** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

** **

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

**OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period EndedMarch 31, 2006**

** **

**Commission File No. 0-22361**

 

**NETBANK, INC.**

(Exact name of registrant as specified in its charter)

 

| **Georgia**                               | ** ** | **58-2224352**                           |
|-------------------------------------------|------------|------------------------------------------|
| (State of incorporation)                  |       | (I.R.S. Employer  Identification Number) |
|                                      |       |                                     |
| **1015 Windward Ridge Parkway**           | ** ** | ** **                               |
| **Alpharetta, Georgia**                   | ** ** | **30005**                                |
| (Address of principal  executive offices) |       | (Zip Code)                               |

 

**(770) 343-6006**

Registrant’s telephone number, including area code:

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required tofile such reports), and (2) has been subject to such filing requirementsfor the past 90 days:  YES ý  NO o

 

Indicate by check mark whether theregistrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Exchange Act Rule 12b-2:Large accelerated filer o        Accelerated filer ý                           Non-accelerated filer o

 

Indicate by check mark whether the registrant is a shellcompany (as defined in Rule 12b-2 of the Exchange Act):YES o  NO ý

 

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practicabledate:

 
| **Class**                     | ** ** | **Shares Outstanding at April 30, 2006** |
|-------------------------------|------------|-------------------------------------------------------------------|
| Common  Stock, par value $.01 |       | 46,336,155                                                        |

 

 

----

 

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

 
| ** **                        | **Page**                                                                                                    |
|-----------------------------------|-------------------------------------------------------------------------------------------------------------|
| ** **                        | ** **                                                                                                  |
| ** **                        | ** **                                                                                                  |
| **Part I. Financial Information** | **3**                                                                                                       |
| ** **                        | ** **                                                                                                  |
| ** **                        | **Item 1. Financial Statements (Unaudited)**                                                                | **3** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Consolidated balance sheets as of March 31,  2006 and December 31, 2005**                                 | **3** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Consolidated statements of operations for the three months ended  March 31, 2006 and 2005**               | **4** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Consolidated statements of shareholders’ equity for the three months ended March 31, 2006 and 2005** | **5** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Consolidated statements of cash flows for the three months ended  March 31, 2006 and 2005**               | **6** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Notes to consolidated financial statements**                                                              | **7** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Item 2. Management’s Discussion and Analysis of Financial Condition  and Results of Operations**     | **20** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Item 3. Quantitative and Qualitative Disclosures  about Market Risk**                                     | **33** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Item 4. Controls and Procedures**                                                                         | **34** |
| ** **                        | ** **                                                                                                  | ** ** |
| **Part II. Other Information**    | **35**                                                                                                      |
| ** **                        | ** **                                                                                                  |
| ** **                        | **Item 1. Legal Proceedings**                                                                               | **35** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Item 1A. Risk Factors**                                                                                   | **37** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Item 2. Unregistered Sales of Equity  Securities and Use of Proceeds**                                    | **37** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Item 3. Defaults Upon Senior Securities**                                                                 | **38** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Item 4. Submission of Matters to a Vote of  Security Holders**                                            | **38** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Item 5. Other Information**                                                                               | **38** |
| ** **                        | ** **                                                                                                  | ** ** |
| ** **                        | **Item 6. Exhibits**                                                                                        | **38** |
| ** **                        | ** **                                                                                                  | ** ** |
| **Signature Page**                | **39**                                                                                                      |
| ** **                        | ** **                                                                                                  |
| **Index to Exhibits**             | **40**                                                                                                      |

 

2

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**Part I. Financial Information**

 

**Item 1. Financial Statements (Unaudited)**

 

**NetBank, Inc.**

**Consolidated Balance Sheets**

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

 
| ** **                                                                                                       | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| ** **                                                                                                       | ** ** | **(unaudited)**          | ** ** | **(audited)**               | ** ** |
| **Assets**                                                                                                       | ** ** | ** **               | ** ** | ** **                  | ** ** |
| Cash and cash equivalents:                                                                                       |       |                     |       |                        |       |
| Cash and due from banks                                                                                          |       | $                        | 151,609    |                        | $          | 126,666 |   |
| Federal funds sold                                                                                               |       | 26,599                   |       | 23,590                      |       |
| Total cash and cash equivalents                                                                                  |       | 178,208                  |       | 150,256                     |       |
| Investment securities available for sale-at  fair value (amortized costs of $628,620 and $638,919, respectively) |       | 606,959                  |       | 626,077                     |       |
| Stock of Federal Home Loan Bank of Atlanta –  at cost                                                       |       | 54,359                   |       | 67,049                      |       |
| Loans held for sale                                                                                              |       | 974,430                  |       | 1,233,918                   |       |
| Loan and lease receivables – net of  allowance for credit losses of $28,302 and $27,601, respectively       |       | 2,192,073                |       | 2,224,363                   |       |
| Mortgage servicing rights – net                                                                             |       | 212,094                  |       | 201,880                     |       |
| Accrued interest receivable                                                                                      |       | 16,849                   |       | 16,698                      |       |
| Furniture, equipment and capitalized software  – net                                                        |       | 54,053                   |       | 54,420                      |       |
| Goodwill and other intangibles – net                                                                        |       | 84,918                   |       | 85,097                      |       |
| Due from servicers and investors                                                                                 |       | 20,699                   |       | 26,557                      |       |
| Other assets                                                                                                     |       | 74,209                   |       | 85,304                      |       |
| **Total assets**                                                                                                 |       | $                        | 4,468,851  |                        | $          | 4,771,619 |   |
|                                                                                                             |       |                     |       |                        |       |
| **Liabilities, minority interests and  shareholders’ equity**                                               |       |                     |       |                        |       |
| **Liabilities:**                                                                                                 |       |                     |       |                        |       |
| Deposits                                                                                                         |       | $                        | 2,826,267  |                        | $          | 2,793,847 |   |
| Other borrowed funds                                                                                             |       | 1,056,692                |       | 1,348,240                   |       |
| Subordinated debt                                                                                                |       | 32,477                   |       | 32,477                      |       |
| Accrued interest payable                                                                                         |       | 17,301                   |       | 17,595                      |       |
| Loans in process                                                                                                 |       | 29,448                   |       | 34,060                      |       |
| Representations and warranties                                                                                   |       | 16,234                   |       | 20,668                      |       |
| Accounts payable and accrued liabilities                                                                         |       | 105,402                  |       | 123,877                     |       |
| Total liabilities                                                                                                |       | 4,083,821                |       | 4,370,764                   |       |
|                                                                                                             |       |                     |       |                        |       |
| Commitments and contingencies – note 12                                                                     |       | —                   |       | —                      |       |
| Minority  interests in affiliates                                                                                |       | 613                      |       | 676                         |       |
|                                                                                                             |       |                     |       |                        |       |
| **Shareholders’ equity:**                                                                                   |       |                     |       |                        |       |
| Preferred stock, no par (10,000,000 shares  authorized; none issued and outstanding)                             |       | —                   |       | —                      |       |
| Common stock, $.01 par (100,000,000 shares  authorized, 52,820,308 and 52,820,308 shares issued, respectively)   |       | 528                      |       | 528                         |       |
| Additional paid-in capital                                                                                       |       | 433,109                  |       | 432,140                     |       |
| Retained earnings                                                                                                |       | 27,173                   |       | 39,005                      |       |
| Accumulated other comprehensive loss, net  of taxes of $8,231 and $4,877, respectively                           |       | (13,430                  | )          | (7,965                      | )          |
| Treasury stock, at cost (6,499,995 and 6,423,691  shares, respectively)                                          |       | (62,963                  | )          | (62,276                     | )          |
| Unearned compensation                                                                                            |       | —                   |       | (1,253                      | )          |
| **Total shareholders’ equity**                                                                              |       | 384,417                  |       | 400,179                     |       |
| **Total liabilities, minority interests and  shareholders’ equity**                                         |       | $                        | 4,468,851  |                        | $          | 4,771,619 |   |

 

See notes to consolidated financial statements.

 

3

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**NetBank, Inc.**

**Consolidated Statements ofOperations**

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

 
| ** **                                                        | ** ** | **Three months ended March 31,** | ** ** |
|-------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                        | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
|                                                              |       |                                                 |       |   |   |
| **Interest income:**                                              |       |                                                 |       |   |   |
| Loans and leases                                                  |       | $                                                    | 57,915     |   | $ | 47,853 |   |
| Investment securities                                             |       | 8,414                                                |       | 8,788 |   |
| Short-term investments                                            |       | 546                                                  |       | 379 |   |
| Total interest income                                             |       | 66,875                                               |       | 57,020 |   |
|                                                              |       |                                                 |       |   |   |
| **Interest expense:**                                             |       |                                                 |       |   |   |
| Deposits                                                          |       | 21,897                                               |       | 13,216 |   |
| Other borrowed funds                                              |       | 17,120                                               |       | 13,027 |   |
| Total interest expense                                            |       | 39,017                                               |       | 26,243 |   |
| Net interest income                                               |       | 27,858                                               |       | 30,777 |   |
| Provision for credit losses                                       |       | 3,057                                                |       | 2,351 |   |
| Net interest income after provision for  credit losses            |       | 24,801                                               |       | 28,426 |   |
|                                                              |       |                                                 |       |   |   |
| **Non-interest income:**                                          |       |                                                 |       |   |   |
| Mortgage  servicing fees                                          |       | 12,619                                               |       | 12,262 |   |
| Amortization of mortgage servicing rights                         |       | (10,604                                              | )          | (10,628 | ) |
| Recovery of mortgage servicing rights                             |       | 3,611                                                |       | 680 |   |
| Gain on sales of securities, net                                  |       | —                                               |       | 2,477 |   |
| Losses on derivatives                                             |       | (6,698                                               | )          | (2,789 | ) |
| Service charges and fees                                          |       | 4,898                                                |       | 4,751 |   |
| Gains on sales of loans and mortgage  servicing rights            |       | 23,980                                               |       | 24,820 |   |
| Other income                                                      |       | 2,191                                                |       | 2,888 |   |
| Total non-interest income                                         |       | 29,997                                               |       | 34,461 |   |
|                                                              |       |                                                 |       |   |   |
| **Non-interest expense:**                                         |       |                                                 |       |   |   |
| Salaries and benefits                                             |       | 34,840                                               |       | 31,723 |   |
| Customer service                                                  |       | 3,353                                                |       | 3,124 |   |
| Marketing                                                         |       | 3,594                                                |       | 2,855 |   |
| Data processing                                                   |       | 4,544                                                |       | 4,375 |   |
| Depreciation and amortization                                     |       | 5,868                                                |       | 5,603 |   |
| Office expenses                                                   |       | 3,428                                                |       | 2,820 |   |
| Occupancy                                                         |       | 6,976                                                |       | 5,901 |   |
| Travel and entertainment                                          |       | 1,255                                                |       | 1,250 |   |
| Professional fees                                                 |       | 3,346                                                |       | 3,990 |   |
| Prepaid lost interest from curtailments                           |       | 615                                                  |       | 1,024 |   |
| Other expenses                                                    |       | 3,697                                                |       | 3,349 |   |
| Total non-interest expense                                        |       | 71,516                                               |       | 66,014 |   |
| Loss before income taxes                                          |       | (16,718                                              | )          | (3,127 | ) |
| Income tax benefit                                                |       | 5,767                                                |       | 1,098 |   |
| Net loss                                                          |       | $                                                    | (10,951    | ) | $ | (2,029 | ) |
|                                                              |       |                                                 |       |   |   |
| Net loss per common and potential common  shares outstanding:     |       |                                                 |       |   |   |
| Basic                                                             |       | $                                                    | (0.24      | ) | $ | (0.04 | ) |
| Diluted                                                           |       | $                                                    | (0.24      | ) | $ | (0.04 | ) |
|                                                              |       |                                                 |       |   |   |
| Weighted average common and potential  common shares outstanding: |       |                                                 |       |   |   |
| Basic and diluted                                                 |       | 46,262                                               |       | 46,366 |   |
|                                                              |       |                                                 |       |   |   |
| Dividends declared on common stock per  share                     |       | $                                                    | 0.02       |   | $ | 0.02 |   |

 

Seenotes to consolidated financial statements.

 

4

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**NetBank, Inc.**

**Consolidated Statements of Shareholders’Equity**

**(unaudited and in 000s)**

** **
| ** **                                                                                    | ** ** | **For the three months ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2006**                                                           | ** ** | **2005** | ** ** |
| **Common shares**                                                                             |       |                                                               |       |   |   |
| Beginning balance                                                                             |       | 52,820                                                             |       | 52,820 |   |
| Issuance of common shares                                                                     |       | —                                                             |       | — |   |
| Ending balance                                                                                |       | 52,820                                                             |       | 52,820 |   |
| **Common stock**                                                                              |       |                                                               |       |   |   |
| Beginning balance                                                                             |       | $                                                                  | 528        |   | $ | 528 |   |
| Issuance of common stock                                                                      |       | —                                                             |       | — |   |
| Ending balance                                                                                |       | $                                                                  | 528        |   | $ | 528 |   |
| **Paid-in capital**                                                                           |       |                                                               |       |   |   |
| Beginning balance                                                                             |       | $                                                                  | 432,140    |   | $ | 432,132 |   |
| Reclassification of unearned compensation  balance upon adoption of SFAS 123(R)               |       | 277                                                                |       | — |   |
| Stock-based compensation cost                                                                 |       | 1,417                                                              |       | — |   |
| Re-issuance of shares of common stock                                                         |       | (725                                                               | )          | — |   |
| Ending balance                                                                                |       | $                                                                  | 433,109    |   | $ | 432,132 |   |
| **Retained earnings**                                                                         |       |                                                               |       |   |   |
| Beginning balance                                                                             |       | $                                                                  | 39,005     |   | $ | 43,849 |   |
| Net loss                                                                                      |       | (10,951                                                            | )          | (2,029 | ) |
| Cash dividends declared                                                                       |       | (926                                                               | )          | (926 | ) |
| Reclassification of unearned compensation  balance upon adoption of SFAS 123(R)               |       | 265                                                                |       | — |   |
| Loss on re-issuance of shares of common  stock                                                |       | (220                                                               | )          | (341 | ) |
| Ending balance                                                                                |       | $                                                                  | 27,173     |   | $ | 40,553 |   |
| **Accumulated other comprehensive loss**                                                      |       |                                                               |       |   |   |
| Beginning balance                                                                             |       | $                                                                  | (7,965     | ) | $ | (1,136 | ) |
| Realized gain on sale of securities, net of  taxes                                            |       | —                                                             |       | (1,536 | ) |
| Unrealized loss on securities, net of taxes                                                   |       | (5,465                                                             | )          | (4,066 | ) |
| Ending balance                                                                                |       | $                                                                  | (13,430    | ) | $ | (6,738 | ) |
| **Treasury stock, at cost**                                                                   |       |                                                               |       |   |   |
| Beginning balance                                                                             |       | $                                                                  | (62,276    | ) | $ | (61,087 | ) |
| Reclassification of unearned compensation  balance upon adoption of SFAS 123(R)               |       | (1,795                                                             | )          | — |   |
| Re-issuances of shares of common stock, net  of purchases                                     |       | 1,108                                                              |       | (2,898 | ) |
| Employee forfeitures of unearned  compensation                                                |       | —                                                             |       | (35 | ) |
| Ending balance                                                                                |       | $                                                                  | (62,963    | ) | $ | (64,020 | ) |
| **Unearned compensation**                                                                     |       |                                                               |       |   |   |
| Beginning balance                                                                             |       | $                                                                  | (1,253     | ) | $ | (259 | ) |
| Reclassification of unearned compensation  balance upon adoption of SFAS 123(R)               |       | 1,253                                                              |       | — |   |
| Amortization of unearned compensation                                                         |       | —                                                             |       | 29 |   |
| Employee forfeitures of unearned  compensation                                                |       | —                                                             |       | 35 |   |
| Ending balance                                                                                |       | $                                                                  | —     |   | $ | (195 | ) |
| **Total shareholders’ equity**                                                           |       | $                                                                  | 384,417    |   | $ | 402,260 |   |
|                                                                                          |       |                                                               |       |   |   |
| **Comprehensive loss**                                                                        |       |                                                               |       |   |   |
| Net loss                                                                                      |       | $                                                                  | (10,951    | ) | $ | (2,029 | ) |
| Realized gain on sale of securities, net of  taxes of $0 and $941, respectively               |       | —                                                             |       | (1,536 | ) |
| Change in unrealized loss on securities,  net of taxes of $(3,350) and $(2,492), respectively |       | (5,465                                                             | )          | (4,066 | ) |
| Comprehensive loss                                                                            |       | $                                                                  | (16,416    | ) | $ | (7,631 | ) |

 

Seenotes to consolidated financial statements.

