**U.S.Securities and Exchange Commission**

**Washington, D.C.  20549**

 

**Form10-Q**

 
| **ý** | ** ** | **Quarterly Report Pursuant To  Section 13 or 15 (d) of the  Securities Exchange Act of 1934** |
|------------|------------|------------------------------------------------------------------------------------------------|

 

**For the Quarter Ended June 30, 2004**

 

**Or**

 
| **o** | ** ** | **Transition Report Pursuant To  Section 13 or 15 (d) of the  Securities Exchange Act of 1934** |
|-------|------------|-------------------------------------------------------------------------------------------------|

 

**Commission file****number 1-31795**

 

**The Washtenaw Group, Inc.**

(Exact name of registrant as specified in its charter)

 
| **Michigan**                                                    | ** ** | **20-0126218**                      |
|-----------------------------------------------------------------|------------|-------------------------------------|
| (State or Other Jurisdiction of  Incorporation or Organization) |       | (IRS Employer   Identification No.) |
|                                                            |       |                                |
| **3767 Ranchero Drive  Ann Arbor, Michigan 48108**              |
| (Address of Principal Executive Offices)                        |
|                                                            |
| **734-662-9733**                                                |
| (Registrant’s Telephone Number, Including Area Code)       |

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.  Yes ý  No o

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act)

Yes o  No ý

 

Indicate the number of sharesoutstanding of each of the issuer’s classes of common equity, as of the latestpracticable date:

 

Common Stock Outstanding as ofJuly 31, 2004

 
| Common  stock, $0.01 Par value | 4,488,351  Shares |
|--------------------------------|-------------------|

 

 

----

 

Index

 
| Part I.  Financial Information                                                                                         |   |
|------------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                   |   |
| Item 1.   Financial Statements (unaudited)                                                              |   |
|                                                                                                                   |   |
| Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003                                                  |   |
|                                                                                                                   |   |
| Consolidated Statements of Income and  Comprehensive Income for the Three and Six Months Ended June 30, 2004 and  2003 |   |
|                                                                                                                   |   |
| Consolidated Statements of Cash Flows for  the Six Months Ended June 30, 2004 and 2003                                 |   |
|                                                                                                                   |   |
| Notes to Consolidated Financial Statements                                                                             |   |
|                                                                                                                   |   |
| Item  2.  Management’s Discussion and  Analysis of Financial Condition and Results of Operations             |   |
|                                                                                                                   |   |
| Item  3.  Quantitative and Qualitative  Disclosures about Market Risk                                             |   |
|                                                                                                                   |   |
| Item  4:  Controls and Procedures                                                                                 |   |
|                                                                                                                   |   |
| Part II.     Other Information                                                                |   |
|                                                                                                                   |   |
| Item 1.  Legal Proceedings                                                                                        |   |
|                                                                                                                   |   |
| Item 2.   Changes in Securities and Use of Proceeds                                                               |   |
|                                                                                                                   |   |
| Item 3.   Defaults Upon Senior Securities                                                                         |   |
|                                                                                                                   |   |
| Item 4.   Submission of Matters to a Vote of Shareholders                                                         |   |
|                                                                                                                   |   |
| Item 5.   Other Information                                                                                       |   |
|                                                                                                                   |   |
| Item 6.   Exhibits and Reports on Form 8-K                                                                        |   |

 

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**THE WASHTENAW GROUP, INC.**

ConsolidatedBalance Sheets

 
| ** **                                                                                                              | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                                                                                              | ** ** | **(Unaudited)**    | ** ** | ** **             | ** ** |
| **ASSETS**                                                                                                              |       |               |       |                   |       |
| Cash and cash equivalents                                                                                               |       | $                  | 100,000    |                   | $          | 100,000 |   |
| Accounts receivable, net                                                                                                |       | 4,971,299          |       | 5,340,932              |       |
| Loans held for sale                                                                                                     |       | 60,144,176         |       | 97,687,823             |       |
| Mortgage servicing rights, net                                                                                          |       | 23,561,036         |       | 24,614,381             |       |
| Other real estate owned                                                                                                 |       | 1,036,772          |       | 925,839                |       |
| Premises and equipment, net                                                                                             |       | 1,648,790          |       | 1,480,988              |       |
| Other assets                                                                                                            |       | 1,353,269          |       | 1,030,653              |       |
|                                                                                                                    |       |               |       |                   |       |
|                                                                                                                    |       | $                  | 92,815,342 |                   | $          | 131,180,616 |   |
|                                                                                                                    |       |               |       |                   |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                           |       |               |       |                   |       |
| Liabilities                                                                                                             |       |               |       |                   |       |
| Due to bank                                                                                                             |       | 10,869,782         |       | 11,074,372             |       |
| Notes payable                                                                                                           |       | 28,648,842         |       | 33,211,685             |       |
| Repurchase agreements                                                                                                   |       | 17,050,428         |       | 43,926,901             |       |
| GNMA repurchase liability                                                                                               |       | 7,359,982          |       | 8,599,700              |       |
| Other liabilities                                                                                                       |       | 9,629,825          |       | 12,162,996             |       |
| Total liabilities                                                                                                       |       | 73,558,859         |       | 108,975,654            |       |
|                                                                                                                    |       |               |       |                   |       |
| Shareholders’ equity                                                                                               |       |               |       |                   |       |
| Preferred stock, $.01 par value 1,000,000  shares authorized; none outstanding                                          |       | —             |       | —                 |       |
| Common stock, $.01 par value 9,000,000  shares authorized 4,488,351 outstanding at June 30, 2004 and December 31,  2003 |       | 44,884             |       | 44,884                 |       |
| Additional paid in capital                                                                                              |       | 1,994,033          |       | 1,955,932              |       |
| Retained earnings                                                                                                       |       | 17,217,566         |       | 20,204,146             |       |
| Total shareholders’ equity                                                                                         |       | 19,256,483         |       | 22,204,962             |       |
|                                                                                                                    |       |               |       |                   |       |
|                                                                                                                    |       | $                  | 92,815,342 |                   | $          | 131,180,616 |   |

