**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

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

 

**AMNETMORTGAGE, INC.**

(Exact name of registrant as specified in its charter)

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

 

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

 

ý  YES    o  NO

 

Indicateby check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of theAct). Yes o No ý

 

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

 
| Common Stock ($0.01) |   | 7,389,133 as of July 30, 2004 |
|----------------------|--------|------------------------------------|

 

 

----

 
| INDEX                                                                                                                                                                                                                 |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                                                                                                                  |   |
| PART I.  FINANCIAL INFORMATION                                                                                                                                                                                   |   |
|                                                                                                                                                                                                                  |   |
| Item 1.  Consolidated Financial Statements                                                                                                                                                                            |   |
|                                                                                                                                                                                                                  |   |
| Consolidated Balance Sheets  at June 30, 2004 and December 31, 2003                                                                                                                                         |   |
|                                                                                                                                                                                                                  |   |
| Consolidated  Statements of Operations and Comprehensive Income (Loss) for the three months  ended June 30, 2004 and June 30, 2003 and for the six months ended  June 30, 2004 and June 30, 2003. |   |
|                                                                                                                                                                                                                  |   |
| Consolidated  Statements of Cash Flows for the six months ended June 30, 2004 and  June 30, 2003.                                                                                                           |   |
|                                                                                                                                                                                                                  |   |
| Notes to  Consolidated Financial Statements                                                                                                                                                                           |   |
|                                                                                                                                                                                                                  |   |
| Item 2. Management’s Discussion  and Analysis of Financial Condition and Results of Operations                                                                                                                   |   |
|                                                                                                                                                                                                                  |   |
| Item  3. Quantitative and Qualitative Disclosures about Market Risk                                                                                                                                                   |   |
|                                                                                                                                                                                                                  |   |
| Item 4 Controls and  Procedures                                                                                                                                                                                       |   |
|                                                                                                                                                                                                                  |   |
| PART II.  OTHER INFORMATION                                                                                                                                                                                      |   |
|                                                                                                                                                                                                                  |   |
| Item 1.  Legal Proceedings                                                                                                                                                                                            |   |
|                                                                                                                                                                                                                  |   |
| Item 2.  Changes in Securities and Use of Proceeds                                                                                                                                                                    |   |
|                                                                                                                                                                                                                  |   |
| Item 3. Defaults Upon  Senior Securities                                                                                                                                                                              |   |
|                                                                                                                                                                                                                  |   |
| Item  4. Submission of Matters to a Vote of Security Holders                                                                                                                                                          |   |
|                                                                                                                                                                                                                  |   |
| Item 5. Other  Information                                                                                                                                                                                            |   |
|                                                                                                                                                                                                                  |   |
| Item 6.  Exhibits and Reports on Form 8-K                                                                                                                                                                             |   |

 

2

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PART I.  FINANCIAL INFORMATION

Item 1.  Consolidated Financial Statements

 

AmNet Mortgage, Inc. and Subsidiaries

ConsolidatedBalance Sheets

(in thousands, except share and per share data) (unaudited)

 
|                                                                                                                                                                         |   | **June 30,  2004** |    | **December 31,  2003** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------|-----------------------------|--------|
|                                                                                                                                                                         |   |                    |    |                        |   |
| **ASSETS**                                                                                                                                                                   |   |                    |    |                        |   |
| Cash and cash equivalents                                                                                                                                                    |   | $                       | 50,944  |                        | $      | 44,400 |   |
| Cash and cash equivalents—restricted                                                                                                                                    |   | 2,290                   |    | 2,100                       |   |
| Mortgage loans held for sale, net, pledged  (lower of cost or market)                                                                                                        |   | 466,281                 |    | 276,781                     |   |
| Mortgage loans held of sale (formerly bond collateral), net (lower of  cost or market)                                                                                       |   | 1,707                   |    | —                      |   |
| Bond collateral, mortgage loans, net                                                                                                                                         |   | 18,457                  |    | 157,872                     |   |
| Bond collateral, real estate owned, net                                                                                                                                      |   | 800                     |    | 3,380                       |   |
| Accounts receivable—mortgage loans  sold/funded                                                                                                                         |   | 5,558                   |    | 3,856                       |   |
| Accrued interest receivable                                                                                                                                                  |   | 1,013                   |    | 2,593                       |   |
| Deferred taxes                                                                                                                                                               |   | 7,497                   |    | 5,694                       |   |
| Other assets                                                                                                                                                                 |   | 6,200                   |    | 5,520                       |   |
|                                                                                                                                                                         |   | $                       | 560,747 |                        | $      | 502,196 |   |
|                                                                                                                                                                         |   |                    |    |                        |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                                |   |                    |    |                        |   |
| Liabilities:                                                                                                                                                                 |   |                    |    |                        |   |
| Short-term debt                                                                                                                                                              |   | $                       | 453,808 |                        | $      | 268,619 |   |
| Long-term debt, net                                                                                                                                                          |   | 18,043                  |    | 130,295                     |   |
| Derivative financial instruments                                                                                                                                             |   | 2,101                   |    | 1,224                       |   |
| Accrued interest payable                                                                                                                                                     |   | 591                     |    | 494                         |   |
| Accrued expenses and other liabilities                                                                                                                                       |   | 7,494                   |    | 12,950                      |   |
| Total liabilities                                                                                                                                                            |   | 482,037                 |    | 413,582                     |   |
| Commitments and contingencies (Note 12)                                                                                                                                 |   |                    |    |                        |   |
| Minority Interest                                                                                                                                                            |   | 155                     |    | 129                         |   |
| Stockholders’ Equity:                                                                                                                                                   |   |                    |    |                        |   |
| Preferred stock, par value $.01 per share;  100,000 shares authorized; no shares issued and outstanding                                                                      |   | —                  |    | —                      |   |
| Common stock, par value $.01 per share;  24,900,000 shares authorized; 7,389,133 shares issued and outstanding in  2004, and 7,873,714 shares issued and outstanding in 2003 |   | 74                      |    | 79                          |   |
| Additional paid-in-capital                                                                                                                                                   |   | 104,258                 |    | 108,719                     |   |
| Accumulated deficit                                                                                                                                                          |   | (25,777                 | )       | (20,313                     | )      |
| Total stockholders’ equity                                                                                                                                              |   | 78,555                  |    | 88,485                      |   |
|                                                                                                                                                                         |   | $                       | 560,747 |                        | $      | 502,196 |   |

 

See accompanying notes to consolidated financial statements.

 

3

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AmNet Mortgage, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Income (Loss),unaudited

(in thousands, except per share data)

 
|                                                                                                                               |   | **For the********Three Months Ended********June 30, 2004** |   | **For the********Three Months Ended  June 30, 2003** |   | **For the********Six Months Ended  June 30, 2004** |   | **For The********Six Months Ended********June 30, 2003** |   |
|------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------|--------|-----------------------------------------------------------|--------|---------------------------------------------------------|--------|---------------------------------------------------------------|--------|
|                                                                                                                               |   |                                                            |   |                                                      |   |                                                    |   |                                                          |   |
| **Revenues**                                                                                                                       |   |                                                            |   |                                                      |   |                                                    |   |                                                          |   |
| Gain on sales of loans                                                                                                             |   | $                                                               | 2,323  |                                                      | $      | 32,971                                                  |   | $                                                             | 17,839 |   | $ | 53,180 |   |
| Derivative financial instruments and market  adjustments                                                                           |   |                                                            |   |                                                      |   |                                                    |   |                                                          |   |
| Derivative financial instruments—forward  sales of mortgage backed securities and options to sell mortgage-backed  securities |   | 10,857                                                          |   | (3,027                                                    | )      | 5,370                                                   |   | (3,080                                                        | )      |
| Market adjustment on interest rate lock  commitments                                                                               |   | 4,390                                                           |   | (6,257                                                    | )      | 3,233                                                   |   | (8,415                                                        | )      |
| Total derivative financial instruments and  market adjustments                                                                     |   | 15,247                                                          |   | (9,284                                                    | )      | 8,603                                                   |   | (11,495                                                       | )      |
| Interest on mortgage assets                                                                                                        |   | 9,569                                                           |   | 10,393                                                    |   | 16,211                                                  |   | 19,639                                                        |   |
| Other income                                                                                                                       |   | 434                                                             |   | 247                                                       |   | 729                                                     |   | 462                                                           |   |
| Total revenue, net of derivative financial  instruments and adjustments                                                            |   | 27,573                                                          |   | 34,327                                                    |   | 43,382                                                  |   | 61,786                                                        |   |
| **Expenses**                                                                                                                       |   |                                                            |   |                                                      |   |                                                    |   |                                                          |   |
| Employee compensation and benefits                                                                                                 |   | 14,399                                                          |   | 12,586                                                    |   | 26,242                                                  |   | 22,070                                                        |   |
| Interest expense                                                                                                                   |   | 4,754                                                           |   | 4,598                                                     |   | 7,994                                                   |   | 8,811                                                         |   |
| Office and occupancy expense                                                                                                       |   | 959                                                             |   | 621                                                       |   | 1,795                                                   |   | 1,188                                                         |   |
| Provision for loan losses                                                                                                          |   | 128                                                             |   | 794                                                       |   | 128                                                     |   | 1,713                                                         |   |
| Gain on sale of real estate owned, net                                                                                             |   | (61                                                             | )      | (330                                                      | )      | (320                                                    | )      | (515                                                          | )      |
| Loss on bond collateral held for sale                                                                                              |   | 880                                                             |   | —                                                    |   | 5,309                                                   |   | —                                                        |   |
| Professional fees                                                                                                                  |   | 1,369                                                           |   | 1,338                                                     |   | 2,404                                                   |   | 2,742                                                         |   |
| Other operating expenses                                                                                                           |   | 4,687                                                           |   | 4,025                                                     |   | 8,940                                                   |   | 7,779                                                         |   |
| Total expenses                                                                                                                     |   | 27,115                                                          |   | 23,632                                                    |   | 52,492                                                  |   | 43,788                                                        |   |
| Income (loss) before income taxes                                                                                                  |   | 458                                                             |   | 10,695                                                    |   | (9,110                                                  | )      | 17,998                                                        |   |
| Income tax (benefit)                                                                                                               |   | 250                                                             |   | 1,190                                                     |   | (3,646                                                  | )      | (3,663                                                        | )      |
| Net income (loss)                                                                                                                  |   | $                                                               | 208    |                                                      | $      | 9,505                                                   |   | $                                                             | (5,464 | ) | $ | 21,661 |   |
|                                                                                                                               |   |                                                            |   |                                                      |   |                                                    |   |                                                          |   |
| Basic weighted average shares outstanding                                                                                          |   | 7,838,504                                                       |   | 7,863,437                                                 |   | 7,856,426                                               |   | 7,863,154                                                     |   |
| Diluted weighted average shares outstanding                                                                                        |   | 8,582,572                                                       |   | 8,470,633                                                 |   | 7,856,426                                               |   | 8,470,350                                                     |   |
|                                                                                                                               |   |                                                            |   |                                                      |   |                                                    |   |                                                          |   |
| Net income (loss) per share basic                                                                                                  |   | $                                                               | 0.03   |                                                      | $      | 1.21                                                    |   | $                                                             | (0.70  | ) | $ | 2.75 |   |
|                                                                                                                               |   |                                                            |   |                                                      |   |                                                    |   |                                                          |   |
| Net income (loss) per share diluted                                                                                                |   | $                                                               | 0.02   |                                                      | $      | 1.12                                                    |   | $                                                             | (0.70  | ) | $ | 2.56 |   |

 

See accompanying notes to consolidated financial statements.

 

4

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AmNet Mortgage, Inc. and Subsidiaries

ConsolidatedStatements of Cash Flows, unaudited

(in thousands)

 
|                                                                                  |   | **For the  Six Months  Ended June 30, 2004** |   | **For the  Six Months  Ended June 30, 2003** |   |
|---------------------------------------------------------------------------------------|--------|---------------------------------------------------|--------|---------------------------------------------------|--------|
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                 |   |                                              |   |                                              |   |
| Net (loss) income                                                                     |   | $                                                 | (5,464 | )                                                 | $      | 21,661 |   |
| Adjustments to reconcile net (loss) income  to net cash used in operating activities: |   |                                              |   |                                              |   |
| Loss on bond collateral held for sale                                                 |   | 5,309                                             |   | —                                            |   |
| Amortization of mortgage assets premiums                                              |   | 980                                               |   | 1,838                                             |   |
| Amortization of CMO capitalized costs                                                 |   | 474                                               |   | 189                                               |   |
| Changes in provision for loan losses                                                  |   | 128                                               |   | 1,713                                             |   |
| Change in real estate owned provision                                                 |   | 401                                               |   | 1,216                                             |   |
| Gain on sale of real estate owned, net                                                |   | (320                                              | )      | (515                                              | )      |
| Proceeds from sale of mortgage loans held  for sale                                   |   | 4,250,085                                         |   | 5,115,960                                         |   |
| Mortgage loan originations                                                            |   | (4,439,585                                        | )      | (5,302,132                                        | )      |
| Increase in restricted cash                                                           |   | (190                                              | )      | (968                                              | )      |
| Increase in loans held for sale, not  pledged (formerly bond collateral)              |   | (7,016                                            | )      | —                                            |   |
| Increase in accounts receivable—mortgage  loans sold/funded                      |   | (1,702                                            | )      | (4,934                                            | )      |
| Decrease in accrued interest receivable                                               |   | 1,580                                             |   | 1,170                                             |   |
| Increase in deferred taxes                                                            |   | (1,803                                            | )      | (9,141                                            | )      |
| Increase in other assets                                                              |   | (678                                              | )      | (1,819                                            | )      |
| Decrease/(increase) in derivative financial  instruments                              |   | 877                                               |   | (1,380                                            | )      |
| Increase in accrued interest payable                                                  |   | 97                                                |   | 13                                                |   |
| (Decrease)/increase in accrued expenses and  other liabilities                        |   | (5,456                                            | )      | 14,263                                            |   |
| Increase in minority interest                                                         |   | 26                                                |   | 4                                                 |   |
| Net cash used in operating activities                                                 |   | (202,257                                          | )      | (162,862                                          | )      |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                 |   |                                              |   |                                              |   |
| Principal payments on bond collateral,  mortgage loans, net                           |   | 23,195                                            |   | 49,203                                            |   |
| Proceeds from sale of bond collateral                                                 |   | 116,022                                           |   | —                                            |   |
| Proceeds from sale of real estate owned                                               |   | 1,589                                             |   | 6,125                                             |   |
| Net cash provided by investing activities                                             |   | 140,806                                           |   | 55,328                                            |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                 |   |                                              |   |                                              |   |
| Payments on long-term debt                                                            |   | (112,727                                          | )      | (60,668                                           | )      |
| Increase in net borrowings from short-term  debt                                      |   | 185,189                                           |   | 181,799                                           |   |
| Stock options exercised                                                               |   | 33                                                |   | 3                                                 |   |
| Purchase of treasury stock                                                            |   | (4,500                                            | )      | —                                            |   |
| Net cash provided by financing activities                                             |   | 67,995                                            |   | 121,134                                           |   |
| Net increase in cash and cash equivalents                                             |   | 6,544                                             |   | 13,600                                            |   |
| Cash and cash equivalents at beginning of  year                                       |   | 44,400                                            |   | 13,640                                            |   |
| Cash and cash equivalents at end of period                                            |   | $                                                 | 50,944 |                                              | $      | 27,240 |   |
| Supplemental information                                                              |   |                                              |   |                                              |   |
| Interest paid                                                                         |   | $                                                 | 7,898  |                                              | $      | 8,795 |   |
| Taxes paid                                                                            |   | $                                                 | 2,784  |                                              | — |   |
| Transfers from bond collateral, mortgage  loans, net to real estate owned             |   | $                                                 | 1,087  |                                              | $      | (3,441 | ) |

 

See accompanying notes to consolidated financial statements.

 

5

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**AMNET MORTGAGE, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1.  Summary of Significant Accounting Policies and Practices**

 

*Basis of Financial StatementPresentation*

 

In May 2004, American Residential Investment Trust, Inc. changed itsname to AmNet Mortgage, Inc.

 

Theconsolidated financial statements include the accounts of AmNet Mortgage, Inc.,a Maryland corporation, American Mortgage Network, Inc., a Delawarecorporation and wholly-owned subsidiary of AmNet Mortgage Inc., AmericanResidential Eagle, Inc., a Delaware special purpose corporation andwholly-owned subsidiary of AmNet and American Residential Eagle 2, Inc.,a Delaware limited purpose corporation and wholly-owned subsidiary of AmericanResidential Eagle, Inc. Substantially all of the assets AmericanResidential Eagle, Inc. are pledged or subordinated to support short orlong-term debt in the form of collateralized mortgage bonds and are notavailable for the satisfaction of general claims of AmNet Mortgage, Inc.American Residential Holdings, Inc. is an affiliate of AmNet Mortgage,Inc. that is consolidated in accordance with FASB Interpretation No. 46R“Consolidation of Variable Interest Entities.” All entities are togetherreferred to as the “Company” or “AmNet.” The Company’s exposure to loss on theassets pledged as collateral is limited to its net investment, as thecollateralized mortgage bonds are non-recourse to the Company. All significantintercompany balances and transactions have been eliminated in theconsolidation of AmNet. Certain reclassifications may have been made to priorinternal period amounts to conform to the current presentation.

 

Inmanagement’s opinion, all adjustments necessary for a fair statement arereflected in the interim periods presented. These adjustments are of a normalrecurring nature. The interim financial data as of June 30, 2004 and forthe six months ended June 30, 2004 and June 30, 2003 is unaudited;however, in the opinion of the Company, the interim data includes alladjustments, consisting only of normal recurring adjustments, necessary for afair statement of the results for the interim periods.

 

Salesof mortgage loans are accounted for under Statement of Financial AccountingStandards (SFAS) No. 140, “Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities.” Mortgage loans are soldwith the mortgage servicing rights released. Gains or losses on sales ofmortgage loans are recognized based on the difference between the sellingprices and the carrying value of the related mortgage loans sold. Deferredorigination fees and expenses are recognized at the time of sale.

 

InMarch 2004, the SEC released Staff Accounting Bulletin (SAB) No. 105,“Application of Accounting Principles to Loan Commitments.” The Companyaccounts for its commitments to extend credit as derivatives and recordschanges in fair value of the commitments in the statement of operations. Theadoption of SAB No. 105 in the second quarter of 2004 did not have asignificant effect on the Company’s financial statements.

 

Pleaserefer to the Company’s Form 10-K for the year ending December 31, 2003,for a detailed discussion of all significant accounting policies.

 

6

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*Stock Options*

 

TheCompany elected to apply APB Opinion No. 25, “Accounting for Stock Issuedto Employees,” in accounting for its stock-based compensation plans: the 1997Stock Incentive Plan, 1997 Stock Option Plan, 1997 Employee Stock Purchase Planand 1997 Outside Directors Stock Option Plan. Accordingly, no compensation costhas been recognized in the financial statements. SFAS 123 “Accounting forStock Based Compensation” requires pro forma disclosures of expense computed asif the fair value based method had been applied in the financial statements ofcompanies that continue to account for such arrangements under OpinionNo. 25.

 

InDecember 2002, the Financial Accounting Standards Board (“FASB”) issuedSFAS 148, “Accounting For Stock Based Compensation Transition andDisclosure,” which amends SFAS No. 123. SFAS No. 148 requires moreprominent and frequent disclosures about the effects of stock-based compensation,which the Company elected to early adopt for the twelve-month period endingDecember 31, 2002. The Company will continue to account for its stockbased compensation according to the provisions of APB Opinion No. 25.

 

TheFASB is currently considering amending SFAS 123, “Accounting for Stock-BasedCompensation,” and APB Opinion No. 25, “Accounting for Stock Issued toEmployees.” The proposed standard will require the Company to recordcompensation expense for all share-based compensation plans. If adopted, this proposedstandard would have a negative impact on our earnings in future periods sincestock options are issued periodically to qualified employees.

