**SECURITIESAND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

** **

----

 

**FORM10-Q**

** **

----

 

**QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF**

**THESECURITIES EXCHANGE ACT OF 1934**

** **

**For The Quarterly Period Ended March 31, 2004**

** **

----

 

**FALCONFINANCIAL INVESTMENT TRUST**

(Exact name of registrant as specified in itscharter)

** **

**Commission file number 000-50509**

 
| **Maryland**                                                    |   | **57-6208172**                       |
|-----------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |   | (I.R.S. EmployerIdentification  No.) |

 

**15 Commerce Road**

**Stamford, CT 06902**

(Addressof principal executive offices) (Zip code)

** **

**203-967-0000**

(Registrant’stelephone number, including area code)

** **

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.

 

Yes    ý        No    o

 

Indicate by checkmark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Exchange Act).

 

Yes    o      No    ý

 

Indicate the number of shares outstanding of each of the issuer’sclasses of common stock, as of the latest practicable date.

 

 

| **(Class)**                    |   | **(Outstanding  as of  May 17, 2004)** |
|--------------------------------|--------|---------------------------------------------|
|                           |   |                                        |
| COMMON SHARES, $0.01 PAR VALUE |   | 15,985,800  SHARES                     |

 

 

----

 

**FALCON FINANCIAL INVESTMENT TRUST ANDPREDECESSOR**

** **

**Index to form 10-Q**

** **
| **PART I**     | Consolidated Financial Information                                                                                                                           |   |
|----------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
|           |                                                                                                                                                         |   |
| Item 1.        | Financial Statements                                                                                                                                         |   |
|           | Consolidated Statements of Financial  Position – March 31, 2004 (unaudited)  and December 31, 2003.                                                     |   |
|           | Consolidated Statements of Operations  (unaudited) – three months ended March 31, 2004  and March 31, 2003                                              |   |
|           | Consolidated Statements of Changes in  Stockholders’ Equity and Other Comprehensive  Income (Loss) (unaudited) – three months ended March 31, 2004 |   |
|           | Consolidated Statements of Cash Flows  (unaudited) – three months ended March 31, 2004  and March 31, 2003                                              |   |
|           | Notes to Consolidated Financial Statements (unaudited)                                                                                                       |   |
| 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                                                                                                                                        |   |
| Item 3.        | Defaults Upon Senior Securities                                                                                                                              |   |
|           |                                                                                                                                                         |   |
| Item 4.        | Submission of Matters to Vote to Security  Holders                                                                                                           |   |
| Item 5.        | Other Information                                                                                                                                            |   |
| Item 6.        | Exhibits and Reports on Form 8-K                                                                                                                             |   |
|           |                                                                                                                                                         |   |
| **Signatures** |                                                                                                                                                         |

 

----

 

**PART I. CONSOLIDATED FINANCIAL INFORMATION**

** **

**ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS**

 

**FALCONFINANCIAL INVESTMENT TRUST****AND PREDECESSOR**

** **

**Consolidated Statements of FinancialPosition**

** **
|                                                                                                                    |   | **Company  March 31, 2004** |        | **Company  December 31, 2003** |       |
|-------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|-------------|--------------------------------|------------|
|                                                                                                                    |   | **(unaudited)**             |        |                           |       |
| **ASSETS**                                                                                                              |   |                        | ** **  |                           | ** ** |
| ASSETS:                                                                                                                 |   |                        |        |                           |       |
| Cash and cash equivalents                                                                                               |   | $                           | 32,612,892  |                           | $          | 25,645,578 |   |
| Loans receivable, net of allowance for  possible loan  losses of $1,318,368 and $1,086,692, respectively                |   | 151,888,877                 |        | 126,076,622                    |       |
| Retained interests in loan securitization                                                                               |   | 7,386,747                   |        | 7,239,136                      |       |
| Due from broker                                                                                                         |   | 2,380,000                   |        | —                         |       |
| Accrued interest receivable                                                                                             |   | 1,003,182                   |        | 994,821                        |       |
| Restricted cash                                                                                                         |   | 2,226,193                   |        | 2,657,660                      |       |
| Property and equipment, net                                                                                             |   | 427,775                     |        | 335,860                        |       |
| Prepaid expenses and other assets                                                                                       |   | 809,685                     |        | 1,497,245                      |       |
|                                                                                                                    |   |                        |        |                           |       |
| Total assets                                                                                                            |   | $                           | 198,735,351 |                           | $          | 164,446,922 |   |
|                                                                                                                    |   |                        |        |                           |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                           |   |                        | ** **  |                           | ** ** |
| LIABILITIES :                                                                                                           |   |                        |        |                           |       |
| Borrowings                                                                                                              |   | $                           | 74,235,213  |                           | $          | 53,475,879 |   |
| Accrued interest payable                                                                                                |   | 171,366                     |        | 255,707                        |       |
| Interest rate swap contracts                                                                                            |   | 2,929,733                   |        | (389,783                       | )          |
| Customer deposits                                                                                                       |   | 61,325                      |        | 140,276                        |       |
| Hold back of loan proceeds                                                                                              |   | 2,226,193                   |        | 2,657,660                      |       |
| Accounts payable and accrued liabilities                                                                                |   | 1,005,756                   |        | 2,405,496                      |       |
|                                                                                                                    |   |                        |        |                           |       |
| Total liabilities                                                                                                       |   | 80,629,586                  |        | 58,545,235                     |       |
|                                                                                                                    |   |                        |        |                           |       |
| COMMITMENTS AND CONTINGENCIES STOCKHOLDERS’  EQUITY:                                                               |   |                        |        |                           |       |
| Preferred shares, $0.01 par value,  50,000,000 authorized  none issued and outstanding                                  |   | —                      |        | —                         |       |
| Common shares, $0.01 par value, 100,000,000  authorized  15,985,800 and 14,105,800 issued and outstanding, respectively |   | 159,858                     |        | 141,058                        |       |
| Additional paid in capital                                                                                              |   | 123,679,281                 |        | 108,020,597                    |       |
| Unearned compensation                                                                                                   |   | (2,650,902                  | )           | (2,840,827                     | )          |
| Accumulated deficit                                                                                                     |   | (1,637,116                  | )           | (1,090,858                     | )          |
| Accumulated other comprehensive income  (loss)                                                                          |   | (1,445,356                  | )           | 1,671,717                      |       |
|                                                                                                                    |   |                        |        |                           |       |
| Total stockholders’ equity                                                                                         |   | 118,105,765                 |        | 105,901,687                    |       |
|                                                                                                                    |   |                        |        |                           |       |
| Total liabilities and stockholders’ equity                                                                         |   | $                           | 198,735,351 |                           | $          | 164,446,922 |   |

** **

See accompanyingnotes to consolidated financial statements

 

1

----

 

**FALCONFINANCIAL INVESTMENT TRUST AND PREDECESSOR**

** **

**ConsolidatedStatements of Operations**

**(unaudited)**

** **
|                                                                              |   | **Company  Three Months  Ended  March 31, 2004** |      | **Predecessor  Three Months  Ended  March 31, 2003** |   |
|-----------------------------------------------------------------------------------|--------|--------------------------------------------------|-----------|------------------------------------------------------|--------|
| REVENUES:                                                                         |   |                                             |      |                                                 |   |
| Interest income on loans.                                                         |   | $                                                | 2,948,798 |                                                 | $      | 1,647,017 |   |
| Interest income on securities purchased  under resale  agreements - related party |   | —                                           |      | 22,732                                               |   |
| Interest income from retained interests                                           |   | 304,474                                          |      | 355,893                                              |   |
| Gain on sale of loans                                                             |   | —                                           |      | 10,696,524                                           |   |
| Gain on sale of retained interests                                                |   | —                                           |      | 265,352                                              |   |
| Gain on securities sold, but not yet  purchased - related party                   |   | —                                           |      | 1,081,269                                            |   |
| Change in value of interest rate swap  contracts                                  |   | (65,483                                          | )         | 678,816                                              |   |
| Income from loan servicing                                                        |   | 112,580                                          |      | 97,842                                               |   |
| Interest and other income                                                         |   | 106,746                                          |      | 18,317                                               |   |
| Total revenues.                                                                   |   | 3,407,115                                        |      | 14,863,762                                           |   |
|                                                                              |   |                                             |      |                                                 |   |
| EXPENSES:                                                                         |   |                                             |      |                                                 |   |
| Interest expense on borrowings                                                    |   | 436,354                                          |      | 187,487                                              |   |
| Interest expense on borrowings - related  party                                   |   | —                                           |      | 672,542                                              |   |
| Interest expense on securities sold, but  not yet  repurchased - related party    |   | —                                           |      | 149,304                                              |   |
| Provision for possible loan losses                                                |   | 231,676                                          |      | —                                               |   |
| Facility fee expense                                                              |   | 750,000                                          |      | 93,750                                               |   |
| Salaries and benefits                                                             |   | 1,414,219                                        |      | 867,440                                              |   |
| Professional fees.                                                                |   | 280,918                                          |      | 86,433                                               |   |
| General and administrative                                                        |   | 479,063                                          |      | 234,714                                              |   |
| Advertising and promotion                                                         |   | 330,974                                          |      | 241,238                                              |   |
| Depreciation and amortization.                                                    |   | 30,169                                           |      | 35,248                                               |   |
|                                                                              |   |                                             |      |                                                 |   |
| Total expenses                                                                    |   | 3,953,373                                        |      | 2,568,156                                            |   |
| Net (loss) income                                                                 |   | $                                                | (546,258  | )                                                    | $      | 12,295,606 |   |
|                                                                              |   |                                             |      |                                                 |   |
| Net loss per share - basic and diluted                                            |   | (0.04                                            | )         |                                                 |   |
|                                                                              |   |                                             |      |                                                 |   |
| Weighted average shares outstanding:                                              |   |                                             |      |                                                 |   |
| Basic                                                                             |   | 15,003,159                                       |      |                                                 |   |
| Diluted                                                                           |   | 15,041,098                                       |      |                                                 |   |

** **

Seeaccompanying notes to consolidated financial statements.

 

2

----

 

**FALCONFINANCIAL INVESTMENT TRUST AND PREDECESSOR**

** **

**ConsolidatedStatements of Changes in Stockholders’ Equity and Comprehensive Income (Loss)**

** **

**Forthe three months ended March 31, 2004**

**(unaudited)**

** **
|                                                          |   | **Common  Stock**                  |   | **Additional  Paid-in  Capital** |    | **Unearned  Compensation** |   | **Retained  Earnings  (Accumlated  Surplus)** |   | **Accumulated  Other  Comprehensive  Income** |       | **Total  Stockholders’  Equity** |   | **Comprehensive  Income (Loss)** |   |
|---------------------------------------------------------------|--------|------------------------------------|--------|----------------------------------|---------|----------------------------|--------|-----------------------------------------------|--------|-----------------------------------------------|------------|---------------------------------------|--------|----------------------------------|--------|
| **Number of  Shares**                                         |   | **Par Value  ($ 0.01 per  share)** |
| BALANCE, December 31, 2003                                    |   | 14,105,800                         |   | $                                | 141,058 |                       | $      | 108,020,597                                   |   | $                                             | (2,840,827 | )                                     | $      | (1,090,858                       | )      | $ | 1,671,717 |   | $ | 105,901,687 |   |   |   |   |
|                                                          |   |                               |   |                             |    |                       |   |                                          |   |                                          |       |                                  |   |                             |   |   |   |
| Net loss                                                      |   |                               |   |                             |    |                       |   |                                          |   | (546,258                                      | )          |                                  |   | (546,258                         | )      | $ | (546,258 | ) |
|                                                          |   |                               |   |                             |    |                       |   |                                          |   |                                          |       |                                  |   |                             |   |   |   |
| Overallotment Transaction on  February 2, 2004:               |   |                               |   |                             |    |                       |   |                                          |   |                                          |       |                                  |   |                             |   |   |   |
| Issuance of shared in connection  with overallotment          |   | 1,875,000                          |   | 18,750                           |    | 16,856,250                 |   |                                          |   |                                          |       |                                  |   | 16,875,000                       |   |   |   |
| Underwriters’ Fee and Offering expenses                  |   |                               |   |                             |    | (1,246,316                 | )      |                                          |   |                                          |       |                                  |   | (1,246,316                       | )      |   |   |
| Issuance of restricted shares to  Employees and Trustees, net |   | 5,000                              |   | 50                               |    | 48,750                     |   | (48,800                                       | )      |                                          |       |                                  |   | —                           |   |   |   |
|                                                          |   |                               |   |                             |    |                       |   |                                          |   |                                          |       |                                  |   |                             |   |   |   |
| Amortization of unearned compensation                         |   |                               |   |                             |    |                       |   | 238,725                                       |   |                                          |       |                                  |   | 238,725                          |   |   |   |
|                                                          |   |                               |   |                             |    |                       |   |                                          |   |                                          |       |                                  |   |                             |   |   |   |
| Unrealized losses on hedging transactions                     |   |                               |   |                             |    |                       |   |                                          |   |                                          |       | (3,254,033                            | )      | (3,254,033                       | )      | (3,254,033 | ) |
|                                                          |   |                               |   |                             |    |                       |   |                                          |   |                                          |       |                                  |   |                             |   |   |   |
| Unrealized gain on retained interests in  securitizations     |   |                               |   |                             |    |                       |   |                                          |   |                                          |       | 136,960                               |   | 136,960                          |   | 136,960 |   |
|                                                          |   |                               |   |                             |    |                       |   |                                          |   |                                          |       |                                  |   |                             |   |   |   |
| Comprehensive loss                                            |   |                               |   |                             |    |                       |   |                                          |   |                                          |       |                                  |   |                             |   | $ | (3,663,331 | ) |
|                                                          |   |                               |   |                             |    |                       |   |                                          |   |                                          |       |                                  |   |                             |   |   |   |
| BALANCE, March 31, 2004                                       |   | 15,985,800                         |   | $                                | 159,858 |                       | $      | 123,679,281                                   |   | $                                             | (2,650,902 | )                                     | $      | (1,637,116                       | )      | $ | (1,445,356 | ) | $ | 118,105,765 |   |   |   |

 

Seeaccompanying notes to consolidated financial statements.

