** **

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

**Washington, D.C.  20549**

** **

**Form 10-Q**

** **

**ý****                                        QuarterlyReport Pursuant To Section 13 or 15 (d) of the                                            SecuritiesExchange Act of 1934**

** **

**For the Quarter Ended September30, 2004**

** **

**Or**

** **

**o****                                      Transition Report Pursuant To Section 13 or15 (d) of the                                          SecuritiesExchange Act of 1934**

** **

**Commission file number 1-31795**

** **

**The Washtenaw Group, Inc.**

(Exact name of registrantas specified in its charter)

** **

| **Michigan**                                                     | ** ** | **20-0126218**                     |
|------------------------------------------------------------------|------------|------------------------------------|
| (State or Other  Jurisdiction of  Incorporation or Organization) |       | (IRS Employer  Identification No.) |

 

 

**3767 Ranchero Drive**

**Ann Arbor, Michigan  48108**

(Address of PrincipalExecutive Offices)

 

**734-662-9733**

(Registrant’s TelephoneNumber, 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 check mark 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 equity, as of the latest practicable date:

 

Common Stock Outstanding as of October 31, 2004

 

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

 

 

Index

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

 

----

 

**THEWASHTENAW GROUP, INC.**

Consolidated Balance Sheet

 
| ** **                                                                                                                    | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|------------------|------------|
| ** **                                                                                                                    | ** ** | **2004**          | ** ** | **2003**         | ** ** |
| ** **                                                                                                                    | ** ** | **(Unaudited)**   | ** ** | ** **       | ** ** |
| **ASSETS**                                                                                                                    |       |              |       |             |       |
| Cash and cash  equivalents                                                                                                    |       | $                 | 100,000    |             | $          | 100,000 |   |
| Accounts  Receivable, net                                                                                                     |       | 8,819,429         |       | 5,340,932        |       |
| Loans held for  sale                                                                                                          |       | 36,001,483        |       | 97,687,823       |       |
| Mortgage  servicing rights,net                                                                                                |       | 18,993,159        |       | 24,614,381       |       |
| Other real  estate owned                                                                                                      |       | 1,209,745         |       | 925,839          |       |
| Premises and  equipment, net                                                                                                  |       | 1,735,238         |       | 1,480,988        |       |
| Other assets                                                                                                                  |       | 750,036           |       | 1,030,653        |       |
|                                                                                                                          |       | $                 | 67,609,090 |             | $          | 131,180,616 |   |
|                                                                                                                          |       |              |       |             |       |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                |       |              |       |             |       |
| Liabilities                                                                                                                   |       |              |       |             |       |
| Due to bank                                                                                                                   |       | $                 | 6,999,229  |             | $          | 11,074,373 |   |
| Notes payable                                                                                                                 |       | 19,290,750        |       | 33,211,684       |       |
| Repurchase  agreements                                                                                                        |       | 8,098,423         |       | 43,926,901       |       |
| GNMA Repurchase  Liability                                                                                                    |       | 6,736,448         |       | 8,599,700        |       |
| Other liabilities                                                                                                             |       | 9,479,336         |       | 12,162,996       |       |
| Total  liabilities                                                                                                            |       | 50,604,186        |       | 108,975,654      |       |
|                                                                                                                          |       |              |       |             |       |
| Shareholders’  equity                                                                                                    |       |              |       |             |       |
| Preferred Stock,  $.01 par value 1,000,000 shares authorized;  none outstanding                                               |       | —            |       | —           |       |
| Common stock,  $.01 par value 9,000,000 shares authorized;  4,488,351 outstanding at September 30, 2004 and December 31, 2003 |       | 44,884            |       | 44,884           |       |
| Additional  paid-in capital                                                                                                   |       | 2,000,424         |       | 1,955,932        |       |
| Retained  earnings                                                                                                            |       | 14,959,596        |       | 20,204,146       |       |
| Total  shareholders’ equity                                                                                              |       | 17,004,904        |       | 22,204,962       |       |
|                                                                                                                          |       | $                 | 67,609,090 |             | $          | 131,180,616 |   |
|                                                                                                                               |            |                   |            |                  |            |  |  |  |

