**UNITED STATESSECURITIES 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 Ended June 30, 2006**

** **

**Commission File No. 0-22361**

** **

**NETBANK, INC.**

(Exact name of registrant asspecified in its charter)

| **Georgia**                                               | ** ** | **58-2224352**                           |
|-----------------------------------------------------------|------------|------------------------------------------|
| (State of  incorporation)                                 |       | (I.R.S. Employer  Identification Number) |
|                                                      |       |                                     |
| **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 mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or forsuch shorter period that the registrant was required to file such reports), and(2) has been subject to such filing requirements for the past 90days:  YES x  NO o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Exchange Act Rule 12b-2:Large accelerated filer o    Acceleratedfiler x             Non-accelerated filer o

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act):YES o  NO x

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

| Class                         | ** ** | **Shares Outstanding at July 31, 2006** |
|-------------------------------|------------|-----------------------------------------|
| Common  Stock, par value $.01 |       | 46,373,702                              |

 

 

----

 

**NETBANK, INC.****TABLE OF CONTENTS**
| **Part I. Financial  Information**                                                                        | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------|
| ** **                                                                                                | ** ** | ** ** |
| **Item 1. Financial Statements  (Unaudited)**                                                             | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Consolidated balance sheets as of  June 30, 2006 and December 31, 2005**                                | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Consolidated statements of  operations for the three and six months ended June 30, 2006 and 2005**      | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Consolidated statements of  shareholders’ equity for the six months ended June 30, 2006 and 2005** | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Consolidated statements of  cash flows for the six months ended June 30, 2006 and 2005**           | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Notes to consolidated  financial statements**                                                           | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Item 2. Management’s  Discussion and Analysis of Financial Condition and Results of Operations**   | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Item 3. Quantitative and  Qualitative Disclosures about Market Risk**                                   | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Item 4. Controls and Procedures**                                                                       | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Part  II. Other Information**                                                                           | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Item 1. Legal Proceedings**                                                                             | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Item 1A. Risk Factors**                                                                                 | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Item 2. Unregistered Sales  of Equity Securities and Use of Proceeds**                                  | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Item 3. Defaults Upon Senior  Securities**                                                              | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Item 4. Submission of  Matters to a Vote of Security Holders**                                          | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Item 5. Other Information**                                                                             | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Item 6. Exhibits**                                                                                      | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Signature Page**                                                                                        | ** ** | ** ** |
| ** **                                                                                                | ** ** | ** ** |
| **Index to  Exhibits**                                                                                    | ** ** | ** ** |

2

----

 

**Part I.Financial Information**

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

 

**NetBank,Inc.**

**Consolidated Balance Sheets**

**(in 000sexcept share amounts)**

** **
| ** **                                                                                                        | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                        | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                                                                        | ** ** | **(unaudited)**   | ** ** | **(audited)**         | ** ** |
| **Assets**                                                                                                        | * *   | * *          | * *   | * *              | * *   |
| Cash and cash  equivalents:                                                                                       |       |              |       |                  |       |
| Cash and due  from banks                                                                                          |       | $                 | 72,807     |                  | $          | 126,666 |   |
| Federal funds  sold                                                                                               |       | 22,948            |       | 23,590                |       |
| Total cash and  cash equivalents                                                                                  |       | 95,755            |       | 150,256               |       |
| Investment  securities available for sale-at fair value (amortized costs of $606,321 and  $638,919, respectively) |       | 574,590           |       | 626,077               |       |
| Stock of Federal  Home Loan Bank of Atlanta – at cost                                                        |       | 46,002            |       | 67,049                |       |
| Loans held for  sale                                                                                              |       | 972,004           |       | 1,233,918             |       |
| Loan and lease  receivables – net of allowance for credit losses of $27,371 and $27,601,  respectively       |       | 2,011,325         |       | 2,224,363             |       |
| Mortgage  servicing rights – net                                                                             |       | 203,406           |       | 201,880               |       |
| Accrued interest  receivable                                                                                      |       | 16,416            |       | 16,698                |       |
| Furniture,  equipment and capitalized software – net                                                         |       | 51,644            |       | 54,420                |       |
| Goodwill and  other intangibles – net                                                                        |       | 77,778            |       | 85,097                |       |
| Due from  servicers and investors                                                                                 |       | 15,641            |       | 26,557                |       |
| Other assets                                                                                                      |       | 77,444            |       | 85,304                |       |
| **Total  assets**                                                                                                 |       | $                 | 4,142,005  |                  | $          | 4,771,619 |   |
|                                                                                                              |       |              |       |                  |       |
| **Liabilities,  minority interests and shareholders’ equity**                                                |       |              |       |                  |       |
| **Liabilities:**                                                                                                  |       |              |       |                  |       |
| Deposits                                                                                                          |       | $                 | 2,721,937  |                  | $          | 2,793,847 |   |
| Other borrowed  funds                                                                                             |       | 867,619           |       | 1,348,240             |       |
| Subordinated  debt                                                                                                |       | 32,477            |       | 32,477                |       |
| Accrued interest  payable                                                                                         |       | 21,223            |       | 17,595                |       |
| Loans in process                                                                                                  |       | 41,153            |       | 34,060                |       |
| Representations  and warranties                                                                                   |       | 21,688            |       | 20,668                |       |
| Accounts payable  and accrued liabilities                                                                         |       | 88,471            |       | 123,877               |       |
| Total  liabilities                                                                                                |       | 3,794,568         |       | 4,370,764             |       |
|                                                                                                              |       |              |       |                  |       |
| Commitments and  contingencies – note 13                                                                     |       | —            |       | —                |       |
| Minority interests in affiliates                                                                                  |       | 638               |       | 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                                                                                       |       | 433,809           |       | 432,140               |       |
| Retained  (deficit) earnings                                                                                      |       | (5,282            | )          | 39,005                |       |
| Accumulated  other comprehensive loss, net of taxes of $12,058 and $4,877, respectively                           |       | (19,673           | )          | (7,965                | )          |
| Treasury stock,  at cost (6,460,691 and 6,423,691 shares, respectively)                                           |       | (62,583           | )          | (62,276               | )          |
| Unearned  compensation                                                                                            |       | —            |       | (1,253                | )          |
| **Total  shareholders’ equity**                                                                              |       | 346,799           |       | 400,179               |       |
| **Total liabilities, minority  interests and shareholders’ equity**                                          |       | $                 | 4,142,005  |                  | $          | 4,771,619 |   |

 

See notes toconsolidated financial statements.

3

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**NetBank, Inc.**

**Consolidated Statements ofOperations**

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

 
| ** **                                                        | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                        | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Interest income:**                                              |       |                                                |       |                                              |       |   |   |   |   |
| Loans and leases                                                  |       | $                                                   | 54,358     |                                              | $          | 53,106 |   | $ | 112,273 |   | $ | 100,959 |   |
| Investment  securities                                            |       | 8,093                                               |       | 8,879                                             |       | 16,507 |   | 17,667 |   |
| Short-term  investments                                           |       | 303                                                 |       | 516                                               |       | 849 |   | 895 |   |
| Total interest  income                                            |       | 62,754                                              |       | 62,501                                            |       | 129,629 |   | 119,521 |   |
|                                                              |       |                                                |       |                                              |       |   |   |   |   |
| **Interest expense:**                                             |       |                                                |       |                                              |       |   |   |   |   |
| Deposits                                                          |       | 23,116                                              |       | 15,598                                            |       | 45,013 |   | 28,814 |   |
| Other borrowed  funds                                             |       | 15,841                                              |       | 15,961                                            |       | 32,961 |   | 28,988 |   |
| Total interest  expense                                           |       | 38,957                                              |       | 31,559                                            |       | 77,974 |   | 57,802 |   |
| Net interest income                                               |       | 23,797                                              |       | 30,942                                            |       | 51,655 |   | 61,719 |   |
| Provision for credit  losses                                      |       | 1,019                                               |       | 2,330                                             |       | 4,076 |   | 4,681 |   |
| Net interest income  after provision for credit losses            |       | 22,778                                              |       | 28,612                                            |       | 47,579 |   | 57,038 |   |
|                                                              |       |                                                |       |                                              |       |   |   |   |   |
| **Non-interest income:**                                          |       |                                                |       |                                              |       |   |   |   |   |
| Mortgage  servicing fees                                          |       | 11,895                                              |       | 13,192                                            |       | 24,514 |   | 25,454 |   |
| Amortization of  mortgage servicing rights                        |       | (9,847                                              | )          | (11,516                                           | )          | (20,451 | ) | (22,144 | ) |
| Impairment of  mortgage servicing rights                          |       | (9,517                                              | )          | (1,700                                            | )          | (5,906 | ) | (1,020 | ) |
| (Losses) gains  on derivatives                                    |       | (4,764                                              | )          | 1,845                                             |       | (11,462 | ) | (944 | ) |
| Gains on sales of investment securities                           |       | —                                              |       | 1,705                                             |       | — |   | 4,182 |   |
| Service charges  and fees                                         |       | 4,898                                               |       | 5,092                                             |       | 9,796 |   | 9,843 |   |
| Gains on sales  of loans and mortgage servicing rights            |       | 11,364                                              |       | 29,932                                            |       | 35,344 |   | 54,752 |   |
| Other income                                                      |       | 1,913                                               |       | 2,691                                             |       | 4,104 |   | 5,579 |   |
| Total non-interest  income                                        |       | 5,942                                               |       | 41,241                                            |       | 35,939 |   | 75,702 |   |
|                                                              |       |                                                |       |                                              |       |   |   |   |   |
| **Non-interest expense:**                                         |       |                                                |       |                                              |       |   |   |   |   |
| Salaries and  benefits                                            |       | 33,842                                              |       | 30,094                                            |       | 68,682 |   | 61,817 |   |
| Customer service                                                  |       | 2,519                                               |       | 3,396                                             |       | 5,872 |   | 6,520 |   |
| Marketing                                                         |       | 3,490                                               |       | 2,366                                             |       | 7,084 |   | 5,221 |   |
| Data processing                                                   |       | 4,693                                               |       | 4,412                                             |       | 9,237 |   | 8,787 |   |
| Depreciation and  amortization                                    |       | 5,814                                               |       | 6,010                                             |       | 11,682 |   | 11,613 |   |
| Office expenses                                                   |       | 4,275                                               |       | 3,002                                             |       | 7,703 |   | 5,822 |   |
| Occupancy                                                         |       | 6,816                                               |       | 5,952                                             |       | 13,792 |   | 11,853 |   |
| Travel and  entertainment                                         |       | 1,424                                               |       | 1,390                                             |       | 2,679 |   | 2,640 |   |
| Professional  fees                                                |       | 3,403                                               |       | 4,815                                             |       | 6,749 |   | 8,805 |   |
| Prepaid lost  interest from curtailments                          |       | 702                                                 |       | 1,059                                             |       | 1,317 |   | 2,083 |   |
| Goodwill  impairment                                              |       | 6,358                                               |       | —                                            |       | 6,358 |   | — |   |
| Other expenses                                                    |       | 3,422                                               |       | 3,483                                             |       | 7,119 |   | 6,832 |   |
| Total non-interest  expense                                       |       | 76,758                                              |       | 65,979                                            |       | 148,274 |   | 131,993 |   |
| Income before income  taxes                                       |       | (48,038                                             | )          | 3,874                                             |       | (64,756 | ) | 747 |   |
| Income tax benefit  (expense)                                     |       | 16,602                                              |       | (1,549                                            | )          | 22,369 |   | (451 | ) |
| **Net (loss) income**                                             |       | $                                                   | (31,436    | )                                                 | $          | 2,325 |   | $ | (42,387 | ) | $ | 296 |   |
|                                                              |       |                                                |       |                                              |       |   |   |   |   |
| Net income per common  and potential common shares outstanding:   |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                             |       | $                                                   | (0.68      | )                                                 | $          | 0.05 |   | $ | (0.92 | ) | $ | 0.01 |   |
| Diluted                                                           |       | $                                                   | (0.68      | )                                                 | $          | 0.05 |   | $ | (0.92 | ) | $ | 0.01 |   |
|                                                              |       |                                                |       |                                              |       |   |   |   |   |
| Weighted average common  and potential common shares outstanding: |       |                                                |       |                                              |       |   |   |   |   |
| Basic                                                             |       | 46,323                                              |       | 46,116                                            |       | 46,293 |   | 46,241 |   |
| Diluted                                                           |       | 46,323                                              |       | 46,492                                            |       | 46,293 |   | 46,538 |   |
|                                                              |       |                                                |       |                                              |       |   |   |   |   |
| Dividends declared on common stock per share                      |       | $                                                   | 0.02       |                                              | $          | 0.02 |   | $ | 0.04 |   | $ | 0.04 |   |

 

Seenotes to consolidated financial statements.

4

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**NetBank, Inc.**

**ConsolidatedStatements of Shareholders’ Equity**

**(unaudited and in 000s)**

** **
| ** **                                                                                          | ** ** | **For the six months ended** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                          | ** ** | **June 30,**                                | ** ** |
| ** **                                                                                          | ** ** | **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 balance upon adoption of SFAS 123R                                    |       | 277                                              |       | — |   |
| Stock-based  compensation                                                                           |       | 2,116                                            |       | — |   |
| Re-issuance of shares  of common stock                                                              |       | (724                                             | )          | 60 |   |
| Ending balance                                                                                      |       | $                                                | 433,809    |   | $ | 432,192 |   |
| **Retained (deficit) earnings**                                                                     |       |                                             |       |   |   |
| Beginning balance                                                                                   |       | $                                                | 39,005     |   | $ | 43,849 |   |
| Net (loss) income                                                                                   |       | (42,387                                          | )          | 296 |   |
| Cash dividends declared                                                                             |       | (1,852                                           | )          | (1,851 | ) |
| Reclassification of  unearned balance upon adoption of SFAS 123R                                    |       | 265                                              |       | — |   |
| Loss on re-issuance of  shares of common stock                                                      |       | (313                                             | )          | (676 | ) |
| Ending balance                                                                                      |       | $                                                | (5,282     | ) | $ | 41,618 |   |
| **Accumulated other comprehensive  loss**                                                           |       |                                             |       |   |   |
| Beginning balance                                                                                   |       | $                                                | (7,965     | ) | $ | (1,136 | ) |
| Realized gain on sale  of securities, net of taxes                                                  |       | —                                           |       | (2,593 | ) |
| Unrealized (loss) gain  on securities, net of taxes                                                 |       | (11,708                                          | )          | 3,241 |   |
| Ending balance                                                                                      |       | $                                                | (19,673    | ) | $ | (488 | ) |
| **Treasury stock, at cost**                                                                         |       |                                             |       |   |   |
| Beginning balance                                                                                   |       | $                                                | (62,276    | ) | $ | (61,087 | ) |
| Unearned compensation  from issuance of restricted stock, net of forfeitures                        |       | —                                           |       | 1,665 |   |
| Reclassification of  unearned balance upon adoption of SFAS 123R                                    |       | (1,795                                           | )          | (3,814 | ) |
| Re-issuance of shares  of common stock, net of purchases                                            |       | 1,488                                            |       | — |   |
| Ending balance                                                                                      |       | $                                                | (62,583    | ) | $ | (63,236 | ) |
| **Unearned compensation**                                                                           |       |                                             |       |   |   |
| Beginning balance                                                                                   |       | $                                                | (1,253     | ) | $ | (259 | ) |
| Amortization of  unearned compensation                                                              |       | —                                           |       | 134 |   |
| Unearned compensation  issued, net of employee forfeitures                                          |       | —                                           |       | (1,400 | ) |
| Reclassification of  unearned balance upon adoption of SFAS 123R                                    |       | 1,253                                            |       | — |   |
| Ending balance                                                                                      |       | $                                                | —     |   | $ | (1,525 | ) |
| **Total shareholders’ equity**                                                                 |       | $                                                | 346,799    |   | $ | 409,089 |   |
|                                                                                                |       |                                             |       |   |   |
| **Comprehensive (loss) income**                                                                     |       |                                             |       |   |   |
| Net (loss) income                                                                                   |       | $                                                | (42,387    | ) | $ | 296 |   |
| Realized gain on  sale of securities, net of taxes of $0 and $1,589, respectively                   |       | —                                           |       | (2,593 | ) |
| Change in  unrealized (loss) gain on securities, net of taxes of $7,176 and $(1,986),  respectively |       | (11,708                                          | )          | 3,241 |   |
| Comprehensive (loss) income                                                                         |       | $                                                | (54,095    | ) | $ | 944 |   |

 

See notes to consolidatedfinancial statements.

5

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**NetBank, Inc.**

**ConsolidatedStatements of Cash Flows**

**(unaudited and in 000s)**

** **
| ** **                                                                                 | ** ** | **Six months ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                 | ** ** | **June 30,**              | ** ** |
| ** **                                                                                 | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| Operating  activities:                                                                     |       |                           |       |   |   |
| Net (loss)  income                                                                         |       | $                              | (42,387    | ) | $ | 296 |   |
| Adjustments to  reconcile net loss to net cash provided by (used in) operating activities: |       |                           |       |   |   |
| Depreciation and  amortization                                                             |       | 11,682                         |       | 11,613 |   |
| Amortization of  premiums on investment securities, loan and lease receivables and debt    |       | 10,712                         |       | 9,344 |   |
| Origination of  loans held for sale                                                        |       | (5,206,014                     | )          | (6,229,079 | ) |
| Repurchase of  previously sold mortgages                                                   |       | (55,899                        | )          | (55,388 | ) |
| Proceeds from  sales of loans held for sale                                                |       | 5,560,490                      |       | 6,121,074 |   |
| Net gains on  sales of mortgage loans and servicing rights                                 |       | (35,344                        | )          | (54,752 | ) |
| Capitalization  of mortgage servicing rights                                               |       | (10,644                        | )          | (9,900 | ) |
| Proceeds from  sales of mortgage servicing rights                                          |       | 3,971                          |       | 964 |   |
| Mark-to-market  adjustment on mortgage servicing rights                                    |       | (21,509                        | )          | 18,193 |   |
| Impairment of  mortgage servicing rights                                                   |       | 5,906                          |       | 1,020 |   |
| Amortization of  mortgage servicing rights, net of recoveries                              |       | 20,451                         |       | 22,144 |   |
| Provision for  credit losses                                                               |       | 4,076                          |       | 4,681 |   |
| Stock-based  compensation cost                                                             |       | 2,264                          |       | — |   |
| Amortization of  unearned compensation                                                     |       | —                         |       | 194 |   |
| Gains on sales  of investment securities, net                                              |       | —                         |       | (4,182 | ) |
| Goodwill  impairment                                                                       |       | 6,358                          |       | — |   |
| Changes in  assets and liabilities which provide (use) cash:                               |       |                           |       |   |   |
| Decrease (increase) in accrued interest receivable                                         |       | 282                            |       | (2,160 | ) |
| Decrease in due from servicers and investors                                               |       | 10,916                         |       | 25,928 |   |
| Decrease (increase) in other assets                                                        |       | 7,860                          |       | (27,542 | ) |
| Increase in accrued interest payable                                                       |       | 3,628                          |       | 3,140 |   |
| Increase in loans in process                                                               |       | 7,093                          |       | 33,653 |   |
| (Decrease) increase in accounts payable and accrued  liabilities                           |       | (28,373                        | )          | 21,848 |   |
| Net cash provided by (used in) operating activities                                        |       | 255,519                        |       | (108,911 | ) |
|                                                                                       |       |                           |       |   |   |
| Investing  activities:                                                                     |       |                           |       |   |   |
| Purchases of  available for sale securities                                                |       | (10,033                        | )          | (391,472 | ) |
| Principal  repayments on available for sale securities                                     |       | 42,490                         |       | 57,179 |   |
| Sales and  maturities of available for sale securities                                     |       | —                         |       | 304,144 |   |
| Bulk purchase of  mortgage servicing rights                                                |       | —                         |       | (36,395 | ) |
| Sales  (purchases) of Federal Home Loan Bank Stock                                         |       | 21,047                         |       | (6,044 | ) |
| Origination and  purchase of loan and lease receivables                                    |       | (271,178                       | )          | (406,554 | ) |
| Proceeds from  sales of loan and lease receivables                                         |       | 103,891                        |       | — |   |
| Principal  repayments on loan and lease receivables                                        |       | 365,678                        |       | 307,136 |   |
| Purchases of  furniture, equipment and capitalization of software, net of disposals        |       | (7,117                         | )          | (5,944 | ) |
| Capitalization  of amortizable intangibles                                                 |       | (252                           | )          | (3,523 | ) |
| Acquisition of  goodwill                                                                   |       | (576                           | )          | (123 | ) |
| Change in  minority interest                                                               |       | (38                            | )          | 105 |   |
| Net cash provided by (used in) investing activities                                        |       | 243,912                        |       | (181,491 | ) |
|                                                                                       |       |                           |       |   |   |
| Financing  activities:                                                                     |       |                           |       |   |   |
| (Decrease)  increase in deposits                                                           |       | (71,910                        | )          | 152,659 |   |
| Proceeds from  other borrowed funds                                                        |       | 8,810,140                      |       | 4,189,983 |   |
| Repayments of  other borrowed funds                                                        |       | (9,290,761                     | )          | (4,030,699 | ) |
| Net proceeds  from issuance of subordinated notes                                          |       | —                         |       | 20,620 |   |
| Net re-issuances  (purchases) of treasury stock                                            |       | 574                            |       | (4,225 | ) |
| Dividend  payments on common stock                                                         |       | (1,852                         | )          | (1,851 | ) |
| Issuance of  restricted stock                                                              |       | (123                           | )          | — |   |
| Net cash (used in) provided by financing activities                                        |       | (553,932                       | )          | 326,487 |   |
| Net (decrease)  increase in cash and cash equivalents                                      |       | (54,501                        | )          | 36,085 |   |
| Cash and cash  equivalents:                                                                |       |                           |       |   |   |
| Cash and cash  equivalents, beginning of period                                            |       | 150,256                        |       | 150,302 |   |
| Cash and cash  equivalents, end of period                                                  |       | $                              | 95,755     |   | $ | 186,387 |   |
|                                                                                       |       |                           |       |   |   |
| Supplemental  disclosures of cash flow information:                                        |       |                           |       |   |   |
| Cash paid during  the period for interest                                                  |       | $                              | 74,346     |   | $ | 54,662 |   |
| Cash paid during the  period for income taxes                                              |       | $                              | 310        |   | $ | 476 |   |

 

See notes toconsolidated financial statements.