 

Hadcompensation cost for the Company’s stock options been recognized based uponthe estimated fair value on the grant date under the fair value methodologyprescribed by SFAS No. 123, as amended by SFAS No. 148, the Company’snet income (loss) and income per share would have been as follows (in thousandsexcept income per share) (unaudited):

 
|                                                                                                                       |   | **Three  Months Ended** |   | **Six Months  Ended**   |   |
|----------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|--------|-------------------------|--------|
|                                                                                                                       |   | **June 30,  2004** |   | **June 30,  2003** |   | **June 30,  2004** |   | **June 30,  2003** |   |
|                                                                                                                       |   |                    |   |                    |   |   |   |   |   |
| Net income (loss) as reported                                                                                              |   | $                       | 208    |                    | $      | 9,505 |   | $ | (5,464 | ) | $ | 21,661 |   |
| Deduct: Total stock-based compensation  expense determined under fair value-based method, net of tax effects (See  Note 9) |   | (136                    | )      | (505                    | )      | (419 | ) | (1,023 | ) |
| Pro forma net income (loss)                                                                                                |   | $                       | 72     |                    | $      | 9,000 |   | $ | (5,883 | ) | $ | 20,638 |   |
| Income (loss) per share:                                                                                                   |   |                    |   |                    |   |   |   |   |   |
| Basic as reported                                                                                                          |   | $                       | 0.03   |                    | $      | 1.21 |   | $ | (0.70 | ) | $ | 2.75 |   |
| Basic pro forma                                                                                                            |   | $                       | 0.01   |                    | $      | 1.14 |   | $ | (0.75 | ) | $ | 2.62 |   |
| Diluted as reported                                                                                                        |   | $                       | 0.02   |                    | $      | 1.12 |   | $ | (0.70 | ) | $ | 2.56 |   |
| Diluted pro forma                                                                                                          |   | $                       | 0.01   |                    | $      | 1.06 |   | $ | (0.75 | ) | $ | 2.44 |   |

 

Theassumptions used to calculate the fair value of options granted are evaluatedand revised as necessary to reflect market conditions and the Company’sexperience. These assumptions have not changed from prior periods.

 

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

 

Forthe six months ending June 30, 2004, the Company sold a majority of themortgage loans it originated to two of its competitors, Countrywide Home Loans,Inc. (62%) and Wells Fargo Funding, Inc. (16%).The Company’s considerations in deciding where to sell loans are price andoperational efficiency.  The Companyalso considers speed of execution and loan product guidelines.  The Company believes that all of the loansit sells currently could be sold to a number of other investors. A CountrywideHome Loans, Inc. entity, Countrywide Warehouse Lending, is also a warehouselender to the Company (see Note 7 Short-TermDebt).

 

7

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**Note 3.  Income Per Share**

 

Thefollowing table illustrates the computation of basic and diluted income pershare (in thousands, except share and per share data) (unaudited):

 
|                                                                                                                     |   | **For the  Three  Months Ended  June 30, 2004** |   | **For the  Three  Months Ended  June 30, 2003** |   | **For the  Six  Months Ended  June 30, 2004** |   | **For the  Six  Months Ended  June 30, 2003** |   |
|--------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------|--------|------------------------------------------------------|--------|----------------------------------------------------|--------|----------------------------------------------------|--------|
| Numerator:                                                                                                               |   |                                                 |   |                                                 |   |                                               |   |                                               |   |
| Numerator for basic income (loss) per share                                                                              |   | $                                                    | 208    |                                                 | $      | 9,505                                              |   | $                                                  | (5,464 | ) | $ | 21,661 |   |
| Denominator:                                                                                                             |   |                                                 |   |                                                 |   |                                               |   |                                               |   |
| Denominator for basic income (loss) per  share - weighted average number of common shares outstanding during the  period |   | 7,838,504                                            |   | 7,863,437                                            |   | 7,856,426                                          |   | 7,863,154                                          |   |
| Denominator for diluted income (loss) per  share                                                                         |   | 8,582,572                                            |   | 8,470,633                                            |   | 7,856,426                                          |   | 8,470,350                                          |   |
|                                                                                                                     |   |                                                 |   |                                                 |   |                                               |   |                                               |   |
| Income (loss) per share - basic                                                                                          |   | $                                                    | 0.03   |                                                 | $      | 1.21                                               |   | $                                                  | (0.70  | ) | $ | 2.75 |   |
| Income (loss) per share - diluted                                                                                        |   | $                                                    | 0.02   |                                                 | $      | 1.12                                               |   | $                                                  | (0.70  | ) | $ | 2.56 |   |

 

Forthe six months ended June 30, 2004 and 2003 there were 1,083,149 and 1,131,904 options, respectively,that were antidilutive and, therefore, not included in the calculations above.

 

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

 

AmNethas pledged loans held for sale totaling approximately $466.3 million to secure credit lines (warehouse facilities) fromfour financial institutions. See Note 7, “Short-Term Debt.” Mortgage loans heldfor sale at June 30, 2004 consist of loans which have been committed forsale of approximately $162.2 million and loansavailable for sale at approximately $304.1 million, all of which are carried atthe lower of cost or market value.

 

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

 

AmNethas pledged collateral in order to secure the long-term debt issued in the formof CMOs. Bond Collateral Mortgage Loans consist primarily of subprime credit30-year mortgage loans secured by first liens on one-to-four family residentialproperties. As of June 30, 2004 and 2003,0% and 17.76%, respectively, of the bond collateral mortgage loans werefixed rate loans. The balance of the bond collateral mortgage loans areadjustable-rate mortgages. All Bond Collateral Mortgage Loans are pledged tosecure repayment of the related long-term debt obligation. All principal and interest(less servicing and related fees) on the bond collateral is remitted to atrustee and is available for payment of the long-term debt obligation. Theobligations under the long-term debt are payable solely from the bondcollateral and are otherwise non-recourse to AmNet.

 

In March of 2004, approximately $113.9 million in mortgage loansbond collateral and approximately $2.3 million in REO bond collateral werereclassified as held for sale.  ByJune 30, 2004 all but 60 mortgage loans totaling approximately $1.7million, had been sold.  These remainingassets are classified as Mortgage loans held for sale (formerly bondcollateral), net.  There is no debtassociated with these assets.  Oneremaining portfolio (CMO/FASIT 1998-1) was not sold.  Bond collateral for this structure is shown as Bond Collateral,Mortgage Loans, net and bond collateral, real estate owned, net.

 

8

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Shownbelow are the components of bond collateral held for investment (after sale ofthe majority of bond collateral assets) at June 30, 2004; compared to thesame components at December 31, 2003 (dollars in thousands) (unaudited):

 
|                                                |   | **CMO/REMIC   2000-2  Securitization** |       | **CMO/REMIC   1999-A  Securitization** |       | **CMO  1999-2  Securitization** |       | **CMO  1999-1  Securitization** |       | **CMO/FASIT  1998-1  Securitization** |       | **TOTAL  Bond  Collateral** |       |
|-----------------------------------------------------|--------|----------------------------------------|------------|----------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|---------------------------------------|------------|-----------------------------|------------|
| **At June 30, 2004**                           |   |                                   | ** ** |                                   | ** ** |                            | ** ** |                            | ** ** |                                  | ** ** |                        | ** ** |
| Mortgage loans                                      |   | $                                      | 0          |                                   | $          | 0                               |       | $                               | 0          |                                  | $          | 0                           |       | $ | 18,600 |   | $ | 18,600 |   |
| Unamortized premium                                 |   | 0                                      |       | 0                                      |       | 0                               |       | 0                               |       | 56                                    |       | 56                          |       |
| Allowance for loan losses                           |   | 0                                      |       | 0                                      |       | 0                               |       | 0                               |       | (199                                  | )          | (199                        | )          |
|                                                |   | $                                      | 0          |                                   | $          | 0                               |       | $                               | 0          |                                  | $          | 0                           |       | $ | 18,457 |   | $ | 18,457 |   |
|                                                |   |                                   |       |                                   |       |                            |       |                            |       |                                  |       |                        |       |
| Weighted average net coupon                         |   | 0                                      | %          | 0                                      | %          | 0                               | %          | 0                               | %          | 9.45                                  | %          | 9.45                        | %          |
| Unamortized premiums as a percent of mortgage loans |   | 0                                      | %          | 0                                      | %          | 0                               | %          | 0                               | %          | 0.30                                  | %          | 0.30                        | %          |
|                                                |   |                                   | ** ** |                                   | ** ** |                            | ** ** |                            | ** ** |                                  | ** ** |                        | ** ** |
| **At December 31, 2003**                       |   |                                   | ** ** |                                   | ** ** |                            | ** ** |                            | ** ** |                                  | ** ** |                        | ** ** |
| Mortgage loans                                      |   | $                                      | 7,068      |                                   | $          | 40,435                          |       | $                               | 58,922     |                                  | $          | 27,021                      |       | $ | 22,668 |   | $ | 156,114 |   |
| Unamortized premium                                 |   | 362                                    |       | 809                                    |       | 1,747                           |       | 749                             |       | 102                                   |       | 3,769                       |       |
| Allowance for loan losses                           |   | (141                                   | )          | (486                                   | )          | (517                            | )          | (311                            | )          | (556                                  | )          | (2,011                      | )          |
|                                                |   | $                                      | 7,289      |                                   | $          | 40,758                          |       | $                               | 60,152     |                                  | $          | 27,459                      |       | $ | 22,214 |   | $ | 157,872 |   |
|                                                |   |                                   |       |                                   |       |                            |       |                            |       |                                  |       |                        |       |
| Weighted average net coupon                         |   | 9.15                                   | %          | 9.49                                   | %          | 9.00                            | %          | 8.88                            | %          | 9.40                                  | %          | 9.17                        | %          |
| Unamortized premiums as a percent of mortgage loans |   | 5.12                                   | %          | 2.00                                   | %          | 2.96                            | %          | 2.77                            | %          | 0.45                                  | %          | 2.41                        | %          |

 

**Note 6.  Derivative Financial Instruments**

 

AmNetmakes commitments to fund mortgages at set interest rates, which are referredto individually as rate lock commitments. Additionally the Company’s loans arenot yet committed for sale at the time of funding. Collectively, rate lockcommitments and funded loans not yet committed for sale are the Company’spipeline.  The value of the rate lockcommitments and uncommitted loans will vary depending on changes in marketinterest rates between the time that a rate lock commitment is made and thetime that the loan funds and is committed for sale to an investor.

 

AmNetattempts to estimate the number of rate lock commitments in the pipeline thatwill not close in order to calculate its interest rate exposure on a dailybasis. AmNet then purchases hedging instruments in order to try to protectprofit margins on the pipeline. The hedging instruments used are forward salesof mortgage-backed securities (“TBA”) and options on forward sales ofmortgage-backed securities. Historically, changes in the price of these instrumentsclosely relate to changes in the value (price) of loans in the pipeline.

 

AtJune 30, 2004 and June 30, 2003 AmNet had the following commitmentsto originate loans and loans not yet committed for sale to investors, andoffsetting hedge coverage as follows (dollars in thousands) (unaudited):

 
|                                                                           |   | **6/30/2004** |    | **6/30/2003** |   |
|--------------------------------------------------------------------------------|--------|---------------|---------|---------------|--------|
| **Interest rate exposure:**                                                    |   |          |    |          |   |
|                                                                           |   |          |    |          |   |
| Commitments to originate loans at set  interest rates (after applying fallout) |   | $             | 473,449 |          | $      | 1,163,221 |   |
|                                                                           |   |          |    |          |   |
| Closed loans not yet committed for sale to  investors                          |   | 304,126       |    | 355,492       |   |
|                                                                           |   |          |    |          |   |
| **Hedge coverage:**                                                            |   |          |    |          |   |
|                                                                           |   |          |    |          |   |
| Forward sales of mortgage-backed securities  (TBA)(notional amount)            |   | 670,500       |    | 1,346,500     |   |
|                                                                           |   |          |    |          |   |
| Options on forward sales of mortgage-backed  securities (notional amount)      |   | 145,000       |    | 280,000       |   |
|                                                                                |        |               |         |               |        |  |  |

 

9

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Interestrate exposure does not directly correlate to hedge coverage without applying anoption adjusted spread and fallout factor (for rate locks).

 

Thefair value of forward sales of mortgage-backed securities and options onforward sales of mortgage-backed securities are based on quoted market pricesfor these instruments. The rate lock commitments are also considered aderivative instrument and are assigned fair values based on the change in thequoted market value of the underlying loans due to market movements, less anestimated factor for loans that will not close (fallout ratio). The falloutratio is affected by the Company’s recent fallout history, interest ratechanges and pipeline characteristics.

 

Thefollowing is a summary of the carrying value of AmNet’s derivative instrumentsas of June 30, 2004 and December 31, 2003 (dollars in thousands)(unaudited):

 
| **June 30, 2004**                                     |   | **Range of  Coupon Rate** |       | **Range of  Notional Amount** |         | **Fair Value** |       | **Range of  Expiration Dates** |       |
|------------------------------------------------------------|--------|---------------------------|------------|-------------------------------|--------------|----------------|------------|--------------------------------|------------|
| ***Forward sales of  mortgage-backed securities (TBAs):*** |   |                      |       |                          |         |           |       |                           |       |
| Fifteen year Fannie Mae                                    |   | 5.0-6.0 MBS               |       | $                             | 2,000-30,000 |           | $          | (2,988                         | )          | Jul 20-Sept 20, 2004 |   |
| Thirty year Fannie Mae                                     |   | 5.5-6.5 MBS               |       | 4000-25,000                   |         | (3,021         | )          | Jul 15-Sept 15, 2004           |       |
| Thirty year Ginnie Mae                                     |   | 5.0-6.0 MBS               |       | 1,000-10,000                  |         | (480           | )          | Jul 22-Sept 22, 2004           |       |
| ***Options on TBAs:***                                     |   |                      |       |                          |         |           |       |                           |       |
| Thirty year Fannie Mae                                     |   | 6.0 Puts                  |       | 20,000-40,000                 |         | 292            |       | Jul 15-Sept 15, 2004           |       |
| ***Rate Lock  Commitments***                               |   |                      |       |                          |         | 4,096          |       |                           |       |
| ***Total derivative  financial instruments***              |   |                      |       |                          |         | $              | (2,101     | )                              |       |   |
|                                                       |   |                      |       |                          |         |           |       |                           |       |
| **December 31, 2003**                                 |   | **Coupon Rate**           | ** ** | **Range of  Notional Amount** | ** **   | **Fair Value** | ** ** | **Range of  Expiration Dates** | ** ** |
| ***TBA***                                                  |   |                      |       |                          |         |           |       |                           |       |
| Fifteen year Fannie Mae                                    |   | 4.5-5.5 MBS               |       | $                             | 3,000-25,000 |           | $          | (803                           | )          | Jan 20-Mar 18, 2004 |   |
| Twenty year Fannie Mae                                     |   | 4.5 MBS                   |       | 2,000                         |         | 56             |       | Feb 12, 2004                   |       |
| Thirty year Fannie Mae                                     |   | 5.0-6.0 MBS               |       | 4,500-20,000                  |         | (1,388         | )          | Jan 14-Mar 15, 2004            |       |
| Thirty year Ginnie Mae                                     |   | 5.0-6.0 MBS               |       | 1,000-8,000                   |         | (122           | )          | Jan 22-Feb 19, 2004            |       |
| ***Options on TBAs:***                                     |   |                      |       |                          |         |           |       |                           |       |
| Thirty year Fannie Mae                                     |   | 5.5 Puts                  |       | 50,000                        |         | 172            |       | Mar 15, 2004                   |       |
| ***Rate Lock  Commitments***                               |   |                      |       |                          |         | 861            |       |                           |       |
| ***Total derivative  financial instruments***              |   |                      |       |                          |         | $              | (1,224     | )                              |       |   |

 

Thefollowing is a summary of the components within total derivative financialinstruments and market adjustments income (expense):(000’s)

 
|                                                                             |   | **For the  Three  Months  Ended June 30,  2004** |   | **For the  Three  Months  Ended June 30,  2003** |   | **For the  Six  Months  Ended June 30,  2004** |   | **For the  Six  Months  Ended June 30,  2003** |   |
|----------------------------------------------------------------------------------|--------|-------------------------------------------------------|--------|-------------------------------------------------------|--------|-----------------------------------------------------|--------|-----------------------------------------------------|--------|
| Derivative financial instruments-income  (expense):                              |   |                                                  |   |                                                  |   |                                                |   |                                                |   |
| TBA gain/(loss) -closed positions                                                |   | $                                                     | 14,406 |                                                  | $      | (7,293                                              | )      | $                                                   | 8,411  |   | $ | (9,570 | ) |
| Options gain/(loss) - closed positions                                           |   | 4,287                                                 |   | —                                                |   | 4,287                                               |   | —                                              |   |
| Change in value of TBAs - open positions                                         |   | (5,698                                                | )      | 5,691                                                 |   | (4,231                                              | )      | 8,366                                               |   |
| Change in value of Options - open positions                                      |   | (2,138                                                | )      | (1,425                                                | )      | (3,097                                              | )      | (1,876                                              | )      |
| Change in market adjustment on interest  rate lock commitments                   |   | 4,390                                                 |   | (6,257                                                | )      | 3,233                                               |   | (8,415                                              | )      |
|                                                                             |   |                                                  |   |                                                  |   |                                                |   |                                                |   |
| Total derivative financial instruments and  market adjustments income (expense): |   | $                                                     | 15,247 |                                                  | $      | (9,284                                              | )      | $                                                   | 8,603  |   | $ | (11,495 | ) |

 

 

10

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**Note 7.  Short-Term Debt**

 

Asof June 30, 2004, mortgage loans held for sale totaling $466.3 million were pledged as collateralfor warehouse facility borrowings of $453.8 millionwith four financial institutions. At June 30, 2004, the Company’s maximumborrowing capacity combined from these four financial institutions was$1.4 billion.  The table belowshows the age of pledged mortgage loans as of June 30, 2004. (unaudited):

 
| **Aging Range**    |   | **Number of  Loans** |   | **Warehouse  line usage** |    | **% of Total** |   |
|--------------------|--------|----------------------|--------|---------------------------|---------|----------------|--------|
|               |   | **(in  thousands)**  |   |
| Less than 30 days  |   | 2,523                |   | $                         | 398,588 |           | 87.8   | % |
| 30 to 60 days      |   | 250                  |   | 46,709                    |    | 10.3           | %      |
| 61 days to 90 days |   | 39                   |   | 8,511                     |    | 1.9            | %      |
| TOTAL              |   | 2,812                |   | $                         | 453,808 |           | 100.0  | % |

 

Ofthe $453.8 million of warehouse line usage at June 30, 2004, $122.4 million was funded through uncommittedwarehouse facilities.

 

Warehouse facilities mature on various dates within one year, generallybearing interest at one-month LIBOR plus spread. The weighted average borrowingrates were 2.63% and 2.69% for the three monthperiod ending June 30, 2004 and June 30, 2003 respectively. Theweighted-average borrowing rate was 2.56% for the six months ending June 30,2004 and 2.71% for the six months ending June 30, 2003. Theweighted-average facility fee was .24% for the six months ending June 30,2004 and .25% for the six months ending June 30, 2003 on theaggregate committed amount of the warehouse facilities. The warehousefacilities are repaid as principal payments on mortgage loans are received, oras the mortgage loans are sold. The agreements governing these facilitiescontain a number of covenants, including covenants based on tangible net worth,net income, and liquidity of the Company. As of June 30, 2004, the Companywas in compliance with all of its warehouse lending agreements.

 

In2001, the Company also entered into a $5 million senior subordinatedsecured revolving loan agreement (“Subordinated Loan Agreement”). TheSubordinated Loan Agreement bore an interest rate of 12%. The $3 million loanbalance was paid off in full in April 2004.

 

InApril of 2004, the Company entered into agreements to sell approximately85% of its mortgage portfolio assets. As a result, approximately $90 million inlong-term debt was reclassified to short-term debt pending sale. During thesecond quarter of 2004 the Company extinguished all of the reclassifiedshort-term debt, using proceeds from the sale of the mortgage loans and realestate owned bond collateral.