 

See accompanying notes to consolidated financial statements

 

3

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**THE WASHTENAW GROUP, INC.**

Consolidated Statements of Income (Unaudited)

 
| ** **                                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                             | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                   |       |                             |       |                           |       |   |   |   |   |
| Interest income                                                        |       | $                                | 1,205,151  |                           | $          | 3,997,158 |   | $ | 2,413,992 |   | $ | 7,059,173 |   |
| Interest expense                                                       |       | 845,919                          |       | 1,957,119                      |       | 1,667,681 |   | 3,496,696 |   |
| Net interest income                                                    |       | 359,232                          |       | 2,040,039                      |       | 746,311 |   | 3,562,477 |   |
|                                                                   |       |                             |       |                           |       |   |   |   |   |
| Noninterest income                                                     |       |                             |       |                           |       |   |   |   |   |
| Servicing income                                                       |       | 2,222,773                        |       | 1,714,144                      |       | 4,611,651 |   | 3,434,101 |   |
| Gain on sales of mortgage servicing rights  and loans, net             |       | 1,879,114                        |       | 15,038,244                     |       | 4,628,091 |   | 26,473,046 |   |
| Other income                                                           |       | 291,292                          |       | 355,643                        |       | 576,834 |   | 562,212 |   |
| Total noninterest income                                               |       | 4,393,179                        |       | 17,108,031                     |       | 9,816,576 |   | 30,469,359 |   |
|                                                                   |       |                             |       |                           |       |   |   |   |   |
| Noninterest expense                                                    |       |                             |       |                           |       |   |   |   |   |
| Compensation and employee benefits                                     |       | 2,632,013                        |       | 6,491,306                      |       | 5,965,099 |   | 11,792,450 |   |
| Occupancy and equipment                                                |       | 452,490                          |       | 444,563                        |       | 871,838 |   | 839,866 |   |
| Telephone                                                              |       | 76,827                           |       | 156,704                        |       | 155,207 |   | 285,904 |   |
| Postage                                                                |       | 112,370                          |       | 207,782                        |       | 260,294 |   | 392,140 |   |
| Amortization of mortgage servicing rights                              |       | 1,967,709                        |       | 1,457,514                      |       | 3,920,936 |   | 2,641,298 |   |
| Mortgage servicing rights valuation  adjustment                        |       | (3,943,903                       | )          | 2,830,175                      |       | (1,041,589 | ) | 4,635,179 |   |
| Loss and provision for loss on loan  repurchases and other real estate |       | 2,248,651                        |       | 1,249,498                      |       | 2,865,485 |   | 2,166,839 |   |
| Other noninterest expense                                              |       | 1,045,101                        |       | 1,118,517                      |       | 2,015,570 |   | 2,051,306 |   |
| Total noninterest expense                                              |       | 4,591,258                        |       | 13,956,059                     |       | 15,012,840 |   | 24,804,982 |   |
| **Income (loss) before income taxes**                                  |       | 161,153                          |       | 5,192,011                      |       | (4,449,953 | ) | 9,226,854 |   |
| Provision for income taxes                                             |       | 44,397                           |       | 1,786,421                      |       | (1,463,372 | ) | 3,162,240 |   |
| **Net income (loss)**                                                  |       | $                                | 116,756    |                           | $          | 3,405,590 |   | $ | (2,986,581 | ) | $ | 6,064,614 |   |
| ** **                                                             |       |                             |       |                           |       |   |   |   |   |
| Basic and diluted earnings (loss) per share                            |       | $                                | 0.03       |                           | $          | 0.76 |   | $ | (0.67 | ) | $ | 1.36 |   |

 

See accompanying notes to consolidated financial statements

 

4

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**THE WASHTENAW GROUP, INC.**

Consolidated Statements of Cash Flows (Unaudited)