 

3

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** **

**THE WASHTENAW GROUP, INC.**

ConsolidatedStatements of Income (Unaudited)

 
| ** **                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                 | ** ** | ** **                            | ** ** |
|                                                       |       | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** |   |
| Interest income                                            |       | $                                     | 759,471    |                                 | $          | 3,865,346 |   | $ | 3,173,463 |   | $ | 10,924,519 |   |
| Interest expense                                           |       | 627,301                               |       | 1,878,526                            |       | 2,294,982 |   | 5,375,221 |   |
| Net interest  income                                       |       | 132,170                               |       | 1,986,820                            |       | 878,481 |   | 5,549,298 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Noninterest  income                                        |       |                                  |       |                                 |       |   |   |   |   |
| Servicing income                                           |       | 2,137,041                             |       | 1,857,838                            |       | 6,748,692 |   | 5,291,939 |   |
| Gain on sales of  mortgage servicing rights and loans, net |       | 1,628,134                             |       | 11,822,407                           |       | 6,252,720 |   | 38,295,453 |   |
| Other income                                               |       | 208,630                               |       | 246,930                              |       | 788,970 |   | 809,141 |   |
| Total  noninterest income                                  |       | 3,973,805                             |       | 13,927,175                           |       | 13,790,382 |   | 44,396,533 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Noninterest  expense                                       |       |                                  |       |                                 |       |   |   |   |   |
| Compensation and  employee benefits                        |       | 2,305,171                             |       | 6,818,980                            |       | 8,270,469 |   | 18,611,430 |   |
| Occupancy and  equipment                                   |       | 509,951                               |       | 418,824                              |       | 1,381,789 |   | 1,258,690 |   |
| Telephone                                                  |       | 84,418                                |       | 160,429                              |       | 239,624 |   | 446,333 |   |
| Postage                                                    |       | 103,862                               |       | 180,414                              |       | 364,157 |   | 572,554 |   |
| Amortization of  mortgage servicing rights                 |       | 2,046,115                             |       | 1,684,337                            |       | 5,967,051 |   | 4,325,636 |   |
| Mortgage  servicing rights valuation adjustment            |       | 100,760                               |       | (2,416,090                           | )          | (940,829 | ) | 2,219,089 |   |
| Loss and  provision for loss on loan repurchases and       |       |                                  |       |                                 |       |   |   |   |   |
| other real  estate                                         |       | 1,576,413                             |       | 2,197,541                            |       | 4,441,898 |   | 4,364,381 |   |
| Other  noninterest expense                                 |       | 794,978                               |       | 1,072,453                            |       | 2,810,348 |   | 3,123,757 |   |
| Total noninterest  expense                                 |       | 7,521,668                             |       | 10,116,888                           |       | 22,534,507 |   | 34,921,870 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| **Income  before income taxes**                            |       | (3,415,693                            | )          | 5,797,107                            |       | (7,865,644 | ) | 15,023,961 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Provision for  income taxes                                |       | (1,157,723                            | )          | 1,962,761                            |       | (2,621,094 | ) | 5,125,001 |   |
| **Net  income (loss)**                                     |       | $                                     | (2,257,970 | )                                    | $          | 3,834,346 |   | $ | (5,244,550 | ) | $ | 9,898,960 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Basic and  diluted earnings (loss) per share               |       | $                                     | (0.50      | )                                    | $          | 0.86 |   | $ | (1.17 | ) | $ | 2.22 |   |
|                                                            |            |                                       |            |                                      |            |  |  |  |  |  |  |  |  |  |

 

4

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** **

**THEWASHTENAW GROUP, INC**

ConsolidatedStatements of Cash Flows (Unaudited)