 

3

----

 

**FALCON FINANCIAL INVESTMENT TRUST AND PREDECESSOR**

** **

**Consolidated and Combined Statementsof Cash Flows**

**(unaudited)**

** **
|                                                                                  |   | **The  Company  Three months ended  March 31,  2004** |       | **The  Predecessor  Three months ended  March 31,  2003** |   |
|---------------------------------------------------------------------------------------|--------|-------------------------------------------------------|------------|-----------------------------------------------------------|--------|
| **Cash flows from operating activities**                                              |   |                                                  |       |                                                      |   |
| Net (loss) income                                                                     |   | $                                                     | (546,258   | )                                                         | $      | 12,295,606 |   |
| Adjustments to reconcile net (loss) income  to net cash used in operating activities: |   |                                                  |       |                                                      |   |
| Gain on sale of loans                                                                 |   | —                                                |       | (10,696,524                                               | )      |
| Gain on sale of retained interests                                                    |   | —                                                |       | (265,352                                                  | )      |
| Depreciation and amortization - property  and equipment                               |   | 30,169                                                |       | 35,248                                                    |   |
| Depreciation and amortization - deferred  origination fees, net of expense            |   | (32,939                                               | )          | (22,242                                                   | )      |
| Provision for possible loan losses                                                    |   | 231,676                                               |       | —                                                    |   |
| Amortization of deferred compensation                                                 |   | 238,725                                               |       | —                                                    |   |
| (Accretion)/amortization of  (discount)/premium on retained interests                 |   | 10,651                                                |       | (26,314                                                   | )      |
| Changes in operating assets and  liabilities:                                         |   |                                                  |       |                                                      |   |
| Increase in securities sold, but not yet  purchased - related party                   |   | —                                                |       | 8,812,177                                                 |   |
| Increase in interest rate swap contracts -  related party                             |   | —                                                |       | (5,900,800                                                | )      |
| Increase in securities purchased under  resale  agreements - related party            |   | —                                                |       | (8,656,620                                                | )      |
| (Decrease) increase in due from broker                                                |   | (2,380,000                                            | )          | 6,440,000                                                 |   |
| (Increase) decrease in accrued interest  receivable                                   |   | (8,361                                                | )          | 1,106,674                                                 |   |
| Decrease (increase) in prepaid expenses and  other assets                             |   | 687,560                                               |       | (228,603                                                  | )      |
| Decrease in due to broker - related party                                             |   | —                                                |       | (1,644,647                                                | )      |
| (Decrease) increase in accrued interest  payable                                      |   | (84,341                                               | )          | 114,500                                                   |   |
| Decrease in accrued interest payable -  related party                                 |   | —                                                |       | (1,855,829                                                | )      |
| (Decrease) increase in customer deposits                                              |   | (78,951                                               | )          | 53,498                                                    |   |
| Decrease in accounts payable and accrued  liabilities                                 |   | (1,399,759                                            | )          | (197,826                                                  | )      |
| Net cash used in operating activities                                                 |   | (3,353,110                                            | )          | (637,052                                                  | )      |
| **Cash flows from investing activities:**                                             |   |                                                  |       |                                                      |   |
| Disbursements for loan originations, net of  fees received                            |   | (26,990,253                                           | )          | (38,747,329                                               | )      |
| Repayments of loans                                                                   |   | 1,045,466                                             |       | 681,087                                                   |   |
| Net proceeds from sale of retained interests                                          |   | —                                                |       | 2,983,560                                                 |   |
| Net proceeds from sale of loans                                                       |   | —                                                |       | 145,464,590                                               |   |
| Net purchases of property and equipment                                               |   | (122,006                                              | )          | (4,294                                                    | )      |
| Net cash (used in) provided by investing  activities                                  |   | (26,066,793                                           | )          | 110,377,614                                               |   |
| **Cash flows from financing activities:**                                             |   |                                                  |       |                                                      |   |
| Proceeds from overallotment                                                           |   | 16,875,000                                            |       | —                                                    |   |
| Payment of overallotment expenses                                                     |   | (1,246,316                                            | )          | —                                                    |   |
| Borrowings from warehouse line of credit                                              |   | 21,804,000                                            |       | 35,834,000                                                |   |
| Repayments of warehouse line of credit                                                |   | (1,045,467                                            | )          | (130,185,825                                              | )      |
| Borrowings from subordinated loans                                                    |   | —                                                |       | 4,934,135                                                 |   |
| Repayments of subordinated loans                                                      |   | —                                                |       | (19,905,820                                               | )      |
| Borrowings from interest capitalization  notes                                        |   | —                                                |       | 69,043                                                    |   |
| Net cash provided by (used in) financing  activities                                  |   | 36,387,217                                            |       | (109,254,467                                              | )      |
| Net increase in cash and cash equivalents                                             |   | 6,967,314                                             |       | 486,093                                                   |   |
| Cash and cash equivalents, beginning of  preiod                                       |   | 25,645,578                                            |       | 610,430                                                   |   |
| Cash and cash equivalents, end of period                                              |   | $                                                     | 32,612,892 |                                                      | $      | 1,096,523 |   |
| **Supplemental disclosure of cash flow  information:**                                |   |                                                  |       |                                                      |   |
| Interest paid                                                                         |   | $                                                     | 520,695    |                                                      | $      | 2,601,358 |   |

 

4

----

 

**FALCON FINANCIAL INVESTMENT TRUST ANDPREDECESSOR**

 

**Notes****toConsolidated Financial Statements**

**(unaudited)**

 

**(1)Organization**

 

FalconFinancial Investment Trust (the “Trust”) is a fully integrated, self-advisedfinance company focused solely on the business of originating and servicingloans to automotive dealers in the United States. The Trust was formed as aMaryland Real Estate Investment Trust (“REIT”) on August 27, 2003. TheTrust was formed to address the specialized capital needs of the automotiveretailing industry. The Trust commenced operations on December 22, 2003when it completed its initial public offering (“IPO”) and concurrentlyconsummated certain other formation transactions, including a merger withFalcon Financial, LLC (the “Predecessor”).

 

The IPOconsisted of the sale of 12,500,000 common shares to the public at a price of$9 per share, generating gross proceeds of $112.5 million. The aggregate proceedsto the Trust, net of underwriters’ discount and offering costs, wasapproximately $102.4 million. Concurrent with the IPO, the Trust issued1,287,500 common shares to the owners of its Predecessor as part of theformation transaction in acquiring the assets and assuming the liabilities ofthe Predecessor. Also concurrently with the IPO, the Trust issued 318,300restricted shares as part of its Equity Incentive Plan to its independenttrustees, trustee nominees, members of senior management and other employees.The total number of common shares outstanding immediately following the IPO was14,105,800. In February 2004, the underwriters exercised theover-allotment and the Trust sold an additional 1,875,000 common shares to thepublic at a price of $9 per share. The aggregate proceeds to the Trust, net ofunderwriters’ discount and offering costs, was approximately $15.6 million,bringing the total aggregate net proceeds of the IPO to approximately $118.0million. The total number of common shares outstanding immediately followingthe over-allotment was 15,985,800, which includes an additional 5,000restricted shares issued in connection with the Equity Incentive Plan.

 

ThePredecessor was owned by Falcon Auto Venture, LLC (40%), SunAmerica, Inc.(30%), and MLQ Investors, LP (an affiliate of Goldman, Sachs & Co.) (30%).Members of the senior management of the Trust owned an 86% interest in FalconAuto Venture, LLC. Subsequent to the IPO, owners of the Predecessorcollectively owned 10.3% of the Trust, with no individual owning greater than5%.

 

Concurrentlywith the completion of the IPO, the Trust authorized 50 million preferred shareof beneficial interest. No preferred shares have been issued.

 

The Trustutilized its net proceeds of $102.4 million to repay $77.8 million inborrowings. After repayment of certain borrowings, the Trust had $24.6 millionin available cash immediately following the IPO.

 

**(2)Summary of Significant Accounting Policies**

 

***(a) Basis of Presentation***

 

The unauditedconsolidated financial statements presented herein include all of the accountsof the Trust and its wholly owned subsidiary Falcon Financial II, LLC(collectively, the “Company”) which commenced operations on December 22,2003. For periods prior to that time, this report includes the financialstatements of the Predecessor and its subsidiary. All intercompany transactionsand account balances have been eliminated in consolidation.

 

Theaccompanying unaudited financial statements have been prepared by management inaccordance with accounting principles generally accepted in the United Statesof America, commonly referred to as GAAP, for interim financial information andin conformity with the rules and regulations of the Securities and ExchangeCommission, commonly referred to as the SEC. Accordingly, they do not includeall of the information and footnotes for complete GAAP financial statements. Inthe opinion

 

5

----

 

of management,the accompanying consolidated financial statements contain all adjustments,consisting of normal recurring adjustments, necessary for a fair statement ofthe Company’s consolidated financial position at March 31, 2004 andDecember 31, 2003 and the results of its operations, changes in shareholders’/members’equity and its cash flows for the three months ended March 31, 2004 and2003.

 

The results ofoperations for the three months ended March 31, 2004 are not necessarilyindicative of the results that may be expected for the full year. Thepreparation of financial statements requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during theperiod.  Actual results could differfrom those estimates. These financial statements should be read in conjunctionwith the Company’s audited consolidated financial statements and footnotesthereto, included in the Company’s transition report on Form 10-K for thetransition period from October 1, 2003 to December 31, 2003.

 

***(b) Cash Flows***

 

For purposesof the statements of cash flows, the Company and its Predecessor consider allhighly liquid investments with maturities of less than three months at the dateof acquisition to be cash equivalents. These assets are carried at cost, whichapproximates fair value. Restricted cash is not considered cash or cashequivalents for the purpose of the statements of cash flows.

 

***(c) Loans, net***

 

The Company originates loans that are underwritten with the intentionof securitizing the receivables in a financing transaction, which will beaccounted for as secured borrowings under the provisions of SFAS Statement No.140, “Accounting for Transfers and Servicing of Financial Assets andExtinguishment of Liabilities”, and carry the loans on the statement offinancial position to maturity. The loans receivable are stated at theirprincipal amount outstanding, less net deferred loan fees, unearned discountsand allowance for loan losses. Nonrefundable origination fees less certainrelated direct costs associated with the origination of the loans are deferredand amortized into interest income over the term of the loan using a methodthat approximates the interest method.

 

All loansoriginated by the Predecessor were underwritten with the intention ofsecuritizing and selling the portfolio and are carried at the lower of cost ormarket value on the statement of financial position. The amount (if any) by whichthe cost exceeds the fair value is recorded in a valuation allowance. Changesin the valuation allowance are recorded in the statement of operations. As ofMarch 31, 2003, no valuation allowance was deemed necessary.

 

***(d)Allowance for Loan Losses***

 

The allowance for loan losses is based on a periodic analysis of theloan portfolio and in management’s judgment, reflects an amount that isadequate to absorb losses inherent in the existing portfolio. In evaluating theportfolio, management considers a variety of factors such as the size of theportfolio, prior loss experience, current and potential risks of the loanportfolio, present financial condition of the borrower, current economicconditions and other portfolio risk characteristics. Provisions for loan lossesare charged to operations. Loans, including impaired loans, are charged againstthe allowance for loan losses when actual losses have been established.

 

A loan is impaired when, based on current information and events, it isprobable that a creditor will be unable to collect all amounts due according tothe contractual terms of the loan agreement. A loss from impairment representsthe amount by which a creditor’s recorded investment in a loan exceeds thepresent value of the expected future cash flows from the loan discounted at theloan’s effective interest rate (including the fair value of the collateral thatmay be part of the loan).  Losses forwhich such provisions for impairment are made, unless applied as a write-downof the recorded investment in the loan, represent a portion of the creditor’sallowance for loan losses.