 

5

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**NetBank, Inc.**

**Consolidated Statements of Cash Flows**

**(unaudited and in 000s)**

 
| ** **                                                                              | ** ** | **Three months ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Operating activities:                                                                   |       |                                             |       |   |   |
| Net loss                                                                                |       | $                                                | (10,951    | ) | $ | (2,029 | ) |
| Adjustments to reconcile net loss to net  cash provided by operating activities:        |       |                                             |       |   |   |
| Depreciation and amortization                                                           |       | 5,868                                            |       | 5,603 |   |
| Amortization of premiums on investment  securities, loan and lease receivables and debt |       | 5,243                                            |       | 4,303 |   |
| Origination of loans held for sale                                                      |       | (2,815,262                                       | )          | (2,738,208 | ) |
| Repurchase of previously sold mortgages                                                 |       | (28,755                                          | )          | (31,039 | ) |
| Proceeds from sales of loans held for sale                                              |       | 3,123,198                                        |       | 2,847,354 |   |
| Net gains on sales of mortgage loans and  servicing rights                              |       | (23,980                                          | )          | (24,820 | ) |
| Capitalization of mortgage servicing rights                                             |       | (4,776                                           | )          | (6,219 | ) |
| Proceeds from sales of mortgage servicing  rights                                       |       | 902                                              |       | 491 |   |
| Mark-to-market adjustment on mortgage  servicing rights                                 |       | (13,480                                          | )          | (5,268 | ) |
| Amortization of mortgage servicing rights,  net of recoveries                           |       | 6,993                                            |       | 9,948 |   |
| Provision for credit losses                                                             |       | 3,057                                            |       | 2,351 |   |
| Stock-based compensation cost                                                           |       | 1,561                                            |       | — |   |
| Amortization of unearned compensation                                                   |       | —                                           |       | 29 |   |
| Gains on sales of investment securities,  net                                           |       | —                                           |       | (2,477 | ) |
| Changes in assets and liabilities which provide  (use) cash:                            |       |                                             |       |   |   |
| Increase in accrued interest receivable                                                 |       | (151                                             | )          | (746 | ) |
| Decrease in due from servicers and  investors                                           |       | 5,858                                            |       | 29,758 |   |
| Decrease (increase) in other assets                                                     |       | 11,095                                           |       | (7,105 | ) |
| Decrease in accrued interest payable                                                    |       | (294                                             | )          | (456 | ) |
| (Decrease) increase in loans in process                                                 |       | (4,612                                           | )          | 20,117 |   |
| (Decrease) increase in accounts payable and  accrued liabilities                        |       | (15,265                                          | )          | 11,464 |   |
| Net cash provided by operating activities                                               |       | 246,249                                          |       | 113,051 |   |
|                                                                                    |       |                                             |       |   |   |
| Investing activities:                                                                   |       |                                             |       |   |   |
| Purchases of available for sale securities                                              |       | (9,996                                           | )          | (161,965 | ) |
| Principal repayments on available for sale  securities                                  |       | 20,220                                           |       | 25,773 |   |
| Sales and maturities of available for sale  securities                                  |       | —                                           |       | 89,044 |   |
| Bulk purchase of mortgage servicing rights                                              |       | —                                           |       | (36,395 | ) |
| Sales (purchases) of Federal Home Loan Bank  Stock                                      |       | 12,690                                           |       | (10,926 | ) |
| Origination and purchase of loan and lease  receivables                                 |       | (151,704                                         | )          | (171,676 | ) |
| Principal repayments on loan and lease  receivables                                     |       | 175,769                                          |       | 137,632 |   |
| Purchases of furniture, equipment and  capitalization of software, net of disposals     |       | (4,603                                           | )          | (2,593 | ) |
| Capitalization of amortizable intangibles                                               |       | (143                                             | )          | (2,002 | ) |
| Acquisition of goodwill                                                                 |       | (576                                             | )          | (7 | ) |
| Change in minority interest                                                             |       | (63                                              | )          | 64 |   |
| Net cash provided by (used in) investing  activities                                    |       | 41,594                                           |       | (133,051 | ) |
|                                                                                    |       |                                             |       |   |   |
| Financing activities:                                                                   |       |                                             |       |   |   |
| Increase (decrease) in deposits                                                         |       | 32,420                                           |       | (47,953 | ) |
| Proceeds from other borrowed funds                                                      |       | 4,893,888                                        |       | 2,132,956 |   |
| Repayments of other borrowed funds                                                      |       | (5,185,436                                       | )          | (2,063,132 | ) |
| Net proceeds from issuance of subordinated  notes                                       |       | —                                           |       | 20,620 |   |
| Net re-issuances (purchases) of treasury  stock                                         |       | 163                                              |       | (3,239 | ) |
| Dividend payments on common stock                                                       |       | (926                                             | )          | (926 | ) |
| Net cash (used in) provided by financing  activities                                    |       | (259,891                                         | )          | 38,326 |   |
| Net increase in cash and cash equivalents                                               |       | 27,952                                           |       | 18,326 |   |
| Cash and cash equivalents:                                                              |       |                                             |       |   |   |
| Cash, beginning of period                                                               |       | 150,256                                          |       | 150,302 |   |
| Cash, end of period                                                                     |       | $                                                | 178,208    |   | $ | 168,628 |   |
|                                                                                    |       |                                             |       |   |   |
| Supplemental disclosures of cash flow  information:                                     |       |                                             |       |   |   |
| Cash paid during the period for interest                                                |       | $                                                | 39,311     |   | $ | 26,699 |   |
| Cash paid during the period for income  taxes                                           |       | $                                                | 318        |   | $ | 527 |   |

 

See notes to consolidated financial statements.

 

6

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**NETBANK, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTSMarch 31, 2006(unaudited)**

 

**1.**                                      ORGANIZATION AND BASIS OF PRESENTATION

** **

NetBank, Inc. is a financial holding companyengaged primarily in retail banking, mortgage banking, business finance andproviding ATM and merchant processing services. NetBank, Inc. wholly owns theoutstanding stock of:  NetBank (“NetBank,FSB” or the “Bank”), a federal savings bank; MG Reinsurance Company (“MGReinsurance”), a captive reinsurance company; NetInsurance, Inc. (“NetInsurance”),a licensed insurance agency; and NB Partners, Inc., a corporation involved instrategic partnering opportunities. NetBank, FSB owns all of the outstandingstock of:  Market Street MortgageCorporation (“Market Street”), a retail mortgage company; NetBank PaymentSystems, Inc. (“NPS”), a provider of ATM and merchant processing services forretail and other non-bank businesses; Meritage Mortgage Corporation (“Meritage”),a wholesale non-conforming mortgage provider; and Financial Technologies, Inc.(“FTI”), a provider of transaction processing services to other financialservices companies. NetBank, FSB’s wholesale mortgage division operates asNetBank Funding Services (“NetBank Funding”); its business financing divisionoperates as “NetBank Business Finance”; its automobile financing divisionoperates as “Dealer Financial Services”; and its recreational vehicle financingdivision operates as “Beacon Credit Services”. The consolidated company is referred to herein as “we,” “us,”  “our,” “NetBank,” or “the Company”.

 

In the opinion of management,the unaudited consolidated financial statements included herein reflect alladjustments, consisting only of normal recurring accruals, which are necessaryfor the fair presentation of the financial condition and results of operationsfor the interim periods presented. Certain information and footnote disclosuresnormally included in financial statements have been condensed or omittedpursuant to applicable rules and regulations of the Securities and ExchangeCommission (“SEC”). The financial statements included herein should be read inconjunction with the financial statements and notes thereto included in ourAnnual Report on Form 10-K filed with the SEC for the year endedDecember 31, 2005 (“2005 Form 10-K”). The results of operations for the interimperiods reported herein are not necessarily indicative of results to beexpected for the full year. Certain 2005 amounts have been reclassified forcomparability with 2006 amounts.

 

Unless otherwise noted, all dollar figures arepresented in thousands (000s), except per share data.  All of the Company’s operations and assetsare located within the United States of America.

 

**2.**                                      ACQUISITIONS

** **

**Duringthe three months ended March 31, 2006, NPS acquired certain assets orprocessing contracts of various smaller ATM and merchant processors.  These acquisitions were accounted for aspurchases, and as such, approximately $103 of amortizable intangibles wererecorded.  Consideration for these assetsand processing contracts totaled $103.**

** **

InDecember 2004, the Company, through its Market Street subsidiary, acquired19 retail branch offices and certain associated assets of Guaranty ResidentialLending, Inc., a mortgage banking business, pursuant to an Asset Purchaseand Assignment Agreement. The consideration paid, including transaction costs,was approximately $2 million. The acquisition was accounted for as a purchase,and, accordingly, all assets and liabilities were recorded at fair value. Assuch, $1.7 million in goodwill, including transaction costs, was recorded. TheCompany paid additional consideration in the first quarter of 2006 of $576 and maybe obligated to pay an additional $788 over the next year provided thatspecific production goals as identified in the Asset Purchase Agreement are met.Any additional payments will be recorded as goodwill.   The results of operations for the acquiredbranches have been included from the date of acquisition.

 

7

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**3.**                                      ACCOUNTING POLICIES

** **

Reference is made to ouraccounting policies described in the notes to consolidated financial statementscontained in our 2005 Form 10-K. The Company has followed those policiesin preparing this report.

 

*Significant Estimates.*The preparation of theconsolidated financial statements in conformity with accounting principlesgenerally accepted in the United States (“GAAP”) requires management to makeestimates and assumptions that affect the amounts reported in the consolidatedfinancial statements and accompanying notes.  Such estimates relate to the Company’sallowance for credit losses; the fair values of loans held for sale, loan andlease receivables, mortgage servicing rights, servicing hedges and the Company’sother hedging instruments; and reserves for estimated losses on representationsand warranties provided to purchasers of loans or mortgage servicing rights.Because of the inherent uncertainties associated with any estimation processand due to possible future changes in market and economic conditions that willaffect fair values, it is possible that actual future results and realizationof the underlying assets and liabilities could differ significantly from theamounts reflected as of the balance sheet date.

 

*Stock-BasedCompensation.*Our stock-based compensation plans aredescribed in note 9 to these consolidated financial statements. Prior toJanuary 1, 2006, we accounted for these stock-based employee compensation plansunder the measurement principles and recognition provisions of AccountingPrinciples Board Opinion No. 25, *Accounting for StockIssued to Employees,*and related Interpretations. Accordingly, werecorded no stock option-based employee compensation cost for options grantedduring the three month period ended March 31, 2005, as all options grantedunder those plans had an exercise price equal to or greater than the marketvalue of the underlying common stock on the date of grant. We also recorded nocompensation cost during the three month period ended March 31, 2005 inconnection with the NetBank, Inc. Employee Stock Purchase Plan (“the Stock Plan”)as the purchase price of the stock was 85% of the market value on the purchasedate.  In accordance with Statement ofFinancial Accounting Standard No. 123 (“SFAS 123”), *Accountingfor Stock-Based Compensation – Transition and Disclosure,*weprovided pro forma net income or loss and net income or loss per share for eachperiod prior to January 1, 2006 as if we had applied the fair value-basedmethod in measuring compensation cost for our share based compensation plans.

 

Effective January 1, 2006, we adopted thefair value recognition provisions of Statement of Financial Accounting StandardsNo. 123(R) (“SFAS 123(R)”), *Share-Based Payment*,using the modified prospective transition method. Under the modifiedprospective transition method, results for prior periods have not beenrestated. In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (“SAB107”), which provides supplemental implementation guidance for SFAS 123(R). Wehave applied the provisions of SAB 107 in our adoption of SFAS 123(R). See note9 to these consolidated financial statements for information on the impact ofour adoption of SFAS 123(R) and the assumptions used to calculate the fairvalue of stock-based employee compensation.

 

*Recent Accounting Pronouncements*

 

On March 17, 2006, the Financial AccountingStandards Board (“FASB”) issued Statement No.156 (“SFAS 156”), *Accounting for Servicing of Financial Assets an amendment of FASBStatement No. 140*, *Accounting for Transfersand Servicing of Financial Assets and Extinguishments of Liabilities.*SFAS 156 requires that all servicing assets and liabilities be initiallymeasured at fair value and allows for two alternatives in the subsequentaccounting for servicing assets and liabilities: the amortization method andthe fair value method.  The amortization method requires that theservicing assets and liabilities be amortized over the remaining estimatedlives of the serviced assets with impairment testing to be performedperiodically.  The fair value method requires the servicing assets andliabilities to be measured at fair value each period with an offset to income. SFAS 156 is to be adopted in the first fiscal year that begins afterSeptember 15, 2006 and early adoption is permitted.  An entity can electthe fair value method at the beginning of any fiscal year provided that interimfinancial statements have not been issued.  However, once the fair valueelection is made, an entity cannot revert back to the amortization method,NetBank has not yet adopted the fair value method.

 

In May 2005, the FASB issued Statement ofFinancial Accounting Standards No. 154 (“SFAS 154”), *AccountingChanges and Error Corrections - a replacement of*

 

8

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APB No. 20, and Statement No. 3, which requiredthe inclusion of the cumulative effect of changes in accounting principle innet income in the period of change.  SFAS 154 establishes, unlessimpracticable, retrospective application to prior periods’ financial statementsas the required method for reporting a voluntary change in accounting principlein the absence of explicit transition requirements specific to the newlyadopted accounting principle.  SFAS 154 is effective for accountingchanges and corrections of errors made in fiscal years beginning after December15, 2005.  The Company will assess the impact of a retrospectiveapplication of a change in accounting principle in accordance with SFAS 154 ifthe need for such a change arises in the future.

 

InMarch 2004, the FASB’s Emerging Issues Task Force (“EITF”) supplementedEITF 03-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*. EITF 03-1 provides guidancefor evaluating whether an investment is other-than-temporarily impaired andrequires disclosures about unrealized losses on available for sale debt andequity securities. In November 2005, FASB Staff Position Statement ofFinancial Accounting Standards No. FAS 115-1 (“FSP FAS 115-1”) was issued toaddress EITF 03-1 implementation issues and outlines a three step model foridentifying investment impairments. FSP FAS 115-1 carries forward thedisclosure requirements of EITF 03-1 and is effective for reporting periodsbeginning after December 15, 2005.  Theadoption of FSP FAS 115-1 did not have a material impact on the Company’sbalance sheet or statement of operations.

 

**4.**                                      LOAN AND LEASE RECEIVABLES

** **

Our portfolio of loan and leasereceivables consists primarily of internally originated 1-4 family first andsecond mortgage loans, home equity loans, automobile loans, business equipmentfinancing leases, marine, and recreational vehicle loans.

 

As of March 31, 2006 andDecember 31, 2005 the Company had unamortized net premiums on its loan andlease receivables of $37,670 and $37,826, respectively. At March 31, 2006 andDecember 31, 2005, $83 and $6, respectively, of the Company’s net premiumswere associated with purchased as opposed to originated loans. The following isa summary of the Company’s loan and lease receivables portfolio:

 
| ** **                       | ** ** | **As of March 31, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|----------------------------------|------------|----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                       | ** ** | **Amount**                                   | ** ** | **%**                                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| First mortgages                  |       | $                                            | 782,763    |                                            | 35.3       | % | $ | 824,431 |   | 36.6 | % |
| Second mortgages                 |       | 107,187                                      |       | 4.8                                             | %          | 115,188 |   | 5.1 | % |
| Leases                           |       | 418,937                                      |       | 18.9                                            | %          | 406,053 |   | 18.0 | % |
| Auto                             |       | 631,648                                      |       | 28.4                                            | %          | 610,924 |   | 27.1 | % |
| Home equity lines                |       | 238,880                                      |       | 10.8                                            | %          | 257,991 |   | 11.5 | % |
| Consumer                         |       | 40,960                                       |       | 1.8                                             | %          | 37,377 |   | 1.7 | % |
| Total                            |       | 2,220,375                                    |       | 100.0                                           | %          | 2,251,964 |   | 100.0 | % |
| Less allowance for credit losses |       | (28,302                                      | )          |                                            |       | (27,601 | ) |   |   |
| Total                            |       | $                                            | 2,192,073  |                                            |       |   | $ | 2,224,363 |   |   |   |

 

Our lease receivables consistprimarily of business equipment leases originated and serviced by the NetBankBusiness Finance division. In addition to originated lease receivables,NetBank, FSB owns a portfolio of purchased lease receivables originated by CommercialMoney Center, Inc. (“CMC”). NetBank, FSB is involved in litigation withthree insurance companies who are sureties on the purchased receivables. Sincethe second quarter of 2002, the entire portfolio of lease receivablesoriginated by CMC has been on non-accrual status pending the outcome of thelitigation.  NetBank, FSB has filed aclaim against CMC and the insurance company sureties for all payments that arecurrently past due, approximately $90 million at March 31, 2006.  The recorded balance of CMC leases receivableas of March 31, 2006 was $25,762.

 

9

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

 

The Company considers a loan or lease receivable to be impaired when itis probable that it will be unable to collect all amounts due according to theoriginal terms of the loan or lease agreement. The Company measures impairment of a loan or lease on a loan-by-loan orlease-by-lease basis.  Amounts ofimpaired loans or leases that are not probable of collection are charged offimmediately.

The following table details the Company’snon-accrual and troubled debt restructurings:

 
| ** **                       | ** ** | **As of  March 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|----------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Loan and lease receivables (1)   |       | $                                        | 31,976     |                                        | $          | 33,049 |   |
| Loans held for sale (1)          |       | $                                        | 41,219     |                                        | $          | 49,635 |   |
| Troubled debt restructurings (2) |       | $                                        | 7,387      |                                        | $          | 6,782 |   |

 

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

 

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

 

Non-performing loan and leasereceivables as of March 31, 2006 and December 31, 2005 included $25,762 and$26,054, respectively, of non-performing lease receivables related to the CMClease portfolio.

 

On average, the Company held approximately$85,024 and $73,412 of restructured and non-accrual loans during the threemonths ended March 31, 2006 and 2005, respectively. Foregone interest for thethree months ended March 31, 2006 and 2005 was approximately $1,377 and $1,064,respectively. The Company had $10,806 and $8,200 in repossessed assetsconsisting primarily of residential mortgage loan foreclosures at March 31,2006 and December 31, 2005, respectively.

 

10

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The following is a summary ofthe allowance for credit losses:

 
| ** **                                                                      | ** ** | **Three months ended March 31,** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------------------------------------|------------|
| ** **                                                                      | ** ** | **2006**                                             | ** ** | **2005** | ** ** |
| **Beginning balance**                                                           |       | $                                                    | 27,601     |   | $ | 24,462 |   |
| Provision for credit losses                                                     |       | 3,057                                                |       | 2,351 |   |
| Charge-offs:                                                                    |       |                                                 |       |   |   |
| First mortgages                                                                 |       | —                                               |       | — |   |
| Second mortgages                                                                |       | (52                                                  | )          | (1 | ) |
| Leases                                                                          |       | (1,919                                               | )          | (1,550 | ) |
| Auto                                                                            |       | (1,500                                               | )          | (901 | ) |
| Home equity lines                                                               |       | (33                                                  | )          | (22 | ) |
| Consumer                                                                        |       | (12                                                  | )          | (27 | ) |
| Total charge-offs                                                               |       | (3,516                                               | )          | (2,501 | ) |
| Recoveries:                                                                     |       |                                                 |       |   |   |
| First mortgages                                                                 |       | —                                               |       | 1 |   |
| Second mortgages                                                                |       | 9                                                    |       | 42 |   |
| Leases                                                                          |       | 515                                                  |       | 448 |   |
| Auto                                                                            |       | 629                                                  |       | 249 |   |
| Home equity lines                                                               |       | 7                                                    |       | 23 |   |
| Consumer                                                                        |       | —                                               |       | — |   |
| Total recoveries                                                                |       | 1,160                                                |       | 763 |   |
| Total charge-offs, net                                                          |       | (2,356                                               | )          | (1,738 | ) |
| **Ending balance**                                                              |       | $                                                    | 28,302     |   | $ | 25,075 |   |
| Allowance for credit losses as a percent of  average loan and lease receivables |       | 1.3                                                  | %          | 1.2 | % |

** **

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

** **

The Company accounts for itsentire mortgage servicing rights (“MSR”) portfolio at the aggregate of thelower of cost or market (“LOCOM”). For purposes of evaluating the MSR portfoliofor impairment, the Company disaggregates its MSR portfolio into two primarygroupings: available for sale and held for sale.

 

The segment of the portfolio designated as available for sale iscomposed of MSRs that were retained out of production pursuant to individualportfolio retention decisions or purchased in bulk transactions. The availablefor sale portfolio is disaggregated for purposes of measuring potentialimpairments according to defined risk tranches. The Company has defined theserisk tranches based upon interest rate band and product type.  With respect to each such risk tranche, thefair value thereof, which is based upon an internal analysis that considerscurrent market conditions, prevailing interest rates, prepayment speeds,default rates and other relevant factors, is compared to amortized carryingvalues of the MSRs for purposes of measuring potential impairment.

 

The segment of the portfolio designated asheld for sale is composed of recently produced MSRs that are scheduled for saleand have been allocated to specific forward servicing sales contracts.  The held for sale portfolio is disaggregatedfor purposes of measuring possible impairments according to the specificforward sales contracts to which the MSR is allocated. For each such risktranche, the fair value is based upon the allocated forward committed deliveryprice, which is compared to amortized carrying value for purposes of measuringpotential impairment.