NineMonths Ended September 30, 2004

 
| ** **                                          | ** ** | **2004**    | ** ** | **2003**    | ** ** |
|-----------------------------------------------------|------------|-------------|------------|-------------|------------|
| **Cash  flows from operating activities**           |       |        |       |        |       |
| Net cash  provided by operating activities          |       | $           | 41,709,291 |        | $          | 19,263,408 |   |
|                                                |       |        |       |        |       |
| **Cash  Flows From Investing Activities:**          |       |        |       |        |       |
| Proceeds from  sales of mortgage servicing rights   |       | 13,096,226  |       | 22,107,697  |       |
| Other real  estate owned, net                       |       | (283,907    | )          | 505,031     |       |
| Property and  equipment expenditures                |       | (697,055    | )          | (606,497    | )          |
| Net cash  provided by investing activities          |       | 12,115,265  |       | 22,006,231  |       |
|                                                |       |        |       |        |       |
| **Cash  flows from financing activities**           |       |        |       |        |       |
| Decrease in due  to bank                            |       | (4,075,144  | )          | (13,436,500 | )          |
| Cash dividends                                      |       | —      |       | (5,038,180  | )          |
| Increase  (decrease) in notes payable due on demand |       | (13,920,934 | )          | 3,458,124   |       |
| Decrease in repurchase  aggreements                 |       | (35,828,478 | )          | (26,253,083 | )          |
| Net cash used by  financing activities              |       | (53,824,556 | )          | (41,269,639 | )          |
|                                                |       |        |       |        |       |
| Net Change in  cash, cash equivalents               |       | —      |       | —      |       |
| Cash and cash  equivalents at beginning of period   |       | 100,000     |       | 100,000     |       |
|                                                |       |        |       |        |       |
| **Cash  and cash equivalents at end of period**     |       | $           | 100,000    |        | $          | 100,000 |   |

 

5

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** **

**THE WASHTENAW GROUP, INC.**

Notesto the Consolidated Financial Statements (Unaudited)

 

**NOTE 1 - SIGNIFICANT ACCOUNTINGPOLICIES**

 

Principles ofConsolidation:

The unauditedconsolidated financial statements as of and for the three and nine monthperiods ended September 30, 2004 and 2003, include the accounts of TheWashtenaw Group, Inc. (“The Washtenaw Group”) and its wholly owned subsidiaryWashtenaw Mortgage Company  (“Washtenaw”)for all periods.  All references hereinto The Washtenaw Group include the consolidated results of its subsidiary.  All significant intercompany accounts andtransactions have been eliminated in consolidation.

 

Operating Segments:

Washtenaw’s operationsinclude one primary segment: mortgage banking.

 

Stock Compensation:

Compensation expense under stock options is reported using theintrinsic value method (market value per share, less option exerciseprice).  Stock-based compensationreflected in net income for the three and nine months ended September 30, 2004is $6,391 and $44,492, respectively as options granted had an exercise priceless than the market price of the underlying common stock at date of grant.  The following table illustrates the effect onnet income and earnings per share if expense was measured using the fair valuerecognition provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation*.

 
| ** **                                                                                               | ** ** | **Three Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|
| ** **                                                                                               | ** ** | **2004**                              | ** ** | **2003** | ** ** |
| Net income  (loss) as reported                                                                           |       | $                                     | (2,257,970 | ) | $ | 3,834,346 |   |
| Deduct:  Incremental stock-based compenstion expense (benefit) determined under fair  value based method |       | 1,140                                 |       | — |   |
| Pro forma net  income (loss)                                                                             |       | $                                     | (2,259,110 | ) | $ | 3,834,346 |   |
|                                                                                                     |       |                                  |       |   |   |
| Basic earnings  (loss) per share as reported                                                             |       | $                                     | (0.50      | ) | $ | 0.86 |   |
| Pro forma basic  earnings (loss) per share                                                               |       | (0.50                                 | )          | 0.86 |   |
|                                                                                                     |       |                                  |       |   |   |
| Diluted earnings  (loss) per share                                                                       |       | $                                     | (0.50      | ) | $ | 0.86 |   |
| Pro forma  diluted earnings (loss) per share                                                             |       | (0.50                                 | )          | 0.86 |   |
|                                                                                                          |            |                                       |            |  |  |  |  |  |