 

6

----

 

***(e) Retained Interests in LoanSecuritizations***

 

ThePredecessor accounted for its loan securitizations in accordance with Statementof Financial Accounting Standards (SFAS) No. 140, *Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities—a replacement of FASB Statement 125*.When the Predecessor sold loans in a securitization, it may retain one or moresubordinated certificates from the certificates issued.  Securitizations may be structured in variousways but generally conform to a common model. Typically, an issuer sells a portfolio of loans to a special-purposeentity established for the sole purpose of purchasing and reselling the loansto a securitization trust.  Thesecuritization trust then may issue bonds or certificates collateralized by theloans transferred to the securitization trust. The proceeds received from these bonds or certificates are used topurchase the loans from the issuing entity. The gain on the sale of loans is the difference between the proceedsfrom the sale of loans (net of related sale costs) and the allocated carryingamount of the receivables sold, including deferred origination fees andcosts.  The Predecessor determined thecarrying amount by allocating the total carrying amount of the loans soldbetween the portion sold and the interests retained based on each portion’srelative fair values at the time of the securitization. Assumptions used incalculating the estimated fair value of such retained interests are subject tovolatility that could materially affect operating results.

 

Retainedinterests in securitizations are accounted for as available for sale securitiesand are carried at estimated fair value, with unrealized gains or lossesincluded in members’ equity (accumulated other comprehensive income or loss).The Company is not aware of an active market for the purchase and sale of theseretained interests at this time; accordingly, the Company estimates the fairvalue of the retained interest by calculating the present value of theestimated expected future cash flows received by the Company after beingreleased by the securitization trust, using a discount rate commensurate withthe risk involved taking into consideration the results of sales ofcertificates owned by the Company to third parties. The cash flows beingdiscounted are adjusted for estimated net losses due to defaults or prepayments.The Company has experienced four defaults (of which one has been fullyresolved, one has cured the default and two are pending resolution) and noprepayments in its retained interests in securitizations at March 31,2004. All other loans are current.

 

Each loansecuritization has a specific credit enhancement in the form of cash flowrequirements that must be met before the Company receives any cash on itsretained interest. The retained interests which the Company holds aresubordinate in the right of payment to all other classes of certificates, whichmust receive their applicable distributions before any cash is available fordistribution to the holders of the retained interests.

 

Changes in thefair value of the retained interests resulting from changes in the timing ofcash flows to be received by the Company or changes in market interest ratesare adjusted through other comprehensive income in members’ equity. Reductionsin the estimated aggregate cash flows to be received by the Company, caused bydefaults or prepayments that result in a reduction to the fair value of theretained interests, are considered an other than temporary impairment and arerecognized through a charge to expense in that period.

 

***(f) Restricted Cash and Holdback of LoanProceeds.***

 

The Companymaintains various escrow accounts on behalf of its borrowers to fund work thatneeds to be performed on the borrower’s property as a condition to the loanagreement. At March 31, 2004 and December 31, 2003 the Company held$2,226,193 and $2,657,660, respectively, of cash collateral for the completionof those projects.

 

7

----

 

***(g) Interest, Fees and Direct Costs on Loans***

 

Interest isaccrued monthly on outstanding principal balances unless management considersthe collection of interest to be uncertain (generally, when loans arecontractually past due three months or more).

 

Originationfees received and direct costs incurred related to the origination of the loansare deferred as an adjustment to the carrying value of the loans held for sale.Origination fees and direct costs incurred are amortized into income over thelife of the related loan. At the time of sale of the related loans, anyremaining deferred fees and costs are recognized as income and included withthe gain or loss on the sale of such loans.

 

***(h) Servicing Income***

 

Underservicing agreements for all Company securitizations, servicing fees for loansin good standing are accrued monthly based upon the then outstanding principalbalances on loans serviced.  The Companyacts as primary servicer and special servicer with respect to loanssecuritized. A subsidiary of the Bank of New York acts as Master Servicer. TheCompany earns a servicing fee of 0.085% per annum (0.095% on the Company’s mostrecently completed securitization in 2003) of the outstanding loan balance withrespect to each loan serviced in its capacity as primary servicer. As specialservicer, the Company will earn a servicing fee of 0.25% per annum of theoutstanding balance of each loan in default. Servicing fees on defaulted loansare earned and paid monthly once a loan enters default status. Currently, thereare two loans in default.  Fees receivedfor loan servicing approximate the actual cost of servicing.

 

***(i) Securities Sold, But Not Yet Purchased***

 

ThePredecessor entered into certain transactions (short sales and purchases, andsecurities resale and repurchase agreements) to mitigate the effects thatchanges in interest rates and credit spreads have on the fair value of itsfixed rate loan portfolio held for sale. In connection with the Predecessor’sshort sales, its obligation to deliver the securities to Goldman, Sachs &Co. is recorded in the statement of financial position under the caption“Securities sold, but not yet purchased”. This liability is carried at marketvalue with any unrealized gain or loss recorded in the statement of operations.The related interest expense is recorded in the income statement of operationsover the period held.

 

***(j) Securities Purchased Under ResaleAgreements***

 

Purchases ofsecurities under agreements to resell and sales of securities under agreementsto repurchase are accounted for as secured lending and financing transactions,respectively. In connection with the Predecessor’s purchase contracts, itsobligation to resell the securities to Goldman, Sachs & Co. is recorded inthe Statement of Financial Position under the caption Securities purchasedunder resale agreements. These assets are carried at the amounts at which theidentical securities will be subsequently resold as specified in theagreements, generally at market value. The related interest income is recordedin the statements of operations over the contract period.

 

***(k) Interest Rate Swap Contracts***

 

The Company enters into forward interest rateswap contracts as a means of mitigating the impact that changes in interestrates and credit spreads have with respect to the forecasted issuance of longterm debt. The contracts are evaluated at inception and on an on-going basis inorder to determine whether the contracts qualify for hedge accounting underSFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities”,as amended and interpreted. The hedge instrument must be highly effective inachieving offsetting changes in the hedged item attributable to the risk beinghedged in order to qualify for hedge accounting treatment. Forward startinginterest rate swaps accounted for cash flow hedges are carried on the statementof financial position at fair value with changes in their fair value recordedin accumulated other comprehensive income (loss). Any ineffectiveness whicharises during the hedging relationship is recognized in interest expense duringthe period in which it arises.

 

8

----

 

 

ThePredecessor entered into interest rate swap arrangements to mitigate the impactthat changes in interest rates and credit spreads have on the value of itsfixed rate loan portfolio held for sale. The term of the derivative contracts is determined by duration of theloans held for sale pool.  Swapcontracts are carried at market value with any unrealized gain or loss recordedin the statement of operations.  Therelated interest income and interest expense is recorded in the statements ofoperations over the period held.

 

***(l) Property and Equipment***

 

Property andequipment are reported at cost less accumulated depreciation. Depreciation isrecorded on a straight-line basis over five years for furniture and fixtures,and three years for computers and equipment. Leasehold improvements areamortized over the remaining term of the respective leases.

 

Depreciation expense for the three months ended March 31, 2004 and2003 was $30,169 and $35,248, respectively.

 

***(m) Equity incentive and Option plan***

 

Immediately prior to the IPO, the Companyadopted an equity incentive plan and issued restricted common shares to itsexecutives, employees and non-employee trustees. Deferred compensation expenseswere recorded by the Company as reduction to stockholders’ equity and chargedto compensation expense on a straight-line basis over the vesting period ofthree years.

 

The options ofthe Predecessor were recorded based on the fair value method as prescribed inSFAS 123, *Accounting for Stock-BasedCompensation*. The option plan was terminated prior to the formationtransaction on December 22, 2003.

 

***(n) Comprehensive Income (Loss)***

 

Comprehensiveincome (loss) represents net income (loss) and certain amounts reporteddirectly in stockholders’ equity, such as net unrealized gain or loss onretained interests in securitizations and the change in the fair value of cashflow hedges. The Company has reported comprehensive income (loss) in thestatements of changes in stockholders’ equity. Accumulated other comprehensive income (loss) reported in the statementsof financial position as of March 31, 2004 and December 31, 2003,represents the accumulated unrealized gain on retained interests insecuritizations and interest rate swaps accounted for as cash flow hedges.

 

***(o) Income Taxes***

 

The Companyhas elected to be treated as a real estate investment trust (hereafter “REIT”)for federal income tax purposes. To maintain its status as a REIT, the Companymust comply with the REIT provisions of the Internal Revenue Code of 1986, asamended (hereafter “IRC”). If the Company distributes 90% of its taxable incometo its shareholders and satisfies the various REIT asset, income, stockownership and other tests under the IRC, the Company generally will not besubject to federal income tax. If the Company fails to qualify as a REIT in anytaxable year, it will be subject to federal income tax (including anyapplicable alternative minimum tax) on its taxable income at regular corporaterates. Even if the Company qualifies as a REIT, it may be subject to federalincome tax and excise tax on its undistributed taxable income and may also besubject to state and local income taxes. The Company’s subsidiary, Falcon Financial II, LLC is a taxable REITsubsidiary (“TRS”) for federal income tax purposes and is fully taxable atnormal corporate tax rates.

 

9

----

 

***(p) Loss per Share***

 

The Company calculates basic earnings pershare by dividing net income (loss) for the period by the weighted-average sharesof its common stock outstanding for that period. Diluted earnings per sharetakes into account the effect of dilutive instruments, such as unvestedrestricted shares, based on the average share price for the period indetermining the number of incremental shares that are added to theweighted-average number of shares outstanding using the treasury stock method.

 

***(q) Reclassifications***

 

Certain items from prior years have beenreclassified to conform with the 2004 classifications.

 

***(r) Recent Accounting Developments***

 

InJanuary 2003, the FASB issued FASB Interpretation (FIN) No. 46‘‘Consolidation of Variable Interest Entities.’’ FIN No. 46 requires a companyto consolidate a variable interest entity (VIE) if the company has variableinterests that give it a majority of the expected losses or a majority of theexpected residual returns of the entity. Prior to FIN No. 46, VIEs werecommonly referred to as SPEs. FIN No. 46, as amended by FIN No. 46-6 “Effective Date of FASB Interpretation 46” which was released by FASB inOctober 2003, is effective for public companies in the first interim orannual period ending after December 15, 2003, if certain conditions aremet.  The Company must apply thestandards of FIN No. 46 in its year end September 30, 2004 financialstatements.  Adoption of this newaccounting standard did not have a material effect on the Company’s financialcondition or results of operations.

 

10

----

 

**(3)Loans and Loans Held for Sale**

 

Loans as of March 31,2004 and December 31, 2003 are summarized as follows:

 

 

|                                                               |   | **March 31,  2004** |        | **December 31,  2003** |   |
|--------------------------------------------------------------------|--------|--------------------------|-------------|-----------------------------|--------|
| Franchise mortgage loans                                           |   | $                        | 154,056,613 |                        | $      | 127,846,080 |   |
| Less: Net deferred loan origination fees  and initial direct costs |   | 849,368                  |        | 682,766                     |   |
| Allowance for possible loan losses                                 |   | (1,318,368               | )           | (1,086,692                  | )      |
| Loans, net                                                         |   | $                        | 151,888,877 |                        | $      | 126,076,622 |   |

 

 

Loansreceivable at March 31, 2004 are comprised of fixed-rate loans withinterest rates ranging between 7.18 % and 9.52%. Maturity dates range from February 1,2011 to April 1, 2023 with 70.4% maturing during 2018. Five loans totalingapproximately $36.8 have balloon payments of approximately $4.0 million onFebruary 1, 2011, approximately $1.5 million on December 1, 2013,approximately $2.0 million on March 1, 2014 and approximately $17.1million on April 1, 2014. There are 20 borrowers located in 16 states.Approximately 44.6% of the principal balance of the loans are to six borrowerslocated in three states (Florida-18.1%, Tennessee-13.9% and Ohio-12.6%). Thereare no other concentrations greater than 10% in any other state or to anyindividual borrower.

 

Loansreceivable at December 31, 2003 are comprised of fixed-rate loans withinterest rates ranging between 8.14 % and 9.52%. Maturity dates range fromFebruary 1, 2011 to April 1, 2023 with 78.9% maturing during 2018.Two loans totaling approximately $9.6 have balloon payments of approximately$4.0 million on February 1, 2011 and approximately $1.5 million onDecember 1, 2013. There are 17 borrowers located in 15 states.Approximately 33.13% of the principal balance of the loans are to threeborrowers located in two states (Florida-22.1% and Virginia-11.03%). There areno other concentrations greater than 10% in any other state or to anyindividual borrower.

 

The Companyoriginates franchise mortgage loans secured by automotive dealerships,including real estate and improvements (real collateral), parts inventory, andblue-sky value (business asset collateral). Blue-sky, or franchise value, is anintangible asset that is a function of, among other things, the businessreputation, brand strength, financial strength, and market share of thedealership. The Company also originates mortgage loans secured by realcollateral.  The Company’s liens onbusiness asset collateral may be subordinated in whole or in part to liens heldby other lenders.

 

There were noloans with unpaid principal or interest balances contractually past due or onnon-accrual status as of March 31, 2004 and December 31, 2003.