 

11

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The following amounts relate to the Company’sMSR portfolio:

 
| ** **                                 | ** ** | **Available for sale** | ** ** | **Held for sale** | ** ** |
|--------------------------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| ** **                                 | ** ** | **March 31,  2006**         | ** ** | **December 31,  2005** | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
| Unpaid Principal Balance (“UPB”) |       | $                                | 12,839,850 |                        | $          | 13,155,256 |   | $ | 160,447 |   | $ | 143,515 |   |
| Carrying value                             |       | $                                | 210,282    |                        | $          | 200,371 |   | $ | 1,812 |   | $ | 1,509 |   |
| Carrying value / UPB                       |       | 1.64                             | %          | 1.52                        | %          | 1.13 | % | 1.05 | % |
| Fair value                                 |       | $                                | 211,151    |                        | $          | 201,034 |   | $ | 1,812 |   | $ | 1,509 |   |
| Fair value / UPB                           |       | 1.64                             | %          | 1.53                        | %          | 1.13 | % | 1.05 | % |
| Weighted average note rate                 |       | 5.89                             | %          | 5.89                        | %          | 6.43 | % | 6.47 | % |
| Weighted average service fee               |       | 0.32                             | %          | 0.32                        | %          | 0.37 | % | 0.35 | % |
| Net basis as multiple                      |       | 5.12                             |       | 4.76                        |       | 3.07 |   | 3.00 |   |
|                                            |            |                                  |            |                             |            |  |  |  |  |  |  |  |  |  |

 

The following table summarizeschanges in the impairment reserve for the Company’s MSRs for the three monthsended March 31, 2006 and 2005:

 
| ** **                   | ** ** | **Three months ended  March 31,** | ** ** |
|------------------------------|------------|--------------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Beginning balance            |       | $                                                | 51,502     |   | $ | 65,557 |   |
| Servicing valuation recovery |       | (3,611                                           | )          | (680 | ) |
| Ending balance               |       | $                                                | 47,891     |   | $ | 64,877 |   |

 

**See note 13 to these consolidated financialstatements for further information regarding the Company’s MSRs.**

 

**7.**                                      DEPOSITS

 

The following table setsforth the dollar amount of deposits and weighted average interest rates of thevarious types of deposit programs offered by the Company:

 
| ** **                             | ** ** | **As of March 31, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|----------------------------------------|------------|----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                             | ** ** | **Amount**                                   | ** ** | **Percentage**                                  | ** ** | **Weighted  average  interest rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest rate** | ** ** |
| Non-interest bearing checking accounts |       | $                                            | 301,370    |                                            | 10.6       | % | — |   | $ | 284,046 |   | 10.2 | % | — |   |
| Interest bearing:                      |       |                                         |       |                                            |       |   |   |   |   |   |   |   |   |
| Checking accounts                      |       | 233,305                                      |       | 8.3                                             | %          | 0.9 | % | 232,658 |   | 8.3 | % | 0.9 | % |
| Money market                           |       | 917,778                                      |       | 32.5                                            | %          | 3.3 | % | 943,432 |   | 33.8 | % | 3.2 | % |
| Certificate of deposit under $100      |       | 1,279,327                                    |       | 45.3                                            | %          | 4.3 | % | 1,240,784 |   | 44.4 | % | 4.0 | % |
| Certificate of deposit over $100       |       | 94,487                                       |       | 3.3                                             | %          | 4.3 | % | 92,927 |   | 3.3 | % | 4.1 | % |
| Total deposits                         |       | $                                            | 2,826,267  |                                            | 100.0      | % |   |   | $ | 2,793,847 |   | 100.0 | % |   |   |

 

Accrued interest as of March 31, 2006 relatedto checking, money market and certificates of deposit accounts was $69, $986and $12,402, respectively.  Accruedinterest as of December 31, 2005 related to checking, money market, andcertificates of deposit accounts was $55, $777 and $12,620, respectively.  At March 31, 2006 and December 31, 2005, $538and $696 of overdrawn deposits were classified as loans, respectively.

 

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**8.****                                     ****BORROWINGS**

 

A summary of borrowings and available borrowings, grouped by year ofmaturity, as of March 31, 2006 follows:

 
| **Type of borrowing**        | ** ** | **Year of  maturity** | ** ** | **Range of stated  interest rates** | ** ** | **Principal amount  outstanding** | ** ** |
|----------------------------------------|------------|----------------------------|------------|----------------------------------------------------|------------|----------------------------------------|------------|
| $25 million line of credit             |       | 2006                       |       | Fed Funds + 0.25                                   | %*         | $                                      | —     |   |
| $75 million master repurchase facility |       | 2006                       |       | LIBOR + 1.25                                       | %*         | —                                 |       |
| $200 million warehouse line of credit  |       | 2006                       |       | LIBOR + 0.85                                       | %*         | —                                 |       |
| FHLB warehouse line                    |       | 2006                       |       | DRC + 0.50                                         | %*         | —                                 |       |
| FHLB overnight facility                |       | 2006                       |       | DRC                                                | *          | 71,700                                 |       |
| FHLB advances                          |       | 2006                       |       | 3.01 to 4.86                                       | %          | 500,000                                |       |
| FHLB advances                          |       | 2007                       |       | 2.57                                               | %          | 40,000                                 |       |
| FHLB advances                          |       | 2009                       |       | 2.45 to 4.64                                       | %          | 75,000                                 |       |
| FHLB advances                          |       | 2010                       |       | 3.63 to 3.97                                       | %          | 150,000                                |       |
| FHLB advances                          |       | 2011                       |       | 4.29 to 4.43                                       | %          | 50,000                                 |       |
| FHLB advances                          |       | 2014                       |       | 2.36 to 2.93                                       | %          | 110,000                                |       |
| Subordinated debt                      |       | 2032                       |       | LIBOR + 3.35                                       | %*         | 4,382                                  |       |
| Subordinated debt                      |       | 2033                       |       | LIBOR + 3.25                                       | %*         | 4,382                                  |       |
| Subordinated debt                      |       | 2034                       |       | LIBOR + 2.85                                       | %*         | 3,093                                  |       |
| Subordinated debt                      |       | 2034                       |       | LIBOR + 3.00                                       | %*         | 20,620                                 |       |
| Repurchase agreement                   |       | 2006                       |       | 4.60                                               | %*         | 59,992                                 |       |
| Total debt                             |       |                       |       |                                               |       | $                                      | 1,089,169  |   |

 

*                                         Indicatesa variable rate.

 

The total borrowings available through the Federal Home Loan Bank (“FHLB”)are determined each quarter based on a percentage of the total assets ofNetBank, FSB subject to limitations of available collateral.  During the first quarter of 2006, the Company’savailable borrowings as a percentage of total assets was reduced from 50% to35%.  The Company accesses this linethrough fixed and convertible term advances, as well as short-term advances,including thirty day and overnight borrowings. Five of the FHLB advances totaling$390,000 are fixed rate. The remaining advances totaling $535,000 are alsofixed rate; however, they may be converted at the FHLB’s option to adjustablerate based on the three month floating LIBOR. The FHLB warehouse line is anadjustable line of credit with a floating rate based on the daily rate credit (“DRC”)plus 50 basis points. This warehouse line can be used to fund mortgagesoriginated by the Company. All of the FHLB advances and the FHLB warehouse lineare secured by investment securities or mortgage loans. At March 31, 2006,$624,724 of investment securities and $1,073,971 of mortgage loans were pledgedto the FHLB as collateral for the various FHLB advances, the FHLB warehouseline and the overnight facility.

 

The $59,992 repurchase agreement was collateralized by $66,440 ofinvestment securities at March 31, 2006. This agreement matured on April 11,2006.

 

The Company’s subordinated debt is supported by trust preferredsecurities, which were issued in 2002, 2003 and 2005 in private pooled transactionsthrough off-balance sheet trusts: NBI Trust I, II, III and IV. Thesubordinated debt and the associated trust preferred securities carry variablerates and were initially priced at LIBOR plus a spread ranging from 2.85% to3.35% with a cap of 12.5% for five years after their respective date ofissuances. Interest payments and the resetting of the rates both occur on aquarterly basis. The debt is scheduled to mature from December 2032through December 2034 and cannot be redeemed by the trust for a minimum offive years after issuance.

 

Most of the revolving lines of credit, warehouse lines of credit (otherthan the FHLB warehouse line) and the master repurchase facilities are securedby mortgage loans and are subject to restrictive covenants. The covenantsinclude certain minimum net worth requirements, minimum tangible net worthrequirements, minimum financial ratios, capital requirements, maintenance ofservicer eligibility for various government agencies and certain minimumliquidity requirements, which are all defined in the terms of the related debtagreements. In addition, the covenants restrict the types of businessactivities in which the Company may engage. The Company was in compliance withall debt covenants in place as of March 31, 2006. Although managementanticipates complying with all current debt covenants, there can be noassurance that the Company or its individual subsidiaries will be able tocomply with all debt covenants in the future. Failure to comply could result inthe acceleration of the repayment of the related financing.

 

13

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Short-term debt outstanding reached thehighest month-end level during the three months ended March 31, 2006 on January31, 2006 with a short-term balance of $1,002,002.

 

**9.**                                      STOCK-BASED COMPENSATION

** **

The Company has adopted the 1996 StockIncentive Plan (the “Stock Plan”), which provides that employees, officers,directors and consultants of NetBank may be granted nonqualified and incentivestock options to purchase shares of common stock of NetBank, shares of NetBankcommon stock, derivative securities related to the value of the common stock,or cash awards.  Up to 9,500,000 sharesof our common stock may be issued under the Stock Plan.  Generally, the options vest within four yearsand expire ten years from the date of the grant.  Vesting ceases immediately upon employeetermination and any vested options are forfeited if not exercised within 90days of termination.  This exercise graceperiod is extended to one year in the case of a recipient’s death ordisability.

 

Prior to January 1, 2006, the Companyaccounted for the Stock Plan under the recognition and measurement provisionsof Accounting Principles Board 25 (“APB 25”), *Accountingfor Stock Issued to Employees,*and related Interpretations, aspermitted by Statement of Financial Accounting Standards No. 123 (“SFAS 123”), *Accounting for Stock-Based Compensation.*  No stock-based employee compensation costrelated to options was recognized in the Statement of Operations for periodsending prior to January 1, 2006, as all options granted under the Stock Planhad an exercise price equal to the market value of the underlying common stockon the date of grant.

 

Effective January 1, 2006, the Companyadopted the fair value recognition provisions of Statement of FinancialAccounting Standards No. 123 (revised 2004), *Share-BasedPayment,*using the modified prospective transition method.  Under this transition method, compensationcost recognized in the first quarter of 2006 includes: (a) compensation costfor all share-based payments granted prior to, but not yet vested as of January1, 2006, based on the grant-date fair value estimated in accordance with theoriginal provisions of SFAS 123, and (b) compensation cost for all share-basedpayments granted subsequent to January 1, 2006, based on the grant-date fairvalue determined in accordance with the provisions of SFAS 123(R).  The Company recognized $1.13 million ofexpense during the quarter ended March 31, 2006 related to stock options.  As provided using the modified prospectivetransition method, results for prior periods have not been restated.

 

In addition to providing for the issuance ofoptions, the Stock Plan also provides for the grant of stock awards.  Compensation expense related to stock awardswas recognized on a straight-line basis over the vesting period and included inthe Statement of Operations before adoption of SFAS 123(R).  With the adoption of SFAS 123(R), effectiveJanuary 1, 2006, the Company modified the calculation of compensation expenserelated to stock awards to include both a straight-line basis over the vestingperiod and an estimation of forfeitures. For the quarters ended March 31, 2006 and 2005, the Company recognized$391 and $23 of expense related to stock awards, respectively.

 

The Company also adopted the Mid-TermIncentive Plan (the “Mid-Term Plan”) which is administered under the StockPlan.  On January 1, 2004, theCompensation Committee granted incentive awards under the Mid-Term Plan.  The awards are payable only if the Companyachieves specified levels of consolidated earnings per share and earnings pershare of its retail banking, financial intermediary and transaction processing segmentsduring the two- and three-year performance periods ending December 31, 2005 and2006, respectively.  Awards aredenominated in cash but payable in shares of restricted stock, with 50 percentof the shares vesting immediately after the last day of the relevantperformance period and 25 percent of the shares vesting at the end of each ofthe first and second years thereafter. In the case of a recipient’s death, disability, retirement, ortermination of employment without cause, awards would vest in full prior to thelast day of the performance period, based on actual performance to the vestingdate.  In addition, if the recipient’semployment is constructively terminated in the 18-month period after a changeof control event, awards vest in full prior to the last day of the performanceperiod, based on actual performance to the vesting date.  No expenses were recognized in 2005 withrespect to the Mid-Term Plan based upon earnings per share results.  During the first quarter of 2006, theCompensation Committee adopted and granted incentive awards for certainexecutives of the Company under an Amended and Restated Mid-Term Incentive Plan(the “New Mid-Term Plan”).  The NewMid-Term Plan is substantially consistent with the original Mid-Term Planexcept that the performance goals are based upon the pre-tax income for theretail banking, financial intermediary and transaction processing segments and consolidatedpre-tax income for two and three year performance periods ending December 31,2007 and 2008, respectively.  Under SFAS123(R), the terms of the New Mid-Term Plan are subject to the classificationcriteria of Statement of Financial Accounting Standards No. 150 (“SFAS

 

14

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150”), *Accounting for CertainFinancial Instruments with Characteristics of both Liabilities and Equity,*sincethe monetary value of the award is predominately fixed and consideredstock-settled debt.  For the quarterended March 31, 2006, the Company recognized $91 of expense with an off-settingliability related to awards issued under the New Mid-Term Plan.

 

On July 1, 2002, the Company established theNetBank, Inc. Employee Stock Purchase Plan (“the Employee Plan”), to allowparticipants to purchase stock in the Company through payroll deductions.  The Employee Plan purchases shares of NetBankcommon stock from the Company on the last day of each quarter at 85% of themarket value on the purchase date. Employees are eligible to enroll in the Employee Plan on January 1,April 1, July 1 and October 1.  There wasno expense recognized during 2005 related to the Employee Plan.  Under SFAS 123(R), the Employee Plan ischaracterized as stock-settled debt and is subject to the classificationcriteria of SFAS 150.  For the quarterended March 31, 2006, the Company recognized $31 of expense with an off-settingliability related to the Employee Plan.

 

SFAS 123(R) requires that a company discloseproforma information for periods prior to its adoption of SFAS 123(R).  The following table illustrates the effect onnet income and earnings per share if the Company had applied the fair valuerecognition provisions of SFAS 123 to options granted under the Company’s stockoption plan for three months ended March 31, 2005.  For purposes of this pro forma disclosure,the value of the options is estimated using a Black-Scholes-Mertonoption-pricing formula and amortized to expense over the options’ vestingperiods.

 
| ** **                                                                                                                                   | ** ** | **For the three months ended  March 31, 2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|
| Net loss, as reported                                                                                                                        |       | $                                                                       | (2,029     | ) |
| Deduct:                                                                                                                                      |       |                                                                    |       |
| Total stock option based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (536                                                                    | )          |
| Pro forma net loss                                                                                                                           |       | $                                                                       | (2,565     | ) |
| (Loss) per share:                                                                                                                            |       |                                                                    |       |
| Basic—as reported                                                                                                                       |       | $                                                                       | (0.04      | ) |
| Basic—pro forma                                                                                                                         |       | $                                                                       | (0.06      | ) |
|                                                                                                                                         |       |                                                                    |       |
| Diluted—as reported                                                                                                                     |       | $                                                                       | (0.04      | ) |
| Diluted—pro forma                                                                                                                       |       | $                                                                       | (0.06      | ) |

 

As a result of adopting SFAS 123(R) onJanuary 1, 2006, the Company’s loss before income taxes and net loss for thequarter ended March 31, 2006, are $1,163 and $762 higher, respectively, than ifit had continued to account for share-based compensation under APB 25. Both the Company's basic and diluted earningsper share would have been $(0.22) for the three months ended March 31, 2006 hadit continued to account for share-based compensation under APB 25.

 

The fair value of each option granted underthe Stock Plan for the three months ended March 31, 2006 and 2005 was estimatedon the date of grant using the Black-Scholes-Merton option-pricing formula withthe following weighted average assumptions:

 
| ** **              | ** ** | **For the three months ended March 31,** | ** ** |
|-------------------------|------------|------------------------------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                                               | ** ** | **2005** | ** ** |
| Fair value              |       | $                                                                      | 2.63       |   | $ | 2.59 |   |
| Expected life (years)   |       | 6.5                                                                    |       | 5 |   |
| Risk-free interest rate |       | 4.52                                                                   | %          | 3.96 | % |
| Dividend rate           |       | 1.08                                                                   | %          | 0.70 | % |
| Expected volatility     |       | 30.58                                                                  | %          | 29.90 | % |
|                         |            |                                                                        |            |  |  |  |  |

 

Expected volatilities are based on thehistorical volatility of the Company’s common stock and other factors.  For options granted prior to 2006, theexpected term of the options is estimated based on historical option exerciseactivity.  For

 

15

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options granted in the first quarter of 2006,the expected term is calculated using the shortcut method based SAB 107. Therisk-free interest rate for the periods within the contractual life of theoption is based on the U.S. Treasury yield curve in effect at the time ofgrant.

 

Option activity under the Stock Plan as ofMarch 31, 2006, and changes during the period ended March 31, 2006 follows:

 
| ** **                               | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Fair Value** | ** ** |
|------------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------|------------|
| Options outstanding at beginning of year |       | 5,033      |       | $                                      | 10.96      |                                                |       |                           |       |   |
| Granted                                  |       | 391        |       | $                                      | 7.38       |                                                |       |                           |       |   |
| Exercised                                |       | —     |       | —                                 |       |                                                |       |                           |       |
| Forfeited                                |       | (27        | )          | $                                      | 10.61      |                                                |       |                           |       |   |
| Cancelled                                |       | (39        | )          | $                                      | 10.13      |                                                |       |                           |       |   |
| Options outstanding at March 31, 2006    |       | 5,358      |       | $                                      | 10.71      |                                                | 6.6        |                           | $          | 8,020 |   |
| Option vested at March 31, 2006          |       | 3,899      |       | $                                      | 11.03      |                                                | 6.1        |                           | $          | 3,146 |   |
| Options exercisable at March 31, 2006    |       | 3,899      |       | $                                      | 11.03      |                                                | 6.1        |                           | $          | 3,146 |   |
|                                          |            |            |            |                                        |            |                                                     |            |                                |            |  |  |  |  |

 

The weighted average grant-date fair value ofoptions granted during the three months ended March 31, 2006 was $2.63. Therewere no options granted or exercised in the first quarter 2006.