Six MonthsEnded June 30,

 
| ** **                                          | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|-----------------------------------------------------|------------|-------------|------------|-------------|------------|
| **Cash flows from operating activities**            | ** ** | ** **  | ** ** | ** **  | ** ** |
| Net cash provided (used) by operating  activities   |       | $           | 23,350,342 |        | $          | (8,152,976 | ) |
| **Cash flows from investing activities**            | ** ** | ** **  | ** ** | ** **  | ** ** |
| Proceeds from sales of mortgage servicing  rights   |       | 8,852,931   |       | 5,242,923   |       |
| Other real estate owned, net                        |       | (110,933    | )          | 140,001     |       |
| Property and equipment expenditures                 |       | (448,434    | )          | (207,057    | )          |
| Net cash provided by investing activities           |       | 8,293,564   |       | 5,175,867   |       |
| **Cash flows from financing activities**            | ** ** | ** **  | ** ** | ** **  | ** ** |
| Increase (decrease) in due to bank                  |       | (204,590    | )          | 15,017,873  |       |
| Cash dividends                                      |       | —      |       | (676,688    | )          |
| Increase (decrease) in notes payable due on  demand |       | (4,562,843  | )          | 12,839,446  |       |
| Decrease in repurchase agreements                   |       | (26,876,473 | )          | (24,203,522 | )          |
| Net cash provided (used) by financing  activities   |       | (31,643,906 | )          | 2,977,109   |       |
| Net change in cash and cash equivalents             |       | —      |       | —      |       |
| Cash and cash equivalents at beginning of  period   |       | 100,000     |       | 100,000     |       |
| **Cash and cash equivalents at end of period**      |       | $           | 100,000    |        | $          | 100,000 |   |

 

See accompanying notes to consolidated financial statements

 

5

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**THE WASHTENAW GROUP, INC.**

Notes to the Consolidated Financial Statements (Unaudited)

 

**NOTE 1 -SIGNIFICANT ACCOUNTING POLICIES**

 

Principles ofConsolidation:

The unaudited consolidatedfinancial statements as of and for the six month period ended June 30, 2004 and2003, include the accounts of The Washtenaw Group, Inc. (“The Washtenaw Group”)and its wholly owned subsidiary Washtenaw Mortgage Company (“Washtenaw”) forall periods.  All references herein toThe Washtenaw Group include the consolidated results of its subsidiary.  All significant intercompany accounts andtransactions have been eliminated in consolidation.

 

OperatingSegments:

Washtenaw’s operations includeone primary segment: mortgage banking.

 

StockCompensation:

Compensation expense understock options is reported using the intrinsic value method.  Stock-based compensation reflected in netincome for the three and six months ended June 30, 2004 is $12,782 and $38,101,respectively as options granted had an exercise price less than the marketprice of the underlying common stock at date of grant.  The following table illustrates the effect onnet income and earnings per share if expense was measured using the fair valuerecognition provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation*.

 
| ** **                                                                                               | ** ** | **Three Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                               | ** ** | **2004**                        | ** ** | **2003** | ** ** |
| Net income as reported                                                                                   |       | $                               | 116,756    |   | $ | 3,405,590 |   |
| Deduct: Incremental stock-based  compensation expense (benefit) determined under fair value based method |       | (3,078                          | )          | — |   |
| Pro forma net income                                                                                     |       | $                               | 119,834    |   | $ | 3,405,590 |   |
|                                                                                                     |       |                            |       |   |   |   |   |
| Basic earnings per share as reported                                                                     |       | $                               | 0.03       |   | $ | 0.76 |   |
| Pro forma basic earnings per share                                                                       |       | 0.03                            |       | 0.76 |   |
|                                                                                                     |       |                            |       |   |   |
| Diluted earnings per share                                                                               |       | $                               | 0.03       |   | $ | 0.76 |   |
| Pro forma diluted earnings per share                                                                     |       | 0.03                            |       | 0.76 |   |

 
| ** **                                                                                               | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                               | ** ** | **2004**                      | ** ** | **2003** | ** ** |
| Net income (loss) as reported                                                                            |       | $                             | (2,986,581 | ) | $ | 6,064,614 |   |
| Deduct: Incremental stock-based  compensation expense (benefit) determined under fair value based method |       | (2,280                        | )          | — |   |
| Pro forma net income (loss)                                                                              |       | $                             | (2,984,571 | ) | $ | 6,064,614 |   |
|                                                                                                     |       |                          |       |   |   |
| Basic earnings (loss) per share as reported                                                              |       | $                             | (0.67      | ) | $ | 1.36 |   |
| Pro forma basic earnings (loss) per share                                                                |       | (0.67                         | )          | 1.36 |   |
|                                                                                                     |       |                          |       |   |   |
| Diluted earnings (loss) per share                                                                        |       | $                             | (0.67      | ) | $ | 1.36 |   |
| Pro forma diluted earnings (loss) per share                                                              |       | (0.67                         | )          | 1.36 |   |

 

Due tothe spin-off (see Note 3), options outstanding of Pelican Financial at December31, 2003 included 10,735 options that were held by employees of Washtenaw.  These options were cancelled during the firstquarter of 2004 and replaced with 21,470 options on stock of The WashtenawGroup at an exercise price of $3.25. These options were granted with an intrinsic value (market value pershare, less option exercise price) substantially equal to the intrinsic valueof the cancelled Pelican Financial options.

 

6

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MortgageServicing Right Hedging:

Beginning April 1, 2004,Washtenaw’s interest rate risk management activities include the hedging ofMSR’s.  Washtenaw utilizes derivativesextensively in connection with its interest rate risk management activities.  Washtenaw is exposed to interest rate risk onits mortgage servicing rights.  As marketrates increase or decrease, the market value of mortgage servicing rights willincrease or decline.  To offset thisinterest rate risk, Washtenaw enters into derivatives, including ten-yeartreasury futures contracts and ten-year treasury put and call options.  In accordance with SFAS 133, all derivativeinstruments are recorded at fair value. Accordingly, ten year treasury futures contracts and ten year treasuryput and call options contracts are carried at fair value, as determined by theamount payable or receivable to/from the counterparty as if the derivativeswere settled at the balance sheet date. The fair value is based on the end of the period pricing from brokeragehouses.  Changes in fair value areincluded in the mortgage servicing rights valuation adjustment in the incomestatement.

