**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

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**FORM10-Q**

 

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**QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OFTHE SECURITIES EXCHANGE ACT OF 1934**

 

**For The Quarterly Period Ended June 30, 2004**

 

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**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. Employer  Identification  No.) |

 

**15 Commerce RoadStamford, 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 August 16, 2004)** |
|--------------------------------|------------|-----------------------------------------|
|                           |       |                                    |
| COMMON SHARES, $0.01 PAR VALUE |       | 15,976,900 SHARES                       |

 

 

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**FALCON FINANCIAL INVESTMENT TRUST ANDPREDECESSOR**

 

**Index to Form 10-Q**

 
| **PART I**     | Consolidated Financial Information                                                                                                           |   |   |
|----------------|----------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|
| ** **     |                                                                                                                                         |   |   |
| Item 1.        | Financial Statements                                                                                                                         |   |   |
|           | Consolidated Statements of Financial  Position – June 30, 2004 (unaudited) and December 31, 2003                                        |   |   |
|           | Consolidated Statements of Operations  (unaudited) – Three and Six Months Ended June 30, 2004 and 2003                                  |   |   |
|           | Consolidated Statements of Changes in  Stockholders’ Equity and Comprehensive Income (unaudited) – Six Months Ended  June 30, 2004 |   |   |
|           | Consolidated Statements of Cash Flows  (unaudited) – Three and Six Months Ended June 30, 2004 and 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, Use of Proceeds and Issuer Purchase of Equity  Securities                                                             |   |   |
| Item  4.       | Submission  of Matters to Vote to Security Holders                                                                                           |   |   |
| Item 6.        | Exhibits and Reports on Form 8-K                                                                                                             |   |   |
|           |                                                                                                                                         |   |
| **Signatures** |                                                                                                                                         |

 

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**PART I. CONSOLIDATED FINANCIAL INFORMATION**

 

**ITEM 1.****CONSOLIDATED FINANCIAL STATEMENTS**

 

**FALCONFINANCIAL INVESTMENT TRUST****ANDPREDECESSOR**

 

**ConsolidatedStatements of Financial Position**

 
| ** **                                                                                                                      | ** ** | **Company   June 30, 2004** | ** **  | **Company  December 31, 2003** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|-------------|--------------------------------|------------|
| ** **                                                                                                                      | ** ** | **(unaudited)**             | ** **  | ** **                     | ** ** |
| **ASSETS**                                                                                                                      |       |                        |        |                           |       |
| ASSETS:                                                                                                                         |       |                        |        |                           |       |
| Cash and cash equivalents                                                                                                       |       | $                           | 30,266,849  |                           | $          | 25,645,578 |   |
| Loans receivable, net of allowance for  possible loan losses of $1,586,118 and $1,086,692, respectively                         |       | 181,786,938                 |        | 126,076,622                    |       |
| Retained interests in loan securitizations                                                                                      |       | 7,993,440                   |        | 7,239,136                      |       |
| Interest rate swap contracts                                                                                                    |       | 2,618,633                   |        | 389,783                        |       |
| Accrued interest receivable                                                                                                     |       | 1,144,062                   |        | 994,821                        |       |
| Restricted cash                                                                                                                 |       | 2,026,404                   |        | 2,657,660                      |       |
| Property and equipment, net                                                                                                     |       | 459,364                     |        | 335,860                        |       |
| Prepaid expenses and other assets                                                                                               |       | 2,241,806                   |        | 1,497,245                      |       |
|                                                                                                                            |       |                        |        |                           |       |
| Total assets                                                                                                                    |       | $                           | 228,537,496 |                           | $          | 164,836,705 |   |
|                                                                                                                            |       |                        |        |                           |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                  |       |                        |        |                           |       |
| LIABILITIES:                                                                                                                    |       |                        |        |                           |       |
| Borrowings                                                                                                                      |       | $                           | 100,408,189 |                           | $          | 53,475,879 |   |
| Accrued interest payable                                                                                                        |       | 315,346                     |        | 255,707                        |       |
| Customer deposits                                                                                                               |       | 530,751                     |        | 140,276                        |       |
| Hold back of loan proceeds                                                                                                      |       | 2,026,404                   |        | 2,657,660                      |       |
| Accounts payable and accrued liabilities                                                                                        |       | 1,495,857                   |        | 2,405,496                      |       |
| Dividends payable                                                                                                               |       | 798,845                     |        | —                         |       |
|                                                                                                                            |       |                        |        |                           |       |
| Total liabilities                                                                                                               |       | 105,575,392                 |        | 58,935,018                     |       |
|                                                                                                                            |       |                        |        |                           |       |
| 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; 15,976,000 and 14,105,800 shares issued and outstanding,  respectively |       | 159,760                     |        | 141,058                        |       |
| Additional paid-in capital                                                                                                      |       | 123,591,179                 |        | 108,020,597                    |       |
| Unearned compensation                                                                                                           |       | (2,323,977                  | )           | (2,840,827                     | )          |
| Accumulated deficit                                                                                                             |       | (2,168,725                  | )           | (1,090,858                     | )          |
| Accumulated other comprehensive income                                                                                          |       | 3,703,867                   |        | 1,671,717                      |       |
|                                                                                                                            |       |                        |        |                           |       |
| Total stockholders’ equity                                                                                                 |       | 122,962,104                 |        | 105,901,687                    |       |
|                                                                                                                            |       |                        |        |                           |       |
| Total liabilities and stockholders’ equity                                                                                 |       | $                           | 228,537,496 |                           | $          | 164,836,705 |   |

 

See accompanyingnotes to unaudited consolidated financial statements

 

1

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**FALCONFINANCIAL INVESTMENT TRUST AND PREDECESSOR**

 

**ConsolidatedStatements of Operations**

**(unaudited)**

** **
| ** **                                                                       | ** ** | **Company  Three Months  Ended  June 30, 2004** | ** ** | **Predecessor   Three Months  Ended  June 30, 2003** | ** ** | **Company  Six Months  Ended  June 30, 2004** | ** ** | **Predecessor  Six Months  Ended  June 30, 2003** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------------|------------|
| REVENUES:                                                                        |       |                                            |       |                                                 |       |                                          |       |                                              |       |
| Interest income on loans                                                         |       | $                                               | 3,527,024  |                                                 | $          | 1,548,049                                     |       | $                                                 | 6,475,822  |   | $ | 3,195,066 |   |
|                                                                             |       |                                            |       |                                                 |       |                                          |       |                                              |       |
| Interest income on securities purchased  under resale agreements - related party |       | —                                          |       | 54,105                                               |       | —                                        |       | 76,837                                            |       |
| Interest income from retained interests                                          |       | 298,610                                         |       | 405,448                                              |       | 603,084                                       |       | 761,341                                           |       |
| Gain on sale of loans                                                            |       | —                                          |       | —                                               |       | —                                        |       | 10,696,524                                        |       |
| Gain on sale of retained interests                                               |       | —                                          |       | —                                               |       | —                                        |       | 265,352                                           |       |
| Changes in fair value of interest rate swap  contracts                           |       | 221,854                                         |       | —                                               |       | 156,371                                       |       | 678,816                                           |       |
| Income from loan servicing                                                       |       | 113,879                                         |       | 110,580                                              |       | 226,459                                       |       | 208,422                                           |       |
| Interest and other income                                                        |       | 368,908                                         |       | 191,236                                              |       | 475,654                                       |       | 209,553                                           |       |
| Total revenues                                                                   |       | 4,530,275                                       |       | 2,309,418                                            |       | 7,937,390                                     |       | 16,091,911                                        |       |
|                                                                             |       |                                            |       |                                                 |       |                                          |       |                                              |       |
| EXPENSES:                                                                        |       |                                            |       |                                                 |       |                                          |       |                                              |       |
| Interest expense on borrowings                                                   |       | 783,012                                         |       | 217,280                                              |       | 1,219,366                                     |       | 407,767                                           |       |
| Interest expense on borrowings - related  party                                  |       | —                                          |       | 737,827                                              |       | —                                        |       | 1,407,369                                         |       |
| Interest expense on securities sold, but  not yet repurchased - related party    |       | —                                          |       | 394,999                                              |       | —                                        |       | 544,303                                           |       |
| Provision for possible loan losses                                               |       | 267,750                                         |       | —                                               |       | 499,426                                       |       | —                                            |       |
| Loss on securities sold, but not yet  purchased - related party                  |       | —                                          |       | 2,447,251                                            |       | —                                        |       | 1,365,982                                         |       |
| Facility fee expense                                                             |       | 780,500                                         |       | 93,750                                               |       | 1,530,500                                     |       | 187,500                                           |       |
| Salaries and benefits                                                            |       | 1,483,414                                       |       | 833,469                                              |       | 2,897,633                                     |       | 1,700,909                                         |       |
| Professional fees                                                                |       | 190,125                                         |       | 48,966                                               |       | 471,043                                       |       | 117,707                                           |       |
| General and administrative                                                       |       | 507,580                                         |       | 244,875                                              |       | 986,643                                       |       | 497,281                                           |       |
| Advertising and promotion                                                        |       | 211,111                                         |       | 136,010                                              |       | 542,085                                       |       | 377,248                                           |       |
| Depreciation and amortization                                                    |       | 39,547                                          |       | 33,307                                               |       | 69,716                                        |       | 68,555                                            |       |
| Total expenses                                                                   |       | 4,263,039                                       |       | 5,187,734                                            |       | 8,216,412                                     |       | 6,674,621                                         |       |
|                                                                             |       |                                            |       |                                                 |       |                                          |       |                                              |       |
| Net income (loss)                                                                |       | $                                               | 267,236    |                                                 | $          | (2,878,316                                    | )          | $                                                 | (279,022   | )  | $ | 9,417,290 |   |
|                                                                             |       |                                            |       |                                                 |       |                                          |       |                                              |       |
|                                                                             |       |                                            |       |                                                 |       |                                          |       |                                              |       |
| Earnings (loss) per common share:                                                |       |                                            |       |                                                 |       |                                          |       |                                              |       |
| Basic and diluted                                                                |       | $                                               | 0.02       |                                                 |       |                                          | $          | (0.02                                             | )          |   |   |
|                                                                             |       |                                            |       |                                                 |       |                                          |       |                                              |       |
| Weighted average shares outstanding:                                             |       |                                            |       |                                                 |       |                                          |       |                                              |       |
| Basic                                                                            |       | 15,662,500                                      |       |                                                 |       | 15,332,830                                    |       |                                              |       |
| Diluted                                                                          |       | 15,697,321                                      |       |                                                 |       | 15,386,170                                    |       |                                              |       |

 

Seeaccompanying notes to unaudited consolidated financial statements.

 

2

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**FALCONFINANCIAL INVESTMENT TRUST AND PREDECESSOR**

 

**ConsolidatedStatements of Changes in Stockholders’ Equity and Comprehensive Income**

 

**Forthe Six Months Ended June 30, 2004**

**(unaudited)**

 
| ** **                                                | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in** | ** ** | **Unearned** | ** ** | **Accumulated**  | ** ** | **Accumulated  Other  Comprehensive** | ** ** | **Total  Stockholders’** | ** ** | **Comprehensive** | ** ** |
|-----------------------------------------------------------|------------|-------------------|------------|-------------------------|------------|--------------|------------|------------------|------------|---------------------------------------|------------|-------------------------------|------------|-------------------|------------|
| ** **                                                | ** ** | **Shares**        | ** ** | **Par  Value**          | ** ** | **Capital**  | ** ** | **Compensation** | ** ** | **Deficit**                           | ** ** | **Income**                    | ** ** | **Equity**        | ** ** | **Income** | ** ** |
| 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                                                  |       |              |       |                    |       |         |       |             |       | (279,022                              | )          |                          |       | (279,022          | )          | $ | (279,022 | ) |
|                                                      |       |              |       |                    |       |         |       |             |       |                                  |       |                          |       |              |       |   |   |
| Over-allotment  transaction on  February 2, 2004:         |       |              |       |                    |       |         |       |             |       |                                  |       |                          |       |              |       |   |   |
| Issuance of  shares in connection with over-allotment     |       | 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  |       | 10,000            |       | 100                     |       | 93,700       |       | (93,800          | )          |                                  |       |                          |       | —            |       |   |   |
|                                                      |       |              |       |                    |       |         |       |             |       |                                  |       |                          |       |              |       |   |   |
| Terminated  restricted shares to employees and trustees   |       | (14,800           |  )    | (148                    | )     | (133,052     | )     | 133,200          |       |                                  |       |                          |       | —            |       |   |   |
|                                                      |       |              |       |                    |       |         |       |             |       |                                  |       |                          |       |              |       |   |   |
| Amortization of  unearned compensation                    |       |              |       |                    |       |         |       | 477,450          |       |                                  |       |                          |       | 477,450           |       |   |   |
|                                                      |       |              |       |                    |       |         |       |             |       |                                  |       |                          |       |              |       |   |   |
| Unrealized gain  on hedging transactions                  |       |              |       |                    |       |         |       |             |       |                                  |       | 1,335,422                     |       | 1,335,422         |       | 1,335,422 |   |
|                                                      |       |              |       |                    |       |         |       |             |       |                                  |       |                          |       |              |       |   |   |
| Unrealized gain  on retained interests in securitizations |       |              |       |                    |       |         |       |             |       |                                  |       | 696,728                       |       | 696,728           |       | 696,728 |   |
|                                                      |       |              |       |                    |       |         |       |             |       |                                  |       |                          |       |              |       |   |   |
| Dividends declared                                        |       |              |       |                    |       |         |       |             |       | (798,845                              | )          |                          |       | (798,845          | )          |   |   |
|                                                      |       |              |       |                    |       |         |       |             |       |                                  |       |                          |       |              |       |   |   |
| BALANCE, June 30,  2004                                   |       | 15,976,000        |       | $                       | 159,760    |         | $          | 123,591,179      |       | $                                     | (2,323,977 | )                             | $          | (2,168,725        | )          | $ | 3,703,867 |   | $ | 122,962,104 |   | $ | 1,753,128 |   |

 

Seeaccompanying notes to unaudited consolidated financial statements.