 

The status of the Company’s nonvested optionsas of March 31, 2006, and changes during the period ended March 31, 2006follows:

 
| ** **                       | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|----------------------------------|------------|------------|------------|---------------------------------------------------------|------------|
| Nonvested, January 1, 2006       |       | 1,587      |       | $                                                       | 3.71       |   |
| Granted                          |       | 391        |       | $                                                       | 2.63       |   |
| Vested                           |       | (473       | )          | $                                                       | 2.39       |   |
| Cancelled, forfeited and expired |       | (46        | )          | $                                                       | 4.09       |   |
| Nonvested, March 31, 2006        |       | 1,459      |       | $                                                       | 3.84       |   |

 

As of March 31, 2006, there was $4,874 oftotal unrecognized compensation cost, net of estimated forfeitures, related tononvested options under the Stock Plan. That cost is expected to be recognized in less than four years.  The total fair value of options vested duringthe period ended March 31, 2006 was $1,132.

 

Restricted stock activity under the StockPlan as of March 31, 2006, and changes during the period ended March 31, 2006follows:

 
| ** **                       | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|----------------------------------|------------|------------|------------|---------------------------------------------------------|------------|
| Nonvested, January 1, 2006       |       | 189        |       | $                                                       | 8.50       |   |
| Granted                          |       | 271        |       | $                                                       | 7.39       |   |
| Vested                           |       | (89        | )          | $                                                       | 8.17       |   |
| Cancelled, forfeited and expired |       | (6         | )          | $                                                       | 7.91       |   |
| Nonvested, March 31, 2006        |       | 365        |       | $                                                       | 7.77       |   |

 

16

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**10.**                               NET LOSS PER COMMON AND COMMON EQUIVALENT SHARE

 

Basic and diluted net loss per common and potential common share hasbeen calculated based on the weighted average number of sharesoutstanding.  The following tablereconciles the numerator and denominator of the basic and diluted net loss percommon and potential common share for the three months ended March 31, 2006 and2005.

 
| ** **                        | ** ** | **Net Loss  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|-----------------------------------|------------|--------------------------------|------------|---------------------------|------------|----------------------------|------------|
| Three months ended March 31, 2006 |       |                           |       |                      |       |                       |       |
| Basic EPS                         |       | $                              | (10,951    | )                         | 46,262     |                       | $          | (0.24 | ) |
| Effect of dilutive securities     |       | —                         |       | —                    |       | —                     |       |
| Diluted EPS                       |       | $                              | (10,951    | )                         | 46,262     |                       | $          | (0.24 | ) |
|                              |       |                           |       |                      |       |                       |       |
| Three months ended March 31, 2005 |       |                           |       |                      |       |                       |       |
| Basic EPS                         |       | $                              | (2,029     | )                         | 46,366     |                       | $          | (0.04 | ) |
| Effect of dilutive securities     |       | —                         |       | —                    |       | —                     |       |
| Diluted EPS                       |       | $                              | (2,029     | )                         | 46,366     |                       | $          | (0.04 | ) |

 

**11.**                               BUSINESS SEGMENTS

** **

During the three months ended March 31, 2006,the Company realigned its operating segments as described in followingparagraph.  All prior period amounts havebeen restated in conformity with the current period presentation.

 

Effective in the first quarter of 2006, theCompany revised its segment reporting format from four to five segmentsincluding retail banking, financial intermediary, transaction processing,servicing asset, and other/corporate overhead. We believe the realignment of the segments provides more transparencyand clarifies our financial results.  Theservicing asset segment captures the investment results of the hedges relatedto the servicing asset segment as well as other costs related to the MSRs.These results were historically reported as part of the retail banking segmentwhich as a result of the new segment format now only captures the operatingresults of the Internet-only bank, the NetBank Business Finance division andthe Dealer Financial Services division.  In addition to the creation ofthe servicing asset segment, the other/corporate overhead segment waspreviously reported as the other/eliminations segment and included primarilycosts charged to the holding company. This segment also now includes overhead costs which were previously recognizedthroughout all segments.  Historicalresults below have been reclassified to conform with current periodpresentation.

 

The retail banking segment’s investmentsprimarily consist of 1-4 family mortgage loans originated by the financialintermediary segment, small business financing loans and leases originated bythe NetBank Business Finance division, auto loans originated by the DealerFinancial Services division, purchased securities for investment, and variousother purchased or retained loan products.  The financial intermediarysegment originates mortgage loans directly with borrowers and purchasesmortgage loans from correspondents and/or brokers.  The financial intermediary segment packagesor pools such loans either inclusive or exclusive of servicing rights for retentionby the retail banking segment or sale into the secondary market.  The financial intermediary segment alsoencompasses the origination of loans for recreational vehicles (RVs), boats andaircraft which are then sold to the retail banking segment for investmentpurposes or to third party investors. The transaction processing segment subservices loans for the retail banksegment, the financial intermediary segment, the servicing asset segment, andfor third-party customers; and provides ATM and merchant processingservices.  The servicing asset segmentmanages the mortgage servicing rights retained by the Company in conjunctionwith the origination of mortgage loans or obtained through bulk acquisitions.  The other/corporate overhead segment containsholding company and overhead expenses along with the elimination ofintersegment gains and losses on loans sold to the retail banking segment,intersegment interest, and intersegment servicing and processing expenses.

 

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The financial information foreach business segment reflects specific identifiable transactions or allocatedtransactions based on an internal allocation method.  The measurement of the performance of thebusiness segments is based on our management structure and is not necessarilycomparable with similar information from any other financial institution. Theinformation presented is also not necessarily indicative of the segment’soperations if they were independent entities.

 
| ** **                                       | ** ** | **For the three months ended March 31, 2006** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  banking**                                                              | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Servicing  asset** | ** ** | **Other/  corporate  overhead** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                                                                | 40,196     |   | $ | 26,574 |   | $ | 7 |   | $ | — |   | $ | 98 |   | $ | 66,875 |   |
| Intersegment interest income                     |       | 23,595                                                                           |       | 57 |   | — |   | 2,344 |   | (25,996 | ) | — |   |
| Total interest income                            |       | 63,791                                                                           |       | 26,631 |   | 7 |   | 2,344 |   | (25,898 | ) | 66,875 |   |
| Interest expense                                 |       | 37,872                                                                           |       | 521 |   | — |   | 4 |   | 620 |   | 39,017 |   |
| Intersegment interest expense                    |       | 4,950                                                                            |       | 19,165 |   | 88 |   | 2,014 |   | (26,217 | ) | — |   |
| Total interest expense                           |       | 42,822                                                                           |       | 19,686 |   | 88 |   | 2,018 |   | (25,597 | ) | 39,017 |   |
| Net interest income                              |       | 20,969                                                                           |       | 6,945 |   | (81 | ) | 326 |   | (301 | ) | 27,858 |   |
| Provision for credit losses                      |       | 2,999                                                                            |       | 58 |   | — |   | — |   | — |   | 3,057 |   |
| Intersegment- servicing and processing fees      |       | —                                                                           |       | — |   | 3,363 |   | — |   | (3,363 | ) | — |   |
| Non-interest income                              |       | 3,631                                                                            |       | 24,662 |   | 4,312 |   | (3,005 | ) | 397 |   | 29,997 |   |
| Non-interest expense                             |       | 19,795                                                                           |       | 35,249 |   | 6,096 |   | 623 |   | 9,753 |   | 71,516 |   |
| Intersegment- servicing and processing  expenses |       | 121                                                                              |       | 739 |   | — |   | 2,503 |   | (3,363 | ) | — |   |
| Pre-tax income (loss)                            |       | $                                                                                | 1,685      |   | $ | (4,439 | ) | $ | 1,498 |   | $ | (5,805 | ) | $ | (9,657 | ) | $ | (16,718 | ) |
| Total assets                                     |       | $                                                                                | 4,021,993  |   | $ | 1,198,194 |   | $ | 44,530 |   | $ | 228,237 |   | $ | (1,024,103 | ) | $ | 4,468,851 |   |

 
| ** **                                       | ** ** | **For the three months ended March 31, 2005** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  banking**                                                              | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Servicing  asset** | ** ** | **Other/  corporate  overhead** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                                                                | 35,823     |   | $ | 21,072 |   | $ | 10 |   | $ | — |   | $ | 115 |   | $ | 57,020 |   |
| Intersegment interest income                     |       | 13,066                                                                           |       | 34 |   | 7 |   | 1,583 |   | (14,960 | ) | — |   |
| Total interest income                            |       | 48,889                                                                           |       | 21,106 |   | 17 |   | 1,583 |   | (14,575 | ) | 57,020 |   |
| Interest expense                                 |       | 24,373                                                                           |       | 1,480 |   | 21 |   | 66 |   | 303 |   | 26,243 |   |
| Intersegment interest expense                    |       | 3,557                                                                            |       | 9,834 |   | — |   | 1,542 |   | (14,933 | ) | — |   |
| Total interest expense                           |       | 27,390                                                                           |       | 11,314 |   | 21 |   | 1,608 |   | (14,630 | ) | 26,243 |   |
| Net interest income                              |       | 20,959                                                                           |       | 9,792 |   | (4 | ) | (25 | ) | 55 |   | 30,777 |   |
| Provision for credit losses                      |       | 2,336                                                                            |       | 15 |   | — |   | — |   | — |   | 2,351 |   |
| Intersegment- servicing and processing fees      |       | —                                                                           |       | — |   | 3,456 |   | — |   | (3,456 | ) | — |   |
| Non-interest income                              |       | 3,936                                                                            |       | 25,702 |   | 4,712 |   | 14 |   | 97 |   | 34,461 |   |
| Non-interest expense                             |       | 17,170                                                                           |       | 34,171 |   | 6,196 |   | 1,024 |   | 7,453 |   | 66,014 |   |
| Intersegment- servicing and processing  expenses |       | 152                                                                              |       | 890 |   | — |   | 2,414 |   | (3,456 | ) | — |   |
| Pre-tax income (loss)                            |       | $                                                                                | 5,237      |   | $ | 418 |   | $ | 1,968 |   | $ | (3,449 | ) | $ | (7,301 | ) | $ | (3,127 | ) |
| Total assets                                     |       | $                                                                                | 4,179,169  |   | $ | 1,303,617 |   | $ | 39,092 |   | $ | 246,331 |   | $ | (1,013,194 | ) | $ | 4,755,015 |   |

 

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

 

The Company was servicing or subservicing forthe benefit of others 106,312 and 109,685 residential loans with unpaidprincipal balances aggregating approximately $13.8 billion and$14.2 billion at March 31, 2006 and December 31, 2005, respectively.Mortgagors’ taxes and insurance escrow funds and investors’ principal andinterest escrow funds totaled

 

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approximately $287 million and $270 millionas of March 31, 2006 and December 31, 2005, respectively. Loans servicedfor others and the related escrow funds are not owned by the Company; however,the majority of the escrow funds are deposited in NetBank, FSB.

 

The Company has issued mortgage-backedsecurities under programs sponsored by Ginnie Mae, Freddie Mac and Fannie Mae.In connection with servicing mortgage-backed securities guaranteed by GinnieMae, Freddie Mac or Fannie Mae, the Company advances certain principal andinterest payments to security holders prior to their collection from specificmortgagors. Additionally, the Company must remit certain payments includingproperty taxes and insurance premiums in advance of collecting them fromspecific mortgagors and make certain payments of attorney’s fees and othercosts related to loans in foreclosure. These amounts are included in servicingadvances under the caption “due from servicers and investors” in theaccompanying consolidated balance sheets. Likewise, during the month that amortgagor pays off his/her mortgage, the Company must accept an interestpayment from the borrower that is pro-rated to the date of payoff and passthrough a full month’s interest to the security holder. The Company includesits projection of the cost of such advances and lost interest on mortgages thatprepay, and the expense of unreimbursed attorney and other costs associatedwith foreclosure in its valuation of its mortgage servicing rights.

 

In the ordinary course of business, theCompany is exposed to liability under representations and warranties made topurchasers and insurers of mortgage loans and the purchasers of mortgageservicing rights. Under certain circumstances, the Company may be required torepurchase mortgage loans or indemnify the purchasers of loans or mortgageservicing rights for losses if there has been a breach of representations orwarranties.  Repurchased loans arecarried at the lower of cost or net realizable value.  As of March 31, 2006 and December 31, 2005,loans held for sale included repurchased loans with a net carrying value of$55.2 million and $63.6 million, respectively.

 

NetBank is unable to determine its maximumexposure under its representations and warranties.  The maximum exposure would be the currentunpaid principal balance of any loan we have ever sold, excluding loans soldwhich specifically excluded our representations and warranties, plus any fee orpremium we received for the sale.  Additionally, we potentially could have torefund any fees or premiums we received for the sale of mortgage servicingrights that are still on the purchasers’ books. However, since we are not the current servicer for the majority of theloans and mortgage servicing rights as described above, we cannot determine ourmaximum exposure.

 

The Company repurchased approximately $29 millionand $31 million of unpaid principal balances during the three months endedMarch 31, 2006 and 2005, respectively. The Company had $16.2 million and $20.7million of reserves for estimated losses on future repurchases as of March 31,2006 and December 31, 2005, respectively.

 

As of March 31, 2006, the Company hadcommitments to fund mortgage loans of $874,783, open-end consumer lines ofcredit of $87,655, undisbursed mortgage construction loans of $145,198,undisbursed leasing commitments of $3,309 and commercial financing commitmentsof $8,927.

 

NetBank, FSB is involved in litigation withthree insurance companies who are sureties on the purchased CMC leases.  Since the second quarter of 2002, the entireportfolio has been on non-accrual status pending outcome of thelitigation.  NetBank, FSB has filed aclaim for all payments that are currently past due, approximately $90 million.  The Company has charged off $50,230 of theunpaid principal balances to date.  AtMarch 31, 2006, the remaining recorded value of the leases is $25,762.

 

**TheCompany is involved in certain legal proceedings, excluding the CMC litigation,incidental to its business.  The Companydoes not believe that the outcome of these proceedings will have a materialadverse effect upon its financial condition, results of operations or cashflows.**

** **

# **13.**                            SUBSEQUENT EVENT

# ** **

On May 1, 2006, the Company issued a pressrelease announcing its intention to sell its mortgage servicing platform alongwith most of its portfolio of mortgage servicing rights.  The Company is in the process of marketingthe platform and the mortgage servicing portfolio to potential buyers.  As of the date of this report, the Companyhad not yet entered into any definitive agreements regarding such a sale.

 

19

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

** **

*The following discussion mayinclude forward-looking statements. Forward-looking statements regarding theintent, belief or current expectations of NetBank, Inc. or its officers anddirectors can be identified by the use of forward-looking terms such as “believe”,“anticipate”, “estimate”, “expect”, “may”, “will”, “should”, “plan”, “intend”, “project”,or other comparable terminology. Various internal and external factors couldcause the Company’s actual results to differ materially from those anticipated bythe forward-looking statements. These factors include, but are in no waylimited to, 1) the evolving nature of the market for Internet banking andfinancial services generally; 2) the public’s perception of the Internet as asecure, reliable channel for transactions; 3) the success of new products andlines of business considered critical to the Company’s long-term strategy, suchas small business banking and transaction processing services; 4) potentialdifficulties in integrating the Company’s operations across its multiple linesof business; 5) the cyclical nature of the mortgage banking industry generally;6) a possible decline in asset quality; 7) changes in general economic oroperating conditions which could adversely affect mortgage loan production andsales, mortgage servicing rights, loan delinquency rates and/or loandefaults;  8) the possible adverseeffects of unexpected changes in the interest rate environment; 9) adverselegal rulings, particularly in the Company’s litigation over leases originatedby Commercial Money Center, Inc.; and/or 10) increased competition andregulatory changes.  The Company’s 2005Form 10-K contains additional details on these and other risks that arematerial to our operations. All forward-looking statements in this report arebased on information available at the time of filing. Except as required by thefederal securities laws, the Company has no obligation to update anyforward-looking statement included herein. Forward-looking statements are made in reliance on the safe harborprovisions of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended.*

 

**General**

 

NetBank, Inc. is a financial holding companyengaged primarily in retail banking, mortgage banking, business finance andproviding ATM and merchant processing services. NetBank, Inc. wholly owns theoutstanding stock of:  NetBank (“NetBank,FSB” or the “Bank”), a federal savings bank; MG Reinsurance Company (“MGReinsurance”), a captive reinsurance company; NetInsurance, Inc. (“NetInsurance”),a licensed insurance agency; and NB Partners, Inc., a corporation involved instrategic partnering opportunities. NetBank, FSB owns all of the outstandingstock of:  Market Street MortgageCorporation (“Market Street”), a retail mortgage company; NetBank PaymentSystems, Inc. (“NPS”), a provider of ATM and merchant processing services forretail and other non-bank businesses; Meritage Mortgage Corporation (“Meritage”),a wholesale non-conforming mortgage provider; and Financial Technologies, Inc.(“FTI”), a provider of transaction processing services to other financialservices companies. NetBank, FSB’s wholesale mortgage division operates asNetBank Funding Services (“NetBank Funding”); its business financing divisionoperates as “NetBank Business Finance”; its automobile financing divisionoperates as “Dealer Financial Services”; and its recreational vehicle financingdivision operates as “Beacon Credit Services”. The consolidated company is referred to herein as “we,” “us,”  “our,” “NetBank,” or “the Company”.

 

In the opinion of management,the unaudited consolidated financial statements included herein reflect alladjustments, consisting only of normal recurring accruals, which are necessaryfor the fair presentation of the financial condition and results of operationsfor the interim periods presented. Certain information and footnote disclosuresnormally included in financial statements have been condensed or omittedpursuant to applicable rules and regulations of the SEC. The financialstatements included herein should be read in conjunction with the financialstatements and notes thereto included in our 2005 Form 10-K. The resultsof operations for the interim periods reported herein are not necessarily indicativeof results to be expected for the full year. Certain 2005 amounts have beenreclassified for comparability with 2006 amounts.

 

Unless otherwise noted, all dollar figures arepresented in thousands (000s), except per share data.  All of the Company’s operations and assetsare located within the United States of America.

 

**Executive Summary and Future Outlook**

 

For the three months endedMarch 31, 2006, we incurred a net loss of $10,951 or $0.24 per share comparedto a net loss of $2,029 or $0.04 per share for the three months ended March 31,2005, a change of $8,922.  NetBank’sresults continue to be adversely impacted by 1) the flattening of the yieldcurve which reduces net interest earned on interest-earning assetsheld-for-sale and held-for-investment, 2) depressed gain on sale margins withinthe financial intermediary segment

 

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resulting from competitiveconditions, 3) continued high volume of repurchase losses related torepresentations and warranties on loans sold, and 4) net losses on hedgingactivities within the servicing asset segment.