 

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

 

Thecomponents of the long-term debt at June 30, 2004 and December 31,2003, along with selected other information are summarized below (dollars inthousands) (unaudited):

 
|                                |   | **CMO/REMIC  2000-2  Securitization** |       | **CMO/REMIC  1999-A  Securitization** |       | **CMO  1999-2  Securitization** |       | **CMO  1999-1  Securitization** |       | **CMO/FASIT  1998-1  Securitization** |       | **TOTAL  Long-Term Debt** |       |
|-------------------------------------|--------|---------------------------------------|------------|---------------------------------------|------------|---------------------------------|------------|---------------------------------|------------|---------------------------------------|------------|---------------------------|------------|
| **At June 30, 2004**           |   |                                  | ** ** |                                  | ** ** |                            | ** ** |                            | ** ** |                                  | ** ** |                      | ** ** |
| Long-term debt                      |   | $                                     | 0          |                                  | $          | 0                               |       | $                               | 0          |                                  | $          | 0                         |       | $ | 18,043 |   | $ | 18,043 |   |
| Capitalized costs on long-term debt |   | 0                                     |       | 0                                     |       | 0                               |       | 0                               |       | —                                |       | —                    |       |
| Total long-term debt                |   | $                                     | 0          |                                  | $          | 0                               |       | $                               | 0          |                                  | $          | 0                         |       | $ | 18,043 |   | $ | 18,043 |   |
|                                |   |                                  |       |                                  |       |                            |       |                            |       |                                  |       |                      |       |
| Weighted average financing rates    |   | 0                                     | %          | 0                                     | %          | 0                               | %          | 0                               | %          | 2.19                                  | %          | 2.19                      | %          |
|                                |   |                                  | ** ** |                                  | ** ** |                            | ** ** |                            | ** ** |                                  | ** ** |                      | ** ** |
| **At December 31, 2003**       |   |                                  | ** ** |                                  | ** ** |                            | ** ** |                            | ** ** |                                  | ** ** |                      | ** ** |
| Long-term debt                      |   | $                                     | 7,182      |                                  | $          | 33,012                          |       | $                               | 51,594     |                                  | $          | 16,753                    |       | $ | 22,229 |   | $ | 130,770 |   |
| Capitalized costs on long-term debt |   | (30                                   | )          | (1                                    | )          | (267                            | )          | (177                            | )          | —                                |       | (475                      | )          |
| Total long-term debt                |   | $                                     | 7,152      |                                  | $          | 33,011                          |       | $                               | 51,327     |                                  | $          | 16,576                    |       | $ | 22,229 |   | $ | 130,295 |   |
|                                |   |                                  |       |                                  |       |                            |       |                            |       |                                  |       |                      |       |
| Weighted average financing rates    |   | 2.24                                  | %          | 1.29                                  | %          | 3.33                            | %          | 1.82                            | %          | 2.14                                  | %          | 2.37                      | %          |

 

11

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**Note 9.  StockPlans**

 

Asof June 30, 2004, shares of common stock were reserved for issuance underthe Company’s stock plans as follows (unaudited):

 
|                                 |   | **1997 Stock  Incentive  Plan** |   | **1997 Stock  Option Plan** |   | **1997  Employee  Stock  Purchase  Plan** |   | **1997  Outside  Director  Stock Option  Plan** |   | **Total** |   |
|--------------------------------------|--------|---------------------------------|--------|-----------------------------|--------|-------------------------------------------|--------|-------------------------------------------------|--------|-----------|--------|
|                                 |   |                            |   |                        |   |                                      |   |                                            |   |      |   |
| Total Options Authorized at 1/1/2004 |   | 315,200                         |   | 1,474,800                   |   | 20,000                                    |   | 210,000                                         |   | 2,020,000 |   |
| Total Options Issued                 |   | 284,800                         |   | 1,421,050                   |   | —                                    |   | 179,500                                         |   | 1,885,350 |   |
| Options Reserved for Issuance        |   | 30,400                          |   | 53,750                      |   | 20,000                                    |   | 30,500                                          |   | 134,650   |   |

 

Stockoption activity during the six months ending June 30, 2004 was as follows(unaudited):

 
|                              |   | **Number of  Options** |   | **Weighted-Average  Exercise Price** |   |
|-----------------------------------|--------|------------------------|--------|--------------------------------------|--------|
|                              |   |                   |   |                                 |   |
| Balance at December 31, 2003 |   | 1,768,100              |   | $                                    | 7.96   |   |
| Granted                           |   | 175,750                |   | 8.38                                 |   |
| Forfeited                         |   | (89,724                | )      | 6.60                                 |   |
| Exercised                         |   | (26,909                | )      | 5.52                                 |   |
| Balance at June 30, 2004     |   | 1,827,217              |   | $                                    | 8.09   |   |

 

AtJune 30, 2004, the range of exercise prices for outstanding options was$1.75 to $15.00 and the weighted-average remaining contractual life ofoutstanding options was 6.20 years.The weighted average exercise price of exercisable outstanding options was $8.01. The table below shows options and prices for all outstanding options atJune 30, 2004 (unaudited):

 
| **Option Exercise Price Range** |   | **Vested** |   | **Unvested** |   | **Number of  Options** |   |
|---------------------------------|--------|------------|--------|--------------|--------|------------------------|--------|
|                            |   |       |   |         |   |                   |   |
| $1.75 to  $3.00                 |   | 101,282    |   | 73,032       |   | 174,314                |   |
| $3.01 to  $5.00                 |   | 206,725    |   | 266,578      |   | 473,303                |   |
| $5.01 to  $7.50                 |   | 307,740    |   | 47,710       |   | 355,450                |   |
| $7.51 to  $10.00                |   | 128,321    |   | 150,429      |   | 278,750                |   |
| $10.01 to  $12.50               |   | 286,675    |   | 2,625        |   | 289,300                |   |
| $12.51 to  $15.00               |   | 256,100    |   | —       |   | 256,100                |   |
|                            |   | 1,286,843  |   | 540,374      |   | 1,827,217              |   |

 

Theper share weighted-average fair value of stock options granted betweenJanuary 1, 2004 and June 30, 2004 is computed quarterly.  For the first quarter ending March 31,2004 the value was $2.48.  For thesecond quarter ending June 30, 2004 the value was $3.47 (See Note 1).  These values were calculated using the Black-Scholesoption-pricing model, using the following weighted-average assumptions(unaudited):

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

 

**Note 10.  Business Segments**

 

TheCompany reports its financial results in two segments: the Mortgage BankingBusiness and the Mortgage Asset Portfolio Business. The Mortgage BankingBusiness originates home mortgage loans through a network of mortgage loanbrokers. These mortgage loans are subsequently sold to financial institutions.The Mortgage Asset Portfolio Business segment manages a portfolio of mortgageloans pledged as collateral for CMO debt.

 

12

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Theaccounting policies of the segments are the same as described in Note 1,“Summary of Significant Accounting Policies and Practices.” The Companyevaluates the performance of its business segments based on revenue andexpenses under the direct control of each business segment. The expense ofpremises and equipment incurred to support business operations are allocatedaccordingly, by segment.

 

Thetable below reflects the total assets at June 30, 2004 and 2003, and thecapital expenditures for six-month periods ending June 30, 2004 and 2003(in thousands) (unaudited):

 
|                                                                     |   | **Mortgage  Banking** |    | **Mortgage  Asset  Portfolio** |   | **Combined  Segments** |   |
|--------------------------------------------------------------------------|--------|-----------------------|---------|--------------------------------|--------|------------------------|--------|
|                                                                     |   |                  |    |                           |   |                   |   |
| Total assets as of June 30, 2004                                    |   | $                     | 502,435 |                           | $      | 58,312                 |   | $ | 560,747 |   |
| Total capital expenditures for the six  months ending June 30, 2004 |   | $                     | 1,084   |                           | $      | —                 |   | $ | 1,084 |   |
|                                                                     |   |                  |    |                           |   |                   |   |
| Total assets as of June 30, 2003                                    |   | $                     | 595,952 |                           | $      | 244,312                |   | $ | 840,264 |   |
| Total capital expenditures for the six  months ending June 30, 2003 |   | $                     | 1,588   |                           | $      | —                 |   | $ | 1,588 |   |

 

13

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Thetables below reflect the year-to-date income statement activity by segment forthe three-month and six-month periods ending June 30, 2004 andJune 30, 2003:

 

AmNet Mortgage, Inc. andSubsidiariesConsolidated Statements ofOperations by Business Segment, unaudited

(in thousands)

 
|                                                                           |   | **For the  Three  Months  Ended June 30,  2004** |   | **For the Three  Months  Ended June 30,  2004** |   | **For the  Three  Months  Ended June 30,  2004** |   | **For the  Six  Months  Ended June 30,  2004** |   | **For the  Six  Months  Ended June 30,  2004** |   | **For the  Six  Months  Ended June 30,  2004** |   |
|--------------------------------------------------------------------------------|--------|-------------------------------------------------------|--------|------------------------------------------------------|--------|-------------------------------------------------------|--------|-----------------------------------------------------|--------|-----------------------------------------------------|--------|-----------------------------------------------------|--------|
|                                                                           |   | **Mortgage  Banking**                                 |   | **Mortgage  Asset  Portfolio**                       |   | **Combined  Segments**                                |   | **Mortgage  Banking**                               |   | **Mortgage  Asset Portfolio**                       |   | **Combined  Segments**                              |   |
|                                                                           |   |                                                  |   |                                                 |   |                                                  |   |                                                |   |                                                |   |                                                |   |
| **Revenues**                                                                   |   |                                                  |   |                                                 |   |                                                  |   |                                                |   |                                                |   |                                                |   |
| Gain on sales of loans                                                         |   | $                                                     | 2,323  |                                                 | $      | —                                                |   | $                                                   | 2,323  |                                                | $      | 17,839                                              |   | $ | — |   | $ | 17,839 |   |
| Derivative financial instruments and market  adjustments                       |   |                                                  |   |                                                 |   |                                                  |   |                                                |   |                                                |   |                                                |   |
| Derivative financial instruments—forward  commitments and options         |   | 10,857                                                |   | —                                               |   | 10,857                                                |   | 5,370                                               |   | —                                              |   | 5,370                                               |   |
| Market adjustment on interest rate lock  commitments                           |   | 4,390                                                 |   | —                                               |   | 4,390                                                 |   | 3,233                                               |   | —                                              |   | 3,233                                               |   |
| Total derivative financial instruments and  market adjustments                 |   | 15,247                                                |   | —                                               |   | 15,247                                                |   | 8,603                                               |   | —                                              |   | 8,603                                               |   |
| Interest on mortgage assets, net of premium  amortization                      |   | 8,994                                                 |   | 575                                                  |   | 9,569                                                 |   | 14,008                                              |   | 2,203                                               |   | 16,211                                              |   |
| Other income                                                                   |   | 66                                                    |   | 368                                                  |   | 434                                                   |   | 145                                                 |   | 584                                                 |   | 729                                                 |   |
| Total revenue, net of derivative financial  instruments and market adjustments |   | 26,630                                                |   | 943                                                  |   | 27,573                                                |   | 40,595                                              |   | 2,787                                               |   | 43,382                                              |   |
| **Expenses**                                                                   |   |                                                  |   |                                                 |   |                                                  |   |                                                |   |                                                |   |                                                |   |
| Employee compensation and benefits                                             |   | 14,263                                                |   | 136                                                  |   | 14,399                                                |   | 25,963                                              |   | 279                                                 |   | 26,242                                              |   |
| Interest expense                                                               |   | 4,422                                                 |   | 332                                                  |   | 4,754                                                 |   | 6,767                                               |   | 1,227                                               |   | 7,994                                               |   |
| Office and occupancy expense                                                   |   | 959                                                   |   | —                                               |   | 959                                                   |   | 1,795                                               |   | —                                              |   | 1,795                                               |   |
| Provision for loan losses                                                      |   | —                                                |   | 128                                                  |   | 128                                                   |   | —                                              |   | 128                                                 |   | 128                                                 |   |
| Gain on sale of real estate owned, net                                         |   | —                                                |   | (61                                                  | )      | (61                                                   | )      | —                                              |   | (320                                                | )      | (320                                                | )      |
| Loss on bond collateral held for sale                                          |   | —                                                |   | 880                                                  |   | 880                                                   |   | —                                              |   | 5,309                                               |   | 5,309                                               |   |
| Professional fees                                                              |   | 1,088                                                 |   | 281                                                  |   | 1,369                                                 |   | 2,001                                               |   | 403                                                 |   | 2,404                                               |   |
| Other operating expenses                                                       |   | 4,460                                                 |   | 227                                                  |   | 4,687                                                 |   | 8,548                                               |   | 392                                                 |   | 8,940                                               |   |
| Total expenses                                                                 |   | 25,192                                                |   | 1,923                                                |   | 27,115                                                |   | 45,074                                              |   | 7,418                                               |   | 52,492                                              |   |
| Income (loss) before income taxes                                              |   | 1,438                                                 |   | (980                                                 | )      | 458                                                   |   | (4,479                                              | )      | (4,631                                              | )      | (9,110                                              | )      |
| Income tax (benefit)                                                           |   | 650                                                   |   | (400                                                 | )      | 250                                                   |   | (1,728                                              | )      | (1,918                                              | )      | (3,646                                              | )      |
| Net income (loss)                                                              |   | $                                                     | 788    |                                                 | $      | (580                                                  | )      | $                                                   | 208    |                                                | $      | (2,751                                              | )      | $ | (2,713 | ) | $ | (5,464 | ) |

 

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|                                                                   |   | **For the  Three  Months  Ended June 30,  2003** |   | **For the  Three  Months  Ended June 30,  2003** |   | **For the  Three  Months  Ended June 30,  2003** |   | **For the  Six  Months  Ended June 30,  2003** |   | **For the  Six  Months  Ended June 30,  2003** |   | **For the  Six  Months  Ended June 30,  2003** |   |
|------------------------------------------------------------------------|--------|-------------------------------------------------------|--------|-------------------------------------------------------|--------|-------------------------------------------------------|--------|-----------------------------------------------------|--------|-----------------------------------------------------|--------|-----------------------------------------------------|--------|
|                                                                   |   | **Mortgage  Banking**                                 |   | **Mortgage  Asset  Portfolio**                        |   | **Combined  Segments**                                |   | **Mortgage  Banking**                               |   | **Mortgage  Asset Portfolio**                       |   | **Combined  Segments**                              |   |
|                                                                   |   |                                                  |   |                                                  |   |                                                  |   |                                                |   |                                                |   |                                                |   |
| **Revenues**                                                           |   |                                                  |   |                                                  |   |                                                  |   |                                                |   |                                                |   |                                                |   |
| Gain on sales of loans                                                 |   | $                                                     | 32,971 |                                                  | $      | —                                                |   | $                                                   | 32,971 |                                                | $      | 53,180                                              |   | $ | — |   | $ | 53,180 |   |
| Derivative financial instruments and market  adjustments               |   |                                                  |   |                                                  |   |                                                  |   |                                                |   |                                                |   |                                                |   |
| Derivative financial instruments—forward  commitments and options |   | (3,027                                                | )      | —                                                |   | (3,027                                                | )      | (3,080                                              | )      | —                                              |   | (3,080                                              | )      |
| Market adjustment on interest rate lock  commitments                   |   | (6,257                                                | )      | —                                                |   | (6,257                                                | )      | (8,415                                              | )      | —                                              |   | (8,415                                              | )      |
| Total derivative financial instruments and  market adjustments         |   | (9,284                                                | )      | —                                                |   | (9,284                                                | )      | (11,495                                             | )      | —                                              |   | (11,495                                             | )      |
| Interest on mortgage assets, net of premium  amortization              |   | 7,561                                                 |   | 2,832                                                 |   | 10,393                                                |   | 13,462                                              |   | 6,177                                               |   | 19,639                                              |   |
| Other income                                                           |   | 34                                                    |   | 213                                                   |   | 247                                                   |   | 51                                                  |   | 411                                                 |   | 462                                                 |   |
| Total revenue                                                          |   | 31,282                                                |   | 3,045                                                 |   | 34,327                                                |   | 55,198                                              |   | 6,588                                               |   | 61,786                                              |   |
|                                                                   |   |                                                  |   |                                                  |   |                                                  |   |                                                |   |                                                |   |                                                |   |
| **Expenses**                                                           |   |                                                  |   |                                                  |   |                                                  |   |                                                |   |                                                |   |                                                |   |
| Employee compensation and benefits                                     |   | 12,449                                                |   | 137                                                   |   | 12,586                                                |   | 21,594                                              |   | 476                                                 |   | 22,070                                              |   |
| Interest expense                                                       |   | 3,447                                                 |   | 1,151                                                 |   | 4,598                                                 |   | 6,122                                               |   | 2,689                                               |   | 8,811                                               |   |
| Office and occupancy expense                                           |   | 621                                                   |   | —                                                |   | 621                                                   |   | 1,188                                               |   | —                                              |   | 1,188                                               |   |
| Provision for loan losses                                              |   | —                                                |   | 794                                                   |   | 794                                                   |   | —                                              |   | 1,713                                               |   | 1,713                                               |   |
| Loss on sale of real estate owned, net                                 |   | —                                                |   | (330                                                  | )      | (330                                                  | )      | —                                              |   | (515                                                | )      | (515                                                | )      |
| Professional fees                                                      |   | 1,183                                                 |   | 155                                                   |   | 1,338                                                 |   | 2,272                                               |   | 470                                                 |   | 2,742                                               |   |
| Other operating expenses                                               |   | 3,826                                                 |   | 199                                                   |   | 4,025                                                 |   | 7,321                                               |   | 458                                                 |   | 7,779                                               |   |
| Total expenses                                                         |   | 21,526                                                |   | 2,106                                                 |   | 23,632                                                |   | 38,497                                              |   | 5,291                                               |   | 43,788                                              |   |
|                                                                   |   |                                                  |   |                                                  |   |                                                  |   |                                                |   |                                                |   |                                                |   |
| Income before income taxes                                             |   | 9,756                                                 |   | 939                                                   |   | 10,695                                                |   | 16,701                                              |   | 1,297                                               |   | 17,998                                              |   |
| Income tax                                                             |   | 3,224                                                 |   | 428                                                   |   | 3,652                                                 |   | 5,050                                               |   | 428                                                 |   | 5,478                                               |   |
| Income tax benefit from utilization of REIT  net operating losses      |   | —                                                |   | (2,462                                                | )      | (2,462                                                | )      | —                                              |   | (9,141                                              | )      | (9,141                                              | )      |
| Net income                                                             |   | $                                                     | 6,532  |                                                  | $      | 2,973                                                 |   | $                                                   | 9,505  |                                                | $      | 11,651                                              |   | $ | 10,010 |   | $ | 21,661 |   |

 

**Note 11.  Income Taxes**

 

During1997, the Company elected to be taxed as a real estate investment trust(“REIT”) under the Internal Revenue Code of 1986, as amended. As a result ofthis election, the Company was not, with certain exceptions, taxed at thecorporate level on the net income distributed to the Company’s shareholders. OnJuly 19, 2002, the shareholders of the Company approved two proposals thatallowed for the conversion of the Company from a REIT to a fully taxableentity. On February 7, 2003, the Company filed a notice with the InternalRevenue Service of its decision to de-REIT, effective beginning January 1,2003.

 

Asa result of the conversion to fully taxable status, an income tax benefit andrelated deferred tax asset of $6.7 million, after valuation allowance, wasrecorded in March of 2003.  As aresult of deferred tax asset realization in 2003 the balance as ofDecember 31, 2003 was $5.7 million. An additional tax benefit of $2.0million was recorded in the first quarter of 2004. The deferred tax asset hasbeen and will continue to be reduced by realization of income tax provisionsover time. For the six month period ending June 30, 2004 the Companyrecorded an assumed income tax benefit for the six months ended June 30,2004 of $3.7 million as a result of a pretax loss of $9.1 million.  This benefit was calculated based on anassumed income tax rate of 41% for 2004.

 

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**Note 12.  Commitments and Contingencies**

 

*Lease Commitments*

 

TheCompany rents certain premises and equipment under non-cancelable operatingleases expiring at various dates through the year 2009. Rental expense undersuch leases is included in office and occupancy expense, and other operatingexpenses. Lease costs totaled $1.9 millionin the six months ending June 30, 2004 and $1.3 million in the sixmonths ending June 30, 2003. Future minimum lease payments under theseleases as of June 30, 2004, are as follows (dollars in thousands)(unaudited):

 
| **Year ending  June 30:** |   |   |   |
|--------------------------------|--------|--------|--------|
| 2005                           |   | $      | 4,352  |   |
| 2006                           |   | 3,127  |   |
| 2007                           |   | 1,838  |   |
| 2008                           |   | 1,249  |   |
| 2009                           |   | 687    |   |
|                           |   | $      | 11,253 |   |

 

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS.