 

**NOTE 2 –BASIS OF PRESENTATION**

 

The accompanying unauditedconsolidated financial statements were prepared in accordance with instructionsfor Form 10-Q and, therefore, do not include information or footnotes necessaryfor a complete presentation of consolidated financial condition, results ofoperations, and cash flows in conformity with U.S. generally acceptedaccounting principles.  However, alladjustments, consisting of normal recurring accruals, which, in the opinion ofmanagement, are necessary for fair presentation of the consolidated financial statements have been included.  The results of operations for the periodended June 30, 2004, are not necessarily indicative of the results that may beexpected for the entire fiscal year or for any other period.  For further information, refer to theconsolidated financial statements and footnotes thereto for the year endedDecember 31, 2003 included in The Washtenaw Group’s Form 10-K.

 

**NOTE3 – SPIN-OFF**

 

On December 31, 2003, PelicanFinancial, the former parent company of Washtenaw, distributed all of theoutstanding shares of Washtenaw to the holders of Pelican Financial commonstock on a share for share basis based on Pelican Financial shareholders ofrecord on December 22, 2003.  Uponcompletion of the distribution on December 31, 2003, Washtenaw is no longer asubsidiary of Pelican Financial.  Duringthe periods presented in the financial statements, Pelican Financial did notincur any expenses on behalf of Washtenaw and no allocation of parent companyexpenses has been reflected in these financial statements.

 

Following the distributioncertain individuals continue to serve as officers of both Washtenaw and PelicanFinancial.  Washtenaw pays their salariesand all other compensation, and Pelican Financial reimburses Washtenaw, as partof the Transitional Services Agreement, for time spent on Pelican Financialmatters.  Prior to 2004, Pelican did notreimburse Washtenaw for these services. Beginning in 2004, officers and other employees providing services toboth companies maintain records of their time spent on the affairs of eachcompany as a basis for determining the reimbursements.

 

7

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**NOTE 4 -EARNINGS PER SHARE**

 

The following summarizes thecomputation of basic and diluted earnings per share.

 
| ** **                                            | ** ** | **Three Months  ended  June 30,  2004** | ** ** | **Three Months  ended  June 30,  2003** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------|------------|-----------------------------------------|------------|
| Basic earnings per share                              |       |                                    |       |                                    |       |
| Net income                                            |       | $                                       | 116,756    |                                    | $          | 3,405,590 |   |
| Weighted average shares outstanding                   |       | 4,488,351                               |       | 4,463,221                               |       |
| Basic earnings per share                              |       | $                                       | 0.03       |                                    | $          | 0.76 |   |
|                                                  |       |                                    |       |                                    |       |
| Diluted earnings per share                            |       |                                    |       |                                    |       |
| Net income                                            |       | $                                       | 116,756    |                                    | $          | 3,405,590 |   |
| Weighted average shares outstanding                   |       | 4,488,351                               |       | 4,463,221                               |       |
| Dilutive effect of assumed exercise of  stock options |       | 2,509                                   |       | —                                  |       |
| Diluted average shares outstanding                    |       | 4,490,860                               |       | 4,463,221                               |       |
| Diluted earnings per share                            |       | $                                       | 0.03       |                                    | $          | 0.76 |   |

 
| ** **                                            | ** ** | **Six Months  ended  June 30,  2004** | ** ** | **Six Months  ended  June 30,  2003** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
| Basic earnings (loss) per share                       |       |                                  |       |                                  |       |
| Net income (loss)                                     |       | $                                     | (2,986,581 | )                                     | $          | 6,064,614 |   |
| Weighted average shares outstanding                   |       | 4,488,351                             |       | 4,463,221                             |       |
| Basic earnings (loss) per share                       |       | $                                     | (0.67      | )                                     | $          | 1.36 |   |
|                                                  |       |                                  |       |                                  |       |
| Diluted earnings (loss) per share                     |       |                                  |       |                                  |       |
| Net income (loss)                                     |       | ($2,986,581                           | )          | $                                     | 6,064,614  |   |
| Weighted average shares outstanding                   |       | 4,488,351                             |       | 4,463,221                             |       |
| Dilutive effect of assumed exercise of  stock options |       | —                                |       | —                                |       |
| Diluted average shares outstanding                    |       | 4,488,351                             |       | 4,463,221                             |       |
| Diluted earnings (loss) per share                     |       | $                                     | (0.67      | )                                     | $          | 1.36 |   |

 

For the six months ended June30, 2004 there were 21,470 stock options outstanding that were not considereddilutive. There were no options outstanding during 2003.

 

8

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Item 2: Management’s Discussion and Analysisof Financial Condition and Results of Operations

 

Forward Looking Statements

 

Certain information in thisForm 10-Q may constitute forward-looking information that involves risks and uncertaintiesthat could cause actual results to differ materially from those estimated.  Persons are cautioned that suchforward-looking statements are not guarantees of future performance and aresubject to various factors that could cause actual results to differ materiallyfrom those estimated.  These factorsinclude, but are not limited to, changes in general economic and marketconditions, legislative and regulatory changes, monetary and fiscal policies ofthe federal government, demand for loan and deposit products and thedevelopment of an interest rate environment that adversely affects the interestrate spread or other income from The Washtenaw Group’s investments andoperations.