 
| ** **                                                                                               | ** ** | **Nine Months Ended  September 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                               | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Net income  (loss) as reported                                                                           |       | $                                    | (5,244,550 | ) | $ | 9,898,960 |   |
| Deduct:  Incremental stock-based compenstion expense (benefit) determined under fair  value based method |       | (1,140                               | )          | — |   |
| Pro forma net  income (loss)                                                                             |       | $                                    | (5,243,410 | ) | $ | 9,898,960 |   |
|                                                                                                     |       |                                 |       |   |   |
| Basic earnings  (loss) per share as reported                                                             |       | $                                    | (1.17      | ) | $ | 2.22 |   |
| Pro forma basic  earnings (loss) per share                                                               |       | (1.17                                | )          | 2.22 |   |
|                                                                                                     |       |                                 |       |   |   |
| Diluted earnings  (loss) per share                                                                       |       | $                                    | (1.17      | ) | $ | 2.22 |   |
| Pro forma  diluted earnings (loss) per share                                                             |       | (1.17                                | )          | 2.22 |   |

 

 

Due to the spin-off (see Note 3), optionsoutstanding of Pelican Financial at December 31, 2003 included 10,735 optionsthat were held by employees of Washtenaw. These options were cancelled during the first quarter of 2004 andreplaced with 21,470 options on stock of The Washtenaw Group at an exerciseprice of $3.25.  These options weregranted with an intrinsic value substantially equal to the intrinsic value ofthe cancelled Pelican Financial options.

 

6

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** **

**NOTE 1 - SIGNIFICANT ACCOUNTINGPOLICIES (Continued)**

 

Mortgage ServicingRights Hedging:

Beginning April 1,2004, Washtenaw’s interest rate risk management activities include the hedgingof mortgage servicing rights (“MSRs”).  Washtenaw utilizes derivatives extensively inconnection with its interest rate risk management activities.   Washtenaw is exposed to interest rate riskon its MSRs.  As market rates increase ordecrease, the market value of MSRs will increase or decline.  To offset this interest rate risk, Washtenawenters into derivatives, including ten-year treasury futures contracts andten-year treasury put and call options. In accordance with SFAS 133, all derivative instruments are recorded atfair value.  Accordingly, ten-yeartreasury futures contracts and ten-year treasury put and call options contractsare carried at fair value, as determined by the amount payable or receivableto/from the counterparty as if the derivatives were settled at the balancesheet date.  The fair value is based onthe end of the period pricing from brokerage houses.  Changes in fair value are included in theMSRs valuation adjustment in the income statement.

 

**NOTE 2 — BASIS OF PRESENTATION**

 

The accompanyingunaudited consolidated financial statements were prepared in accordance withinstructions for Form 10-Q and, therefore, do not include information orfootnotes necessary for a complete presentation of consolidated financialcondition, results of operations, and cash flows in conformity with U.S.generally accepted accounting principles. However, all adjustments, consisting of normal recurring accruals,which, in the opinion of management, are necessary for fair presentation of theconsolidated financial statements have been included.  The results of operations for the period endedSeptember 30, 2004, are not necessarily indicative of the results that may beexpected for the entire fiscal year or for any other period.  For further information, refer to theconsolidated financial statements and footnotes thereto for the year endedDecember 31, 2003 included in The Washtenaw Group’s Form 10-K.

 

**NOTE 3 —SPIN-OFF**

 

On December 31, 2003,Pelican Financial, the former parent company of The Washtenaw Group andWashtenaw, distributed all of the outstanding shares of The Washtenaw Group tothe holders of Pelican Financial common stock on a share for share basis basedon Pelican Financial shareholders of record on December 22, 2003.  Upon completion of the distribution onDecember 31, 2003, The Washtenaw Group and Washtenaw are no longer a subsidiaryof Pelican Financial.  During the periodspresented in the financial statements, Pelican Financial did not incur anyexpenses on behalf of The Washtenaw Group and Washtenaw and no allocation ofparent company expenses has been reflected in these financial statements.

 

Following thedistribution certain individuals continue to serve as officers of both TheWashtenaw Group, Washtenaw and Pelican Financial.  The Washtenaw Group pays their salaries andall other compensation, and Pelican Financial reimburses The Washtenaw Group,as part of the Transitional Services Agreement, for time spent on PelicanFinancial matters.  Prior to 2004,Pelican did not reimburse The Washtenaw Group for these services.  Beginning in 2004, officers and otheremployees providing services to both companies maintain records of their timespent on the affairs of each company as a basis for determining thereimbursements.

