financial condition ofour Company. Additionally, should an investor or group of investors experiencean adverse trend of non-compliant loans from our Company, we could lose theprivilege of selling loans to the investor(s), which could have a materialadverse impact on our ability to sell our loans and thus adversely impact theresults of operations or the financial condition of the Company.

 

*TheCompany Provides Loans to Sub-prime Borrowers which May Adversely AffectEarnings*

 

In March of 2004,the Company began lending to sub-prime borrowers. Credit risks associated withsub-prime mortgage loans will be greater than those associated with mortgageloans that conform to FNMA and FHLMC guidelines. The principal differencebetween sub-prime mortgage loans and conforming mortgage loans is thatsub-prime mortgage loans typically include one or more of the following: worsecredit and income histories of the mortgagors, higher loan-to-value ratios,reduced or alternative documentation required for approval of the mortgagors,different types of properties securing the mortgage loans, higher loan sizesand the mortgagor’s non-owner occupancy status with respect to the mortgagedproperty. We have added personnel in a centralized sub-prime underwriting andfunding center to help mitigate the risks associated with these loans, howeverthere can be no assurance that all sub-prime loans will be able to be sold toinvestors at a profit. If we are not successful, higher overhead incurred toproduce these loans may not be covered by the income derived from sub-primelending.

 

*OurLoan Recourse Reserve is Difficult to Estimate Given Our Limited History in theMortgage Banking Business*

 

We began our MortgageBanking segment in November of 2001. Mortgage loans we sell to investorsprovide for repurchase of loans which become delinquent within varyingtimeframes. Our limited history makes it difficult to assess the amount ofrecourse reserves which should be provided given these recourse arrangements.Therefore there is no assurance that our recourse reserves are adequate.

 

*TheNationwide Scope of Our Operations Exposes Us to Risks of Noncompliance with anIncreasing and Inconsistent Body of Complex Laws and Regulations at theFederal, State and Local Levels*

 

We originate mortgageloans in many states. We must comply with the laws and regulations, as well asjudicial and administrative decisions, of all of these jurisdictions, as wellas an extensive body of federal laws and regulations. The 

 

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volume of new or modifiedlaws and regulations has increased in recent years and in addition, individualcities and counties have begun to enact laws that restrict loan originationactivities in those cities and counties. The laws and regulations of each ofthese jurisdictions are different, complex and, in some cases, in directconflict with each other. As our operations continue to grow, it may be moredifficult to comprehensively identify, to accurately interpret and to properlyprogram our technology systems and effectively train our personnel with respectto all of these laws and regulations, thereby potentially increasing ourexposure to the risks of noncompliance with these laws and regulations.

 

Our failure to complywith these laws can lead to the following consequences, any of which could havean adverse effect on our ability to operate our business and our financialresults:

•               civil and criminal liability;

•               loss of approved status;

•               demands for indemnification orloan repurchases from purchasers of our loans;

•               class action lawsuits;

•               assignee liability, which maymake our loans unsaleable; and

•               administrative enforcementactions.

 

*TheIncreasing Number of State and Local “Anti-predatory Lending” Laws May RestrictOur Ability to Originate or Increase Our Risk of Liability With Respect ToCertain Mortgage Loans and Could Increase Our Costs of Doing Business*

 

In recent years, severalfederal, state and local laws, rules and regulations have been adopted, or areunder consideration, that are intended to eliminate so-called “predatory”lending practices. These laws, rules and regulations impose certainrestrictions on loans on which certain points and fees or the annual percentagerate (“APR”) exceeds specified thresholds. Some of these restrictions expose alender to risks of litigation and regulatory sanction no matter how carefully aloan is underwritten. In addition, an increasing number of these laws, rulesand regulations seek to impose liability for violations on purchases of loans,regardless of whether a purchaser knew of or participated in the violation.