 

### **OVERVIEW**

### ** **

The Washtenaw Group, Inc.serves as the holding company of Washtenaw Mortgage Company.  The Washtenaw Group’s operations involvecorrespondent, wholesale and retail mortgage banking.  The operation involves the origination andpurchase of single-family residential mortgage loans in approximately 40states, the sale of these loans, usually on a pooled and securitized basis, inthe secondary market, and the servicing of mortgage loans for investors.

 

The Washtenaw Group’s earningsare primarily dependent upon three sources: net interest income, which is thedifference between interest earned on interest-earning assets and interest paidon interest-bearing liabilities; fee income from servicing mortgages held byinvestors; and gains realized on sales of mortgage loans and mortgage servicingrights.  These revenues are in turnsignificantly affected by factors such as changes in prevailing interest ratesand in the yield curve (that is, the difference between prevailing short-termand long-term interest rates), as well as changes in the volume of mortgageoriginations nationwide and prepayments of outstanding mortgages.

 

In 2004, competition for newloans has increased, which has resulted in a reduction of loan originations andthe profit per loan for Washtenaw.  As aresult, in the current interest rate environment, it is unlikely Washtenaw willbe profitable from operations for the remainder of 2004.  On a positive note, Washtenaw retained asignificant portion of mortgage loan servicing during 2003, at relatively lowcapitalized values, which has increased in value as mortgage interest ratesincreased.  Management is planning tosell a portion of the loan servicing portfolio in the third quarter to generatecash for general operating purposes.

 

The focus in 2004 will continueto be loan quality.  As the loan brokersbecome more desperate for production, Washtenaw will typically see an increasein loans with misrepresentation in varying levels.  Management will continue to focus onimplementing procedures to improve asset quality and thereby reduce the costsassociated with loan repurchases.  Loanrepurchases are the greatest challenge management currently faces in improvingfinancial performance.

 

**CRITICALACCOUNTING POLICIES**

 

## **Theaccounting policies that have the greatest impact on theWashtenaw Group’s financial condition and results of operations and thatrequires the most judgment relate to its mortgage activities.  The Washtenaw Group’s accounting policy forgain on sale of loans, mortgage servicing rights (MSR), interest rate riskmanagement activities and litigation and claims have not changed since December31, 2003.  These accounting policies aredescribed more fully in the annual report on Form 10-K for the year endedDecember 31, 2003.**

## ** **

Beginning April 1, 2004,Washtenaw’s interest rate risk management activities include the hedging ofMSR’s.  Washtenaw utilizes derivativesextensively in connection with its interest rate risk managementactivities.  Washtenaw is exposed tointerest rate risk on its mortgage servicing rights.  As market rates increase or decrease, themarket value of mortgage servicing rights will increase or decline.  To offset this interest rate risk, Washtenawenters into derivatives, including ten year treasury futures contracts and tenyear treasury put and call options.  Inaccordance with SFAS 133, all derivative instruments are recorded at fairvalue.  Accordingly, ten-year treasuryfutures contracts and ten-year treasury put and call options contracts arecarried at fair value, as determined by the amount payable or receivableto/from the counterparty as if the derivatives were settled at the balancesheet date.  The fair value is based 

 

9

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onthe end of the period pricing from brokerage houses.  Changes in fair value are included in themortgage servicing rights valuation adjustment in the income statement.

 

## **EARNINGS PERFORMANCE**

## ** **

The Washtenaw Group reportednet income of $117,000 for the three months ended June 30, 2004 compared to netincome of $3.4 million for the three months ended June 30, 2003.  Basic and diluted earningsper share was $0.03 per share compared to earnings of $0.76 per sharefor the quarter ended June 30, 2004 and 2003 respectively. The Washtenaw Groupreported net loss of $3.0 million for the six months ended June 30, 2004compared to net income of $6.1 million for the six months ended June 30,2003.  Basic and diluted earnings pershare was a loss of $0.67 per share compared to earnings of $1.36 per share forthe six months ended June 30, 2004 and 2003 respectively.

 

## **RESULTS OF OPERATIONS**

## ** **

Loan Production

Loan production was $600.4million and $1.3 billion for the three months ended June 30, 2004 and 2003,respectively.  The volume of loansproduced for the six months ended June 30, 2004 totaled $778 million as comparedto $2.2 billion for the six months ended June 30, 2003, a decrease of $1.4billion or 64%.  The decrease was theresult of rising interest rates during the six months ended June 30, 2004.

 

Noninterest Income

Noninterest income was $4.4million and $17.1 million for the three months ended June 30, 2004 and 2003,respectively. Total noninterest income for the six months ended June 30, 2004was $9.8 million, compared to $30.5 million for the six months ended June 30,2003, a decrease of $20.7 million or 68%. This decrease was primarily due to an83% decrease in the gain on sales of mortgage servicing rights and loans.  The decrease in gain on sale of mortgageservicing rights and loans was primarily due to a decrease in the overall newloan origination volume in the first six months of 2004.  In addition, the gains onsale of mortgage servicing rights and loans was affected by reducedprofit margins on each new loan origination as a result of the current interestrate environment.