 

*RetailBanking.* The retail banking segment includes operations ofthe Internet-only bank, the NetBank Business Finance division as well as theDealer Financial Services division.   The retailbanking segment achieved pre-tax income of $1,685 during the first quarter of2006, a $3,552 decrease over the comparable period in 2005. The Internet-onlybank’s results declined by $3,061 relating primarily to an increase innon-interest expense of $2,397 and a decrease in gains on sales of loans of$501.  NetBank Business Finance reporteda decrease in their period over period pre-tax income of $541. This decreasewas primarily driven by an increase in provision for credit losses of $913 butwas partially off-set by an increase in net interest income of $241.  Provision expense for the retail bankingsegment as a whole increased by $663 period over period as a result thecontinued retention of auto loans, HELOCs, and business financing leases.  These loans and leases generally have a highrisk adjusted yield. Despite the decline in the in pre-tax earnings, we believethis segment is crucial to a balanced earnings approach and anticipatemeaningful contributions to our earnings in the future.

 

*FinancialIntermediary*. The financial intermediary segment originates both conforming andnon-conforming products through our network of brokers and correspondents aswell as directly with consumers through our 83 branch offices.  The financial intermediary segment recorded apre-tax loss of $4,439 for the first quarter of 2006, a $4,857 pre-tax declineperiod over period.  This decline wasprimarily driven by a $3,020 decline in net interest income resulting from thecontinuing flattening of the yield curve. Severe competitive pressures throughout the industry have alsocontributed to a decrease in gains on sales of loans and mortgage servicingrights of $851.  Although the financialintermediary segment has experienced a decline this quarter due to the cyclicalnature of the mortgage business, we continue to believe that the mortgagebusiness is an integral part of our operations that could add significant valuein the future.

 

The conforming mortgage operations within thefinancial intermediary segment recorded a pre-tax loss of $4,011 for the firstquarter of 2006 compared to pre-tax income of $2,659 during the same quarter in2005.  This decline was primarily theresult of a 19-basis point decline in the revenue margins and a 16-basis pointincrease in expenses. Margins continue to be severely depressed resulting in adecrease in net interest income of $2,866 as the yield curve continues toremain flat. Generally, we earn long-term interest rates on loans held for saleand finance those loans with short-term borrowings.  As the yield curve flattens, net interestmargin compresses.  If the yield curvecontinues to remain flat, we will continue to have declines in net interestmargins.

 

The non-conforming operations within thefinancial intermediary segment recorded a pre-tax loss of $1,023 during thefirst quarter of 2006 compared to a pre-tax loss of $2,445 during the samequarter in 2005, a $1,422 improvement. Decreases in non-interest expenses of $2,964 contributed to theimprovement but were off-set by declines in gain on sales of loans of$1,219.  Gains on sales of loanscontinues to be impacted by adverse competitive conditions within theindustry.  In addition, non-conformingoperations have experienced a decline in production of $24,949 to $605,234 asmortgage interest rates continue to rise. Although we believe that secondquarter production is likely to increase, the results of the non-conformingoperations may remain volatile over coming quarters.

 

*TransactionProcessing.* The transaction processing segment housesour servicing factory and NPS.  Thissegment recorded pre-tax income of $1,498 for the three month period endedMarch 31, 2006 compared to pre-tax income of $1,968 for the same period in2005. The decrease relates primarily to a reduction in pre-tax earnings at NPSof $527 off-set by improvements in operating expenses of $228 within theservicing factory.  Despite declines inpre-tax earnings, we believe the transaction processing segment will providesignificant contributions to earnings in the future and help us achieve a morebalanced earnings approach.

 

*ServicingAsset.* The servicing asset segment manages the MSRs weretain in conjunction with the origination of mortgage loans or obtain throughbulk acquisition.  The servicing assetsegment reported a pre-tax loss of $5,805 for the three months ended March 31,2006 compared to a pre-tax loss of $3,449 for the same period in 2005, a changeof $2,356.  This change is primarilyattributable to decreased net hedge results of $3,434.  Decreased net hedge results were off-set byincreased service fee revenues of $471.

 

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As previously stated in ourpress release issued May 1, 2006, we are actively marketing our mortgage servicingplatform and the majority of our mortgage servicing rights to potentialbuyers.  We have not yet entered anydefinitive agreement.

 

*Other/CorporateOverhead.* The Other/corporate overhead segmentincludes holding company and overhead expenses along with the elimination ofinter-segment gains and losses on loans sold to the retail banking segment fromthe financial intermediary segment. The other/corporate overhead segmentincurred a $9,657 pre-tax loss for the three months ended March 31, 2006compared to a pre-tax loss of $7,301 for the comparable period of 2005.  The $2,356 change was primarily related toexpenses related to the adoption of SFAS 123(R).

 

*CapitalManagement Program*. Notwithstanding the fact that NetBank met all of the regulatory capitalrequirements placed upon it and its subsidiaries at March 31, 2006 and was “wellcapitalized” under such guidelines at such date, the Company has a proactivecapital management program in order to ensure that NetBank, FSB remains “wellcapitalized” under relevant OTS guidelines. As part of this program, the Company reviews capital allocations tolines of business that have been performing below target or that may requiregreater investment to reach the right scale. The goal is to deploy capital into strategic areas with greater or morestable long-term profitability prospects. Given NetBank, FSB’s current capital levels, management has voluntarilymoderated its pursuit of additional asset growth and other growth initiativesuntil the current capital pressures ease. For more information regarding our regulatory capital requirements, see “Liquidityand Capital Resources - Capital Resources” below.

 

*Risk andContingencies*. Reference is made to the discussionsunder Item 1A. “Risk Factors” and “Future Outlook” in Item 7. Management’sDiscussion and Analysis of Financial Condition and Results of operations in the2005 Form 10-K for further information regarding the risks and challenges ofour business. Reference is made to note 12 of the notes to consolidatedfinancial statements included in this report and to Item 1. Legal Proceedingsin Part II of this report for additional discussion of certain risks andcontingencies that may affect us.

 

# **FinancialCondition**

# ** **

*General. *Our assets totaled $4,468,851 at March 31,2006, a decrease of $302,768 or 6.3% from December 31, 2005.  This is primarily the result of decreases of$259,488 in loans held for sale and $32,290 in loan and lease receivables.  The decrease in loans held for sale isprimarily the result of sales of mortgage loans outpacing production during thethree months ended March 31, 2006.  Thedecrease in loans held for sale enabled us to pay down other borrowed funds by$291,548 during the three month period ended March 31, 2006.

 

*InvestmentSecurities.*  For the three months ended March 31,2006, the investment security portfolio decreased by $19,118. This decrease wassubstantially due to principal repayments on mortgage-backed securities of$20,220 and change in net unrealized losses of $8,819. The decrease was offset,in part, by the purchase of $9,996 of new investment securities.

 

The following tables set forth certain information relating to ouravailable for sale securities:

 
| **As of March 31, 2006** | ** ** | **Amortized  cost** | ** ** | **Unrealized  gains** | ** ** | **Unrealized  losses** | ** ** | **Estimated  fair value** | ** ** |
|----------------------------------------------|------------|---------------------|------------|-----------------------|------------|------------------------|------------|--------------------------------|------------|
| U.S. Government agencies - MBS               |       | $                   | 527,587    |                  | $          | —                 |       | $                              | 17,828     |   | $ | 509,759 |   |
| Collateralized mortgage obligations          |       | 56,425              |       | 3                     |       | 1,723                  |       | 54,705                         |       |
| U.S. treasury securities                     |       | 13,331              |       | —                |       | 1,256                  |       | 12,075                         |       |
| Agency bonds                                 |       | 27,383              |       | —                |       | 898                    |       | 26,485                         |       |
| Habitat bonds and other                      |       | 3,894               |       | 41                    |       | —                 |       | 3,935                          |       |
| Total                                        |       | $                   | 628,620    |                  | $          | 44                     |       | $                              | 21,705     |   | $ | 606,959 |   |

 
| **As of December 31, 2005** | ** ** | **Amortized  cost** | ** ** | **Unrealized  gains** | ** ** | **Unrealized  losses** | ** ** | **Estimated  fair value** | ** ** |
|-------------------------------------------------|------------|---------------------|------------|-----------------------|------------|------------------------|------------|--------------------------------|------------|
| U.S. Government agencies - MBS                  |       | $                   | 535,369    |                  | $          | 24                     |       | $                              | 10,680     |   | $ | 524,713 |   |
| Collateralized mortgage obligations             |       | 59,049              |       | 3                     |       | 1,450                  |       | 57,602                         |       |
| U.S. treasury securities                        |       | 13,131              |       | —                |       | 351                    |       | 12,780                         |       |
| Agency bonds                                    |       | 27,512              |       | —                |       | 504                    |       | 27,008                         |       |
| Habitat bonds and other                         |       | 3,858               |       | 116                   |       | —                 |       | 3,974                          |       |
| Total                                           |       | $                   | 638,919    |                  | $          | 143                    |       | $                              | 12,985     |   | $ | 626,077 |   |

 

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*Loans held for sale.* As more fullydescribed in note 3 of the notes to the consolidated financial statements included in our 2005 Form 10-K, loans held for sale are carried at theaggregate of the lower of cost or market until sold, typically 30 to 90 daysafter origination or purchase. The majority of the non-performing loans heldfor sale consists of loans which have been repurchased under representationsand warranties provided to purchasers. Once a loan has been repurchased, it isgenerally resold at a price less than the repurchase price. Upon repurchase,reserves are transferred from the reserve for representations and warranties toa valuation reserve for repurchased loans to record such loans at estimated netrealizable value. At March 31, 2006 and December 31, 2005, the aggregate fairvalue of loans held for sale exceeded the aggregate cost.

 

Thefollowing tables set forth information regarding our portfolio of loans heldfor sale:

 
| ** **                                   | ** ** | **Gross UPB** | ** ** | **Reserve** | ** ** | **Non-  performing** | ** ** |
|----------------------------------------------|------------|--------------------|------------|-------------|------------|----------------------|------------|
| **As of March 31, 2006** | ** ** | ** **         | ** ** | ** **  | ** ** | ** **           | ** ** |
| Conforming mortgages                         |       | $                  | 602,382    |        | $          | 3,886                |       | $ | 19,901 |   |
| Non-conforming mortgages                     |       | 258,345            |       | 8,541       |       | 21,318               |       |
| Construction                                 |       | 117,853            |       | 193         |       | —               |       |
| Commercial / recreational                    |       | 8,517              |       | 47          |       | —               |       |
| Total loans held for sale                    |       | $                  | 987,097    |        | $          | 12,667               |       | $ | 41,219 |   |

 
| ** **                                      | ** ** | **Gross UPB** | ** ** | **Reserve** | ** ** | **Non-  performing** | ** ** |
|-------------------------------------------------|------------|--------------------|------------|-------------|------------|----------------------|------------|
| **As of December 31, 2005** | ** ** | ** **         | ** ** | ** **  | ** ** | ** **           | ** ** |
| Conforming mortgages                            |       | $                  | 811,602    |        | $          | 3,266                |       | $ | 25,630 |   |
| Non-conforming mortgages                        |       | 346,940            |       | 9,283       |       | 24,005               |       |
| Construction                                    |       | 84,429             |       | 191         |       | —               |       |
| Commercial / recreational                       |       | 3,734              |       | 47          |       | —               |       |
| Total loans held for sale                       |       | $                  | 1,246,705  |        | $          | 12,787               |       | $ | 49,635 |   |

 

The Company, when required to repurchase mortgage loans, bundles suchloans in pools and re-sells them. The $8,416 decline in non-performing loansheld for sale is primarily related to such re-sales of mortgage loans duringthe three months ended March 31, 2006. The size of the repurchase inventory,which is primarily comprised of non-performing loans, will vary depending onthe timing of the repurchases and the subsequent dispositions.

 

*Loan and Lease Receivables.*  For thethree months ended March 31, 2006, the loan and lease receivables portfoliodecreased $32,290 or 1.5%. Thedecrease in loan and lease receivables was primarily due to principalreductions and prepayments of $175,769, offset, in part by the retention of$88,771 of auto loans, $51,350 of business equipment finance leases, $9,008 inhome equity lines of credit (“HELOCs”), and $2,575 of marine and recreationalvehicle loans.

 

*Asset Quality and Non-performing Assets.* Weperiodically review the performance of our loan and lease receivables portfolioby reviewing charge-offs, delinquency statistics, and various other industrystatistics. Large non-homogeneous credits are reviewed on a loan-by-loan orlease-by-lease basis, whereas relatively small credits with similar riskcharacteristics are reviewed on a pool-by-pool basis. If a decline in creditquality for a specific pool or individual loan or lease is noted, we recordadditional allowance through a charge to the provision for credit losses. Theallowance for credit losses is maintained at a level estimated to be adequateto provide for probable losses in the loan and lease receivables portfolio. Wedetermine the adequacy of the allowance based upon reviews of individual loansand leases or pools as applicable, recent loss experience, current economicconditions, the risk characteristics of the various categories of loans andleases and other pertinent factors. Our non-performing assets as a percentageof gross UPB improved from 1.47% at December 31, 2005, to 1.44% at March 31,2006, as the level of non-performing assets declined by $1,073. In the CMC litigation, the court in themulti-district litigation ruled in favor of the banks and against one of thesureties, Illinois Union during the third quarter of 2005. With respect to theother two sureties, the court did not grant the banks’ motion, but insteadstated that the banks must prove that they were the intended “obligee” in theleases and that there was no fraud on the part of the banks. We believe thatthe facts and circumstances and evidence gathered in discovery will support ourclaim as obligee under the bonds and will support the conclusion that there wasno fraud committed by NetBank, FSB. It is important to note that NetBank, FSBis not technically a party to these rulings since it previously withdrew itsmotion

 

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forjudgment on the pleadings. The court has provided NetBank, FSB an opportunityto renew its interest in the motion as it relates to Illinois Union so theIllinois Union ruling could eventually apply to NetBank, FSB. Reference is madeto Item 1. Legal Proceedings in Part II of this report for additionalinformation related to the Company’s ongoing CMC litigation.

 

The following tables detail our held for investment loan and leasereceivables portfolio, the associated allowance for credit losses, andnon-performing assets:

 
| ** **                                   | ** ** | **Gross UPB** | ** ** | **Allocated  Allowance** | ** ** | **(1) Non-performing** | ** ** |
|----------------------------------------------|------------|--------------------|------------|--------------------------|------------|-----------------------------|------------|
| **As of March 31, 2006** | ** ** | ** **         | ** ** | ** **               | ** ** | ** **                  | ** ** |
| First mortgages                              |       | $                  | 782,763    |                     | $          | 2,463                       |       | $ | 3,005 |   |
| Second mortgages                             |       | 107,187            |       | 2,930                    |       | 601                         |       |
| Leases                                       |       | 393,175            |       | 15,367                   |       | 1,492                       |       |
| Auto                                         |       | 631,648            |       | 3,066                    |       | 205                         |       |
| Home equity lines                            |       | 238,880            |       | 4,218                    |       | 911                         |       |
| Consumer                                     |       | 40,960             |       | 258                      |       | —                      |       |
| Loan and lease receivables                   |       | 2,194,613          |       | 28,302                   |       | 6,214                       |       |
| CMC leases (2)                               |       | 25,762             |       | —                   |       | 25,762                      |       |
| Total loan and lease receivables             |       | $                  | 2,220,375  |                     | $          | 28,302                      |       | $ | 31,976 |   |

 
| ** **

** **           | ** ** | **Gross UPB** | ** ** | **Allocated  Allowance** | ** ** | **(1) Non-  performing** | ** ** |
|----------------------------------|------------|--------------------|------------|--------------------------|------------|-------------------------------|------------|
| **As of December 31, 2005**      | ** ** | ** **         | ** ** | ** **               | ** ** | ** **                    | ** ** |
| First mortgages                  |       | $                  | 824,431    |                     | $          | 2,463                         |       | $ | 2,836 |   |
| Second mortgages                 |       | 115,188            |       | 2,973                    |       | 498                           |       |
| Leases                           |       | 379,999            |       | 14,771                   |       | 2,737                         |       |
| Auto                             |       | 610,924            |       | 2,948                    |       | 471                           |       |
| Home equity lines                |       | 257,991            |       | 4,244                    |       | 452                           |       |
| Consumer                         |       | 37,377             |       | 202                      |       | 1                             |       |
| Loan and lease receivables       |       | 2,225,910          |       | 27,601                   |       | 6,995                         |       |
| CMC leases (2)                   |       | 26,054             |       | —                   |       | 26,054                        |       |
| Total loan and lease receivables |       | $                  | 2,251,964  |                     | $          | 27,601                        |       | $ | 33,049 |   |

 

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(1)   Non-performing includes all loans that are 90days or more contractually past due including loans which have been restructured.The Company also held $7,387 and $6,782 of restructured loans which wereperforming in accordance with the restructured terms as of March 31, 2006 andDecember 31, 2005, respectively.

(2)   Reference is made to note 4 of the notes tothe consolidated financial statements included in this report for additionaldetails regarding the CMC lease portfolio.

 

*Mortgage Servicing Rights.*For the three months ended March 31, 2006,the MSR portfolio increased $10,214 or 5%. The increase was primarily driven bythe capitalization of $4,776 from the retention of MSRs, and an increase invalue of $17,091, including a $3,611 valuation recovery. These increases werepartially offset by $10,604 of amortization, and $1,049 net impact of sales ofMSRs. During the three month period ended March 31, 2006, NetBank recorded adecrease of $17,504 in the market value of the derivatives portfolio hedgingthe MSRs. The fair value of the derivative portfolio hedging the MSRs isrecorded in other assets.

 

Thefollowing table provides a sensitivity analysis of the fair values of the MSRportfolio:

 

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| ** **                                 | ** ** | **As of  March 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|--------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|
| Fair value                                 | ** ** | $                                        | 212,963    |                                        | $          | 202,543 |   |
| Weighted average life in years             | ** ** | 5.6                                      |       | 5.2                                         |       |
|                                       |       |                                     |       |                                        |       |
| Prepayment speed assumption (annual rate)  | ** ** | 12.50                                    | %          | 13.70                                       | %          |
| Impact on fair value of 10% adverse change | ** ** | $                                        | (10,773    | )                                           | $          | (9,442 | ) |
| Impact on fair value of 20% adverse change | ** ** | $                                        | (21,677    | )                                           | $          | (18,579 | ) |
|                                       |       |                                     |       |                                        |       |
| Discount rate                              | ** ** | 10.47                                    | %          | 10.83                                       | %          |
| Impact on fair value of 10% adverse change | ** ** | $                                        | (14,117    | )                                           | $          | (9,177 | ) |
| Impact on fair value of 20% adverse change | ** ** | $                                        | (21,425    | )                                           | $          | (16,194 | ) |

 

The sensitivities above are hypothetical andshould be used with caution. As the figures indicate, changes in fair valuebased on a 10% variation in assumptions generally cannot be extrapolatedbecause the relationship of the change in assumption to the change in fairvalue may not be linear. Also, in the table above, the effect of a variation ina particular assumption on the fair value of the available for sale servicingrights is calculated without changing any other assumption; in reality, changesin one factor may result in changes in another, which might magnify orcounteract the sensitivities. The analysis above excludes the impact of ourhedging activities related to the available for sale servicing rights.