6

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** **

**NETBANK,INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

**June 30,2006**

**(unaudited)**

**1.             ORGANIZATION AND BASIS OFPRESENTATION**

NetBank, Inc. is a financial holding company engaged primarily inretail banking, mortgage banking, business finance and providing ATM andmerchant processing services. NetBank, Inc. wholly owns the outstanding stockof:  NetBank (“NetBank, FSB” or the “Bank”),a federal savings bank; MG Reinsurance Company (“MG Reinsurance”), a captivereinsurance company; NetInsurance, Inc. (“NetInsurance”), a licensed insuranceagency; and NB Partners, Inc., a corporation involved in strategic partneringopportunities. NetBank, FSB owns all of the outstanding stock of:  Market Street Mortgage Corporation (“MarketStreet”), a retail mortgage company; NetBank Payment Systems, Inc. (“NPS”), aprovider of ATM and merchant processing services for retail and other non-bankbusinesses; Meritage Mortgage Corporation (“Meritage”), a wholesalenon-conforming mortgage provider; and Financial Technologies, Inc. (“FTI”), aprovider of transaction processing services to other financial servicescompanies. NetBank, FSB’s wholesale mortgage division operates as NetBankFunding Services (“NetBank Funding”); its business financing division operatesas “NetBank Business Finance”; its automobile financing division operates as “DealerFinancial Services”; and its recreational vehicle financing division operatesas “Beacon Credit Services”.  Theconsolidated company is referred to herein as “we,” “us,”  “our,” “NetBank,” or “the Company”.

In the opinion of management, the unaudited consolidated financialstatements included herein reflect all adjustments, consisting only of normalrecurring accruals, which are necessary for the fair presentation of thefinancial condition and results of operations for the interim periodspresented. Certain information and footnote disclosures normally included infinancial statements have been condensed or omitted pursuant to applicablerules and regulations of the Securities and Exchange Commission (“SEC”). Thefinancial statements included herein should be read in conjunction with thefinancial statements and notes thereto included in our Annual Report onForm 10-K filed with the SEC for the year ended December 31, 2005 (“2005Form 10-K”). The results of operations for the interim periods reported hereinare not necessarily indicative of results to be expected for the full year.Certain 2005 amounts have been reclassified for comparability with 2006amounts.

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

**2.             ACQUISITIONS**

**During the six monthsended June 30, 2006, NPS acquired certain assets or processing contracts ofvarious smaller ATM and merchant processors. These acquisitions were accounted for as purchases, and as such,approximately $146 of amortizable intangibles were recorded.  Consideration for these assets and processingcontracts totaled $146.**

In December 2004, the Company, through itsMarket Street subsidiary, acquired 19 retail branch offices and certainassociated assets of Guaranty Residential Lending, Inc., a mortgagebanking business, pursuant to an Asset Purchase and Assignment Agreement. Theconsideration paid, including transaction costs, was approximately $2 million.The acquisition was accounted for as a purchase, and, accordingly, all assetsand liabilities were recorded at fair value. As such, $1.7 million in goodwill,including transaction costs, was recorded. The Company paid additionalconsideration in the first quarter of 2006 of $576 and is obligated to pay anadditional $788 in 2007 based on specific production goals as identified in theAsset Purchase and Assignment Agreement. Any additional payments will berecorded as goodwill.   The results ofoperations for the acquired branches have been included from the date ofacquisition.

7

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**3.             ACCOUNTING POLICIES**

Reference is made to our accounting policies describedin the notes to consolidated financial statements contained in our 2005Form 10-K. The Company has followed those policies in preparing thisreport.

*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 and six month periods ended June 30, 2005, as all optionsgranted under those plans had an exercise price equal to or greater than themarket value of the underlying common stock on the date of grant. We alsorecorded no compensation cost during the three and six month periods ended June30, 2005 in connection with the NetBank, Inc. Employee Stock Purchase Plan (“theStock Plan”).  In accordance withStatement of Financial Accounting Standards No. 123 (“SFAS 123”), *Accounting for 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 the fair value recognitionprovisions of Statement of Financial Accounting Standards No. 123(R) (“SFAS123(R)”), *Share-Based Payment*, using the modifiedprospective transition method. Under the modified prospective transitionmethod, results for prior periods have not been restated. In March 2005, theSEC issued Staff Accounting Bulletin No. 107 (“SAB 107”), which providessupplemental implementation guidance for SFAS 123(R). We have applied theprovisions of SAB 107 in our adoption of SFAS 123(R). See note 9 to theseconsolidated financial statements for information on the impact of our adoptionof SFAS 123(R) and the assumptions used to calculate the fair value ofstock-based employee compensation.

*Recent Accounting Pronouncements*

In July of 2006, the Financial Accounting Standards Board issued FinalInterpretation No. 48 (“FIN 48”), *Accounting for**Uncertainty in Income Taxes.*    FIN 48 clarifies the accounting for incometaxes by prescribing the minimum recognition threshold a tax position isrequired to meet before being recognized in the financial statements.  FIN 48 also provides guidance onderecognition, measurement, classification, interest and penalties, accountingin interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15,2006.  We are currently evaluating the effectsthat the adoption of FIN 48 could have on our consolidated results ofoperations, financial position and cash flows.

On March 17, 2006, the Financial Accounting Standards Board issuedStatement No. 156 (“SFAS 156”), *Accounting for Servicingof Financial Assets an amendment of FASB Statement No. 140*, *Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities*.  SFAS 156 requires that allservicing assets and liabilities be initially measured at fair value and allowsfor two alternatives in the subsequent accounting for servicing assets andliabilities: the amortization method and the fair value method.  Theamortization method requires that the servicing assets and liabilities beamortized over the remaining estimated lives of the serviced assets withimpairment testing to be performed

8

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periodically.  The fair value method requires the servicing assetsand liabilities to be measured at fair value each period with an offset toincome.  SFAS 156 is to be adopted in the first fiscal year that beginsafter September 15, 2006 and early adoption is permitted.  An entity canelect the fair value method at the beginning of any fiscal year provided thatinterim financial statements have not been issued.  However, once the fairvalue election is made, an entity cannot revert back to the amortizationmethod. NetBank is currently evaluating the available alternatives.

In May 2005, the FASB issued Statement of Financial AccountingStandards No. 154 (“SFAS 154”), *Accounting Changes andError Corrections a replacement of Accounting Principles Board Opinion No. 20,Accounting Changes*, and Statement of Financial Accounting StandardsNo. 3, *Reporting Accounting Changes in Interim FinancialStatements,* which required the inclusion of the cumulative effect ofchanges in accounting principle in net income in the period of change. SFAS 154 establishes, unless impracticable, retrospective application to priorperiods’ financial statements as the required method for reporting a voluntarychange in accounting principle in the absence of explicit transitionrequirements specific to the newly adopted accounting principle.  SFAS 154is effective for accounting changes and corrections of errors made in fiscalyears beginning after December 15, 2005.  The Company will assess theimpact of a retrospective application of a change in accounting principle inaccordance with SFAS 154 if the need for such a change arises in the future.

In March 2004, the FASB’sEmerging Issues Task Force (“EITF”) supplemented EITF 03-1, *The Meaning of Other-Than-Temporary Impairment and Its Application toCertain Investments*. EITF 03-1 provides guidance for evaluatingwhether an investment is other-than-temporarily impaired and requiresdisclosures about unrealized losses on available for sale debt and equitysecurities. In November 2005, FASB Staff Position Statement of FinancialAccounting Standards No. FAS 115-1 (“FSP FAS 115-1”) was issued to address EITF03-1 implementation issues and outlines a three step model for identifyinginvestment impairments. FSP FAS 115-1 carries forward the disclosurerequirements of EITF 03-1 and is effective for reporting periods beginningafter December 15, 2005.  The adoption ofFSP FAS 115-1 did not have a material impact on the Company’s balance sheet orstatement of operations.

**4.             LOAN AND LEASE RECEIVABLES**

Our portfolio ofloan and lease receivables consists primarily of internally originated 1-4family first and second mortgage loans, home equity loans, automobile loans,business equipment financing leases, marine loans and recreational vehicleloans.

As of June 30,2006 and December 31, 2005, the Company had unamortized net premiums onits loan and lease receivables of $34,690 and $37,826, respectively. At June30, 2006 and December 31, 2005, $31 and $6, respectively, of the Company’snet premiums were associated with purchased as opposed to originated loans. Thefollowing is a summary of the Company’s loan and lease receivables portfolio:
|                                   | ** ** | **As of June 30, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                        | ** ** | **Amount**                                  | ** ** | **%**                                           | ** ** | **Amount** | ** ** | **%** | ** ** |
| First mortgages                   |       | $                                           | 730,429    |                                            | 35.8       | % | $ | 824,431 |   | 36.6 | % |
| Second mortgages                  |       | 99,472                                      |       | 4.9                                             | %          | 115,188 |   | 5.1 | % |
| Leases                            |       | 438,462                                     |       | 21.5                                            | %          | 406,053 |   | 18.0 | % |
| Auto                              |       | 618,011                                     |       | 30.3                                            | %          | 610,924 |   | 27.1 | % |
| Home equity  lines                |       | 110,205                                     |       | 5.4                                             | %          | 257,991 |   | 11.5 | % |
| Consumer                          |       | 42,117                                      |       | 2.1                                             | %          | 37,377 |   | 1.7 | % |
| Total                             |       | 2,038,696                                   |       | 100.0                                           | %          | 2,251,964 |   | 100.0 | % |
| Less allowance  for credit losses |       | (27,371                                     | )          |                                            |       | (27,601 | ) |   |   |
| Total                             |       | $                                           | 2,011,325  |                                            |       |   | $ | 2,224,363 |   |   |   |

 

**Our lease receivablesconsist primarily of business equipment leases originated and serviced by theNetBank Business Finance division. In addition to originated lease receivables,NetBank, FSB owns a portfolio of purchased lease receivables originated byCommercial Money Center, Inc. (“CMC”). NetBank, FSB is involved inlitigation with three**

9

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**insurance companies whoare sureties on the purchased receivables. Since the second quarter of 2002,the entire portfolio of lease receivables originated by CMC has been onnon-accrual status pending the outcome of the litigation.  NetBank, FSB has filed a claim against CMCand the insurance company sureties for all payments that are currently pastdue, approximately $90 million at June 30, 2006.  The recorded balance of CMC leases receivableas of June 30, 2006 was $25,615.**

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

The Companyconsiders a loan or lease receivable to be impaired when it is probable that itwill be unable to collect all amounts due according to the original terms ofthe loan or lease agreement.  The Companymeasures impairment of a loan or lease on a loan-by-loan or lease-by-leasebasis.  Amounts of impaired loans orleases that are not probable of collection are charged off immediately.

The following table details the Company’s non-accrualand troubled debt restructurings:
|                                   | ** ** | **As of**              | ** ** | **As of**                  | ** ** |
|-----------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                        | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
| Loan and lease  receivables (1)   |       | $                           | 31,842     |                            | $          | 33,049 |   |
| Loans held for  sale (1)          |       | $                           | 33,283     |                            | $          | 49,635 |   |
| Troubled debt  restructurings (2) |       | $                           | 8,978      |                            | $          | 6,782 |   |

 

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(1)          All loans and leases over 90 days contractually past due are placed onnon-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 andlease receivables as of June 30, 2006 and December 31, 2005 included $25,615and $26,054, respectively, of non-performing lease receivables related to the CMClease portfolio.

Onaverage, the Company held approximately $68,777 and $64,087 of restructured andnon-accrual loans during the three months ended June 30, 2006 and 2005,respectively. Foregone interest for the three months ended June 30, 2006 and2005 was approximately $1,125 and $926, respectively. Foregone interest for thesix months ended June 30, 2006 and 2005 was approximately $2,312 and $1,852,respectively. The Company had $10,528 and $8,200 in repossessed assetsconsisting primarily of residential mortgage loan foreclosures at June 30, 2006and December 31, 2005, respectively.

The following is asummary of the allowance for credit losses:
|                                                                       | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                            | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Beginning  balance**                                                |       | $                                                   | 28,302     |                                              | $          | 25,075 |   | $ | 27,601 |   | $ | 24,462 |   |
| Provision for  credit losses                                          |       | 1,019                                               |       | 2,330                                             |       | 4,076 |   | 4,681 |   |
| Charge-offs:                                                          |       |                                                |       |                                              |       |   |   |   |   |
| First mortgages                                                       |       | (8                                                  | )          | (8                                                | )          | (8 | ) | (8 | ) |
| Second mortgages                                                      |       | (54                                                 | )          | (527                                              | )          | (106 | ) | (528 | ) |
| Leases                                                                |       | (1,845                                              | )          | (1,124                                            | )          | (3,764 | ) | (2,674 | ) |
| Auto                                                                  |       | (1,057                                              | )          | (791                                              | )          | (2,557 | ) | (1,692 | ) |
| Home equity lines                                                     |       | (23                                                 | )          | (135                                              | )          | (56 | ) | (157 | ) |
| Consumer                                                              |       | (17                                                 | )          | (49                                               | )          | (29 | ) | (76 | ) |
| Total charge-offs                                                     |       | (3,004                                              | )          | (2,634                                            | )          | (6,520 | ) | (5,135 | ) |
| Recoveries:                                                           |       |                                                |       |                                              |       |   |   |   |   |
| First mortgages                                                       |       | —                                              |       | —                                            |       | — |   | 1 |   |
| Second mortgages                                                      |       | 83                                                  |       | 45                                                |       | 92 |   | 87 |   |
| Leases                                                                |       | 444                                                 |       | 425                                               |       | 959 |   | 873 |   |
| Auto                                                                  |       | 411                                                 |       | 289                                               |       | 1,040 |   | 538 |   |
| Home equity lines                                                     |       | 116                                                 |       | 262                                               |       | 123 |   | 285 |   |
| Consumer                                                              |       | —                                              |       | —                                            |       | — |   | — |   |
| Total recoveries                                                      |       | 1,054                                               |       | 1,021                                             |       | 2,214 |   | 1,784 |   |
| Total charge-offs, net                                                |       | (1,950                                              | )          | (1,613                                            | )          | (4,306 | ) | (3,351 | ) |
| **Ending  balance**                                                   |       | $                                                   | 27,371     |                                              | $          | 25,792 |   | $ | 27,371 |   | $ | 25,792 |   |
|                                                                  |       |                                                |       |                                              |       |   |   |   |   |
| Allowance for credit  losses as a percent of average loans and leases |       | 1.2                                                 | %          | 1.2                                               | %          | 1.3 | % | 1.2 | % |

 

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

TheCompany accounts for its entire mortgage servicing rights (“MSR”) portfolio atthe aggregate of the lower of cost or market (“LOCOM”). For purposes ofevaluating the MSR portfolio for impairment, the Company disaggregates its MSRportfolio into two primary groupings: available for sale and held for sale.

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

Duringthe second quarter of 2006, the Company announced its intention to sell itsmortgage servicing platform along with most of its portfolio of mortgageservicing rights.  The Company is in theprocess of marketing the platform and the mortgage servicing portfolio topotential buyers.  As of the date of thisreport, the Company had not yet entered into any definitive agreementsregarding such a sale.  However, based onthe range of bids, general level of interest and other information we havereceived to date as a result of the marketing process, management determinedduring its preparation and review of these financial statements that thecarrying value of the mortgage servicing rights asset should be reduced to moreclosely reflect this market information and, accordingly, recorded a $15,000 write-downin the second quarter of 2006.

Thesegment of the portfolio designated as held for sale is composed of recentlyproduced MSRs that are scheduled for sale and have been allocated to specificforward servicing sales contracts.  Theheld for sale portfolio is disaggregated for purposes of measuring possibleimpairments according to the specific forward sales contracts to which the MSRis allocated. For each such risk tranche, the fair value is based upon theallocated forward committed delivery price, which is compared to amortizedcarrying value for purposes of measuring potential impairment.

Thefollowing amounts relate to the Company’s MSR portfolio:
|                                             | ** ** | **Available for sale** | ** ** | **Held for sale** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **June 30,**                | ** ** | **December 31,**       | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
| ** **                                  | ** ** | **2006**                         | ** ** | **2005**                    | ** ** | **2006** | ** ** | **2005** | ** ** |
| Unpaid Principal  Balance (“UPB”) |       | $                                | 12,447,505 |                        | $          | 13,155,256 |   | $ | 72,472 |   | $ | 143,515 |   |
| Carrying value                              |       | $                                | 202,432    |                        | $          | 200,371 |   | $ | 974 |   | $ | 1,509 |   |
| Carrying value /  UPB                       |       | 1.63                             | %          | 1.52                        | %          | 1.34 | % | 1.05 | % |
| Fair value                                  |       | $                                | 203,342    |                        | $          | 201,034 |   | $ | 974 |   | $ | 1,509 |   |
| Fair value / UPB                            |       | 1.63                             | %          | 1.53                        | %          | 1.34 | % | 1.05 | % |
| Weighted average  note rate                 |       | 5.90                             | %          | 5.89                        | %          | 6.53 | % | 6.47 | % |
| Weighted average  service fee               |       | 0.32                             | %          | 0.32                        | %          | 0.30 | % | 0.35 | % |
| Net basis as multiple                       |       | 5.08                             |       | 4.76                        |       | 4.55 |   | 3.00 |   |

 

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The following table summarizes changes in the impairment reserve forthe Company’s MSRs for the three and six months ended June 30, 2006 and 2005:
|                                             | ** ** | **Three months ended June 30,** | ** ** | **Six months ended June 30,** | ** ** |
|---------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Beginning  balance                          |       | $                                                   | 47,891     |                                              | $          | 64,877 |   | $ | 51,502 |   | $ | 65,557 |   |
| Servicing  valuation (recapture) impairment |       | (5,482                                              | )          | 1,700                                             |       | (9,093 | ) | 1,020 |   |
| Ending balance                              |       | $                                                   | 42,409     |                                              | $          | 66,577 |   | $ | 42,409 |   | $ | 66,577 |   |

 

**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 June 30, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amount**                                  | ** ** | **Percentage**                                  | ** ** | **Weighted  average  interest rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest rate** | ** ** |
| Non-interest  bearing checking accounts |       | $                                           | 260,409    |                                            | 9.6        | % | — |   | $ | 284,046 |   | 10.2 | % | — |   |
| Interest  bearing:                      |       |                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| Checking accounts                       |       | 216,818                                     |       | 8.0                                             | %          | 0.9 | % | 232,658 |   | 8.3 | % | 0.9 | % |
| Money market                            |       | 814,166                                     |       | 29.9                                            | %          | 3.3 | % | 943,432 |   | 33.8 | % | 3.2 | % |
| Certificate of deposit under $100       |       | 1,332,051                                   |       | 48.9                                            | %          | 4.5 | % | 1,240,784 |   | 44.4 | % | 4.0 | % |
| Certificate of deposit over $100        |       | 98,493                                      |       | 3.6                                             | %          | 4.5 | % | 92,927 |   | 3.3 | % | 4.1 | % |
| Total deposits                          |       | $                                           | 2,721,937  |                                            | 100.0      | % |   |   | $ | 2,793,847 |   | 100.0 | % |   |   |

 

Accruedinterest as of June 30, 2006 related to checking, money market and certificatesof deposit accounts was $61, $815 and $16,320, respectively.  Accrued interest as of December 31, 2005related to checking, money market, and certificates of deposit accounts was$55, $777 and $12,620, respectively.  AtJune 30, 2006 and December 31, 2005, $649 and $696 of overdrawn deposits wereclassified as loans, respectively.

**8.             BORROWINGS**

A summary of borrowings and available borrowings, grouped by year ofmaturity, as of June 30, 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 + 0.70                                       | %*         | —                                 |       |
| $200 million  warehouse line of credit  |       | 2006                             |       | LIBOR + 0.80                                       | %*         | —                                 |       |
| FHLB warehouse  line of credit          |       | 2006                             |       | DRC + 0.50                                         | %*         | —                                 |       |
| FHLB overnight  advances                |       | 2006                             |       | DRC                                                | *          | 11,000                                 |       |
| Repo facility                           |       | 2006                             |       | 5.11                                               | %          | 56,619                                 |       |
| FHLB advances                           |       | 2006                             |       | 3.38% to 5.31                                      | %          | 400,000                                |       |
| FHLB advances                           |       | 2007                             |       | 2.57                                               | %          | 40,000                                 |       |
| FHLB advances                           |       | 2009                             |       | 2.45                                               | %          | 50,000                                 |       |
| 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                                 |       |
|                                    |       |                             |       |                                               |       | $                                      | 900,096    |   |

 

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*              Indicates avariable rate.

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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 2006, theCompany’s available borrowings as a percentage of total assets was reduced from50% to 30%.  In addition, if the Company’sadvances total greater than 20% of total assets, eligible securities must be pledged.  The Company accesses the FHLB advancefacility through fixed and convertible term advances, as well as short-termadvances, including thirty day and overnight borrowings. FHLB advances arefixed rate; however, $735,000 may be converted at the FHLB’s option to anadjustable rate based on LIBOR. The FHLB warehouse line is an adjustable lineof credit with a floating rate based on the daily rate credit (“DRC”) plus 50basis points. This warehouse line can be used to fund mortgages originated bythe Company. All of the FHLB advances and the FHLB warehouse line are securedby investment securities or mortgage loans. At June 30, 2006, $530,218 ofinvestment securities and $880,397 of mortgage loans were pledged to the FHLBas collateral for the various FHLB advances, the FHLB warehouse line and theovernight facility.

The $56,619 repo facility was collateralized by $64,456 of investmentsecurities at June 30, 2006. This facility matured on July 11, 2006.

The Company’s subordinated debt is supported by trust preferredsecurities, which were issued in 2002, 2003 and 2005 in private pooledtransactions through off-balance sheet trusts: NBI Trust I, II, III andIV. The subordinated debt and the associated trust preferred securities carryvariable rates and were initially priced at LIBOR plus a spread ranging from2.85% to 3.35% with a cap of 12.5% for five years after their respective dateof issuances. 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 facility are secured bymortgage loans and are subject to restrictive covenants. The covenants includecertain 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 June 30, 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.

Short-termdebt outstanding reached the highest month-end level during the six monthsended June 30, 2006 on January 31, 2006 with a short-term balance of$1,002,002.

**9.             STOCK-BASED COMPENSATION**

TheCompany has adopted the 1996 Stock Incentive Plan (the “Stock Plan”), whichprovides that employees, officers, directors and consultants of NetBank may begranted nonqualified and incentive stock options to purchase shares of commonstock of NetBank, shares of NetBank common stock, derivative securities relatedto the value of the common stock, or cash awards.  Up to 9,500,000 shares of our common stockmay be issued under the Stock Plan. Generally, the options vest within four years and expire ten years fromthe date of the grant.  Vesting ceasesimmediately upon employee

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terminationand any vested options are forfeited if not exercised within 90 days oftermination.  This exercise grace periodis extended to one year in the case of a recipient’s death or disability.