 

Loan Servicing

At June 30, 2004, Washtenawserviced $2.5 billion of loans compared to $2.4 billion at June 30, 2003, a 4%increase.  Washtenaw has an agreement tosell the servicing rights related to mortgage loan production on a monthlybasis.  During the six months ended June30, 2004, Washtenaw was selling approximately 86% of its mortgage servicingrights under this agreement.  The remainder of the loan servicing rights created are retainedin the mortgage loan servicing portfolio.

 

At June 30, 2004 and 2003, withthe exception of servicing related to loans held for sale in Washtenaw’s loanportfolio and servicing sold but not yet delivered, all loan servicing wasperformed for others.  Service feeincome, net of amortization was $255,000 and $257,000 for the three monthsended and $691,000 and $793,000 for the six months ended June 30, 2004 and 2003respectively.  Servicing income increased$508,000 and $1.2 million due to the increase in the servicing portfolio;however, the increase in amortization of mortgage servicing rights more thanoffset the increase in income.  Theincrease in amortization is related to the effect of the low interest rateenvironment, which has increased actual and expected prepayment rates used todetermine amortization rates.

 

Noninterest Expense

Noninterest expense was $4.6million and $14.0 million for the three months ended June 30, 2004 and 2003,respectively. Total noninterest expense for the six months ended June 30, 2004was $15.0 million, compared to $24.8 million for the same period in 2003, adecrease of $9.8 million or 39%. The decrease was primarily due to the decreasein employee compensation and benefits expenses and a favorable mortgageservicing rights valuation, offset by an increase in the amortization ofmortgage servicing rights and an increase in the loss and provision for loss onloan repurchases and other real estate. The decrease in employee compensation and benefits was the result of adecrease in operations staff due to attrition, closing the operations center inCalifornia, a reduction in overtime expense, a reduction in commissioncompensation paid to the sales staff and the reduction in management bonuscompensation. The positive mortgage servicing rights valuation adjustment wasdue to an increase in mortgage interest rates during the period, resulting indecreases in expected prepayment speeds, which project the expected runoff ofthe mortgage loan servicing portfolio based on comparing the interest rates ofthe loans in the portfolio 

 

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againstcurrent market interest rates.  Theincrease in amortization of mortgage servicing rights is the result of theincrease in mortgage loan servicing portfolio and the increased speed in whichthe asset is being amortized due to the higher prepayment speeds when theservicing asset was created.

 

The increase in the loss andprovision for loss on loan repurchases and other real estate was due to anincrease in repurchase requests and an increase in the expected loss onrepurchase requests as a result of historical experience.  Typically, these loans arenon-performing.  Washtenaw continues therebuttal of these loans on a loan-by-loan basis.  The reserve is established based onhistorical repurchase experience and current repurchase requests.  Also, Washtenaw establishes a reserve forrepurchases based on mortgage loan production. For the periods ended June 30, 2004 and December 31, 2003, the pendingpossible repurchases totaled 63 and 80 loans with a total principal balance of$5.5 million and $6.7 million.  Thereserve for loan repurchases at the periods ended June 30, 2004 and December31, 2003 was $3.7 million.  Managementbelieves the liability established is sufficient to cover the estimated losseson the loans subject to repurchase.

 

**BALANCESHEET ANALYSIS**

 

The following is a discussionof the consolidated balance sheet of The Washtenaw Group.

 

## **ASSETS**

At June 30, 2004, total assetsof The Washtenaw Group equaled $92.8 million as compared to $131.2 million atDecember 31, 2003, a decrease of $38.4 million or 29%. The decrease isprimarily due to the decrease in loans held for sale and mortgage servicingrights.

 

Loans Held for Sale

Loans held for sale were $60.1million at June 30, 2004 compared to $97.7 million at December 31, 2003.  This decrease of $37.6 million or 38% was theresult of a decrease in mortgage loan production.

 

Mortgage Servicing Rights

Mortgage servicing rights were$23.6 million at June 30, 2004, a decrease of $1.1 million or 4% from $24.6million at December 31, 2003.  This isthe result of a bulk servicing sale of $275 million in the quarter ended June30, 2004.  The mortgage servicing rightasset was decreased by $2.8 million as a result of the sale.  In addition $3.9 million of amortization wasrecorded for the six months ended June 30, 2004.  The decreases were offset by Washtenawretaining the mortgage servicing rights on a portion of current mortgage loanproduction and an increase in the value of the mortgage servicing rights of $4.4million as mortgage interest rates increased. In general, servicing right values tend to decline in a falling interestrate environment and increase in a rising interest rate environment.  Management cannot predict future marketinterest rate levels or the magnitude of future servicing valuationadjustments; however, the potential for further impairment charges existdepending on the mortgage interest rate environment.

 

In April 2004, Washtenaw beganhedging a portion of its mortgage loan servicing portfolio.  During the quarter, management has usedten-year treasury futures contracts and ten-year treasury putand call options to hedge against the reduction in the value of themortgage servicing rights due to a decline in mortgage interest rates.  The derivative instruments were purchased toprotect between 20% and 25% of the servicing rights that can be hedged againstdeclining interest rates.  All fixed rateloan servicing may be hedged, while arms and balloons are not.  For the three months ended June 30, 2004,Washtenaw recognized a $4.4 million favorable mortgage servicing rightvaluation adjustment.  During the sameperiod, Washtenaw incurred a $467,000 loss on mortgage servicing rights hedgingactivity.