 

**(4) Allowance for Possible Loan Losses**

 

The Company establishes an allowance forpossible loan losses to reserve for losses inherent in its loan portfolio. Thefollowing summarizes the activity in the allowance for possible loan losses forthe period from December 31, 2003 through March 31, 2004:

 
| Balance at December 31, 2003  |   | $       | 1,086,692 |   |
|------------------------------------|--------|---------|-----------|--------|
| Provision for possible loan losses |   | 231,676 |      |
| Balance at March 31, 2004          |   | $       | 1,318,368 |   |

 

11

----

 

**(5) Derivative Instruments and HedgingActivities**

 

The Companyenters into forward starting interest rate swap transactions to mitigate theeffect that changes in interest rates and credit spreads have on the forecastedissuance of long-term debt. In swap transactions, the Company will generallyenter into an interest rate swap contract, receiving a floating rate ofinterest and paying a fixed rate of interest. The term of the swap contracts isdetermined by the duration of the forecasted long-term debt to be issued. Theseswaps are accounted for as cash flow hedges and changes in their fair value arerecorded in other comprehensive income.

 

ThePredecessor entered into certain transactions (short sales and purchases,securities resale and repurchase agreements, and interest rate swaps) to mitigatethe effect that changes in interest rates and credit spreads have on the fairvalue of its fixed rate loan portfolio held for sale. Periods of risinginterest rates and widening credit spreads decrease the fair value of the loanportfolio held for sale.  Generally, thePredecessor entered into these transactions when the rate was locked on apending loan just prior to the closing of the loan.  The new loan was added to the pool of loans being held for saleand the pool then reviewed to determine what, if any, additional hedgingtransaction was to be executed. Generally, the Predecessor shorted U.S. Treasuries and invested theproceeds in repurchase agreements with Goldman, Sachs & Co. with U.S.Treasury notes as the underlying securities. In swap transactions, thePredecessor generally entered into an interest rate swap contract, receiving afloating rate of interest and paying a fixed rate of interest. The term of theswap contracts was determined by duration of the loans held for sale pool. ThePredecessor had a contractual obligation to settle the repurchase and swapagreements with Goldman, Sachs & Co. at the current fair value on therepurchase date. These contracts have been recorded as free standingderivatives with changes in fair value recorded in earnings.

 

As ofMarch 31, 2004, the Company had four forward starting interest rate swapcontracts accounted for as cash flow hedges on which the Company pays fixed andreceived floating.  The contracts had atotal notional amount of $94,271,976 and a fair value of ($2,929,733). Therewas no accrued interest on these contracts at March 31, 2004. Thecontracts had maturity dates ranging from April 1, 2014 toDecember 1, 2016. Fixed interest rates ranged from 4.045% to 4.815% and afloating rate of 1.10%.

 

As ofDecember 31, 2003, the Company had four forward starting interest rateswap contracts accounted for as cash flow hedges on which the Company paysfixed and received floating.  Thecontracts had a total notional amount of $94,271,976 and a fair value of$389,783. There was no accrued interest on these contracts at December 31,2003. The contracts had maturity dates ranging from April 1, 2014 toDecember 1, 2016. Fixed interest rates ranged from 4.045% to 4.815% and afloating rate of 1.12%.

 

As of March31, 2004 and December 31, 2003, included in accumulated other comprehensiveincome (loss) for the forward starting interest rate swap contracts was($2,864,250) and $389,783, respectively. The balance at March 31, 2004 is net of $65,483 that was reclassified tothe statement of operations for ineffectiveness in the hedge relationship.

 

12

----

 

**(6)Loan Securitization**

 

Through aspecial purpose bankruptcy remote subsidiary, the Predecessor entered intosecuritization transactions that qualified as sales for financial reportingpurposes, resulting in off-balance sheet accounting treatment. The Predecessorretained rated and nonrated certificates issued in connection with thesecuritization transaction.

 

In February 2003,the Predecessor completed Falcon Auto Dealership Loan Trust Certificates2003-1, securitizing loans with a principal balance of $141,060,558, receivingnet proceeds (after the payment of expenses) of  $145,464,590 and retaining rated and non-rated certificates withan allocated book value of $4,962,378 and a fair value of $5,431,623. Thesecuritization transaction resulted in a pretax gain of $10,696,524. Theproceeds from the securitization were used to pay down borrowings outstandingunder the warehouse line of credit and the senior subordinated loan.

 

InFebruary 2003, the Predecessor sold 100% of its rated retained interest inthe 2003-1 Trust to a third party. The Predecessor received proceeds of$2,983,560 and realized a gain of $265,352.

 

InAugust 2003, a delinquency was experienced in the 2003-1 Trust for a loanwith an unpaid principal balance of approximately $9.5 million. The loandefaulted in September 2003 and the Predecessor estimated that there wouldbe an other than temporary reduction in the aggregate cash flows that thePredecessor expects to receive from the 2003-1 Trust for its unrated retainedinterest.  Accordingly, the Predecessorcharged $422,477 to expense, which was the amount considered to be other thantemporary decline in the Predecessor’s fair value of the unrated retainedinterest. This estimated reduction in aggregate cash flows was based onmanagement’s assessment of the amounts it would ultimately collect on thedefaulted loan.

 

InOctober 2003, Moody’s downgraded the Class A-1 and A-2 certificates in the2003 securitization from From Aaa to Aa1, the Class B certificates from Aa2 toAa3, the Class C certificates from A2 to A3, the Class D certificates from Baa2to Baa3, the Class E certificates from Ba2 to Ba3, and the Class F certificatesfrom B3 to Caa2. In November 2003, Moody’s further downgraded the theClass A-1 and A-2 certificates in this securitization from Aa1 to Aa2, theClass B certificates from Aa3 to A1, the Class C certificates from A3 to Baa1, theClass D certificates from Baa3 to Ba1, the Class E certificates fromBa3 to B3,and the Class F certificates from Caa2 to Caa3. In November 2003, FitchRatings downgraded the Class E certificates in this securitization from BB toB+ and the Class F certificates from B to CC. Additionally, Fitch Ratingsplaced the Class B, C, D, E and F certificates on rating watch for potentialdowngrade. Fitch Ratings affirmed the Class A certificates at AAA.  There have been no other ratings downgradessubsequent to November 2003.

 

InJanuary 2004, a delinquency was experienced in the 2001-1 Trust for a loanwith an unpaid principal balance of approximately $2.5 million. The loandefaulted in January 2004 and the Company estimated that there would be another than temporary reduction in the aggregate cash flows that the Companyexpects to receive from the 2001-1 Trust for its unrated retained interest.While this delinquency resulted in an estimated $0.2 million reduction in thevalue of the retained interest on the 2001-1 Trust, it was offset by unrealizedgains in accumulated other comprehensive income for the 2001-1 transaction andaccordingly, did not result in a charge to the statement of operations. Thisestimated reduction in aggregate cash flows was based on management’sassessment of the amounts it would ultimately collect on the defaulted loan.The real estate collateral for this loan was foreclosed upon.

 

For the 1999-1Trust, 2000-1 Trust, 2001-1 Trust and the 2003-1 Trust, the Master Servicer feerate was 0.065% (0.055% on the 2003-1 Trust), the Primary Servicer fee rate was0.085% (0.095% on the 2003-1 Trust) and the Trustee fee rate was 0.010%.

 

13

----

 

The activityrelated to the Company’s retained interests for the three months endedMarch 31, 2004 is as follows:

 

 

|                           |   | **Three  Months ended  March 31, 2004** |      |
|--------------------------------|--------|----------------------------------------------|-----------|
| Balance at beginning of period |   | $                                            | 7,239,136 |   |
| Interest income recorded       |   | 304,474                                      |      |
| Cash received                  |   | (293,823                                     | )         |
| Fair value adjustments         |   | 136,960                                      |      |
| Balance at end of period       |   | $                                            | 7,386,747 |   |

 

The Company’skey assumptions used to value the retained interests at March 31, 2004 arethe loss/prepayment rate over the life of the transaction (which range from3.10% to 5.88%), and the discount rates applied to the future cash flows (whichrange from 14.37% to 18.80%).  Theseassumptions are consistent with the assumption used at December 31, 2003 tovalue the retained interests.  Theresult of changing the key economic and sensitivity of the current fair valueof retained interest to an immediate 10% and 20% adverse change in thoseassumptions would not be materially different than those previously discussedin the Company’s Transition Report on Form 10-K for the transition period endedDecember 31, 2003.

 

As of March31, 2004 and December 31, 2003 net unrealized gains for the Company's retainedinterests in securitizations included in accumulated other comprehensive income(loss) was $1,418,893 and $1,281,933, respectively.

 

**(7)Borrowings**

 

ThePredecessor entered into a $150 million Revolving Warehouse Financing Agreementdated January 7, 1998 (the “Warehouse Loan Agreement”) with ABN AMRO Bank,N.V., as lender, and SunAmerica Life Insurance Company or SALIC (an affiliateof SunAmerica, Inc.), as guarantor (collectively, the “Lenders”), solely forthe purpose of originating loans. SALIC, along with Goldman Sachs Mortgage Company (an affiliate ofGoldman, Sachs & Co.), as a result of a participation agreement between twoentities, were the guarantors of the Warehouse Loan Agreement.  As guarantors, each of the entities was paidfees of $197,998.  The fees are shown onthe statements of operations within the caption “interest expense—relatedparty.”  The maturity date isOctober 1, 2004.  This creditfacility was collateralized by the loans held for sale.  The Company is required to make prepaymentsunder the warehouse facility under certain circumstances.  Among other things, in the event that acustomer defaulted on a scheduled loan payment that is not cured within 30days, such loan was to be treated as a defaulted receivable and the Companyrequired to prepay the outstanding principal amount of the borrowings incurredunder the warehouse facility in respect of such defaulted receivable.  Interest was calculated using a 30 daycommercial paper rate plus 300 basis points until December 22, 2003, whenit was reduced to a 30 day commercial paper rate plus 200 basis points (whichincludes amounts paid to the guarantors as described above.)  The interest rates as of March 31, 2004and December 31, 2003 were 3.03% and 3.09%, respectively. The outstandingbalance as of March 31, 2004 and December 31, 2003 was $74,235,213and $53,475,879, respectively.  On April28, 2004, the outstanding balance under the Warehouse Loan Agreement was paidin full and the Warehouse Loan Agreement was terminated, as described below inNote 10 - Subsequent Events.

 

The Companyentered into a $19.3 million Amended and Restated Senior Subordinated LoanAgreement dated January 7, 1998, with Goldman Sachs Mortgage Company andSALIC. The agreement provided for a $5.0 million working capital loan, a $2.0million hedge loan and $12.3 million for loan originations. The interest rateon the senior subordinated loan was 12%, with 9% payable in cash and 3% accruedand capitalized. This loan was paid-in-full on December 23, 2003 and theloan terminated.

 

ThePredecessor entered into a $0.5 million Junior Subordinated Loan Agreementdated April 19, 1999 with Falcon Auto Venture, LLC. The agreement providedfor a $0.5 million working capital loan. The interest rate on the junior subordinated loan was 12%, with 9%payable in cash and 3% accrued and capitalized. This loan was paid-in-full onDecember 23, 2003 and the loan terminated.

 

14

----

 

The Warehouse Loan Agreement required thatthe Company maintain certain financial covenants related to aggregateindebtedness, net income, net worth, leverage ratio, capital expenditures andlease commitments.  In addition, theWarehouse Loan Agreement also specified various events (“Termination Events”)that would allow the Lenders to terminate the warehouse facility in itsentirety should one of these events occur, including, among other things, (i) amaterial adverse change in the Company’s business, financial condition orprospects or (ii) a downgrade or other impairment of the rating of any notesissued in the Company’s securitization transactions.  In October 2003 and November 2003, the notes issued inthe Company’s Falcon Trust Series 2003-1 securitization were downgraded by theratings agencies.  The Company receiveda waiver from the Lenders for this Termination Event.

 

**(8)Equity Incentive and Option Plan**

 

InNovember 2003, the Company adopted the 2003 Equity Incentive Plan toprovide incentives to employees, non-employee trustees and other serviceproviders to stimulate their efforts toward the Company’s continued success,long-term growth and profitability and to attract, reward and retain keypersonnel. The plan approved 725,658 restricted common shares reserved forissuance, of which 318,300 were issued immediately prior to the closing of theIPO, with the remaining 407,358 shares available for future issuance. The318,300 shares issued were valued at the IPO price of $9 per share and recordedin equity under the caption of unearned compensation. During the three monthsended March 31, 2004, 10,000 additional shares valued at $9.38 per sharewere issued and 5,000 shares were retired bringing the outstanding restrictedshares to 323,300.  The shares vest overthree years and will be amortized into the statement of operations ascompensation expense ratably over the vesting period.