Priorto January 1, 2006, the Company accounted for the Stock Plan under therecognition and measurement provisions of Accounting Principles Board 25 (“APB25”), *Accounting for Stock Issued to Employees,*andrelated Interpretations, as permitted by Statement of Financial AccountingStandards No. 123, *Accounting for Stock-BasedCompensation.*  No stock-basedemployee compensation cost related to options was recognized in the Statementof Operations for periods ending prior to January 1, 2006, as all optionsgranted under the Stock Plan had an exercise price equal to the market value ofthe underlying common stock on the date of grant.

EffectiveJanuary 1, 2006, the Company adopted the fair value recognition provisions ofStatement of Financial Accounting Standards No. 123 (revised 2004), *Share-Based Payment,*using the modified prospectivetransition method.  Under this transitionmethod, compensation cost recognized in 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 $0.41 million and$1.54 million of expense during the three and six months ended June 30, 2006related to stock options, respectively. As provided using the modified prospective transition method, resultsfor prior periods have not been restated.

In addition to providing for the issuance of options, the Stock Planalso provides for the grant of stock awards. Compensation expense related to stock awards was recognized on astraight-line basis over the vesting period and included in the Statement ofOperations before adoption of SFAS 123(R). With the adoption of SFAS 123(R) effective January 1, 2006, the Companymodified the calculation of compensation expense related to stock awards toinclude both a straight-line basis over the vesting period and an estimation offorfeitures.   For the three months endedJune 30, 2006 and 2005, the Company recognized $321 and $165 of expense relatedto stock awards, respectively. For the six months ended June 30, 2006 and 2005,the Company recognized $712 and $187 of expense related to stock awards,respectively.

The Company also adopted the Mid-Term Incentive Plan (the “Mid-TermPlan”) which is administered under the Stock Plan.  On January 1, 2004, the CompensationCommittee 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 processingsegments during the two- and three-year performance periods ending December 31,2005 and 2006, 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 andconsolidated pre-tax income for two and three year performance periods endingDecember 31, 2007 and 2008, respectively. Under SFAS 123(R), the terms of the New Mid-Term Plan are subject to theclassification criteria of Statement of Financial Accounting Standards No. 150(“SFAS 150”), *Accounting for Certain Financial Instrumentswith Characteristics of both Liabilities and Equity,*since themonetary value of the award is predominately fixed and considered stock-settleddebt.  For the three and six months endedJune 30, 2006, the Company recognized $56 and $148, respectively, of expensewith an off-setting liability related to awards issued under the New Mid-TermPlan.

On July 1, 2002, the Company established the NetBank, Inc. Employee StockPurchase Plan (“the Employee Plan”), to allow participants to purchase stock inthe Company through payroll deductions. The Employee Plan purchases shares of NetBank common stock from theCompany on the last day of each quarter at 85% of the market value on thepurchase

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date.  Employees are eligible toenroll in the Employee Plan on January 1, April 1, July 1 and October 1.  There was no expense recognized during 2005related to the Employee Plan.  Under SFAS123(R), the Employee Plan is characterized as stock-settled debt and is subjectto the classification criteria of SFAS 150. For the three and six months ended June 30, 2006, the Company recognized$33 and $64, respectively, of expense with an off-setting liability related tothe Employee Plan.

SFAS 123(R) requires that a company disclose proforma information forperiods prior to its adoption of SFAS 123(R). The following table illustrates the effect on net income and earningsper share if the Company had applied the fair value recognition provisions ofSFAS 123 to options granted under the Company’s stock option plan for the threeand six months ended June 30, 2005.  Forpurposes of this pro forma disclosure, the value of the options is estimatedusing a Black-Scholes-Merton option-pricing formula and amortized to expenseover the options’ vesting periods.
|                                                                                                                                                     | ** ** | **Three months  ended June 30,  2005** | ** ** | **Six months  ended June 30,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Net income, as  reported                                                                                                                            |       | $                                                     | 2,325      |                                                | $          | 296 |   |
|                                                                                                                                                |       |                                                  |       |                                                |       |
| Deduct total  stock option-based employee compensation expense determined under fair value  based method for all awards, net of related tax effects |       | (1,144                                                | )          | (1,891                                              | )          |
| Pro forma net  income (loss)                                                                                                                        |       | $                                                     | 1,181      |                                                | $          | (1,595 | ) |
|                                                                                                                                                |       |                                                  |       |                                                |       |
| Earnings per  share:                                                                                                                                |       |                                                  |       |                                                |       |
| Basic – as reported                                                                                                                            |       | $                                                     | 0.05       |                                                | $          | 0.01 |   |
| Basic – pro forma                                                                                                                              |       | $                                                     | 0.03       |                                                | $          | (0.03 | ) |
|                                                                                                                                                |       |                                                  |       |                                                |       |
| Diluted – as reported                                                                                                                          |       | $                                                     | 0.05       |                                                | $          | 0.01 |   |
| Diluted – pro  forma                                                                                                                           |       | $                                                     | 0.03       |                                                | $          | (0.03 | ) |

 

As a result of adopting SFAS 123(R) on January 1, 2006,  the Company’s loss before income taxes andnet loss for the quarter ended June 30, 2006, are $445 and $263 higher,respectively, than if it had continued to account for share-based compensationunder APB 25.

The fair value of each option granted under the Stock Plan for thethree months ended June 30, 2006 and 2005 was estimated on the date of grantusing the Black-Scholes-Merton option-pricing formula with the followingweighted average assumptions:
|                          | ** ** | **For the three months ended  June 30,** | ** ** |
|--------------------------|------------|-------------------------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                                          | ** ** | **2005** | ** ** |
| Fair value               |       | $                                                                 | 2.52       |   | $ | 2.59 |   |
| Expected life  (years)   |       | 6.5                                                               |       | 5 |   |
| Risk-free interest  rate |       | 5.02                                                              | %          | 3.96 | % |
| Dividend rate            |       | 1.08                                                              | %          | 0.70 | % |
| Expected volatility      |       | 30.58                                                             | %          | 29.90 | % |
|                          |            |                                                                   |            |  |  |  |  |

 

Expected volatilities are based on the historical volatility of theCompany’s common stock and other factors. For options granted prior to 2006, the expected term of the options isestimated based on historical option exercise activity.  For options granted in 2006, the expectedterm is calculated using the shortcut method based on guidance from SAB 107 for

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the vesting and original contractual terms. The risk-free interest ratefor the periods within the contractual life of the option is based on the U.S.Treasury yield curve in effect at the time of grant.

Option activity under the Stock Plan as of June 30, 2006, and changesduring the six months ended June 30, 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                                   |       | 496        |       | $                                      | 7.27       |                                                |       |                           |       |   |
| Exercised                                 |       | (19        | )          | $                                      | 4.93       |                                                |       |                           |       |   |
| Forfeited                                 |       | (53        | )          | $                                      | 11.56      |                                                |       |                           |       |   |
| Cancelled                                 |       | (108       | )          | $                                      | 10.11      |                                                |       |                           |       |   |
| Options  outstanding at June 30, 2006     |       | 5,349      |       | $                                      | 10.65      |                                                | 6.3        |                           | $          | 21,720 |   |
| Options vested  at June 30, 2006          |       | 3,976      |       | $                                      | 10.94      |                                                | 6.3        |                           | $          | 16,471 |   |
| Options exercisable at  June 30, 2006     |       | 3,976      |       | $                                      | 10.94      |                                                | 6.3        |                           | $          | 16,471 |   |

 

Option activity under the Stock Plan as of June 30, 2006, and changesduring the quarter ended June 30, 2006 follows:
|                                              | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Fair Value** | ** ** |
|----------------------------------------------|------------|------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------|------------|
| Options  outstanding at beginning of quarter |       | 5,358      |       | $                                      | 10.71      |                                                |       |                           |       |   |
| Granted                                      |       | 105        |       | $                                      | 6.84       |                                                |       |                           |       |   |
| Exercised                                    |       | (19        | )          | $                                      | 4.93       |                                                |       |                           |       |   |
| Forfeited                                    |       | (28        | )          | $                                      | 12.52      |                                                |       |                           |       |   |
| Cancelled                                    |       | (67        | )          | $                                      | 10.11      |                                                |       |                           |       |   |
| Options  outstanding at June 30, 2006        |       | 5,349      |       | $                                      | 10.65      |                                                | 6.3        |                           | $          | 21,720 |   |
| Options vested  at June 30, 2006             |       | 3,976      |       | $                                      | 10.94      |                                                | 6.3        |                           | $          | 16,471 |   |
| Options exercisable at  June 30, 2006        |       | 3,976      |       | $                                      | 10.94      |                                                | 6.3        |                           | $          | 16,471 |   |

 

The weighted average grant-date fair value of options granted duringthe three months ended June 30, 2006 was $2.52.

The status of the Company’s nonvested options as of June 30, 2006, andchanges during the period ended June 30, 2006 follows:
|                                   | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------|------------|------------|------------|---------------------------------------------------------|------------|
| Nonvested,  January 1, 2006       |       | 1,587      |       | $                                                       | 3.71       |   |
| Granted                           |       | 496        |       | $                                                       | 2.61       |   |
| Vested                            |       | (578       | )          | $                                                       | 2.41       |   |
| Cancelled,  forfeited and expired |       | (132       | )          | $                                                       | 3.70       |   |
| Nonvested, June 30,  2006         |       | 1,373      |       | $                                                       | 3.87       |   |

 

As of June 30, 2006, there was $4,228 of total unrecognizedcompensation cost, net of estimated forfeitures, related to nonvested optionsunder the Stock Plan.  That cost isexpected to be recognized in less than four years.  The total fair value of options vested duringthe quarter ended June 30, 2006 was $695.

Restricted stock activity under the Stock Plan as of June 30, 2006, andchanges during the six months ended June 30, 2006 follows:

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|                                   | ** ** | **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 |       | (16        | )          | $                                                       | 8.05       |   |
| Nonvested, June 30,  2006         |       | 355        |       | $                                                       | 7.76       |   |

 

Restrictedstock activity under the Stock Plan as of June 30, 2006, and changes during thequarter ended June 30, 2006 follows:
|                                   | ** ** | **Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------|------------|------------|------------|---------------------------------------------------------|------------|
| Nonvested, March  31, 2006        |       | 365        |       | $                                                       | 7.77       |   |
| Granted                           |       | —     |       | —                                                  |       |
| Vested                            |       | —     |       |                                                    |       |
| Cancelled,  forfeited and expired |       | (10        | )          | $                                                       | 8.13       |   |
| Nonvested, June 30,  2006         |       | 355        |       | $                                                       | 7.76       |   |

 

**10.          GOODWILL AND INTANGIBLES**

**The Company accounts for goodwill in accordance with Statement ofFinancial Accounting Standards No. 142, “Goodwill and Other Intangible Assets,”(“SFAS 142”).  SFAS 142 requires thatentities assess the fair value of all acquisition-related goodwill on areporting unit basis.  We review therecorded value of goodwill for impairment at least annually during the thirdquarter of each year, or earlier if events or changes in circumstances indicatethat the carrying amount may exceed fair value. During the preparation and review of the these financial statements,management determined, based on currently available market information as wellas general trends in the industry, to record a goodwill impairment of $6,358with respect to the second quarter of 2006 related to our 2004 acquisition ofBeacon Credit Services.  The impairmentcharge eliminated all of the goodwill related to the Beacon acquisition.**

**Changes in the carrying amount of goodwill and intangible assets for thesix months ended June 30, 2006 by reportable segment are as follows:**
|                                | ** ** | **Retail Banking** | ** ** | **Financial  Intermediary** | ** ** | **Transaction  Processing** | ** ** | **Other** | ** ** | **Total** | ** ** |
|--------------------------------|------------|-------------------------|------------|-----------------------------|------------|-----------------------------|------------|-----------|------------|-----------|------------|
| Balance,  December 31, 2005    |       | $                       | 1,311      |                        | $          | 49,512                      |       | $         | 34,009     |      | $          | 265 |   | $ | 85,097 |   |
| Goodwill  acquired             |       | —                  |       | 576                         |       | —                      |       | —    |       | 576       |       |
| Intangible  assets acquired    |       | —                  |       | —                      |       | 252                         |       | —    |       | 252       |       |
| Goodwill  impairment           |       | —                  |       | (6,358                      | )          | —                      |       | —    |       | (6,358    | )          |
| Intangible asset  amortization |       | —                  |       | —                      |       | (1,789                      | )          | —    |       | (1,789    | )          |
| Balance, June 30, 2006         |       | $                       | 1,311      |                        | $          | 43,730                      |       | $         | 32,472     |      | $          | 265 |   | $ | 77,778 |   |

 

**11.          NET (LOSS) INCOME PER COMMON ANDCOMMON 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 and six months ended June 30,2006 and 2005.

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|                                 | ** ** | **Net (Loss)  Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|---------------------------------|------------|------------------------------------------|------------|---------------------------|------------|----------------------------|------------|
| Six months ended  June 30, 2006 |       |                                     |       |                      |       |                       |       |
| Basic EPS                       |       | $                                        | (42,387    | )                         | 46,293     |                       | $          | (0.92 | ) |
| Effect of  dilutive securities  |       | —                                   |       | —                    |       | —                     |       |
| Diluted EPS                     |       | $                                        | (42,387    | )                         | 46,293     |                       | $          | (0.92 | ) |
|                            |       |                                     |       |                      |       |                       |       |
| Six months ended  June 30, 2005 |       |                                     |       |                      |       |                       |       |
| Basic EPS                       |       | $                                        | 296        |                      | 46,241     |                       | $          | 0.01 |   |
| Effect of  dilutive securities  |       | —                                   |       | 297                       |       | —                     |       |
| Diluted EPS                     |       | $                                        | 296        |                      | 46,538     |                       | $          | 0.01 |   |

 
|                                   | ** ** | **Net (Loss)  Income  (Numerator)** | ** ** | **Shares  (Denominator)** | ** ** | **Per Share  Amount** | ** ** |
|-----------------------------------|------------|------------------------------------------|------------|---------------------------|------------|----------------------------|------------|
| Three months  ended June 30, 2006 |       |                                     |       |                      |       |                       |       |
| Basic EPS                         |       | $                                        | (31,436    | )                         | 46,323     |                       | $          | (0.68 | ) |
| Effect of  dilutive securities    |       | —                                   |       | —                    |       | —                     |       |
| Diluted EPS                       |       | $                                        | (31,436    | )                         | 46,323     |                       | $          | (0.68 | ) |
|                              |       |                                     |       |                      |       |                       |       |
| Three months  ended June 30, 2005 |       |                                     |       |                      |       |                       |       |
| Basic EPS                         |       | $                                        | 2,325      |                      | 46,116     |                       | $          | 0.05 |   |
| Effect of  dilutive securities    |       | —                                   |       | 376                       |       | —                     |       |
| Diluted EPS                       |       | $                                        | 2,325      |                      | 46,492     |                       | $          | 0.05 |   |

 

**12.          BUSINESS SEGMENTS**

Effectivein the first quarter of 2006, the Company revised its segment reporting formatfrom four to five segments:  retailbanking, financial intermediary, transaction processing, servicing asset, andother/corporate overhead.  We believe therealignment of the segments more closely represents management’s view of thebusiness than the previous method.  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 Online bank, the NetBank Business Finance division and theDealer Financial Services division.  In addition to the creation of theservicing asset segment, the other/corporate overhead segment was previouslyreported as the other/eliminations segment and included primarily costs chargedto the holding company.  This segmentalso now includes overhead costs which were previously recognized throughoutall segments.  Historical results belowhave been reclassified to conform with current period presentation.

Theretail banking segment’s investments primarily consist of 1-4 family mortgageloans originated by the financial intermediary segment, small businessfinancing loans and leases originated by the NetBank Business Finance division,auto loans originated by the Dealer Financial Services division, purchasedsecurities for investment, and various other purchased or retained loanproducts.  The financial intermediary segment originates mortgage loansdirectly with borrowers and purchases mortgage loans from correspondents and/orbrokers.  The financial intermediarysegment packages or pools such loans either inclusive or exclusive of servicingrights for retention by the retail banking segment or sale into the secondarymarket.  The financial intermediarysegment also encompasses the origination of loans for recreational vehicles(RVs), boats and aircraft which are then sold to the retail banking segment forinvestment purposes

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orto third party investors.  Thetransaction processing segment subservices loans for the retail bank segment,the financial intermediary segment, the servicing asset segment, and forthird-party customers; and provides ATM and merchant processing services.  The servicing asset segment manages themortgage servicing rights retained by the Company in conjunction with theorigination of mortgage loans or obtained through bulk acquisitions.  The other/corporate overhead segment containsholding company and overhead expenses along with the elimination of intersegmentgains and losses on loans sold to the retail banking segment, intersegmentinterest, and intersegment servicing and processing expenses.

The financial information for each business segment reflects specificidentifiable transactions or allocated transactions based on an internalallocation method.  The measurement ofthe performance of the business segments is based on our management structureand is not necessarily comparable with similar information from any otherfinancial institution. The information presented is also not necessarilyindicative of the segment’s operations if they were independent entities.
| ** **                                       | ** ** | **For the three months ended June 30, 2006** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  Banking**                                                             | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Servicing  asset** | ** ** | **Other/  corporate  overhead** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                                                               | 38,537     |   | $ | 24,055 |   | $ | 7 |   | $ | — |   | $ | 155 |   | $ | 62,754 |   |
| Intersegment interest  income                    |       | 22,671                                                                          |       | 54 |   | — |   | 3,093 |   | (25,818 | ) | — |   |
| Total interest income                            |       | 61,208                                                                          |       | 24,109 |   | 7 |   | 3,093 |   | (25,663 | ) | 62,754 |   |
| Interest expense                                 |       | 37,166                                                                          |       | 1,041 |   | — |   | 90 |   | 660 |   | 38,957 |   |
| Intersegment interest  expense                   |       | 5,736                                                                           |       | 18,000 |   | 102 |   | 2,116 |   | (25,954 | ) | — |   |
| Total interest expense                           |       | 42,902                                                                          |       | 19,041 |   | 102 |   | 2,206 |   | (25,294 | ) | 38,957 |   |
| Net interest income                              |       | 18,306                                                                          |       | 5,068 |   | (95 | ) | 887 |   | (369 | ) | 23,797 |   |
| Provision for credit  losses                     |       | 972                                                                             |       | 47 |   | — |   |   |   | — |   | 1,019 |   |
| Intersegment- servicing  and processing fees     |       | —                                                                          |       | — |   | 3,113 |   | — |   | (3,113 | ) | — |   |
| Non-interest income                              |       | 4,456                                                                           |       | 12,972 |   | 3,572 |   | (14,436 | ) | (622 | ) | 5,942 |   |
| Non-interest expense                             |       | 20,884                                                                          |       | 40,307 |   | 5,959 |   | 716 |   | 8,892 |   | 76,758 |   |
| Intersegment- servicing and  processing expenses |       | 118                                                                             |       | 586 |   | — |   | 2,409 |   | (3,113 | ) | — |   |
| Pre-tax income (loss)                            |       | $                                                                               | 788        |   | $ | (22,900 | ) | $ | 631 |   | $ | (16,674 | ) | $ | (9,883 | ) | $ | (48,038 | ) |
| Total assets                                     |       | $                                                                               | 3,726,977  |   | $ | 1,166,666 |   | $ | 41,726 |   | $ | 214,850 |   | $ | (1,008,214 | ) | $ | 4,142,005 |   |

 
| ** **                                       | ** ** | **For the three months ended June 30, 2005** | ** ** |
|--------------------------------------------------|------------|---------------------------------------------------------------------------------|------------|
| ** **                                       | ** ** | **Retail  banking**                                                             | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Servicing  asset** | ** ** | **Other/corporate  overhead** | ** ** | **Consolidated** | ** ** |
| Interest income                                  |       | $                                                                               | 36,843     |   | $ | 25,325 |   | $ | 9 |   | $ | — |   | $ | 324 |   | $ | 62,501 |   |
| Intersegment interest  income                    |       | 16,934                                                                          |       | 150 |   | (1 | ) | 2,353 |   | (19,436 | ) | — |   |
| Total interest income                            |       | 53,777                                                                          |       | 25,475 |   | 8 |   | 2,353 |   | (19,112 | ) | 62,501 |   |
| Interest expense                                 |       | 28,713                                                                          |       | 2,267 |   | 11 |   | 64 |   | 504 |   | 31,559 |   |
| Intersegment interest  expense                   |       | 4,598                                                                           |       | 13,032 |   | 6 |   | 2,121 |   | (19,757 | ) | — |   |
| Total interest expense                           |       | 33,311                                                                          |       | 15,299 |   | 17 |   | 2,185 |   | (19,253 | ) | 31,559 |   |
| Net interest income                              |       | 20,466                                                                          |       | 10,176 |   | (9 | ) | 168 |   | 141 |   | 30,942 |   |
| Provision for credit  losses                     |       | 2,316                                                                           |       | 14 |   | — |   |   |   | — |   | 2,330 |   |
| Intersegment- servicing  and processing fees     |       | —                                                                          |       | — |   | 3,435 |   | — |   | (3,435 | ) | — |   |
| Non-interest income                              |       | 3,683                                                                           |       | 31,652 |   | 4,647 |   | 1,246 |   | 13 |   | 41,241 |   |
| Non-interest expense                             |       | 18,186                                                                          |       | 33,437 |   | 6,458 |   | 1,060 |   | 6,838 |   | 65,979 |   |
| Intersegment- servicing  and processing expenses |       | 146                                                                             |       | 955 |   | — |   | 2,334 |   | (3,435 | ) | — |   |
| Pre-tax income (loss)                            |       | $                                                                               | 3,501      |   | $ | 7,422 |   | $ | 1,615 |   | $ | (1,980 | ) | $ | (6,684 | ) | $ | 3,874 |   |
| Total assets                                     |       | $                                                                               | 4,280,627  |   | $ | 1,573,489 |   | $ | 40,998 |   | $ | 227,297 |   | $ | (1,167,644 | ) | $ | 4,954,767 |   |

 