 

It is against our policyto engage in predatory lending practices. We have generally avoided originatingloans that exceed the APR or “points and fees” thresholds of these laws, rulesand regulations. The companies that buy our loans and/or provide financing forour loans origination operations generally do not want to buy or finance suchloans. The continued enactment of these laws, rules and regulations may preventus from making certain loans. In addition, the difficulty of managing the riskspresented by these laws, rules and regulations may decrease the availability ofwarehouse financing and the overall demand for loans, making it difficult tofund, sell or securitize any of our loans. If we relax our restrictions onloans subject to these laws, rules and regulations because the companies whichbuy our loans and/or provide financing for our loan origination operationsrelax their restrictions, we will be subject to greater risks for actual orperceived non-compliance with such laws, rules and regulations, includingdemands for indemnification or loan repurchases from our lenders and loanpurchasers, class action lawsuits, increased defenses to foreclosure ofindividual loans in default, individual claims for significant monetary damagesand administrative enforcement actions. The growing number of these laws, rulesand regulations will likely increase our cost of doing business as we arerequired to develop systems and procedures to ensure that we do not violate anyaspect of these new requirements. Any of the foregoing could materially andadversely affect our business, financial condition, liquidity and results ofoperations.

 

*AnInterruption In or Breach of Our Information Systems May Result In LostBusiness*

 

We rely heavily uponcommunications and information systems to conduct our business. As we implementour growth strategy and increase our volume of loan production, that reliancewill increase. Any failure or interruption or breach in security of ourinformation systems or the third-party information systems on which we relycould cause underwriting or other delays and could result in fewer loanapplications being received, slower processing of applications and reducedefficiency in loan servicing. We utilize proprietary software for our main loanorigination system. This software is not fully documented and we have a limitednumber of employees who are knowledgeable about this application. We cannotassure you that systems failure or interruptions will not occur, or if they dooccur that they will be adequately addressed by us or the third parties onwhich we rely. The occurrence of any failures or interruptions couldsignificantly harm our business.

 

*TheSuccess and Growth of Our Business Will Depend Upon Our Ability to Adapt to,Implement and Maintain Technological Changes*

 

Our mortgage loanorigination business is currently dependent upon our ability to effectivelyinterface with our brokers, borrowers and other third parties and toefficiently process loan applications and fund loans. The origination processis becoming more dependent upon technological advancement, such as the abilityto process applications over the internet, accept electronic signatures, andprovide process status updates instantly and other customer-expected conveniencesthat are cost-efficient to our process. Implementing this new technology andbecoming proficient with it may also require significant capital expenditures.As these requirements increase in the future, we will have to fully developthese technological capabilities to remain competitive or our business could besignificantly harmed.

 

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*We MustAttract and Retain Qualified Account Executives and Qualified Personnel toProduce Our Desired Level of Revenues*

 

The Company relies oncommissioned account executives to generate loan referrals from professionalmortgage brokers. These account executives typically have establishedrelationships with brokers. The Company’s overall loan fundings are dependentupon the number of account executives, and as such, sustained loan productionand market share growth are dependent on the successful retention andrecruitment of the sales force. Similarly, the Company relies on the expertiseof its employees in other facets of operations, including underwriting, capitalmarkets, risk management, and finance and accounting. Given the dependency onthe job market for qualified employees, to continue our growth poses thepotential risk that the Company will not be able to attract and retainqualified employees.

 

*CapitalShortages Could Impede the Ability to Execute Our Mortgage Banking Strategy*

 

Our mortgage bankingactivities require a significant level of cash reserves and capital to supportloan inventories and overhead exposure. Additionally, while we utilizewarehouse credit facilities to fund our loan origination activity, we mustinvest cash equity in our loan inventories approximating 1% to 4% of the costbasis of these loans. While we believe our capital base, cash reserves and cashflow from the sale of a majority of our Mortgage Asset Portfolio Business andmortgage banking revenues will be sufficient to enable us to execute ourmortgage banking strategy, there can be no assurances that capital shortageswill not occur, requiring us to raise additional debt or equity capital ordecrease or cease our origination activities.