 

3

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**FALCON FINANCIAL INVESTMENT TRUST AND PREDECESSOR**

 

**ConsolidatedStatements of Cash Flows**

**(unaudited)**

** **
| ** **                                                                                          | ** ** | **Company   Three Months   Ended   June 30, 2004** | ** ** | **Predecessor   Three Months  Ended  June 30, 2003** | ** ** | **Company  Six Months  Ended  June 30, 2004** | ** ** | **Predecessor   Six Months   Ended   June 30, 2003** | ** ** |
|-----------------------------------------------------------------------------------------------------|------------|----------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------|------------|------------------------------------------------------|------------|
| **Cash flows from operating activities:**                                                           |       |                                               |       |                                                 |       |                                          |       |                                                 |       |
| Net income (loss)                                                                                   |       | $                                                  | 267,236    |                                                 | $          | (2,878,316                                    | )          | $                                                    | (279,022   | ) | $ | 9,417,290 |   |
| Adjustments to reconcile net income (loss)  to net cash (used in) provided by operating activities: |       |                                               |       |                                                 |       |                                          |       |                                                 |       |
| Gain on sale of loans                                                                               |       | —                                             |       | —                                               |       | —                                        |       | (10,696,524                                          | )          |
| Gain on sale of retained interests                                                                  |       | —                                             |       | —                                               |       | —                                        |       | (265,352                                             | )          |
| Changes in fair value of interest rate swap  contracts                                              |       |                                               | (221,854   | )                                                    | —     |                                          | (156,371   | )                                                    | —     |   |
| Depreciation and amortization - property  and equipment                                             |       | 39,547                                             |       | 33,307                                               |       | 69,716                                        |       | 68,555                                               |       |
| Depreciation and amortization - deferred  origination fees, net of expense                          |       | (36,123                                            | )          | (18,739                                              | )          | (69,062                                       | )          | (40,981                                              | )          |
| Provision for possible loan losses                                                                  |       | 267,750                                            |       | —                                               |       | 499,426                                       |       | —                                               |       |
| Amortization of unearned compensation                                                               |       | 238,725                                            |       | —                                               |       | 477,450                                       |       | —                                               |       |
| (Accretion) amortization of (discount)  premium on retained interests                               |       | (46,925                                            | )          | 22,301                                               |       | (57,576                                       | )          | (4,013                                               | )          |
| Changes in operating assets and  liabilities:                                                       |       |                                               |       |                                                 |       |                                          |       |                                                 |       |
| Increase in securities sold, but not yet  purchased - related party                                 |       | —                                             |       | 23,291,448                                           |       | —                                        |       | 32,103,625                                           |       |
| Increase in interest rate swap contracts                                                            |       | (501,328                                           | )          | —                                               |       | (501,328                                      | )          | (5,900,800                                           | )          |
| Increase in securities purchased under  resale agreements - related party                           |       | —                                             |       | (23,739,820                                          | )          | —                                        |       | (32,396,440                                          | )          |
| Decrease (increase) in due from broker                                                              |       | 2,380,000                                          |       | (39,730                                              | )          | —                                        |       | 6,400,270                                            |       |
| (Increase) decrease in accrued interest  receivable                                                 |       | (140,880                                           | )          | (428,360                                             | )          | (149,241                                      | )          | 678,314                                              |       |
| (Increase) decrease in prepaid expenses and  other assets                                           |       | (1,432,121                                         | )          | 180,637                                              |       | (744,561                                      | )          | (47,966                                              | )          |
| Decrease in due to broker - related party                                                           |       | —                                             |       | (55,131                                              | )          | —                                        |       | (1,699,778                                           | )          |
| Increase (decrease) in accrued interest  payable                                                    |       | 143,980                                            |       | (212,944                                             | )          | 59,639                                        |       | (98,444                                              | )          |
| Increase (decrease) in accrued interest  payable - related party                                    |       | —                                             |       | 880,825                                              |       | —                                        |       | (975,004                                             | )          |
| Increase (decrease) in customer deposits                                                            |       | 469,426                                            |       | (195,037                                             | )          | 390,475                                       |       | (141,539                                             | )          |
| Increase (decrease) in accounts payable and  accrued liabilities                                    |       | 254,371                                            |       | 27,235                                               |       | (1,145,368                                    | )          | (170,591                                             | )          |
| Net cash provided by (used in) operating  activities                                                |       | 1,681,804                                          |       | (3,132,324                                           | )          | (1,605,823                                    | )          | (3,769,378                                           | )          |
| **Cash flows from investing activities:**                                                           |       |                                               |       |                                                 |       |                                          |       |                                                 |       |
| Disbursements for loan originations, net of  fees received                                          |       | (31,257,591                                        | )          | (46,455,102                                          | )          | (58,313,327                                   | )          | (85,202,431                                          | )          |
| Repayments of loans                                                                                 |       | 1,127,181                                          |       | 4,020,333                                            |       | 2,172,647                                     |       | 4,701,420                                            |       |
| Net proceeds from sale of retained  interests                                                       |       | —                                             |       | —                                               |       | —                                        |       | 2,983,560                                            |       |
| Net proceeds from sale of loans                                                                     |       | —                                             |       | —                                               |       | —                                        |       | 145,464,590                                          |       |
| Capital expenditures, net                                                                           |       | (71,214                                            | )          | (14,560                                              | )          | (193,220                                      | )          | (18,854                                              | )          |
| Net cash (used in) provided by investing  activities                                                |       | (30,201,624                                        | )          | (42,449,329                                          | )          | (56,333,900                                   | )          | 67,928,285                                           |       |
| **Cash flows from financing activities:**                                                           |       |                                               |       |                                                 |       |                                          |       |                                                 |       |
| Proceeds from over-allotment                                                                        |       | —                                             |       | —                                               |       | 16,875,000                                    |       | —                                               |       |
| Payment of over-allotment expenses                                                                  |       | —                                             |       | —                                               |       | (1,246,316                                    | )          | —                                               |       |
| Borrowings from warehouse line of credit                                                            |       | 101,200,000                                        |       | 42,872,000                                           |       | 123,004,000                                   |       | 78,706,000                                           |       |
| Repayments of warehouse line of credit                                                              |       | (75,026,223                                        | )          | (3,720,174                                           | )          | (76,071,690                                   | )          | (133,905,999                                         | )          |
| Borrowings from subordinated loans                                                                  |       | —                                             |       | 7,147,766                                            |       | —                                        |       | 12,081,901                                           |       |
| Repayments of subordinated loans                                                                    |       | —                                             |       | (950,160                                             | )          | —                                        |       | (20,855,980                                          | )          |
| Borrowings from interest capitalization  notes                                                      |       | —                                             |       | 62,526                                               |       | —                                        |       | 131,569                                              |       |
| Repayments of interest capitalization notes                                                         |       | —                                             |       | (686,107                                             | )          | —                                        |       | (686,107                                             | )          |
| Net cash provided by (used in) financing  activities                                                |       | 26,173,777                                         |       | 44,725,851                                           |       | 62,560,994                                    |       | (64,528,616                                          | )          |
| Net (decrease) increase in cash and cash  equivalents                                               |       | (2,346,043                                         | )          | (855,802                                             | )          | 4,621,271                                     |       | (369,709                                             | )          |
| Cash and cash equivalents, beginning of  period                                                     |       | 32,612,892                                         |       | 1,096,523                                            |       | 25,645,578                                    |       | 610,430                                              |       |
| Cash and cash equivalents, end of period                                                            |       | $                                                  | 30,266,849 |                                                 | $          | 240,721                                       |       | $                                                    | 30,266,849 |   | $ | 240,721 |   |
|                                                                                                |       |                                               |       |                                                 |       |                                          |       |                                                 |       |
| **Supplemental disclosure of cash flow  information:**                                              |       |                                               |       |                                                 |       |                                          |       |                                                 |       |
| Interest paid                                                                                       |       | $                                                  | 638,756    |                                                 | $          | 744,199                                       |       | $                                                    | 1,158,816  |   | $ | 2,009,831 |   |
| Interest received                                                                                   |       | $                                                  | 3,197,038  |                                                 | $          | 1,015,242                                     |       | $                                                    | 6,110,079  |   | $ | 3,213,623 |   |
|                                                                                                |       |                                               |       |                                                 |       |                                          |       |                                                 |       |
| **Supplemental disclosure of non-cash flow  information:**                                          |       |                                               |       |                                                 |       |                                          |       |                                                 |       |
| Interest payable on interest rate swaps                                                             |       | $                                                  | 235,729    |                                                 | $          | —                                        |       | $                                                    | 235,729    |   | $ | — |   |
| Changes in fair value of interest rate swap  agreements                                             |       | $                                                  | 4,589,455  |                                                 | $          | —                                        |       | $                                                    | 1,335,422  |   | $ | — |   |
| Changes in fair value of retained interests  in securitization                                      |       | $                                                  | 559,768    |                                                 | $          | 57,391                                        |       | $                                                    | 696,728    |   | $ | 292,370 |   |
| Allocated basis of retained interest in  2003-1 securitization                                      |       | $                                                  | —     |                                                 | $          | —                                        |       | $                                                    | —     |   | $ | 4,948,353 |   |
| Dividends declared                                                                                  |       | $                                                  | 798,845    |                                                 | $          | —                                        |       | $                                                    | 798,845    |   | $ | — |   |

 

See accompanying notes to unaudited consolidated financial statements.

 

4

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**FALCON FINANCIAL INVESTMENT TRUST ANDPREDECESSOR**

 

**Notes to Consolidated 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, 2003 when itcompleted its initial public offering (“IPO”) and concurrently consummatedcertain other formation transactions, including a merger with Falcon 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 aggregateproceeds to 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 318,300 restrictedshares as part of its Equity Incentive Plan to its independent trustees,trustee nominees, members of senior management and other employees. The totalnumber 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 an86% interest in Falcon Auto Venture, LLC. Subsequent to the IPO, owners of thePredecessor collectively owned 10.3% of the Trust, with no individual owninggreater than 5%.

 

Concurrentlywith the completion of the IPO, the Trust authorized 50.0 million preferredshares of 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 AccountingPolicies**

 

***(a) Basis of Presentation – Interim FinancialStatements***

 

The unauditedinterim consolidated financial statements presented herein include all of theaccounts of 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. All intercompany transactions and accountbalances have been eliminated in consolidation.

 

5

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Theaccompanying unaudited financial statements have been prepared by management inaccordance with accounting principles generally accepted in the United Statesof America, commonly referred to as U.S. GAAP, for interim financialinformation and in conformity with the rules and regulations of the Securitiesand Exchange Commission, commonly referred to as the SEC for reporting on theQuarterly Report on Form 10-Q. Accordingly, they do not include all of theinformation and footnotes for complete U.S. GAAP financial statements andshould be read in conjunction with the audited consolidated financialstatements and related notes thereto as of and for the period ended December31, 2003, contained in the Company’s Transition Report on Form 10-K for thetransition period from October 1, 2003 to December 31, 2003 filed with the SECon March 30, 2004. In the opinion of management, the accompanying unauditedinterim consolidated financial statements contain all adjustments, consistingof normal recurring adjustments, necessary for a fair presentation of theCompany’s consolidated financial position at June 30, 2004 andDecember 31, 2003, the results of its operations and its cash flows forthe three and six months ended June 30, 2004 and 2003, and changes inshareholders’ equity and comprehensive income for the six months ended June 30,2004.

 

The results ofoperations for any interim period are not necessarily indicative of the resultsthat may be expected for the full year. The preparation of financial statementsrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ materially fromthose estimates and assumptions.

 

***(b) Cash and Cash Equivalents***

 

For purposesof the statements of cash flows, the Company and its Predecessor consider allhighly liquid investments with original maturities of less than three months atthe date of acquisition to be cash equivalents. These assets are carried atcost, which approximates fair value. Restricted cash is not considered as cashor cash equivalents for the purpose of the statements of cash flows.

 

***(c) Loans Receivable, 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 Statementof Financial Accounting Standards (SFAS) No. 140, “*Accounting for Transfers and Servicing of Financial Assets andExtinguishments of Liabilities—a replacement of FASB Statement 125”*(“SFAS No. 140”), and carry the loans on the statements offinancial position to maturity. The loans receivable are stated at theirprincipal amount outstanding, less net deferred loan fees, unearned discountsand allowance for possible loan losses. Nonrefundable origination fees lesscertain related direct costs associated with the origination of the loans aredeferred and amortized into interest income over the term of the loan using amethod that 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 statements of financial position. The amount, if any, bywhich the cost exceeds the fair value, is recorded as a valuation allowance.Changes in the valuation allowance are recorded in the statements ofoperations. As of June 30, 2003, no valuation allowance was deemed necessary.

 

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

 

The allowance for possible loan losses is based on a periodic analysisof the loan 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.

 

The Company accounts for its allowance for losses on loans in accordancewith SFAS No. 5, “*Accounting for Contingencies”*(“SFAS No. 5”) and SFAS No. 114, “*Accounting by Creditorsfor Impairment of a Loan”* (“SFAS No. 114”)*.*  Both Statements require the Company toevaluate the collectibility of both contractual interest and principal loanpayments.   SFAS No. 5 requires theaccrual of a loss when it is probable that a loan has been impaired and theamount of the loss can be reasonably estimated. SFAS No. 114 requires that impaired loans be measured based upon thepresent value of expected future cash flows discounted at the loan’s effectiveinterest rate, or as an alternative, at the loan’s observable market price orfair value of the collateral.  A loan isimpaired when, based on current information and events, it is probable that acreditor will be unable to collect all amounts due according to the contractualterms of the loan agreement. A loss from impairment represents the amount bywhich a creditor’s recorded investment in a loan exceeds the present value ofthe expected future cash flows from the loan discounted at the loan’s effectiveinterest rate (including the fair value of the collateral that may be part ofthe loan).  Lossesfor 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.

 

6

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

 

ThePredecessor accounted for its loan securitizations in accordance with SFAS No.140. When the Predecessor sold loans in a securitization, it may have retainedone or more subordinated 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 selling costs) and the allocatedcarrying amount of the receivables sold, including deferred origination feesand costs.  The Predecessor determinedthe carrying 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 stockholders’ equity within the caption accumulated othercomprehensive income (loss). The Company is not aware of an active market forthe purchase and sale of these retained interests at this time and accordingly,the Company estimates the fair value of the retained interest by calculatingthe present value of the estimated expected future cash flows received by theCompany after being released by the securitization trust, using a discount ratecommensurate with the risk involved taking into consideration the results ofsales of certificates owned by the Company to third parties. The cash flowsbeing discounted are adjusted for estimated net losses due to defaults orprepayments. The Company has experienced four defaulted loans since inception(of which one has been fully resolved and three are pending resolution) and noprepayments in its retained interests in securitizations as of June 30, 2004and December 31, 2003. 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 theCompany holds are subordinate in the right of payment to all other classes ofcertificates, which must receive their applicable distributions before any cashis available for distribution 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 accumulated other comprehensive income (loss) withinstockholders’ equity. Reductions in the estimated aggregate cash flows to bereceived by the Company, caused by defaults or prepayments that result in areduction to the fair value of the retained interests, are considered an otherthan temporary impairment and are recognized through a charge to expense inthat 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 June 30, 2004 and December 31, 2003, the Company held$2,026,404 and $2,657,660, respectively, of cash collateral for the completionof those projects.

 

***(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 loansis deferred as an adjustment to the carrying value of the loan portfolio.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 loans.