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| ** **                                      | ** ** | **For the six months ended  June 30, 2006** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **Retail  banking**                         | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Servicing  asset** | ** ** | **Other/  corporate overhead** | ** ** | **Consolidated** | ** ** |
| Interest income                                 |       | $                                           | 78,733     |   | $ | 50,629 |   | $ | 14 |   | $ | — |   | $ | 253 |   | $ | 129,629 |   |
| Intersegment interest income                    |       | 46,266                                      |       | 111 |   | — |   | 5,437 |   | (51,814 | ) | — |   |
| Total interest income                           |       | 124,999                                     |       | 50,740 |   | 14 |   | 5,437 |   | (51,561 | ) | 129,629 |   |
| Interest expense                                |       | 75,038                                      |       | 1,562 |   | — |   | 94 |   | 1,280 |   | 77,974 |   |
| Intersegment interest expense                   |       | 10,686                                      |       | 37,165 |   | 190 |   | 4,130 |   | (52,171 | ) | — |   |
| Total interest expense                          |       | 85,724                                      |       | 38,727 |   | 190 |   | 4,224 |   | (50,891 | ) | 77,974 |   |
| Net interest income                             |       | 39,275                                      |       | 12,013 |   | (176 | ) | 1,213 |   | (670 | ) | 51,655 |   |
| Provision for credit losses                     |       | 3,971                                       |       | 105 |   | — |   | — |   | — |   | 4,076 |   |
| Intersegment- servicing and processing fees     |       | —                                      |       | — |   | 6,476 |   | — |   | (6,476 | ) | — |   |
| Non-interest income                             |       | 8,087                                       |       | 38,074 |   | 7,884 |   | (17,441 | ) | (665 | ) | 35,939 |   |
| Non-interest expense                            |       | 40,679                                      |       | 75,556 |   | 12,055 |   | 1,339 |   | 18,645 |   | 148,274 |   |
| Intersegment- servicing and processing expenses |       | 239                                         |       | 1,325 |   | — |   | 4,912 |   | (6,476 | ) | — |   |
| Pre-tax income (loss)                           |       | $                                           | 2,473      |   | $ | (26,899 | ) | $ | 2,129 |   | $ | (22,479 | ) | $ | (19,980 | ) | $ | (64,756 | ) |
| Total assets                                    |       | $                                           | 3,726,977  |   | $ | 1,166,666 |   | $ | 41,726 |   | $ | 214,850 |   | $ | (1,008,214 | ) | $ | 4,142,005 |   |

 
| ** **                                      | ** ** | **For the six months ended  June 30, 2005** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                      | ** ** | **Retail  banking**                         | ** ** | **Financial  intermediary** | ** ** | **Transaction  processing** | ** ** | **Servicing  asset** | ** ** | **Other/corporate  overhead** | ** ** | **Consolidated** | ** ** |
| Interest income                                 |       | $                                           | 72,666     |   | $ | 46,397 |   | $ | 19 |   | $ | — |   | $ | 439 |   | $ | 119,521 |   |
| Intersegment interest income                    |       | 30,000                                      |       | 184 |   | 6 |   | 3,936 |   | (34,126 | ) | — |   |
| Total interest income                           |       | 102,666                                     |       | 46,581 |   | 25 |   | 3,936 |   | (33,687 | ) | 119,521 |   |
| Interest expense                                |       | 53,086                                      |       | 3,747 |   | 32 |   | 130 |   | 807 |   | 57,802 |   |
| Intersegment interest expense                   |       | 8,155                                       |       | 22,866 |   | 6 |   | 3,663 |   | (34,690 | ) | — |   |
| Total interest expense                          |       | 61,241                                      |       | 26,613 |   | 38 |   | 3,793 |   | (33,883 | ) | 57,802 |   |
| Net interest income                             |       | 41,425                                      |       | 19,968 |   | (13 | ) | 143 |   | 196 |   | 61,719 |   |
| Provision for credit losses                     |       | 4,652                                       |       | 29 |   | — |   | — |   | — |   | 4,681 |   |
| Intersegment- servicing and processing fees     |       | —                                      |       | — |   | 6,891 |   | — |   | (6,891 | ) | — |   |
| Non-interest income                             |       | 7,619                                       |       | 57,354 |   | 9,359 |   | 1,260 |   | 110 |   | 75,702 |   |
| Non-interest expense                            |       | 35,356                                      |       | 67,608 |   | 12,654 |   | 2,084 |   | 14,291 |   | 131,993 |   |
| Intersegment- servicing and processing expenses |       | 298                                         |       | 1,845 |   | — |   | 4,748 |   | (6,891 | ) | — |   |
| Pre-tax income (loss)                           |       | $                                           | 8,738      |   | $ | 7,840 |   | $ | 3,583 |   | $ | (5,429 | ) | $ | (13,985 | ) | $ | 747 |   |
| Total assets                                    |       | $                                           | 4,280,627  |   | $ | 1,573,489 |   | $ | 40,998 |   | $ | 227,297 |   | $ | (1,167,644 | ) | $ | 4,954,767 |   |

 

**13.          COMMITMENTS,CONTINGENCIES AND GUARANTEES**

 

TheCompany was servicing or subservicing for the benefit of others 101,478 and109,685 residential loans with unpaid principal balances aggregatingapproximately $13.1 billion and $14.2 billion at June 30, 2006 andDecember 31, 2005, respectively. Mortgagors’ taxes and insurance escrowfunds and investors’ principal and interest escrow funds totaled approximately$246 million and $270 million as of June 30, 2006 and December 31, 2005,respectively. Loans serviced for others and the related escrow funds are notowned by the Company; however, the majority of the escrow funds are deposited inNetBank, FSB.

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TheCompany has issued mortgage-backed securities under programs sponsored byGinnie Mae, Freddie Mac and Fannie Mae. In connection with servicingmortgage-backed securities guaranteed by Ginnie Mae, Freddie Mac or Fannie Mae,the Company advances certain principal and interest payments to securityholders prior to their collection from specific mortgagors. Additionally, theCompany must remit certain payments including property taxes and insurancepremiums in advance of collecting them from specific mortgagors and makecertain payments of attorney’s fees and other costs related to loans inforeclosure. These amounts are included in servicing advances under the caption“due from servicers and investors” in the accompanying consolidated balancesheets. Likewise, during the month that a mortgagor pays off his/her mortgage,the Company must accept an interest payment from the borrower that is pro-ratedto the date of payoff and pass through a full month’s interest to the securityholder. The Company includes its projection of the cost of such advances andlost interest on mortgages that prepay, and the expense of unreimbursedattorney and other costs associated with foreclosure in its valuation of itsmortgage servicing rights.

Inthe ordinary course of business, the Company is exposed to liability underrepresentations and warranties made to purchasers and insurers of mortgageloans and the purchasers of mortgage servicing rights. Under certaincircumstances, the Company may be required to repurchase mortgage loans orindemnify the purchasers of loans or mortgage servicing rights for losses ifthere has been a breach of representations or warranties.  Repurchased loans are carried at the lower ofcost or net realizable value.  As of June30, 2006 and December 31, 2005, loans held for sale included repurchased loanswith a net carrying value of $40.0 million and $63.6 million, respectively.

NetBankis unable to determine its maximum exposure under its representations andwarranties.  The maximum exposure wouldbe the current unpaid principal balance of any loan we have ever sold,excluding loans sold which specifically excluded our representations andwarranties, plus any fee or premium 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.

TheCompany repurchased approximately $55,899 and $55,388 of unpaid principalbalances during the six months ended June 30, 2006 and 2005, respectively. TheCompany had $21.7 million and $20.7 million of reserves for estimated losses onfuture repurchases as of June 30, 2006 and December 31, 2005,respectively.

Asof June 30, 2006, the Company had commitments to fund mortgage loans of$994,087, open-end consumer lines of credit of $73,563, undisbursed mortgageconstruction loans of $195,848, undisbursed leasing commitments of $4,461 andcommercial financing commitments of $10,628.

NetBank,FSB is involved in litigation with three insurance companies who are suretieson the purchased CMC leases.  Since thesecond quarter of 2002, the entire portfolio has been on non-accrual statuspending outcome of the litigation. NetBank, FSB has filed a claim for all payments that are currently pastdue, approximately $90 million at June 30, 2006.  The Company has charged off $50,230 of theunpaid principal balances to date.  AtJune 30, 2006, the remaining recorded value of the leases is $25,615.

**The Company is involved incertain legal proceedings, excluding the CMC litigation, incidental to itsbusiness.  The Company does not believethat the outcome of these proceedings will have a material adverse effect uponits financial condition, results of operations or cash flows.**

**Item2: Management’s Discussion and Analysis of Financial Condition and Resultsof Operations**

*Thefollowing discussion may include forward-looking statements. Forward-lookingstatements regarding the intent, belief or current expectations of NetBank,Inc. or its officers and directors can be identified by the use offorward-looking terms such as “believe”, “anticipate”, “estimate”, “expect”, “may”,“will”, “should”, “plan”, “intend”, “project”, or other comparable terminology.Various internal and external factors could cause the Company’s actual resultsto differ materially from those anticipated by the forward-looking statements.These factors include, but are in no way limited to, 1) the evolving nature ofthe market for Internet banking and financial services generally; 2) the public’sperception of the Internet as a secure, reliable channel for transactions; 3)the success of new products and lines of business considered*

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*criticalto the Company’s long-term strategy, such as small business banking andtransaction processing services; 4) potential difficulties in integrating theCompany’s operations across its multiple lines of business; 5) the cyclicalnature of the mortgage banking industry generally; 6) a possible decline inasset quality; 7) changes in general economic or operating conditions whichcould adversely affect mortgage loan production and sales, mortgage servicingrights, loan delinquency rates and/or loan defaults;  8) the possible adverse effects of unexpectedchanges in the interest rate environment; 9) adverse legal rulings,particularly in the Company’s litigation over leases originated by CommercialMoney Center, Inc.; and/or 10) increased competition and regulatorychanges.  The Company’s 2005 Form 10-Kcontains additional details on these and other risks that are material to ouroperations. All forward-looking statements in this report are based oninformation available at the time of filing. Except as required by the federalsecurities laws, the Company has no obligation to update any forward-lookingstatement 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 company engaged primarily in retail banking,mortgage banking, business finance and providing ATM and merchant processingservices. NetBank, Inc. wholly owns the outstanding stock of:  NetBank (“NetBank, FSB” or the “Bank”), afederal savings bank; MG Reinsurance Company (“MG Reinsurance”), a captivereinsurance company; NetInsurance, Inc. (“NetInsurance”), a licensed insuranceagency; and NB Partners, Inc., a corporation involved in strategic partneringopportunities. NetBank, FSB owns all of the outstanding stock of:  Market Street Mortgage Corporation (“MarketStreet”), a retail mortgage company; NetBank Payment Systems, Inc. (“NPS”), aprovider of ATM and merchant processing services for retail and other non-bankbusinesses; Meritage Mortgage Corporation (“Meritage”), a wholesalenon-conforming mortgage provider; and Financial Technologies, Inc. (“FTI”), aprovider of transaction processing services to other financial servicescompanies. NetBank, FSB’s wholesale mortgage division operates as NetBankFunding Services (“NetBank Funding”); its business financing division operatesas “NetBank Business Finance”; its automobile financing division operates as “DealerFinancial Services”; and its recreational vehicle financing division operatesas “Beacon Credit Services”.  Theconsolidated company is referred to herein as “we,” “us,”  “our,” “NetBank,” or “the Company”.

In the opinion ofmanagement, the unaudited consolidated financial statements included hereinreflect all adjustments, consisting only of normal recurring accruals, whichare necessary for the fair presentation of the financial condition and resultsof operations for the interim periods presented. Certain information andfootnote disclosures normally included in financial statements have beencondensed or omitted pursuant to applicable rules and regulations of the SEC.The financial statements included herein should be read in conjunction with thefinancial statements and notes thereto included in our 2005 Form 10-K. Theresults of operations for the interim periods reported herein are notnecessarily indicative of results to be expected for the full year. Certain2005 amounts have been reclassified for comparability with 2006 amounts.

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

**ExecutiveSummary and Future Outlook**

For the three monthsended June 30, 2006, we incurred a net loss of $31,436 or $0.68 per sharecompared to net income of $2,325 or $0.05 per share for the three months endedJune 30, 2005, a change of $33,761. NetBank’s results continue to be adversely impacted by 1) continued highvolume of repurchase losses related to representations and warranties on loansold, 2) net losses on hedging activities within the servicing asset segment aswell as impairment charges, 3) the flattening of the yield curve which reducesnet interest earned on interest-earning assets held for sale andheld-for-investment, and 4) depressed gain on sale margins within the financialintermediary segment.  In addition,during the second quarter of 2006, NetBank recorded a one-time goodwillimpairment charge associated with its 2004 acquisition of Beacon CreditServices of $6,358 and a $15,000 write-down with respect to the carrying valueof mortgage servicing rights.  During thesecond quarter of 2006, the Company announced its intention to sell itsmortgage servicing platform along with most of its portfolio of mortgageservicing rights.

*Retail Banking.* The retail banking segment includes operationsof the Online bank, the NetBank Business Finance division as well as the DealerFinancial Services division.   The retail banking segment achievedpre-tax income of $788

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during the secondquarter of 2006, a $2,713 decrease over the comparable period in 2005. TheOnline bank’s results declined by $2,717 primarily as a result of a decrease innet interest income of $2,840 and an increase in non-interest expense of$1,028. These decreases were off-set in part by improved provision expense of$1,948 and an increase in gain on sales of loans of $308.  QuickPost, PowerPost and Net Serv contributedto the segment’s decline by $3,194.  NetBank Business Finance reported a decrease in period over periodpre-tax income of $252. This decrease was primarily driven by an increase inprovision for credit losses of $750, partially off-set by an improvement in netinterest income of $325.  DealerFinancial Services reported improved results of $256 period over periodprimarily due to improvements in net interest income of $354 and a reduction inprovision expense of $146.  Provisionexpense for the retail banking segment as a whole decreased by $1,364 periodover period as a result of the sale of $103,891 of HELOCs.

*Financial Intermediary*.  The financial intermediary segment originatesboth conforming and non-conforming products through our network of brokers andcorrespondents as well as directly with consumers through our 75 branchoffices.  The financial intermediarysegment recorded a pre-tax loss of $22,900 for the second quarter of 2006, a$30,322 pre-tax decline period over period. This decline was primarily driven by a $18,376 decline in gain on salesof loans and MSRs resulting from increased provision expenses related torepresentations and warranties of $11,819. The remaining decline in gain on sales of loans and MSRs is attributableto severe competitive pressures within industry which have resulted indepressed margins.  Net interest incomealso declined by $5,299 as a result of the flattening of the yield curve andreduced production volumes.  In addition,net Beacon Credit Services results declined by $6,204 primarily due to aone-time goodwill impairment charge of $6,358 recognized during the secondquarter.

Theconforming mortgage operations within the financial intermediary segmentrecorded a pre-tax loss of $7,317 for the second quarter of 2006 compared topre-tax income of $5,263 during the same quarter in 2005.  This decline was primarily the result of a 20-basispoint decline in the revenue margins and a 39-basis point increase in expenses.Margins continue to be severely depressed resulting in a decrease in netinterest income of $4,166 as the yield curve continues to remain flat.Generally, we earn long-term interest rates on loans held for sale and financethose loans with short-term borrowings. As the yield curve flattens, net interest margin compresses.  If the yield curve continues to remain flat,we will continue to have declines in net interest margins.  Furthermore, gain on sales of loans and MSRsdeclined by $3,825 due to increased provision expense related torepresentations and warranties of $6,735. In addition, sales of loans period over period declined by $381,491 or16% although there was a 39-basis point increase in expenses related primarilyto reduced leverage of fixed expenses resulting from lower production volumes.

Thenon-conforming operations within the financial intermediary segment recorded apre-tax loss of $9,848 during the second quarter of 2006 compared to a pre-taxincome of $1,437 during the same quarter in 2005, a $11,285 change.  The decline is primarily attributable todecreased gain on sales of loans and MSRs of $14,551 resulting from increasedprovision expense for representations and warranties of $5,215.  In addition, sales of loans period overperiod declined by $262,068 or 33%.  Inaddition, production decreased $386,336 or 45% although there was a 25-basispoint increase in expenses relating primarily to reduced leverage of fixedexpenses resulting from lower production volume.  Although we believe that third quarterproduction is likely to increase somewhat, the results of the non-conformingoperations may remain volatile over coming quarters especially if repurchaselevels continue to remain high.

*Transaction Processing.*The transaction processing segment houses our servicing factory and NPS.  This segment recorded pre-tax income of $631for the three month period ended June 30, 2006 compared to pre-tax income of$1,615 for the same period in 2005. The decrease relates primarily to areduction in pre-tax earnings at NPS of $1,057 off-set by improvements inoperating expenses of $593 within the servicing factory.

*Servicing Asset.*The servicing asset segment manages the MSRs we retain in conjunction with theorigination of mortgage loans or obtain through bulk acquisition.  The servicing asset segment reported apre-tax loss of $16,674 for the three months ended June 30, 2006 compared to apre-tax loss of $1,980 for the same period in 2005, a change of $14,694.  This change was primarily attributable todecreased net hedge results of $16,231 period over period and reflected the$15,000 write-down in the second quarter of 2006 of the carrying value of themortgage servicing rights.  Thisimpairment was recorded based on information received through the marketingprocess of selling our mortgage servicing rights.  We have not yet entered into any definitiveagreement.

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*Other/Corporate Overhead.*The other/corporate overhead segment includes holding company and overheadexpenses along with the elimination of inter-segment gains and losses on loanssold to the retail banking segment from the financial intermediary segment. Theother/corporate overhead segment incurred a $9,883 pre-tax loss for the threemonths ended June 30, 2006 compared to a pre-tax loss of $6,684 for thecomparable period of 2005.  The $3,199change was primarily related to increased salaries and benefits expense as wellas increases in amortization.

*Capital Management Program. *Notwithstanding the factthat NetBank met all of the regulatory capital requirements placed upon it andits subsidiaries at June 30, 2006 and was “well capitalized” under applicableOffice of Thirft Supervision (“OTS”) guidelines at such date, the Company has aproactive capital management program in order to ensure that NetBank, FSBremains “well capitalized.”  As part ofthis program, the Company reviews capital allocations to lines of business thathave been performing below target or that may require greater investment toreach the right scale.  The goal is todeploy capital into strategic areas with greater or more stable long-termprofitability prospects.  Given NetBank,FSB’s current capital levels, management has voluntarily moderated its pursuitof additional asset growth and other growth initiatives until the currentcapital pressures ease.  For moreinformation regarding our regulatory capital requirements, see “Liquidity andCapital Resources – Capital Resources” below.

*Risk and Contingencies*.Reference is made to the discussions under Item 1A. “Risk Factors” and “FutureOutlook” in Item 7. Management’s Discussion and Analysis of Financial Conditionand Results of operations in the 2005 Form 10-K for further informationregarding the risks and challenges of our business. Reference is made to note12 of the notes to consolidated financial statements included in this reportand to Item 1. Legal Proceedings in Part II of this report for additionaldiscussion of certain risk and contingencies that may affect us.

# **Financial Condition**

*General. *Our assets totaled $4,142,005 at June 30, 2006, a decrease of $629,614or 13% from December 31, 2005.  This isprimarily the result of decreases of $261,914 in loans held for sale and$213,038 in loan and lease receivables. The decrease in loans held for sale and loan and lease receivablesenabled us to pay down other borrowed funds by $480,621 during the six monthperiod ended June 30, 2006.

*Investment Securities.* For the six months ended June 30, 2006, the investment security portfoliodecreased by $51,487. This decrease was primarily due to principal repaymentson mortgage-backed securities of $42,490 and change in net unrealized losses of$18,889. The decrease was offset, in part, by the purchase of $10,033 of newinvestment securities.

The following tables set forth certain information relating to ouravailable for sale securities:
| As of June 30, 2006 | ** ** | **Amortized  cost** | ** ** | **Unrealized  gains** | ** ** | **Unrealized  losses** | ** ** | **Estimated  fair value** | ** ** |
|-----------------------------------------|------------|---------------------|------------|-----------------------|------------|------------------------|------------|--------------------------------|------------|
| U.S. Government agencieis – MBS    |       | $                   | 508,136    |                  | $          | —                 |       | $                              | 26,515     |   | $ | 481,620 |   |
| Collateralized mortgage obligations     |       | 53,467              |       | 6                     |       | 2,162                  |       | 51,312                         |       |
| U.S. treasury securities                |       | 13,533              |       | —                |       | 1,836                  |       | 11,697                         |       |
| Agency bonds                            |       | 27,254              |       | —                |       | 1,215                  |       | 26,039                         |       |
| Oher                                    |       | 3,931               |       | —                |       | 9                      |       | 3,922                          |       |
| Total                                   |       | $                   | 606,321    |                  | $          | 6                      |       | $                              | 31,737     |   | $ | 574,590 |   |

 
| 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                         |       |
| Oher                                        |       | 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 June 30, 2006 andDecember 31, 2005, the aggregate fair value of loans held for sale exceeded theaggregate cost.

Thefollowing tables set forth information regarding our portfolio of loans heldfor sale:
| As of June 30, 2006 | ** ** | **Gross UPB** | ** ** | **Reserve** | ** ** | **Non-  performing** | ** ** |
|-----------------------------------------|------------|--------------------|------------|-------------|------------|----------------------|------------|
| Conforming mortgages                    |       | $                  | 617,088    |        | $          | 3,811                |       | $ | 19,001 |   |
| Non-conforming mortgages                |       | 194,127            |       | 7,453       |       | 14,282               |       |
| Construction                            |       | 166,081            |       | 339         |       | —               |       |
| Commercial / recreational               |       | 6,358              |       | 47          |       | —               |       |
| Total loans held for sale               |       | $                  | 983,654    |        | $          | 11,650               |       | $ | 33,283 |   |

 
| As of December 31, 2005 | ** ** | **Gross UPB** | ** ** | **Reserve** | ** ** | **Non-  performing** | ** ** |
|---------------------------------------------|------------|--------------------|------------|-------------|------------|----------------------|------------|
| 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, whenrequired to repurchase mortgage loans, bundles such loans in pools and re-sellsthem.  The $16,352 decline innon-performing loans held for sale is primarily related to such re-sales ofmortgage loans during the six months ended June 30, 2006.  The size of the repurchase inventory, whichis primarily comprised of non-performing loans, will vary depending on thetiming of the repurchases and the subsequent dispositions.

*Loan and Lease Receivables.* For the six months ended June 30, 2006, the loan and lease receivablesportfolio decreased $213,038 or 10%.  The decrease in loan and lease receivableswas primarily due to principal reductions and prepayments of $365,677 and asales of HELOCs of $103,891.  Thesedecreases were offset, in part, by the retention of $154,315 of auto loans,$109,873 of business equipment finance leases, $2,771 in home equity lines ofcredit (“HELOCs”), and $4,219 of marine and recreational vehicle loans.