 

*The statements contained in this Form 10-Q that are notpurely historical are forward looking statements, including statementsregarding our expectations, hopes, beliefs, intentions, or strategies regardingthe future. Such statements use the words “expect,” “will,” “may,”“anticipate,” “goal,” “intend,” “seek,” “believe,” “plan,” “strategy” andderivatives of such words. Forward looking statements in this report includethose statements regarding:*

 

•                                          *the percentage of interestrate lock commitments that will likely result in mortgage loan fundings;*

 

•*                                         **our expectation of beingable to renew, increase and syndicate our warehouse borrowing facilities;*

 

•*                                         **the expectation thatAmNet’s primary source of revenues will be interest income and gains on salesof loans, net of gains or losses on derivative financial instruments;*

 

•*                                         **our belief that the qualityof our loan products and services will permit us to gain market share even ifdemand for mortgages declines;*

 

•*                                         **our expectationssurrounding the total size of the loan origination market, our ability toexpand our sales force and customer base to originate loans, expand marketshare and be profitable in a potentially declining market, our loan originationvolume and our expectations regarding higher loan costs and our target profitmargins on each loan;*

 

•*                                         **our expectationssurrounding our cash requirements, expenses (including our ability to controlour fixed expenses), cash flow from operations, the sufficiency of our capitalbase, the sufficiency of our cash reserves and our sources of liquidity,including our ability to maintain our warehouse lending facilities and thefactors we expect to affect our ability to do so;*

 

•*                                         **the expected adequacy ofour various reserves;*

 

•*                                         **our intention to expandcertain areas of our operations and the expected costs of doing so;*

 

•*                                         **our intention to continueto try and hedge against market fluctuations in interest rates and protectprofit margins on our loan pipeline and loans, the instruments we intend to useand the expected inverse relationship of gains on hedging to margins on loansales;*

 

•*                                         **the expected correlation ofour profitability to loan origination volume;*

 

•*                                         **our belief that we willcontinue to qualify for correspondent lending programs and our ability to findalternative buyers for loans we originate;*

 

•*                                         **the expected concentrationof our loans in California;*

 

•*                                         **the sub-prime loans weoffer and plan to offer and the operations and risks related to suchoriginations;*

 

•*                                         **our expectation thatinterest rates will rise and refinance demand will fall and the anticipatedeffect on various aspects of our business from changes in interest rates,including increased loan generation cost per loan and changes in the value ofour loans and our derivatives;*

 

•*                                         **our expectations regardingthe sale of the sixty mortgage loans remaining from sale the of portfolioassets and the proceeds we expect to receive;*

 

•*                                         **our expectations regardingthe factors necessary to remain profitable;*

 

•*                                         **our expectation thatrevenues and expenses from our Mortgage Asset Portfolio Business will continueto decline;*

 

•*                                         **our expected effective taxrates, the impact of our deferred tax assets, the reduction of those assetsover time and the possible need to establish a valuation account related to taxbenefits;*

 

•*                                         **who we anticipate will beour competitors;*

 

•*                                         **the anticipated impact ofchanges in laws;*

 

•*                                         **our expectation that thepurchase loan business will become a greater portion of our originations andthe*

 

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*related impact of seasonality;*

 

•*                                         **our expected increasingreliance on information technology systems and the necessity of developing andupgrading such systems;*

* *

*•**                                         **our expectations regardingthe impact of an amendment to FASB statement 123;*

* *

*•**                                         **our expectations regardingthe future mixture of loans we will originate and the related impact on ourreserves; and*

* *

*•**                                         **the correlation between ourcost of funds and market interest rates.*

 

*These forward looking statements are based on informationavailable to us on the date hereof, and we assume no obligation to update anysuch forward looking statements. It is important to note that our actualresults and timing of certain events could differ materially from those in suchforward looking statements.  Some of themost significant risks that we face that could harm our future operatingresults or prevent us from meeting our goals and objectives are the following:*

 

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

 

•                  *We have expanded our branchsystem and fixed expenses over the past year in a contracting market.  Additionally, our market share increases aredependent on retaining and expanding our sales force and broker customer base,which is more challenging in a highly competitive market environment.*

 

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

 

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

 

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

 

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

 

•                  *We have mortgage loansremaining for sale from the sale of mortgage portfolio assets. There can be noassurance that these loans will be sold in a timely manner and therefore ourcash would remain invested in these loans.*

 

•                  *We have created reservesfor trailing losses from the sale of portfolio assets. This estimate may proveto be inadequate thereby reducing cash and our earnings for additional costsincurred.*

 

*Other factors that may impact our results, include but arenot limited to, general economic conditions, the world political climate,unexpected expense increases, overall interest rates, volatility in interestrates, the shape of the yield curve, changes in accounting rules or their application, changes in the marginsfor gains on sale of originated loans, changes in the demand of mortgagebrokers for our loan products and services or of loan purchasers for originatedloans, increases in prepayment rates and default rates, changes in therequirements of correspondent loan programs or our ability to meet suchrequirements and changes in our anticipated cash requirements. These and otherrisk factors that could cause actual results to differ materially are set forthin more detail in this item under the heading “Business Risk Factors.”*

 

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**Introduction**

 

OurCompany was founded in 1997 as an externally managed Real Estate InvestmentTrust. Until 2001, substantially all of our operations consisted of theacquisition of residential mortgages for investment purposes. In mid-2001, ourBoard of Directors and management determined that it was in the best interestof the stockholders to fundamentally shift our strategic direction to mortgagebanking. We started the transition in 2001 by forming AmNet to engage in mortgagebanking activities. In order to more closely align our name with ouractivities, we changed our name from American Residential Investment Trust,Inc. to AmNet Mortgage, Inc., as of May 5, 2004. Effective January 1, 2002we began reporting our financial results in two segments: the Mortgage BankingBusiness and the Mortgage Asset Portfolio Business.

 

OurMortgage Banking segment originates mortgage loans predominately to primequality borrowers secured by first trust deeds through a network of independentmortgage brokers. A concentration of our business is in California (26.2% ofloans originated in the first six months of 2004); however, we do business on anationwide basis. We sell the loans that we originate to institutionalpurchasers on a servicing-released basis.

 

Weuse a dedicated sales force to offer our loan products to approved wholesalemortgage brokers, who refer their clients’ loans to us for underwriting andfunding. Loans meeting our underwriting criteria are generally approved and fundedat our regional underwriting loan centers. Our headquarters office performsvarious functions through multiple departments including establishment ofpolicy, risk management, secondary marketing, and loan delivery to investors,finance, accounting, administration, marketing, human resources, andinformation technology.

 

Ourmortgage banking operations represented 93.6% ofour revenue for the six months ended June 30, 2004. During the first sixmonths of 2004, two branch offices and three regional offices were opened for atotal of twenty-seven offices. The number of employees company-wide increasedfrom 648 to 702 employees during the first six months of 2004.

 

Weborrow funds under our warehouse credit facilities to fund and accumulate loansprior to sale to correspondent investors on a servicing-released basis.Currently we have four warehouse facilities that enable us to borrow up to anaggregate of $1.4 billion. We are generally allowed to borrow from 96% to99% of the lesser of par or market value of the loans, and must comply withvarious lender covenants restricting, among other things, the absolute level ofleverage, requiring minimum levels of cash reserves and requiring certainlevels of profitability.

 

Wegenerate revenue in our Mortgage Banking Business segment three principal ways:

 

•                                          *Gain on loan sales*. Loan rates, fees and discount points areset based on our targeted gain on sale. This is referred to as our pricingmargin. We currently sell the loans that we originate to institutional purchasers,on a servicing-released basis, for cash. We record the difference between thesale price of loans that we have sold and our cost to originate the loans soldas gain on loan sales. We recognize revenue at the time that we complete theloan sale, which is generally when we receive loan sale proceeds from thepurchaser.  Gain on loan sales alsoincludes fees we charge for loan origination such as underwriting fees, loandocument preparation fees and wiring fees.

 

•                                          *Hedging.*Hedginginstruments are used to help mitigate exposure to interest rate fluctuations.The gains or losses from this activity will correspond to revenue derived fromloan sales. Typically higher than expected gains from the sale of loans will beoffset by hedging losses, while lower than expected gains from the sale ofloans will be offset by hedging gains. Hedging gains or losses are included inthe consolidated statements of operation and comprehensive income as derivativefinancial instruments and market adjustments.

 

•                                          *Interest income*. From the time we fund a loan until the timewe sell the loan, we earn interest on the loan, which is paid by the borrower.The interest that we earn is partially offset by the interest we pay under ourwarehouse credit facilities used to finance our mortgage originations.

 

Theexpenses in our Mortgage Banking segment include variable costs such ascommissions, loan expenses and contract labor, as well as fixed overheadexpenses such as personnel, rent, supplies and utilities.

 

Wehave continued to generate revenues and expenses from our Mortgage AssetPortfolio Business. Revenues and expenses from this segment of our businesshave declined in the second quarter of 2004 due to the sale of the majority ofthe portfolio assets in May 2004. We put up for sale approximately 85% of ourportfolio and completed the majority of sales prior to June 30, 2004. Netproceeds totaled approximately $24.9 million.

 

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***Our 2nd Quarter 2004 Highlights(Executive Overview)***

 

Ouroperating results for the second quarter of 2004 were dominated by thefollowing:

 

•                  Based on a decision to liquidate the majorityof our remaining mortgage asset portfolio, we entered into purchase and salecontracts to sell bond collateral mortgage assets, and we used a portion of theproceeds to redeem all of the related collateralized long-term debt. Sixtymortgage loans remain to be sold as of June 30, 2004 with a market valueof $2.5 million and a book value of $1.7 million.

 

Wedetermined that the market value of the bond collateral assets (sold andunsold) was lower than the carrying value which necessitated a valuationadjustment in March 2004 when the decision was made to sell the portfolio.The valuation adjustment for the period ended June 30, 2004 wasapproximately $5.3 million which includes among other things: sale expenses,write off of capitalized costs and premiums, net realizable sale adjustmentsand $750 thousand of reserves for trailing expenses and losses. The valuationadjustment (loss on bond collateral held for sale) for the second quarter of2004 was approximately $880 thousand.

 

Asof June 30, 2004 net proceeds from the portfolio sales totaledapproximately $24.9 million which was received in the three month period endingJune 30, 2004.  An additional $1.7million is expected to be received upon sale of the sixty unsold mortgageloans. As of July 31, 2004, forty-three mortgage loans remain unsold.

 

•                  Our Mortgage Banking segment fundedapproximately $2.6 billion in loan volume for the period while funding forthe same period in 2003 was $3.2 billion. This represents a decline of approximately 19% from the second quarterof 2003 production. Rates for thirty-year fixed rate mortgages increased duringthe second quarter of 2004 from 5.52% at March 31, 2004 to 6.25% atJune 30, 2004 according to Freddie Mac rates for thirty-year fixed-ratemortgages. Generally, demand for loans decreased beginning in lateApril of 2004 due to both higher interest rates and decreased refinanceactivity and accordingly our funding volume declined month over month duringthe second quarter of 2004. In the second quarter of 2003 a large portion ofloans were refinances. The graph below shows monthly loan productioncomparisons between the second quarters of 2004 and 2003.

 

 
|   |   | **(in  millions)** |   |
|--------|--------|--------------------|--------|
|   |   | **2004**           |   | **2003** |   |
| April  |   | $                  | 1,147  |   | $ | 1,030 |   |
| May    |   | 751                |   | 876 |   |
| June   |   | 666                |   | 1,301 |   |
|        |        |                    |        |  |  |  |  |

 

•                                         We expect the trend of reduced loan refinanceactivity from 2003 levels to continue for the remainder of 2004.  According to the Mortgage BankersAssociation (“MBA”) the overall loan production market is contracting from $3.8trillion in 2003 to $2.5 trillion in 2004.

 

•                                         Revenues totaled $27.6 million. This revenuewas sufficient to cover variable and fixed expenses totaling $25.2 million forthe mortgage banking segment.

 

•                                          Cash and cash equivalents increased by $23.3million during the second quarter of 2004 from $27.6 million at March 31,2004 to $50.9 million at June 30, 2004. Thekey factors in this increase were the portfolio sales which nettedapproximately $24.9 million and cash generated by the mortgage banking segmentoffset by cash used to repurchase outstanding stock.

 

•                                          Werepurchased 511,490 shares of our outstanding common stock during the secondquarter of 2004. Included in this total was the purchase of 500,000 sharesthrough a privately negotiated transaction with a

 

20

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single entity. The purchase price of thistransaction was $8.80 per share resulting in a total cash outlay of $4.5million.

 

•                                          Mortgage loans held for sale are subject totiming differences related to recognition of income or expense. AtJune 30, 2004 loans held for sale or committed for sale containedapproximately $5.1 million in gains (as compared to approximately $4.1 millionat March 31, 2004) which would only be recognized at the time of loan salewhile offsetting hedging losses were recognized at June 30, 2004 andMarch 31, 2004.

 

**Critical Accounting Policies**

 

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

 

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

 

• Derivative hedging activities/determinationof fair values

• Income taxes and benefits

• Allowance for loan losses – bond collateralmortgage loans

• Amortization of premiums on bond collateralloans

• Loan loss reserves – mortgage loans held forsale

 

Pleaserefer to the Company’s Form 10-K for the year ending December 31, 2003,for a detailed discussion of these policies.

 

**Management’s Financial Analysis**

 

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

 

*Gross Margins -*The Mortgage Banking segmentgenerates gain on the sale of loans. These gains are a function of the volume of loans sold in the period,and the value of the loans at the time these loans are committed for sale to aninvestor.  We also generate gains andlosses on the derivative financial instruments that we acquire to hedge ourtargeted gain on sale of the loans.  Weconsider our gross margin to be the sum of our (i) gain on sale of loans and(ii) total derivative financial instruments and market adjustments.  This sum expressed as a percentage of ourloan sales volume is our gross margin percentage.

 

When we develop the pricing of our loans, we incorporate a target grossmargin percentage that we expect to obtain. We then provide rate lock commitments to borrowers based on that pricingand the related target gross margin percentage.  However, if interest rates increase between the time we make arate lock commitment and commit a loan for sale, then the market value of theloan would be reduced and we would not achieve our target marginpercentage.  Accordingly, we acquirederivative financial instruments to hedge, or protect, our target margins frominterest rate movements.  We hedge ourloans from the time of a rate lock commitment to the time the loan is committedfor sale to an investor.

 

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

 

*Net Interest Income* - We earn interest income and incur interest expense in both segments ofour operations. In the Mortgage Banking Business, we earn interest on a loanfrom the date the loan is funded until sale of the loan to an investor.Accordingly, interest income is a function of the volume of loans funded, theinterest rate on the loans and the length of time the loans are held. To theextent we fund loans with borrowings under our warehouse facilities, we recordinterest expense based on the same factors. Similarly, in the Mortgage AssetPortfolio Business, we generate revenue from the interest we

 

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receiveon the mortgage loans we hold for investment and we incur interest expense onthe borrowings used to finance our loan portfolio.

 

Becausethe interest income and interest expense in each segment of our business areclosely related and dependant on many of the same factors, in particular thevolume of loans we originate or hold for investment, management believes thatit is helpful in understanding our operations to analyze the impact of interestincome and expense together within each segment of our operations. For thisreason, the discussion below provides information regarding the net interestincome (interest income less interest expense) generated by each segment.Management believes that this is consistent with how financial analyststypically consider interest in analyzing mortgage banking operations.

 

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

 

**Results of Operations**

 

***Three Month Results***

 

MortgageBanking Business

 

OurMortgage Banking Business recorded net income of $788.1 thousand for thethree-month period ending June 30, 2004 as compared to net income of $6.5million in 2003 for the same period. These results were due in large part to(i) a 17% decrease in loan sales volume and revenues reflecting acontracted overall mortgage loan origination marketplace from 2003; (ii)decreased gross margins on loan sales; and (iii) increased expensesreflecting the expansion of regional and branch offices over the past year.

 

**($ amountsin 000’s) (unaudited)**

 
|                                                                                                                  |   | **Three  Months Ended  June 30, 2004** |       | **Three  Months Ended  June 30, 2003** |       | **2004  Increase (Decrease)** |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|------------|---------------------------------------------|------------|-------------------------------|--------|
|                                                                                                                  |   | **Amount  Income  (Expense)**               |       | **Basis  Points**                           |       | **Amount  Income  (Expense)** |   | **Basis  Points** |   | **Amount** |   | **Basis  Points** |   |
|                                                                                                                  |   |                                        |       |                                        |       |                          |   |   |   |   |   |   |   |
| Loans sold, net                                                                                                       |   | $                                           | 2,608,531  |                                        | —     |                          | $      | 3,133,407 |   | — |   | $ | (524,876 | ) | — |   |
|                                                                                                                  |   |                                        |       |                                        |       |                          |   |   |   |   |   |   |   |
| Revenues:                                                                                                             |   |                                        |       |                                        |       |                          |   |   |   |   |   |   |   |
| Premiums                                                                                                              |   | 33,200                                      |       | 127.27                                      |       | 73,433                        |   | 234.35 |   | (40,233 | ) | (107.08 | ) |
| Broker fees                                                                                                           |   | 5,986                                       |       | 22.95                                       |       | 10,580                        |   | 33.76 |   | (4,594 | ) | (10.81 | ) |
| Mortgage broker premiums                                                                                              |   | (31,786                                     | )          | (121.86                                     | )          | (46,258                       | )      | (147.63 | ) | 14,472 |   | 25.77 |   |
| Premium recapture and loan loss provisions                                                                            |   | (1,871                                      | )          | (7.17                                       | )          | (1,679                        | )      | (5.36 | ) | (192 | ) | (1.81 | ) |
| Deferred origination costs                                                                                            |   | (3,206                                      | )          | (12.29                                      | )          | (3,104                        | )      | (9.91 | ) | (102 | ) | (2.38 | ) |
| **Gain on sales of loans**                                                                                            |   | **$**                                       | **2,323**  | ** **                                  | **8.91**   | ** **                    | **$**  | **32,972** | ** ** | **105.22** | ** ** | **$** | **(30,649** | **)** | **(96.31** | **)** |
| Derivative financial instruments and market  adjustments                                                              |   | 15,247                                      |       | 58.45                                       |       | (9,284                        | )      | (29.63 | ) | 24,531 |   | 88.08 |   |
| **Gain on sale of loans, after  derivative financial instruments and market adjustments (“gross margins”)** |   | **$**                                       | **17,570** | ** **                                  | **67.36**  | ** **                    | **$**  | **23,688** | ** ** | **75.59** | ** ** | **$** | **(6,118** | **)** | **(8.23** | **)** |
| Interest on mortgage assets                                                                                           |   | 8,994                                       |       | 34.48                                       |       | 7,561                         |   | 24.13 |   | 1,433 |   | 10.35 |   |
| Other income                                                                                                          |   | 66                                          |       | 0.25                                        |       | 35                            |   | 0.11 |   | 31 |   | 0.14 |   |
| **Total revenue (Mortgage Banking  Segment)**                                                                         |   | **$**                                       | **26,630** | ** **                                  | **102.09** | ** **                    | **$**  | **31,284** | ** ** | **99.83** | ** ** | **$** | **(4,654** | **)** | **2.26** | ** ** |

 

22

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Weexpect the trend of reduced loan production from 2003 levels to continue forthe remainder of 2004. The overall loan production market is contracting from$3.8 trillion in 2003 to $2.5 trillion in 2004 according to the MBA. The marketis projected to be $1.0 trillion in the second half of 2004.

 

Gainon the sales of loans decreased for the quarter ended June 30, 2004,primarily due to our decrease in volume of loan sales and narrower gross margins.Our gain on the sale of loans was made up of a combination of various accountcategories which are summarized in the chart above, and quantified in basispoints to loan sales volume. Premiums represent the price at which we sell theloans to investors in excess of the principal balance of loans sold. Brokerfees represent various charges to brokers for services rendered which aredeferred and recognized as part of the gain on the sales of the loans. Premiumsand broker fees are offset by capitalized (deferred) loan origination costs.The largest deferred cost associated with loan production is broker premiums,or yield spread premiums. Other offsets to gain on sale include (i) loanpremiums repaid to investors (“premium recapture”) and loan loss provisions and(ii) deferred origination costs, which are recognized at the time of loansale. Premium recapture expenses represent repayment of a portion of certainloan sale premiums to investors on previously sold loans which subsequentlypayoff within six months of loan sale. We sell a substantial portion of ourloans to two of our competitors.  If ourcompetitors stop purchasing our loans on favorable terms, we could be requiredto find alternate purchasers and/or accept unfavorable terms.  In either case, this could reduce ourrevenues and earnings.