 

InSeptember 1999, the Predecessor adopted the Falcon Financial, LLC OptionPlan. The Predecessor granted certain employees options, which generallyexpired 10 years from the grant date, to purchase membership interests in thePredecessor at prices not less than the market value of the membershipinterests on the grant date. Option exercise prices were determined by referenceto comparable public company market values and earnings multiples. Optionsvested at a rate of 20% per year beginning one year after the date of hire. ThePredecessor did not incur an expense associated with the option plan for thethree months ended March 31, 2003. The plan was terminated prior to theformation transaction on December 22, 2003 and thru that date no optionshad been exercised.

 

**(9)Commitments and Contingencies**

 

***(a) Financial Instruments with Off-BalanceSheet Risk***

 

The Company’sfinancial instruments with off-balance sheet risk were limited to fixed-ratemortgage loan origination commitments with total contractual amounts of $0 and$2.2 million as of March 31, 2004 and December 31, 2003,respectively. These instruments involve elements of credit risk and interestrate risk in addition to the amounts recognized in the statements of financialposition. The contractual amounts represent the Company’s maximum potentialexposure to credit loss but do not necessarily represent future cash requirementssince certain commitments may expire without being funded. Loan commitmentsgenerally have fixed expiration dates or other termination clauses and mayrequire payment of a fee by the customer. Commitments are subject to theCompany’s credit approval process, including a case-by-case evaluation of thecustomer’s creditworthiness and related collateral requirements. The Companycollected cash deposits in connection with these commitments of $0 and $19,534,as of March 31, 2004 and December 31, 2003, respectively.

 

15

----

 

**(10)Related Party Transactions**

 

The Company isinvolved in significant financing, risk management and other transactions, andhas had significant related party balances, with Goldman, Sachs & Co. (anaffiliate of MLQ Investors, LP), SunAmerica, Inc. and Falcon Auto Venture, LLC,both directly and indirectly through affiliates and subsidiaries of theentities. The Company enters into these transactions in the ordinary course ofbusiness and believes that the terms of these transactions are on market termsthat could be obtained from unrelated third parties. As of December 22,2003 after the IPO transaction, the aforementioned related parties are nolonger considered related parties as their ownership of the Company has beensignificantly reduced (less than 5%).

 

Included inthe Statement of Operations are revenues and expenses resulting from variousfinancing, capital markets transactions and loan sales transactions. Thefollowing table sets forth the related party revenues and expenses included inthe respective captions on the Statement of Operations for the three monthsended March 31, 2003. The amounts reflect the related party transactionswith Goldman, Sachs & Co., except where otherwise indicated and are asfollows:

 
|                                                                                                                                 |   | **Three  months ended  March 31,2003** |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|
| Interest income on securities purchased  under resale agreements                                                                     |   | $                                           | 22,732 |   |
| Gain on sale of loans-fee expense                                                                                                    |   | (1,414,936                                  | )      |
| Change in value of interest rate swap  contracts                                                                                     |   | 678,816                                     |   |
| Gain on securities sold, but not yet  purchased                                                                                      |   | 1,081,269                                   |   |
| Interest expense on borrowings ($328,099  and $16,343  related to SunAmerica,  Inc. and Falcon Auto Venture, LLC, respectively) |   | 672,542                                     |   |
| Interest expense on securities sold ,but  not yet repurchased                                                                        |   | 149,304                                     |   |
|                                                                                                                                 |   |                                        |   |
| Facility fee expense ($46,875  related to SunAmerica, Inc.)                                                                     |   | 93,750                                      |   |
|                                                                                                                                      |        |                                             |        |  |

 

**(10)Subsequent Events**

 

***New Credit Line***

 

On April 28, 2004, the Company entered into a $150 millionRevolving Warehouse Financing Agreement with iStar Financial Inc., solely forthe purpose of originating loans.  Thefacility may be increased to $200 million at the Company’s option with theconsent of iStar. Interest is calculated using LIBOR plus 290 basispoints.  Under the facility, iStarfinanced all of the Company’s existing outstanding loans that were financedunder the previously existing warehouse facility, which was terminated.  In connection with entering into the newfacility, the Company paid a fee of $1,875,000 to iStar and a termination feeof $199,500 to the lenders under the previously existing facility.

 

The warehouse credit line is secured by, among other things, theCompany’s loans.  All payments made byborrowers in respect of such loans are applied on a monthly basis to payoutstanding fee and interest obligations under the new warehouse credit lineand to reduce the principal amount outstanding under the new warehouse creditline by an amount equal to the portion of the payments on the loans thatconstitute payments of principal.

 

The maturity date of the new warehouse credit line is April 10,2005.  The availability of funds underthis credit line is subject to, among other things, compliance with specifiedfinancial covenants relating to leverage ratio, net worth, limitations oncapital expenditures and limitations on total indebtedness, as describedbelow.  The Company is required underthe warehouse facility to maintain a ratio of consolidated total debt toconsolidated net worth not in excess of 4:1 and a consolidated net worth of notless

 

16

----

 

than $80 million.  The Companygenerally may not maintain indebtedness outside the new warehouse credit lineother than indebtedness to fund obligations under the Company’s hedgingarrangements, purchase money indebtedness for the acquisition of assets not inexcess of $1,000,000, indebtedness in connection with securitizationtransactions and certain capital leases. In order to make a borrowing under the facility, either Vernon B.Schwartz, the Company’s Chairman and Chief Executive Officer, or David A. Karp,the Company’s President and Chief Financial Officer, must be employed as asenior executive officer of the Company with the same decision making authorityas on April 28, 2004.

 

The lender under the new warehouse credit line will generally fund upto 80%, the advance rate, of the principal amount of eligible loans that theCompany originates with the lender’s approval. The maximum funding available for any individual loan is not permittedto exceed $20 million.  Inaddition, the lender will not fund an amount in excess of 66.6% of theaggregate market value of the eligible loans.

 

The Company is required to make prepayments under the new warehousecredit line under certain circumstances. Among other things, the Company may be required to make prepayments upona decrease in the aggregate market value of the eligible loan portfolio.  Specifically, in the event that the lenderdetermines that the product of the market value of the eligible loans in theloan portfolio and the aggregate maximum advance rate of 66.6% is less than theaggregate outstanding principal amount under the warehouse credit line, then,subject to an exception for certain market value fluctuations of less than 5%,the Company will be required to prepay amounts borrowed under the new warehousecredit line sufficient to eliminate such deficiency.  The new warehouse credit line also specifies various events thatwould allow the lender to terminate the warehouse credit line in its entirety,including, among other things, the Company’s failure to qualify as a realestate investment trust under the Internal Revenue Code or a change of control.

 

***Changes inIndependent Public Accountant***

 

On April 16, 2004, the Company was notifiedby KPMG LLP (“KPMG”) that KPMG will resign as the Company’s principalaccountants upon completion of the review of the Company’s consolidatedfinancial statements as of and for the three month period ended March 31, 2004.

 

17

----

 

**ITEM2. Management’s Discussion and Analysis of Financial Condition and Results ofOperations**

 

You shouldread the following in conjunction with the accompanying unaudited consolidatedfinancial statements and related notes.

 

Statementscontained in this Form 10-Q which are not historical fact may beforward-looking statements within the meaning of Section 21(e) of theSecurities Exchange Act of 1934 (the ‘‘Exchange Act’’). We intend suchforward-looking statements to be covered by the safe harbor provisions forforward-looking statements contained in Section 21(e) of the Exchange Act.Forward-looking statements relate to expectations, beliefs, projects, futureplans and strategies, anticipated events or trends and similar expressionsconcerning matters that are not historical facts. In some cases, you canidentify forward-looking statements by terms such as “anticipate,” “believe,”“could,” “estimate,” “expect,” “intend,” “may,” “plan,” “potential” “should,”“will” and “would” or the negative of these terms or other comparableterminology.

 

Theforward-looking statements are based on our beliefs, assumptions andexpectations of our future performance, taking into account all informationcurrently available to us. These beliefs, assumptions and expectations canchange as a result of many possible events or facts, not all of which are knownto us or are within our control. If a change occurs, our business, financialcondition, liquidity and results of operations may vary materially from thoseexpressed in our forward-looking statements. You should carefully consider thefactors referenced in this report, including those set forth under the sectionscaptioned ‘‘Management’s Discussion and Analysis of Financial Condition andresults of Operations’’ and ‘‘Business.’’ Among the factors about which we havemade assumptions are the following:

 

• demand for our products;

 

• our ability to originate loans inaccordance with the terms of our new warehouse credit line;

 

• our ability to complete additionalsecuritizations;

 

• the stability of the automotive dealermarket;

 

• the ability of automotive dealers tomake loan payments to us;

 

• our ability to operate as a realestate investment trust; and

 

• national and local economic and marketconditions, including changes in interest rates.

 

Although webelieve that the expectations reflected in the forward-looking statements arereasonable, we cannot guarantee future results, levels of activity, performanceor achievements. You should not place undue reliance on these forward-lookingstatements, which speak only as of the date this Form 10-Q is filed with theSEC.

 

**Overview**

 

We are a fully integrated, self-advised REIT focused on the business oforiginating and servicing loans to automotive dealers in the United States. We havealso provided loans to select motorcycle dealers on a limited basis.  We have elected to be taxed as a REIT forfederal income tax purposes and are the successor to Falcon Financial, LLC,which was organized in Delaware in May 1997.

 

18

----

 

We closed our first loan in February 1998 and we have originated atotal of 114 loans representing approximately $690 million in aggregate initialprincipal amount through March 31, 2004. For the three months ended March 31, 2004, we originated 3 loanstotaling $27.3 million in aggregate initial principal amount and, as ofMarch 31, 2004, our portfolio consisted of 20 loans with an aggregateoutstanding principal balance of $154.1 million, and we had $0.0 millionin outstanding loan commitments. Our portfolio of 20 loans as of March 31,2004 had an average principal amount of $7.7 million, a weighted-averageremaining term of 160 months and a weighted-average interest rate of 8.86%.  To date, our loans have been long-term,fixed-rate, cash flow-based and generally under $15 million in loansize.  We have successfully securitizedfour pools of our loans in 1999, 2000, 2001 and 2003 totaling 92 loansrepresenting $517.0 million in aggregate principal amount at the date ofsecuritization, and we continue to provide primary servicing for all of oursecuritized loans.

 

We derive our revenues primarily from loan payments of interest andprincipal made by automotive dealers under loans we originate and from actingas primary servicer for our securitized loans. Historically, we also havederived revenues from gain on the sale of loans that we held and pooled forsecuritization because those transactions were structured as off-balance sheettransactions, as described below under the heading “—Off-Balance SheetArrangements.”  We currently intend tostructure our securitizations as on-balance sheet secured financings, andtherefore do not expect to record any gain on sale in connection with futuresecuritizations.  We expect that we willincur losses initially until our volume of loan originations increasessufficiently to offset the increased general and administrative expenses.

 

We enter into forward starting interest rate swap transactions tomitigate the effect that changes in interest rates and credit spreads have onthe forecasted issuance of long-term debt. In swap transactions, we willgenerally enter into an interest rate swap contract, receiving a floating rateof interest and paying a fixed rate of interest. The term of the swap contractsis determined by the duration of the forecasted long-term debt to be issued.The forward starting swaps are accounted for as cash flow hedges, thereforechanges in the fair value of the swaps are recorded in other comprehensiveincome.

 

Interest rates have recently begun to rise during the second quarter of2004, with many economists currently anticipating further increases during theremainder of 2004.  Changes in interestrates can affect our ability to originate loans, the value of our retainedinterests in securitization pools and our ability to securitize loans.  We only recently began to offervariable-rate loan products, which are an important part of our growthstrategy.  We are uncertain at this timeof the impact, if any, that any future interest rate increases may have on themix of new variable-rate loans and traditional fixed-rate loans that we areable to originate during the remainder of 2004.

 

A period of continued rising interest rates in the future also couldresult in a decline in the value of our retained interests in securitizationpools.  We have not historically andcurrently do not intend to enter into hedging transactions to mitigate ourexposure to interest rate risk relating to the value of our retainedinterests.  We periodically seek tosecuritize our pool of loans as an important source of funding for ourbusiness.  An increase in interest ratescould affect our ability to securitize our existing loans on favorable terms orat all.

 

Our business depends on our access to external sources of financing ata cost we can absorb while still generating an attractive risk-adjusted returnon the loans we fund using the proceeds of our financings.  We funded our operations primarily throughthe net proceeds from our initial public offering and subsequent over-allotmentand our $150 million warehouse line of credit.

 

We have experienced only four loan defaults since our inception.  The first defaulted loan was in our 2001securitization and resulted in a loss of principal of $2.8 million. Onedefault has been cured and the borrower was current with respect to itsobligations as of March 31, 2004.  Thetwo other defaults relate to loans in our 2003 securitization and 2001securitization, respectively. Although these loan defaults have not yet beenresolved, we have estimated losses upon the resolution of these loans ofapproximately $3.5 million and $1.0 million, respectively.  These estimated losses were taken intoconsideration when establishing the value of retained interests held by us inconnection with the securitized pools in which these loans are held andresulted in a charge of $0.4 million and $0.2 million, respectively.  We cannot provide any assurance that theloss will fall within the range indicated. When we have sold our loans into a securitization, we make certainassumptions about loan losses in calculating the estimated fair value of ourretained interests in the securitizations. We will account for our futuresecuritizations as on-balance sheet financings.  Accordingly, we have established a reserve for possible loanlosses for estimated losses inherent in our loan portfolio.