 

*We AreSubject To Losses Due To Errors or Fraudulent Acts On The Part Of LoanApplicants, Employees or Mortgage Brokers*

 

Mortgage brokers whoassist loan applicants in obtaining mortgage loans refer all of the mortgageloans originated by us. As such, the loan application, property appraisal,credit report and other supporting documentation are furnished by the mortgagebroker and used by our underwriters to make approval or denial decisions. Therecould also be the potential of collusion between the broker and an employee toproduce a fraudulent loan. Our employees usually have little contact with loanapplicants, and rely on the mortgage broker to obtain and furnish all of thedocumentation supporting the mortgage loan application. Mortgage brokers maymake mistakes in completing the documentation for a loan leading to anincreased risk of our holding a non-saleable loan or of indemnifying orrepurchasing loans from investors.

 

Further, in rare cases,the mortgage broker may knowingly or unknowingly submit an application whereinmultiple parties to the transaction (borrower, appraiser, seller, or titleinsurer) work in collusion to inflate the property value and/or falsify otherdocumentation in order to obtain a mortgage loan. These types of fraudulentmortgage loans will have a high risk of default, and will likely not be fullyrecoverable through disposition of the underlying property securing themortgage loans. Additionally, in the case of Alternative A loans, which is somecases permit the borrower to “state” their income but not have to provideincome documentation, the mortgage broker may intentionally coach a borrower tomake material misrepresentations in order to qualify for a loan.

 

Should material fraud bedetected on a mortgage loan prior to sale to an investor, the mortgage loan mayhave to be sold at a significant discount or may not be saleable. Shouldmaterial fraud or mistakes in loan documentation be detected after a mortgageloan is sold to a correspondent investor, we may be required to repurchase theloan or indemnify the investor. While the investor and/or we can initiateforeclosure proceedings on any loan deemed to be fraudulently obtained, wecould incur significant losses on these fraudulent mortgage loans if principalor interest is not fully recovered through the foreclosure and disposition ofthe underlying property securing the mortgage loan.

 

We have established riskmanagement and quality control committees to set policy and manage exposure tocredit losses due to fraud, compliance errors or non-compliance with ourunderwriting standards. Regular quality control audits are done onrepresentative samples of mortgage loans and all mortgage loans submitted bybrokers who come under suspicion in the normal course business. Additionally,we have numerous controls and processes to ensure that all of the mortgageloans applications submitted through mortgage brokers are not based on fraudulentor intentionally misrepresented documentation. However, there can be noassurances that the broker and/or borrowers do not submit fraudulent orinaccurate documentation that is not detected by our personnel or by electronicfraud checks utilized by us. Should we originate significant numbers offraudulent loans or loans based on inaccurate documentation, our results ofoperations and financial condition could be materially adversely affected.

 

*If WeAre Unable to Maintain and Expand Our Network of Independent Brokers, Our LoanOrigination Business Will Decrease*

 

All of our mortgage loanoriginations come from independent brokers. Our brokers are not contractuallyobligated to do business with us. Many of our brokers have not been in businessmore than a few years. Further, our competitors also have relationships withour brokers and actively compete with us in our efforts to expand our brokernetworks. Accordingly, we cannot assure you that we will be successful inmaintaining our existing relationships or expanding our broker networks, thefailure of which would significantly harm our business, financial condition,liquidity and results of operations.