*Asset Quality and Non-performingAssets.* We periodically review the performance of our loanand lease receivables portfolio by reviewing charge-offs, delinquencystatistics, and various other industry statistics.  Large non-homogeneous credits are reviewed ona loan-by-loan or lease-by-lease basis, whereas relatively small credits withsimilar risk characteristics are reviewed on a pool-by-pool basis.  If a decline in credit quality for a specificpool or individual loan or lease is noted, we record additional allowancethrough a charge to the provision for credit losses.  The allowance for credit losses is maintainedat a level estimated to be adequate to provide for probable losses in the loanand lease receivables portfolio. We determine the adequacy of the allowancebased upon reviews of individual loans and leases or pools as applicable,recent loss experience, current economic conditions, the risk characteristicsof the various categories of loans

25

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and leases and otherpertinent factors. Our non-performing assets as a percentage of gross UPBincreased slightly from 1.47% at December 31, 2005, to 1.56% at June 30, 2006,as the level of non-performing assets declined by $1,207 while total loans andleases receivable declined 213,038. 

NetBank,FSB is involved in litigation with three insurance companies who are suretieson purchased lease receivables originated by Commercial Money Center, Inc.(“CMC”). Reference is made to Item 1. “Legal Proceedings” in Part IIof this report for detailed information related to the Company’s ongoing CMClitigation. In July 2006, in the CMC litigation, the Court in themulti-district legislation (“MDL” Court) issued a Revised Case Management Plan.In that plan, the MDL Court lifted the stay on expert discovery and orderedthat the parties disclose experts supporting their claims and exchange expertreports. The MDL Court also ordered that dispositive motions, such as NetBank,FSB’s planned new motion for summary judgment against the sureties, must befiled between January 15, 2007 and January 31, 2007. Based upon the revisedplan issued by the MDL Court, the Company does not expect any resolution ofNetBank, FSB’s claims against the sureties prior to the Spring of 2007.

The following tablesdetail our held for investment loan and lease receivables portfolio, theassociated allowance for credit losses, and non-performing assets:
| As of June 30, 2006               | ** ** | **Gross UPB** | ** ** | **Allocated  Allowance** | ** ** | **(1) Non-  performing** | ** ** |
|-----------------------------------|------------|---------------|------------|--------------------------|------------|--------------------------|------------|
| First mortgages                   |       | $             | 730,429    |                     | $          | 2,307                    |       | $ | 2,051 |   |
| Second mortgages                  |       | 99,472        |       | 2,958                    |       | 417                      |       |
| Leases                            |       | 412,847       |       | 15,966                   |       | 1,717                    |       |
| Auto                              |       | 618,011       |       | 3,375                    |       | 418                      |       |
| Home equity lines                 |       | 110,205       |       | 2,459                    |       | 1,624                    |       |
| Consumer                          |       | 42,117        |       | 306                      |       | —                   |       |
| Loan and lease  receivables       |       | 2,013,081     |       | 27,371                   |       | 6,227                    |       |
| CMC leases (2)                    |       | 25,615        |       | —                   |       | 25,615                   |       |
| Total loan and lease  receivables |       | $             | 2,038,696  |                     | $          | 27,371                   |       | $ | 31,842 |   |

 
| As of December 31, 2005           | ** ** | **Gross UPB** | ** ** | **Allocated  Allowance** | ** ** | **(1) Non-  performing** | ** ** |
|-----------------------------------|------------|---------------|------------|--------------------------|------------|--------------------------|------------|
| 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 90 daysor more contractually past due including loans which have beenrestructured.  The Company also held$8,330 and $6,782 of restructured loans which were performing in accordancewith the restructured terms as of June 30, 2006 and December 31, 2005,respectively.

(2) Reference is made to note 5 and 13 of the notes tothe consolidated financial statements included in this report for additionaldetails regarding the CMC lease portfolio.

*Mortgage Servicing Rights.*  Forthe six months ended June 30, 2006, the MSR portfolio increased $1,526 or1%.  The increase was primarily driven bythe capitalization of $8,294 from the retention of MSRs, and an increase invalue of $15,603, net of a $5,906 valuation provision.  These increases were partially offset by$20,451 of amortization, and $1,920 net impact of sales of MSRs.  During the six month period ended June 30,2006, NetBank recorded a decrease of $12,250 in the market value of thederivatives portfolio hedging the MSRs. The fair value of the derivative portfolio hedging the MSRs is recordedin other assets.

26

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Thefollowing table provides a sensitivity analysis of the fair value of theavailable for sale MSRs portfolio:
|                                             | ** ** | **As of  June 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|
| Fair value                                  |       | $                                       | 203,342    |                                        | $          | 201,034 |   |
| Weighted average  life in years             |       | 6.0                                     |       | 5.2                                         |       |
|                                        |       |                                    |       |                                        |       |
| Prepayment speed  assumption (annual rate)  |       | 11.30                                   | %          | 13.70                                       | %          |
| Impact on fair  value of 10% adverse change |       | $                                       | (10,345    | )                                           | $          | (9,442 | ) |
| Impact on fair  value of 20% adverse change |       | $                                       | (18,471    | )                                           | $          | (18,579 | ) |
|                                        |       |                                    |       |                                        |       |
| Discount rate                               |       | 9.89                                    | %          | 10.83                                       | %          |
| Impact on fair  value of 10% adverse change |       | $                                       | (7,451     | )                                           | $          | (9,177 | ) |
| Impact on fair value of  20% adverse change |       | $                                       | (14,557    | )                                           | $          | (16,194 | ) |

 

Thesensitivities above are hypothetical and should be used with caution.  As the figures indicate, changes in fairvalue based 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 thetable above, the effect of a variation in a particular assumption on the fairvalue of the available for sale servicing rights is calculated without changingany other assumption; in reality, changes in one factor may result in changesin another, which might magnify or counteract 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 MSRportfolio was $11,308 at June 30, 2006 compared to $23,558 at December 31,2005, a decrease of $12,250. The derivatives consist primarily of commitmentsto purchase mortgage pool securities, options, floors, swaps, swaptions, caps,and floors.  The value of the derivativeshedging the pipeline of MSRs was $2 at June 30, 2006 compared to a loss of $993at December 31, 2005.  The value of ourloan commitments for which the interest rate is locked (“rate locks”) decreasedin value to a loss of $485 at June 30, 2006 compared to a gain of $1,592 atDecember 31, 2005, a decrease of $2,077. Our portfolio of mandatory deliverycommitments hedging our rate locks reflected a gain of $604 at June 30, 2006compared to a loss of $1,081 at December 31, 2005. Both the rate locks andcorresponding mandatory delivery commitments are marked-to-market and reflectedin our consolidated statement of operations. The value of the mandatorydelivery commitments hedging our inventory of closed loans reflected a gain of$1,902 at June 30, 2006 compared to a loss of $2,852 at December 31, 2005, animprovement of $4,754. Since a portion of the mandatory delivery commitmentsqualify for hedge accounting, a basis adjustment was recorded to our inventoryof mortgage loans held for sale for the effective hedges.

*Liabilities.* Our total liabilities decreased $576,196during the six months ended June 30, 2006. The decrease was primarily related to decreases of $480,621 in otherborrowed funds, $35,406 in accounts payable and accrued liabilities, and$71,910 in deposits. These decreases were offset, in part, by increases of$7,093 in loans in process, $3,628 in accrued interest payable and $1,020 inrepresentations and warranties.  We wereable to reduce other borrowed funds as a result of the decreases in loans heldfor sale and loans and leases receivable during the six month period ended June30, 2006.

*Deposits.*  Deposits were $2,721,937 at June 30, 2006, a3% decrease compared to $2,793,847 at December 31, 2005.  As of June 30, 2006, deposits represented 75%of total interest-bearing liabilities (including deposits, other borrowedfunds, and subordinated debt) outstanding; Federal Home Loan Bank (“FHLB”)advances, warehouse lines of credit, and repurchase agreements representedapproximately 24% in the aggregate of total interest bearing liabilities; andsubordinated debt was only 1%.  We willcontinue working to expand our relationships with new and existing customers toincrease our deposit base.

27

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The following tablesummarizes our deposits:
|                                         | ** ** | **As of June 30, 2006** | ** ** | **As of December 31, 2005** | ** ** |
|-----------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                              | ** ** | **Amount**                                  | ** ** | **Percentage**                                  | ** ** | **Weighted  average  interest  rate** | ** ** | **Amount** | ** ** | **Percentage** | ** ** | **Weighted  average  interest rate** | ** ** |
| Non-interest  bearing checking accounts |       | $                                           | 260,409    |                                            | 9.6        | % | — |   | $ | 284,046 |   | 10.2 | % | — |   |
| Interest  bearing:                      |       |                                        |       |                                            |       |   |   |   |   |   |   |   |   |
| Checking accounts                       |       | 216,818                                     |       | 8.0                                             | %          | 0.9 | % | 232,658 |   | 8.3 | % | 0.9 | % |
| Money market                            |       | 814,166                                     |       | 29.9                                            | %          | 3.3 | % | 943,432 |   | 33.8 | % | 3.2 | % |
| Certificate of deposit under $100       |       | 1,332,051                                   |       | 48.9                                            | %          | 4.5 | % | 1,240,784 |   | 44.4 | % | 4.0 | % |
| Certificate of deposit over $100        |       | 98,493                                      |       | 3.6                                             | %          | 4.5 | % | 92,927 |   | 3.3 | % | 4.1 | % |
| Total deposits                          |       | $                                           | 2,721,937  |                                            | 100        | % |   |   | $ | 2,793,847 |   | 100.0 | % |   |   |

 

*Reserve for Representations andWarranties.*The reserve for representations and warranties ismaintained at a level estimated to be adequate to cover future losses on loanswhich we may be required to repurchase under representations and warrantiesprovided to purchasers and insurers of mortgage loans. We establish the reservefor future losses by reducing current period gain on sale of loans.  The reserve increased $1,020 during the sixmonths ended June 30, 2006.  Thisincrease is primarily attributable to an increase in provision, partiallyoffset by charges to the reserve relating to prepayments that trigger earlyprepayment claims by buyers of loans and net charges on loans repurchased orindemnified under seller representations and warranties.  The majority of repurchases occur during thefirst 24 months following the date of sale. We have experienced an increase in the frequency and severity related torepurchases; however, it is still uncertain whether this trend will continue orabate.  If the trend continues toincrease in future periods, it would require us to continue to provide forlosses at higher levels to cover future losses on the disposition ofrepurchased loans.

*Shareholders’ Equity.*  Total shareholders’ equity decreased $53,380for the six months ended June 30, 2006. The decline is primarily due to a change of $11,708 in accumulated othercomprehensive loss, $44,287 in retained (deficit) earnings, and $307 intreasury stock.  These changes wereoffset, in part, by a $1,669 increase in additional paid in capital and adecline in unearned compensation of $1,253. The $44,287 decline in retained (deficit) earnings is primarily theresult of the net loss of $42,387 for the six months ended June 30, 2006,$1,852 of dividends, and $313 of losses on the reissuance of treasury stock,and an increase of $265 resulting from reclassification of unearnedcompensation upon adoption of SFAS 123(R). The change in treasury stock is the result of the repurchase of 6,000shares of common stock offset by the reissuance of 61,137 shares under theemployee stock purchase plan and 19,256 shares related to option exercises.Further, upon adoption of SFAS 123(R), we reclassified 111,393 shares ofrestricted stock granted to treasury stock, net of vested shares.  We plan to continue to repurchase sharesperiodically in the public market or through private transactions.  As of June 30, 2006, 1,086,573 sharesremained available for repurchase under the current Board authorization.

**Results of Operations – Threemonths ended June 30, 2006 compared to the three months ended June 30, 2005**

*General.* Net loss for the three months ended June 30, 2006 was $31,436 or $0.68 pershare, compared to net income of $2,325 or $0.05 per share for the same periodin 2005.  The current quarter wasnegatively impacted by the $15,000 write-down to mortgage servicingrights as well as continued declines in gains on sales of mortgage loans andmortgage servicing rights due to continued high repurchase levels as well ascompetitive pressures on margins.  Inaddition, we recorded a one-time goodwill impairment charge related to BeaconCredit Services of $6,358.

*Interest Income*. Our interest income for the three months ended June 30, 2006 was $62,754compared to $62,501 for the same period in 2005.  This increase was the result of the averageyield increasing by 61-basis points to 6.09% of interest-earning assets off-setby a decrease of $441,641 in the average balance of interest-earning assets.  Reference is made to the rate volume variancetable set forth below for additional detail regarding the changes in interestincome.

28

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*Interest Expense*.Total interest expense for the three months ended June 30, 2006 was $38,957compared to $31,559 for the same period of 2005.  The $7,398 increase is due to an increase102-basis in the average cost of funds off-set in part by a decrease in theaverage balance of interest-bearing liabilities of $317,569.  For the three months ended June 30, 2006compared to same period of 2005, interest expense on deposits increased $7,518as a result of increases in the average interest rate paid coupled with a$160,580 increase in the average outstanding balance of deposits.  For the three months ended June 30, 2006, interestexpense on other borrowed funds (including short-term debt, FHLB advances, andconvertible subordinated debt) was $15,841 compared to $15,961 for the sameperiod of 2005.  The $120 decrease ininterest expense related to other borrowed funds is a result of increases inthe average cost of funds of 117-basis points off-set by decreases in theaverage outstanding balance of debt of $478,149.  Reference is made to the rate volume variancetable set forth below for additional detail regarding the changes in interestincome.

*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 and interest-bearingliabilities.  Net interest income was$23,797 or 2.03% of average interest-earning assets for the three months endedJune 30, 2006 compared to $30,942 or 2.44% of average interest-earning assetsfor the three months ended June 30, 2005. The 41-basis point decline is primarily due to a flattening of the yieldcurve as recent increases in short-term rates have not carried through to thelong end of the yield curve. The rates we pay on our deposits and short-termborrowings is generally related to the short end of the yield curve; whereasthe yield we earn on our mortgage loans held for sale is based primarily on thelong end of the curve.

The followingtable details the relative interest rates and average balances of ourinterest-earning assets and interest-bearing liabilities for the three monthsended June 30, 2006 and 2005:

 
| **Average Balance** | ** ** | **Average Yield /   Rate** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** **                          | ** ** | **Variance attributable  to**              |       |
|--------------------------|------------|-------------------------------------------|------------|------------|------------|--------------|------------|-------------------------------------|------------|-------------------------------------------------|------------|
| **2006**                 | ** ** | **2005**                                  | ** ** | **2006**   | ** ** | **2005**     | ** ** | ** **                          | ** ** | **2006**                                        | ** ** | **2005** | ** ** | **Variance** | ** ** | **Rate** | ** ** | **Volume (3)** |   |
|                     |       |                                      |       |       |       |         |       | **Interest-earning  assets:**       |       |                                            |       |   |   |   |   |   |   |   |   |
| $                        | 24,386     |                                      | $          | 60,719     |       | 4.95         | %          | 3.40                                | %          | Short-term  investments                         |       | $ | 302 |   | $ | 516 |   | $ | (214 | ) | $ | 236 |   | $ | (450 | ) |
| 682,024                  |       | 774,570                                   |       | 4.75       | %          | 4.59         | %          | Investment  securities (1)          |       | 8,093                                           |       | 8,879 |   | (786 | ) | 312 |   | (1,098 | ) |
| 1,280,164                |       | 1,587,778                                 |       | 7.23       | %          | 6.25         | %          | Loans held for  sale (2)            |       | 23,139                                          |       | 24,795 |   | (1,656 | ) | 3,904 |   | (5,560 | ) |
| 2,137,928                |       | 2,143,076                                 |       | 5.84       | %          | 5.28         | %          | Loans and leases  receivable (2)    |       | 31,220                                          |       | 28,311 |   | 2,909 |   | 2,984 |   | (75 | ) |
| 4,124,502                |       | 4,566,143                                 |       | 6.09       | %          | 5.48         | %          | Total  interest-earning assets      |       | 62,754                                          |       | 62,501 |   | 253 |   | 7,436 |   | (7,183 | ) |
|                     |       |                                      |       |       |       |         |       |                                |       |                                            |       |   |   |   |   |   |   |   |   |
|                     |       |                                      |       |       |       |         |       | **Interest-bearing  liabilities:**  |       |                                            |       |   |   |   |   |   |   |   |   |
| 220,554                  |       | 233,159                                   |       | 1.43       | %          | 1.34         | %          | Checking accounts                   |       | 786                                             |       | 783 |   | 3 |   | 48 |   | (45 | ) |
| 858,406                  |       | 1,067,740                                 |       | 3.15       | %          | 2.35         | %          | Money market                        |       | 6,764                                           |       | 6,285 |   | 479 |   | 2,128 |   | (1,649 | ) |
| 1,390,193                |       | 1,007,674                                 |       | 4.48       | %          | 3.39         | %          | Certificates of  deposit            |       | 15,566                                          |       | 8,530 |   | 7,036 |   | 2,753 |   | 4,283 |   |
| 883,477                  |       | 1,036,872                                 |       | 5.20       | %          | 3.48         | %          | Short-term debt                     |       | 11,477                                          |       | 9,031 |   | 2,446 |   | 4,439 |   | (1,993 | ) |
| 451,923                  |       | 776,677                                   |       | 3.30       | %          | 3.32         | %          | FHLB advances                       |       | 3,726                                           |       | 6,437 |   | (2,711 | ) | (33 | ) | (2,678 | ) |
| 32,477                   |       | 32,477                                    |       | 7.86       | %          | 6.07         | %          | Subordinated debt                   |       | 638                                             |       | 493 |   | 145 |   | 145 |   | — |   |
| 3,837,030                |       | 4,154,599                                 |       | 4.06       | %          | 3.04         | %          | Total  interest-bearing liabilities |       | 38,957                                          |       | 31,559 |   | 7,398 |   | 9,480 |   | (2,082 | ) |
| —                   |       | —                                    |       | 2.03       | %          | 2.44         | %          | Net interest  margin                |       | 23,797                                          |       | 30,942 |   | (7,145 | ) | (2,044 | ) | (5,101 | ) |
| 287,472                  |       | 411,544                                   |       | 0.28       | %          | 0.27         | %          | Interest free  sources              |       | —                                          |       | — |   | — |   | — |   | — |   |
| $                        | 4,124,502  |                                      | $          | 4,566,143  |       | 2.31         | %          | 2.71                                | %          | Net interest  income to interest-earning assets |       | $ | 23,797 |   | $ | 30,942 |   | $ | (7,145 | ) | $ | (2,044 | ) | $ | (5,101 | ) |

 

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

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

(3)          Variances attributable to the rate andvolume mix are included in the volume variances.

29

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*Provision for Credit Losses.* The provision for credit losses was $1,019 for the three months ended June 30,2006 compared to $2,330 for the same period of 2005.  The decrease in provision for credit lossesrelates primarily to the sale of $103,891 of HELOCS during the second quarter,off-set in part by provisions related to 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-interestincome declined by $35,299 to $5,942 for the three months ended June 30, 2006compared to the same period of 2005.  Weexperienced increased losses on derivatives of $6,609 during the three monthsended June 30, 2006 compared to the same period of 2005 as well as declines onour gains on sales of loans and MSRs of $18,568 due to increased provisionlevels related to representations and warranties.  Additionally, increased expenses in theimpairment of MSRs of $7,817 also contributed to the decline in non-interestincome. Impairment expenses increased primarily due to a $15,000 write-down ofmortgage servicing rights that occurred during the second quarter of 2006. Theremaining decline in gain on sales of loans and MSRs is attributable to severe competitivepressures within the industry which have resulted in depressed margins.

*Non-interest Expense.* Non-interest expense includes all operating expenses such as salaries andbenefits, marketing, and general and administrative expenses.  Non-interest expense increased $10,779 forthe three months ended June 30, 2006 compared to the same period of 2005.  This increase was primarily driven by the$3,748 increase in salaries and benefits related to the adoption of SFAS 123(R)and the acquisition of Major Mortgage in the third quarter of 2005.  Likewise, marketing costs have increased$1,124 related to the growth in our retail mortgage operations.  In addition, we recorded a one-time goodwillimpairment charge of $6,358 during the second quarter of 2006 related to our2004 acquisition of Beacon Credit Services. These increases were offset, in part, by reductions in professional feesof $1,412.

* Adoption of SFAS 123(R)*.  On January 1, 2006, we adopted SFAS 123(R)using the modified prospective transition method.  Unlike the modified retrospective transitionmethod, the modified prospective transition method has no impact on priorperiod financial statements.  Prior tothe adoption of SFAS 123(R), we accounted for stock based compensation underthe provisions of APB Opinion No. 25, “Accounting for Stock Issued to Employees”.  As such, no compensation cost was recognizedin the consolidated statement of operations related to the Employee StockPurchase Plan or options as all options granted had an exercise price equal tothe market value of the underlying common stock on the grant date.  Compensation expense was previouslyrecognized related to the Mid-Term Incentive Plan and stock awards.

As a result of theadoption, loss before income taxes for the three months ended June 30, 2006includes $821 of stock based compensation costs.  As of June 30, 2006, there was $6,644 ofunrecognized compensation cost, net of estimated forfeitures, related to stockbased compensation.  This cost isexpected to be recognized over a weighted average period of less than 4 yearson a straight line basis.  TheBlack-Scholes-Merton pricing model was used to calculate the fair value ofstock options and stock grants, and no cumulative effect of accountingadjustment was required.  In anticipationof the adoption of SFAS123(R), during 2005 we began granting certain employeesa combination of stock options and stock awards as opposed to all stockoptions, and accelerated the vesting of all options which had a strike price inexcess of $14.00.  We have no immediateplans to modify share based payment arrangements.  See note 9 of the notes to the consolidatedfinancial statements included herein for further information regarding sharebased payments including assigned assumptions.