 

19

----

 

We plan to focus on internal growth of our business by expanding ourloan product offerings to include our new variable-rate cash flow-based andfixed-rate and variable-rate real estate mortgage loan products, which werecently introduced in the marketplace. We expect to incur additional costs to introduce these new products aswe must hire additional employees and increase our marketing, advertising andunderwriting efforts.  We also expect toface increased competition from established providers in connection with ouroffering of real estate mortgage loan products, which could affect the profitabilityof these products.

 

We intend to pay regular quarterly distributions of all orsubstantially all of our REIT taxable income to holders of our common shares.Any future distributions we make will be at the discretion of our board oftrustees and will depend upon, among other things, our actual results ofoperations.  Our actual results ofoperations and our ability to pay distributions will be affected by a number offactors, including the revenue we receive from our loans, our ability tocomplete additional loan securitizations, our operating expenses, the abilityof our customers to meet their loan payment obligations and unanticipatedexpenditures.

 

The discussion of financial condition and results of operations relatesin part to our predecessor, Falcon Financial, LLC, a Delaware limited liabilitycompany formed in 1997.  Immediatelyprior to the closing of our initial public offering, Falcon Financial, LLCmerged with and into Falcon Financial Investment Trust, a newly formed Marylandreal estate investment trust.  Inconnection with our election to be taxed as a REIT following the completion ofour initial public offering, we have a fiscal year ending on December 31,as opposed to a fiscal year ending on September 30, which was used by ourpredecessor.  The results for the threemonths ended March 31, 2003 included herein are the results of ourpredecessor, Falcon Financial, LLC.

 

**Off-Balance Sheet Arrangements**

 

Historically, we have funded our business in substantial part with theproceeds from four securitization transactions in 1999, 2000, 2001 and 2003totaling $517.0 million in aggregate principal amount at the date ofsecuritization. After originating a sufficient number of loans to develop apool available for securitization, our approach has been to subsequently sellthe loans we originate in a securitization transaction. These securitizationtransactions have been critically important to us as a primary source of fundsto originate loans.

 

We have structured each of our four securitizations as off-balancesheet transactions, and therefore we have recorded gain on sale with respect tothe loans included in each securitization. We currently intend to structure our future securitizations ason-balance sheet secured financings. As a result of this anticipated change instructuring future securitizations, comparisons of our future results ofoperations to our historical operating results may not be meaningful.  In particular, we do not expect to record anygain on sale in connection with future securitizations and instead willcontinue to recognize interest income associated with each loan we originateand interest expense associated with secured borrowings even after we place theloan into securitization.  Inconjunction with the secured financing transaction, we will record securedborrowings as well as the associated securitization expenses, which will beamortized over the term of the financing. Since the future transactions will not be sale transactions, theassociated loan receivables will remain on our financial statements instead ofbeing removed as was the case historically with a sale securitizationtransaction.  The effect on the futurefinancial statements will be that the loan receivable portfolio along with ourborrowings will continue to increase with each new loan we issue.  The increase in loan assets and relatedliabilities will also create a corresponding increase in interest income onloans along with an increase in interest expense from the relatedfinancings.  Since we will no longer beselling the loan assets, there will be no gain on sale of loans recorded in thestatement of operations, nor will there be a related retained interest as aresult of future securitizations recorded on the balance sheet.  The total portfolio of loans, theirapplicable financing arrangements, their interest income and related interestexpense and a provision for and allowance for potential loan losses will bereflected on our financial statements. The on-balance sheet approach will also show the earnings over theentire term of the loan on a more consistent basis as compared to showingearnings for a short period and then reflecting a gain on sale transaction, aswas the case historically.  The impactof securitizing loans using on-balance sheet treatment is that the economicbenefit of our loans will be realized over their life, rather than recognizingtheir present value early in their economic life in the form of gain on sale.

 

20

----

 

Our ability to complete additional securitizations in the future may beaffected by several factors, including the following:

 

•                  disruptionsin the credit quality and performance of our loan portfolio and the performanceof loans included in our prior securitizations;

 

•                  anymaterial downgrading or withdrawal of ratings assigned to securities issued inour prior securitizations;

 

•                  disruptionsin the capital markets generally; or

 

•                  anyfailure by us to adequately service our loan portfolio.

 

For each previous and future securitization transaction, the loan trustcertificates represent beneficial interests in one or more trust fundsestablished by our special purpose bankruptcy remote subsidiary.  The trust fund assets consist primarily ofbonds issued by a trust established by the special purpose subsidiary.  The bonds are generally secured by loanssecured by interests in real estate used in the operation of automotivedealerships and also secured by a lien on the business assets, includingautomobile parts and equipment and intangible property but not the dealership’sautomobile inventory.

 

We also are subject to off-balance sheet risk in the normal course ofour business from commitments we make to extend credit to automotive dealers.As of March 31, 2004 and December 31, 2003, we had commitments toextend credit to our customers of $0 and $2.2 million, respectively, andamounts available under our warehouse credit line of $75.8 million and$96.5 million, respectively, to fund such commitments.

 

**Critical Accounting Policies and ManagementEstimates**

 

Our unaudited consolidated financial statements include all of theaccounts of our Company. The preparation of financial statements in accordancewith GAAP requires management to make estimates and assumptions in certaincircumstances that affect the amounts reported in the accompanying unauditedconsolidated financial statements. In the preparation of these financialstatements, management uses its best estimates and judgments as they relate tocertain amounts which are included in the financial statements, giving adequateconsideration to materiality. We believe that our estimates and assumptions arereasonable and that there is not a great likelihood that materially differentamounts would be reported relating to the accounting policies as described inNote 2 of the accompanying unaudited consolidated financial statements.However, the application of these accounting policies involves the exercise ofjudgment and use of estimates as to future uncertainties and, as a result, actualresults could differ from those estimates. The following summarizes theCompany's Critical Accounting Policies which have been reviewed with theCompany's audit committee:

 

***Loansand Loans Held for Sale***

 

We originate loans that areunderwritten with the intention of securitizing the receivables in a financingtransaction, which will be accounted for as secured borrowings under theprovisions of SFAS Statement No. 140, “Accounting for Transfers andServicing of Financial Assets and Extinguishment of Liabilities”, and carry theloans on the statement of financial position to maturity. The loans receivableare stated at their principal amount outstanding, less net deferred loan fees,unearned discounts and allowance for loan losses. Nonrefundable originationfees less certain related direct costs associated with the origination of theloans are deferred and amortized into interest income over the term of the loanusing a method that approximates the interest method.

 

All loans originated by ourpredecessor were underwritten with the intention of selling by way of asecuritization transaction and were accounted for as loans held for sale on thestatement of financial position. The amount (if any) by which the cost basis ofthe loans exceeds their estimated fair value is recorded through a valuationallowance. Changes in the valuation allowance are recorded in the statement ofoperations.

 

***Allowancefor Possible Loan Losses***

 

The allowance for possible loanlosses is based on a periodic analysis of the loan portfolio and inmanagement’s judgment, reflects an amount that is adequate to absorb lossesinherent in the existing loan portfolio. In evaluating the portfolio,management considers a variety of factors such as the size of the portfolio,prior loss experience, current and potential risks of the loan portfolio,present financial condition of the borrower, current economic conditions andother portfolio risk characteristics. Provisions for possible loan losses arecharged to operations. Loans, including impaired loans, are charged off againstthe allowance for loan losses when actual losses have been established.

 

A loan is impaired when, basedon current information and events, it is probable that a creditor will beunable to collect all amounts due according to the contractual terms of theloan agreement. A loss from impairment represents the amount by which acreditor’s recorded investment in a loan exceeds the present value of theexpected future cash flows from the loan discounted at the loan’s effective interestrate (including the fair value of the collateral that may be part of the loan).Losses for which such provisions for impairment are made, unless applied as awrite-down of the recorded investment in the loan, represent a portion of thecreditor’s allowance for loan losses.

 

21

----

 

***RetainedInterests in Loan Securitizations***

 

Historically, we have soldthrough securitization transactions substantially all of the loans weoriginate. We account for our loan securitizations in accordance with Statementof Financial Accounting Standards (SFAS) No. 140, *Accounting for Transfers and Servicing of FinancialAssets and Extinguishment of Liabilities—a replacement of FASB Statement 125*.When we sold loans in a securitization, we retained one or more subordinatedcertificates from the certificates issued. Securitizations may be structured invarious ways but generally conform to a common model. Typically, an issuersells a portfolio of loans to a special-purpose entity established forthe sole purpose of purchasing and reselling the loans to a securitizationtrust. The securitization trust then may issue bonds or certificatescollateralized by the loans transferred to the securitization trust. Theproceeds received from these bonds or certificates are used to purchase theloans from the issuing entity. The gain on the sale of loans is the differencebetween the proceeds from the sale of loans, net of related sale costs, and theallocated carrying amount of the receivables sold, including deferredorigination fees and costs. We determine the carrying amount by allocating thetotal carrying amount of the loans sold between the portion sold and theinterests retained based on each portion’s relative fair values at the time ofthe securitization. Assumptions used in calculating the estimated fair value ofsuch retained interests are subject to volatility that could materially affectoperating results.

 

Retained interests insecuritizations are accounted for as available for sale securities and arecarried at estimated fair value, with unrealized gains or losses included instockholders’ equity (accumulated other comprehensive income or loss). We arenot aware of an active market for the purchase and sale of these retainedinterests at this time; accordingly, we estimate the fair value of the retainedinterest by calculating the present value of the estimated expected future cashflows received by us after being released by the securitization trust, using adiscount rate commensurate with the risk involved. The cash flows beingdiscounted are adjusted for estimated net losses due to defaults or prepaymentsof the underlying loans. As of March 31, 2004, we had two loans indefault, one of which related to a loan in our 2003 securitization and theother to our 2001 securitization. The loan default relating to the 2003securitization has not yet been resolved and we have estimated the loss uponresolution of the defaulted loan of approximately $3.5 million. Theestimated loss resulted in a reduction in the estimated value of our retainedinterest in the 2003 securitization of approximately $0.7 million as ofSeptember 30, 2003. The second loan default, which related to our 2001securitization has not yet been resolved and we have estimated the loss uponresolution of the defaulted loan of approximately $1.0 million. Theestimated loss resulted in a reduction in the estimated value of our retainedinterest in the 2001 securitization of approximately $0.2 million as ofDecember 31, 2003. We cannot provide any assurance that the losses willfall within the range indicated. During the three months ended March 31, 2004,the real estate collateral for the loan in default in the 2001-1securitization (with an outstanding balance of approximately $2.5 million)was foreclosed upon. All other loans included in our securitization pools arecurrent.

 

Each loan securitization has aspecific credit enhancement in the form of cash flow requirements that must bemet before we receive any cash on our retained interest.

 

Changes in the fair value of theretained interests resulting from changes in the timing of cash flows to bereceived by us or changes in market interest rates are adjusted through othercomprehensive income in members’ equity. Reductions in the estimated aggregatecash flows to be received by us, caused by defaults or prepayments or thetiming of expected future cash flows that result in a reduction to the fairvalue below the historical cost basis of the retained interests, are consideredan other than temporary impairment and are recognized through a charge toexpense in that period.

 

***DerivativeInstruments and Hedging Activities***

 

In June 1998, the FinancialAccounting Standards Board (FASB) issued Statement of Financial AccountingStandards (SFAS) No. 133, *Accountingfor Derivative Instruments and Hedging Activities*. InJune 1999, the FASB issued SFAS No. 137, *Accounting for Derivative Instruments and Hedging Activities—Deferralof the Effective Date of SFAS No. 133*. In June 2000, theFASB issued SFAS No. 138, *Accountingfor Certain Derivative Instruments and Certain Hedging Activities, an amendmentof SFAS No. 133*. These Statements, collectively referred to asSFAS No. 133, establish accounting and reporting standards requiring thatevery derivative instrument, including certain derivative instruments embeddedin other contracts, be recorded on the balance sheet as either an asset orliability measured at its fair value. Changes in the fair value of thederivative are to be recognized currently in earnings

 

22

----

 

unless specific hedge accounting criteria aremet. Special accounting for qualifying hedges allows gains and losses onderivatives to offset related results on the hedged items in the statement ofoperations and requires that a company must document, designate, and assess theeffectiveness of transactions that receive hedge accounting under SFASNo. 133.

 

We enter into forward startinginterest rate swap transactions to mitigate the effect that changes in interestrates and credit spreads have on the forecasted issuance of long-term debt. Inswap transactions, we will generally enter into an interest rate swap contract,receiving a floating rate of interest and paying a fixed rate of interest. Theterm of the swap contracts is determined by duration of the forecastedlong-term debt issuance. These swap transactions are accounted for as cash flowhedges, therefore, changes in their estimated fair value are recorded in othercomprehensive income.