 

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*We Maybe Subject to Fines or Other Penalties Based Upon the Conduct of OurIndependent Brokers*

 

The mortgage brokers fromwhich we obtain loans have legal obligations to which they are subject. Whilethese laws may not explicitly hold the originating lenders responsible for thelegal violations of mortgage brokers, increasingly federal and state agencieshave sought to impose such assignee liability. Recently, for example, theUnited States Federal Trade Commission (“FTC”) entered into a settlementagreement with a mortgage lender in which the FTC characterized a broker thathad placed all of its loan production with a single lender as the “agent” ofthe lender, and the FTC imposed a fine on the lender in part because, as “principal,”the lender was legally responsible for the mortgage broker’s unfair and deceptiveacts and practices. The United States Justice Department in the past has soughtto hold a mortgage lender responsible for the pricing practices of its mortgagebrokers, alleging that the mortgage lender was directly responsible for thetotal fees and charges paid by the borrower under the Fair Housing Act even ifthe lender neither dictated what the mortgage broker could charge nor kept themoney for its own account. Accordingly, we may be subject to fines or otherpenalties based upon the conduct of our independent mortgage brokers.

 

*We are Opening a Correspondent Lending Division ina Highly Competitive Marketplace with No Previous Company Experience.*

 

During the third quarter of 2004 we began hiringhighly seasoned correspondent lending employees in anticipation of startingcorrespondent lending activity in November 2004.  Although these employees have experience withcorrespondent lending we, as a Company, have no experience in correspondentlending.  Lack of experience may lead tomistakes and miscalculations with the resulting effect of revenue loss.  There can be no assurance we will beprofitable in correspondent lending, and we may in fact lose money in thisactivity.

 

**RisksAssociated with Our Mortgage Asset Portfolio Business**

 

InMay 2004, we sold the majority of our bond collateral mortgage loans and bondcollateral real estate owned.  Proceedsfrom the sale were used to retire $116.0 million of bond debt, leaving $15.9million of bond debt at September 30, 2004. As such, the Mortgage Asset Portfolio Business is not expected to have amaterial impact on the Company’s financial statements going forward.  The risks associated with our remainingMortgage Asset Portfolio Business are outlined in our 2003 form 10-K filed withthe SEC on March 30, 2004.

 

*ThePurchasers of the Portfolios Have the Right to Make the Company RepurchaseLoans Sold to Them.  A Reserve has BeenProvided by the Company For This Purpose and Provide Coverage for TrailingTransaction Expenses.*

 

Inconnection with the companies purchasing bond collateral we providedprotections under our representation and warranties within the sale agreementsthat we would repurchase any loans found to be out of compliance with agreedupon standards.  We are also underobligation to pay any trailing transaction costs.  The Company has estimated the cost of theseitems and set up a reserve based on the estimate.  There can be no assurances that thisprovision will be sufficient.  As ofSeptember 30, 2004 the provision for costs related to the bond collateral saleswas $184.6 thousand.

 

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

A primary market riskfacing our Company is interest rate risk, which is highly sensitive to manyfactors, including governmental monetary and tax policies, domestic andinternational economic and political considerations and other factors beyondour control. We attempt to manage this risk in our Mortgage Banking andMortgage Asset Portfolio Businesses.

 

**MortgageBanking Business**

 

*InterestRate Risk*

 

Rate lock commitments andmortgage loans held for sale are subject to market price fluctuation untilcommitted for sale. These fluctuations are primarily tied to changes in marketinterest rates and the relationship of short-term rates to long-term rates. Inorder to mitigate this risk, a variety of financial derivative instruments(including forward mandatory mortgage security sales (TBA) and options on TBAsales) are utilized to hedge or mitigate market price fluctuations. Theseinstruments are classified as derivative financial instruments on our financialstatements. Our hedge positions are continually adjusted based on routine andongoing quantification of our risk, but hedges may or may not be fullysuccessful in complete risk mitigation. In particular, our capital marketspersonnel must make estimates of the percentage of rate lock commitmentsexpected to close under different interest rate changes. Losses on the sale ofmortgage loans not offset by corresponding gains on hedge positions, or hedgingactivity not offset by corresponding gains on the sale of mortgages, couldadversely impact

results of operations andour financial position.