 

7

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***(h) Servicing Income***

 

Under servicingagreements for all of the Company securitizations, servicing fees for loans ingood standing are accrued monthly based upon the then outstanding principalbalances of 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 a 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 into default status. Currently,there are three loans in default.  Feesreceived for 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 statements of financial position under the captionsecurities sold, but not yet purchased. This liability is carried at marketvalue with any unrealized gain or loss recorded in the statements ofoperations. The related interest expense recorded in the statements ofoperations over the period held for the three and six months ended June 30,2003 was $394,999 and $544,303, respectively.

 

***(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 statements of financial position. These assets are carried at the amountsat which the identical securities will be subsequently resold as specified inthe agreements, generally at market value. The related interest income recordedin the statements of operations for the three and six months ended June 30,2003 was $54,105 and $76,837, respectively.

 

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

 

The Companyenters into forward interest rate swap contracts as a means of mitigating theimpact that changes in interest rates and credit spreads have with respect tothe forecasted issuance of long-term debt. The contracts are evaluated atinception and on an on-going basis in order to determine whether the contractsqualify for hedge accounting under SFAS No. 133, “*Accountingfor Derivative Instruments and Hedging Activities”*, asamended 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 as cash flow hedges are carried in thestatements of financial position at fair value with changes in their fair valuerecorded in accumulated other comprehensive income (loss). Any ineffectivenesswhich arises during the hedging relationship is recognized in statements ofoperations during the period in which it arises.

 

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.  Swap contractsare carried at fair value with any unrealized gain or loss recorded in thestatements of operations.  The relatedinterest income and interest expense is recorded in the statements ofoperations over the periods held. The aggregate net interest expense and marketvalue change for the three and six months ended June 30, 2003 was $0 and$678,816, respectively.

 

8

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***(l) Property and Equipment, net***

 

Property andequipment, net are reported at cost less accumulated depreciation. Depreciationis recorded on a straight-line basis over five years for furniture and fixturesand three years for computers and equipment. Leasehold improvements areamortized over the shorter of the estimated useful life or the remaining termof the respective leases.

 

The componentsof property and equipment, net at June 30, 2004 and December 31, 2003 are asfollows:

 
| ** **                                       | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| ** **                                       | ** ** | **(unaudited)**    | ** ** | ** **             | ** ** |
| Furniture and fixtures                           |       | $                  | 334,505    |                   | $          | 322,140 |   |
| Computers and equipment                          |       | 577,267            |       | 396,412                |       |
| Leasehold improvements                           |       | 79,363             |       | 79,363                 |       |
| Gross property and equipment, at cost            |       | 991,135            |       | 797,915                |       |
|                                             |       |               |       |                   |       |
| Less: accumulated depreciation and  amortization |       | (531,771           | )          | (462,055               | )          |
| Property and equipment, net                      |       | $                  | 459,364    |                   | $          | 335,860 |   |

 

Depreciationand amortization expense for the three and six months ended June 30, 2004 and2003 was $39,547 and $69,716 and $33,307 and $68,555, respectively.

 

***(m) Equity Incentive and Option Plans***

 

Immediately prior to the IPO, the Companyadopted an Equity Incentive Plan and issued restricted common shares to itsexecutives, employees and non-employee trustees. Unearned compensation expensewas recorded by the Company as reduction to stockholders’ equity and charged tocompensation expense on a straight-line basis over the vesting period of threeyears.  The compensation expense for thethree and six months ended June 30, 2004 was $238,725 and $477,450,respectively.

 

In September1999, the Predecessor adopted the Falcon Financial, LLC Option Plan.  The options of the Predecessor were recordedbased on the fair value method as prescribed in SFAS No. 123, “*Accounting for Stock-Based Compensation.”*The option plan was terminated prior to the formation transaction 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.  Accumulated othercomprehensive income (loss) reported in the statements of financial position asof June 30, 2004 and December 31, 2003, represents the accumulatedunrealized gain (loss) on retained interests in securitizations and interestrate swaps accounted for as cash flow hedges. The components of comprehensive income (loss) for the three and sixmonths ended June 30, 2004 are as follows:

 
| **(Unaudited)**                                           | ** ** | **Three Months  Ended  June 30, 2004** | ** ** | **Six Months  Ended  June 30, 2004** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| Net income (loss)                                         |       | $                                      | 267,236    |                                 | $          | (279,022 | ) |
|                                                      |       |                                   |       |                                 |       |
| Unrealized gain on hedging transactions                   |       | 4,589,455                              |       | 1,335,422                            |       |
|                                                      |       |                                   |       |                                 |       |
| Unrealized gain on retained interests in  securitizations |       | 559,768                                |       | 696,728                              |       |
|                                                      |       |                                   |       |                                 |       |
| Comprehensive income                                      |       | $                                      | 5,416,459  |                                 | 1,753,128  |   |
|                                                           |            |                                        |            |                                      |            |  |  |

 

9

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***(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, stock ownership and other tests required under the IRC, the Companygenerally will not be subject to federal income tax. If the Company fails toqualify as a REIT in any taxable year, it will be subject to federal income taxincluding any applicable alternative minimum tax on its taxable income atregular corporate rates. Under certain circumstances, if the Company qualifiesas a REIT, it may be subject to federal income tax and excise tax on itsundistributed taxable income and may also be subject to state and local incometaxes.  The Company’s subsidiary, FalconFinancial II, LLC is a taxable REIT subsidiary for federal income tax purposesand is fully taxable at normal corporate tax rates.

 

***(p) Earnings (Loss) Per Common Share***

 

The Company calculates basic earning (loss)per share by dividing net income (loss) for the period by the weighted-averageshares of its common stock outstanding for that period. Dilutedearning (loss) per share takes into account the effect of dilutive instruments,such as unvested restricted shares, based on the average share price for theperiod in determining the number of incremental shares that are added to theweighted-average number of shares outstanding using the treasury stock method.

 

Thereconciliation of shares used in the basic and diluted earnings (loss) percommon share computations for the three and six months ended June 30, 2004,respectively, is as follows (unaudited):

 
| ** **                                  | ** ** | **Three Months Ended  June 30, 2004** | ** ** | **Six Months Ended  June 30, 2004** | ** ** |
|---------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
|                                        |       |                                  |       |                                |       |
| Net income (loss)                           |       | $                                     | 267,236    |                                | $          | (279,022 | ) |
|                                        |       |                                  |       |                                |       |
| Weighted average shares outstanding         |       | 15,981,565                            |       | 15,654,160                          |       |
| Effect of dilutive securities:              |       |                                  |       |                                |       |
| Unvested restricted shares                  |       | (319,065                              | )          | (321,330                            | )          |
|                                        |       |                                  |       |                                |       |
| Basic weighted average shares outstanding   |       | 15,662,500                            |       | 15,332,830                          |       |
| Effect of dilutive securities:              |       |                                  |       |                                |       |
| Dilutive impact of restricted shares        |       | 34,821                                |       | 53,340                              |       |
|                                        |       |                                  |       |                                |       |
| Diluted weighted average shares outstanding |       | 15,697,321                            |       | 15,386,170                          |       |
|                                        |       |                                  |       |                                |       |
| Earnings (loss) per common share:           |       |                                  |       |                                |       |
| Basic and diluted                           |       | $                                     | 0.02       |                                | $          | (0.02 | ) |

 

***(q) Reclassifications***

 

Certain items from prior periods have beenreclassified to conform to current period presentation.

 

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

 

InJanuary 2003, the FASB issued Interpretation No. 46, “*Consolidation of Variable Interest Entities”*, an interpretation of ARB 51 (FIN 46). Theinterpretation provides guidance on consolidating variable interest entities(“VIE”) and applies immediately to variable interests created after January 31,2003.  The guidelines of theinterpretation as revised by FIN 46 (revised December 31, 2003), “*Consolidation of VariableInterest Entities”* (FIN 46R)became applicable to the Company in the first quarter of 2004 for variableinterest entities created before February 1, 2003.  The interpretation requires VIEs, formerlyreferred to as special purpose entities, to be consolidated if the equityinvestment at risk is not sufficient to permit an entity to finance itsactivities without support from other parties, or the equity investors lackcertain specified characteristics. Adoption of this new accounting standard did not have a material effecton the Company’s financial condition or results of operations.

 

10

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**(3) Loans Receivable, net**

 

Loansreceivable, net as of June 30, 2004 and December 31, 2003 are summarizedas follows:

 
| ** **                                                         | ** ** | **June 30,  2004** | ** **  | **December 31, 2003** | ** ** |
|--------------------------------------------------------------------|------------|--------------------|-------------|----------------------------|------------|
| ** **                                                         | ** ** | **(unaudited)**    | ** **  | ** **                 | ** ** |
| Loans                                                              |       | $                  | 184,429,432 |                       | $          | 127,846,080 |   |
| Less: Net deferred loan origination fees  and initial direct costs |       | (1,056,376         | )           | (682,766                   | )          |
| Allowance for possible loan losses                                 |       | (1,586,118         | )           | (1,086,692                 | )          |
| Loans, net                                                         |       | $                  | 181,786,938 |                       | $          | 126,076,622 |   |

 

Loansreceivable at June 30, 2004 are comprised of fixed-rate and variable-rate loanswith interest rates ranging between 7.18% and 9.52% and 4.15% and 5.75%,respectively. Maturity dates range from February 1, 2011 toApril 1, 2023 with 68.3% maturing during 2018. Eight loans totalingapproximately $58.4 million have balloon payments of approximately $3.4 millionon June 1, 2009, approximately $4.0 million on February 1, 2011,approximately $6.2 million on July 1, 2011, approximately $1.5 million onDecember 1, 2013, approximately $2.0 million on March 1, 2014,approximately $17.1 million on April 1, 2014 and approximately $12.0 millionon July 1, 2014. There are 23 borrowers located in 18 states. Approximately45.5% of the outstanding principal balance of the loans is to seven borrowerslocated in three states (Florida-23.6%, Tennessee-11.5%, and Ohio-10.4%). 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 with interestrates ranging between 8.14% and 9.52%. Maturity dates range from February 1,2011 to April 1, 2023 with 78.9% maturing during 2018. Two loans totalingapproximately $9.6 million have balloon payments of approximately $4.0 millionon February 1, 2011 and approximately $1.5 million on December 1, 2013.There are 17 borrowers located in 15 states. Approximately 33.13% of theprincipal balance of the loans is to three borrowers located in two states(Florida-22.1% and Virginia-11.03%). There are no other concentrations greaterthan 10% in any other state or to any individual 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 June 30, 2004 and December 31, 2003.

 

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

 

The Company establishes an allowance for possible loan losses toreserve for losses inherent in the Company’s loan portfolio. The followingsummarizes the activity in the allowance for possible loan losses for theperiod from December 31, 2003 through June 30, 2004 (unaudited):

 
| Balance at December 31, 2003       |   | $       | 1,086,692 |   |
|------------------------------------|--------|---------|-----------|--------|
| Provision for possible loan losses |   | 499,426 |      |
| Balance at June 30, 2004           |   | $       | 1,586,118 |   |

 

11

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**(5)Derivative Instruments and Hedging Activities**

 

In June 1998, theFinancial Accounting Standards Board (FASB) issued SFAS No. 133, “*Accounting for Derivative Instruments and HedgingActivities”*(“SFAS No.133”). In June 1999, the FASB issued SFAS No. 137, “*Accounting for Derivative Instruments and HedgingActivities—Deferral of the Effective Date of SFAS No. 133*.” InJune 2000, the FASB issued SFAS No. 138, “*Accounting for Certain Derivative Instruments and Certain HedgingActivities, an amendment of SFAS No. 133*.” In April 2003, theFASB issued SFAS No. 149, *“Amendment ofStatement 133 on Derivative Instruments and Hedging Activities.”*These Statements, collectively referred to as SFAS No. 133, establishaccounting and reporting standards requiring that every derivative instrument,including certain derivative instruments embedded in other contracts, berecorded on the balance sheet as either an asset or liability measured at itsfair value. Changes in the fair value of the derivative are to be recognizedcurrently in earnings unless specific hedge accounting criteria are met.Special accounting for qualifying hedges allows gains and losses on derivativesto offset related results on the hedged items in the statements of operationsand requires that a company document, designate, and assess the effectivenessof transactions that receive hedge accounting under SFAS No. 133.

 

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 accumulated other comprehensive income (loss).

 

ThePredecessor entered into certain transactions (short sales and purchases,securities resale and repurchase agreements, and interest rate swaps) tomitigate the effect that changes in interest rates and credit spreads have onthe fair value of its fixed-rate loan portfolio held for sale. Periods ofrising interest rates and widening credit spreads decrease the fair value ofthe loan portfolio held for sale. Generally, the Predecessor entered into these transactions when the ratewas locked on a pending loan just prior to the closing of the loan.  The new loan was added to the pool of loansbeing held for sale and the pool was then reviewed to determine what, if any,additional hedging transaction was to be executed.  Generally, the Predecessor shorted U.S.Treasuries and invested the proceeds in repurchase agreements with Goldman,Sachs & Co. with U.S. Treasury notes as the underlying securities. In swaptransactions, the Predecessor generally entered into an interest rate swapcontract, receiving a floating rate of interest and paying a fixed rate ofinterest. The term of the swap contracts was determined by duration of theloans held for sale pool. The Predecessor had a contractual obligation tosettle the repurchase and swap agreements with Goldman, Sachs & Co. at thecurrent fair value on the repurchase date. These contracts have been recorded asfree standing derivatives with changes in fair value recorded in results ofoperations.

 

As of June 30,2004, the Company had nine forward starting interest rate swap contractsaccounted for as cash flow hedges on which the Company paid fixed and receivedfloating.  The contracts had a totalnotional amount of $124,485,777 and a fair value of $2,382,904. There wasaccrued interest on these contracts of $235,729 at June 30, 2004. The contractshad maturity dates ranging from April 1, 2014 to February 28, 2018. Fixed interest rates ranged from 4.045% to 5.315% and a floatingrate of 1.369%.

 

As ofDecember 31, 2003, the Company had four forward starting interest rateswap contracts accounted for as cash flow hedges on which the Company paidfixed 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 from4.045% to 4.815% and a floating rate of 1.12%.

 

As of June 30,2004 and December 31, 2003, included in accumulated other comprehensive income(loss) for the forward starting interest rate swap contracts was $1,725,205 and$389,783, respectively.

 

**(6) Loan Securitizations**

 

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 non-rated certificates issued in connection with thesecuritization transaction.

 

InFebruary 2003, the Predecessor completed Falcon Auto Dealership Loan TrustCertificates 2003-1, securitizing loans with a principal balance of$141,060,558, receiving net proceeds (after the payment of expenses) of$145,464,590 and retaining rated and non-rated certificates with an allocatedbook value of $4,962,378 and a fair value of $5,431,623. The securitizationtransaction resulted in a pretax gain of $10,696,524. The proceeds from thesecuritization were used to pay down borrowings outstanding under the warehouseline of credit and the senior subordinated loans.

 

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.