 

Theuse of derivative financial instruments is key to protecting our profit marginsbetween the time of the interest rate lock to when the loan is sold to aninvestor. We use forward sales of mortgage backed securities (TBA) andoptions on forward sales of mortgage-backed securities as our primary hedginginstruments. Due to increases in mortgage interest rates during most of thesecond quarter of 2004 and decreases in interest rates in the second quarter of2003, we recorded net gains on derivative financial instruments of$15.2 million and net losses of $9.3 million, respectively.  During the second quarter of 2004, wecontinued with the same strategy of using forward sales of mortgage-backedsecurities and options on mortgage-backed securities.

 

Our gross margins were $17.6 million for the three months endedJune 30, 2004 or 67 basis points on $2.6 billion in loan sales volume adecline of $6.1 million from $23.7 million or 76 basis points on $3.1 billionin loan sales volume for the comparable period in 2003. Loan sales volumedeclined $525 million. This decline was a major contributor in our reduction inthe dollar amount of gross margins. The remaining decline was due to the loweroverall gross margins that resulted from lower pricing reflecting competitivepressures. In total, premium recapture and lossprovisions are comparable between quarters. However, loan loss provisionincreased by $1.2 million for the second quarter of 2004 versus the same periodin 2003, while premium recapture expense declined by $972.8 thousand. Theincrease in loan loss provision in the second quarter of 2004 was the resulttiming differences related the amount of loans subject to losses. Going forwardwe generally expect premium recapture expense to decline due to the overalldecline in refinance loans. Conversely while we believe that our underwritingprocess is sound and effective, loan loss provisions may increase in the futuredue to a higher mix of Alt-A loans which have more complex

 

23

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underwriting and are more likely to be rejected by investors if we sellloans which do not meet the investors’ underwriting criteria.

 

Mortgage loans are carried at the lower of cost or market value. Assuch, our loan sale gains are recognized at the time loan sale proceeds arereceived from investors. Consequently, any increase in the value of loans dueto interest rate movements will not yet be recorded in our gross margin, whilecorresponding losses caused by the same interest rate movements will berecorded in our gross margins. This situation occurred at both March 31, 2004and June 30, 2004. Our actual gross margin percentages in each quarter, afterconsidering the above mentioned timing differences, were close to our targetmargin percentages and accordingly, we believe that our hedging program wassuccessful in protecting profit margins on our loan originations in bothquarters.  However, our hedgingstrategies may not be successful in mitigating our risks associated withinterest rate changes in future periods. In particular, for new loan productswith large loan balances, short terms, and loan products with adjustable rates,our hedging process may not be effective at certain times.

 

Werecorded interest income of $9.0 million for the three months endedJune 30, 2004. We earn interest on a loan from the date the loan is fundeduntil final disposition. Accordingly, interest income is a function of thevolume of loans funded, the interest rate on the loans and the length of timethe loans are held prior to sale. To the extent we fund loans with borrowingsunder our warehouse facilities, we record interest expense based on the samefactors. Interest expense for the period was $4.4 million. The resultingnet interest income earned on loan inventories was $4.6 million,representing 18 basis points on second quarter 2004 loan production of$2.6 billion. For the comparable period ended June 30, 2003 interestincome was $7.6 million and interest expense was $3.4 million. Thisresulted in net interest earned of $4.2 million, representing 13 basispoints on second quarter 2003 loan production of $3.2 billion. Net interestincome increased in a rising interest rate environment because our cost offunds does not necessarily rise in conjunction with market interest rates.

 

Totalexpenses incurred in the Mortgage Banking Business for the three months endedJune 30, 2004 were approximately $25.2 million. Operating expenses, whichincluded all expenses except interest expense (employee compensation andbenefits, office and occupancy expense and other operating expenses), wereapproximately $20.8 million for the three months ended June 30, 2004.For the comparable period ended June 30, 2003, there were approximately$21.5 million of total expenses of which approximately $18.1 millionwere operating expenses. The increase in operating expenses in 2004 was due tothe ongoing expansion of our mortgage banking operations, which are comprisedof regional and branch loan production offices and headquarters operations. Forthe three months ended June 30, 2004, expenses included approximately$4.9 million in sales commissions, which vary in direct proportion withthe volume of funded loans, or approximately 19 basis points (.19%) on$2.6 billion in funded loans. Operating expenses totaled $20.8 million, orapproximately 80 basis points (.80%), on $2.6 billion in funded loans inthe second quarter of 2004. Total variable and fixed basis point operatingexpenses (which is a measurement of the cost per loan) increased for the threemonths ended June 30, 2004 and June 30, 2003 (from 56 basis points in2003 to 81 basis points in 2004). The operating cost per loan increased from$1,013 in 2003 to $1,421 per loan in the second quarter of 2004. The increasedcost per loan in 2004 compared to the cost in the second quarter of 2003 showsthat the reduced loan production in the second quarter of 2004 also reducedefficiency due to a larger branch system (over capacity in some branches) andhigher headquarters overhead.

 

Thetable below provides the relationship between estimated fixed, variable andtotal expenses for the three months ended June 30, 2004 and 2003 (dollarsin thousands) (unaudited):

 
| **2004  Mortgage Banking Expenses** |   | **Estimated Variable  Expenses** |       | **Estimated Fixed  Expenses** |       | **Total Expenses** |       |
|-------------------------------------|--------|----------------------------------|------------|-------------------------------|------------|--------------------|------------|
|                                |   |                             |       |                          |       |               |       |
| Employee compensation and benefits  |   | $                                | 6,067      |                          | $          | 8,196              |       | $ | 14,263 |   |
| Office and occupancy expense        |   | —                           |       | 959                           |       | 959                |       |
| Professional fees                   |   | 170                              |       | 918                           |       | 1,088              |       |
| Other operating expense             |   | 1,222                            |       | 3,238                         |       | 4,460              |       |
| **Total operating  expenses**       |   | **7,459**                        | ** ** | **13,311**                    | ** ** | **20,770**         | ** ** |
| Interest expense                    |   | 4,422                            |       | —                        |       | 4,422              |       |
| **Total expenses**                  |   | **$**                            | **11,881** | ** **                    | **$**      | **13,311**         | ** ** | **$** | **25,192** | ** ** |

 

24

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| **2003  Mortgage Banking Expenses** |   | **Estimated Variable  Expenses** |       | **Estimated Fixed  Expenses** |       | **Total Expenses** |       |
|-------------------------------------|--------|----------------------------------|------------|-------------------------------|------------|--------------------|------------|
|                                |   |                             |       |                          |       |               |       |
| Employee compensation and benefits  |   | $                                | 7,069      |                          | $          | 5,380              |       | $ | 12,449 |   |
| Office and occupancy expense        |   | —                           |       | 621                           |       | 621                |       |
| Professional fees                   |   | 293                              |       | 890                           |       | 1,183              |       |
| Other operating expense             |   | 1,468                            |       | 2,358                         |       | 3,826              |       |
| **Total operating  expenses**       |   | **8,830**                        | ** ** | **9,249**                     | ** ** | **18,079**         | ** ** |
| Interest expense                    |   | 3,447                            |       | —                        |       | 3,447              |       |
| **Total expenses**                  |   | **$**                            | **12,277** | ** **                    | **$**      | **9,249**          | ** ** | **$** | **21,526** | ** ** |

 

Theeffective federal and state tax rate for this segment was estimated to be 41%.  In 2003, we had a combined federal and stateeffective tax rate of approximately 30% primarily due to the realization of ouroperating loss carry forwards associated with our start-up operating losses.

 

Interestrate movements are difficult to predict, but it is recognized that interestrates on residential mortgages were historically low, and refinance demand wasvery strong during the latter part of the first quarter of 2004 andApril of the second quarter. Revised projections by the MBA (April 2004)for mortgage loan originations for the remainder of 2004 indicate an increasein interest rates and a reduction of refinance demand over the next 3 quarters.Our financial projections for the second half of 2004 assume an increase inloan production over first quarter 2004 levels, principally due to anexpectation of a larger sales force and continued market share penetration andgrowth.  Increased loan productionlevels and management of overhead expenses are the keys to achievingprofitability for the remainder of 2004. Wherever possible we are managingstaffing levels and utilizing as much of our existing infrastructure toprocess our loan production (adjust staffing size to an optimal level ofefficiency) while growing our sales presence in existing and new markets. In summary, we have been and will continueto expand our business operations, primarily in sales areas, and control ourfixed expenses in a contracting market. Our strategy requires us to capture an increasing percentage of themarket in a highly competitive environment, which will put pressure on ourgross margins.  If we are not able to dothis, we would likely experience losses due to our increased level of expenses.

 

Mortgage Asset Portfolio Business 

 

Our Mortgage Asset Portfolio Business recorded anet loss of $580.3 thousand for the three month period ending June 30,2004 as compared to an after tax gain of $3.0 million in 2003 for the sameperiod. This decline was due in large part to the expenses recorded upon thesale of approximately 85% of our portfolio assets.

 

Weheld mortgage assets of approximately $137.4 million as of March 31,2004. As of June 30, 2004 mortgage assets were approximately $21.0million.  This reduction was based on adecision to liquidate the majority of our remaining portfolio.

 

Themajority of our mortgage asset portfolio was sold in May 2004. As ofJune 30, 2004, we have received approximately $24.9 million in cash fromthe sales of portfolio assets, net of repayment of long-term debt (bonds). Werecorded approximately $880 thousand to the loss on bond collateral held forsale in the second quarter of 2004 which is included in the total valuationadjustment expense of $5.3 million for the six months ended June 30, 2004.We expect to receive approximately $1.7 million in cash (net of reserves) fromsale of the remaining loans to be sold subsequent to June 30, 2004. Thereis no debt associated with the remaining mortgage loans to be sold subsequentto June 30, 2004.

 

Asa result of the portfolio sale, the Mortgage Asset Portfolio Business willbecome a minor part of both revenue and expense on a consolidated basis. Forthe second quarter of 2004, total revenue was approximately $943 thousand whilein the second quarter of 2003, total revenue was $3.0 million. Expenses for thesecond quarter of 2004 were approximately $1.9 million, while expenses for thesecond quarter of 2003 were $2.1 million.

 

***Six Month Results***

 

MortgageBanking Business

 

OurMortgage Banking Business recorded net income of $2.8 million for thesix-month period ending June 30, 2004 as compared to net income of $11.7million in 2003 for the same period. These results were due in large part to(i) a 17% decrease in loan sales volume and revenues reflecting acontracted overall mortgage loan origination marketplace from 2003; (ii) adecreased gross margin on loan sales; and (iii) increased expensesreflecting the expansion of regional and branch offices over the past year.

 

25

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|                                                                                                                  |   | **Six Months  Ended  June 30, 2004**   |       | **Six Months  Ended  June 30, 2003** |      | **2004  Increase (Decrease)** |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|------------|-------------------------------------------|-----------|-------------------------------|--------|
|                                                                                                                  |   | **Amount  Income  (Expense)**               |       | **Basis  Points**                         |      | **Amount  Income  (Expense)** |   | **Basis  Points** |   | **Amount** |   | **Basis  Points** |   |
|                                                                                                                  |   | **($ amounts  in 000’s) (unaudited):** |       |
|                                                                                                                  |   |                                        |       |                                      |      |                          |   |   |   |   |   |   |   |
| Loans sold, net                                                                                                       |   | $                                           | 4,250,085  |                                      | —    |                          | $      | 5,115,817 |   | — |   | $ | (865,732 | ) | — |   |
|                                                                                                                  |   |                                        |       |                                      |      |                          |   |   |   |   |   |   |   |
| Revenues:                                                                                                             |   |                                        |       |                                      |      |                          |   |   |   |   |   |   |   |
| Premiums                                                                                                              |   | 71,942                                      |       | 169.27                                    |      | 116,832                       |   | 228.37 |   | (44,890 | ) | (59.10 | ) |
| Broker fees                                                                                                           |   | 10,168                                      |       | 23.92                                     |      | 16,283                        |   | 31.83 |   | (6,115 | ) | (7.90 | ) |
| Mortgage broker premiums                                                                                              |   | (55,440                                     | )          | (130.44                                   | )         | (71,216                       | )      | (139.21 | ) | 15,776 |   | 8.76 |   |
| Premium recapture and loan loss provisions                                                                            |   | (3,195                                      | )          | (7.52                                     | )         | (3,147                        | )      | (6.15 | ) | (48 | ) | (1.37 | ) |
| Deferred origination costs                                                                                            |   | (5,636                                      | )          | (13.26                                    | )         | (5,572                        | )      | (10.89 | ) | (64 | ) | (2.37 | ) |
| **Gain on sales of loans**                                                                                            |   | **$**                                       | **17,839** | ** **                                | **41.97** | ** **                    | **$**  | **53,180** | ** ** | **103.95** | ** ** | **$** | **(35,341** | **)** | **(61.98** | **)** |
| Derivative financial instruments and market  adjustments                                                              |   | 8,603                                       |       | 20.24                                     |      | (11,495                       | )      | (22.47 | ) | 20,098 |   | 42.71 |   |
| **Gain on sale of loans, after  derivative financial instruments and market adjustments (“gross margins”)** |   | **$**                                       | **26,442** | ** **                                | **62.21** | ** **                    | **$**  | **41,685** | ** ** | **81.48** | ** ** | **$** | **(15,243** | **)** | **(19.27** | **)** |
| Interest on mortgage assets                                                                                           |   | 14,008                                      |       | 32.96                                     |      | 13,462                        |   | 26.31 |   | 546 |   | 6.65 |   |
| Other income                                                                                                          |   | 145                                         |       | 0.34                                      |      | 51                            |   | 0.10 |   | 94 |   | 0.24 |   |
| **Total revenue (Mortgage Banking  Segment)**                                                                         |   | **$**                                       | **40,595** | ** **                                | **95.52** | ** **                    | **$**  | **55,198** | ** ** | **107.90** | ** ** | **$** | **(14,603** | **)** | **(12.38** | **)** |

 

Gainon the sales of loans decreased for the six months ended June 30, 2004,primarily due to our decrease in volume of loan sales and narrower marginsparticularly in the first three months of 2004. Our gain on the sale of loanswas made up of a combination of various account categories which are summarizedin the chart above, and quantified in basis points to loan sales volume.

 

Theuse of derivative financial instruments is a key to protecting our profit marginsbetween the time of the interest rate lock to when the loan is sold to aninvestor. Due to increases in mortgage interest rates during the lasthalf of the six month period ending June 30, 2004 and decreases ininterest rates for the same period of 2003, we recorded net gains on derivativefinancial instruments of $8.6 million and net losses of $11.5 million,respectively.

 

Our gross margins were $26.4 million for the six months endedJune 30, 2004 or 62 basis points on $4.3 billion in loan sales volume adecline of $15.2 million from $41.7 million or 81 basis points on $5.1 billionin loan sales volume for the comparable period in 2003.  Loan sales volume declined $866 million.This decline was a major contributor in our reduction in the dollar amout ofgross margins. The remaining decline was due to the lower overall gross marginsthat resulted from lower pricing reflecting competitive pressures. In total, premium recapture and loss provisions are comparablebetween quarters. However, loan loss provision increased by $1.4 millionfor the second quarter of 2004 versus the same period in 2003, while premiumrecapture expense declined by $1.3 million. Going forward we generally expectpremium recapture expense to decline due to the overall decline in refinanceloans. Conversely, while we believe that our underwriting process is sound andeffective, loan loss provisions may increase in the future due to a higher mixof Alt-A loans which have more complex underwriting and are more likely to berejected by investors if we sell loans which do not meet the investors’underwriting criteria.

 

Comparison between the first six months of 2003 and 2004 shows adecline in our gross margin rate from 81 basis points to 62 basis points.  Market conditions remain extremely competitiveas interest rates increased during most of the six month period endingJune 30, 2004.  Competitive pricingpressures remained a key factor in our reduced margins. Our actual gross marginpercentages in each six month period were close to our target marginpercentages and accordingly, we believe that our hedging program was successfulin protecting profit margins on our loan originations in both periods.

 

26

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Werecorded interest income of $14.0 million for the six months endedJune 30, 2004 and interest expense for the period was $6.8 million.The resulting net interest income earned on loan inventories was$7.2 million, representing 16 basis points on the first six months of 2004loan production of $4.4 billion. For the comparable period endedJune 30, 2003 interest income was $13.5 million and interest expensewas $6.1 million. This resulted in net interest earned of$7.4 million, representing 14 basis points for six months endingJune 30, 2003 loan production of $5.3 billion.

 

Totalexpenses incurred in the Mortgage Banking Business for the six months endedJune 30, 2004 were approximately $45.1 million. Operating expenses, whichincluded all expenses except interest expense (employee compensation andbenefits, office and occupancy expense and other operating expenses), wereapproximately $38.3 million for the six months ended June 30, 2004.For the comparable period ended June 30, 2003, there were approximately$38.5 million of total expenses of which approximately $32.4 millionwere operating expenses. The increase in operating expenses in 2004 was due tothe ongoing expansion of our mortgage banking operations, which are comprisedof regional and branch loan production offices and headquarters operations. Forthe six months ended June 30, 2004, expenses included approximately$8.2 million in sales commissions, which vary in direct proportion withthe volume of funded loans, or approximately 19 basis points (.19%) on$4.4 billion in funded loans. Operating expenses totaled $38.3 million, orapproximately 87 basis points (.87%), on $4.4 billion in funded loans.Total variable and fixed basis point operating expenses (which is a measurementof the cost per loan) increased for the six months ended June 30, 2004 andJune 30, 2003 (from 61 basis points in 2003 to 86 basis points in 2004).The operating cost per loan increased from $1,096 in 2003 to $1,518 per loanfor the six months ended June 30, 2004. The increased cost per loan in2004 compared to the cost in  2003 showsthat the reduced loan production in the second quarter of 2004 also reducedefficiency due to a larger branch system (over capacity in some branches) andhigher headquarters overhead.

 

Thetable below provides the relationship between estimated fixed, variable andtotal expenses for the six months ended June 30, 2004 and 2003 (dollars inthousands) (unaudited):

 
| **2004  Mortgage Banking Expenses** |   | **Estimated  Variable  Expenses** |       | **Estimated  Fixed  Expenses** |       | **Total  Expenses** |       |
|-------------------------------------|--------|-----------------------------------|------------|--------------------------------|------------|---------------------|------------|
|                                |   |                              |       |                           |       |                |       |
| Employee compensation and benefits  |   | $                                 | 9,868      |                           | $          | 16,095              |       | $ | 25,963 |   |
| Office and occupancy expense        |   | —                            |       | 1,795                          |       | 1,795               |       |
| Professional fees                   |   | 321                               |       | 1,680                          |       | 2,001               |       |
| Other operating expense             |   | 2,597                             |       | 5,951                          |       | 8,548               |       |
| **Total operating expenses**        |   | **12,786**                        | ** ** | **25,521**                     | ** ** | **38,307**          | ** ** |
| Interest expense                    |   | 6,767                             |       | —                         |       | 6,767               |       |
| **Total expenses**                  |   | **$**                             | **19,553** | ** **                     | **$**      | **25,521**          | ** ** | **$** | **45,074** | ** ** |
|                                |   |                              |       |                           |       |                |       |
| **2003  Mortgage Banking Expenses** |   | **Estimated  Variable  Expenses** | ** ** | **Estimated  Fixed  Expenses** | ** ** | **Total  Expenses** | ** ** |
|                                |   |                              |       |                           |       |                |       |
| Employee compensation and benefits  |   | $                                 | 11,341     |                           | $          | 10,253              |       | $ | 21,594 |   |
| Office and occupancy expense        |   | —                            |       | 1,188                          |       | 1,188               |       |
| Professional fees                   |   | 547                               |       | 1,725                          |       | 2,272               |       |
| Other operating expense             |   | 2,801                             |       | 4,520                          |       | 7,321               |       |
| **Total operating expenses**        |   | **14,689**                        | ** ** | **17,686**                     | ** ** | **32,375**          | ** ** |
| Interest expense                    |   | 6,122                             |       | —                         |       | 6,122               |       |
| **Total expenses**                  |   | **$**                             | **20,811** | ** **                     | **$**      | **17,686**          | ** ** | **$** | **38,497** | ** ** |

 

27

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Thetable below provides a six month comparative view of loan production for 2004and 2003 (unaudited):

 

 
|     |   | **(in  millions)** |   |
|----------|--------|--------------------|--------|
|     |   | **2004**           |   | **2003** |   |
| January  |   | $                  | 435    |   | $ | 598 |   |
| February |   | 558                |   | 618 |   |
| March    |   | 877                |   | 862 |   |
| April    |   | 1,147              |   | 1,030 |   |
| May      |   | 751                |   | 876 |   |
| June     |   | 666                |   | 1,301 |   |
|          |        |                    |        |  |  |  |  |

 

Mortgage Asset Portfolio Business

 

Our Mortgage Asset Portfolio Business recorded a net loss of $2.7million for the six month period ending June 30, 2004 as compared to netincome gain of $10 million in 2003 for the same period. This decline was due inlarge part to the expenses recorded upon the sale of approximately 85% of ourportfolio assts.