*Retail Banking Segment.*

The table below providesan overview of the pre-tax results of operations for the retail bankingsegment:
|                                               | ** ** | **For the three months ended June 30,** | ** **    |
|-----------------------------------------------|------------|-----------------------------------------------------------------------|---------------|
| ** **                                    | ** ** | **2006**                                                              | ** **    | **2005** | ** ** | **Change** | ** ** |
| Net interest  income                          | ** ** | **$**                                                                 | **18,306**    |   | $ | 20,467 |   | $ | (2,161 | ) |
| Provision for  credit losses                  | ** ** | **972**                                                               |          | 2,316 |   | (1,344 | ) |
| Net interest income after provision           | ** ** | **17,334**                                                            |          | 18,151 |   | (817 | ) |
| Gains on sales  of loans                      | ** ** | **308**                                                               |          | — |   | 308 |   |
| Fees, charges  and other income               | ** ** | **3,650**                                                             |          | 3,683 |   | (33 | ) |
| Total banking revenues                        | ** ** | **21,292**                                                            |          | 21,834 |   | (542 | ) |
| Total banking expenses                        | ** ** | **17,310**                                                            |          | 18,333 |   | (1,023 | ) |
| Pre-tax banking results                       | ** ** | **3,982**                                                             |          | 3,501 |   | 481 |   |
| Net QuickPost, PowerPost and NetServ results  | ** ** | **(3,194**                                                            | **)**         | — |   | (3,194 | ) |
| Pre-tax income                                | ** ** | **$**                                                                 | **788**       |   | $ | 3,501 |   | $ | (2,713 | ) |
|                                          | ** ** | ** **                                                            |          |   |   |   |   |
| Average earning  assets                       | ** ** | **$**                                                                 | **4,324,185** |   | $ | 4,496,414 |   | $ | (172,229 | ) |
| QuickPost  transactions                       | ** ** | **238,674**                                                           |          | — |   | 238,674 |   |
|                                          |       |                                                                  |          |   |   |   |   |
| **Operations  to average earning assets**     | ** ** | ** **                                                            | ** **    | ** ** | ** ** | ** ** | ** ** |
| Net interest income  after provision          | ** ** | **1.60**                                                              | **%**         | 1.61 | % | (0.01 | )% |
| Gain on sale,  fees, charges and other income | ** ** | **0.37**                                                              | **%**         | 0.33 | % | 0.04 | % |
| Total banking  revenues                       | ** ** | **1.97**                                                              | **%**         | 1.94 | % | 0.03 | % |
| Total banking  expenses                       | ** ** | **1.60**                                                              | **%**         | 1.63 | % | (0.03 | )% |
| Pre-tax income                                | ** ** | **0.37**                                                              | **%**         | 0.31 | % | 0.06 | % |

 

Note: The above table disaggregates the results of our QuickPost, PowerPostand NetServ initiatives.

30

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The retail bankingsegment recorded pre-tax income of $788 in the second quarter of 2006, a $2,713decrease over the comparable period in 2005. The majority of the declinerelates to several start-up initiatives the company has been developing. Thecompany recorded a pre-tax loss of $3,194 on these particular product lines.They include QuickPost, PowerPost and NetServ. QuickPost is a deposit- andpayment-forwarding service that allows consumers of participating financialinstitutions to drop off deposits or payments at locations of UPS storesnationwide. PowerPost allows small business banking customers to deposit checksthey receive directly into their NetBank account using a check imaging andclearing device. NetServ is a private-label online banking platform the companysells to smaller financial institutions.

The Online bank’sresults improved $477 primarily due to reduced provision expense as result ofsales of HELOCs. A decrease in non-interest expense also contributed toimproved results of the Online bank’s results. The segment was negativelyimpacted by decreased net interest income of $2,161 as a result of thecontinued flattening of the yield curve as well as a decline of $172,229 in theaverage balance of interest earning assets.

*FinancialIntermediary Segment.*

The following table highlights the financial intermediary segment’spre-tax results and production and sales activities:
|                                      | ** ** | **For the three months ended June 30,** | ** **    |
|--------------------------------------|------------|-----------------------------------------------------------------------|---------------|
| ** **                           | ** ** | **2006**                                                              | ** **    | **2005** | ** ** | **Change** | ** ** |
| Net interest  income                 | ** ** | **$**                                                                 | **4,781**     |   | $ | 10,080 |   | $ | (5,299 | ) |
| Gain on sales of  loans and MSRs     | ** ** | **10,434**                                                            |          | 28,810 |   | (18,376 | ) |
| Other income                         | ** ** | **895**                                                               |          | 1,081 |   | 186 |   |
| Net Beacon  Credit Services results  | ** ** | **(6,332**                                                            | **)**         | (128 | ) | (6,204 | ) |
| Net MG  Reinsurance results          | ** ** | **597**                                                               |          | 850 |   | (253 | ) |
| Total revenues                       | ** ** | **10,375**                                                            |          | 40,693 |   | (30,318 | ) |
| Salary and  employee benefits        | ** ** | **18,022**                                                            |          | 16,814 |   | 1,208 |   |
| Occupancy and  depreciation expense  | ** ** | **6,108**                                                             |          | 6,524 |   | (416 | ) |
| Other expenses                       | ** ** | **9,145**                                                             |          | 9,933 |   | (788 | ) |
| Total expenses                       | ** ** | **33,275**                                                            |          | 33,271 |   | 4 |   |
| Pre-tax (loss) income                | ** ** | **$**                                                                 | **(22,900**   | **)** | $ | 7,422 |   | $ | (30,322 | ) |
|                                 |       |                                                                  |          |   |   |   |   |
| Production                           | ** ** | **$**                                                                 | **2,582,727** |   | $ | 3,455,499 |   | $ | (872,772 | ) |
| Sales (includes  intersegment sales) | ** ** | **$**                                                                 | **2,494,743** |   | $ | 3,138,302 |   | $ | (643,559 | ) |
|                                 |       |                                                                  |          |   |   |   |   |
| Total revenues  to sales             | ** ** | **0.42**                                                              | **%**         | 1.30 | % | (0.88 | )% |
| Total expenses  to production        | ** ** | **1.29**                                                              | **%**         | 0.96 | % | 0.83 | % |
| Pre-tax margin                       | ** ** | **(0.87**                                                             | **)%**        | 0.34 | % | (1.21 | )% |

 

31

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Note: The ratio of revenues to sales is based onmortgage banking sales, which includes inter-segment sales to the retail banksegment. The above table disaggregates the results of Beacon Credit Servicesand MG Reinsurance.

For the three monthsended June 30, 2006, the financial intermediary segment had a pre-tax loss$22,900 versus pre-tax income of $7,422 for the same period in 2005.  A decrease in net interest income of $5,299contributed to the decline.  Generally,NetBank earns a long-term interest rate on loans held for sale and financesthose loans with short-term borrowings. As the yield curve flattens, the net interest margin compresses.  Gain on sales of loans and MSRs alsodecreased by $18,376 due to higher provision levels of $11,819 related to ourrepresentations and warranties on sold loans and due to declining sales.  Furthermore, decreased Beacon Credit Servicesresults of $6,204 related to the goodwill impairment charge of $6,358 alsocontributed to the decline in earnings.

*Transaction Processing Segment.*

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

The following tablehighlights the results of operations for the transaction processing segment: 
|                | ** ** | **For the three months ended June 30,** | ** ** |
|----------------|------------|-----------------------------------------------------------------------|------------|
| ** **     | ** ** | **2006**                                                              | ** ** | **2005** | ** ** | **Change** | ** ** |
| Total revenue  | ** ** | **$**                                                                 | **5,173**  |   | $ | 6,594 |   | $ | (1,421 | ) |
| Total expenses | ** ** | **4,542**                                                             |       | 4,979 |   | (437 | ) |
| Pre-tax income | ** ** | **$**                                                                 | **631**    |   | $ | 1,615 |   | $ | (984 | ) |

 

The transactionprocessing segment recorded pre-tax income of $631, a $984 decrease period overperiod. The reduction in pre-tax income was primarily due to the decline inpre-tax results at NPS of $1,057 period over period off-set by an increase inresults of $73 within the servicing factory. Although the number of loans serviced within the servicing factory hasdeclined, the pre-tax margin per loan has improved nine dollars for thequarter-ending June 30, 2006.

*Servicing Asset Segment.*

The servicing assetsegment manages the MSRs retained by the Company in conjunction with theorigination of mortgage loans or obtained through bulk transactions.  The servicing asset segment recorded apre-tax loss of $16,674 for the three months ended June 30, 2006, a change of$14,694 from the same period in 2005. The changes were primarily attributable to the decrease period overperiod in net hedge results of $16,231 which reflected the $15,000 write-downin the second quarter of 2006 to the carrying value of mortgage servicingrights. This charge was recorded based on information received through themarketing process of selling our mortgage servicing platform and the majorityof our MSRs including bids received and general interest in the asset. 
|                          | ** ** | **For the three months ended June 30,** | ** **  |
|--------------------------|------------|-----------------------------------------------------------------------|-------------|
| ** **               | ** ** | **2006**                                                              | ** **  | **2005** | ** ** | **Change** | ** ** |
| Net interest  income     | ** ** | **$**                                                                 | **887**     |   | $ | 168 |   | $ | 719 |   |
| Servicing fees           | ** ** | **9,700**                                                             |        | 10,555 |   | (855 | ) |
| Other income             | ** ** | **35**                                                                |        | 84 |   | (49 | ) |
| Total revenue            | ** ** | **10,622**                                                            |        | 10,807 |   | (185 | ) |
| Amortization of  MSRs    | ** ** | **9,890**                                                             |        | 11,343 |   | (1,453 | ) |
| Subservicing  fees paid  | ** ** | **2,409**                                                             |        | 2,334 |   | 75 |   |
| Other expenses           | ** ** | **716**                                                               |        | 1,060 |   | (344 | ) |
| Total expenses           | ** ** | **13,015**                                                            |        | 14,737 |   | (1,722 | ) |
| Pre-tax servicing margin | ** ** | **(2,393**                                                            | **)**       | (3,930 | ) | 1,537 |   |
| (Loss) gain on hedges    | ** ** | **(4,764**                                                            | **)**       | 3,650 |   | (8,414 | ) |
| Impairment of MSRs       | ** ** | **(9,517**                                                            | **)**       | (1,700 | ) | (7,817 | ) |
| Net hedge results        | ** ** | **(14,281**                                                           | **)**       | 1,950 |   | (16,231 | ) |
| Net pre-tax loss         | ** ** | **$**                                                                 | **(16,674** | **)** | $ | (1,980 | ) | $ | (14,694 | ) |

 

32

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*Other/Corporate Overhead Segment.*

The other/corporateoverhead segment contains holding company and overhead expenses along with theelimination of inter-segment gains and losses on loans sold to the retailbanking segment from the financial intermediary segment. Overhead expenses thatare wholly attributable to a line of business are recognized within thatbusiness, while overhead expenses that relate to multiple lines of business arepooled and reported within the other/corporate overhead segment.  The other/corporate overhead segment incurreda $9,883 pre-tax loss for the three months ended June 30, 2006 compared to apre-tax loss of $6,684 for the comparable period of 2005.  The increased expenses reflect increasedsalaries and benefits costs as well as increased depreciation and amortization.

**Results of Operations – Six monthsended June 30, 2006 compared to the six months ended June 30, 2005**

*General.* Net loss for the six months ended June 30, 2006 was $42,387 or $0.92 per share,compared to net income of $296 or $0.01 per share for the same period in2005.  The six months ended June 30, 2006was negatively impacted by a $15,000 write-down to MSRs as well as continueddeclines in gain on sales of loans and MSRs.  Gain on sales of loans decreased primarily asa result of increased provisioning related to our representations andwarranties.  The continued flattening ofthe yield curve also resulted in a decrease in net interest income of$10,064.  Additionally, losses onderivates increased by $10,518 period over period and we recorded a goodwillimpairment charge related to our 2004 acquisition of Beacon Credit Services of$6,358.

*Interest Income*. Our interest income for the six months ended June 30, 2006 was $129,629compared to $119,521 for the same period in 2005.  This increase was the result of the averageyield increasing by 67 basis points to 6.08% of interest-earning assets coupledwith a decrease of $148,969 in the average balance of interest-earningassets.  Reference is made to the ratevolume variance table set forth below for additional detail regarding thechanges in interest income.

*Interest Expense*.Total interest expense for the six months ended June 30, 2006 was $77,974compared to $57,802 for the same period of 2005.  The $20,172 increase is due to an increase of104-basis point increase in the average cost of funds off-set in part by adecline in the average balance of interest-bearing liabilities of $45,893.  For the six months ended June 30, 2006compared to same period of 2005, interest expense on deposits increased $16,199as a result of increases in the average interest rate paid coupled with a$223,024 increase in the average outstanding balance of deposits.  For the six months ended June 30, 2006,interest expense on other borrowed funds (including short-term debt, FHLBadvances, and convertible subordinated debt) was $32,961 compared to $28,988for the same period of 2005.  The $3,973increase in interest expense related to other borrowed funds is a result ofincreases in the average cost of funds. Reference is made to the rate volume variance table set forth below foradditional detail regarding the changes in interest 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.  Netinterest income was $51,655 or 2.17% of average interest-earning assets for thesix months ended June 30, 2006 compared to $61,719 or 2.54% of averageinterest-earning assets for the six months ended June 30, 2005.  The 37-basis point decline is primarily dueto a flattening of the yield curve as recent increases in short-term rates havenot carried 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 relative interest rates and averagebalances of our interest-earning assets and interest-bearing liabilities forthe six months ended June 30, 2006 and 2005:

33

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| **Average Balance** | ** ** | **Average Yield /   Rate** | ** ** | ** ** | ** ** | **Interest** | ** ** | ** **                         | ** ** | **Variance attributable  to**             |       |
|--------------------------|------------|-------------------------------------------|------------|------------|------------|--------------|------------|------------------------------------|------------|------------------------------------------------|------------|
| **2006**                 | ** ** | **2005**                                  | ** ** | **2006**   | ** ** | **2005**     | ** ** | ** **                         | ** ** | **2006**                                       | ** ** | **2005** | ** ** | **Variance** | ** ** | **Rate** | ** ** | **Volume (3)** |   |
|                     | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **   | ** ** | **Interest-earning assets:**       | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| $                        | 37,794     |                                      | $          | 81,144     |       | 4.49         | %          | 2.21                               | %          | Short-term investments                         |       | $ | 848 |   | $ | 895 |   | $ | (47 | ) | $ | 925 |   | $ | (972 | ) |
| 696,540                  |       | 775,102                                   |       | 4.74       | %          | 4.56         | %          | Investment securities (1)          |       | 16,508                                         |       | 17,667 |   | (1,159 | ) | 698 |   | (1,857 | ) |
| 1,360,001                |       | 1,437,000                                 |       | 7.14       | %          | 6.32         | %          | Loans held for sale (2)            |       | 48,581                                         |       | 45,378 |   | 3,203 |   | 5,892 |   | (2,689 | ) |
| 2,171,701                |       | 2,121,759                                 |       | 5.87       | %          | 5.24         | %          | Loans and leases receivable (2)    |       | 63,692                                         |       | 55,581 |   | 8,111 |   | 6,684 |   | 1,427 |   |
| 4,266,036                |       | 4,415,005                                 |       | 6.08       | %          | 5.41         | %          | Total interest-earning assets      |       | 129,629                                        |       | 119,521 |   | 10,108 |   | 14,199 |   | (4,091 | ) |
|                     |       |                                      |       |       |       |         |       |                               |       |                                           |       |   |   |   |   |   |   |   |   |
|                     | ** ** | ** **                                | ** ** | ** ** | ** ** | ** **   | ** ** | **Interest-bearing liabilities:**  | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| 221,861                  |       | 232,235                                   |       | 1.40       | %          | 1.32         | %          | Checking accounts                  |       | 1,554                                          |       | 1,527 |   | 27 |   | 93 |   | (66 | ) |
| 890,625                  |       | 1,101,006                                 |       | 3.11       | %          | 2.18         | %          | Money market                       |       | 13,857                                         |       | 11,998 |   | 1,859 |   | 5,120 |   | (3,261 | ) |
| 1,376,808                |       | 933,029                                   |       | 4.30       | %          | 3.28         | %          | Certificates of deposit            |       | 29,602                                         |       | 15,289 |   | 14,313 |   | 4,758 |   | 9,555 |   |
| 972,739                  |       | 967,244                                   |       | 4.89       | %          | 3.22         | %          | Short-term debt                    |       | 23,806                                         |       | 15,556 |   | 8,250 |   | 8,076 |   | 174 |   |
| 492,934                  |       | 771,814                                   |       | 3.21       | %          | 3.26         | %          | FHLB advances                      |       | 7,920                                          |       | 12,599 |   | (4,679 | ) | (193 | ) | (4,486 | ) |
| 32,477                   |       | 28,009                                    |       | 7.61       | %          | 5.95         | %          | Subordinated debt                  |       | 1,235                                          |       | 833 |   | 402 |   | 232 |   | 170 |   |
| 3,987,444                |       | 4,033,337                                 |       | 3.91       | %          | 2.87         | %          | Total interest-bearing liabilities |       | 77,974                                         |       | 57,802 |   | 20,172 |   | 18,086 |   | 2,086 |   |
| —                   |       | —                                    |       | 2.17       | %          | 2.54         | %          | Net interest margin                |       | 51,655                                         |       | 61,719 |   | (10,064 | ) | (3,887 | ) | (6,177 | ) |
| 278,592                  |       | 381,668                                   |       | 0.25       | %          | 0.26         | %          | Interest free sources              |       | —                                         |       | — |   | — |   | — |   | — |   |
| $                        | 4,266,036  |                                      | $          | 4,415,005  |       | 2.42         | %          | 2.80                               | %          | Net interest income to interest-earning assets |       | $ | 51,655 |   | $ | 61,719 |   | $ | (10,064 | ) | $ | (3,887 | ) | $ | (6,177 | ) |

 

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

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

(3)          Variances attributable to the rate andvolume mix are included in the volume variances.

*Provision for Credit Losses.* The provision for credit losses was $4,076 for the six months ended June 30,2006 compared to $4,681 for the same period of 2005.  The decrease in provision for credit lossesrelates primarily to HELOC sales of $103,891 off-set by continued retention ofauto loans and business financing leases compared to the 2005 period. Referenceis made to the heading “Financial Condition - Asset Quality and Non-performingAssets” above for additional detail concerning the determination of provisionexpense related to maintaining the proper level of allowance for credit losses.

*Non-interest Income.* Non-interestincome declined by $39,763 to $35,939 for the six months ended June 30, 2006 comparedto the same period of 2005.  Weexperienced increased losses on derivatives of $10,518 during the six monthsended June 30, 2006 compared to the same period of 2005 as well as declines onour gains on sales of loans and MSRs of $19,408 primarily reflecting increasedprovision levels related to representations and warranties on loans sold.  Additionally, increased expenses on theimpairment of MSRs of $4,886 (which reflects the effect of the $15,000 write-downin the second quarter 2006 to the carrying value of mortgage servicing rights)as well as a decline in gain on sales of investment securities of $4,182contributed to the decline in non-interest income.

*Non-interest Expense.* Non-interest expense includes all operating expenses such as salaries andbenefits, marketing, and general and administrative expenses.  Non-interest expense increased $16,281 forthe six months ended June 30, 2006 compared to the same period of 2005.  This increase reflected the $6,865 increasein salaries and benefits related to the acquisition of Major Mortgage in thethird quarter of 2005 as well as the adoption of SFAS 123(R).  Occupancy costs also increased $1,939 as aresult of the Major Mortgage acquisition. In addition, we recorded a one time goodwill impairment charge of $6,358during the second quarter of 2006 related to our 2004 acquisition of BeaconCredit Services.  These increases wereoffset, in part, by reductions in professional fees of $2,056 as well as $766related to prepaid lost interest from curtailments.

34

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*Adoptionof SFAS 123(R)*.  OnJanuary 1, 2006, we adopted SFAS 123(R) using the modified prospectivetransition method.  Unlike the modifiedretrospective transition method, the modified prospective transition method hasno impact on prior period financial statements. Prior to the adoption of SFAS 123(R), we accounted for stock basedcompensation under the provisions of APB Opinion No. 25, “Accounting for StockIssued 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 expensewas previously recognized related to the Mid-Term Incentive Plan and stockawards.

As a result of theadoption, loss before income taxes for the six months ended June 30, 2006includes $2,382 of stock based compensation costs.  As of June 30, 2006, there was $6,644 ofunrecognized compensation cost, net of estimated forfeitures, related to stockbased compensation.  This cost isexpected to be recognized over a weighted average period of less than 4 yearson a straight line basis.  TheBlack-Scholes-Merton pricing model was used to calculate the fair value ofstock options and stock grants, and no cumulative effect of accountingadjustment was required.  In anticipationof the adoption of SFAS123(R), we began granting certain employees acombination of stock options and stock awards as opposed to all stock options,and accelerated the vesting of all options which had a strike price in excessof $14.00.  We have no immediate plans tomodify share based payment arrangements. See note 9 of the notes to the consolidated financial statementsincluded herein for further information regarding share based paymentsincluding assigned assumptions.

*RetailBanking Segment.*

The table belowprovides an overview of the pre-tax results of operations for the retailbanking segment:
|                                               | ** ** | **For the six months ended June 30,** | ** **    |
|-----------------------------------------------|------------|---------------------------------------------------------------------|---------------|
| ** **                                    | ** ** | **2006**                                                            | ** **    | **2005** | ** ** | **Change** | ** ** |
| Net interest  income                          | ** ** | **$**                                                               | **39,275**    |   | $ | 41,426 |   | $ | (2,151 | ) |
| Provision for  credit losses                  | ** ** | **3,971**                                                           |          | 4,652 |   | (681 | ) |
| Net interest income after provision           | ** ** | **35,304**                                                          |          | 36,774 |   | (1,470 | ) |
| Gains on sales  of loans                      | ** ** | **308**                                                             |          | 501 |   | (193 | ) |
| Fees, charges  and other income               | ** ** | **7,022**                                                           |          | 7,118 |   | (96 | ) |
| Total banking revenues                        | ** ** | **42,634**                                                          |          | 44,393 |   | (1,759 | ) |
| Total banking expenses                        | ** ** | **35,080**                                                          |          | 35,655 |   | (575 | ) |
| Pre-tax banking results                       | ** ** | **7,554**                                                           |          | 8,738 |   | (1,184 | ) |
| Net QuickPost,  PowerPost and NetServ results | ** ** | **(5,081**                                                          | **)**         | — |   | (5,081 | ) |
| Pre-tax (loss) income                         | ** ** | **$**                                                               | **2,473**     |   | $ | 8,738 |   | $ | (6,265 | ) |
|                                          |       |                                                                |          |   |   |   |   |
| Average earning  assets                       | ** ** | **$**                                                               | **4,466,920** |   | $ | 4,400,824 |   | $ | 66,096 |   |
|                                          |       |                                                                |          |   |   |   |   |
| **Operations  to average earning assets**     | ** ** | ** **                                                          | ** **    | ** ** | ** ** | ** ** | ** ** |
| Net interest  income after provision          | ** ** | **1.58**                                                            | **%**         | 1.67 | % | (0.09 | )% |
| Gain on sale,  fees, charges and other income | ** ** | **0.33**                                                            | **%**         | 0.35 | % | (0.02 | )% |
| Total banking  revenues                       | ** ** | **1.91**                                                            | **%**         | 2.02 | % | (0.11 | )% |
| Total banking  expenses                       | ** ** | **1.57**                                                            | **%**         | 1.62 | % | (0.05 | )% |
| Pre-tax income  retail banking results        | ** ** | **0.34**                                                            | **%**         | 0.40 | % | (0.06 | )% |

 

Note: The above table disaggregates the results of ourQuickPost, PowerPost and NetServ initiatives.