 

*Derivatives.*The value of derivatives hedging the MSR portfolio was $6,054 at March31, 2006 compared to $23,558 at December 31, 2005, a decrease of $17,504. Thederivatives consist primarily of commitments to purchase mortgage poolsecurities, options, floors, swaps, swaptions, caps, and floors. The value ofthe derivatives hedging the pipeline of MSRs was $2 at March 31, 2006 comparedto a loss of $993 at December 31, 2005. The value of our loan commitments forwhich the interest rate is locked (“rate locks”) decreased in value to a lossof $1,980 at March 31, 2006 compared to a gain of $1,592 at December 31, 2005,a decrease of $3,572. Our portfolio of mandatory delivery commitments hedgingour rate locks reflected a gain of $1,199 at March 31, 2006 compared to a lossof $1,081 at December 31, 2005. Both the rate locks and corresponding mandatorydelivery commitments are marked-to-market and reflected in our consolidated statementof operations. The value of the mandatory delivery commitments hedging ourinventory of closed loans reflected a gain of $3,040 at March 31, 2006 comparedto a loss of $2,852 at December 31, 2005, an improvement of $5,892. Since aportion of the mandatory delivery commitments qualify for hedge accounting, abasis adjustment was recorded to our inventory of mortgage loans held for salefor the effective hedges.

 

*Liabilities.*Our total liabilities decreased$286,943 during the three months ended March 31, 2006. The decrease wasprimarily related to decreases of $291,548 in other borrowed funds, $18,475 inaccounts payable and accrued liabilities, $4,612 in loans in process, $4,434 inrepresentations and warranties, and $294 in accrued interest payable. Thesedecreases were offset, in part, by an increase of $32,420 in deposits. We wereable to reduce other borrowed funds as a result of the decrease in loans heldfor sale during the quarter ended March 31, 2006.

 

*Deposits.*Deposits were $2,826,267 at March31, 2006, a 1% increase compared to $2,793,847 at December 31, 2005. As ofMarch 31, 2006, deposits represented 72% of total interest-bearing liabilities(including deposits, other borrowed funds, and subordinated debt) outstanding;Federal Home Loan Bank (“FHLB”) advances, warehouse lines of credit, andrepurchase agreements represented approximately 27% in the aggregate; andsubordinated debt was only 1%. We will continue working to expand ourrelationships with new and existing customers to increase our deposit base.

 

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The following table summarizes our deposits:

 
| ** **                             | ** ** | **As of March 31, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|----------------------------------------|------------|----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                             | ** ** | **Amount**                                   | ** ** | **Percentage**                                  | ** ** | **Weighted  average  interest rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest rate** | ** ** |
| Non-interest bearing checking accounts |       | $                                            | 301,370    |                                            | 10.6       | % | — |   | $ | 284,046 |   | 10.2 | % | — |   |
| Interest bearing:                      |       |                                         |       |                                            |       |   |   |   |   |   |   |   |   |
| Checking accounts                      |       | 233,305                                      |       | 8.3                                             | %          | 0.9 | % | 232,658 |   | 8.3 | % | 0.9 | % |
| Money market                           |       | 917,778                                      |       | 32.5                                            | %          | 3.3 | % | 943,432 |   | 33.8 | % | 3.2 | % |
| Certificate of deposit under $100      |       | 1,279,327                                    |       | 45.3                                            | %          | 4.3 | % | 1,240,784 |   | 44.4 | % | 4.0 | % |
| Certificate of deposit over $100       |       | 94,487                                       |       | 3.3                                             | %          | 4.3 | % | 92,927 |   | 3.3 | % | 4.1 | % |
| Total deposits                         |       | $                                            | 2,826,267  |                                            | 100.0      | % |   |   |   | $ | 2,793,847 |   | 100.0 | % |   |   |
|                                        |            |                                              |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |

* *

*Reserve for Representations and Warranties.*Thereserve for representations and warranties is maintained at a level estimatedto be adequate to cover future losses on loans which we may be required torepurchase under representations and warranties provided to purchasers. Weestablish the reserve for future losses by reducing current period gain on saleof loans. The reserve declined by $4,434 during the three months ended March31, 2006. This decline is primarily attributable to the decline in the volumeof loans sold during 2005 and 2004, a reduction in prepayments that triggerearly prepayment claims by buyers of loans, and a reduction in estimated lossesrelated to several large, suspected customer misrepresentation situations. Themajority of repurchases occur during the first 24 months following the date ofsale. Recently we have experienced an increase in the frequency and severityrelated to repurchases; however, it is still uncertain whether this trend willcontinue or abate. If the trend continues to increase in future periods, itwould require us to continue to provide for losses at higher levels to coverfuture losses on the disposition of repurchased loans.

 

*Shareholders’ Equity.*Total shareholders’equity decreased $15,762 for the three months ended March 31, 2006. The declineis primarily due to a change of $5,465 in accumulated other comprehensive loss,$11,832 in retained earnings, and $687 in treasury stock. These changes wereoffset, in part, by a $5,969 increase in additional paid in capital and adecline in unearned compensation of $1,253. The decline in retained earnings isprimarily the result of the net loss of $10,951 for the three months endedMarch 31, 2006, $926 of dividends, $220 of losses on the reissuance of treasurystock, and an increase of $265 resulting from reclassification of unearnedcompensation upon adoption of SFAS 123(R). The change in treasury stock is theresult of the repurchase of 6,000 shares of common stock offset by thereissuance of 119,009 shares under the employee stock purchase plan andrestricted stock grants. Further, upon adoption of SFAS 123(R), we reclassified189,313 shares of restricted stock granted to treasury stock. We plan to continueto repurchase shares periodically in the public market or through privatetransactions. As of March 31, 2006, 1,086,573 shares remained available forrepurchase under current Board authorization.

 

**Results of Operations – Three months ended March 31, 2006 compared tothe three months ended March 31, 2005**

 

*General.*  Net loss for the three monthsended March 31, 2006 was $10,951 or $0.24 per share, compared to a net loss of$2,029 or $0.04 per share for the same period in 2005. The current quarter wasnegatively impacted by the continued flattening of the yield curve whichresulted in decreased net interest income. Declines in gains on sales ofmortgage loans and net servicing results also contributed to this quarter’sloss. In addition, we experienced increased salaries and benefits costsprimarily attributable to the adoption of SFAS 123 (R) and increased occupancyexpenses primarily related to the acquisition of Major Mortgage in the thirdquarter of 2005.

 

*Interest Income*.  Our interest income forthe three months ended March 31, 2006 was $66,875 compared to $57,020 for thesame period in 2005. This increase was the result of the average yieldincreasing by 67 basis points to 6.07% of

 

26

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interest-earning assets coupled with an increase of $186,402 in theaverage balance of interest-earning assets. Reference is made to the ratevolume variance table set forth below for additional detail regarding thechanges in interest income.

 

*Interest Expense*. Total interest expense forthe three months ended March 31, 2006 was $39,017 compared to $26,243 for thesame period of 2005. The $12,774 net increase is due to an increase of $225,785in the average balance of interest-bearing liabilities and a 109-basis pointincrease in the average cost of funds. For the three months ended March 31,2006 compared to same period of 2005, interest expense on deposits increased$8,681 as a result of increases in the average interest rate paid coupled witha $285,469 increase in the average outstanding balance of deposits. For thethree months ended March 31, 2006, interest expense on other borrowed funds(including short-term debt, FHLB advances, and convertible subordinated debt)was $17,120 compared to $13,027 for the same period of 2005. The $4,093increase in interest expense related to other borrowed funds is a result ofincreases in the average cost of funds. Reference is made to the rate volumevariance table set forth below for additional detail regarding the changes ininterest income.

 

*Net Interest Income.*Net interest income isdetermined by interest rate spread, which is the difference between the yieldsearned on interest-earning assets and the rates paid on interest-bearingliabilities, and the relative amounts of interest-earning assets andinterest-bearing liabilities. Net interest income was $27,858 or 2.30% ofaverage interest-earning assets for the three months ended March 31, 2006compared to $30,777 or 2.72% of average interest-earning assets for the threemonths ended March 31, 2005. The 42-basis point decline is primarily due to aflattening of the yield curve as recent increases in short-term rates have notcarried through to the long end of the yield curve. The rates we pay on ourdeposits and short-term borrowings is generally related to the short end of theyield curve; whereas the yield we earn on our mortgage loans held for sale isbased primarily on the long end of the curve.

 

The following table details the relativeinterest rates and average balances of our interest-earning assets andinterest-bearing liabilities for the three months ended March 31, 2006 and2005:

 
| **Average Balance** | ** ** | **Average Yield /  Rate** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** **                          | ** ** | **Variance attributable  to**              | ** ** |
|--------------------------|------------|-------------------------------------|------------|------------|------------|--------------|------------|-------------------------------------|------------|-------------------------------------------------|------------|
| **2006**                 | ** ** | **2005**                            | ** ** | **2006**   | ** ** | **2005**     | ** ** | ** **                          | ** ** | **2006**                                        | ** ** | **2005** | ** ** | **Variance** | ** ** | **Rate** | ** ** | **Volume (3)** | ** ** |
| ** **               |       |                                |       |       |       |         |       | **Interest-earning  assets:**       |       |                                            |       |   |   |   |   |   |   |   |   |
| $                        | 51,201     |                                | $          | 58,867     |       | 4.27         | %          | 2.58                                | %          | Short-term  investments                         |       | $ | 546 |   | $ | 379 |   | $ | 167 |   | $ | 249 |   | $ | (82 | ) |
| 711,055                  |       | 775,634                             |       | 4.73       | %          | 4.53         | %          | Investment  securities (1)          |       | 8,414                                           |       | 8,788 |   | (374 | ) | 390 |   | (764 | ) |
| 1,439,837                |       | 1,286,221                           |       | 7.07       | %          | 6.40         | %          | Loans held  for sale (2)            |       | 25,442                                          |       | 20,583 |   | 4,859 |   | 2,145 |   | 2,714 |   |
| 2,205,473                |       | 2,100,442                           |       | 5.89       | %          | 5.19         | %          | Loans and  leases receivable (2)    |       | 32,473                                          |       | 27,270 |   | 5,203 |   | 3,657 |   | 1,546 |   |
| 4,407,566                |       | 4,221,164                           |       | 6.07       | %          | 5.40         | %          | Total  interest-earning assets      |       | 66,875                                          |       | 57,020 |   | 9,855 |   | 6,441 |   | 3,414 |   |
|                     |       |                                |       |       |       |         |       |                                |       |                                            |       |   |   |   |   |   |   |   |   |
| ** **               |       |                                |       |       |       |         |       | **Interest-bearing  liabilities:**  |       |                                            |       |   |   |   |   |   |   |   |   |
| 223,168                  |       | 231,310                             |       | 1.38       | %          | 1.29         | %          | Checking  accounts                  |       | 768                                             |       | 744 |   | 24 |   | 52 |   | (28 | ) |
| 922,843                  |       | 1,134,272                           |       | 3.07       | %          | 2.01         | %          | Money market                        |       | 7,093                                           |       | 5,713 |   | 1,380 |   | 3,005 |   | (1,625 | ) |
| 1,363,423                |       | 858,383                             |       | 4.12       | %          | 3.15         | %          | Certificates  of deposit            |       | 14,036                                          |       | 6,759 |   | 7,277 |   | 2,078 |   | 5,199 |   |
| 1,062,001                |       | 897,615                             |       | 4.64       | %          | 2.91         | %          | Short-term  debt                    |       | 12,329                                          |       | 6,525 |   | 5,804 |   | 3,896 |   | 1,908 |   |
| 533,944                  |       | 766,950                             |       | 3.14       | %          | 3.21         | %          | FHLB  advances                      |       | 4,194                                           |       | 6,162 |   | (1,968 | ) | (138 | ) | (1,830 | ) |
| 32,477                   |       | 23,541                              |       | 7.35       | %          | 5.78         | %          | Subordinated  debt                  |       | 597                                             |       | 340 |   | 257 |   | 93 |   | 164 |   |
| 4,137,856                |       | 3,912,071                           |       | 3.77       | %          | 2.68         | %          | Total  interest-bearing liabilities |       | 39,017                                          |       | 26,243 |   | 12,774 |   | 8,986 |   | 3,788 |   |
| —                   |       | —                              |       | 2.30       | %          | 2.72         | %          | Net interest  margin                |       | 27,858                                          |       | 30,777 |   | (2,919 | ) | (2,545 | ) | (374 | ) |
| 269,710                  |       | 309,093                             |       | 0.23       | %          | 0.20         | %          | Interest  free sources              |       | —                                          |       | — |   | — |   | — |   | — |   |
| $                        | 4,407,566  |                                | $          | 4,221,164  |       | 2.53         | %          | 2.92                                | %          | Net interest  income to interest-earning assets |       | $ | 27,858 |   | $ | 30,777 |   | $ | (2,919 | ) | $ | (2,545 | ) | $ | (374 | ) |

 

----

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

 

27

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

(3)   Variances attributable to the rate and volumemix are included in the volume variances.

 

*Provision for Credit Losses.*  Theprovision for credit losses was $3,057 for the three months ended March 31,2006 compared to $2,351 for the same period of 2005. The increase in provisionrelates primarily to the increased retention of auto loans and businessfinancing leases compared to the 2005 period. Reference is made to the heading “FinancialCondition - Asset Quality and Non-performing Assets” above for additionaldetail concerning the determination of provision expense related to maintainingthe proper level of allowance for credit losses.

 

*Non-interest Income.* Non-interest incomedeclined by $4,464 to $29,997 for the three months ended March 31, 2006compared to the same period of 2005. We experienced increased losses onderivatives of $3,909 during the three months ended March 31, 2006 compared tothe same period of 2005 as well as declines on our gains on sales of loans andMSRs of $840.

 

*Non-interest Expense.*  Non-interestexpense includes all operating expenses such as salaries and benefits,marketing, and general and administrative expenses. Non-interest expenseincreased $5,502 or 8% for the three months ended March 31, 2006 compared tothe same period of 2005. This increase was primarily driven by the $3,117increase in salaries and benefits related to the adoption of SFAS 123(R) and a$1,075 increase in occupancy costs related primarily to the acquisition ofMajor Mortgage in the third quarter of 2005. Likewise, marketing costs haveincreased $739 related to the growth in our retail mortgage operations. Theseincreases are offset, in part, by reductions in prepaid lost interest fromcurtailments of $409 due to reduced early payoffs of mortgage loans.

 

*Adoption of SFAS 123(R)*. On January 1, 2006,we adopted SFAS 123(R) using the modified prospective transition method. Unlikethe modified retrospective transition method, the modified prospective methodhas no impact on prior period financial statements. Prior to the adoption ofSFAS 123 (R), we accounted for stock based compensation under the provisions ofAPB Opinion No. 25, “Accounting for Stock Issued to Employees”. As such, nocompensation cost was recognized in the consolidated statement of operationsrelated to the Employee Stock Purchase Plan or options as all options grantedhad an exercise price equal to the market value of the underlying common stockon the grant date. Compensation expense was previously recognized related tothe Mid-Term Incentive Plan and stock awards.

 

As a result of the adoption, loss before income taxes for the threemonths ended March 31, 2006 include $1,561 of stock based compensation costs. Asof March 31, 2006, there was $7,794 of unrecognized compensation cost, net ofestimated forfeitures, related to stock based compensation. This cost isexpected to be recognized over a weighted average period of less than 4 yearson a straight line basis. The Black-Scholes-Merton pricing model was used tocalculate the fair value of stock options and stock grants, and no cumulativeeffect of accounting adjustment was required. In anticipation of the adoptionof SFAS 123(R), we began granting certain employees a combination of stockoptions and stock awards as opposed to all stock options, and acclerated thevesting of all options which had a strike price in excess of $14.00. We have noimmediate plans to modify share based payment arrangements. See note 9 of thenotes to the consolidated financial statements included herein for furtherinformation regarding share based payments including assigned assumptions. 

 

*Retail Banking Segment.*

 

The table below provides an overview of the pre-tax results ofoperations for the retail banking segment:

 
| ** **                                    | ** ** | **For the three months ended March 31,** | ** ** |
|-----------------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **2006**                                                               | ** ** | **2005** | ** ** | **Change** | ** ** |
| Net interest income                           | ** ** | $                                                                      | 20,969     |   | $ | 20,959 |   | $ | 10 |   |
| Provision for credit losses                   | ** ** | 2,999                                                                  |       | 2,336 |   | 663 |   |
| Net interest income after provision           | ** ** | 17,970                                                                 |       | 18,623 |   | (653 | ) |
| Gains on sales of loans                       | ** ** | —                                                                 |       | 501 |   | (501 | ) |
| Fees, charges and other income                | ** ** | 3,631                                                                  |       | 3,435 |   | 196 |   |
| Total revenues                                | ** ** | 21,601                                                                 |       | 22,559 |   | (958 | ) |
| Total expenses                                | ** ** | 19,916                                                                 |       | 17,322 |   | 2,594 |   |
| Pre-tax income                                | ** ** | $                                                                      | 1,685      |   | $ | 5,237 |   | $ | (3,552 | ) |
|                                          |       |                                                                   |       |   |   |   |   |
| Average earning assets                        | ** ** | $                                                                      | 4,609,654  |   | $ | 4,305,234 |   | $ | 304,420 |   |
|                                          |       |                                                                   |       |   |   |   |   |
| **Operations to average earning assets**      |       |                                                                   |       |   |   |   |   |
| Net interest income after provision           | ** ** | 1.56                                                                   | %          | 1.73 | % | (0.17 | )% |
| Gain on sale, fees, charges and other  income | ** ** | 0.32                                                                   | %          | 0.37 | % | (0.05 | )% |
| Banking revenues                              | ** ** | 1.88                                                                   | %          | 2.10 | % | (0.22 | )% |
| Total expenses                                | ** ** | 1.73                                                                   | %          | 1.61 | % | 0.12 | % |
| Pre-tax income                                | ** ** | 0.15                                                                   | %          | 0.49 | % | (0.34 | )% |

 

28

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The retail banking segment recorded pre-taxincome of $1,685 in the first quarter of 2006, a $3,552 decrease over thecomparable period in 2005. The Internet-only banking and leasing operationscontributed to the retail banking segment decrease by declining $3,061 and$541, respectively. The segment was negatively impacted by increased provision forcredit losses of $663 as a result of the continued retention of leases andautomobile loans. In addition, operating expenses increased by $2,594 primarilydue to increases in expenses related to our QuickPost initiative and thecontinued growth of our Dealer Financial Services operations. Net interestincome increased due to a $304,420 increase in the average balance of interestearning assets offset in part by a 17-basis point decrease in net interestincome after provision relating to the flattening of the yield curve.