 

Our predecessor has entered intocertain transactions (short sales and purchases, securities resale andrepurchase agreements, and interest rate swaps) to mitigate the effect thatchanges in interest rates and credit spreads have on the fair value of itsfixed rate loan portfolio held for sale. Periods of rising interest rates andwidening credit spreads decrease the fair value of the loan portfolio held forsale. Generally, we enter into these transactions when the rate is locked on apending loan just prior to the closing of the loan. The new loan is added tothe pool of loans being held for sale and the pool is then reviewed todetermine what, if any, additional hedging transaction is to be executed.Generally, our predecessor shorted U.S. Treasuries and invested the proceeds inrepurchase agreements with Goldman, Sachs & Co. with U.S. Treasurynotes as the underlying securities. In swap transactions, our predecessorentered into an interest rate swap contract, receiving a floating rate of interestand paying a fixed rate of interest. The term of the swap contracts isdetermined by duration of the loans held for sale pool. Our predecessor has acontractual obligation to settle the repurchase and swap agreements withGoldman, Sachs & Co. at the current fair value on the repurchase date.These contracts have been recorded as free standing derivatives with changes infair value recorded in earnings.

 

We carry each of the derivativeinstruments on our statement of financial condition at fair value or amounts thatapproximate fair value. The determination of fair value is fundamental to ourstatement of financial condition and operations. The fair value of a financialinstrument is the amount at which the instrument could be exchanged in acurrent transaction between willing parties, other than in a forced orliquidation sale. Quoted market prices in active markets are the best evidenceof fair value and we use them when available. We typically obtain them throughelectronic quotations or published prices. If quoted market prices in activemarkets are not available, our estimate of fair value is based on, ifavailable, quoted prices or recent transactions in less active markets and/orprices of similar instruments. We typically obtain this type of information throughbroker quotes or third-party pricing sources.

 

23

----

 

**Results of operations for the three monthsended March 31, 2004 and 2003**

 

***Revenue***

 

Total revenue for the three months ended March 31, 2004, or FirstQuarter 2004, decreased by approximately $11.5 million, or 77.1%, toapproximately $3.4 million from approximately $14.9 million for the threemonths ended March 31, 2003, or First Quarter 2003. The decrease wasprimarily due to decreases in gain on sale of loans, gain on sale of retainedinterests and gain on sale of securities sold, but not yet purchased. Thesedecreases were partially offset by increases in interest income on loans,change in value of interest rate swap contracts and other income.

 

Interest income on loans for First Quarter 2004 increased byapproximately $1.3 million, or 79.4%, to approximately $2.9 million fromapproximately $1.6 million in First Quarter 2003. The increase was primarilydue to an increase in the weighted average portfolio of loans, approximately$132.7 million in First Quarter 2004, as compared to approximately $85.3million in First Quarter 2003, as well as an increase in the weighted averageinterest rate on loans, approximately 8.9% in First Quarter 2004, as compared toapproximately 8.0 % in First Quarter 2003.

 

Interest income from retained interests for First Quarter 2004decreased by approximately $0.1 million, or 14.5%, to approximately $0.3million from approximately $0.4 million in First Quarter 2003. The decrease wasprimarily due to the effect of two loans in our securitized pools which havedefaulted.

 

We did not record any gain on sale of loans in First Quarter 2004,while we recorded a gain on sale of loans for First Quarter 2003 ofapproximately $10.7 million as a result of the securitization transaction2003-1. We intend to account for all future securitizations as on-balance sheetsecured financings, and as such will no longer be subject to gain on saleaccounting.

 

Gain on sale of retained interests for First Quarter 2003 wasapproximately $0.3 million as a result of a sale of one of the retainedinterests in the 2003-1 transaction. There were no sales of retained interestsduring First Quarter 2004.

 

Gain on securities sold, but not yet purchased for First Quarter 2003was approximately $1.1 million as a result of market fluctuations and thecomposition of our hedging instruments. We did not use this hedging instrumentduring First Quarter 2004.

 

Change in value of interest rate swap contracts for First Quarter 2004decreased by approximately $0.8 million to a loss of approximately $0.1 millionfrom a gain of approximately $0.7 million in First Quarter 2003. The increasewas primarily due to market fluctuations and the composition of our hedginginstruments.

 

Income from loan servicing for First Quarter 2004 increased slightlyover First Quarter 2003 to approximately $0.1 million, or 15.1%. The increasewas primarily due to the loan servicing income from an additionalsecuritization which was completed in February  2003.

 

Other income for First Quarter 2004 increased by approximately $0.1million to approximately $0.1 million from approximately $0.0 million in FirstQuarter 2003. The increase was due to interest income earned on our  cash and cash equivalents during FirstQuarter 2004, primarily as a result of the unexpended proceeds from our initialpublic offering and over-allotment.

 

***Expenses***

 

Total expenses for First Quarter 2004 increased by approximately $1.4million, or 53.9%, to approximately $4.0 million from approximately $2.6million in First Quarter 2003. The increase was primarily due to increases inprovision for possible loan losses, facility fee expense, professional fees,salaries and benefits and general and administrative expenses. These increaseswere partially offset by decreases in interest expense on borrowings andinterest expense on securities sold, not yet purchased.

 

Total interest expense on borrowings for First Quarter 2004 decreasedby approximately $0.4 million, or 49.3%, to approximately $0.4 million fromapproximately $0.8 million in First Quarter 2003. The decrease was primarilydue to 

 

24

----

 

a decrease in the weighted average debt balance and a decrease in theweighted average interest rate for First Quarter 2004. The weighted averageinterest rate for our borrowings during First Quarter 2004 was approximately2.96% as compared to approximately 3.78% during First Quarter 2003. Theweighted average debt balance during First Quarter 2004 was approximately $59.0million as compared to approximately $91.1 million during First Quarter 2003.

 

Interest expense on securities sold, but not yet purchased for FirstQuarter 2004 decreased by approximately $0.1 million, or 100%, to $0.0 millionfrom approximately $0.1 million in First Quarter 2003. The decrease wasprimarily due to market fluctuations and the composition of our hedginginstruments.

 

Bad debt expense for First Quarter 2004 was approximately $0.2 million.Prior to December 22, 2003, no bad debt expense was recorded.

 

Facility fee expense for First Quarter 2004 increased by approximately$0.7 million to approximately $0.8 million from approximately $0.1 million inFirst Quarter 2003. The increase was due to increased facility fees associatedwith the extension of our warehouse line of credit.

 

Salaries and benefits for First Quarter 2004 increased by approximately$0.5 million, or 63.0%, to approximately $1.4 million from approximately $0.9million in First Quarter 2003. The increase was primarily due to increases insalaries and bonuses paid or accrued, as well as the amortization of deferredcompensation expense relating to the restricted share grants.

 

Professional fees for First Quarter 2004 increased by approximately$0.2 million to approximately $0.3 million from approximately $0.1 million inFirst Quarter 2003. The increase was primarily due to increases in legal,accounting and auditing fees.

 

General and administrative expenses for First Quarter 2004 increased byapproximately $0.3 million, or 104.1%, to approximately $0.5 million fromapproximately $0.2 million in First Quarter 2003. The increase was primarilydue to an increase in insuranceexpense.                            .

 

Advertising and promotion for First Quarter 2004 increased byapproximately $0.1 million, or 37.2%, to approximately $0.3 million fromapproximately $0.2 million in First Quarter 2003. The increase was primarilydue to an increase in advertising relating to the new loanproducts.                            .

 

***Net loss***

 

The net loss for First Quarter 2004 was approximately $0.5 million, ascompared to a gain of approximately $12.3 million in First Quarter 2003.

 

**Financial Condition, Liquidity and Capital Resources**

 

***Cash and CashEquivalents***

 

As of March 31, 2004 and December 31, 2003 we had $32.6million and $25.6 million, respectively, in cash and cash equivalents. Weinvest cash on hand in short-term liquid investments.  We expect to fund new loan originations using borrowings underour new warehouse line of credit and proceeds from our initial public offering.

 

***Retained Interestsin Loan Securitizations***

 

As of March 31, 2004 and December 31, 2003 we had retainedinterests in loan securitizations of $7.4 million and $7.2 million,respectively.

 

25

----

 

As of March 31, 2004 our retained interests consisted of thefollowing securities with estimated fair values as indicated:

 
| Falcon Franchise Loan Trust Certificates,  Series 1999-1 Class F       |   | $         | 2,071,320 |   |
|-----------------------------------------------------------------------------|--------|-----------|-----------|--------|
| Falcon Franchise Loan Trust Certificates,  Series 1999-1 Class G       |   | 1,149,593 |      |
| Falcon Franchise Loan Trust Certificates,  Series 2000-1 Class G       |   | 1,128,761 |      |
| Falcon Auto Dealership Loan Trust  Certificates, Series 2001-1 Class G |   | 1,316,633 |      |
| Falcon Auto Dealership Loan Trust  Certificates, Series 2003-1 Class G |   | 1,720,440 |      |
|                                                                        |   |      |      |
|                                                                        |   | $         | 7,386,747 |   |

 

We estimate the fair value of the retained interest by calculating thepresent value of the estimated expected future cash flows received by us, usinga discount rate commensurate with the risk involved. We have experienced onlyfour loan defaults since our inception. The first defaulted loan was in our 2001 securitization and resulted ina loss of principal of $2.8 million. One default has cured and ispresently current with respect to their obligations.  The two other defaults relate to loans in our 2003 securitizationand 2001 securitization, respectively. Although these loan defaults have notyet been resolved, we have estimated losses upon the resolution of these loansof approximately $3.5 million and $1.0 million, respectively.  We took into account these estimated losseswhen establishing the value of retained interests held by us in connection withthe securitized pools in which these loans are held and resulted in a charge of$0.4 million and $0.2 million, respectively. We cannot provide any assurance that the loss will fall within the rangeindicated.

 

***Liquidity andBorrowings***

 

*Liquidity.*  Our short term liquidity requirementsconsist primarily of funds necessary to originate new loans to automotivedealers and to pay for other expenditures including interest and principalpayments on our warehouse line and subordinated debt, net interest expense onour hedging activities, salaries and employee benefits, general and administrativeexpenses, advertising and promotions and capital expenditures.

 

Our primary sources of liquidity for the three months endedMarch 31, 2004 were net proceeds from the over-allotment and borrowingsfrom our warehouse line of credit. Our primary sources of liquidity for thethree months ended March 31, 2003 were net proceeds from the sale ofloans, borrowings from subordinated loans and borrowings from a warehouse lineof credit. We have historically funded our short-term liquidity requirementsfrom these three sources.

 

We expect cash from additional borrowings on existing and futurewarehouse lines of credit, proceeds from the completion of additionalsecuritizations, the proceeds of our IPO and over-allotment and cash fromoperations to be adequate to support our operations for the next12 months.

 

*Loan Securitization Transactions.*  We sold at issuance $104.6 million ofloan trust certificates through securitization transactions in 1999,$111.6 million in 2000, $122.2 million in 2001 and $123.4 millionin 2003. To finance our business, we are substantially dependent uponcompleting additional loan securitizations in the future. Factors that couldaffect our future ability to securitize loans that we originate includeinvestor demand, credit spreads relative to other investments and the generallevel of interest rates relative to other types of investments. We cannotprovide any assurances that we will be able to complete additional loansecuritizations on favorable terms or at all.

 

26

----

 

*Termination of existing warehouse credit line*

 

We entered into a $150 million Revolving Warehouse FinancingAgreement in January 1998 with SunAmerica Life Insurance Company, orSALIC, and ABN AMRO Bank, N.V., solely for the purpose of originating loans.SALIC, along with Goldman Sachs Mortgage Company, as a result of aparticipation agreement between the two entities, are the guarantors of theRevolving Warehouse Financing Agreement. As guarantors, each of the entities waspaid fees of $197,998 for the three months ended March 31, 2003. The feesare shown on the statements of operations within the caption “interestexpense—related party.” Interest was calculated using a 30-day commercial paperrate plus 300 basis points until December 22, 2003 when it was decreasedto a 30-day commercial paper rate plus 200 basis points. As of March 31,2004 and December 31, 2003, the outstanding balance was $74.2 millionand $53.5 million, respectively. The interest rate as of March 31,2004 and December 31, 2003 was 3.03% and 3.09%, respectively.  In connection with entering into our newwarehouse credit line described below, we paid in full the outstanding balanceon April 28, 2004.

 

The warehouse credit line was secured by, among other things, all loansin our portfolio that have not been securitized. We expect to fund loans usingour warehouse credit line until we complete a loan securitization, whichgenerally means that we rely upon the warehouse credit line to fund loans forless than one year. All payments made by our customers in respect of such loansare applied on a monthly basis to pay outstanding fee and interest obligationsunder the warehouse credit line and to reduce the principal amount outstandingunder the warehouse credit line by an amount equal to the portion of thepayments on our loans that constitute payments of principal. Any amountsremaining after such application are paid to us.