The retail bankingsegment recorded pre-tax income of $2,473 in the second quarter of 2006, a$6,265 decrease over the comparable period in 2005. The majority of the declinerelates to several start-up transaction processing initiatives the company hasbeen developing. The company recorded a pre-tax loss of $5,081 on theseparticular product lines. They include QuickPost, PowerPost and NetServ.QuickPost is a deposit- and payment-forwarding service that allows consumers ofparticipating financial institutions to drop off deposits or payments atlocations of UPS Stores nationwide. PowerPost allows small business bankingcustomers to deposit checks they receive directly into their NetBank accountusing a check imaging and clearing device. NetServ is a private-label onlinebanking platform the company sells to smaller financial institutions.

Leasing operationsresults declined by $793 which can be attributed to increased provision expenseof $1,663. The Dealer Financial Services division reported increased results of$306 mainly due to the increased net interest income of $954. Net interestincome for the entire segment declined due to the flattening of the yieldcurve.

35

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*FinancialIntermediary Segment.*

The followingtable highlights the financial intermediary segment’s pre-tax results andproduction and sales activities:
|                                      | ** ** | **For the six months ended June 30,** | ** **    |
|--------------------------------------|------------|---------------------------------------------------------------------|---------------|
| ** **                           | ** ** | **2006**                                                            | ** **    | **2005** | ** ** | **Change** | ** ** |
| Net interest  income                 | ** ** | **$**                                                               | **11,474**    |   | $ | 19,793 |   | $ | (8,319 | ) |
| Gain on sales of  loans and MSRs     | ** ** | **33,324**                                                          |          | 52,111 |   | (18,787 | ) |
| Other income                         | ** ** | **1,419**                                                           |          | 1,795 |   | (376 | ) |
| Net Beacon  Credit Services results  | ** ** | **(6,618**                                                          | **)**         | (797 | ) | (5,821 | ) |
| Net MG  Reinsurance results          | ** ** | **1,478**                                                           |          | 1,723 |   | (245 | ) |
| Total revenues                       | ** ** | **41,077**                                                          |          | 74,625 |   | (33,548 | ) |
| Salary and  employee benefits        | ** ** | **36,316**                                                          |          | 35,470 |   | 846 |   |
| Occupancy and  depreciation expense  | ** ** | **12,343**                                                          |          | 12,726 |   | (383 | ) |
| Other expenses                       | ** ** | **19,317**                                                          |          | 18,589 |   | 728 |   |
| Total expenses                       | ** ** | **67,976**                                                          |          | 66,785 |   | 1,191 |   |
| Pre-tax (loss) income                | ** ** | **$**                                                               | **(26,899**   | **)** | $ | 7,840 |   | $ | (34,739 | ) |
|                                 |       |                                                                |          |   |   |   |   |
| Production                           | ** ** | **$**                                                               | **5,397,989** |   | $ | 6,232,108 |   | $ | (834,119 | ) |
| Sales (includes  intersegment sales) | ** ** | **$**                                                               | **5,389,050** |   | $ | 5,898,765 |   | $ | (509,715 | ) |
|                                 |       |                                                                |          |   |   |   |   |
| Total revenues  to sales             | ** ** | **0.76**                                                            | **%**         | 1.27 | % | (0.51 | )% |
| Total expenses  to production        | ** ** | **1.26**                                                            | **%**         | 1.07 | % | 0.19 | % |
| Pre-tax margin                       | ** ** | **(0.50**                                                           | **)%**        | 0.20 | % | (0.70 | )% |

 

Note: The ratio of revenues to sales is based onmortgage banking sales, which includes inter-segment sales to the retail banksegment. The above table disaggregates the results of Beacon Credit Servicesand MG Reinsurance.

For the six monthsended June 30, 2006, the financial intermediary segment had a pre-tax loss$26,899 versus pre-tax income of $7,840 for the same period in 2005.  A decrease in net interest income of $8,319contributed to the decline.  Generally,NetBank earns a long-term interest rate on loans held for sale and financesthose loans with short-term borrowings. As the yield curve flattens, the net interest margin compresses.  In addition, decreased gain on sales of loansand MSRs of $18,787 also contributed to the decline.  This decrease is primarily the results ofincreased provision of $12,082 during the six months ended June 30, 2006resulting from our representations and warranties on sold loans as well asdeclining sales period over period. Furthermore, net Beacon Credit Services results declined $5,821 relatedto the goodwill impairment charge recorded during the second quarter of 2006 of$6,358.

*TransactionProcessing Segment.*

The transaction processing segment provides ATM and merchant processingservices and subservices loans for the retail banking segment, the financialintermediary segment, the servicing asset segment and third party customers.

The followingtable highlights the results of operations for the transaction processingsegment: 
|                | ** ** | **For the six months ended June 30,** | ** ** |
|----------------|------------|---------------------------------------------------------------------|------------|
| ** **     | ** ** | **2006**                                                            | ** ** | **2005** | ** ** | **Change** | ** ** |
| Total revenues | ** ** | **$**                                                               | **11,398** |   | $ | 13,228 |   | $ | (1,830 | ) |
| Total expenses | ** ** | **9,269**                                                           |       | 9,645 |   | (376 | ) |
| Pre-tax income | ** ** | **$**                                                               | **2,129**  |   | $ | 3,583 |   | $ | (1,454 | ) |

 

36

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The transactionprocessing segment recorded pre-tax income of $2,129, a $1,454 decrease periodover period. The reduction in pre-tax income was primarily due to the declinein pre-tax results at NPS of $1,584 off-set by an increase in results of $130within the servicing factory.  Althoughthe number of loans serviced within the servicing factory has declined, thepre-tax margin per loan has improved nine dollars for the six months endingJune 30, 2006.

*ServicingAsset Segment.*

The servicingasset segment manages the MSRs retained by the Company in conjunction with theorigination of mortgage loans or obtained through bulk transactions.  The servicing asset segment recorded apre-tax loss of $22,479 for the six months ended June 30, 2006, a change of$17,050 from the same period in 2005. The changes were primarily attributable to the decrease period overperiod in net hedge results of $19,665 which reflected the $15,000 write-downin the second quarter of 2006 to the carrying value of mortgage servicingrights.  This charge was recorded basedon information received through the marketing process of selling our mortgageservicing portfolio and the majority of our MSRs including bids received andgeneral interest in the asset. 
|                          | ** ** | **For the six months ended June 30,** | ** ** |
|--------------------------|------------|---------------------------------------------------------------------|------------|
| ** **               | ** ** | **2006**                                                            | ** ** | **2005** | ** ** | **Change** | ** ** |
| Net interest  income     |       | $                                                                   | 1,213      |   | $ | 143 |   | $ | 1,070 |   |
| Servicing fees           |       | 20,301                                                              |       | 20,685 |   | (384 | ) |
| Other income             |       | 63                                                                  |       | 150 |   | (87 | ) |
| Total revenue            |       | 21,577                                                              |       | 20,978 |   | 599 |   |
| Amortization of  MSRs    |       | 20,437                                                              |       | 21,872 |   | (1,435 | ) |
| Subservicing  fees paid  |       | 4,912                                                               |       | 4,748 |   | 164 |   |
| Other expenses           |       | 1,339                                                               |       | 2,084 |   | (745 | ) |
| Total expenses           |       | 26,688                                                              |       | 28,704 |   | (2,016 | ) |
| Pre-tax servicing margin |       | (5,111                                                              | )          | (7,726 | ) | 2,615 |   |
| (Loss) gain on hedges    |       | (11,462                                                             | )          | 3,317 |   | (14,779 | ) |
| Impairment of MSRs       |       | (5,906                                                              | )          | (1,020 | ) | (4,886 | ) |
| Net hedge results        |       | (17,368                                                             | )          | 2,297 |   | (19,665 | ) |
| Net pre-tax loss         |       | $                                                                   | (22,479    | ) | $ | (5,429 | ) | $ | (17,050 | ) |

 

*Other/CorporateOverhead Segment.*

Theother/corporate overhead segment contains holding company and overhead expensesalong with the elimination of inter-segment gains and losses on loans sold tothe retail banking segment from the financial intermediary segment. Overheadexpenses that are wholly attributable to a line of business are recognizedwithin that business, while overhead expenses that relate to multiple lines ofbusiness are pooled and reported within the other/corporate overhead segment.  The other/corporate overhead segment incurreda $19,980 pre-tax loss for the six months ended June 30, 2006 compared to apre-tax loss of $13,985 for the comparable period of 2005.  The $5,995 change reflects expenses relatedto increased salaries and benefits costs as well as increased depreciation andamortization.

# **Critical Accounting Policies**

Senior management, in conjunction with the Audit Committee of the Boardof Directors, has identified valuation of the MSR portfolio, determination ofthe allowance for credit losses, liabilities for representations and warrantieson loans and MSRs sold and accounting for derivative financial instruments asour most critical accounting policies. These policies

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were identified as beingthe most critical based on the SEC’s guidance in identifying them based onwhether 1) the accounting estimate required management to make assumptionsabout matters that were highly uncertain at the time the accounting estimatewas made and 2) different estimates reasonably could have been used in the currentperiod, or changes in the accounting estimate that are reasonably likely tooccur from period to period, would have a material impact on the presentationof the financial condition or results of operations. Management believes thatgiven current information, its judgments, estimates and assumptions used inthese policies are appropriate.  Forfurther information regarding our critical accounting policies, refer to theheading “Critical Accounting Policies” on page 60 of our 2005 Form 10-K.

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

In the normal course ofbusiness, we have contractual obligations to make scheduled payments for ouroperating leases; our liability to repurchase loans under representations andwarranties provided to purchasers of our mortgage loans and MSRs; and principaland interest payments on borrowed funds. We are not a party to any off-balancesheet financing arrangements and do not hold unconsolidated interests in anyvariable interest entities that could give rise to future contractualobligations. For information as of December 31, 2005 regarding the schedule ofamounts contractually due, please refer to the discussion under the heading “ContractualObligations and Off-Balance Sheet Arrangements” on page 62 of our 2005 Form10-K.

# **Liquidity and Capital Resources**

*Liquidity. *NetBank’s liquidity, represented by cash and cashequivalents, is a product of its operating, investing, and financingactivities.  Our primary sources of fundsare deposits, borrowings, prepayments and maturities of outstanding loans,sales of loans, sales or maturities of investment securities and othershort-term investments, and funds provided from operations.  While scheduled loan payments and maturinginvestment securities and short-term investments are relatively predictablesources of funds, deposit flows and loan prepayments are greatly influenced bygeneral interest rates, economic conditions, and competition. We can use cashgenerated through the retail deposit market, our traditional funding source, tooffset the cash utilized in investing activities.  Our available for sale securities andshort-term interest-earning assets can also be used to provide liquidity forlending and other operational requirements. Net cash outflows for the six months ended June 30, 2006 was $54,501compared to net cash inflows of $36,085 for the same period in 2005.  The change in the 2006 period primarilyrelated to the net increase in repayments of other borrowed funds of $639,905.  This cash outflow was offset, in part, byincreases in inflows of $85,592 related to principal payments received on loanand lease receivables and a $76,841 increase in proceeds from sales of loan andlease receivables during the period.

As an additional source of funds, NetBank, Inc. had available underexisting line of credit agreements $1.8 billion at June 30, 2006.  Reference is made to note 8 of the notes toconsolidated financial statements included in this report for additionaldetails regarding the available lines of credit.

We use deposits as our principal source offunds.  For the six months ended June 30,2006, deposits decreased by $71,910 to $2.722 billion from $2.794 billion as ofDecember 31, 2005.  Our deposit productsinclude checking, money market and certificates of deposit accounts.  Deposit account terms vary, with theprincipal differences being the minimum balance required, the time periods thefunds must remain on deposit, and the interest rate.  We are competitive in the types of accounts,services and ranges of interest rates offered on deposit products.  Although market demand generally dictateswhich deposit maturities and rates will be accepted by the public, we intend tocontinue to promote checking, money market and certificates of deposit to theextent possible consistent with asset and liability management goals.

*Capital Resources.*NetBank and NetBank, FSB are subject to various regulatory capitalrequirements administered by the federal banking agencies, including theOTS.   Failure of either company to meetminimum capital requirements can initiate certain mandatory and possiblyadditional discretionary actions by regulators that, if undertaken, could havea direct material effect on our consolidated financial statements. Undercapital adequacy guidelines and the regulatory framework for prompt correctiveaction, NetBank, FSB must meet specific capital guidelines that involvequantitative measures of NetBank, FSB’s assets, liabilities, and certainoff-balance sheet items as calculated under regulatory accounting practices.NetBank, FSB’s capital amounts and classifications are also subject toqualitative judgments by the

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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.

Quantitative measures established by regulation to ensure capitaladequacy require NetBank, FSB to maintain minimum amounts and ratios as setforth in the following table. The OTS requires NetBank, FSB to maintain minimumratios of tangible capital to tangible assets of 1.5%, core capital to tangibleassets of 4.0% and total capital 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** | ** ** |
| **June  30, 2006**                           | ** ** | ** ** | ** ** | ** **                                   | ** ** | ** **                                                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Total capital  (to risk-weighted assets)     |       | $          | 303,715    |                                         | 10.79      | %                                                                                                                       | $          | 225,181 |   | 8.00 | % | $ | 281,476 |   | 10.00 | % |
| Core capital (to  adjusted total assets)     |       | $          | 276,344    |                                         | 6.77       | %                                                                                                                       | $          | 163,375 |   | 4.00 | % | $ | 204,218 |   | 5.00 | % |
| Tangible capital  (to adjusted total assets) |       | $          | 276,344    |                                         | 6.77       | %                                                                                                                       | $          | 61,266 |   | 1.50 | % | N/A |   | N/A |   |
| Tier I capital  (to risk-weighted assets)    |       | $          | 276,344    |                                         | 9.82       | %                                                                                                                       | N/A        |   | N/A |   | $ | 168,885 |   | 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 must adhere to various U.S.Department of Housing and Urban Development (“HUD”) regulatory guidelinesincluding required minimum net worth to maintain their FHA approved lendingstatus.  Failure to comply with the HUDguidelines could result in withdrawal of this certification.  As of June 30, 2006, Market Street andMeritage were in compliance with HUD guidelines.  NetBank and its subsidiaries are subject tovarious other capital requirements by secondary market investors andstates.  None of these capital requirementsare more stringent than the OTS capital requirements.  Failure to comply with these restrictionscould have a material adverse impact on the Company’s results ofoperations.  All of the capitalrequirements placed upon NetBank and its subsidiaries were met as of June 30,2006.

# **Item 3. Quantitative and Qualitative Disclosuresabout Market Risk**

Our principalbusinesses are retail banking and the origination and purchase of loans as wellproviding business equipment financing leases. These businesses are funded bycustomer deposits and, to the extent necessary, other borrowed funds.Consequently, a significant portion of our assets and liabilities are monetaryin nature and fluctuations in interest rates will affect future net interestincome and cash flows. Interest rate risk is our primary market risk exposure.For the six months ended June 30, 2006, the only derivative financialinstruments that we entered into were associated with hedging activitiesrelated to the portfolio of mortgage loans held for sale, the pipeline ofmortgage loans for which the interest rate has been locked, hedging thesecuritization and sale of portfolio loans, the owned MSRs portfolio and theMSRs associated with the pipeline of mortgage loans for which the interest ratehas already been locked. Our exposure to market risk is reviewed on a regularbasis by management.

The following table shows the carrying values and fair values of ourportfolio of assets and liabilities:

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|                                                                                                                        | ** ** | **As of June 30,** | ** ** | **If interest rates were to** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2006**                          | ** ** | **Increase**                                      | ** ** | **Decrease** | ** ** | **Increase** | ** ** | **Decrease** | ** ** |
| ** **                                                                                                             | ** ** | **Carrying**                      | ** ** | **Estimated**                                     | ** ** | **25 basis points** | ** ** | **50 basis points** | ** ** |
| ** **                                                                                                             | ** ** | **Amount**                        | ** ** | **Fair Value**                               | ** ** | **Estimated Fair Value** | ** ** | **Estimated Fair Value** | ** ** |
| **Assets:**                                                                                                            | ** ** | ** **                        | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash and cash  equivalents                                                                                             |       | $                                 | 95,755     |                                              | $          | 95,755 |   | $ | 95,755 |   | $ | 95,755 |   | $ | 95,755 |   | $ | 95,755 |   |
| Investment securities  available for sale                                                                              |       | 574,590                           |       | 574,590                                           |       | 567,513 |   | 581,644 |   | 560,942 |   | 588,570 |   |
| Mortgage loans held for  sale                                                                                          |       | 972,004                           |       | 973,596                                           |       | 967,534 |   | 978,474 |   | 951,580 |   | 983,518 |   |
| Mandatory  delivery commitments                                                                                        |       | 2,505                             |       | 2,505                                             |       | (1,674 | ) | (2,736 | ) | (1,609 | ) | (3,763 | ) |
| Mortgage loan  purchase commitments                                                                                    |       | (485                              | )          | (485                                              | )          | 5,474 |   | (4,064 | ) | 10,814 |   | (8,232 | ) |
| Loan and lease  receivables-net of allowance for credit losses                                                         |       | 2,011,325                         |       | 1,976,818                                         |       | 1,969,298 |   | 1,984,347 |   | 1,961,746 |   | 1,991,853 |   |
| Mortgage servicing  rights                                                                                             |       | 203,406                           |       | 204,316                                           |       | 208,983 |   | 194,967 |   | 214,249 |   | 185,681 |   |
| Swaps, swaptions, caps,  floors and forward purchase commitments hedging mortgage servicing rights  available for sale |       | 11,310                            |       | 11,310                                            |       | 6,044 |   | 19,676 |   | 2,877 |   | 31,906 |   |
| Total interest rate  sensitive assets                                                                                  |       | 3,870,410                         |       | 3,838,405                                         |       | 3,818,927 |   | 3,848,063 |   | 3,796,354 |   | 3,865,288 |   |
| Non-interest rate  sensitive assets                                                                                    |       | 271,595                           |       | 317,957                                           |       | 271,595 |   | 271,595 |   | 271,595 |   | 271,595 |   |
| Total assets                                                                                                           |       | $                                 | 4,142,005  |                                              | $4,156,362 |   | $ | 4,090,522 |   | $ | 4,119,658 |   | $ | 4,067,949 |   | 4,136,883 |   |
| ** **                                                                                                             | ** ** | ** **                        | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **Liabilities:**                                                                                                       | ** ** | ** **                        | ** ** | ** **                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Non-interest bearing  deposits                                                                                         |       | $                                 | 260,409    |                                              | $          | 260,409 |   | $ | 260,409 |   | $ | 260,409 |   | $ | 260,409 |   | $ | 260,409 |   |
| Interest bearing  deposits                                                                                             |       | 1,030,984                         |       | 902,610                                           |       | 898,909 |   | 906,438 |   | 895,318 |   | 910,534 |   |
| Interest bearing  certificates of deposit                                                                              |       | 1,430,544                         |       | 1,419,597                                         |       | 1,416,612 |   | 1,422,603 |   | 1,413,630 |   | 1,425,626 |   |
| Short-term borrowings                                                                                                  |       | 442,619                           |       | 442,416                                           |       | 442,329 |   | 442,503 |   | 442,242 |   | 442,591 |   |
| Long-term borrowings                                                                                                   |       | 425,000                           |       | 415,855                                           |       | 414,763 |   | 416,967 |   | 413,686 |   | 418,103 |   |
| Subordinated debt                                                                                                      |       | 32,477                            |       | 32,477                                            |       | 32,477 |   | 32,477 |   | 32,477 |   | 32,477 |   |
| Total interest rate  sensitive liabilities                                                                             |       | 3,622,033                         |       | 3,473,364                                         |       | 3,465,499 |   | 3,481,397 |   | 3,457,762 |   | 3,489,740 |   |
| Non-interest rate  sensitive liabilities                                                                               |       | 172,535                           |       | 172,535                                           |       | 172,535 |   | 172,535 |   | 172,535 |   | 172,535 |   |
| Total liabilities                                                                                                      |       | 3,794,568                         |       | 3,645,899                                         |       | 3,638,034 |   | 3,653,932 |   | 3,630,297 |   | 3,662,275 |   |
| Minority interest                                                                                                      |       | 638                               |       | 638                                               |       | 638 |   | 638 |   | 638 |   | 638 |   |
| Shareholders’ equity                                                                                              |       | 346,799                           |       | 509,825                                           |       | 451,850 |   | 465,088 |   | 437,014 |   | 473,970 |   |
| Total liabilities, minority interest and shareholders’ equity                                                     |       | $                                 | 4,142,005  |                                              | $          | 4,156,362 |   | $ | 4,090,522 |   | $ | 4,119,658 |   | $ | 4,067,949 |   | $ | 4,136,883 |   |

 

Fair values of financial assets and liabilities areestimated using several methods. The first method is by use of directlyobservable market prices. This method applies to most of the loans held forsale and investment securities available for sale which trade in highly liquidmarkets. A second method employs the use of market benchmarks. In this method,a benchmark financial asset or liability is selected which matches many of thecharacteristics of the financial instrument being evaluated.  The instrument being evaluated is then pricedat a spread relative to the benchmark instrument. This method applies to manyloan and lease receivables. A third method used to estimate the fair value ofan instrument employs approximating a spread over a readily available marketindex or yield curve. This method is used where no directly observable marketexists and no suitable benchmark instrument can be found. Many deposit accountsare evaluated in this manner. Based on these fair value estimates, the dataindicates that the net value of assets and liabilities exceeds that of theirassociated carry value. Most of this excess value is derived from theorigination of interest bearing deposits. Additionally, the table shows theexposure of the portfolio to theoretical instantaneous and parallel changes inmarket interest rates of 25 and 50 basis points. These simulated values arecreated using complex financial models which incorporate many assumptions.Prudent balance sheet management dictates that changes in value for oneinstrument should be offset to some extent by another balance sheet instrument.For example, the largest single component of market exposure is loan and leasereceivables. This category declines in theoretical value by $7.5 million for a25 basis point increase in rates. This exposure is mitigated by the duration ofinterest bearing deposits having offsetting exposure of $3.7 million, andinterest bearing certificates of deposit with offsetting exposure of $3.0million. While most of the risk is balanced out in this manner, the datasuggests that the Company benefits in a declining interest rate environment,versus a rise in interest rates. This is commonly referred to as a liabilitysensitive position. Management carefully manages the exposure to these scenariosimulations and many others, which are intended to be broadly representative ofthe likely future path of interest rates. In examining the table presentedabove, one point that is worth consideration, as a simplifying assumption, isthat this analysis assumes that risk exposure is passively rather than activelymanaged; in other words,

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management does not attempt to alter the balancesheet position to changing market levels. In practice, however, managementclosely monitors market exposure levels and actively manages the position.