 

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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 aggregatecash flows that the Predecessor expects to receive from the 2003-1 Trust forits unrated retained interest. Accordingly, the Predecessor charged $422,477 to expense, which was theamount considered to be other than temporary decline in the Predecessor’s fairvalue of the unrated retained interest. This estimated reduction in aggregatecash flows was based on management’s assessment of the amount it wouldultimately collect on the defaulted loan.

 

InOctober 2003, Moody’s downgraded the Class A-1 and A-2 certificates in the2003 securitization from Aaa to Aa1, the Class B certificates from Aa2 to Aa3,the Class C certificates from A2 to A3, the Class D certificates from Baa2 toBaa3, the Class E certificates from Ba2 to Ba3, and the Class F certificatesfrom B3 to Caa2. In November 2003, Moody’s further downgraded the ClassA-1 and A-2 certificates in this securitization from Aa1 to Aa2, the Class Bcertificates from Aa3 to A1, the Class C certificates from A3 to Baa1, theClass D certificates from Baa3 to Ba1, the Class E certificates from Ba3 to B3 andthe 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 an other than temporary reduction in the aggregate cashflows that the Company expects to receive from the 2001-1 Trust for its unratedretained interest. While this delinquency resulted in an estimated $0.2 millionreduction in the value of the retained interest on the 2001-1 Trust, it wasoffset by unrealized gains in accumulated other comprehensive income (loss) forthe 2001-1 transaction and accordingly, did not result in a charge to thestatements of operations. This estimated reduction in aggregate cash flows wasbased on management’s assessment of the amount it would ultimately collect onthe defaulted loan. The real estate collateral for this loan was foreclosedupon.

 

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%.

 

In August2004, a delinquency was experienced in the 2001-1 Trust for a loan with anunpaid principal balance of approximately $5.4 million.  The loan defaulted in August 2004. The impactof the defaulted loan on the value of the Company’s retained interest in the2001-1 Trust can not be determined until such time that management hascompleted its assessment of the foreseeable recovery in connection with suchloan.  As such, the Company has notrecorded a change in the value of its retained interest in the 2001-1 Trust atthis time.

 

The activityrelated to the Company’s retained interests as of June 30, 2004 and December31, 2003 is as follows:

 

| ** **                                                                         | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                         | ** ** | **(Unaudited)**   | ** ** | ** **            | ** ** |
| Balance at beginning of period, January 1,  2004 and October 1, 2003, respectively |       | $                 | 7,239,136  |                  | $          | 7,347,881 |   |
| Interest income recorded                                                           |       | 603,084           |       | 375,517               |       |
| Cash received                                                                      |       | (545,508          | )          | (360,589              | )          |
| Fair value adjustments, net of other than  temporary decline in value              |       | 696,728           |       | (123,673              | )          |
| Balance at end of period                                                           |       | $                 | 7,993,440  |                  | $          | 7,239,136 |   |

 

The Company’skey assumptions used to value the retained interests at June 30, 2004 are theloss/prepayment rate over the life of the transaction (which ranges from 2.88%to 5.12%), and the discount rates applied to the future cash flows (whichranges from 14.5% to 18.0%).  Theseassumptions are consistent with the assumption used at December 31, 2003 tovalue the retained interests.  The resultof changing the key economic and sensitivity of the current fair value ofretained 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 June 30,2004 and December 31, 2003, net unrealized gains for the Company’s retainedinterests in securitizations included in accumulated other comprehensive income(loss) was $1,978,662 and $1,281,934, respectively.

 

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**(7) Borrowings**

 

***Credit Line***

 

OnApril 28, 2004, the Company entered into a $150.0 million RevolvingWarehouse Financing Agreement with iStar Financial Inc., solely for the purposeof originating loans, which replaced the previously existing facility, $150.0million Revolving Warehouse Financing Agreement dated January 7, 1998 withABN AMRO Bank, N.V., as lender, and SunAmerica Life Insurance Company or SALIC(an affiliate of SunAmerica, Inc.), as guarantor.  The new facility may be increased to $200.0million at the Company’s option with the consent of iStar. Interest iscalculated using 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 concurrent with this transaction.  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 in thequarter ended June 30, 2004.  Theinterest rate as of June 30, 2004 was 3.29%. The outstanding balance as of June30, 2004 was $100,408,189.

 

The warehousecredit line is secured by, among other things, the Company’s loans.  All payments made by borrowers in respect ofsuch loans are applied on a monthly basis to pay the outstanding fee andinterest 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 maturitydate of the new warehouse credit line is April 10, 2005.  The availability of funds under this creditline is subject to, among other things, compliance with specified financialcovenants relating to leverage ratio, net worth, limitations on capitalexpenditures and limitations on total indebtedness, as described below.  The Company is required under the warehousefacility to maintain a ratio of consolidated total debt to consolidated networth not in excess of 4:1 and a consolidated net worth of not less

than$80.0 million.  The Company generally maynot maintain indebtedness outside the new warehouse credit line other thanindebtedness to fund obligations under the Company’s hedging arrangements,purchase money indebtedness for the acquisition of assets not in excess of $1.0million, indebtedness in connection with securitization transactions and certaincapital leases.  In order to make aborrowing under the facility, either Vernon B. Schwartz, the Company’s Chairmanand Chief Executive Officer, or David A. Karp, the Company’s President andChief Financial Officer, must be employed as a senior executive officer of theCompany with the same decision making authority as on April 28, 2004.

 

The lenderunder the new warehouse credit line will generally fund up to 80%, the advancerate, of the principal amount of eligible loans that the Company originates withthe lender’s approval.  The maximumfunding available for any individual loan is not permitted to exceed$20.0 million.  In addition, thelender will not fund an amount in excess of 66.6% of the aggregate market valueof the eligible loans.

 

The Company isrequired to make prepayments under the new warehouse credit line under certaincircumstances.  Among other things, theCompany may be required to make prepayments upon a decrease in the aggregatemarket value of the eligible loan portfolio. Specifically, in the event that the lender determines that the productof the market value of the eligible loans in the loan portfolio and theaggregate 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%, the Company will berequired to prepay amounts borrowed under the new warehouse credit linesufficient to eliminate such deficiency. The new warehouse credit line also specifies various events that wouldallow 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.

 

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ThePredecessor entered into a $150.0 million Revolving Warehouse FinancingAgreement dated January 7, 1998 (the “Warehouse Loan Agreement”) with ABNAMRO Bank, N.V., as lender, and SunAmerica Life Insurance Company or SALIC (anaffiliate of SunAmerica, Inc.), as guarantor (collectively, the “Lenders”),solely for the purpose of originating loans. SALIC, along with Goldman Sachs Mortgage Company (an affiliate ofGoldman, Sachs & Co.), as a result of aparticipation agreement between two entities, were the guarantors of theWarehouse Loan Agreement.  As guarantors,each of the entities were paid fees of $87,133 and$259,980 for the three and six months ended June 30, 2003.  The fees are shown in the statements ofoperations within the caption interest expense—related party.  The maturity date was October 1,2004.  This credit facility wascollateralized by the loans held for sale. The Company was required to make prepayments under the warehousefacility under certain circumstances. Among other things, in the event that a customer defaulted on ascheduled loan payment that is not cured within 30 days, such loan would betreated as a defaulted receivable and the Company would be required to prepaythe outstanding principal amount of the borrowings incurred under the warehousefacility 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 rate as of December 31,2003 was 3.09%.  The outstanding balanceas of December 31, 2003 was $53,475,879. On April 28, 2004, the outstanding balance under the Warehouse LoanAgreement was paid in full and the Warehouse Loan Agreement was terminated.

 

The Warehouse Loan Agreement required that the Company maintain certainfinancial covenants related to aggregate indebtedness, net income, net worth,leverage ratio, capital expenditures and lease commitments.  In addition, the Warehouse Loan Agreementalso specified various events (“Termination Events”) that would allow theLenders to terminate the warehouse facility in its entirety should one of theseevents occur, including, among other things, (i) a material adverse change inthe Company’s business, financial condition or prospects or (ii) a downgrade orother impairment of the rating of any notes issued in the Company’ssecuritization transactions.  InOctober 2003 and November 2003, the notes issued in the Company’sFalcon Trust Series 2003-1 securitization were downgraded by the ratingsagencies.  The Company received a waiverfrom the Lenders for this Termination Event.

 

***Senior Subordinated Debt***

 

ThePredecessor entered into a $19.3 million Amended and Restated SeniorSubordinated Loan Agreement dated January 7, 1998 with Goldman SachsMortgage Company and SALIC. The agreement provided for a $5.0 million workingcapital loan, a $2.0 million hedge loan and $12.3 million for loanoriginations. The interest rate on the senior subordinated loan was 12%, with9% payable in cash and 3% accrued and capitalized. This loan was paid in fullon December 23, 2003 and the loan terminated.  Interest expense for the three and six monthsended June 30, 2003 was $721,484 and $1,374,376, respectively.

 

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. Interest expense for the three and six months ended June 30, 2003 was$16,343 and $32,993, respectively.

 

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

 

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 for issuance,of which 318,300 were issued immediately prior to the closing of the IPO, withthe remaining 407,358 shares available for future issuance. The 318,300 sharesissued were valued at the IPO price of $9 per share and recorded instockholders’ equity under the caption of unearned compensation. During thethree and six months ended June 30, 2004, 0 and 10,000 additional shares valuedat $9.38 per share were issued and 9,800 and 14,800 shares, respectively, wereretired bringing the outstanding restricted shares to 313,500.  The shares vest over three years and will beamortized into the statements of operations as compensation expense ratablyover the vesting period.

 

InSeptember 1999, the Predecessor adopted the Falcon Financial, LLC OptionPlan. The Predecessor granted certain employees options, which generallyexpired ten 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 byreference to comparable public company market values and earnings multiples.Options vested at a rate of 20% per year beginning one year after the date ofhire. The Predecessor did not incur an expense associated with the option planfor the three and six months ended June 30, 2003. The plan was terminated priorto the formation transaction on December 22, 2003 and through that date nooptions had been exercised.

 

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**(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 June 30, 2004 and December 31, 2003, respectively.These instruments involve elements of credit risk and interest rate risk inaddition to the amounts recognized in the statements of financial position. Thecontractual amounts represent the Company’s maximum potential exposure tocredit loss but do not necessarily represent future cash requirements sincecertain commitments may expire without being funded. Loan commitments generallyhave fixed expiration dates or other termination clauses and may requirepayment of a fee by the customer. Commitments are subject to the Company’scredit approval process, including a case-by-case evaluation of the customer’screditworthiness and related collateral requirements. The Company collectedcash deposits in connection with these commitments of $0 and $19,534 as of June30, 2004 and December 31, 2003, respectively.

 

***(b) Operating Leases and ContractualObligations***

 

As of June 30, 2004, theCompany was obligated under noncancelable operating lease agreements for officespace and computer equipment.  The futureminimum lease payments under these lease agreements at June 30, 2004 were:

 
| 2004 (July 1 to December 31) |   | $       | 103,287   |   |
|------------------------------|--------|---------|-----------|--------|
| 2005                         |   | 206,190 |      |
| 2006                         |   | 208,248 |      |
| 2007                         |   | 218,049 |      |
| 2008                         |   | 227,853 |      |
| Thereafter                   |   | 807,276 |      |
|                         |   | $       | 1,770,903 |   |

 

The Companyhad previously entered into employment agreements with three members of seniormanagement.  Effective July 1, 2004, theCompany entered into an employment agreement with an additional member ofsenior management.  The agreements rangein terms from eighteen to thirty-six months, subject to additional one yearrenewals. The future minimum salary expense relating to these agreements is$987,500, $1,075,000 and $750,000 for the years ended December 31, 2004,2005 and 2006, respectively.

 

**(10) Related Party Transactions**

 

The Company isinvolved in significant financing, risk management and other transactions, andhad 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 theseentities. The Company entered into these transactions in the ordinary course ofbusiness and believed that the terms of these transactions were on market termsthat could be obtained from unrelated third parties. As of December 22,2003, after the IPO transaction, the aforementioned related parties were nolonger considered related parties as their ownership of the Company has beensignificantly reduced to less than 5%.

 

Included inthe statements 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 in the statements of operations for the three and sixmonths ended June 30, 2003, respectively. The amounts reflect the related partytransactions with Goldman, Sachs & Co., except where otherwise indicatedand are as follows:

 
| **(Unaudited)**                                                                                                                                                                                                                | ** ** | **Three Months Ended  June 30, 2003** | ** ** | **Six Months Ended  June 30, 2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| Interest income on securities purchased  under resale agreements – related party                                                                                                                                          |       | $                                     | 54,105     |                                | $          | 76,837 |   |
| Gain on sale of loans (fee expense)                                                                                                                                                                                            |       | —                                |       | (1,414,936                          | )          |
| Changes in fair value of interest rate swap  contracts                                                                                                                                                                         |       | —                                |       | 678,816                             |       |
| Loss on securities sold, but not yet  purchased – related party                                                                                                                                                           |       | 2,447,251                             |       | 1,365,982                           |       |
| Interest expense on borrowings – related  party ($360,742 and $16,343 and $687,188 and $32,993 related to SunAmerica, Inc.  and Falcon Auto Venture, LLC for the three and six months ended June 30,  2003, respectively) |       | 737,827                               |       | 1,407,369                           |       |
| Interest expense on securities sold, but  not yet repurchased – related party                                                                                                                                             |       | 394,999                               |       | 544,303                             |       |
|                                                                                                                                                                                                                           |       |                                  |       |                                |       |
| Facility fee expense ($46,875 and $93,750  for the three and six months ended June 30, 2003, respectively, related to  SunAmerica, Inc.)                                                                                       |       |                                  | 93,750     |                                |       | 187,500 |   |

 

**(11)Dividends**

 

On July 14,2004, the Company declared a cash dividend of $798,845, or $0.05 per commonshare applicable to the three-month period ended June 30, 2004,and payable to shareholders of record on August 2, 2004.  The dividend is payable on August 16,2004.

 

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**ITEM 2****.****Management’s Discussion and Analysis of Financial Condition andResults of Operations**

 

Management’sDiscussion and Analysis of Financial Conditions and Results of Operations(“MD&A”) is provided as a supplement to the accompanying unaudited consolidatedfinancial statements and footnotes in Item 1 — Financial Statements to helpprovide an understanding of our financial condition, changes in our financialcondition and results of operations.  TheMD&A is organized as follows:

 

***Forward-looking statements*.**** **This sectiondiscusses how certain forward-looking statements made by us throughout theMD&A are based on management’s present expectations about future events andare inherently susceptible to uncertainty and changes in circumstances.

 

***Overview***.  This section provides a general descriptionof our business.

 

***Off-Balance Sheet Arrangements.***  This section provides a description of ouroff-balance sheet arrangements such as retained interests and securitizationsand their material effects in our financial position, changes in financialposition and results of operations.