 

*Financial IntermediarySegment.*

 

The following table highlights the financialintermediary segment’s pre-tax results and production and sales activities:

 
| ** **                          | ** ** | **For the three months ended March 31,** | ** ** |
|-------------------------------------|------------|------------------------------------------------------------------------|------------|
| ** **                          | ** ** | **2006**                                                               | ** ** | **2005** | ** ** | **Change** | ** ** |
| Net interest income                 | ** ** | $                                                                      | 6,693      |   | $ | 9,713 |   | $ | (3,020 | ) |
| Gain on sales of loans and MSRs     | ** ** | 22,450                                                                 |       | 23,301 |   | (851 | ) |
| Other income                        | ** ** | 524                                                                    |       | 714 |   | (190 | ) |
| Net Beacon Credit Services results  | ** ** | (286                                                                   | )          | (669 | ) | 383 |   |
| Net MG Reinsurance results          | ** ** | 881                                                                    |       | 873 |   | 8 |   |
| Total revenues                      | ** ** | 30,262                                                                 |       | 33,932 |   | (3,670 | ) |
| Salary and employee benefits        | ** ** | 18,294                                                                 |       | 18,656 |   | (362 | ) |
| Occupancy and depreciation expense  | ** ** | 6,235                                                                  |       | 6,202 |   | 33 |   |
| Other expenses                      | ** ** | 10,172                                                                 |       | 8,656 |   | 1,516 |   |
| Total expenses                      | ** ** | 34,701                                                                 |       | 33,514 |   | 1,187 |   |
| Pre-tax (loss) income               | ** ** | $                                                                      | (4,439     | ) | $ | 418 |   | $ | (4,857 | ) |
|                                |       |                                                                   |       |   |   |   |   |
| Production                          | ** ** | $                                                                      | 2,815,262  |   | $ | 2,776,609 |   | $ | 38,653 |   |
| Sales (includes intersegment sales) | ** ** | $                                                                      | 2,894,307  |   | $ | 2,760,463 |   | $ | 133,844 |   |
|                                |       |                                                                   |       |   |   |   |   |
| Total revenues to sales             | ** ** | 1.05                                                                   | %          | 1.23 | % | (0.18 | )% |
| Total expenses to production        | ** ** | 1.23                                                                   | %          | 1.21 | % | 0.02 | % |
| Pre-tax margin                      | ** ** | (0.18                                                                  | )%         | 0.02 | % | (0.20 | )% |

 

Note: The ratio of revenuesto sales is based on mortgage banking sales, which includes inter-segment salesto the retail bank segment.

 

For the three months ended March 31, 2006, the financial intermediarysegment had a pre-tax loss $4,439 versus pre-tax income of $418 for the sameperiod in 2005. A decrease in net interest income of $3,020 contributed to thedecline.

 

29

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Generally, NetBank earns a long-term interest rate on loans held forsale and finances those loans with short-term borrowings. As the yield curveflattens, the net interest margin compresses. In addition, operating expensesfor this segment increased $1,187 and gain on sales of loans and MSRs decreased$851. As outlined in previous filings with the SEC, the Company recorded aspecial provision of $3,500 as a reduction in gain on sales of loans and MSRsduring the third quarter of 2005. During the first quarter of 2006, the Companyrecovered $2,009 and recorded it as an increase to gain on sales of loans andMSRs. 

 

Although there has been a slight increase in sales, production volumeshave remained relatively flat. Margins on sales have remained depressedreflecting the continued strong competitive conditions.

 

*Transaction Processing Segment.*

 

Thetransaction processing segment provides ATM and merchant processing servicesand subservices loans for the retail banking segment, financial intermediarysegment, the servicing asset segment and third party customers.

 

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

 
| ** **     | ** ** | **For the three months ended March 31,** | ** ** |
|----------------|------------|------------------------------------------------------------------------|------------|
| ** **     | ** ** | **2006**                                                               | ** ** | **2005** | ** ** | **Change** | ** ** |
| Total revenue  | ** ** | **$**                                                                  | **6,225**  |   | $ | 6,634 |   | $ | (409 | ) |
| Total expenses | ** ** | **4,727**                                                              |       | 4,666 |   | 61 |   |
| Pre-tax income | ** ** | **$**                                                                  | **1,498**  |   | $ | 1,968 |   | $ | (470 | ) |

 

30

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The transaction processing segment recorded pre-tax income of $1,498, a$470 decrease period over period. The reduction in pre-tax income was primarilydue to the decline in pre-tax results at NPS of $527 off-set by an increase inresults of $57 within the servicing factory. Although the number of loansserviced within the servicing factory has declined, the pre-tax margin per loanhas improved nine dollars.

 

*Servicing Asset Segment.*

 

The servicing asset segment manages the MSRs retained by the Company inconjunction with the origination of mortgage loans or obtained through bulktransactions. The servicing asset segment recorded a pre-tax loss of $5,805 forthe three months ended March 31, 2006, a change of $2,356 from the same periodin 2005. The changes were primarily attributable to the decrease period overperiod in net hedge results of $3,434. Hedge performance came under pressureduring the first quarter of 2006 as the margin between mortgage rates and swapscompressed sharply. The decline in net hedge results was off-set by increasesin net interest income of $351 and servicing fees of $471. 

 
| ** **               | ** ** | **For the three months ended March 31,** | ** ** |
|--------------------------|------------|------------------------------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                                               | ** ** | **2005** | ** ** | **Change** | ** ** |
| Net interest income      |       | $                                                                      | 326        |   | $ | (25 | ) | $ | 351 |   |
| Servicing fees           |       | 10,601                                                                 |       | 10,130 |   | 471 |   |
| Other income             |       | 28                                                                     |       | 66 |   | (38 | ) |
| Total revenue            |       | 10,955                                                                 |       | 10,171 |   | 784 |   |
| Amortization of MSRs     |       | 10,547                                                                 |       | 10,529 |   | 18 |   |
| Subservicing fees paid   |       | 2,503                                                                  |       | 2,414 |   | 89 |   |
| Other expenses           |       | 623                                                                    |       | 1,024 |   | (401 | ) |
| Total expenses           |       | 13,673                                                                 |       | 13,967 |   | (294 | ) |
| Pre-tax servicing margin |       | (2,718                                                                 | )          | (3,796 | ) | 1,078 |   |
| Loss on hedges           |       | (6,698                                                                 | )          | (333 | ) | (6,365 | ) |
| Recovery of MSRs         |       | 3,611                                                                  |       | 680 |   | 2,931 |   |
| Net hedge results        |       | (3,087                                                                 | )          | 347 |   | (3,434 | ) |
| Net pre-tax loss         |       | $                                                                      | (5,805     | ) | $ | (3,449 | ) | $ | (2,356 | ) |

* *

*Other/Corporate Overhead Segment.*

 

The other/corporate overhead segment contains holding company andoverhead expenses along with the elimination of inter-segment gains and losseson loans sold to the retail banking segment from the financial intermediarysegment. Overhead expenses that are wholly attributable to a line of businessare recognized within that business, while overhead expenses that relate tomultiple lines of business are pooled and reported within the other/corporateoverhead segment. The other/corporate overhead segment incurred a $9,657pre-tax loss for the three months ended March 31, 2006 compared to a pre-taxloss of $7,301 for the comparable period of 2005. The $2,356 change reflects expensesrelated to the adoption of SFAS 123(R).

 

# **CriticalAccounting Policies**

# ** **

Seniormanagement, in conjunction with the Audit Committee of the Board of Directors,has identified valuation of the MSR portfolio, determination of the allowancefor credit losses, liabilities for representations and warranties on loans andMSRs sold and accounting for derivative financial instruments as our mostcritical accounting policies. These policies were identified as being the mostcritical based on the SEC’s guidance in identifying them based on whether 1)the accounting estimate required management to make assumptions about mattersthat were highly uncertain at the time the accounting estimate was made and 2)different estimates reasonably could have been used in the current period, orchanges in the accounting estimate that are reasonably likely to occur fromperiod to period, would have a material impact on the presentation of thefinancial condition or results of operations. Management believes that givencurrent information, its judgments, estimates and assumptions used in thesepolicies are appropriate. For further information regarding our criticalaccounting policies, refer to the heading “Critical Accounting Policies” onpage 60 of our 2005 Form 10-K.

 

31

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# **ContractualObligations and Off-Balance Sheet Arrangements**

# ** **

Inthe normal course of business, we have contractual obligations to makescheduled payments for our operating leases; our liability to repurchase loansunder representations and warranties provided to purchasers of our mortgageloans and MSRs; and principal and interest payments on borrowed funds. We arenot a party to any off-balance sheet financing arrangements and do not holdunconsolidated interests in any variable interest entities that could give riseto future contractual obligations. For information as of December 31, 2005regarding the schedule of amounts contractually due, please refer to thediscussion under the heading “Contractual Obligations and Off-Balance SheetArrangements” on page 62 of our 2005 Form 10-K.

 

# **Liquidityand Capital Resources**

# ** **

*Liquidity.*NetBank’s liquidity, represented bycash and cash equivalents, is a product of its operating, investing, andfinancing activities. Our primary sources of funds are deposits, borrowings,prepayments and maturities of outstanding loans, sales of loans, sales ormaturities of investment securities and other short-term investments, and fundsprovided from operations. While scheduled loan payments and maturing investmentsecurities and short-term investments are relatively predictable sources offunds, deposit flows and loan prepayments are greatly influenced by generalinterest rates, economic conditions, and competition. We can use cash generatedthrough the retail deposit market, our traditional funding source, to offsetthe cash utilized in investing activities. Our available for sale securitiesand short-term interest-earning assets can also be used to provide liquidityfor lending and other operational requirements. Net cash inflows for the threemonths ended March 31, 2006 was $27,952 compared to $18,326 the same period in2005. The increase in the 2006 period primarily related to the increase of$32,420 in deposits and an increase in proceeds from the sales of loans heldfor sale of $275,844. These cash inflows were offset, in part, by increases inoutflows of $77,054 related to originations of loans held for sale and netoutflows of $291,548 related to other borrowed funds. The increase in proceedsfrom loans held for sale was primarily a function of mortgage loan salesincreasing $165,505 for the three months ended March 31, 2006 compared to thesame period a year ago.

 

As an additional source of funds, NetBank, Inc. had available underexisting line of credit agreements $1.8 billion at March 31, 2006. Reference ismade to note 8 of the notes to consolidated financial statements included inthis report for additional details regarding the available lines of credit.

 

We use deposits as our principal source offunds. For the three months ended March 31, 2006, deposits increased by $32,420to $2.826 billion from $2.794 billion as of December 31, 2005. Our depositproducts include checking, money market and certificates of deposit accounts. Depositaccount terms vary, with the principal differences being the minimum balancerequired, the time periods the funds must remain on deposit, and the interestrate. We are competitive in the types of accounts, services and ranges ofinterest rates offered on deposit products. Although market demand generallydictates which deposit maturities and rates will be accepted by the public, weintend to continue to promote checking, money market and certificates ofdeposit to the extent possible consistent with asset and liability managementgoals.

 

*CapitalResources.**  *NetBankand NetBank, FSB are subject to various regulatory capital requirementsadministered by the federal banking agencies, including the Office of ThriftSupervision (the “OTS”). Failure of either company to meet minimum capitalrequirements can initiate certain mandatory and possibly additionaldiscretionary actions by regulators that, if undertaken, could have a directmaterial effect on our consolidated financial statements. Under capitaladequacy guidelines and the regulatory framework for prompt corrective action,NetBank, FSB must meet specific capital guidelines that involve quantitativemeasures of NetBank, FSB’s assets, liabilities, and certain off-balance sheetitems as calculated under regulatory accounting practices. NetBank, FSB’scapital amounts and classifications are also subject to qualitative judgmentsby the regulators about components, risk weightings and other factors. Undercurrent regulatory guidelines, NetBank, FSB may not make a capital distributionto the Company without prior approval of the OTS. Current guidelines require,among other things, that NetBank, FSB not make an unapproved capitaldistribution in excess of its current period year-to-date undistributedearnings plus the preceding two years undistributed earnings and in no eventmake a distribution which would cause NetBank, FSB to be less than adequatelycapitalized as defined below.

 

32

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Quantitativemeasures established by regulation to ensure capital adequacy require NetBank,FSB to maintain minimum amounts and ratios as set forth in the following table.The OTS requires NetBank, FSB to maintain minimum ratios of tangible capital totangible assets of 1.5%, core capital to tangible assets of 4.0% and totalcapital to risk-weighted assets of 8.0%. The following table presents informationrelated to NetBank, FSB along with capital requirements mandated by the OTS:

 
| ** **                                  | ** ** | **Actual** | ** ** | **For capital adequacy  purposes** | ** ** | **To be categorized as Well  Capitalized under prompt  corrective action plan** | ** ** |
|---------------------------------------------|------------|------------|------------|----------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                  | ** ** | **Amount** | ** ** | **Ratio**                                    | ** ** | **Amount**                                                                                                              | ** ** | **Ratio** | ** ** | **Amount** | ** ** | **Ratio** | ** ** |
| **March 31, 2006**                          | ** ** | ** ** | ** ** | ** **                                   | ** ** | ** **                                                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total capital (to risk-weighted assets)     |       | $          | 326,416    |                                         | 10.31      | %                                                                                                                       | $          | 253,343 |   | 8.00 | % | $ | 316,678 |   | 10.00 | % |
| Core capital (to adjusted total assets)     |       | $          | 298,114    |                                         | 6.83       | %                                                                                                                       | $          | 174,495 |   | 4.00 | % | $ | 218,119 |   | 5.00 | % |
| Tangible capital (to adjusted total assets) |       | $          | 298,114    |                                         | 6.83       | %                                                                                                                       | $          | 65,436 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital (to risk-weighted assets)    |       | $          | 298,114    |                                         | 9.41       | %                                                                                                                       | N/A        |   | N/A |   | $ | 190,007 |   | 6.00 | % |
| **December 31, 2005**                       |       |       |       |                                         |       |                                                                                                                    |       |   |   |   |   |   |   |
| Total capital (to risk-weighted assets)     |       | $          | 330,510    |                                         | 10.32      | %                                                                                                                       | $          | 256,277 |   | 8.00 | % | $ | 320,346 |   | 10.00 | % |
| Core capital (to adjusted total assets)     |       | $          | 302,909    |                                         | 6.51       | %                                                                                                                       | $          | 186,257 |   | 4.00 | % | $ | 232,821 |   | 5.00 | % |
| Tangible capital (to adjusted total assets) |       | $          | 302,909    |                                         | 6.51       | %                                                                                                                       | $          | 69,846 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital (to risk-weighted assets)    |       | $          | 302,909    |                                         | 9.46       | %                                                                                                                       | N/A        |   | N/A |   | $ | 192,208 |   | 6.00 | % |

 

In addition, NetBank’s subsidiaries engaged in mortgage banking mustadhere to various U.S. Department of Housing and Urban Development (“HUD”)regulatory guidelines including required minimum net worth to maintain theirFHA approved lending status. Failure to comply with the HUD guidelines couldresult in withdrawal of this certification. As of March 31, 2006, Market Streetand Meritage were in compliance with HUD guidelines. NetBank and itssubsidiaries are subject to various other capital requirements by secondarymarket investors and states. None of these capital requirements are morestringent than the OTS capital requirements. Failure to comply with theserestrictions could have a material adverse impact on the Company’s results ofoperations. All of the capital requirements placed upon NetBank and itssubsidiaries were met as of March 31, 2006.

 

# **Item3. Quantitative and Qualitative Disclosures about Market Risk**

# ** **

Our principal businesses are retail banking and the origination andpurchase of loans as well providing business equipment financing leases. Thesebusinesses are funded by customer deposits and, to the extent necessary, otherborrowed funds. Consequently, a significant portion of our assets andliabilities are monetary in nature and fluctuations in interest rates willaffect future net interest income and cash flows. Interest rate risk is ourprimary market risk exposure. For the three months ended March 31, 2006, theonly derivative financial instruments that we entered into were associated withhedging activities related to the portfolio of mortgage loans held for sale,the pipeline of mortgage loans for which the interest rate has been locked,hedging the securitization and sale of portfolio loans, the owned MSRsportfolio and the MSRs associated with the pipeline of mortgage loans for whichthe interest rate has already been locked. Our exposure to market risk isreviewed on a regular basis by management.

 

Reference is made to Item 7A. Quantative and Qualitative DisclosuresAbout Market Risk on page 75 of our 2005 Form 10-K for additional detailsregarding the Company’s exposure to management of market risk.

 

NetBank, FSB, like other savings banks, measures interest rate risk isbased on a Net Portfolio Value (“NPV”) analysis. NPV equals the present valueof expected net cash flows from existing assets minus the present value ofexpected net cash flows from existing liabilities. An NPV ratio is determinedby dividing NPV by the present value of assets.

 

33

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The following table sets forth the estimated NetBank, FSB NPV ratios asof March 31, 2006 and December 31 and March 31, 2005 assuming rate shocksof +300 to -100 basis points:

 

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

 

| **Rate shock  (in basis points)** | ** ** | **As of  March 31, 2006** | ** ** | **As of  December 31, 2005** | ** ** | **As of  March 31, 2005** | ** ** | **Minimum as of  March 31, 2006** | ** ** |
|--------------------------------------------------|------------|------------------------------------------|------------|---------------------------------------------|------------|------------------------------------------|------------|-------------------------------------------------------|------------|
| **+300**                                         | ** ** |                                     | 8.18       | %                                           | 7.35       | %                                        | 8.40       | %                                                     | 4.00       | % |
| **+200**                                         | ** ** |                                     | 8.64       | %                                           | 7.93       | %                                        | 8.69       | %                                                     | 6.00       | % |
| **+100**                                         | ** ** |                                     | 9.12       | %                                           | 8.51       | %                                        | 9.25       | %                                                     | 6.00       | % |
| **Flat**                                         | ** ** |                                     | 9.47       | %                                           | 9.01       | %                                        | 9.72       | %                                                     | 6.00       | % |
| **-100**                                         | ** ** |                                     | 10.08      | %                                           | 9.55       | %                                        | 10.06      | %                                                     | 6.00       | % |

 

Minimumratios for NPV risk are established by the Board of Directors as prudent levelsfor the respective interest rate scenarios. Lower NPV ratios denote more marketrate sensitivity for a given rate scenario. As of March 31, 2006, the analysisindicates sensitivity to rising market interest rates. This sensitivity is,however, well within the Board approved limits for these scenarios. Computationof prospective effects of hypothetical rate changes is based on manyassumptions, including relative levels of market interest rates, loanprepayments and deposit decay. They should not be relied upon as indicative ofactual results. Further, the computations do not contemplate certain actionsmanagement could undertake in response to changes in interest rates.

 

**Item 4. Controls and Procedures**

 

**Management’sConclusion on the Effectiveness of Disclosure Controls and Procedures**

 

*Evaluationof Disclosure Controls and Procedures.* We evaluatedthe effectiveness of the design and operation of our “disclosure controls andprocedures,” as defined in Rule 13a-15(e) under the Securities Exchange Act of1934, as amended (the “Exchange Act”), as of the end of the period covered bythis report. This evaluation (the “controls evaluation”) was done under thesupervision and with the participation of management, including our chiefexecutive officer (“CEO”) and chief financial executive (“CFO”).  