 

We held mortgage assets of approximately $161.3 million as ofDecember 31, 2003.  As ofJune 30, 2004 mortgage assets were approximately $21.0 million. Thisreduction was based on a decision to liquidate the majority of our portfoliopreviously explained in section titled “Three Month Results”.

 

For the six months ended June 30, 2004, total revenue wasapproximately $2.8 million while for the same period in 2003 total revenue was$6.6 million. Expenses for the first six months of 2004 were approximately $7.4million, while expenses for the same period of 2003 were $5.3 million.Approximately $5.3 million of expense the six month period ending June 30,2004 expenses are related to portfolio sales. Included in the total MortgageAsset Portfolio Business expense of approximately $7.4 million for the sixmonths ended June 30, 2004, are $5.3 million of valuation adjustmentexpense related to the sale of bond collateral.

 

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***Liquidity andCapital Resources***

 

*General*

 

Our sources of liquidity during the six months ended June 30, 2004primarily consisted of the following:

 

•                                          borrowingsunder our warehouse and other credit facilities;

 

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

 

•                                          sale of the majority of our Mortgage AssetPortfolio;

 

•                                          excessinterest spread in the Mortgage Asset Portfolio Business, net of repayments toservicers for past principal and interest advances on completed real estate owneddispositions.

 

Our primary cash requirements included:

 

•                                          fundingour mortgage loan originations;

 

•                                          hedginglosses;

 

•                                          interestexpense under our warehouse facilities;

 

•                                          operatingexpenses, including commissions;

 

•                                          repaymentof our borrowings;

 

•                                          repurchase of stock; and

 

•                                          maintaininga “restricted cash” account, which includes amounts required to be held bycertain warehouse line providers that may not be used in our operations or asequity for other warehouse lines of credit.

 

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

 

*Cash Generated By and Used In Our Operations*

 

During the six months ended June 30, 2004, on a consolidated basiswe had net positive cash flow of $6.5 million. The principal factors impactingour positive cash flow are:

 

•                  Net increases inour cash investment in loan inventories totaled approximately $4.4million.  Our warehouse line lendingagreements allow us to borrow from 96% to 99% of the lesser of par or marketvalue for each mortgage loan. We pay an additional 1% to 2% of the loanprincipal amount in fees or yield spread premium to the mortgage brokers.Lastly, a small portion of our loan inventory is funded with equity capital. Wetypically have cash invested totaling between 2% to 4% of the principal amountof loans held for sale, which is recouped when the loans are purchased byinvestors. Mortgage loans held for sale increased from approximately $276.8million at December 31, 2003 to approximately $466.3 million atJune 30, 2004. An increase in the amount of loan inventory, either byholding loans for longer periods, or due to increased loan funding volume, willcause cash reserves necessary to carry loan inventories to increase in directproportion to the inventory held.

 

•                  Sale of portfolio assets provided net cash of$24.9 million.

 

•                  Stock repurchaseof 511,490 shares for $4.5 million.

 

•                  Paid short term debt facility of $3.0million.

 

•                  Consolidated cash revenues collected exceededpayments of consolidated cash expenses by approximately $1.3 million.

 

•                  Weprepaid warehouse line facility fees and workers compensation premiums totaling$1.1 million, paid state taxes totaling $2.7 million (approximately  $2.5 million will be applied against futureCalifornia corporate income taxes), had capital expenditures that totaledapproximately $1.1 million, and paid 2003 accrued bonuses and incentives thattotaled approximately $2.8 million.

 

We anticipate that our future liquidity will be predominantly impactedby our mortgage banking activities. For the remainder of 2004, whereverpossible, we are managing staffing levels and utilizing as much of our existinginfrastructure to balance our loan production while growing our sales presencein existing and new markets. Our market share growth strategy is designed togenerate loan volumes from new customers and increased business with existingcustomers in order to sustain,

 

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and potentially increase loan production, despite a continuedcontraction in the overall loan origination market. We will attempt to increasethe proportion of variable costs while controlling fixed costs to minimizetotal expenses and maximize capacity utilization as we execute our market sharegrowth strategy. For the remainder of 2004, we expect to originate $650 millionto $750 million per month of new mortgage loans and fund these originationswith equity capital and warehouse facility borrowings. We expect our loaninventories to generally grow in proportion to growth in funding volume, andconsequently expect to make additional cash investments in loan inventories.  We also expect to continue to engage inhedging transactions that may require cash investment to maintain or adjusthedged positions. If our funding volumes do not generate sufficient revenues,we may utilize cash to fund operating losses. We intend to use cash reserves,borrowings under the warehouse facilities as well as cash flow generated fromthe origination and sale of mortgage loans, to fund our operations. We aretherefore dependent on significant levels of warehouse financing to helpexecute our mortgage banking strategy. Furthermore, we must originate minimumlevels of loans ($650 million to $750 million) to be profitable. See BusinessRisk Factors in Item 1. Management believes that our company hassufficient sources of liquidity at June 30, 2004 to meet anticipatedbusiness requirements for the foreseeable future.

 

*Short-Term Debt*

 

As ofJune 30, 2004, short-term debt consists of $454 million of revolvingcredit lines (warehouse facilities) used to fund our lending activities. As ofJune 30, 2004, mortgage loans held for sale totaling $466 millionwere pledged as collateral for the warehouse facilities. We are dependent onour warehouse lending facilities to operate our business.  We must maintain, renew or replace ourwarehouse lines of credit in order to continue to fund loans.  Our warehouse facilities consist ofborrowings of $454 million with four financial institutions. AtJune 30, 2004, our maximum available borrowings combined, from these fourfinancial institutions is $1.4 billion. These facilities typically advance96% to 99% of the lesser of par or market value of the loans pledged ascollateral. Such financing is currently provided primarily under (i) a364-day secured mortgage warehousing revolving credit agreement, dated as ofNovember 26, 2001, (the “Bank Credit Agreement”) with JPMorgan/Chase Bank;(ii) secured mortgage warehousing revolving credit agreement, originallydated March 28, 2002, (the “UBS Warburg Agreement”) with UBS Warburg RealEstate Securities Inc.; (iii) secured mortgage warehousing revolvingcredit agreement, originally dated October 11, 2002, (the “CountrywideAgreement”) with Countrywide Warehouse Lending, Inc.; and (iv) a 364-daysecured mortgage warehousing revolving credit agreement, dated as ofSeptember 15, 2003, (the “RFC Agreement”) with Residential FundingCorporation. These warehouse facilities are repaid as principal payments onmortgage loans are received, or as the mortgage loans are sold. The agreementsgoverning these facilities contain a number of covenants, including covenantsbased on tangible net worth, cash flows, net income, and liquidity of ourCompany. During the second quarter of 2004 certain loan agreement covenantswere modified to delay quarterly profitability threshold review until September30, 2004. As of June 30, 2004, we were in compliance with our warehouselending agreements. We believe we are in good standing with our warehouseproviders and is in the process of renegotiating warehouse lending covenantsand increasing warehouse loan limits. Any future reductions or restrictions inour warehouse capacity could reduce the volume of loans that we are able tofund and could therefore reduce our revenues and earnings.

 

In2001, we also entered into a $5 million senior subordinated securedrevolving loan agreement (Subordinated Loan Agreement). The Subordinated LoanAgreement bore interest at 12% and as of March 31, 2004, there was $3million in borrowings outstanding. The loan was paid off in April 2004 andthe Subordinated Loan Agreement was cancelled. We therefore will have nofurther access to this borrowing facility.

 

InApril of 2004, we entered into agreements to sell 85% of our mortgageportfolio assets. As a result, at March 31, 2004, we reclassifiedapproximately $90 million of our long-term debt to short-term debt. Netproceeds from the portfolio sales totaled approximately $24.9 million in thesecond quarter of 2004. We expect to receive an additional $1.7 million priorto December 31, 2004 from the remaining sixty loans held as of June 30,2004. As of July 31, 2004 forty-three mortgage loans remain unsold.

 

*Long-Term Debt—Non Recourse Mortgage- Backed Notes*

 

Ourlong-term debt consists of CMO/FASIT 1998-1 mortgage-backed notes, which arecollateralized by bond collateral mortgage loans and bond collateral realestate owned. Obligations under the mortgage-backed notes are payable solelyfrom the proceeds from the bond collateral and are otherwise non-recourse tothe Company.

 

*Rate Lock Commitments to Borrowers and Commitments to SellLoans*

 

Inthe ordinary course of business, we make rate lock commitments to borrowerswhich obligate us to fund mortgages at set interest rates. The values of theunderlying loans, and thus our expected gain on the subsequent funding and saleof these loans, may be impacted by subsequent changes in market interestrates. Accordingly, we attempt to protect (or hedge) our pricing margins byutilizing forward sales of TBAs and options on TBAs. The hedges typicallyincrease or decrease in value in correlation to offsetting decreases orincreases in the value of the loans. As loans fund, we typically sell or assignour hedges and enter into mandatory loan sale commitments with ourcorrespondent investors.

 

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The following table summarizes our rate lock commitments and ourcommitments to sell mortgage-backed securities and mortgage loans (dollars inthousands) (unaudited):

 
|                                                                   |   | **6/30/04** |    | **6/30/03** |   |
|------------------------------------------------------------------------|--------|-------------|---------|-------------|--------|
| Commitments to originate loans at set interest  rates                  |   | $           | 799,974 |        | $      | 1,811,795 |   |
| Forward sales of mortgage-backed securities (TBA  and options on TBAs) |   | 815,500     |    | 1,626,500   |   |
| Mandatory commitments to sell mortgage loans held  for sale            |   | 162,155     |    | 220,805     |   |
|                                                                        |        |             |         |             |        |  |  |

 

For the purposes of hedging our interest rate exposure on our pipeline,we make various assumptions in order to estimate the rate lock commitmentswhich will not close (fallout ratio). The fallout ratio is applied to the totalpipeline to arrive at the net exposure to interest rate changes in the market.The pipeline, after applying the fallout ratio, amounted to $473.4 million and$1,163.2 million at June 30, 2004 and 2003, respectively. Included in ourpipeline are uncommitted loans held for sale of $304.1 million and $355.5million at June 30, 2004 and June 30, 2003 respectively. The ratelock commitments on our pipeline are hedged utilizing forward sales ofmortgage-backed securities and options. Some of these commitments mayultimately be denied by our Company or declined by the borrower, and therefore,the commitment amounts do not necessarily represent future cash requirements.

 

*Lease and Long-Term Debt Commitments*

 

In order to better understand our future obligations under our leasesand long-term debt agreements, the table below shows our expected futurepayments for these debt instruments.

 
|                                                  |   | **Payments  Due by Period  (dollars in thousands) (unaudited)** |   |
|-------------------------------------------------------|--------|-----------------------------------------------------------------|--------|
| **Contractual Obligations as of  June 30, 2004** |   | **Total**                                                       |   | **Less than  1  Year** |   | **1-3  Years** |   | **3-5  Years** |   | **More Than  5  Years** |   |
|                                                  |   |                                                            |   |   |   |   |   |   |   |   |   |
| Long-Term Debt                                        |   | $                                                               | 18,043 |   | $ | 9,078 |   | $ | 6,576 |   | $ | 2,389 |   | $ | 0 |   |
| Operating Leases                                      |   | 11,253                                                          |   | 4,352 |   | 4,965 |   | 1,936 |   | — |   |
| Total                                                 |   | $                                                               | 29,296 |   | $ | 13,430 |   | $ | 11,541 |   | $ | 4,325 |   | $ | 0 |   |

 

Long-term debt is in theform of bonds which are directly tied to bond collateral (assets) and are inthe form of mortgage loans.

 

**BusinessRisk Factors**

 

**Risks Associated with Our MortgageBanking Business**

 

*We Have a Limited Operating History in the MortgageOrigination Industry, Which Makes it Difficult to Evaluate Our Current BusinessPerformance and Future Prospects*

 

OurCompany was formed in 1997 and operated as a mortgage REIT (mortgage portfolioinvestment) until the fourth quarter of 2001, at which time we beganoriginating and selling residential mortgages (mortgage banking). As a result,comparisons between financial performance in current quarters and past quartersmay not be helpful in evaluating our current performance or our futureprospects. The market for mortgage originations have been dominated byunprecedented levels of refinances in 2002 and 2003 due to historically low interestrates. While our executive officers have extensive mortgage origination andmortgage banking experience, and we have hired experienced personnel in ourmortgage banking subsidiary, the Company does not have a significant history asa mortgage banking company and many uncertainties exist as competitors addressthe significant contraction of the mortgage market. This may limit our abilityto evaluate our current performance and project our future performance.

 

*We Expect Our Fixed Operating Expenses to Continue toIncrease, Which May Adversely Affect Our Results of Operations*

 

OurMortgage Banking Business had a net loss ofapproximately $2.8 million (after income tax benefits) for the six monthperiod ended June 30, 2004. These losses were primarily attributable to adecline in loan funding volumes and revenues and higher overhead expenses ascompared to the same period in 2003. We expect to incur additional costsand expenses related to the expansion of our sales force and regionalunderwriting centers. If this expansion does not result in adequate revenues,our financial performance will suffer. We must generate approximately $650million to $750 million in sales volume per month, depending on pricing marginsachieved, to meet our expense obligations. We are expanding our businessoperations and increasing our fixed expenses in a contracting market.  Our strategy requires us to capture anincreasing percentage of the market in a highly competitive environment whichwill put pressure on our gross margins. If we are not able to do this, we would likely experience losses due toour increased level of expenses. In addition, we expect to realize income taxbenefits against future profits and taxes, some of the tax benefits may have tobe reversed (valuation account established) in the future if significantoperating losses occur, or if we determine at a future date that forecastedoperating profits may not be sufficient to fully utilize deferred tax assets.See “Overhead Expenses May Not Be Covered by Sufficient Revenues to SustainProfitable Operations.”

 

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*We May Not Be Able to Effectively Manage the Growth of OurBusiness*

 

Overthe past three years, we have experienced rapid growth. In the beginning of2001, we had approximately 20 employees. As of June 30, 2004, we hadapproximately 702 employees. Many of these employees have very limitedexperience with us and a limited understanding of our systems. Many of ourfinancial, operational and managerial systems were designed for a smallbusiness and have only recently been upgraded or replaced to support largerscale operations. If we fail to manage our growth effectively, our expensescould increase, negatively affecting our financial results.

 

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

 

The origination market was an estimated $3.8trillion in 2003 due to low interest rates which spurred both strong home salesand refinance demand. In 2004, the origination market is expected to contractto $2.5 trillion. Competitiveness will increase in this shrinking mortgagemarket, putting pressure on the market competitors to reduce revenues tosustain origination volumes and market share. Wherever possible we are managingstaffing levels and utilizing  ourexisting infrastructure to load balance our loan production while growing oursales presence in existing and new markets. Our expansion is based onincreasing variable costs while controlling fixed costs to minimize operatinglosses and maximizing capacity utilization. There can be no assurance that thisstrategy will be successful in the face of stiffening competition amid acontracting marketplace.

 

*Competition in the Mortgage Banking Industry and Demand forMortgages May Hinder Our Ability to Achieve or Sustain Profitable OriginationLevels*

 

Oursuccess in the Mortgage Banking Business depends, in large part, on our abilityto originate loans in sufficient quantity such that the gain on sales of loansnet of hedge costs are in excess of both fixed and variable overhead costs.There can be no assurance that we will be able to originate sufficient levelsof mortgages to achieve and sustain profitability. In originating and sellingloans, we compete with investment banking firms, savings and loan associations,banks, mortgage bankers and other entities originating residential 1-4 unitmortgages, many of which have greater financial resources than us. We also facecompetition from companies already established in these markets. In addition tothe level of home purchase activity, the origination market is directly tied tothe general level of interest rates and refinance activity. The originationmarket was an estimated $3.8 trillion in 2003, due to strong home sales, lowinterest rates and strong refinance demand. In 2004 the origination market isexpected to contract to $2.5 trillion. Competitiveness will increase in thisshrinking mortgage market, putting pressure on the market competitors to reducerevenues to sustain origination volumes and market share. We believe that thevariety and the price competitiveness of our loan products and customer servicelevels will allow us to gain market share over the next several years, even asthe overall market for mortgages declines; however, there can be no assurancethat we will be able to successfully and profitably compete.

 

*Overhead Expenses May Not Be Covered By Sufficient RevenuesTo Sustain Profitable Operations*

 

Wehave made a number of fixed overhead commitments to establish the operationaland administrative infrastructure necessary to support our loan originationbusiness. At June 30, 2004, lease commitments for headquarter and regionaloffices totaled approximately 169,800 square feet. There were 702 employees whichinclude 121 which are paid solely by commissions. The balance of employees aresalaried or hourly employees. In order to achieve profitability at thisstaffing level, our monthly loan sales volume must be approximately $700 to$900 million. By the end of the third quarter of 2004 we will have reducedour staffing level and other fixed expenses to enable profitable levels at the$650 to $750 million monthly sales volume level, but there can be no assurancethis can be accomplished. Since our revenues are tied directly to the level ofloan production and subsequent sale, it is imperative that we achieve aprofitable level of originations, and the level of future profitability frommortgage banking will be in direct correlation to the level of loan originationvolume. During the first six months of 2004, interest rates increased, and loanoriginations decreased to the point of unprofitability for the entire period.Interest rate movements are not easily projected and may adversely affectfinancial results in the future. There can be no assurances that we will beable to maintain loan origination volumes sufficient to cover our fixedoverhead costs, and should we incur significant operating losses, our capitalbase and cash reserves could be materially adversely impacted.

 

*Mortgage Banking Revenues Can Fluctuate From Period toPeriod Based on a Number of Factors*

 

Ouroperating results have and may in the future fluctuate significantly fromperiod to period as a result of a number of factors, including the volume of loanorigination, interest rates and the level of unrealized gains/losses in unsoldloans, pipeline loans or positions in derivative securities. Accordingly, theconsolidated net income of our Company may fluctuate from period to period.

 

*Our Financial Results Fluctuate As a Result of Seasonalityand Other Timing Factors, Which Makes It Difficult To Predict Our FuturePerformance and May Affect the Price of Our Common Stock*

 

Althoughthe refinance portion of our Mortgage Banking Business is not seasonal, ourpurchase business is generally subject to seasonal trends. During 2003, ourrefinance business grew to 90% of our activity. In 2004, as we return to morenormal markets and purchase and refinance activity become more equal,seasonality will again become a significant factor in our business. Seasonalitytrends reflect the general pattern of housing sales, which typically peakduring the spring

 

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andsummer seasons. Our quarterly operating results have fluctuated in the past andare expected to fluctuate in the future, reflecting the seasonality of theindustry.