 

***Critical accounting policy and use ofestimates***. This section discusses those accounting policies that are bothconsidered important to our financial condition and operating results andrequire significant judgment and estimates on the part of management in theirapplication.

 

***Results of operations***.  This section provides an analysis of ourresults of operations for the three and six months ended June 30, 2004 and2003.  In addition, a brief descriptionis provided of transactions and events that impact comparability of the resultsbeing analyzed.

 

***Liquidity and capital resources***.  This section provides an analysis of our cashposition and cash flows as well as a discussion of our financingarrangements.  In this section, we alsosummarize related party transactions and recent accounting pronouncements.

 

**Forward-LookingStatements**

 

Statementscontained in this Quarterly Report on Form 10-Q which are not historical factmay be forward-looking statements within the meaning of Section 21(e) ofthe Securities Exchange Act of 1934, as amended (the ‘‘Exchange Act’’). Weintend such forward-looking statements to be covered by the safe harborprovisions for forward-looking statements contained in Section 21(e) ofthe Exchange Act, as amended. Forward-looking statements relate toexpectations, beliefs, projections, future plans and strategies, anticipatedevents or trends and similar expressions concerning matters that are nothistorical facts. In some cases, you can identify forward-looking statements byterms such as “anticipate,” “believe,” “continue,” “estimate,” “predict,”“expect,” “intend,” “may,” “plans,” “potential,” “should,”  “could, “ “will,” and “would,” or thenegative of these terms or other comparable terminology.

 

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 can changeas a result of many possible events or facts, not all of which are known to usor 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 ‘‘Overview.’’ Among the factors about which we havemade assumptions are the following:

 

•  demand forour products;

 

•  our abilityto originate loans in accordance with the terms of our new warehouse creditline;

 

•  current collateralvalues, where appropriate;

 

•  our abilityto complete additional securitizations;

 

•  the stabilityof the automotive dealer market;

 

•  creditconcentrations;

 

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•  the abilityof automotive dealers to make loan payments to us;

 

•  levels of andtrends in delinquencies and impaired loans;

 

•  levels of andtrends in recoveries of prior charge-offs;

 

•  experience,ability, and depth of lending management and credit administration staff;

 

•  our abilityto operate as a real estate investment trust (“REIT”); and

 

•  national andlocal economic and market conditions, 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 of this Quarterly Report on Form10-Q filed with the SEC.  We provide accessto this interim report and all other reports and amendments, if any, filed byus with the Securities and Exchange Commission (“SEC”), which can be accessed,free of charge, through our website athttp://investor.falconfinancial.com/edgar.cfm on the same day that they areelectronically filed with the SEC.  Theinformation found on our website is not part of this or any other report wefile with or furnish to the SEC.  Ourexecutive offices are located at 15 Commerce Road, Stamford, CT 06902.

 

**Overview**

 

We are a fully integrated, self-advised REIT focused on the business oforiginating and servicing loans to automotive dealers in the United States. Wehave also 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 (the“Predecessor”), which was organized in Delaware in May 1997.

 

We closed our first loan in February 1998 and we have originated atotal of 117 loans representing approximately $721.0 million in aggregateinitial principal amount through June 30, 2004. For the three months ended June 30, 2004, we originated three loanstotaling approximately $31.5 million in aggregate initial principal amount and,as of June 30, 2004, our portfolio consisted of 23 loans with an aggregateoutstanding principal balance of approximately $184.4 million, and we had nooutstanding loan commitments. Our portfolio of 23 loans as of June 30, 2004 hadan average principal amount of approximately $8.0 million, aweighted-average remaining term of 147 months and a weighted-average interestrate of 8.49%.  To date, our loans havebeen long-term, fixed- and variable-rate, cashflow-based as well as mortgaged-based and generally under approximately$19.0 million in loan size.  We havesuccessfully securitized four pools of our loans in 1999, 2000, 2001 and 2003totaling 92 loans representing approximately $517.0 million in aggregateprincipal amount at the date of securitization and we continue to provideprimary servicing for all of our securitized 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 increases sufficientlyto 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 comprehensive income.

 

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 have only recently beganto offer variable-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 willoriginate during the remainder of 2004.

 

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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 retained interests.  We periodically seek to securitize our poolof loans as an important source of funding for our business.  An increase in interest rates could affectour ability to securitize our existing loans on favorable terms or at 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 fund our operations primarily through thenet proceeds from our initial public offering and subsequent over-allotment andour $150.0 million warehouse line of credit.

 

We haveexperienced only four defaulted loans since our inception.  The first defaulted loan was in our 2001securitization and resulted in a loss of principal of approximately$2.8 million.  Two other defaultsrelated to loans in our 2003 and 2001 securitization. Although these loandefaults have not yet been resolved, we have estimated losses upon theresolution of these loans of approximately $3.5 million and $1.0 million,respectively.  These estimated losseswere taken into consideration when establishing the value of retained interestsheld by us in connection with the securitized pools in which these loans areheld and resulted in a charge of approximately $0.4 million and $0.2 million infiscal 2003 and 2002, respectively.  Wecannot provide any assurance that the loss will fall within the amountsindicated.  The final default relates toa loan in our 2001 securitization in which the borrower defaulted.  In August 2004, the unpaid principal balanceunder the loan was approximately $5.4 million as of June 30, 2004.  The loan defaulted in August 2004. The impactof the defaulted loan on the value of our retained interest in the 2001-1 Trustcan not be determined until such time that management has completed itsassessment of the foreseeable recovery in connection with such loan.  As such, we have not recorded a change in thevalue of our retained interest in the 2001-1 Trust at this time but may do soin the future.

 

When we have sold our loans into a securitization, we made 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 secured financings.  Accordingly, we have established a reservefor possible loan losses for estimated losses inherent in our loan portfolio.

 

We plan to focus on internal growth of our business by expanding ourloan product offerings to include our new variable-rate cash flow-based and fixed-rateand variable-rate real estate mortgage loan products, which we recentlyintroduced in the marketplace.  We expectto incur additional costs to introduce these new products as we hire additionalemployees and increase our marketing, advertising and underwritingefforts.  We also expect to faceincreased competition from established providers in connection with ouroffering of real estate mortgage loan products, which could affect theprofitability of these products.

 

On July 14, 2004, we declared a cash dividend of $798,845, or $0.05 percommon share applicable to the three-month period ended June 30, 2004, and payable to shareholders of record on August 2,2004.  The dividend is payable on August16, 2004.

 

We intend to continue 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 of operations.  Our actual results of operations and ourability to pay distributions will be affected by a number of factors,including the revenue we receive from our loans, our ability to completeadditional loan securitizations, our operating expenses, the ability of ourcustomers 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 threeand six months ended June 30, 2003 included herein are the results of ourPredecessor.

 

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**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 approximately $517.0 million in aggregate principal amount at thedate of securitization. After originating a sufficient number of loans todevelop a pool available for securitization, our approach has been tosubsequently sell the loans we originate in a securitization transaction. Thesesecuritization transactions have been critically important to us as a primarysource of funds to 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 each secured borrowings even after weplace the loan 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 consolidated financialstatements instead of being removed as was the case historically with a salesecuritization transaction.  The effecton the future consolidated financial statements will be that the loanreceivable portfolio along with our borrowings will continue to increase witheach new loan we issue.  The increase inloan assets and related liabilities will also create a corresponding increasein interest income on loans along with an increase in interest expense from therelated financings.  Since we will nolonger be selling the loan assets, there will be no gain on sale of loansrecorded in the statements of operations, nor will therebe a related retained interest as a result of future securitizations recordedin the balance sheets.  The totalportfolio of loans, their applicable financing arrangements, their interestincome and related interest expense and a provision and allowance for potentialloan losses will be reflected on our consolidated financial statements.  The on-balance sheet approach will also showthe earnings over the entire term of the loan on a more consistent basis ascompared to showing earnings for a short period and then reflecting a gain onsale transaction, as was the case historically. The impact of securitizing loans using on-balance sheet treatment isthat the economic benefit of our loans will be realized over their life, ratherthan recognizing their present value early in their economic life in the formof gain on sale.

 

Our ability to complete additional securitizationsin the future may be affected by several factors, including the following:

 

•                  disruptions in the credit quality and performance of ourloan portfolio and the performance of loans included in our priorsecuritizations;

•                  any material downgrade or withdrawal of ratings assigned tosecurities issued in our prior securitizations;

•                  disruptions in the capital markets; or

•                  any failure 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 loans,interests in real estate used in the operation of automotive dealerships aswell as secured by a lien on the business assets, including automobile partsand equipment and intangible property but not the dealership’s automobileinventory.

 

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 June 30, 2004 and December 31, 2003, we had commitments to extendcredit to our customers of $0 and approximately $2.2 million,respectively, and amounts available under our warehouse credit line ofapproximately $49.6 million and $96.5 million, respectively, to fundsuch commitments.

 

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**Critical Accounting Policies and ManagementEstimates**

 

Our unaudited consolidated financial statements and relateddisclosures, which are prepared to conform withaccounting principles generally accepted in the United Statements of America(U.S. GAAP), require us 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 and assumptions as to future uncertainties and,as a result, actual results could differ materially from those estimates andassumptions.

 

We considered the most critical accounting policies and use ofestimates in our unaudited consolidated financial statements to be thosesurrounding:

 

(1)           loans;

 

(2)           allowancefor possible loan losses;

 

(3)           retainedinterest in loan securitizations; and

 

(4)           derivativeinstruments and hedging activities.

 

Theseaccounting policies, the bases for these estimates and their potential impactto our unaudited consolidated financial statements and related disclosures,should any of these estimates change, are further described as follows:

*** ***

***(1)Loans***

 

We originate loans that are underwritten with the intention ofsecuritizing the receivables in a financing transaction, which will beaccounted for as secured borrowings under the provisions of Statement ofFinancial Accounting Standards (SFAS)  No. 140, “*Accountingfor Transfers and Servicing of Financial Assets and Extinguishment ofLiabilities —a replacement ofFASB Statement 125*” (“SFAS No. 140”), and carry the loans on thestatements of financial position to maturity. The loans receivable are statedat their principal amount outstanding, less net deferred loan fees, unearneddiscounts and allowance for possible 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 our Predecessor were underwritten with theintention of selling by way of a securitization transaction and were accountedfor as loans held for sale on the statements of financial position. The amount,if any, by which the cost basis of the loans exceeds their estimated fair value is recorded through a valuation allowance. Changes inthe valuation allowance are recorded in the statements of operations.  As of June 30, 2004 and December 31, 2003, novaluation allowance was deemed necessary.

 

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

 

The allowance for possible loan losses is based on a periodic analysisof the loan portfolio and in management’s judgment, reflects an amount that isadequate to absorb losses inherent in the existing loan portfolio. Inevaluating the portfolio, management considers a variety of factors such as thesize of the portfolio, prior loss experience, current and potential risks ofthe loan portfolio, present financial condition of the borrower, currenteconomic conditions and other portfolio risk characteristics. Provisions forpossible loan losses are charged to operations. Loans, including impairedloans, are charged off against the allowance for loan losses when actual losseshave been established.

 

We account for our allowance for losses on loans in accordance withSFAS No. 5, *"Accounting for Contingencies"*("SFAS No. 5") and SFAS No. 114, *"Accounting byCreditors for Impairment of a Loan"* (SFAS No. 114").  Both Statements require that we evaluate thecollectibility of both contractual interest and principal loan payments.  SFAS No. 5 requires the accrual of a losswhen it is probable that a loan has been impaired and the amount of the losscan be reasonably estimated.  SFAS No.114 requires that impaired loans be measured based upon the present value ofexpected future cash flows discounted at the loan's effective interest rate, oras an alternative, at the loan's obervable market price or fair value of thecollateral.  A loan is impaired when,based on 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 effectiveinterest rate (including the fair value of the collateral that may be part ofthe loan). Losses for which such provisions forimpairment are made, unless applied as a write-down of the recorded investmentin the loan, represent a portion of the creditor’s allowance for loan losses.

 

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***(3)Retained Interests in Loan Securitizations***

 

Historically, we have sold through securitization transactionssubstantially all of the loans we originate. We account for our loansecuritizations in accordance with SFAS No. 140. When we sold loans in asecuritization, we retained one or more subordinated certificates from thecertificates issued. Securitizations may be structured in various ways butgenerally conform to a common model. Typically, an issuer sells a portfolio ofloans to a special purpose entity established for the sole purpose ofpurchasing and reselling the loans to a securitization trust. Thesecuritization trust then may issue bonds or certificates collateralized by theloans transferred to the securitization trust. The proceeds received from thesebonds or certificates are used to purchase the loans from the issuing entity.The gain on the sale of loans is the difference between the proceeds from thesale of loans, net of related selling costs, and the allocated carrying amountof the receivables sold, including deferred origination fees and costs. Wedetermine the carrying amount by allocating the total carrying amount of theloans sold between the portion sold and the interests retained based on eachportion’s relative fair values at the time of the securitization. Assumptionsused in calculating the estimated fair value of such retained interests aresubject to volatility 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 stockholders’ equity within the caption, accumulated othercomprehensive income (loss). We are not aware of an active market for thepurchase and sale of these retained interests at this time and accordingly, weestimate the fair value of the retained interest by calculating the presentvalue of the estimated expected future cash flows received by us after beingreleased by the securitization trust, using a discount rate commensurate withthe risk involved. The cash flows being discounted are adjusted for estimatednet losses due to defaults or prepayments of the underlying loans. As of June30, 2004, we had three loans in default, one of which related to a loan in our2003 securitization and the other two to our 2001 securitization. The loandefault relating to the 2003 securitization has not yet been resolved and wehave estimated the loss upon resolution of the defaulted loan of approximately$3.5 million. The estimated loss resulted in a reduction in the estimated valueof our retained interest in the 2003 securitization of approximately $0.7million as of September 30, 2003. The second loan default, which related to our2001 securitization has not yet been resolved and wehave estimated the loss upon resolution of the defaulted loan of approximately$1.0 million. The estimated loss resulted in a reduction in the estimated valueof our retained interest in the 2001 securitization of approximately $0.2million as of December 31, 2003. We cannot provide any assurance that thelosses will fall within the range indicated. During the six months ended June30, 2004, the real estate collateral for the loan in default in the 2001securitization (with an outstanding balance of approximately $2.5 million) wasforeclosed upon. The third default relates to a loan in our 2001securitization.  In August 2004, adelinquency was experienced in the 2001 Trust for a loan with an unpaidprincipal balance of approximately $5.4 million.  The loan defaulted in August 2004.  The impact of the defaulted loan on the valueof our retained interest in the 2001 Trust can not be determined until suchtime that management has completed its assessment of the foreseeable recoveryin connection with such loan.  As such,we have not recorded a change in the value of our retained interest in the2001-1 Trust at this time.  All otherloans included in our securitization pools are current.