 

Washtenaw intends to sellapproximately $500 million in mortgage servicing rights during the quarterended September 30, 2004.  Managementanticipates this will reduce the mortgage servicing rights asset byapproximately $5.0 million at the sale date. At the time of the sale, management will reduce its hedge positionaccordingly in an effort to hedge the same overall percentage of the mortgageservicing rights.

 

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## **LIABILITIES**

## ** **

At June 30, 2004, the totalliabilities of The Washtenaw Group were $73.6 million as compared to $109.0million at December 31, 2003, a decrease of $35.4 million or 33%. This decreasewas primarily due to decreases in repurchase agreements, notes payable andother liabilities.

 

Notes Payable

Notes payable was $28.6 millionat June 30, 2004 compared to $33.2 million at December 31, 2003.  This decrease of $4.6 million or 14% wasprimarily caused by the significant decrease in loan originations during thequarter ended June 30, 2004.  The notespayable represent the warehouse line of credit that Washtenaw uses to fund itsloan production until such time that the loans are sold to the secondarymarket.

 

Repurchase Agreements

Repurchase agreements were$17.1 million at June 30, 2004 compared to $43.9 million at December 31,2003.  This decrease of $26.9 million or61% was primarily the result of decreased loan originations during the quarterended June 30, 2004.  Also, Washtenaw isselling more loans to investors that do not allow the transfer to repurchaseagreements.  The use of the repurchaseagreements is limited to loans sold to the Federal National MortgageAssociation (“FNMA”).

 

LIQUIDITY AND CAPITAL RESOURCES

 

Liquidity Management

The objective of liquiditymanagement is to ensure the availability of sufficient resources to meet allfinancial commitments and to capitalize on opportunities for businessexpansion.  Liquidity managementaddresses the ability to meet deposit withdrawals either on demand or bycontractual maturity, to repay other borrowings as they mature and to make newloans and investments as opportunities arise.

 

To date The Washtenaw Group hasconducted no business other than managing its investments in Washtenaw.  The Washtenaw Group’s source of funds isdividends paid by Washtenaw. Washtenaw’s sources of funds include cash fromgains on sales of mortgage loans and servicing, net interest income, servicingfees and borrowings. Washtenaw sells its mortgage loans generally on a monthlybasis to generate cash for operations. Washtenaw’s uses of cash in theshort-term include the funding of mortgage loan purchases and originations andpurchases of mortgage servicing rights, payment of interest, repayment ofamounts borrowed pursuant to warehouse lines of credit, operating andadministrative expenses, income taxes and capital expenditures.  Long-term uses of cash may also include thefunding of securitization activities or portfolios of loan or servicing assets.

 

Washtenaw funds its businessthrough the use of a warehouse line of credit and the use of agreements torepurchase.  The agreements to repurchasetypically have terms of less than 90 days and are treated as a source offinancing.  The warehouse line of credithas a limit of $80 million, of which $9.0 million represents a sublimit forservicing under contract for sale, and $4.8 million represents a workingcapital sublimit.  Borrowing pursuant tothe warehouse line of credit totaled $28.6 million at June 30, 2004 and $33.2million at December 31, 2003.  Includedin the total warehouse line borrowing at June 30, 2004 and December 31, 2003was $5.1 million and zero under the sublimit for servicing under contract forsale. The interest rate on the warehouse line of credit is the Federal FundsRate plus 1.50% resulting in an effective rate of 2.75% at June 30, 2004 and2.50% at December 31, 2003.  The effectiveinterest rate on the agreements to repurchase was 2.15% at June 30, 2004 and1.90% at December 31, 2003.

 

Washtenaw intends to sellapproximately $500 million in mortgage servicing rights during the quarterended September 30, 2004.  Managementanticipates this will generate approximately $4.0 to $5.0 million in cashdepending on the sales price.  A portionof the proceeds will be received at the sale date while the remainder isreceived upon transfer of the loans, typically thirty to sixty days later.

 

Washtenaw purchases its loanseither by wiring funds to the closing agent or sending a draft.  The decision is based on the requirements ofthe state where the loan is being purchased. When a draft is used, Washtenaw begins earning 

 

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intereston the day the draft is issued but does not incur any cost of funds until thedraft is presented to the bank.  When thedraft clears the bank, Washtenaw will either borrow money on its warehouse lineof credit or through its agreements to repurchase depending on the type ofloan.  Outstanding drafts totaled $10.9million at June 30, 2004 and $11.1 million at December 31, 2003.

 

The Washtenaw Group’s abilityto continue to purchase loans and mortgage servicing rights and to originatenew loans is dependent in large part upon its ability to sell the mortgageloans at par or for a premium or to sell the mortgage servicing rights in thesecondary market in order to generate cash proceeds to repay borrowingspursuant to the warehouse facility, thereby creating borrowing capacity to fundnew purchases and originations.  Thevalue of and market for The Washtenaw Group’s loans and mortgage servicingrights are dependent upon a number of factors, including the borrower creditrisk classification, loan-to-value ratios and interest rates, general economicconditions, warehouse facility interest rates and governmental regulations.