 

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

 

*Contracting Mortgage Origination Market May Adversely ImpactOur Business*

 

According to the Mortgage Bankers Association, 2003was a record year with $3.8 trillion in mortgage loan originations; however,2004 is currently projected to be $2.5 trillion. This expected contraction isdue to generally higher mortgage interest rates and a decline in the level ofloan refinancing. We anticipate higher costs per loan and lower per loanrevenue as a direct consequence of the expected market contraction andincreased competition. Increased market share in existing markets and plannedexpansion into new markets may be insufficient to prevent an overall decline inresults of operations. The growth of our business may also be adverselyimpacted due to general market contractions. We are expanding our businessoperations and increasing expenses in a contracting market.  Our strategy requires us to capture anincreasing percentage of the market in a highly competitive environment, whichwill put pressure on our gross margins. If we are not able to accomplish this strategy, we would likelyexperience losses due to our increased level of expenses.

 

*Our Hedging Strategies May Not Be Successful in MitigatingOur Risks Associated With Interest Rate Changes*

 

Weuse forward sales of mortgage-backed loan securities (TBA) and options onmortgage-backed securities (MBS) which are classified as derivative financialinstruments, to provide a level of protection against interest rate risks. Whenrates change we expect to record a gain or loss on derivatives which would beoffset by an inverse change in the value of our rate lock commitments and loansnot yet committed for sale. We cannot assure you, however, that our use ofderivatives will offset all of our risk related to changes in interest rates.There have been periods, and it is possible that there will be periods in thefuture, during which we will incur losses after accounting for our derivativefinancial instruments. The derivative financial instruments we select may nothave the desired effect of reducing our interest rate risk. In addition, thenature and timing of hedging transactions may influence the effectiveness ofthese strategies. If we poorly design strategies or improperly executetransactions we could actually increase our exposure to interest rate risk andpotential losses. In addition, hedging strategies involve transaction and othercosts. We cannot assure you that our hedging strategy and the derivatives thatwe use will adequately offset the risk of interest rate volatility or that ourhedging transactions will not result in losses.

 

Weoffer loan programs of many terms, from thirty year fixed interest rate loansto one year adjustable rate loans. The hedging instruments used, on balance,correlate satisfactorily with the thirty and fifteen year loan programs. Thehedging instruments used for our shorter term loan programs and adjustableinterest rate loans have a somewhat lower correlation to changes in marketinterest rates than do thirty year term programs. Consequently, the design ofour hedge strategy may not be effective at certain times and this occurrencecould be amplified for these shorter term loan programs.

 

*Volatility in Interest Rates May Adversely Affect OurResults of Operations and Our Financial Position*

 

Ourprimary source of revenue is from gains on sales of loans, net of gains orlosses on derivative financial instruments. We set rates and pay brokerpremiums for loans we fund based on a pricing process designed to create atargeted profit margin on each loan. Appropriately pricing these loans can becomplex, and we may not always successfully price our loans with adequatemargin to compensate us for the risk of interest rate volatility.

 

Thevalue of the mortgage loans that we originate is at risk due to fluctuations ininterest rates during two time periods: (1) the period beginning when wehave committed to funding the loan (rate lock commitments) and ending when theloan closes, or funds; and (2) the time period beginning when the loancloses and ending when we commit to sell, or sell the loans to third-partypurchasers (uncommitted loans). These rate lock commitments and uncommittedloans held for sale are collectively referred to as our pipeline. To manage theinterest rate risk of our pipeline, we continuously project the percentage ofthe pipeline loans we expect to close. Because projecting a percentage ofpipeline loans that will close is especially difficult during periods ofvolatile interest rates, we cannot assure that our projections will beaccurate. On the basis of such projections, we use forward sales ofmortgage-backed securities (TBA) and options on MBS, which are classified asderivative instruments. These “hedges” are designed to mitigate the adverseimpact interest rate fluctuations may have on the value of the pipeline. Ouruse of hedges is based in part on our estimates as to the percentage of loansthat will close, and therefore we cannot assure you that our use of derivativesecurities will offset the risk of changes in interest rates.

 

Ifinterest rates change, the actual percentage of pipeline loans that close maydiffer from the projected percentage. A sudden significant increase in interestrates can cause a higher percentage of pipeline loans to close than projected.We may not have made forward sales commitments to sell these additional loansand consequently may incur significant losses upon their sale at current marketprices, which may not be offset by gains in the value of derivative securities,adversely affecting results of operations. Likewise, if a lower percentage ofpipeline loans closes than was projected, due to a sudden decrease in interestrates or otherwise, we have and may in the future adjust our hedge positions ormandatory sales commitments at a significant cost, adversely affecting ourresults of operations. This risk is greater during times of interest ratevolatility.

 

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*We Are Subject to Counterparty Risks on Loan SaleCommitments and Hedging Transactions*

 

Inconnection with our mortgage loan sales, which involve the sale of mortgageloans and mortgage-backed securities on a forward or other deferred deliveryand payment basis, we may enter into forward sales of mortgage-backedsecurities (TBA) and options on MBS in connection with our hedging activities.We have credit risk exposure to the extent purchasers/sellers are unable tomeet the terms of their forward purchase/sale contracts. As is customary in themarketplace, none of the forward payment obligations of any of ourcounterparties is currently secured or subject to margin requirements. Weattempt to limit our credit exposure on forward sales arrangements on mortgageloans and mortgage-backed securities by entering into forward contracts onlywith institutions that we believe are acceptable credit risks, and which havesubstantial capital and an established track record in correspondent lending.We further attempt to limit our credit exposure on hedging transactions bydealing with a wide variety of firms. If counterparties do not perform, ourresults of operations may be adversely affected.

 

*Failure to Renew and Obtain Adequate Financing May AdverselyAffect Results Of Operations*

 

We currently have revolving warehouse borrowing facilities in placetotaling $1.4 billion. These facilities enable AmNet to fund up toapproximately $1.6 billion on a monthly basis. In order to continue ouroperations, we must maintain, renew or replace warehouse lines of credit. Thereare a number of financial institutions which specialize in lending to mortgagebanking companies and these types of secured borrowings. We expect to renew ourcurrent warehouse facilities with JP Morgan/Chase Bank, UBS Warburg Real EstateSecurities, Countrywide Warehouse Lending, Inc. and Residential FundingCorporation. Failure to renew facilities would limit our potential to fundloans and may adversely affect our financial results. Among the factors thatwill affect our ability to renew and expand our warehouse line borrowings arefinancial market conditions and the value and performance of our Company priorto the time of such financing. There can be no assurance that any suchfinancing can be successfully completed at advantageous rates or at all. Ourwarehouse credit facilities contain extensive restrictions and covenants that,among other things, require us to satisfy specified financial, asset qualityand loan performance tests. If we fail to meet or satisfy any of thesecovenants, we would be in default under these agreements and our lenders couldelect to declare all amounts outstanding under the agreements to be immediatelydue and payable, enforce their interests against collateral pledged under suchagreements and restrict our ability to make additional borrowings. During thesecond quarter of 2004 certain loan agreement covenants were modified to delayquarterly profitability threshold review until September 30, 2004. There can beno assurance that we will be able to comply with these delayed thresholdreviews. These agreements also contain cross-default provisions, so that if adefault occurs, under one agreement, the lenders under our other agreementscould also declare a default. Any default under our credit facilities couldhave an adverse effect on our financial results. As of June 30, 2004, wewere in compliance with our warehouse lending agreements.

 

Thecovenants and restrictions in our warehouse credit facilities may restrict ourability to, among other things:

 

•                                          incur additional debt by virtue of havingwarehouse loan covenants;

 

•                                          make certain investments or acquisitions;

 

•                                          repurchase or redeem capital stock;

 

•                                          engage in mergers or consolidations;

 

•                                          finance loans with certain attributes;

 

•                                          reduce liquidity below certain levels; and

 

•                                          hold loans for longer than established timeperiods.

 

Theserestrictions may interfere with our ability to obtain financing or to engage inother business activities, which may significantly harm our business financialcondition, liquidity and results of operations.

 

*We Sell a Substantial Portion of Loans We Originate toCompetitors*

 

Wehave warehouse line facilities with Countrywide. We also sell a portion of ourloans to two of our competitors, Countrywide Home Loans, Inc., 62% in the first six months of 2004, and 16% were sold to Wells Fargo for the same timeperiod. If either Countrywide or Wells Fargo changes its correspondent lendingstrategy or procedures, or stops purchasing our loans on favorable terms, wecould be required to find alternate purchasers and/or accept unfavorable terms.We could also be forced to find other sources of warehouse line lending. Any ofthese results may have an adverse effect on our results of operations.

 

*Dependency on Correspondent Investors, Secondary Markets*

 

Ourability to generate gains on the sale of mortgages is largely dependent uponthe continuation of correspondent lending programs offered by largecorrespondent lenders, as well as our continued eligibility to participate insuch programs. Although we are in good standing with a number of largecorrespondent lenders and are not aware of any proposed discontinuation of, orsignificant reduction in, the operation of such programs, any such changescould have a material

 

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adverseeffect on our operations. We anticipate that we will continue to remaineligible to participate in such programs, but any significant impairment ofsuch eligibility would materially adversely affect our operations.

 

*Our Origination Activity Is Concentrated In California,Making Our Results Subject to Adverse Economic Conditions In California.*

 

Alarge proportion of loans we fund areconcentrated in California (26.2% of allloans closed for the six month period ended June 30, 2004). Although wehave expanded our operations on the East Coast of the United States, asignificant portion of our loan origination volume is likely to be based inCalifornia for the foreseeable future. Consequently, our results of operationsand financial condition are dependent upon general trends in the Californiaeconomy and its residential real estate market. Residential real estate marketdeclines may adversely affect the levels of new mortgages in California or thevalue paid by correspondent lenders for loans in California, potentiallyadversely affecting our results of operations and financial condition.

 

*Non-saleable or Repurchased Loans May Adversely ImpactResults of Operations and Our Financial Position*

 

Inconnection with the sale of loans to correspondent investors, we make a varietyof representations and warranties regarding the loans, including those that arecustomary in the industry relating to, among other things, compliance withlaws, regulations and investor program standards and the accuracy ofinformation on the loan documents and in the loan file. In the event that aninvestor finds that a loan or group of loans violates our representations, theinvestor may require us to repurchase the loan or loan group and bear anypotential related loss on the disposition of the loans, or provide anindemnification for any losses sustained by the investor on the loans.Additionally, we may originate a loan that does not meet investor underwritingcriteria or has some other defect, requiring us to sell the loans at asignificant discount. We have hired experienced personnel at all levels andhave established significant controls to ensure that all loans are originatedto our underwriting standards, and are maintained in compliance with all of therepresentations made by us in connection with our loan sale agreements.However, there can be no assurances that mistakes will not be made or thatcertain employees will not deliberately violate our lending policies and,accordingly, we are subject to repurchase risk and losses on unsaleable loans.Typically, with respect to any loan that might be repurchased or unsaleable, wewould correct the flaws if possible and re-sell the loan in the market. We havecreated repurchase reserves to provide for this contingency on our financialstatements, but there can be no assurances that loan losses associated withrepurchased or unsaleable loans will not adversely impact results of operationsor the financial condition of our Company.

 

*The Company is Beginning to Lend to Sub-prime Borrowerswhich May Adversely Affect Earnings*

 

Beginningin March of 2004, the Company began lending to sub-prime borrowers. Creditrisks associated with sub-prime mortgage loans will be greater than thoseassociated with mortgage loans that conform to FNMA and FHLMC guidelines. Theprincipal difference between sub-prime mortgage loans and conforming mortgageloans is that sub-prime mortgage loans typically include one or more of thefollowing: worse credit and income histories of the mortgagors, higherloan-to-value ratios, reduced or alternative documentation required forapproval of the mortgagors, different types of properties securing the mortgageloans, higher loan sizes and the mortgagor’s non-owner occupancy status withrespect to the mortgaged property. We have added personnel in a centralizedsub-prime underwriting and funding center to help mitigate the risks associatedwith these loans, however there can be no assurance that all sub-prime loanswill be able to be sold to investors at a profit. If we are not successful, higheroverhead incurred to produce these loans may not be covered by the incomederived from sub-prime lending.

 

*Our of Recourse Reserve is Difficult to Estimate Given OurLimited History in the Mortgage Banking Business*

 

Webegan our Mortgage Banking segment in November of 2001. Mortgage loans wesell to investors provide for repurchase of loans which become delinquentwithin varying timeframes. Our limited history makes it difficult to assess theamount of recourse reserves which should be provided given these recoursearrangements. Therefore there is no assurance that our recourse reserves areadequate.

 

*The Nationwide Scope of Our Operations Exposes Us to Risksof Noncompliance with an Increasing and Inconsistent Body of Complex Laws andRegulations at the Federal, State and Local Levels*

 

Weoriginate mortgage loans in many states. We must comply with the laws andregulations, as well as judicial and administrative decisions, of all of thesejurisdictions, as well as an extensive body of federal laws and regulations.The volume of new or modified laws and regulations has increased in recentyears, and, in addition, individual cities and counties have begun to enactlaws that restrict loan origination activities in those cities and counties.The laws and regulations of each of these jurisdictions are different, complexand, in some cases, in direct conflict with each other. As our operationscontinue to grow, it may be more difficult to comprehensively identify, toaccurately interpret and to properly program our technology systems andeffectively train our personnel with respect to all of these laws andregulations, thereby potentially increasing our exposure to the risks ofnoncompliance with these laws and regulations.

 

Ourfailure to comply with these laws can lead to the following consequences, anyof which could have an adverse effect on our ability to operate our businessand our financial results:

 

35

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•                                          civil and criminal liability;

 

•                                          loss of approved status;

 

•                                          demands for indemnification or loanrepurchases from purchasers of our loans;

 

•                                          class action lawsuits;

 

•                                          assignee liability, which may make our loansunsaleable; and

 

•                                          administrative enforcement actions.

 

*The Increasing Number of State and Local “Anti-predatoryLending” Laws May Restrict Our Ability to Originate or Increase Our Risk ofLiability With Respect To Certain Mortgage Loans and Could Increase Our Costsof Doing Business*

 

Inrecent years, several federal, state and local laws, rules and regulations havebeen adopted, or are under consideration, that are intended to eliminateso-called “predatory” lending practices. These laws, rules and regulationsimpose certain restrictions on loans on which certain points and fees or theannual percentage rate (“APR”) exceeds specified thresholds. Some of theserestrictions expose a lender to risks of litigation and regulatory sanction nomatter how carefully a loan is underwritten. In addition, an increasing numberof these laws, rules and regulations seek to impose liability for violations onpurchases of loans, regardless of whether a purchaser knew of or participatedin the violation.

 

Itis against our policy to engage in predatory lending practices, and we havegenerally avoided originating loans that exceed the APR or “points and fees”thresholds of these laws, rules and regulations, because the companies that buyour loans and/or provide financing for our loans origination operationsgenerally do not want to buy or finance such loans. The continued enactment ofthese laws, rules and regulations may prevent us from making certain loans andmay cause us to reduce the APR or the points and fees on loans that we do make.In addition, the difficulty of managing the risks presented by these laws, rulesand regulations may decrease the availability of warehouse financing and theoverall demand for loans, making it difficult to fund, sell or securitize anyof our loans. If we relax our restrictions on loans subject to these laws,rules and regulations because the companies which buy our loans and/or providefinancing for our loan origination operations relax their restrictions, we willbe subject to greater risks for actual or perceived non-compliance with suchlaws, rules and regulations, including demands for indemnification or loanrepurchases from our lenders and loan purchasers, class action lawsuits,increased defenses to foreclosure of individual loans in default, individualclaims for significant monetary damages and administrative enforcement actions.The growing number of these laws, rules and regulations will likely increaseour cost of doing business as we are required to develop systems and proceduresto ensure that we do not violate any aspect of these new requirements. Any ofthe foregoing could materially and adversely affect our business, financialcondition, liquidity and results of operations.

 

*An Interruption In or Breach of Our Information Systems MayResult In Lost Business*

 

Werely heavily upon communications and information systems to conduct ourbusiness. As we implement our growth strategy and increase our volume of loanproduction, that reliance will increase. Any failure or interruption or breachin security of our information systems or the third-party information systemson which we rely could cause underwriting or other delays and could result infewer loan applications being received, slower processing of applications andreduced efficiency in loan servicing. We utilize proprietary software for ourmain loan origination system. This software is not fully documented and we havea limited number of employees who are knowledgeable about this program. Wecannot assure you that systems failure or interruptions will not occur, or ifthey do occur that they will be adequately addressed by us or the third partieson which we rely. The occurrence of any failures or interruptions couldsignificantly harm our business.

 

*The Success and Growth of Our Business Will Depend Upon OurAbility to Adapt to, Implement and Maintain Technological Changes*

 

Ourmortgage loan origination business is currently dependent upon our ability toeffectively interface with our brokers, borrowers and other third parties andto efficiently process loan applications and fund loans. The originationprocess is becoming more dependent upon technological advancement, such as theability to process applications over the internet, accept electronicsignatures, and provide process status updates instantly and othercustomer-expected conveniences that are cost-efficient to our process.Implementing this new technology and becoming proficient with it may alsorequire significant capital expenditures. As these requirements increase in thefuture, we will have to fully develop these technological capabilities toremain competitive or our business will be significantly harmed.

 

*We Must Attract and Retain Qualified Account Executives andQualified Personnel to Produce Our Desired Level of Revenues*

 

TheCompany relies on commissioned account executives to generate loan referralsfrom professional mortgage brokers. These account executives typically haveestablished relationships with broker clients. The Company’s overall loanfundings are in direct proportion to the number of account executives, and assuch, sustained loan production and market share growth are dependent on thesuccessful retention and recruitment of the sales force. Similarly, the Companyrelies on

 

36

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theexpertise of its employees in other facets of operations, includingunderwriting, capital markets, risk management, and finance and accounting.Given the dependency on the job market for qualified employees, to continue ourgrowth poses the potential risk that the Company will not be able to attractand retain qualified employees.

 

*Capital Shortages Could Impede the Ability to Execute OurMortgage Banking Strategy*

 

Ourmortgage banking activities require a significant level of cash reserves andcapital to support loan inventories and overhead exposure. Additionally, whilewe utilize warehouse credit facilities to fund our loan origination activity,we must invest cash equity in our loan inventories approximating 1% to 4% ofthe cost basis of these loans. While we believe our capital base, cash reservesand cash flow from the sale of a majority of our Mortgage Asset PortfolioBusiness and mortgage banking revenues will be sufficient to enable us toexecute our mortgage banking strategy, there can be no assurances that capitalshortages will not occur, requiring us to raise additional debt or equitycapital or decrease or cease our origination activities.

 

*We Are Subject To Losses Due To Fraudulent Acts On The PartOf Loan Applicants, Employees or Mortgage Brokers*

 

Mortgagebrokers who assist loan applicants in obtaining mortgage loans refer all of themortgage loans originated by us. As such, the loan application, propertyappraisal, credit report and other supporting documentation are furnished bythe mortgage broker and used by our underwriters to make approval or denial decisions.There could also be the potential of collusion between the broker and anemployee to produce a fraudulent loan. Our employees usually have littlecontact with applicants, and rely on the mortgage broker to obtain and furnishall of the documentation supporting the mortgage loan application. Mortgagebrokers may make mistakes in completing the documentation for a loan leading toan increased risk of our holding a non-saleable loan or of indemnifying orrepurchasing loans from investors.

 

Further,in rare cases, the mortgage broker may knowingly or unknowingly submit anapplication wherein multiple parties to the transaction (borrower, appraiser,seller, or title insurer) work in collusion to inflate the property valueand/or falsify other documentation in order to obtain a mortgage loan. Thesetypes of fraudulent mortgage loans will have a high risk of default, and willlikely not be fully recoverable through disposition of the underlying propertysecuring the mortgage loans.

 

Shouldmaterial fraud be detected on a mortgage loan prior to sale to an investor, themortgage loan may have to be sold at a significant discount or may not besaleable. Should material fraud or mistakes in loan documentation be detectedafter a mortgage loan is sold to a correspondent investor, we may be requiredto repurchase the loan or indemnify the investor. While the investor and/or wecan initiate foreclosure proceedings on any loan deemed to be fraudulentlyobtained, we could incur significant losses on these fraudulent mortgage loansif principal or interest is not fully recovered through the foreclosure anddisposition of the underlying property securing the mortgage loan.