 

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**MortgageAsset Portfolio Business**

 

*InterestRate Risk*

 

Our operating results forthis business segment will depend in large part on differences between theincome earned from our assets (net of credit losses) and our borrowing costs.All but $1.3 million of this business segment’s bond collateral and real estateowned are pledged as collateral for long-term debt (securitizations). In mostcases, the income from assets will respond more slowly to interest ratefluctuations than the cost of borrowings, which creates a mismatch betweenasset yields and borrowing rates. Consequently, changes in interest rates, particularly short-terminterest rates, may influence the Mortgage Asset Portfolio Business net income.Long-term debt interest rates are tied to LIBOR.  Increases in these rates will tend todecrease net income from the Mortgage Asset Portfolio Business.

 

**SensitivityAnalysis**

 

The methods we have usedin our sensitivity analysis have not changed significantly sinceDecember 31, 2003, although our mortgage asset portfolio is significantlydiminished in size as a result of asset sales since that date.

 

We have performed varioussensitivity analyses that quantify the net financial impact of changes ininterest rates on our interest rate-sensitive assets, liabilities andcommitments. These analyses presume an instantaneous parallel shift of theyield curve. Various techniques are employed to value the underlying financialinstruments, and these techniques rely upon a number of critical assumptions.The scenarios presented in the table below are illustrative. Actual experiencemay differ materially from the estimated amounts presented for each scenario.To the extent that yield curve shifts are non-parallel, and to the extent thatactual variations in significant assumptions differ from those applied forpurposes of the valuations, the resultant valuations can also be expected tovary. Such variances may prove material.

 
| ** **                                                            | ** ** | **(dollars in thousands)**  | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                            | ** ** | ** **                  | ** ** | ** ** | ** ** | **If Interest Rates Were To** | ** ** |
| ** **                                                            | ** ** | **September 30, 2004** | ** ** | **Increase** | ** ** | **Decrease** | ** ** | **Increase** | ** ** | **Decrease** | ** ** |
| ** **                                                            | ** ** | **Carrying Amount**         | ** ** | **Estimated  Fair Value** | ** ** | **50 Basis Points  Estimated Fair Value** | ** ** | **100 Basis Points  Estimated Fair Value** | ** ** |
| Interest-earning assets:                                              |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                                             |       | $                           | 46,133     |   | $ | 46,133 |   | $ | 46,133 |   | $ | 46,133 |   | $ | 46,133 |   | $ | 46,133 |   |
| Mortgage loans held for sale, net, pledged, (lower of cost or market) |       | 394,368                     |       | 399,023 |   | 397,534 |   | 400,302 |   | 396,005 |   | 401,532 |   |
| Derivative financial instruments                                      |       | 237                         |       | 237 |   | 744 |   | (1,759 | ) | (110 | ) | (5,024 | ) |
| Bond collateral and real estate owned, net                            |       | 17,197                      |       | 17,447 |   | 17,443 |   | 17,449 |   | 17,441 |   | 17,454 |   |
| Total interest-earning assets                                         |       | $                           | 457,935    |   | $ | 462,840 |   | $ | 461,854 |   | $ | 462,125 |   | $ | 459,469 |   | $ | 460,095 |   |
|                                                                  |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                                         |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Short-term debt                                                       |       | $                           | 380,791    |   | $ | 380,791 |   | $ | 380,791 |   | $ | 380,791 |   | $ | 380,791 |   | $ | 380,791 |   |
| Long-term debt, net                                                   |       | 15,869                      |       | 15,869 |   | 15,869 |   | 15,869 |   | 15,869 |   | 15,869 |   |
| Total interest-bearing liabilities                                    |       | $                           | 396,660    |   | $ | 396,660 |   | $ | 396,660 |   | $ | 396,660 |   | $ | 396,660 |   | $ | 396,660 |   |
|                                                                       |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The following describesthe methods and assumptions used by the Company in estimating fair values.