 

*Objectives of Controls*. Disclosure controls and procedures aredesigned so that information required to be disclosed in our reports filedunder the Exchange Act, such as this quarterly report on Form 10-Q, isrecorded, processed, summarized and reported within the time periods specified inthe SEC’s rules and forms. Disclosure controls and procedures are also intendedto ensure that such information is accumulated and communicated to ourmanagement, including the CEO and CFO, as appropriate to allow timely decisionsregarding required disclosure. In designing and evaluating disclosure controlsand procedures, management recognizes that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives, and management is required to applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

 

*Conclusions*. Based upon the controls evaluation, our CEOand CFO have concluded that as of March 31, 2006, our disclosure controls andprocedures are effective to provide reasonable assurance that the foregoingobjectives are achieved.

 

*Changesin Internal Control over Financial Reporting*. There were no changes in our internalcontrol over financial reporting, as defined in Rule 13a-15(f) under theExchange Act, during the period covered by this report that have materiallyaffected, or are reasonably likely to materially affect, our internal controlover financial reporting.

 

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# **PART II. Other Information**

# ** **

# **Item 1. Legal Proceedings**

# ** **

*Illinois Union Insurance Co. v. Commercial MoneyCenter, Inc., et al., Case No. CV-01-0685-KJD-RJJ (DistrictCourt of Nevada)*and relatedcases now pending in *In re Commercial MoneyCenter, Inc. Equipment Lease Litigation in the United States DistrictCourt for the Northern District of Ohio, Eastern Division, MDL CaseNo. 1:02-CV-16000*; the pending bankruptcy cases of CommercialMoney Center, Inc. and Commercial Servicing Corporation titled *In re: Commercial Money Center, Inc. and Commercial ServicingCorporation*, Bankruptcy No. 02-09721-H7 (Jointly Administered),United States Bankruptcy Court For The Southern District of California; and *In re Commercial Money Center, Inc., Debtor (Kipperman v. NetBank,FSB)*, Adversary Proceeding No. 03-90331-JH, In the UnitedStates Bankruptcy Court for the Southern District of California, *appeal**pending**NetBank, F.S.B. v. Richard M. Kipperman, Chapter 7 Trustee for theBankruptcy Estates of Commercial Money Centers, Inc. and CommercialServicing Corporation v. NetBank, F.S.B*, United States BankruptcyAppellate Panel of the Ninth Circuit; BAP No. SC-05-1238

 

Asreported in previous filings, NetBank, FSB, filed a complaint inJanuary 2002 against Commercial Money Center, Inc. (“CMC”), IllinoisUnion Insurance Company (“Illinois Union”), Safeco Insurance Company of America(“Safeco”), and Royal Indemnity Company (“Royal,” and together with IllinoisUnion, Safeco and Royal, collectively referred to as the “Sureties”). CMC wasthe originator and subservicer of various equipment leases (the “Leases”).NetBank, FSB purchased most of the payment streams generated by the subjectLeases from CMC (the “Payment Streams”). The Sureties are insurance companiesthat issued surety bonds and insurance policies guaranteeing payment of thePayment Streams (the “Bonds”) and that also served as master servicers of theleases. The NetBank, FSB action alleges several claims, including claims forbreach of contract, fraud, and bad faith, and seeks, among other things,payment under and enforcement of the Bonds. The Judicial Panel onMulti-District Litigation (the “MDL Judicial Panel”) consolidated the actionsinvolving NetBank, FSB with more than 35 other cases pending around the countryinvolving other banks and financial institutions that were seeking to enforcesurety bonds and insurance policies relating to payment streams sold by CMC.All pre-trial activity is currently being held in the United States DistrictCourt for the Northern District of Ohio (the “MDL Court”).

 

Asreported in previous filings, NetBank, FSB had joined with the other claimants(the “Claimants”) in a motion for judgment on the pleadings (“ConsolidatedMotion for Judgment on the Pleadings” or “Consolidated Motion”), which motionwas filed on January 31, 2003. NetBank, FSB later withdrew its motion forjudgment on the pleadings and on March 25, 2005 filed a Motion for PartialSummary Judgment (the “Summary Judgment Motion”) or, in the alternative, aMotion for Suggestion of Remand (the “Remand Motion”). The Summary JudgmentMotion seeks judgment as a matter of law on NetBank, FSB’s breach of contractclaims. The Remand Motion requested that, in lieu of deciding the SummaryJudgment Motion, the MDL Court instead suggest to the MDL Judicial Panel thatthe claims of NetBank, FSB be remanded to the United States District Court forthe District of Nevada. The Sureties filed oppositions to the Remand Motion,and they have argued that they do not need to respond to the Summary Judgment Motionuntil an unspecified date in the future after the MDL Court rules on thepending Consolidated Motion for Judgment on the Pleadings. The MDL Court deniedthe Remand Motion, but has not ruled on the Summary Judgment Motion.

 

OnAugust 19, 2005, the MDL Court entered two orders on the Claimants’Consolidated Motion for Judgment on the Pleadings. The Court granted theClaimants’ motion with respect to Illinois Union Insurance Company (the “IllinoisUnion Order”), finding that Illinois Union was liable as a matter of law underthe bonds that it issued and could not assert fraud of CMC as a defense.Because NetBank, FSB had previously withdrawn from the Consolidated Motion inorder to file the Summary Judgment Motion, the MDL Court held that NetBankcould file a motion to renew its interest in the Consolidated Motion so thatthe Illinois Union Order could apply to NetBank, FSB. NetBank filed its motionto renew its interest, and Illinois Union has filed an opposition.

 

Inthe second order on the Claimants’ Consolidated Motion, the MDL Court deniedthe Motion with respect to all the remaining sureties, including Royal andSafeco. The MDL Court held that it could not determine, based on the pleadingsalone, whether the Claimants were the intended obligees under the Bonds and,therefore, whether fraud of CMC could constitute a defense to the Sureties’obligation to pay under the terms of the Bonds. The MDL Court went on to hold,however, that if the Claimants are ultimately determined to be the obligeesunder the Bonds, the Sureties will be precluded from raising a defense offraudulent inducement by CMC.

 

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OnOctober 31, 2005, the MDL Court ordered that the parties mediate theirrespective claims with a retired federal court judge in Cleveland, Ohio.NetBank, FSB participated in separate mediation sessions with each of theSureties, but none of NetBank, FSB’s claims were settled through thiscourt-ordered mediation process, which concluded on March 15, 2006. Duringthe mediation process, all further filings in the case have been stayed, exceptfor matters relating to NetBank, FSB’s motion to renew interest and motionsseeking final or partial final judgment against Illinois Union.

 

On May 9, 2006, the MDL Courtruled on whether the Illinois Union Order applies to NetBank, FSB. The MDLCourt held that NetBank, FSB would be entitled to the benefit of the IllinoisUnion rulings, which barred Illinois Union from raising fraud by CMC andinsurance related defenses as defenses to payment. The MDL Court also suggestedthat NetBank, FSB would be entitled to judgment as a matter of law with respectto the Bonds issued by Illinois Union prior to December 2000, but declined toenter judgment at this time because of allegations of fraud on the part ofNetBank, FSB with respect to certain Bonds, so-called replacement bonds, issuedin January 2001. The MDL Court held that Illinois Union’s allegations of fraudby NetBank, FSB in connection with the issuance of the replacement bonds weresufficient to get past the pleading stage of the litigation. However, the courtnoted that NetBank, FSB had previously moved for summary judgment againstIllinois Union and suggested that now, in light of the ruling, NetBank, FSBcould re-file its motion for summary judgment to dispose of all remainingbreach of contract issues, including the alleged fraud by NetBank, FSB inrespect of the replacement bonds, pursuant to a scheduling order to be issuedby the MDL Court at a later date. The MDL Court left open the issue of whetherIllinois Union would be permitted to amend its pleadings to allege new defensesor claims not expressly covered by the Illinois Union Order and stated thatthis issue would be decided when the MDL Court rules on Illinois Union’s pendingmotion for leave to amend its pleadings. The MDL Court made it clear, however,that Illinois Union would not be permitted to amend to avoid the impact of theIllinois Union Order.

 

TheCompany believes that based on the overall facts and circumstances, thedefenses asserted by the Sureties will fail and that NetBank, FSB willultimately prevail on its claims.

 

Also,as reported in previous filings, on May 30, 2002, CMC filed for bankruptcyprotection. Shortly thereafter, Commercial Servicing Corporation (“CSC”), anaffiliate of CMC, also filed bankruptcy. The bankruptcy cases and relatedproceedings are not a part of the consolidated action in the MDL Court. On September 4, 2003, the Trustee inbankruptcy for CMC and CSC initiated an adversary proceeding in the bankruptcycases by filing a Complaint against NetBank, FSB seeking to avoid NetBank, FSB’sinterest in the Payment Streams and their supporting Bonds relating to theRoyal guaranteed pools of Leases (the “Adversary Proceeding”). On May 6,2004, NetBank, FSB filed a motion for partial summary judgment against theTrustee. The Trustee filed a cross-motion for partial summary judgment againstNetBank, FSB on June 18, 2004. On January 27, 2005, the BankruptcyCourt entered its Memorandum Decision granting the Trustee’s motion for partialsummary judgment and denying NetBank, FSB’s motion for partial summaryjudgment. On February 28, 2005, the Bankruptcy Court entered an orderdenying NetBank, FSB’s Motion for Partial Summary Judgment and granting theTrustee’s Cross-Motion for Summary Judgment. On April 27, 2005, theBankruptcy Court entered a judgment conforming to the Memorandum Decision. OnMay 20, 2005, the Bankruptcy Court entered an amended judgment conformingto the Memorandum Decision. The Bankruptcy Court held in the MemorandumDecision that NetBank, FSB was required, but failed, to perfect its interest inthe Payment Streams that were transferred to it from CMC in the subjecttransactions and that the subject transactions were loans rather than sales.Also on May 20, 2005, NetBank, FSB appealed the amended judgment to theBankruptcy Appellate Panel for the Ninth Circuit Court of Appeals. OnMay 25, 2005, NetBank, FSB sought a stay pending appeal of the turnoverprovisions of the amended judgment from the Bankruptcy Court. The BankruptcyCourt denied the request for stay on August 1, 2005. Instead of seekingappellate review of the denial of the motion to stay, NetBank, FSB entered intoan agreement with the Trustee whereby the Trustee agreed to safely hold thedisputed Bonds pending conclusion of the appellate process. The BankruptcyAppellate Panel heard oral argument in the case on March 23, 2006. NetBank,FSB is awaiting the ruling of the Bankruptcy Appellate Panel.

 

In the meantime, many of the parties to the CMC and CSCbankruptcy cases resolved their disputes and entered into a Global SettlementAgreement, which was approved by the Bankruptcy Court on May 31, 2005. TheGlobal Settlement Agreement resolved all issues regarding ownership of thePayment Streams that were at issue in the Adversary Proceeding, howeverownership of the Royal issued Bonds remains an issue in the AdversaryProceeding, as discussed above. Pursuant to the Global Settlement Agreement,NetBank, FSB received a settlement payment during the second quarter of 2005 ofapproximately $4 million. In addition, the Global Settlement Agreement providedthat NetBank, FSB receive, retroactive to October 1, 2004, 100% of all leasepayments made by lessees of Payment Streams transferred to NetBank, FSB. Also,NetBank, FSB was relieved of any obligation to share with the Trustee anyfuture payments made to NetBank, FSB by anyof the Sureties.

 

NetBank,FSB intends to vigorously pursue its claims against all the Sureties, includingclaims for any loss associated with the claims brought by the Trustee againstNetBank, FSB. At this time, the Company is unable to express an opinion as tothe likelihood of loss, or the amount or range of potential loss, with regardto this matter.

 

*Clayton v. Commercial Money Center, Inc., CaseNo. BC 253169 (CA Sup. Ct., Los Angeles County)*

 

OnJune 27, 2001, several lessees of equipment leased from CMC filed suit inLos Angeles Superior Court against CMC and several John Doe defendants allegingthat the Leases violated California usury laws, the California Financial Code,and the California Unfair Business Practices Act. The plaintiff lessees wereseeking to rescind or reform their obligations under the Leases and wereseeking to recover statutory damages and attorney’s fees. The plaintiffssubsequently amended their complaint to name NetBank, FSB, several otherinvestor banks, and several surety companies as co-defendants in the action.After CMC filed for bankruptcy, the action was removed to the bankruptcy courtin the Central District of California, but the plaintiffs subsequently agreedto withdraw their claims against CMC and were successful in their motion toremand the case back to state court.

 

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OnMarch 15, 2004, the Superior Court sustained demurrers and motions toquash filed by NetBank, FSB and various other defendants on certain of theplaintiffs’ claims. The Superior Court sustained the demurrers under theCalifornia Financial Code, without leave to amend. The Superior Court alsosustained demurrers on the Unfair Business Practices Act, with leave to amendthe claims to add greater specificity to the claims, but without leave to amendas to unnamed representatives of the alleged class of plaintiffs harmed. TheSuperior Court also granted motions to strike: (1) plaintiffs’ claimsunder the California Unfair Business Practices Act as to unnamed representativeplaintiffs; (2) plaintiffs’ request for restitution (the named plaintiffsmay amend to establish individual entitlement to restitution);(3) plaintiffs’ request for disgorgement; (4) plaintiffs’ request forpunitive damages; (5) plaintiffs’ request for compensatory damages underthe California Unfair Business Practices Act; and (6) plaintiffs’ requestfor attorneys’ fees.

 

OnApril 29, 2004, the plaintiffs served an amended complaint againstNetBank, FSB alleging claims for, among other things, violations of anothersection of the California Financial Code, unfair competition underSection 17200 of the California Business and Professions Code and usury.On October 26, 2004, the court overruled the defendants’ demurrers to thethird amended complaint. However, on December 13, 2004, the court issued astay in the action pending a decision by the appeals court on the plaintiffs’claims that were dismissed without leave to amend. No discovery has been takenin this case and we expect no resolution of these surviving claims prior to theoutcome of plaintiffs’ appeal. The Company intends to vigorously defend theamended claims in the Clayton action and to pursue recovery against Safeco,Royal, and Illinois Union in the Company’s existing action against them for anydamages and costs incurred in this case.

 

**Item 1A. Risk Factors**

 

Informationon risk factors is set forth under the heading, “Special Note RegardingForward-Looking Statements” in Part I of this Quarterly Report on Form 10-Q andin Item 1A. “Risk Factors” of Part I to our 2005 Form 10-K. There have been nomaterial changes from the risk factors previously described in our 2005 Form10-K.

 

**Item 2. Unregistered Sales of EquitySecurities and Use of Proceeds**

 

InAugust 2002, the Board of Directors approved a plan to repurchase up to 1million shares of the Company’s common stock. The plan was subsequentlyincreased by 1 million shares in October 2002, 2 million shares inJanuary 2003, 1 million shares in April 2004 and 1 million shares inApril 2005. As summarized below, there was minimal repurchase activity for thethree months ended March 31, 2006.

 
| **Period**                            | ** ** | **Total Number  of Shares  Purchased** | ** ** | **Average Price  Paid Per Share** | ** ** | **Total Number of  Shares (or Units)  Purchased as Part  of Publicly  Announced Plans or  Programs** | ** ** | **Maximum Number  (or Appropriate  Dollar Value) of  Shares (or Units)  that May Yet Be  Purchased Under  the Plans or  Programs** | ** ** |
|---------------------------------------|------------|--------------------------------------------------|------------|--------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Balance as of  December 31, 2005      |       | 571,391                                          |       | —                                           |       | 571,391                                                                                                                                           |       | 1,092,573                                                                                                                                                                                      |       |
| January 1 through  January 31, 2006   |       | —                                           |       | —                                           |       | —                                                                                                                                            |       | 1,092,573                                                                                                                                                                                      |       |
| February 1  through February 28, 2006 |       | —                                           |       | —                                           |       | —                                                                                                                                            |       | 1,092,573                                                                                                                                                                                      |       |
| March 1 through  March 31, 2006       |       | 6,000                                            |       | 7.52                                             |       | 6,000                                                                                                                                             |       | 1,086,573                                                                                                                                                                                      |       |
|                                  |       |                                             |       |                                             |       |                                                                                                                                              |       |                                                                                                                                                                                           |       |
| Total                                 |       | 577,391                                          |       | —                                           |       | 577,391                                                                                                                                           |       |                                                                                                                                                                                           |       |

 

Asof May 1, 2006, 1,086,573 shares remained available for repurchase undercurrent Board authority.

 

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Referenceis made to the discussion under the heading “Dividends” under Item 5. Marketfor Registrant’s Common Equity, Related Shareholder Matters and IssuerPurchases of Equity Securities of our 2005 Form 10-K for a description ofcurrent OTS regulations applicable to the ability of NetBank, FSB to paydividends and make other capital distributions to the Company.

 

**Item 3. DefaultsUpon Senior Securities**

 

None.

 

**Item4. Submission of Matters to a Vote of Security Holders**

** **

None.

 

**Item 5. Other Information**

** **

**None.**

** **

**Item 6. Exhibits**

 

Theexhibits listed in the accompanying index to exhibits are filed or incorporatedby reference as part of this report, unless otherwise provided in the index toexhibits.

 

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#### **SIGNATURE**

#### ** **

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

 
|                | NETBANK, INC. |
|---------------------|---------------|
|                |          |
|                | By:           | /s/ Steven F. Herbert |   |
|                |          | Steven F. Herbert |
|                |          |   |
| Dated: May 10, 2006 |          | *Chief Finance Executive**(principal accounting officer and**duly authorized officer)* |

 

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**INDEX TOEXHIBITS**

** **
| **Exhibit** |       |                                                                                                                                                        |       | **Incorporated by Reference** |       | **Filed**            |       |
|-------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|----------------------|------------|
| **Number**  | ** ** | **Exhibit Description**                                                                                                                                | ** ** | **Form**                                | ** ** | **File Number** | ** ** | **Exhibit** | ** ** | **Filing Date** | ** ** | **Herewith** |   |
|        |       |                                                                                                                                                        |       |                                    |       |                 |       |   |   |   |   |   |   |
| 31.1        |       | Certification  Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities  Exchange Act of 1934, as amended—Chief Executive Officer |       |                                    |       |                 |       |   |   |   |   | ý |   |
|        |       |                                                                                                                                                        |       |                                    |       |                 |       |   |   |   |   |   |   |
| 31.2        |       | Certification  Pursuant to Rules 13a-14(a) and 15d-14(a) under the Securities  Exchange Act of 1934, as amended—Chief Financial Officer |       |                                    |       |                 |       |   |   |   |   | ý |   |
|        |       |                                                                                                                                                        |       |                                    |       |                 |       |   |   |   |   |   |   |
| 32.1        | **†** | Certification  Pursuant to 18 U.S.C. Section 1350—Chief Executive Officer and Chief  Finance Executive                                            |       |                                    |       |                 |       |   |   |   |   | ý |   |

 

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**†****     **The certification attached as Exhibit 32.1 that accompanies this report isnot deemed filed with the Securities and Exchange Commission and is not to beincorporated by reference into any filing of NetBank, Inc. under the SecuritiesAct of 1934, as amemded, or the Securities Exchange Act of 1934, as amended,whether made before or after the date of this report, irrespective of anygeneral incorporation language contained in such filing.

 

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