 

Wehave established risk management and quality control committees to set policyand manage exposure to credit losses due to fraud, compliance errors ornon-compliance with our underwriting standards. Regular quality control auditsare done on representative samples of mortgage loans and all mortgage loanssubmitted by brokers who come under suspicion in the normal course business.Additionally, we have numerous controls and processes to ensure that all of themortgage loans applications submitted through mortgage brokers are not based onfraudulent or intentionally misrepresented documentation. However, there can beno assurances that the broker and/or borrowers do not submit fraudulent orinaccurate documentation that is not detected by our personnel or by electronicfraud checks utilized by us. Should we originate significant numbers offraudulent loan or loans based on inaccurate documentation, our results ofoperations and financial condition could be materially adversely affected.

 

*If We Are Unable to Maintain and Expand Our Network ofIndependent Brokers, Our Loans Origination Business Will Decrease*

 

Allof our mortgage loan originations come from independent brokers. Our brokersare not contractually obligated to do business with us. Many of our brokershave not been in business more than a few years. Further, our competitors alsohave relationships with our brokers and actively compete with us in our effortsto expand our broker networks. Accordingly, we cannot assure you that we willbe successful in maintaining our existing relationships or expanding our brokernetworks, the failure of which would significantly harm our business, financialcondition, liquidity and results of operations.

 

*We May be Subject to Fines or Other Penalties Based Upon theConduct of Our Independent Brokers*

 

Themortgage brokers from which we obtain loans have legal obligations to whichthey are subject. While these laws may not explicitly hold the originatinglenders responsible for the legal violations of mortgage brokers, increasinglyfederal and state agencies have sought to impose such assignee liability.Recently, for example, the United States Federal Trade Commission (“FTC”)entered into a settlement agreement with a mortgage lender in which the FTCcharacterized a broker that had placed all of its loan production with a singlelender as the “agent” of the lender, and the FTC imposed a fine on the lenderin part because, as “principal,” the lender was legally responsible for themortgage broker’s unfair and deceptive acts and practices. The United StatesJustice Department in the past has sought to hold a mortgage lender responsiblefor the pricing practices of its mortgage brokers, alleging that the mortgagelender was directly responsible for

 

37

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thetotal fees and charges paid by the borrower under the Fair Housing Act even ifthe lender neither dictated what the mortgage broker could charge nor kept themoney for its own account. Accordingly, we may be subject to fines or otherpenalties based upon the conduct of our independent mortgage brokers.

 

*A Housing and Urban Development Department (“HUD”) ProposedRule to Reform Real Estate Settlement Procedures (“RESPA”) May Adversely Affectthe Way We Conduct Business with Mortgage Brokers*

 

HUDis proposing to improve the manner in which mortgage broker fees are disclosed byrequiring that yield spread premiums (“YSP”) (and other mortgage brokercompensation) be reported as payments from the lender. The purpose of thiswould be to have the mortgage broker only receive direct compensation fromborrowers and attempt to eliminate disputes regarding improper broker payments.This proposed rule may adversely affect our business by requiring changes insystems and procedures which may cause delays and re-work to meet regulatoryrequirements.

 

**Risks Associated with Our Mortgage Asset Portfolio Business**

 

InMay 2004, we sold the majority of our bond collateral mortgage loans andbond collateral real estate owned. Proceeds from the sale were used to retire $116.0 million of bond debt, leaving $18.0 million of bond debt at June 30, 2004.As such, the Mortgage Asset Portfolio Business is not expected to have amaterial impact on the Company’s financial statements going forward. The risksassociated with our remaining Mortgage Asset Portfolio Business are outlined inour 2003 form 10-K filed with the SEC on March 30, 2004.

 

*The Purchasers of the PortfoliosFailed to Purchase all of the Bond Collateral and We Are Now Trying  to Sell the Remainder of  the Assets to Another Purchaser or Attemptto Enforce Remedies under Representations and Warranties Obtained from theOriginal Seller/Servicers Which May No Longer be Enforceable*

 

Inconnection with their due diligence, the firms purchasing the majority of theremaining bond collateral rejected approximately $4.5 million of certain loansdue to non-compliance with regulatory requirements in place at the time theloans were originated.  We haveprotections under the representation and warranties provided by the originalseller/servicers from which we purchased the loans, and we expect to successfullyexercise those remedies. Some of the rejected loans were subsequently sold toother buyers and closed prior to June 30, 2004. Remaining rejected loansare being put out to bid and are expected to be sold prior to December 31,2004. The cost and losses expected to be incurred from the final disposition ofthe rejected mortgage loans has been accrued in our financial statements,however there can be no assurances that these provisions will besufficient.  As of June 30, 2004 wehad approximately $1.7 million of these loans which are carried at theirestimated realizable value.

 

However,the protections afforded by the representations and warranties obtained fromthe original seller/servicer may no longer be enforceable. Certainsellers/servicers may no longer be in existence or the passage of time may haverendered the claim for a breach uncertain. In this event, we would need tore-sell or refinance the collateral and potentially incur cost or losses in thedisposition of these assets and potentially utilize cash recourses to carrythese assets in the meantime. Accordingly, while we have received approximately $24.9 million in loansale proceeds and expect to receive an additional $1.7 million in loan saleproceeds before December 31, 2004; there can be no assurance all of the$1.7 million will be received or significant delays in loan sales will notoccur.

 

ITEM 3.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

 

Aprimary market risk facing our Company is interest rate risk, which is highlysensitive to many factors, including governmental monetary and tax policies,domestic and international economic and political considerations and otherfactors beyond our control. We attempt to manage this risk in our MortgageBanking and Mortgage Asset Portfolio Businesses.

 

**Mortgage Banking Business**

 

*Interest Rate Risk*

 

Ratelock commitments and mortgage loans held for sale are subject to market pricefluctuation until committed for sale. These fluctuations are primarily tied tochanges in market interest rates and the relationship of short-term rates tolong-term rates. In order to mitigate this risk, a variety of financialderivative instruments (including forward mandatory mortgage security sales(TBA) and options on TBA sales) are utilized to hedge or mitigate market pricefluctuations. These instruments are classified as derivative financialinstruments on our financial statements. Our hedge positions are continuallyadjusted based on routine and ongoing quantification of our risk, but hedgesmay or may not be fully successful in complete risk mitigation. In particular,our capital markets personnel must make estimates of the percentage of ratelock commitments expected to close under different interest rate changes.Losses on the sale of mortgage loans not offset by corresponding gains on hedgepositions, or hedging activity not offset by corresponding gains on the sale ofmortgages, could adversely impact 

 

38

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resultsof operations and our financial position.

 

**Mortgage Asset Portfolio Business**

 

*Interest Rate Risk*

 

Ouroperating results for this business segment will depend in large part ondifferences between the income earned from our assets (net of credit losses)and our borrowing costs. All but $1.7 million of this business segment’s bondcollateral and real estate owned are pledged as collateral for long-term debt(securitizations). In most cases, the income from assets will respond moreslowly to interest rate fluctuations than the cost of borrowings, which createsa mismatch between asset yields and borrowing rates.  Consequently, changes in interest rates, particularly short-terminterest rates, may influence the Mortgage Asset Portfolio Business net income.Long-term debt interest rates are tied to LIBOR.  Increases in these rates will tend to decrease net income fromthe Mortgage Asset Portfolio Business.

 

*Other Risks*

 

Wehave sold approximately 85% of ourportfolio and retired related debt. As of June 30, 2004 approximately $1.7 million of mortgage loans were notaccepted by buyers of our portfolio sale. We are currently seeking other buyers for these loans.   If new buyers cannot be located we may haveto arrange alternative short-term financing and our costs of carrying theseassets could increase significantly. Our estimates of net proceeds and expensescould also be affected by these changes.

 

**Sensitivity Analysis**

 

Themethods we have used in our sensitivity analysis have not changed significantlysince December 31, 2003. Our mortgage asset portfolio (although diminishedin size as a result of asset sales) is subject to interest rate risk.

 

Wehave performed various sensitivity analyses that quantify the net financialimpact of changes in interest rates on our interest rate-sensitive assets,liabilities and commitments. These analyses presume an instantaneous parallelshift of the yield curve. Various techniques are employed to value theunderlying financial instruments, and these techniques rely upon a number ofcritical assumptions. The scenarios presented in the table below areillustrative. Actual experience may differ materially from the estimatedamounts presented for each scenario. To the extent that yield curve shifts arenon-parallel, and to the extent that actual variations in significant assumptionsdiffer from those applied for purposes of the valuations, the resultantvaluations can also be expected to vary. Such variances may prove material.

 
|                                                                   |   |                    |    |                      |   | **If  Interest Rates Were To**             |   |
|------------------------------------------------------------------------|--------|-------------------------|---------|---------------------------|--------|--------------------------------------------|--------|
|                                                                   |   | **June 30,  2004** |    | **Increase**              |   | **Decrease**                               |   | **Increase** |   | **Decrease** |   |
|                                                                   |   | **Carrying  Amount**    |    | **Estimated  Fair Value** |   | **50 Basis  Points  Estimated Fair Value** |   | **100 Basis  Points  Estimated Fair Value** |   |
| Interest-earning assets:                                               |   |                    |    |                      |   |                                       |   |   |   |   |   |   |   |
| Cash and cash equivalents                                              |   | $                       | 50,944  |                      | $      | 50,944                                     |   | $ | 50,944 |   | $ | 50,944 |   | $ | 50,944 |   | $ | 50,944 |   |
| Mortgage loans held for sale, net, pledged,  (lower of cost or market) |   | 466,281                 |    | 471,347                   |   | 465,618                                    |   | 475,867 |   | 459,672 |   | 480,102 |   |
| Bond collateral and real estate owned, net                             |   | 19,257                  |    | 19,641                    |   | 19,637                                     |   | 19,647 |   | 19,635 |   | 19,653 |   |
| Total interest-earning assets                                          |   | $                       | 536,482 |                      | $      | 541,932                                    |   | $ | 536,199 |   | $ | 546,458 |   | $ | 530,251 |   | $ | 550,699 |   |
|                                                                   |   |                    |    |                      |   |                                       |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                                          |   |                    |    |                      |   |                                       |   |   |   |   |   |   |   |
| Short-term debt                                                        |   | $                       | 453,808 |                      | $      | 453,808                                    |   | $ | 453,808 |   | $ | 453,808 |   | $ | 453,808 |   | $ | 453,808 |   |
| Long-term debt, net                                                    |   | 18,043                  |    | 18,043                    |   | 18,043                                     |   | 18,043 |   | 18,043 |   | 18,043 |   |
| Derivative financial instruments                                       |   | 2,101                   |    | 2,101                     |   | (7,367                                     | )      | 2,687 |   | (12,524 | ) | 8,212 |   |
| Total interest-bearing liabilities                                     |   | $                       | 473,952 |                      | $      | 473,952                                    |   | $ | 464,484 |   | $ | 474,538 |   | $ | 459,327 |   | $ | 480,063 |   |

 

Thefollowing describes the methods and assumptions used by the Company inestimating fair values.

 

*Cash and Cash Equivalents*

 

Thecarrying amount for cash and cash equivalents approximates fair value becausethese instruments are demand

 

39

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depositsand money market accounts and do not present unanticipated interest rate orcredit concerns.

 

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

 

Thefair value is estimated based on quoted market prices from institutionalinvestors for similar types of mortgage loans. A portion of mortgage loans heldfor sale are committed for sale under mandatory sale arrangements and as suchare not re-valued for subsequent changes in interest rates.

 

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

 

Thefair value of Bond Collateral is estimated based on quoted market prices fromdealers and brokers for similar types of mortgage loans in the bulk mortgagemarket. Market prices reflect various assumptions as to prepayment rates, loanlosses and financing costs.

 

*Derivatives*

 

Fairvalues of forward sales of mortgage-backed securities and options onmortgage-backed securities are based on quoted market prices for theseinstruments. Fair values of our commitments to originate loans are based on anydifference in the value of the loans expected to close between the time of therate lock commitment and the current market value.

 

*Short-Term Debt*

 

Thefair value of the warehouse line debt and short-term debt related to bondcollateral held for sale approximates the carrying amounts because of theshort-term nature of the debt and interest on the debt fluctuates with marketinterest rates.

 

*Long-Term Debt*

 

Thefair value of long-term debt is estimated based upon all long-term debt beingat variable rates and therefore cost approximates fair market value.

 

ITEM 4.  CONTROLS AND PROCEDURES

 

(a) Under the supervisionand with the participation of our management, including our principal executiveofficer and principal financial officer, we evaluated the effectiveness of ourdisclosure controls and procedures, as such term is defined under Rule13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended.Based on this evaluation, our principal executive officer and principalfinancial officer concluded that our disclosure controls and procedures wereeffective as of the end of the period covered by this quarterly report.

 

(b)There has been no change in our internal control over financial reportingidentified in connection with the evaluation required by paragraph (d) ofExchange Act Rule 13a-15 that occurred during the period covered by thisquarterly report that has materially affected, or is reasonably likely tomaterially affect, our internal control over financial reporting.

 

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PART II.  OTHER INFORMATION

 
| ITEM  1. |   | LEGAL PROCEEDINGS                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|     |   | The Company filed a lawsuit in 2003 for breach of contract,  unfair competition and misappropriation of trade secrets against LoanCity.com  and other individuals. On March 10, 2004, the Company was awarded  $3.4 million in compensatory and punitive damages. LoanCity.com and  other defendants posted a surety bond for approximately $5 million.  If an appeal of the verdict is made by  LoanCity.com and the other defendants, the court would require the process to  begin by the end of 2004. |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| ITEM  2. |   | CHANGES IN SECURITIES AND  USE OF PROCEEDS                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|     |   | Our Purchase of Equity  Securities                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|     |   | **Period**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |   | **Total  Number of  Shares Purchased** |   | **Average  Price Paid  per Share** |   | **Total  Number of  Shares Purchased  as Part of Publicly  Announced Plan or  Program** |   | **Maximum  Number  of Shares that May  Yet Be Purchased  Under the Plan or  Program** |   |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |   |   |   |   |   |   |   |   |
|     |   | Month #1  (April 1, 2004  to April 30, 2004)                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |   | — |   | — |   | — |   | 400,000 |   |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |   |   |   |   |   |   |   |   |
|     |   | Month #2  (May 1, 2004  to May 31, 2004)                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |   | — |   | — |   | — |   | 400,000 |   |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |   |   |   |   |   |   |   |   |
|     |   | Month #3  (June 1, 2004  to June 30, 2004)                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |   | 511,490  (purchased from  6/4/04 to 6/24/04)  (Note 1) |   | $ | 8.81 |   | 11,490 |   | 388,510 |   |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |   |   |   |   |   |   |   |   |
|     |   | Total                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                    |   | 511,490 |   | $ | 8.81 |   | 11,490 |   | 388,510 |   |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |   |   |   |   |   |   |   |   |
|          |
|     |   | Note  1) The Company purchased 500,000 shares through a privately negotiated  transaction with a single entity.                                                                                                                                                                                                                                                                                                                                                                                                          |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |   |   |   |   |   |   |   |   |   |
| ITEM  3. |   | DEFAULTS UPON SENIOR  SECURITIES                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|     |   | Not  applicable.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|     |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
| ITEM  4. |   | SUBMISSION OF MATTERS TO A  VOTE OF SECURITY HOLDERS                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|          |        |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

The Company distributed its Definitive Proxy Statement, Proxy andAnnual Report to Stockholders on or about

 

July 1, 2004 for its Annual Meeting of Stockholders heldAugust 12, 2004.  At the Company’sAnnual Meeting, the stockholders were asked to consider two proposals.

 

The first proposal considered by the stockholders of the Annual Meetinginvolved the election of three Class I directors.  The existing Board of Directors selected three nominees, all ofwhom ran unopposed and each of whom was then serving as a Class Idirector.  The nominees of the Board,and the voting results with respect thereto, were:

 
| **Name**         |   | **Votes For** |   | **Withheld** |   |
|------------------|--------|---------------|--------|--------------|--------|
| H. James Brown   |   | 6,445,376     |   | 826,245      |   |
| David Nierenberg |   | 7,236,526     |   | 35,095       |   |
| Herbert Tasker   |   | 7,104,136     |   | 167,485      |   |

 

The following directors’ terms of office continued after the AnnualMeeting: Robert A. Gunst, Keith Johnson, Richard T. Pratt, John M. Robbins,Robert T. Barnum, and Mark J. Riedy.

 

The second proposal considered by the stockholders of the annualmeeting involved the approval of the 2004 Equity Incentive Plan (the “2004Plan”).  The 2004 Plan is intended toreplace our 1997 Stock Incentive Plan, 1997 Stock Option Plan and 1997 OutsideDirectors Plan (collectively the “Prior Plans”) which terminate upon approvalof the 2004 Plan by the

 

41

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stockholders.

 

Approval of the 2004 Plan by the stockholders combines previouslyauthorized but unissued stock options of One Hundred Nine Thousand Six HundredFifty (109,650) shares with a new authorization of Five Hundred Thousand(500,000) shares.  The voting results asto the second proposal were as follows:

 
|      |   | **For**   |   | **Against** |   | **Abstentions** |   | **Broker  Non-Votes** |   |
|-----------|--------|-----------|--------|-------------|--------|-----------------|--------|-----------------------|--------|
| 2004 Plan |   | 3,900,953 |   | 408,110     |   | 10,007          |   | 2,953,151             |   |

 

ITEM 5.  OTHERINFORMATION

 

None

 

ITEM 6.  EXHIBITSAND REPORTS ON 8-K

 
| (a)    |   | Exhibits |   |                                                                                                                                                                                    |
|--------|--------|----------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |     |   |                                                                                                                                                                                    |
|   | *      | 3.1      |   | Second  Articles of Amendment and Restatement of the Registrant                                                                                                                         |
|   | ****   | 3.1  A   |   | Articles  of Amendment (regarding name change)                                                                                                                                          |
|   | **     | 3.2      |   | Fourth  Amended and Restated Bylaws of the Registrant                                                                                                                                   |
|   | ***    | 4.1      |   | Registration  Rights Agreement dated February 11, 1997                                                                                                                             |
|   | **     | 4.3      |   | First  Amended and Restated Rights Agreement between the Company and American Stock  Transfer and Trust Company dated as of February 2, 1999 and amended as  of March 4, 2004 |
|   |   | 10.27    |   | 2004  Equity Incentive Plan                                                                                                                                                             |
|   |   | 10.28    |   | Stock  Repurchase Agreement                                                                                                                                                             |
|   |   | 10.29    |   | Supplemental  Executive Retirement Plan                                                                                                                                                 |
|   |   | 31.1     |   | Section 302  CEO Certification                                                                                                                                                     |
|   |   | 31.2     |   | Section 302  CFO Certification                                                                                                                                                     |
|   |   | 32.1     |   | Section 906  CEO Certification                                                                                                                                                     |
|   |   | 32.2     |   | Section 906  CFO Certification                                                                                                                                                     |

 

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|   | *    |   |   | Incorporated by reference to our annual report on  Form 10-K for the fiscal year ended December 31, 2002 filed  March 31, 2003    |
|--------|------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------|
|   | **   |   |   | Incorporated by reference to our annual report on  Form 10-K for the fiscal year ended December 31, 2003 filed on  March 30, 2004 |
|   | ***  |   |   | Incorporated by reference to our registration  statement on Form S-11 filed September 25, 1997                                         |
|   | **** |   |   | Incorporated by reference to our quarterly report  form 10-Q for the fiscal quarter ended March 31, 2004 filed May 17,  2004.          |

 
| (b)    |   |      |   | Reports  on Form 8-K – The Company filed or furnished the following reports on form  8-K during the quarter |
|--------|--------|-----------|--------|------------------------------------------------------------------------------------------------------------------|
|   |   |      |   |                                                                                                             |
|   |   | **Date**  |   | **Items**                                                                                                        |
|   |   | 5/13/2004 |   | Item  7 Exhibits (press release furnished)                                                                       |
|   |   |      |   | Item  12 results of operations and financial condition                                                           |

 

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SIGNATURES

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 
|                              | AMNET  MORTGAGE, INC. |
|-----------------------------------|-----------------------|
|                              |                  |   |   |
| Dated:  August 16, 2004 | By:                   |  /s/  Judith A. Berry |   |
|                              |                  |   | Judith  A. Berry, |
|                              |                  |   | Executive  Vice President |
|                              |                  |   | Chief  Financial Officer |
|                                   |                       |  |  |  |  |

 

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