 

Washtenaw generally grantscommitments to fund mortgage loans for up to 30 days at a specified term andinterest rate.  The commitments arecommonly known as rate-lock commitments. At June 30, 2004, Washtenaw had outstanding rate-lock commitments tolend $96.7 million for mortgage loans. Because these commitments may expire without being drawn upon, they donot necessarily represent future cash commitments.  Also, as of June 30, 2004, Washtenaw hadoutstanding commitments to sell $89.5 million of mortgage loans.  These commitments usually are funded within90 days.

 

Item 3: Quantitative and Qualitative Disclosure AboutMarket Risk

 

For a discussion of TheWashtenaw Group’s asset/liability management policies as well as the potentialimpact of interest rate changes upon the market value of The Washtenaw Group’sportfolio, see The Washtenaw Group’s Annual Report to Shareholders and Form10-K.  Management believes that there hasbeen no material change in The Washtenaw Group’s asset/liability position orthe market value of The Washtenaw Group’s portfolio since December 31, 2003.

 

Item 4: Controls and Procedures

 

Washtenaw, under thesupervision and with the participation of its management, including itsprincipal executive officer and principal financial officer, evaluated theeffectiveness of the design and operation of its disclosure controls and proceduresas of the end of the period covered by this report.  Based on this evaluation, the principalexecutive officer and principal financial officer concluded that Washtenaw’sdisclosure controls and procedures are effective in reaching a reasonable levelof assurance that information required to be disclosed by Washtenaw in thereports that it files or submits under the Securities Exchange Act of 1934 isrecorded, processed, summarized and reported within the time period specifiedin the Securities and Exchange Commission’s rules and forms.

 

The principal executive officerand principal financial officer also conducted an evaluation of internalcontrol over financial reporting (“Internal Control”) to determine whether anychanges in Internal Control occurred during the fiscal quarter that havematerially affected or which are reasonably likely to materially affectInternal Control.  Based on thatevaluation, there has been no such change during the quarter covered by thisreport.

 

A control system, no matter howwell conceived and operated, can provide only reasonable, not absolute,assurance that the objectives of the control system are met.  Further, the design of a control system mustreflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs.  Because of the inherent limitations in allcontrol systems, no evaluation of controls can provide absolute assurance thatall control issues and instances of fraud, if any, within Washtenaw have been detected.  Because of the inherent limitations in acost-effective control system, misstatements due to error or fraud may occurand not be detected.  Washtenaw conductsperiodic evaluations to enhance, where necessary, its procedures and controls.

 

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Part II. Other Information

 

Item 1.  LegalProceedings

 

There have been no materialchanges to the pending legal proceedings to which The Washtenaw Group is aparty since the filing of the registrant’s Form 10-K, nor have there been anymaterial legal proceedings to which The Washtenaw Group is a party institutedsince that date.

 

Item 2. Changes in Securities and Use of Proceeds

 

(a) NotApplicable

(b) Not Applicable

(c) NotApplicable

(d) NotApplicable

(e) NotApplicable

 

Item 3. Defaults Upon Senior Securities

 

Not Applicable.

 

Item 4. Submission of Matters to a Vote of Shareholders

 

The Washtenaw Group, Inc heldits 2004 Annual Meeting of Shareholders on April 22, 2004.  The following directors were elected at theannual meeting to serve a three year term.

 
| ** **        | ** ** | **For**   | ** ** | **Against** | ** ** | **Abstentions** | ** ** |
|-------------------|------------|-----------|------------|-------------|------------|-----------------|------------|
| Robert C. Huffman |       | 3,883,048 |       | 6,200       |       | 0               |       |
| Scott D. Miller   |       | 3,883,048 |       | 6,200       |       | 0               |       |
| Howard M. Nathan  |       | 3,883,048 |       | 6,200       |       | 0               |       |

 

A vote was taken to ratify theappointment of Crowe Chizek and Company LLC as independent auditors for thefiscal year ending December 31, 2004. The appointment was approved by the following votes:  3,874,134 for, 100 against, and 15,034abstained.

 

Item 5.  OtherInformation

 

None

 

Item 6. Exhibits and Reports on Form 8-K

 

(a)          Exhibits

 
| 31.1   |   | Certification  of Principal Executive Officer                                                                           |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                    |
| 31.2   |   | Certification  of Principal Financial Officer                                                                           |
|   |   |                                                                                                                    |
| 32     |   | Certification  Pursuant to 18 U.S.C. Section 1350 as Adopted Pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002 |

 

(b)         Reportson Form 8-K

 

April 24, 2004 to announce the financialresults of the quarter ended March 31, 2004.

 

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The Washtenaw Group, Inc. and Subsidiary

Signatures

 

Under the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this Report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

 
| Date: August  13, 2004 | /s/ Charles  C. Huffman                       |   |
|------------------------|-----------------------------------------------|--------|
|                   | Charles C.  Huffman                           |
|                   | President and Chief Executive Officer         |
|                   |                                          |
|                   |                                          |
| Date: August  13, 2004 | /s/ Howard  M. Nathan                         |   |
|                   | Howard M.  Nathan                             |
|                   | Vice  President and Chief Financial Officer   |
|                   | (Principal  Financial and Accounting Officer) |
|                        |                                               |        |  |

 

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