 

Each loan securitization has a specific credit enhancement in the formof cash flow requirements that must be met before we receive any cash on ourretained interest.

 

Changes in the fair value of the retained interests resulting fromchanges in the timing of cash flows to be received by us or changes in marketinterest rates are adjusted through accumulated other comprehensive income(loss) within stockholders’ equity. Reductions in the estimated aggregate cashflows to be received by us, caused by defaults or prepayments or the timing ofexpected future cash flows that result in a reduction to the fair value belowthe historical cost basis of the retained interests, are considered an otherthan temporary impairment and are recognized through a charge to expense inthat period.

 

***(4)Derivative Instruments and Hedging Activities***

 

In June 1998,the Financial Accounting Standards Board (FASB) issued SFAS No. 133, “*Accounting for Derivative Instruments and HedgingActivities”*(“SFAS No.133”). In June 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*.”  InApril 2003, the FASB issued SFAS No. 149, *“Amendmentof Statement 133 on Derivative Instruments and Hedging Activities.” *These Statements, collectivelyreferred to as SFAS No. 133, establish accounting and reporting standardsrequiring that every derivative instrument, including certain derivativeinstruments embedded in other contracts, be recorded on the balance sheet aseither an asset or liability measured at its fair value. Changes in the fairvalue of the derivative are to be recognized currently in earnings unlessspecific hedge accounting criteria are met. Special accounting for qualifyinghedges allows gains and losses on derivatives to offset related results on thehedged items in the statements of operations and requires that a companydocument, designate, and assess the effectiveness of transactions that receivehedge accounting under SFAS No. 133.

 

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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 duration of the forecasted long-term debt issuance. These swaptransactions are accounted for as cash flow hedges, therefore, changes in theirestimated fair value are recorded in accumulated other comprehensive income(loss).

 

Our Predecessor entered into certain transactions (short sales andpurchases, securities resale and repurchase agreements, and interest rateswaps) to mitigate the effect that changes in interest rates and credit spreadshave on the fair value of its fixed-rate loan portfolio held for sale. Periodsof rising interest rates and widening credit spreads decrease the fair value ofthe loan portfolio held for sale. Generally, we entered into these transactionswhen the rate is locked on a pending loan just prior to the closing of the loan.The new loan was added to the pool of loans being held for sale and the poolwas then reviewed to determine what, if any, additional hedging transaction wasto be executed. Generally, our Predecessor shorted U.S. Treasuries and investedthe proceeds in repurchase agreements with Goldman, Sachs & Co. withU.S. Treasury notes as the underlying securities. In swap transactions, ourPredecessor entered into an interest rate swap contract, receiving a floatingrate of interest and paying a fixed rate of interest. The term of the swapcontracts is determined by duration of the loans held for sale pool. OurPredecessor had a contractual obligation to settle the repurchase and swapagreements with Goldman, Sachs & Co. at the current fair value on the repurchasedate. These contracts have been recorded as free standing derivatives withchanges in fair value recorded in results of operations.

 

We carry each of the derivative instruments on our statements offinancial condition at fair value or amounts that approximate fair value. Thedetermination of fair value is fundamental to our statements of financialcondition and results of operations. The fair value of a financial instrumentis the amount at which the instrument could be exchanged in a currenttransaction between willing parties, other than in a forced or liquidationsale. Quoted market prices in active markets are the best evidence of fairvalue 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.

 

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**Results of Operations for the Three MonthsEnded June 30, 2004 and 2003**

 

The results of operations that follow should be read in conjunctionwith our critical accounting policies and estimates summarized above as well asour accompanying unaudited consolidated financial statements and notes theretocontained in Item 1 – Financial Statements of this report.

 

***Revenues***

 

Total revenues for the threemonths ended June 30, 2004 increased by approximately $2.2 million, or 96.2%,to approximately $4.5 million for the three months ended June 30, 2004 fromapproximately $2.3 million for the threemonths ended June 30, 2003. The increase was primarily due to increases ininterest income on loans, changes in fair value of interest rate swap contractsand interest and other income. These increases were partially offset by adecrease in interest income from retained interests.

 

Interest income on loans for the three months ended June 30, 2004 increased by approximately $2.0million, or 127.8%, to approximately $3.5 million for the three months endedJune 30, 2004 from approximately $1.5 million for the three months ended June 30, 2003. The increase was primarily due toan increase in the weighted average portfolio of loans to approximately $160.3million for three months ended June 30, 2004 as compared to approximately $67.1million for the three monthsended June 30, 2003, which was offset by a decrease in the weighted averageinterest rate on loans to approximately 8.8% in the three months ended June 30, 2004 as compared to approximately 9.3%for the three months ended June30, 2003.

 

Interest income from retained interests for the three months ended June 30, 2004decreased by approximately $0.1 million, or 26.4%, to approximately $0.3million for the three months ended June 30, 2004 from approximately $0.4million for the three monthsended June 30, 2003. The decrease was primarily due to the effect of twodefaulted loans in our securitized pools.

 

Changes in fair value of interest rate swap contracts for the three months ended June 30, 2004increased by approximately $0.2 million to a gain of approximately $0.2 millionfor the three months ended June 30, 2004 from a gain of $0 for the three months ended June 30, 2003. Theincrease was primarily due to the composition of our hedging instruments andthe fact that we held no positions for the three months ended June 30, 2003.

 

Interest and other income for the three months ended June 30, 2004 increased by approximately $0.2million, or 92.9% to approximately $0.4 million for the three months ended June30, 2004 from approximately $0.2 million for the three months ended June 30, 2003. The increase was primarilyattributable to a loan assumption fee earned during the three months ended June 30, 2004.

 

***Expenses***

 

Total expenses for the threemonths ended June 30, 2004 decreased by approximately $0.9 million, or 17.8%,to approximately $4.3 million from approximately $5.2 million for the three months ended June 30, 2003. Thedecrease was primarily due to decreases in interest expense on borrowings andinterest expense on borrowings – related party combined,interest expense on securities sold, but not yet repurchased – related party,and loss on securities sold, but not yet purchased – related party.  The decrease was partially offset byincreases in provision for possible loan losses, facility fee expense, salariesand benefits, professional fees, general and administrative expenses andadvertising and promotion.

 

Interest expense on borrowings and interest expense on borrowings –related party combined for the three months ended June 30, 2004 decreased byapproximately $0.2 million, or 18.0%, to approximately $0.8 million for the three months ended June 30, 2004 fromapproximately $1.0 million for the three months ended June 30, 2003. Thedecrease was primarily due to a decrease in the weighted average interest ratefor the three months ended June 30, 2004 as compared to the same prior yearperiod primarily attributable to the pay down of the Predecessor warehouse lineof credit at higher rates of interest with certain related parties which wasterminated on April 28, 2004 concurrently with the iStar new warehouse creditline transaction.  The overall decreasewas partially offset by an increase in the weighted average debt balance forthe three months ended June 30, 2004 as compared to the same period in theprior year as a result of increased borrowings attributable to the growth of ourloan portfolio.  The weighted averageinterest rate for our borrowings during the three months ended June 30, 2004was approximately 3.8% as compared to approximately 5.66% during the threemonths ended June 30, 2003. The weighted average debt balance during the threemonths ended June 30, 2004 was approximately $81.7 million as compared toapproximately $67.3 million during the three months ended June 30, 2003.

 

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Interest expense on securities sold, but not yet repurchased – relatedparty for the three months ended June 30, 2004 decreased by approximately $0.4million, or 100%, to $0 for the three months ended June 30, 2004 fromapproximately $0.4 million for the three months ended June 30, 2003.  We no longer enter into certain derivativeinstruments, such as short sales and purchases, securities resale andrepurchase agreements.

 

Provision for possible loan losses is charged to earnings to bring thetotal allowance for loan losses to a level considered appropriate by managementbased on historical experience, trends in the level of delinquent and problemloans, the volume and type of lending conducted by us, the status of past dueprincipal and interest payments including any adverse situations that mayaffect the borrower’s ability to repay and general economic conditions,particularly as such conditions relate to our market share.  As a result of such analysis, managementrecorded approximately $0.3 million provision for losses on loans for the threemonths ended June 30, 2004 which was predicated upon approximately $31.5million of new loan originations during the current three-month period.  Prior to December 22, 2003, we did notrecord a provision for losses on loans.

 

Loss on securities sold, but not yet purchased for the three monthsended June 30, 2004 and 2003 was $0 and approximately $2.4 million,respectively.  We no longer enter intocertain derivative instruments, such as short sales and purchases, securitiesresale and repurchase agreements.

 

Facility fee expense for the three months ended June 30, 2004 increasedby approximately $0.7 million, or 732.5% to approximately $0.8 million for thethree months ended June 30, 2004 from approximately $0.1 million for the threemonths ended June 30, 2003. The increase was due to increased facility feesassociated with the extension of our prior warehouse line of credit coupledwith a termination fee paid to the lenders under the previously existedwarehouse credit line.

 

Salaries and benefits for the three months ended June 30, 2004increased by approximately $0.7 million, or 78.0%, to approximately $1.5million for the three months ended June 30, 2004 from approximately $0.8million for the three months ended June 30, 2003. The increase was primarily dueto increases in salaries and bonuses paid or accrued as well as theamortization of unearned compensation expense relating to the restricted sharegrants.

 

Professional fees for the three months ended June 30, 2004 increased byapproximately $0.1 million, or 288.3% to approximately $0.2 million for thethree months ended June 30, 2004 from approximately $0.1 million for the threemonths ended June 30, 2003. The increase was primarily due to increases inlegal, accounting and auditing fees including resources required to comply withregulations mandated by the Sarbanes-Oxley Act of 2002.

 

General and administrative expenses for the three months ended June 30,2004 increased by approximately $0.3 million, or 107.3%, to approximately $0.5million for the three months ended June 30, 2004 from approximately $0.2million for the three months ended June 30, 2003. The increase was primarilydue to an increase in insurance expense and public company related expenses.

 

Advertising and promotion for the three months ended 30, 2004 increasedby approximately $0.1 million, or 55.2%, to approximately $0.2 million for thethree months ended June 30, 2004 from approximately $0.1 million for the threemonths ended June 30, 2003. The increase was primarily due to an increase inadvertising relating to the introduction of new loan products.

 

***Net profit (loss)***

 

The net income for the three months ended June 30, 2004 wasapproximately $0.3 million as compared to a loss of approximately $2.9 millionfor the three months ended June 30, 2003.

 

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**Results of Operations for the Six MonthsEnded June 30, 2004 and 2003**

 

***Revenues***

 

Total revenues for the six months ended June 30, 2004 decreased byapproximately $8.2 million, or 50.7% to approximately $7.9 million for the sixmonths ended June 30, 2004 from approximately $16.1 million for the six monthsended June 30, 2003. The decrease was primarily due to decreases in interestincome from retained interests, a gain on sale of loans, a gain on sale ofretained interest and changes in fair value of interest rate swap contracts.The overall decrease was partially offset by an increase in interest income onloans and interest and other income.

 

Interest income on loans for the six months ended June 30, 2004increased by approximately $3.3 million, or 102.7%, to approximately $6.5million for the six months ended June 30, 2004 from approximately $3.2 millionfor the six months ended June 30, 2003. The increase was primarily due to anincrease in the weighted average portfolio of loans to approximately $146.5million for six months ended June 30, 2004 as compared to approximately $76.2million for the six months ended June 30, 2003 as well as an increase in theweighted average interest rate on loans to approximately 8.8% for the sixmonths ended June 30, 2004 as compared to approximately 8.7 % for the sixmonths ended June 30, 2003.

 

Interest income from retained interests for the six months ended June30, 2004 decreased by approximately $0.2 million, or 20.8%, to approximately$0.6 million for the six months ended June 30, 2004 from approximately $0.8million for the six months ended June 30, 2003. The decrease was primarily dueto the effect of two defaulted loans in our securitized pools.

 

Gain on sale of loans for the six months ended June 30, 2003 wasapproximately $10.7 million which resulted from the securitization transaction2003-1.  We did not record any gain onsale of loans in the six months ended June 30, 2004.  We intend to account for all futuresecuritizations as on-balance sheet secured financings, and as such will nolonger be subject to gain on sale accounting.

 

Gain on sale of retained interests for the six months ended June 30,2003 was approximately $0.3 million which resulted from a sale of one of theretained interests in the 2003-1 securitization transaction.  There were no sales of retained interestsduring the six months ended June 30, 2004.

 

Changes in value of interest rate swap contracts for the six monthsended June 30, 2004 decreased by approximately $0.5 million, or 77% to a gainof approximately $0.2 million for the six months ended June 30, 2004 from again of approximately $0.7 million for the six months ended June 30, 2003. Thedecrease was primarily due to market fluctuations and the composition of ourhedging instruments.

 

Interest and other income for the six months ended June 30, 2004increased by approximately $0.3 million, or 127.0% to $0.5 million for the sixmonths ended June 30, 2004 from $0.2 million as compared to the same period in2003.  The increase was primarilyattributable to a loan assumption fee earned during the six months ended June30, 2004.

 

***Expenses***

 

Total expenses for the six months ended June 30, 2004 increased byapproximately $1.5 million, or 23.1% to approximately $8.2 million fromapproximately $6.7 million in the six months ended June 30, 2003.  The increase was primarily due to increasesin provision for possible loan losses, facility fee expense, salaries andbenefits, professional fees, general and administrative expenses andadvertising and promotion. The overall increase was partially offset bydecreases in interest expense on borrowings and interest expense on borrowings– related party combined, interest expense on securities sold, not yetrepurchased – related party and loss on securities sold, but not yetrepurchased – related party.

 

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Total interest expense on borrowings and interest expense on borrowings– related party combined for the six months ended June 30, 2004 decreased byapproximately $0.6 million, or 32.8%, to approximately $1.2 million for the sixmonths ended June 30, 2004 from approximately $1.8 million for the six monthsended June 30, 2003. The decrease was primarily due to a decrease in theweighted average interest rate and weighted average debt balance for the sixmonths ended June 30, 2004 as compared to the same prior year period primarilyattributable to the pay down of the Predecessor warehouse line of credit athigher rates of interest with certain related parties, which was terminated onApril 28, 2004 concurrently with the iStar new warehouse credit linetransaction.  The overall decrease wasoffset by an increase in borrowings attributable to the growth of our loanportfolio.  The weighted average interestrate for our borrowings during the six months ended June 30, 2004 wasapproximately 3.50% as compared to approximately 4.26% during the six monthsended June 30, 2003. The weighted average debt balance during the six monthsended June 30, 2004 was approximately $69.7 million as compared toapproximately $85.1 million during the six months ended June 30, 2003 whichresulted from the pay down of the Predecessor warehouse line of credit withcertain related parties which was terminated on April 28, 2004 concurrentlywith the iStar new warehouse credit line transaction.