NetBank, FSB, likeother savings banks, measures interest rate risk based on a Net Portfolio Value(“NPV”) analysis. NPV equals the present value of expected net cash flows fromexisting assets minus the present value of expected net cash flows fromexisting liabilities. An NPV ratio is determined by dividing NPV by the presentvalue of assets. The following table sets forth the estimated NetBank, FSB NPVratios as of June 30, 2006 and December 31 and June 30, 2005 assuming rateshocks of +300 to -100 basis points:

##### **Limits and currentNPV ratios for NetBank, FSB**

| Rate shock  (in basis points) | ** ** | **As of  June 30, 2006** | ** ** | **As of  December 31, 2005** | ** ** | **As of  June 30, 2005** | ** ** | **Minimum as of  June 30, 2006** | ** ** |
|----------------------------------------------|------------|-----------------------------------------|------------|---------------------------------------------|------------|-----------------------------------------|------------|------------------------------------------------------|------------|
| **+300**                                     |       | 8.32                                    | %          | 7.35                                        | %          | 8.13                                    | %          | 4.00                                                 | %          |
| **+200**                                     |       | 8.68                                    | %          | 7.93                                        | %          | 8.30                                    | %          | 6.00                                                 | %          |
| **+100**                                     |       | 9.04                                    | %          | 8.51                                        | %          | 8.47                                    | %          | 6.00                                                 | %          |
| **Flat**                                     |       | 9.40                                    | %          | 9.01                                        | %          | 8.66                                    | %          | 6.00                                                 | %          |
| **-100**                                     |       | 10.16                                   | %          | 9.55                                        | %          | 8.89                                    | %          | 6.00                                                 | %          |

 

Minimum ratios for NPV risk are established by the Board of Directorsas prudent levels for the respective interest rate scenarios. Lower NPV ratiosdenote more market rate sensitivity for a given rate scenario.  As of June 30, 2006, the analysis indicatessensitivity to rising market interest rates. This sensitivity is, however, well within the Board approved limits forthese scenarios.  Computation ofprospective effects of hypothetical rate changes is based on many assumptions,including relative levels of market interest rates, loan prepayments anddeposit decay. They should not be relied upon as indicative of actual results.Further, the computations do not contemplate certain actions management couldundertake in response to changes in interest rates.

**Item 4. Controls and Procedures**

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

*Evaluationof Disclosure Controls and Procedures*. We evaluated the effectiveness of the design and operation of our “disclosurecontrols and procedures,” as defined in Rule 13a-15(e) under the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”), as of the end of theperiod covered by this report. This evaluation (the “controls evaluation”) wasdone under the supervision and with the participation of management, includingour chief executive officer (“CEO”) and chief financial executive (“CFO”).

*Objectivesof Controls*.Disclosure controls and procedures are designed so that information required tobe disclosed in our reports filed under the Exchange Act, such as this quarterlyreport on Form 10-Q, is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms. Disclosure controls andprocedures are also intended to ensure that such information is accumulated andcommunicated to our management, including the CEO and CFO, as appropriate toallow timely decisions regarding required disclosure. In designing andevaluating disclosure controls and procedures, management recognizes that anycontrols and procedures, no matter how well designed and operated, can provideonly reasonable assurance of achieving the desired control objectives, andmanagement is required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

*Conclusions*. Based upon the controls evaluation, our CEOand CFO have concluded that as of June 30, 2006, our disclosure controls andprocedures are effective to provide reasonable assurance that the foregoingobjectives are achieved.

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*Changesin Internal Control over Financial Reporting*. There were no changes in our internal control over financial reporting,as defined in Rule 13a-15(f) under the Exchange Act, during the period coveredby this report that have materially affected, or are reasonably likely tomaterially affect, our internal control over financial reporting.

# **PART II.  Other Information**

# **Item1.  Legal Proceedings**

*Illinois Union Insurance Co. v. Commercial Money Center, Inc., etal., Case No. CV-01-0685-KJD-RJJ (District Court ofNevada)*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 ofCommercial Money Center, Inc. and Commercial Servicing Corporation titled *In re: Commercial Money Center, Inc. and Commercial ServicingCorporation*, Bankruptcy No. 02-09721-H7 (JointlyAdministered), United States Bankruptcy Court For The Southern District ofCalifornia; and *In re Commercial Money Center, Inc.,Debtor (Kipperman v. NetBank, FSB)*, Adversary Proceeding No. 03-90331-JH,In the United States Bankruptcy Court for the Southern District of California, *appeal**pending**NetBank, F.S.B. v. Richard M. Kipperman, Chapter 7 Trustee for the BankruptcyEstates of Commercial Money Centers, Inc. and Commercial ServicingCorporation v. NetBank, F.S.B*, United States Bankruptcy AppellatePanel of the Ninth Circuit; BAP No. SC-05-1238

As reported in previous filings, NetBank, FSB, fileda complaint in January 2002 against Commercial Money Center, Inc. (“CMC”),Illinois Union Insurance Company (“Illinois Union”), Safeco Insurance Companyof America (“Safeco”), and Royal Indemnity Company (“Royal,” and together withIllinois Union, Safeco and Royal, collectively referred to as the “Sureties”).CMC was the 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 for breachof contract, fraud, and bad faith, and seeks, among other things, payment underand enforcement of the Bonds. The Judicial Panel on Multi-District Litigation(the “MDL Judicial Panel”) consolidated the actions involving NetBank, FSB withmore than 35 other cases pending around the country involving other banks andfinancial institutions that were seeking to enforce surety bonds and insurancepolicies relating to payment streams sold by CMC. All pre-trial activity iscurrently being held in the United States District Court for the NorthernDistrict of Ohio (the “MDL Court”).

As reported in previous filings, NetBank, FSB hadjoined with the other claimants (the “Claimants”) in a motion for judgment onthe pleadings (“Consolidated Motion for Judgment on the Pleadings” or “ConsolidatedMotion”), which motion was filed on January 31, 2003. NetBank, FSB laterwithdrew its motion for judgment on the pleadings and on March 25, 2005filed a Motion for Partial Summary Judgment (the “Summary Judgment Motion”) or,in the alternative, a Motion for Suggestion of Remand (the “Remand Motion”).The Summary Judgment Motion seeks judgment as a matter of law on NetBank, FSB’sbreach of contract claims. The Remand Motion requested that, in lieu ofdeciding the Summary Judgment Motion, the MDL Court instead suggest to the MDLJudicial Panel that the claims of NetBank, FSB be remanded to the United StatesDistrict Court for the District of Nevada. The Sureties filed oppositions tothe Remand Motion, and they have argued that they do not need to respond to theSummary Judgment Motion until an unspecified date in the future after the MDLCourt rules on the pending Consolidated Motion for Judgment on thePleadings. The MDL Court denied the Remand Motion, and, as a result ofsubsequent rulings described below, the MDL Court deemed the Summary Judgment Motionwithdrawn without prejudice to the filing of a new Summary Judgment Motion inearly 2007, following the close of expert discovery.

On August 19, 2005, the MDL Court entered twoorders on the Claimants’ Consolidated Motion for Judgment on the Pleadings. TheCourt granted the Claimants’ motion with respect to Illinois Union InsuranceCompany (the “Illinois Union Order”), finding that Illinois Union was liable asa matter of law under the bonds that it issued and could not assert fraud ofCMC as a defense. Because NetBank, FSB had previously withdrawn from theConsolidated Motion in order to file the Summary Judgment Motion, the MDL Courtheld that NetBank could file a motion to renew its interest in the ConsolidatedMotion so that the Illinois Union Order could apply to NetBank, FSB. NetBankfiled its motion to renew its interest, and Illinois Union has filed anopposition. In the second order on the Claimants’ Consolidated Motion, the MDLCourt denied the Motion with respect to all the remaining sureties, includingRoyal and Safeco. The MDL Court held that it could not determine, based on thepleadings alone, whether the Claimants were the intended obligees under theBonds and, therefore, whether fraud of CMC could constitute a defense to theSureties’ obligation to pay under the terms of the

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Bonds. The MDL Court went on to hold, however, thatif the Claimants are ultimately determined to be the obligees under the Bonds,the Sureties will be precluded from raising a defense of fraudulent inducementby CMC.

On October 31, 2005, the MDL Court ordered thatthe parties mediate their respective claims with a retired federal court judgein Cleveland, Ohio. NetBank, FSB participated in separate mediation sessionswith each of the Sureties, but none of NetBank, FSB’s claims were settledthrough this court-ordered mediation process, which concluded on March 15,2006.

On May 9, 2006, the MDL Court ruled on whether theIllinois Union order applies to NetBank, FSB. The MDL Court held that NetBank, FSB would be entitled to the benefit ofthe Illinois Union rulings, which barred Illinois Union from raising fraud byCMC and insurance related defenses as defenses to payment.  The MDL Court also suggested that NetBank,FSB would be entitled to judgment as a matter of law with respect to the Bondsissued by Illinois Union prior to December 2000, but declined to enter judgmentat that time because of allegations of fraud on the part of NetBank, FSB withrespect to certain Bonds, so-called replacement bonds, issued in December2000.  The MDL Court held that IllinoisUnion’s allegations of fraud on the part of NetBank, FSB in connection with theissuance of the replacement bonds were sufficient to get past the pleadingstage of the litigation.  However, thecourt noted that NetBank, FSB had previously moved for summary judgment againstIllinois Union and suggested that now, in light of the MDL Court ruling, NetBank,FSB could 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.  TheMDL Court left open the issue of whether Illinois Union would be permitted toamend its pleadings to allege new defenses or claims not expressly covered bythe Illinois Union Order and stated that this issue would be decided when theMDL Court rules on Illinois Union’s pending motion for leave to amend itspleadings.  The MDL Court made it clear,however, that Illinois Union would not be permitted to amend to avoid theimpact of the Illinois Union Order.

On July 19, 2006, the MDL Court issued a RevisedCase Management Plan.  In that plan, theMDL Court lifted the stay on expert discovery that it had entered in andordered that the parties commence expert discovery. The MDL Court also orderedthat expert discovery shall end on December 20, 2006.  The MDL Court also ordered that dispositivemotions, such as NetBank, FSB’s planned new motion for summary judgment againstthe Sureties, must be filed between January 15, 2007 and January 31, 2007.  Based upon the Plan issued by the MDL Court,the Company does not expect any resolution of NetBank, FSB’s claims against theSureties prior to Spring of 2007.

The Company believes that based on the overall factsand circumstances, the defenses asserted by the Sureties will fail and thatNetBank, FSB will ultimately prevail on its claims.

Also, as reported in previous filings, onMay 30, 2002, CMC filed for bankruptcy protection. Shortly thereafter,Commercial Servicing Corporation (“CSC”), an affiliate of CMC, also filedbankruptcy. The bankruptcy cases and related proceedings are not a part of theconsolidated action in the MDL Court. OnSeptember 4, 2003, the Trustee in bankruptcy for CMC and CSC initiated anadversary proceeding in the bankruptcy cases by filing a Complaint againstNetBank, FSB seeking to avoid NetBank, FSB’s interest in the Payment Streamsand their supporting Bonds relating to the Royal guaranteed pools of Leases(the “Adversary Proceeding”). On May 6, 2004, NetBank, FSB filed a motionfor partial summary judgment against the Trustee. The Trustee filed across-motion for partial summary judgment against NetBank, FSB on June 18,2004. On January 27, 2005, the Bankruptcy Court entered its MemorandumDecision granting the Trustee’s motion for partial summary judgment and denyingNetBank, FSB’s motion for partial summary judgment. On February 28, 2005,the Bankruptcy Court entered an order denying NetBank, FSB’s Motion for PartialSummary Judgment and granting the Trustee’s Cross-Motion for Summary Judgment.On April 27, 2005, the Bankruptcy Court entered a judgment conforming tothe Memorandum Decision.  On May 20,2005, the Bankruptcy Court entered an amended judgment conforming to theMemorandum Decision. The Bankruptcy Court held in the Memorandum Decision thatNetBank, FSB was required, but failed, to perfect its interest in the PaymentStreams that were transferred to it from CMC in the subject transactions andthat the subject transactions were loans rather than sales. Also onMay 20, 2005, NetBank, FSB appealed the amended judgment to the BankruptcyAppellate Panel for the Ninth Circuit Court of Appeals. On May 25, 2005,NetBank, FSB sought a stay pending appeal of the turnover provisions of theamended judgment from the Bankruptcy Court. The Bankruptcy Court denied therequest for stay on August 1, 2005. Instead of seeking appellate review ofthe denial of the motion to stay, NetBank, FSB entered into an agreement withthe Trustee whereby the Trustee agreed to safely hold the disputed Bondspending conclusion of the appellate process. The Bankruptcy Appellate Panelheard oral argument in the case on March 23, 2006.  

On August 2, 2006, theBankruptcy Appellate Panel issued its Opinion (the “BAP Opinion’’). In the BAPOpinion, the Bankruptcy Appellate Panel reversed the Bankruptcy Court’sdecision that the Payment Streams on the Royal Bonds were chattel paper ratherthan payment intangibles under the Uniform Commercial Code. Therefore,perfection would have been automatic if the transactions involving the PaymentStreams were “sales” rather than “loans.” However, the Panel affirmed theBankruptcy Court’s decision that the transactions were more properlycharacterized as loans rather than sales. Nevertheless, the Panel found thatNetBank, FSB raised genuine issues of fact as to whether its interests wereperfected by possession through an agent such as Royal, and that the Trusteedid not meet his burden on this issue by submitting uncontested evidenceregarding who held the leases at the relevant times. The panel held that thisgenuine issue of material fact precludes summary judgment for the Trustee.Accordingly, the Panel remanded the case back to the Bankruptcy Court for adetermination as to who had possession of the Royal Leases.

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In the meantime, many of theparties to the CMC and CSC bankruptcy cases resolved their disputes and enteredinto a Global Settlement Agreement, which was approved by the Bankruptcy Courton May 31, 2005. The Global Settlement Agreement resolved all issuesregarding ownership of the Payment Streams that were at issue in the AdversaryProceeding, however ownership of the Royal issued Bonds remains an issue in theAdversary Proceeding, as discussed above. Pursuant to the Global SettlementAgreement, NetBank, FSB received a settlement payment during the second quarterof 2005 of approximately $4 million. In addition, the Global SettlementAgreement provided that 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 claimsagainst all the Sureties, including claims for any loss associated with theclaims brought by the Trustee against NetBank, FSB. At this time, the Companyis unable to express an opinion as to the likelihood of loss, or the amount orrange of potential loss, with regard to this matter.

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

On June 27, 2001, several lessees of equipmentleased from CMC filed suit in Los Angeles Superior Court against CMC andseveral John Doe defendants alleging that the Leases violated California usurylaws, the California Financial Code, and the California Unfair BusinessPractices Act. The plaintiff lessees were seeking to rescind or reform theirobligations under the Leases and were seeking to recover statutory damages andattorney’s fees. The plaintiffs subsequently amended their complaint to nameNetBank, FSB, several other investor banks, and several surety companies asco-defendants in the action. After CMC filed for bankruptcy, the action wasremoved to the bankruptcy court in the Central District of California, but theplaintiffs subsequently agreed to withdraw their claims against CMC and weresuccessful in their motion to remand the case back to state court.

On March 15, 2004, the Superior Court sustaineddemurrers and motions to quash filed by NetBank, FSB and various otherdefendants on certain of the plaintiffs’ claims. The Superior Court sustainedthe demurrers under the California Financial Code, without leave to amend. TheSuperior Court also sustained demurrers on the Unfair Business Practices Act,with leave to amend the claims to add greater specificity to the claims, butwithout leave to amend as to unnamed representatives of the alleged class ofplaintiffs harmed. The Superior Court also granted motions to strike:(1) plaintiffs’ claims under the California Unfair Business Practices Actclaims as to unnamed representative plaintiffs; (2) plaintiffs’ requestfor restitution (the named plaintiffs may amend to establish individualentitlement to restitution); (3) plaintiffs’ request for disgorgement;(4) plaintiffs’ request for punitive damages; (5) plaintiffs’ requestfor compensatory damages under the California Unfair Business Practices Act;and (6) plaintiffs’ request for attorneys’ fees.

On April 29, 2004, the plaintiffs served anamended complaint against NetBank, FSB alleging claims for, among other things,violations of another section of the California Financial Code, unfaircompetition under Section 17200 of the California Business and ProfessionsCode and usury. On October 26, 2004, the court overruled the defendants’demurrers to the third amended complaint. However, on December 13, 2004,the court issued a stay in the action pending a decision by the appeals courton the plaintiffs’ claims that were dismissed without leave to amend. Nodiscovery has been taken in this case and we expect no resolution of thesesurviving claims prior to the outcome 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**

In addition to those risk factors previously describedin Item 1A. “Risk Factors” of Part I to our 2005 Form 10-K, and under theheading, “Special Note Regarding Forward-Looking Statements” in Part I of thisQuarterly Report on Form 10-Q, investors should carefully consider thefollowing risks:

***Sale of mortgage servicing platform along withmortgage servicing rights may adversely impact our earnings***

During the second quarter of 2006, we announced ourintention to sell our mortgage servicing platform along with most of ourmortgage servicing rights. As of the end of the second quarter of 2006, werecorded a $15,000 write-down of the carrying value of our mortgage servicingrights to more closely reflect indications of interest we received inconnection with marketing the potential sale. We can give no assurance that wewill not be required to record further impairment charges in the future or thatwe will be able to sell the mortgage servicing rights at a value in excess ofour carrying value or that we will be able to sell the platform withoutincurring additional charges. If we do record further write-downs or charges inthe future or sell such assets at a loss, it could adversely impact ourearnings.

***Our capital management strategies may not besuccessful***

Based on a number of market and economic factors,including, but not limited to, a continued flattened yield curve and pricingpressures on our mortgage business, we have implemented a disciplined approachto optimizing capital allocations to redirect scarce capital fromunderperforming businesses to better performing ones that carry the greatestlong-term strategic significance to the company. Our intention to sell ourmortgage servicing platform along with most of our mortgage servicing rights ispart of this ongoing capital strategy. In addition, we have suspended thepayment of our quarterly dividend. We can give no assurance that our capitalmanagement strategies will be successful in improving our results of operationsor financial condition.

**Item2.  Unregistered Sales of EquitySecurities and Use of Proceeds**

In August 2002, the Board of Directors approved a plan torepurchase up to 1 million shares of the Company’s common stock. The plan wassubsequently increased by 1 million shares in October 2002, 2 millionshares in January 2003, 1 million shares in April 2004 and 1 millionshares in April 2005. There were no repurchases during the three months ended June30, 2006.

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As of August 1, 2006, 1,086,573 shares remained available forrepurchase under current Board authority.

Reference is made to the discussion under the heading “Dividends” underItem 5. Market for Registrant’s Common Equity, Related Shareholder Matters andIssuer Purchases of Equity Securities of our 2005 Form 10-K for a descriptionof current OTS regulations applicable to the ability of NetBank, FSB to paydividends and make other capital distributions to the Company.

**Item3.  Defaults Upon Senior Securities**

None.

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

OurBoard of Directors is divided into three classes that serve staggeredthree-year terms.  At the 2006 AnnualMeeting of Shareholders of NetBank, Inc. held on May 2, 2006, the shareholderselected the following persons to the Company’s Board of Directors until the2009 Annual Meeting of Shareholders, or until his successor is elected andqualified, by the votes indicated below:  
| **Name**              | ** ** | **For**    | ** ** | **Withheld** | ** ** |
|-----------------------|------------|------------|------------|--------------|------------|
|                  |       |       |       |         |       |
| David W. Johnson, Jr. |       | 30,040,675 |       | 3,591,535    |       |
|                  |       |       |       |         |       |
| Robin C. Kelton       |       | 30,667,901 |       | 2,964,309    |       |
|                  |       |       |       |         |       |
| Thomas H. Muller, Jr. |       | 30,667,901 |       | 2,964,801    |       |

 

Directors continuing in office until the 2007 Annual Meeting ofShareholders are Stuart M. Cable, Joel A. Smith, III and Eula L. Adams.  Directors continuing in office until the 2008Annual Meeting of Shareholders are J. Stephen Heard and Douglas K. Freeman.

Also at the 2006 Annual Meeting of Shareholders, the shareholdersratified the appointment of Ernst & Young LLP as the Company’s independentauditors for fiscal year 2006 by the votes indicated below:
| For        | ** ** | **Against** | ** ** | **Abstained** | ** ** |
|------------|------------|-------------|------------|---------------|------------|
|       |       |        |       |          |       |
| 33,376,870 |       | 252,821     |       | 2,519         |       |

 

**Item 5.  Other Information**

**None.**

**Item 6.  Exhibits**

The exhibits listed in theaccompanying index to exhibits are filed or incorporated by reference as partof this report, unless otherwise provided in the index to exhibits.

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**SIGNATURE**

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned thereunto duly authorized.
|                       | NETBANK, INC. |
|-----------------------|---------------|
|                  |          |
|                  | By:           | /s/ Steven F. Herbert |   |
|                  |          | Steven F. Herbert |
| Dated: August 8, 2006 | * *      | *Chief Finance Executive  (principal accounting officer and  duly authorized officer)* |

 

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**INDEX TO EXHIBITS**
| **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 certificationattached as Exhibit 32.1 that accompanies this report is not deemed filed withthe Securities and Exchange Commission and is not to be incorporated byreference into any filing of NetBank, Inc. under the Securities Act of 1934, asamemded, or the Securities Exchange Act of 1934, as amended, whether madebefore or after the date of this report, irrespective of any generalincorporation language contained in such filing.**

 

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