 

*Cash and Cash Equivalents*

 

The carrying amount forcash and cash equivalents approximates fair value because these instruments aredemand

deposits and money marketaccounts and do not present unanticipated interest rate or credit concerns.

 

*Mortgage Loans Held For Sale,net, pledged, (lower of cost or market)*

 

The fair value isestimated based on quoted market prices from institutional investors forsimilar types of mortgage loans. A portion of mortgage loans held for sale arecommitted for sale under mandatory sale arrangements and as such are notre-valued for subsequent changes in interest rates.

 

*Bond Collateral, Mortgage Loansand Real Estate Owned, Net*

 

The fair value of BondCollateral is estimated based on quoted market prices from dealers and brokersfor similar 

 

42

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types of mortgage loansin the bulk mortgage market. Market prices reflect various assumptions as toprepayment rates, loan losses and financing costs.

 

*Derivatives*

 

Fair values of forwardsales of mortgage-backed securities and options on mortgage-backed securitiesare based on quoted market prices for these instruments. Fair values of ourcommitments to originate loans are based on any difference in the value of theloans expected to close between the time of the rate lock commitment and thecurrent market value.

 

*Short-Term Debt*

 

The fair value of thewarehouse line debt and short-term debt related to bond collateral held forsale approximates the carrying amounts because of the short-term nature of thedebt and interest on the debt fluctuates with market interest rates.

 

*Long-Term Debt*

 

The fair value oflong-term debt is estimated based upon all long-term debt being at variablerates and therefore cost approximates fair market value.

 

ITEM 4. CONTROLS AND PROCEDURES

 

(a) Under the supervision and with the participationof our management, including our principal executive officer and principalfinancial officer, we evaluated the effectiveness of our disclosure controlsand procedures, as such term is defined under Rule 13a-15(e) promulgated underthe Securities Exchange Act of 1934, as amended. Based on this evaluation, ourprincipal executive officer and principal financial officer concluded that ourdisclosure controls and procedures were effective as of the end of the periodcovered by this quarterly report.

 

(b) There has been nochange in our internal control over financial reporting identified inconnection with the evaluation required by paragraph (d) of Exchange Act Rule13a-15 that occurred during the period covered by this quarterly report thathas materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

43

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| PART II.  | OTHER INFORMATION                                            |
|----------------|--------------------------------------------------------------|
|           |                                                         |
| ITEM 1.        | LEGAL PROCEEDINGS                                            |
|           |                                                         |
|           | None.                                                        |
|           |                                                         |
| ITEM 2.   | UNREGISTERED SALES OF  EQUITY SECURITIES AND USE OF PROCEEDS |

 

 

Our Purchase of EquitySecurities
| **Period**                                                   | ** ** | **Total Number of Shares Purchased** | ** ** | **Average Price Paid per Share** | ** ** | **Total Number of Shares Purchased as Part of Publicly Announced Plan  or Program (1)** | ** ** | **Maximum Number of Shares that May Yet Be Purchased Under the Plan or  Program** | ** ** |
|--------------------------------------------------------------|------------|--------------------------------------|------------|----------------------------------|------------|-----------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|
|                                                         |       |                                 |       |                             |       |                                                                                    |       |                                                                              |       |
| Month #1 (July 1, 2004 to July 31, 2004)                |       | —                               |       | —                           |       | —                                                                                  |       | 388,510                                                                           |       |
|                                                         |       |                                 |       |                             |       |                                                                                    |       |                                                                              |       |
| Month #2 (August 1, 2004 to August 31, 2004)                 |       | 32,800                               |       | $                                | 7.86       |                                                                                    | 32,800     |                                                                              | 355,710    |   |
|                                                         |       |                                 |       |                             |       |                                                                                    |       |                                                                              |       |
| Month #3 (September 1, 2004 to September 30, 2004) |       | 48,400                               |       | 7.88                             |       | 48,400                                                                                  |       | 307,310                                                                           |       |
|                                                         |       |                                 |       |                             |       |                                                                                    |       |                                                                              |       |
| Total                                                        |       | 81,200                               |       | $                                | 7.87       |                                                                                    | 81,200     |                                                                              | 307,310    |   |

 

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(1) We announced the repurchase program on May 13, 2004. A total of400,000 shares were approved for repurchase. There is no expiration date forthis repurchase program.