 

Interest expense on securities sold, but not yet repurchased – relatedparty for the six months ended June 30, 2004 decreased by approximately $0.5million to $0 for the six months ended June 30, 2004 from approximately $0.5million for the six months ended June 30, 2003. We no longer enter into certain derivative instruments, such as shortsales and purchases, securities resale and repurchase agreements.

 

Provision for possible loan losses is charged to earnings to bring thetotal allowance for loan losses to a level considered appropriate by managementbased on historical experience, trends in the level of delinquent and problemloans, the volume and type of lending conducted by us, the status of past dueprincipal and interest payments including any adverse situations that mayaffect the borrower’s ability to repay and general economic conditions,particularly as such conditions relate to our market share.  As a result of such analysis, managementrecorded approximately $0.5 million provision for losses on loans for the sixmonths ended June 30, 2004 which was predicated upon approximately $58.8million of new loans during the current six-month period. Prior toDecember 22, 2003, we did not record a provision for losses on loans.

 

Loss on securities sold, but not yet purchased for the six months endedJune 30, 2004 and 2003 was $0 and approximately $1.4 million, respectively. We nolonger enter into certain derivative instruments, such as short sales andpurchases, securities resale and repurchase agreements.

 

Facility fee expense for the six months ended June 30, 2004 increasedby approximately $1.3 million, or 716.3% to approximately $1.5 million for thesix months ended June 30, 2004 from approximately $0.2 million for the sixmonths ended June 30, 2003. The increase was due to increased facility feesassociated with the extension of our prior warehouse line of credit coupledwith a termination fee paid to the lenders under the previously existedwarehouse credit line.

 

Salaries and benefits for the six months ended June 30, 2004 increasedby approximately $1.2 million, or 70.4% to approximately $2.9 million for thesix months ended June 30, 2004 from approximately $1.7 million for the sixmonths ended June 30, 2003. The increase was primarily due to increases insalaries and bonuses paid or accrued as well as the amortization of unearnedcompensation expense relating to the restricted share grants.

 

Professional fees for the six months ended June 30, 2004 increased byapproximately $0.4 million, or 300.2% to approximately $0.5 million for the sixmonths ended June 30, 2004 from approximately $0.1 million for the six monthsended June 30, 2003. The increase was primarily due to increases in legal,accounting and auditing fees including resources required to comply withregulations mandated by the Sarbanes-Oxley Act of 2002.

 

General and administrative expenses for the six months ended June 30,2004 increased by approximately $0.5 million, or 98.4% to approximately $1.0million for the six months ended June 30, 2004 from approximately $0.5 millionfor the six months ended June 30, 2003. The increase was primarily due to anincrease in insurance expense and public company related expenses.

 

Advertising and promotion for the six months ended June 30, 2004increased by approximately $0.2 million, or 43.7% to approximately $0.6 millionfor the six months ended June 30, 2004 from approximately $0.4 million for thesix months ended June 30, 2003. The increase was primarily due to an increasein advertising relating to the introduction of new loan products.

 

***Net income (loss)***

 

The net loss for the six months ended June 30, 2004 was approximately$0.3 million as compared to earnings of approximately $9.4 million for the sixmonths ended June 30, 2003.

 

27

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**Liquidity and Capital Resources**

 

As of June 30, 2004 and December 31, 2003, we had approximately$30.3 million and $25.6 million, respectively, in cash and cash equivalents. Weinvest cash on hand in short-term liquid investments.  Similar to other financial institutions, wemust ensure that sufficient funds are available to meet loan commitments,expenses and other obligations that arise in the ordinary course ofbusiness.  Control of our cash flowrequires the anticipation of deposit flows and loan payments.  Our primary sources of funds are deposits,borrowings and principal and interest payment on loans.  We use funds from deposit inflows, proceedsfrom our borrowings and principal and interest payments on loans primarily tofund new loan originations using borrowings under our new warehouse line ofcredit and proceeds from our initial public offering and over-allotment.  Details of our cash inflows and outflows forthe three and six months ended June 30, 2004 and 2003 are detailed as follows(unaudited):

 

***Cash Inflows andOutflows***

 

During the three months ended June 30, 2004, the net decrease in cashand cash equivalents was approximately $2.3 million compared to a net decreaseof approximately $0.9 million during the three months ended June 30, 2003.  As reported on our consolidated statements ofcash flows, our decrease in cash and cash equivalents during the three monthsended June 30, 2004 and 2003 is summarized as follows (unaudited):

 

 
| ** **                                           | ** ** | **Three Months Ended  June 30, 2004** | ** ** | **Three Months Ended  June 30, 2003** | ** ** |
|------------------------------------------------------|------------|---------------------------------------|------------|---------------------------------------|------------|
|                                                 |       |                                  |       |                                  |       |
| Net cash provided by (used in) operating  activities |       | $                                     | 1,681,804  |                                  | $          | (3,132,324 | ) |
| Net cash used in investing activities                |       | (30,201,624                           | )          | (42,449,329                           | )          |
| Net cash provided by financing activities            |       | 26,173,777                            |       | 44,725,851                            |       |
|                                                 |       |                                  |       |                                  |       |
| Total decrease in cash and cash equivalents          |       | $                                     | (2,346,043 | )                                     | $          | (855,802 | ) |

 

Details of our cash inflows and outflows are as follows during thethree months ended June 30, 2004:

 

*Operating Activities:*  During the three months ended June 30, 2004and 2003, net cash provided was approximately $1.7 million as compared to netcash used of approximately $3.1 million in cash and cash equivalents inoperating activities, respectively.  Thiswas comprised primarily of our net income of approximately $0.3 million and anincrease of working capital of approximately $1.1 million coupled with non-cashcharges totaling approximately $0.3 million. The components of our net income are detailed in our Results ofOperations section included above in this Item. Components of our significant non-cash adjustments are as follows forthe three months ended June 30, 2004:

 

•                  Provisionfor possible loan losses of approximately $0.3 million;

•                  Amortizationof unearned compensation of approximately $0.2 million; and

•                  Changesin fair value of swaps of approximately ($0.2) million.

 

*Investing Activities:*  Cash flow used in investing activities wasapproximately $30.2 million for the three months ended June 30, 2004 ascompared with approximately $42.4 million for the three months ended June 30,2003.  Specific investing activity duringthe three months ended June 30, 2004 and 2003 was as follows:

 

•                  Duringthe three months ended June 30, 2004, loans originations net of fees receivedwas approximately $31.3 million offset by repayments in connection withscheduled loan amortizations of approximately $1.2 million.

•                  Duringthe three months ended June 30, 2004, we invested approximately $0.07 millionin capital equipment.  This compares toapproximately $0.02 million in the same period in 2003 primarily attributableto the upgradingour loan administration and accounting software in the current period.

 

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*Financing Activities:*  During the three months ended June 30, 2004,cash flows from financing activities provided approximately $26.2 million,which consisted of borrowings from our warehouse line of credit, net of relatedrepayments.

 

During the six months ended June 30, 2004, the net increase in cash andcash equivalents was approximately $4.6 million compared to a net increase ofapproximately $0.4 million during the six months ended June 30, 2003.  As reported on our consolidated statements ofcash flows, our increase (decrease) in cash and cash equivalents during the sixmonths ended June 30, 2004 and 2003 is summarized as follows (unaudited):

 
| ** **                                              | ** ** | **Six Months Ended  June 30, 2004** | ** ** | **Six Months Ended  June 30, 2003** | ** ** |
|---------------------------------------------------------|------------|-------------------------------------|------------|-------------------------------------|------------|
|                                                    |       |                                |       |                                |       |
| Net cash used in operating activities                   |       | $                                   | (1,605,823 | )                                   | $          | (3,769,378 | ) |
| Net cash (used in) provided by investing  activities    |       | (56,333,900                         | )          | 67,928,285                          |       |
| Net cash provided by (used in) by financing  activities |       | 62,560,994                          |       | (64,528,616                         | )          |
|                                                    |       |                                |       |                                |       |
| Total increase (decrease) in cash and cash  equivalents |       | $                                   | 4,621,271  |                                | $          | (369,709 | ) |

 

Details of our cash inflows and outflows are as follows during the sixmonths ended June 30, 2004:

 

*Operating Activities:*  During the six months ended June 30, 2004, weused approximately $1.6 million and $3.8 million in cash and cash equivalentsin operating activities, respectively. This was comprised primarily of our net loss of approximately $0.3million and a decrease of working capital of approximately $2.1 million coupledwith non-cash charges totaling approximately $0.8 million.  The components of our net income are detailedin our Results of Operations section included above in this Item.  Components of our significant non-cashadjustments are as follows:

 

•                  Provisionfor possible loan losses of approximately $0.5 million;

•                  Amortizationof unearned compensation of approximately $0.5 million; and

•                  Changesin fair value of swaps of approximately ($0.2) million.

 

*Investing Activities:*  Cash flow used in investing activities wasapproximately $56.3 million for the six months ended June 30, 2004 as comparedwith approximately $67.9 million generated from investing activities for thesix months ended June 30, 2003.  Specificinvesting activity during the six months ended June 30, 2004 and 2003 was asfollows:

 

•                  Duringthe six months ended June 30, 2004, loans originations net of fees received wasapproximately $58.3 million offset by repayments in connection with scheduledloan amortizations of approximately $2.2 million.

•                  Duringthe six months ended June 30, 2004, we invested approximately $0.2 million incapital equipment.  This compares toapproximately $0.02 million in the same period in 2003 primarily attributableto the upgradingour loan administration and accounting software in the current period.

 

*Financing Activities:*  During the six months ended June 30, 2004,cash flows from financing activities provided approximately $62.6 million,which consisted of borrowings from our warehouse line of credit, net of relatedrepayments coupled with net proceeds from the over-allotment.

 

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***Retained Interestsin Loan Securitizations***

 

As of June 30, 2004 and December 31, 2003, we had retainedinterests in loan securitizations of approximately $8.0 million and $7.2million, respectively.  As of June 30,2004 and December 31, 2003, our retained interests consisted of the followingsecurities with estimated fair values as indicated:

 
| ** **                                                                  | ** ** | **June 30, 2004** | ** ** | **December 31, 2003** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| Falcon Franchise Loan Trust Certificates,  Series 1999-1 Class F       |       | $                 | 2,074,344  |                  | $          | 2,054,037 |   |
| Falcon Franchise Loan Trust Certificates,  Series 1999-1 Class G       |       | 1,231,747         |       | 1,140,252             |       |
| Falcon Franchise Loan Trust Certificates,  Series 2000-1 Class G       |       | 1,202,661         |       | 1,123,955             |       |
| Falcon Auto Dealership Loan Trust  Certificates, Series 2001-1 Class G |       | 1,498,043         |       | 1,229,460             |       |
| Falcon Auto Dealership Loan Trust  Certificates, Series 2003-1 Class G |       | 1,986,645         |       | 1,691,432             |       |
|                                                                        |       |              |       |                  |       |
|                                                                        |       | $                 | 7,993,440  |                  | $          | 7,239,136 |   |

 

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 approximately $2.8 million.  Two other defaults related to loans in our2003 securitization and 2001 securitization. Although these loan defaults havenot yet been resolved, we have estimated losses upon the resolution of theseloans of approximately $3.5 million and $1.0 million in fiscal 2003 and 2002,respectively.  We took into account theseestimated losses when establishing the value of retained interests held by usin connection with the securitized pools in which these loans are held andresulted in a charge of approximately $0.4 million and approximately $0.2million in fiscal 2003 and 2002, respectively. We cannot provide any assurance that the loss will fall within the rangeindicated.  The final default relates toa loan in our 2001 securitization.  InAugust 2004, a delinquency was experienced in the 2001-1 Trust for a loan withan unpaid principal balance of approximately $5.4 million.  The loan defaulted in August 2004. The impactof the defaulted loan on the value of our retained interest in the 2001-1 Trustcan not be determined until such time that management has completed itsassessment of the foreseeable recovery in connection with such loan.  As such, we have not recorded a change in thevalue of our retained interest in the 2001-1 Trust at this time.

 

In April 2004, a publicly traded dealership group acquired threeautomobile dealerships, which secured loans held in two of our securitizationpools, 2001-1 and 2003-1.  Thesubsidiaries of the dealership group assumed the obligations under theloans.  In connection with thesetransactions, the loan collateral and financial covenants were released andreplaced with bank letters of credit from Bank of America in the full amount ofthe outstanding principal balance.  Thiscollateral replacement strengthened the quality of both securitization pools asit improved the quality of the collateral available to support the loan balanceof the dealerships.

 

***Liquidity andBorrowings***

 

*Liquidity.*  Our short-term liquidity requirements consistprimarily of funds necessary to originate new loans to automotive dealers andto pay for other expenditures including interest and principal payments on ourwarehouse line, interest expense on our hedging activities, salaries andemployee benefits, general and administrative expenses, advertising andpromotions and capital expenditures.

 

Our primary sources of liquidity for the three and six months endedJune 30, 2004 were net proceeds from the over-allotment and borrowings from ourwarehouse line of credit. Our primary sources of liquidity for the three andsix months ended June 30, 2003 were net proceeds from the sale of loans,borrowings from our warehouse line of credit. We have historically funded ourshort-term liquidity requirements from these sources.

 

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

 

*Loan SecuritizationTransactions.* We sold at issuance of approximately $104.6 million,$111.6 million, $122.2 million, and $123.4 million of loan trustcertificates through securitization transactions in 1999, 2000, 2001 and 2003,respectively. 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 otherinvestments and the general level of interest rates relative to other types ofinvestments. We cannot provide any assurances that we will be able to completeadditional loan securitizations on favorable terms or at all.

 

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*Termination of Existing Warehouse Credit Line*

 

We entered into a $150.0 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 were paid fees of approximately $87,133 and $259,980 for thethree and six months ended June 30, 2004, respectively. The fees are shown onthe statements of operations within the caption interest expense onborrowings–related party. Interest was calculated using a 30-day commercialpaper rate plus 300 basis points until December 22, 2003 when it wasdecreased to a 30-day commercial paper rate plus 200 basis points. As ofDecember 31, 2003, the outstanding balance was approximately$53.5 million. The interest rate as of December 31, 2003 was3.09%.  In connection with entering intoour new warehouse credit line described below, we paid in full the outstandingbalance on 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 is paid to us.

 

*New Warehouse Credit Line*

 

On April 28, 2004, we entered into a $150.0 million RevolvingWarehouse Financing Agreement with iStar Financial Inc. (‘iStar”), solely forthe purpose of originating loans.  Thefacility may be increased to $200.0 million at our option with the consent ofiStar. Interest is calculated using LIBOR plus 290 basis points.  Under the facility, iStar financed all of theCompany’s existing outstanding loans that were financed under the previouslyexisting warehouse facility, which was terminated.  In connection with entering into the newfacility, we paid a fee of $1,875,000 to iStar and a termination fee of$199,500 to the lenders under the previously existing facility.  As of June 30, 2004, the outstanding balancewas approximately $100.4 million. The interest rate as of June 30, 2004 was3.29%.