 

*New warehouse credit line*

 

On April 28, 2004, we entered into a $150 million Revolving WarehouseFinancing Agreement with iStar Financial Inc., solely for the purpose of originatingloans.  The facility may be increased to$200 million at our option with the consent of iStar. Interest is calculatedusing LIBOR plus 290 basis points. Under the facility, iStar financed all of the company’s existingoutstanding loans that were financed under the previously existing warehousefacility, which was terminated.  Inconnection with entering into the new facility, we paid a fee of $1,875,000 toiStar and a termination fee of $199,500 to the lenders under the previouslyexisting facility.

 

The warehouse credit line is secured by, among other things, ourloans.  All payments made by borrowersin respect of such loans are applied on a monthly basis to pay outstanding feeand interest obligations under the new warehouse credit line and to reduce theprincipal amount outstanding under the new warehouse credit line by an amountequal to the portion of the payments on the loans that constitute payments ofprincipal.

 

The maturity date of our new warehouse credit line is April 10,2005.  The availability of funds underthis credit line is subject to, among other things, our compliance with specifiedfinancial covenants relating to leverage ratio, net worth, limitations oncapital expenditures and limitations on total indebtedness, as describedbelow.  We are required under thewarehouse facility to maintain a ratio of consolidated total debt toconsolidated net worth not in excess of 4:1 and a consolidated net worth of notless than $80 million.  We generally maynot maintain indebtedness outside the new warehouse credit line other thanindebtedness to fund obligations under our hedging arrangements, purchase moneyindebtedness for the acquisition of assets not in excess of $1,000,000,indebtedness in connection with our securitization transactions and certaincapital leases.  In order to make aborrowing under the facility, either Vernon B. Schwartz, our Chairman and ChiefExecutive Officer, or David A. Karp, our President and Chief Financial Officer,must be employed as a senior executive officer of our company with the samedecision making authority as on April 28, 2004.

 

The lender under the new warehouse credit line will generally fund upto 80%, the advance rate, of the principal amount of eligible loans that weoriginate with the lender’s approval. The maximum funding available for any individual loan is not permittedto exceed $20 million.  Inaddition, the lender will not fund an amount in excess of 66.6% of theaggregate market value of our eligible loans.

 

We are required to make prepayments under the new warehouse credit lineunder certain circumstances.  Amongother things, we may be required to make prepayments upon a decrease in theaggregate market value of our eligible loan portfolio.  Specifically, in the event that the lenderdetermines that the product of the market value of the eligible loans in ourloan portfolio and the aggregate

 

27

----

 

maximum advance rate of 66.6% is less than the aggregate outstandingprincipal amount under the warehouse credit line, then, subject to an exceptionfor certain market value fluctuations of less than 5%, we will be required toprepay amounts borrowed under the new warehouse credit line sufficient toeliminate such deficiency.  The newwarehouse credit line also specifies various events that would allow the lenderto terminate the warehouse credit line in its entirety, including, among otherthings, our failure to qualify as a real estate investment trust under theInternal Revenue Code or a change of control.

 

***Commitments***

 

As of March 31, 2004, wewere obligated under noncancelable operating lease agreements for office spaceand computer equipment.  The futureminimum lease payments under these lease agreements at March 31, 2004were:

 
| 2004 (April 1 to March 31) |   | $       | 143,325   |   |
|----------------------------|--------|---------|-----------|--------|
| 2005                       |   | 198,453 |      |
| 2006                       |   | 208,248 |      |
| 2007                       |   | 218,049 |      |
| 2008                       |   | 227,853 |      |
| Thereafter                 |   | 807,276 |      |
|                       |   | $       | 1,803,204 |   |

 

As of March 31, 2004, wewere obligated to repay the $74.2 million in outstanding borrowings under ourwarehouse credit line by the expiration date of October 1, 2004, which werepaid in full on April 28, 2004 in connection with entering into our newwarehouse credit line.

 

We have entered into employmentagreements with three members of senior management. The agreements range interm from two to three years, subject to additional one year renewals. Thefuture minimum salary expense relating to these agreements is $900,000,$900,000 and $750,000 for the years ended December 31, 2004, 2005 and2006, respectively.

 

***CapitalExpenditures***

 

We expect to upgrade our loanadministration and accounting software in the first six months of 2004 at acost of approximately $0.3 million. We do not anticipate incurring anyother significant capital expenditures in the 2004.

 

**Related Party Transactions**

 

We are involved in significant financing, risk management and othertransactions, and have significant related party balances, with Goldman,Sachs & Co., an affiliate of MLQ Investors, L.P., SunAmericaInvestments, Inc., SALIC, an affiliate of SunAmerica Investments, Inc., and Falcon Auto Venture, LLC both directlyand indirectly through affiliates and subsidiaries of the entities. We enterinto these transactions in the ordinary course of business and believe that theterms of these transactions are on market terms that could be obtained fromunrelated third parties. As of December 22, 2003 after the IPOtransaction, the aforementioned related parties are no longer consideredrelated parties as their ownership of the Company has been significantlyreduced (less than 5%)

 

Included inthe Statement of Operations are revenues and expenses resulting from variousfinancing, capital markets transactions and loan sales transactions. Thefollowing table sets forth the related party revenues and expenses included inthe respective captions on the Statement of Operations for the three monthsended March 31, 2003. The amounts reflect the related party transactionswith Goldman, Sachs & Co., except where otherwise indicated and are asfollows:

 
|                                                                                                                                 |   | **Three  months ended  March 31,2003** |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------------------------------|--------|
| Interest income on securities purchased  under resale agreements                                                                     |   | $                                           | 22,732 |   |
| Gain on sale of loans-fee expense                                                                                                    |   | (1,414,936                                  | )      |
| Change in value of interest rate swap  contracts                                                                                     |   | 678,816                                     |   |
|                                                                                                                                 |   |                                        |   |
| Gain on securities sold, but not yet  purchased                                                                                      |   | 1,081,269                                   |   |
| Interest expense on borrowings ($328,099  and $16,343  related to SunAmerica,  Inc. and Falcon Auto Venture, LLC, respectively) |   | 672,542                                     |   |
| Interest expense on securities sold ,but  not yet repurchased                                                                        |   | 149,304                                     |   |
|                                                                                                                                 |   |                                        |   |
| Facility fee expense ($46,875  related to SunAmerica, Inc.)                                                                     |   | 93,750                                      |   |
|                                                                                                                                      |        |                                             |        |  |

 

**ITEM3. Quantitative and Qualitative Disclosers About Market Risk**

 

Market risk refers to the risk of loss from adverse changes in thelevel of one or more market prices, rate indices, or other market factors.  We are exposed to market risk primarily fromchanges in interest rates and credit spreads. These two main risks are very sensitive to a variety of factorsincluding political, economic, monetary and tax policies and other factorsoutside of our control.  As describedbelow, we use some derivative financial instruments to manage or hedge interestrate risks related to our loans held for sale portfolio.  We do not use derivatives for trading orspeculative purposes and only enter into contracts with major financialinstitutions based on their credit ratings and other factors.

 

***Interest RateExposure***

 

The primary interest rate exposure to which we are subject to relatesto our fixed-rate loan portfolio, our forecasted issuance of long-term debt,interest rate swaps, our floating rate warehouse line of credit and ourretained interests in securitization pools. Any change in the general level ofinterest rates in the market can affect our net interest income in either apositive or negative manner. Net interest income is the difference between theincome earned from interest bearing assets less the expense incurred relatingto interest bearing liabilities. Fluctuations in the interest rate environmentcan also affect our ability to acquire new loans, the value of our loanportfolio and our ability to finance the loans.

 

28

----

 

 

We enter into forward starting interest rate swap transactions tomitigate the effect that changes in interest rates and credit spreads have onthe forecasted issuance of long-term debt. In swap transactions, we willgenerally enter into an interest rate swap contract, receiving a floating rateof interest and paying a fixed rate of interest. The term of the swap contractsis determined by the duration of the forecasted long-term debt to be issued.The forward starting swaps are accounted for as cash flow hedges, thereforechanges in the fair value of the swaps are recorded in other comprehensiveincome.

 

We have not historically and currently do not intend to enter intohedging transactions to mitigate our interest rate exposure relating to thevalue of our retained interests in securitization pools. The fair value of ourloan portfolio can decline during periods of rising interest rates and wideningcredit spreads. Generally, we enter into these transactions when the rate islocked on a pending loan. In swap transactions, we will generally enter into aninterest rate swap contract, receiving a floating rate of  interest and paying a fixed rate ofinterest. The term of the swap contracts is determined by the duration of theforecasted long-term debt to be issued. We have a contractual obligation tosettle the repurchase and swap agreements with Goldman, Sachs & Co. at thecurrent fair value on the repurchase date.

 

**ITEM4. Controls and Procedures**

 

As of  March 31, 2004, ourprincipal executive officer and our principal financial officer have performedan evaluation of the effectiveness of our disclosure controls and procedures(as defined in Rules 13a-14(c) and 15d-14(c) of the Securities Exchange Act of1934, or Exchange Act, and concluded that our disclosure controls andprocedures are effective to ensure that information required to be disclosed bythe issuer in the reports that it files or submits under the exchange Act isrecorded, processed, summarized and reported, within the time periods specifiedin the Securities and Exchange Commission, or SEC, rules and forms.  The officers have also concluded that therewere no significant changes in our internal controls or in other factors thatcould significantly affect these controls subsequent to the date of theirevaluation, including any corrections with regard to significant deficienciesand material weaknesses.  There havebeen no significant changes in our internal controls or in other factors whichcould significantly affect internal controls subsequent to March 31, 2004.

 

29

----

 

**PART IIOTHER INFORMATION**

 

**Item 1.**                                   **LegalProceedings**

 

Notapplicable

 

**Item 2.**                                   **Changes inSecurities**

 

On December 22, 2003, we closed the sale of 12.5 million common shares inour initial public offering pursuant to a registration statement that wasdeclared effective on December 16, 2003 (Registration No. 333-108603). OnFebruary 2, 2004, we sold 1.875 million common shares pursuant to the exerciseof the underwriters' over-allotment option.

 

**Item 3.**                                   **Defaults UponSenior Securities**

 

Notapplicable

 

**Item 4.**                                   **Submission ofMatters to Vote to Security Holders**

 

Notapplicable

 

**Item 5.**                                   **OtherInformation**

 

Notapplicable

 

**Item 6.**                                   **Exhibits andReports on Form 8-K.**

 

(a)             Exhibits:

 
| **Exhibit No.** |   | **Description**                                                                                                                                                                                                                                                                                  |
|-----------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |   |                                                                                                                                                                                                                                                                                             |
| 3.1*            |   | Amended  and Restated Declaration of Trust.                                                                                                                                                                                                                                                      |
| 3.2*            |   | Bylaws  of the Company.                                                                                                                                                                                                                                                                          |
| 4.1*            |   | Form  of Common Share Certificate.                                                                                                                                                                                                                                                               |
| 10.1            |   | Revolving  Warehouse Financing Agreement, dated as of April 28, 2004, among Falcon  Financial Investment Trust, iStar Financial Inc. and The Bank of New York  (incorporated by reference to the registrant’s Current Report on Form 8-K,  filed with the SEC on April 29, 2004). |
| 31.1            |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.  Section 1350).                                                                                                                                                                                    |
| 31.2            |   | Certification  pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.  Section 1350).                                                                                                                                                                                    |
| 32.1            |   | Written  Statement of Chief Executive Officer and Chief Financial Officer pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C.  Section 1350).                                                                                                                        |

 

----

*Incorporated by reference to the registrant’s registration statement onForm S-11, File No. 333-108603.

 

(b)Reports on Form 8-K.

 

OnJanuary 26, 2004, the Company filed a Current Report on Form 8-K to reportan accounting treatment change.

 

OnJanuary 26, 2004, the Company filed a Current Report on Form 8-K to reportthe extension of the deadline of the underwriters’ over-allotment option inconnection with the Company’s initial public offering.

 

OnMarch 24, 2004, the Company filed a Current Report on Form 8-K to reportthat it had issued a press release to announce its financial results for thequarter ended December 31, 2003.

 

OnMarch 25, 2004, the Company filed a Current Report on Form 8-K to reportthat it had entered into an amendment to its revolving warehouse financingfacility.

 

30

----

 

**SIGNATURES**

 

Pursuant to the requirements of the Securities and Exchange Act of1934, the registrant has duly caused this report to be signed on its behalf bythe undersigned thereunto duly authorized.

 

 
|         | FALCON FINANCIAL INVESTMENT TRUST                            |
|--------------|--------------------------------------------------------------|
|         | **(Registrant)**                                             |
|         |                                                         |
|         |                                                         |
| May 17, 2004 | By:                                                          | /s/ Vernon B. Schwartz |
|         | **Vernon B. Schwartz  Chairman and Chief Executive Officer** |
|         | **(principal executive officer)**                            |
|         |                                                         |
|         |                                                         |
| May 17, 2004 | By:                                                          | /s/ David A. Karp |
|         | **David A. Karp  President and Chief Financial Officer**     |
|         | **(principal financial officer)**                            |

 

31

----