 

 
| ITEM 3. | DEFAULTS UPON SENIOR  SECURITIES                     |
|---------|------------------------------------------------------|
|    | Not  applicable.                                     |
|    |                                                 |
| ITEM 4. | SUBMISSION OF MATTERS TO A  VOTE OF SECURITY HOLDERS |
|    |                                                 |
|    | None                                                 |
|    |                                                 |
| ITEM 5. | OTHER INFORMATION                                    |
|    |                                                 |
|    | (a)   None                            |
|    | (b)   None                            |
|    |                                                 |
| ITEM 6. | EXHIBITS                                             |

 

 
| (a)    |   | Exhibits | ** ** | ** **                                                                                                                                                                              |
|--------|--------|----------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |     |       |                                                                                                                                                                                    |
|   | (1)    | 3.1      |       | Second Articles of  Amendment and Restatement of the Registrant                                                                                                                         |
|   | (4)    | 3.1 A    |       | Articles of Amendment  (regarding name change)                                                                                                                                          |
|   | (2)    | 3.2      |       | Fourth Amended and  Restated Bylaws of the Registrant                                                                                                                                   |
|   | (3)    | 4.1      |       | Registration Rights  Agreement dated February 11, 1997                                                                                                                             |
|   | (2)    | 4.3      |       | First Amended and  Restated Rights Agreement between the Company and American Stock Transfer and  Trust Company dated as of February 2, 1999 and amended as of  March 4, 2004 |
|   | (5)    | 10.20    |       | Executive Employment  between AmNet Mortgage, Inc. and John Robbins                                                                                                                     |
|   | (5)    | 10.21    |       | Executive Employment  between AmNet Mortgage, Inc. and Jay Fuller                                                                                                                       |
|   | (5)    | 10.22    |       | Executive Employment  between AmNet Mortgage, Inc. and Judith A. Berry                                                                                                                  |
|   | (5)    | 10.23    |       | Executive Employment  between AmNet Mortgage, Inc. and Lisa Faulk                                                                                                                       |
|   |   | 31.1     |       | Section 302 CEO  Certification                                                                                                                                                     |

 

44

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|   |   | 31.2 |   | Section 302 CFO  Certification |
|--------|--------|------|--------|-------------------------------------|
|   |   | 32.1 |   | Section 906 CEO  Certification |
|   |   | 32.2 |   | Section 906 CFO  Certification |

----

|   | (1) |   |   | Incorporated  by reference to our annual report on Form 10-K for the fiscal year ended  December 31, 2002 filed March 31, 2003    |
|--------|-----|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------|
|   | (2) |   |   | Incorporated  by reference to our annual report on Form 10-K for the fiscal year ended  December 31, 2003 filed on March 30, 2004 |
|   | (3) |   |   | Incorporated  by reference to our registration statement on Form S-11 filed  September 25, 1997                                        |
|   | (4) |   |   | Incorporated  by reference to our quarterly report form 10-Q for the fiscal quarter ended  March 31, 2004 filed May 17, 2004.          |
|   | (5) |   |   | Incorporated  by reference to our current report on Form 8-K filed October 6, 2004                                                          |

 

 

45

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SIGNATURES

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                      | AMNET MORTGAGE, INC. |
|---------------------------|----------------------|
|                      |                 |   |   |
| Dated: November 15,  2004 | By:                  | /s/ Judith A. Berry |   |
|                      |                 | Judith A. Berry, |
|                      |                 | Executive Vice  President  Chief Financial Officer |

 

 

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