 

The warehouse credit line is secured by, among other things, ourloans.  All payments made by borrowers inrespect of such loans are applied on a monthly basis to pay the 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 $80.0 million.  We generallymay not 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 $1.0 million, indebtednessin connection with our securitization transactions and certain capitalleases.  In order to make a borrowingunder the facility, either Vernon B. Schwartz, ourChairman and Chief Executive Officer, or David A. Karp, our President and ChiefFinancial Officer, must be employed as a senior executive officer of ourCompany with the same decision 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 $20.0 million.  In addition,the lender will not fund an amount in excess of 66.6% of the aggregate marketvalue of our eligible loans.

 

We are required to make prepayments under the new warehouse credit lineunder certain circumstances.  Among otherthings, we may be required to make prepayments upon a decrease in the aggregatemarket value of our eligible loan portfolio. Specifically, in the event that the lender determines that the productof the market value of the eligible loans in our loan portfolio and theaggregate maximum advance rate of 66.6% is less than the aggregateoutstanding principal amount under the warehouse credit line, then, subject toan exception for certain market value fluctuations of less than 5%, we will berequired to prepay amounts borrowed under the new warehouse credit linesufficient to eliminate such deficiency. The new warehouse credit line also specifies various events that wouldallow the lender to terminate the warehouse credit line in its entirety,including, among other things, our failure to qualify as a real estateinvestment trust under the Internal Revenue Code or a change of control.

 

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***Commitments andSignificant Contractual Obligations***

 

As ofJune 30, 2004, we were obligated under noncancelable operating lease agreementsfor office space and computer equipment. The future minimum lease payments under these lease agreements at June30, 2004 were:

 
| 2004 (July 1 to December 31) |   | $       | 103,287   |   |
|------------------------------|--------|---------|-----------|--------|
| 2005                         |   | 206,190 |      |
| 2006                         |   | 208,248 |      |
| 2007                         |   | 218,049 |      |
| 2008                         |   | 227,853 |      |
| Thereafter                   |   | 807,276 |      |
|                         |   | $       | 1,770,903 |   |

 

We hadpreviously entered into employment agreements with three members of seniormanagement. Effective July 1, 2004, we entered into an employment agreementwith an additional member of senior management. The agreements range in terms from fifteen to thirty-six months, subjectto additional one year renewals. The future minimum salary expense relating tothese agreements is $987,500, $1,075,000 and $750,000 for the years endedDecember 31, 2004, 2005 and 2006, respectively.

*** ***

***Capital Expenditures***

 

We arein the process of upgrading our loan administration and accounting software for2004 at a cost of approximately $0.3 million. We do not anticipateincurring any other significant capital expenditures in 2004.

** **

**Related Party Transactions**

 

Wewere involved in significant financing, risk management and other transactions,and have significant related party balances with Goldman, Sachs & Co.,an affiliate of MLQ Investors, L.P., SunAmerica Investments, Inc., SALIC,an affiliate of SunAmerica Investments, Inc., and Falcon Auto Venture, LLC alldirectly and indirectly through affiliates and subsidiaries of the entities. Weentered into these transactions in the ordinary course of business and believethat the terms of these transactions are on market terms that could be obtainedfrom unrelated third parties. As of December 22, 2003 after the IPOtransaction, the aforementioned related parties were no longer consideredrelated parties as their ownership of the Company has been significantlyreduced to less than 5%.

 

Included in the statementsof operations are revenues and expenses resulting from various financing,capital markets transactions and loan sales transactions. The following tablesets forth the related party revenues and expenses included in the respectivecaptions in the statements of operations for the three and six months endedJune 30, 2003. The amounts reflect the related party transactions with Goldman,Sachs & Co., except where otherwise indicated and are as follows(unaudited):

 
| ** **                                                                                                                                                                                                                          | ** ** | **Three Months Ended  June 30, 2003** | ** ** | **Six Months Ended  June 30, 2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| Interest income on securities purchased  under resale agreements – related party                                                                                                                                               |       | $                                     | 54,105     |                                | $          | 76,837 |   |
| Gain on sale of loans (fee expense)                                                                                                                                                                                                 |       | —                                |       | (1,414,936                          | )          |
| Changes in fair value of interest rate swap  contracts                                                                                                                                                                              |       | —                                |       | 678,816                             |       |
|                                                                                                                                                                                                                                |       |                                  |       |                                |       |
| Loss on securities sold, but not yet  purchased – related party                                                                                                                                                                |       | 2,447,251                             |       | 1,365,982                           |       |
| Interest expense on borrowings – related party ($360,742 and $16,343 and $687,188 and  $32,993 related to  SunAmerica, Inc. and Falcon Auto Venture, LLC for the three and six months  ended June 30, 2003, respectively) |       | 737,827                               |       | 1,407,369                           |       |
| Interest expense on securities sold, but  not yet repurchased – related party                                                                                                                                                  |       | 394,999                               |       | 544,303                             |       |
|                                                                                                                                                                                                                                |       |                                  |       |                                |       |
| Facility fee expense ($46,875 and $93,750  related to SunAmerica, Inc. for the three and six months ended June 30, 2003,  respectively)                                                                                             |       | 93,750                                |       | 187,500                             |       |
|                                                                                                                                                                                                                                     |            |                                       |            |                                     |            |  |  |

 

**Recent Accounting Developments**

 

InJanuary 2003, the FASB issued Interpretation No. 46, “*Consolidation of Variable Interest Entities,”  an*interpretation of ARB 51 (FIN 46). The interpretation provides guidanceon consolidating variable interest entities (“VIE”) and applies immediately tovariable interests created after January 31, 2003.  The guidelines of the interpretation asrevised by FIN 46 (revised December 31, 2003), “*Consolidation of Variable Interest Entities”* (FIN 46R) became applicable to the Companyin the first quarter of 2004 for variable interest entities created beforeFebruary 1, 2003.  Theinterpretation requires VIEs, formerly referred to as special purpose entities,to be consolidated if the equity investment at risk is not sufficient to permitan entity to finance its activities without support from other parties, or theequity investors lack certain specified characteristics.  Adoption of this new accounting standard didnot have a material effect on the Company’s financial condition or results ofoperations.

 

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**ITEM 3****.****Quantitative and QualitativeDisclosure About Market Risk**

 

Marketrisk refers to the risk of loss from adverse changes in the level of one ormore 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 taxpolicies and other factors outside of our control.  As described below, we use some derivativefinancial instruments to manage or hedge interest rate risks related to ourloans.  We do not use derivatives fortrading or speculative purposes and only enter into contracts with majorfinancial institutions based on their credit ratings and other factors.

*** ***

***Interest Rate Exposure***

 

Theprimary interest rate exposure to which we are subject to relates to ourfixed-rate and variable-rate loan portfolio, our forecasted issuance oflong-term debt, interest rate swaps, our floating rate warehouse line of creditand our retained interests in securitization pools. Any change in the generallevel of interest rates in the market can affect our net interest income ineither a positive or negative manner. Net interest income is the differencebetween the income earned from interest bearing assetsless the expense incurred relating to interest bearing liabilities.Fluctuations in the interest rate environment can also affect our ability toacquire new loans, the value of our loan portfolio and our ability to financethe loans.

 

Weenter 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, we will generally enter intoan interest rate swap contract, receiving a floating rate of interest andpaying a fixed rate of interest. The term of the swap contracts is determinedby the duration of the forecasted long-term debt to be issued. The forwardstarting swaps are accounted for as cash flow hedges, therefore changes in thefair value of the swaps are recorded in accumulated other comprehensive income(loss).

 

Wehave not historically and currently do not intend to enter into hedgingtransactions to mitigate our interest rate exposure relating to the value ofour retained interests in securitization pools. The fair value of our loanportfolio 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 afixed rate of interest. The term of the swap contracts is determined by theduration of the forecasted long-term debt to be issued. We have a contractualobligation to settle the repurchase and swap agreements with Goldman, Sachs& Co. at the current fair value on the repurchase date.

 

***Fair Value of Financial Instruments***

 

As of June 30, 2004, ourloan portfolio consisted of our fixed-rate and variable-rate loan portfolio atfixed rates ranging between 7.18% and 9.52% and variable rates ranging between4.15% and 5.75%, respectively. Consequently, we do not have significant cash flow exposure on our loanportfolio.  However, the market value ofour loan portfolio is subject to significant fluctuation due to changes inmarket interest rates.  Among otherfactors, changes in interest rates affect the fair value of our loanportfolio.  Refer to Critical AccountingPolicies and Use of Estimates in Item 2 – Management’s Discussion and Analysisof Financial Condition and Results of Operations for additional information.

 

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**ITEM 4****.****Controls and Procedures**

 

As of the end of the period covered by this report, our principalexecutive officer and our principal financial officer carried out an evaluationof the effectiveness of our “disclosure controls and procedures” (as defined inRules 13a-14(c) and 15d-14(c) of the Securities Exchange Act of 1934 (orExchange Act).  Based upon and as of thatdate of evaluation, these officers have concluded that our disclosure controlsand procedures are in effect such that all material information relating to usrequired to be disclosed in our periodic filings with the Securities andExchange Commission (i) is recorded, processed, summarized and reported withinthe required time period, and (ii) is accumulated and communicated to Company’smanagement, including our principal executive officer and our principalfinancial officer, as appropriate, to allow timely decisions regarding requireddisclosure.

 

There have been no significant changes in our internal controls overfinancial reporting or in other factors, which could significantly affectcontrols over financial reporting subsequent to the date our management carriedits evaluation, including any corrections with regard to significantdeficiencies and material weaknesses.

 

**Limitations Inherent in all Controls**

 

The Company’s management, including the principal executive officer andprincipal financial officer, recognize that our disclosure controls and ourinternal controls (discussed above) cannot prevent all error or all attempts atfraud.  Any control system, no matter howwell crafted and operated, can only provide reasonable, and not absoluteassurance of achieving the desired control objectives, and managementnecessarily was required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.  Because of the inherent limitations in anycontrol system, no evaluation or implementation of a control system can providecomplete assurance that all control issues and all possible instances of fraudhave been or will be detected.

 

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**PART II****OTHER INFORMATION**

 

**Item 1.**                                   **Legal****Proceedings**

 

Weare not party to any material litigation proceedings.

 

**Item 2.**                                   **Changesin Securities****,Use of Proceeds and Issuer Purchase of Equity Securities**

 

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 4.**                                   **Submission****of Matters to Vote to SecurityHolders**

 

OnJuly 14, 2004, we held our Annual Meeting of Shareholders in Stamford,Connecticut. The following matter was submitted to a vote of security holders:

 

Ourshareholders voted to elect the following members of our Board of Directors forterms of one year each:

 

| **Nominees**       | ** ** | **In Favor** | ** ** | **Against** | ** ** | **Abstain** | ** ** |
|--------------------|------------|--------------|------------|-------------|------------|-------------|------------|
| Vernon B. Schwartz |       | 11,752,203   |       | 4,825       |       | —      |       |
| David A. Karp      |       | 11,737,103   |       | 19,925      |       | —      |       |
| Thomas F. Gilman   |       | 11,722,203   |       | 34,825      |       | —      |       |
| James K. Hunt      |       | 11,722,203   |       | 34,825      |       | —      |       |
| Maryann N. Keller  |       | 11,722,203   |       | 34,825      |       | —      |       |
| George G. Lowrance |       | 11,722,203   |       | 34,825      |       | —      |       |

 

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**Item 6.**                                   **Exhibitsand Reports****on Form 8-K**

 

(a)             Exhibits:

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                                                                                                              |
|-----------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.19           |       | Employment  agreement dated July 1, 2004 between Falcon Financial Investment Trust and  Ralph L. Miller.                                                                                                                                                     |
| 31.1            |       | Chief  Executive Officer Certification pursuant to Rule 13a-14(a) and Rule  15-d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                  |
| 31.2            |       | Chief  Financial Officer Certification pursuant to Rule 13a-14(a) and Rule  15-d-14(a) of the Securities Exchange Act of 1934, as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).                                  |
| 32.1            |       | Chief  Executive Officer and Chief Financial Officer Certification pursuant to Rule  13a-14(b) and Rule 15-d-14(b) of the Securities and Exchange Act of 1934, as  adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (filed  herewith). |

 

(b)Reports on Form 8-K:

 

The Company filed with the Securities and ExchangeCommission on April 22, 2004, a Current Report on Form 8-K for the April 16,2004 event reporting the public dissemination of a press release announcingthat the Company was notified by KPMG LLP (“KPMG”) that KPMG will resign as theCompany’s principal accountants upon completion of the review of the Company’sconsolidated financial statements as of and for the three-month period endedMarch 31, 2004.  KPMG’s resignation was not recommended or approved by theCompany’s audit committee.

 

The Company filed with theSecurities and Exchange Commission on April 29, 2004, a Current Report on Form8-K for the April 28, 2004 event reporting the public dissemination of a pressrelease announcing that the Company entered into a $150.0 million RevolvingWarehouse Financing Agreement with iStar Financial Inc., solely for the purposeof originating loans.  The facility may be increased to $200.0 million atour option and with the consent of iStar.

 

The Company filed with the Securities and ExchangeCommission on May 13, 2004, a Current Report on Form 8-K for the May 12,2004 event reporting the public dissemination of a press release announcing itsfinancial results for the quarter ended March 31, 2004.

 

The Company filed with the Securities and ExchangeCommission on May 19, 2004, a Current Report on Form 8-K for the May 17, 2004event reporting the public dissemination of a press release announcing that theCompany was notified by KPMG LLP (“KPMG”) on April 16, 2004 that KPMG wouldresign as the Company’s principal accountants upon completion of the review ofthe Company’s consolidated financial statements as of and for the three-monthperiod ended March 31, 2004.  KPMG completed this review on May 17, 2004.

 

The Company filed with the Securities and ExchangeCommission on June 29, 2004, a Current Report on Form 8-K for the June 29, 2004event reporting the public dissemination of a press release announcing theappointment of BDO Seidman, LLP as the Company’s principal accountants,effective June 29, 2004.

 

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**SIGNATURES**

 

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

 
|            | FALCON FINANCIAL INVESTMENT TRUST                            |
|-----------------|--------------------------------------------------------------|
| ** **      | **(Registrant)**                                             |
|            |                                                         |
|            |                                                         |
| August 16, 2004 | By:                                                          | /s/ Vernon B. Schwartz |
| ** **      | **Vernon B. Schwartz  Chairman and Chief Executive Officer** |
| ** **      | **(principal executive officer)**                            |
|            |                                                         |
|            |                                                         |
| August 16, 2004 | By:                                                          | /s/ David A. Karp |
| ** **      | **David A. Karp  President and Chief Financial Officer**     |
| ** **      | **(principal financial officer)**                            |

 

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