 

7

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**NOTE 4 - EARNINGS PER SHARE**

 

The following summarizesthe computation of basic and diluted earnings per share.

 
| ** **                                            | ** ** | **Three Months**  | ** ** | **Three Months**  | ** ** |
|-------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                            | ** ** | **Ended**         | ** ** | **Ended**         | ** ** |
| ** **                                            | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                            | ** ** | **2004**          | ** ** | **2003**          | ** ** |
| Basic earnings  (loss) per share                      |       |              |       |              |       |
| Net income  (loss)                                    |       | $                 | (2,257,970 | )                 | $          | 3,834,346 |   |
| Weighted  averages shares outstanding                 |       | 4,488,351         |       | 4,463,221         |       |
| Basic earnings  (loss) per share                      |       | $                 | (0.50      | )                 | $          | 0.86 |   |
|                                                  |       |              |       |              |       |
| Diluted earnings  (loss) per share                    |       |              |       |              |       |
| Net income  (loss)                                    |       | $                 | (2,257,970 | )                 | $          | 3,834,346 |   |
| Weighted average  shares outstanding                  |       | 4,488,351         |       | 4,463,221         |       |
| Dilutive effect  of assumed exercise of stock options |       | —            |       | —            |       |
| Diluted average  shares outstanding                   |       | 4,488,351         |       | 4,463,221         |       |
| Diluted earnings  (loss) per share                    |       | $                 | (0.50      | )                 | $          | 0.86 |   |

 
| ** **                                            | ** ** | **Nine Months**   | ** ** | **Nine Months**   | ** ** |
|-------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                            | ** ** | **Ended**         | ** ** | **Ended**         | ** ** |
| ** **                                            | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                            | ** ** | **2004**          | ** ** | **2003**          | ** ** |
| Basic earnings  (loss) per share                      |       |              |       |              |       |
| Net income  (loss)                                    |       | $                 | (5,244,550 | )                 | $          | 9,898,960 |   |
| Weighted  averages shares outstanding                 |       | 4,488,351         |       | 4,463,221         |       |
| Basic earnings  (loss) per share                      |       | $                 | (1.17      | )                 | $          | 2.22 |   |
|                                                  |       |              |       |              |       |
| Diluted earnings  (loss) per share                    |       |              |       |              |       |
| Net income  (loss)                                    |       | $                 | (5,244,550 | )                 | $          | 9,898,960 |   |
| Weighted average  shares outstanding                  |       | 4,488,351         |       | 4,463,221         |       |
| Dilutive effect  of assumed exercise of stock options |       | —            |       | —            |       |
| Diluted average  shares outstanding                   |       | 4,488,351         |       | 4,463,221         |       |
| Diluted earnings  (loss) per share                    |       | $                 | (1.17      | )                 | $          | 2.22 |   |
|                                                       |            |                   |            |                   |            |  |  |  |  |

 

For the nine monthsended September 30, 2004 there were 21,470 stock options outstanding that werenot considered dilutive. There were no options outstanding during 2003.

 

8

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Item 2: Management’s Discussion and Analysis ofFinancial Condition and Results of Operations

 

Forward-LookingStatements

 

Certaininformation in this Form 10-Q may constitute forward-looking information thatinvolves risks and uncertainties that could cause actual results to differmaterially from those estimated.  Personsare cautioned that such forward-looking statements are not guarantees of futureperformance and are subject to various factors that could cause actual resultsto differ materially from those estimated. These factors include, but are not limited to, changes in generaleconomic and market conditions, legislative and regulatory changes, monetaryand fiscal policies of the federal government, demand for mortgage loanproducts, prepayments on the mortgage loan servicing portfolio and thedevelopment of an interest rate environment that adversely affects the interestrate spread or other income from The Washtenaw Group’s investments andoperations.

 

### **OVERVIEW**

 

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

 

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

In 2004, competition fornew loans has increased, which has resulted in a reduction of loan originationsand the profit per loan for Washtenaw. As a result, in the current interest rate environment, it is unlikelyWashtenaw will be profitable from operations for the remainder of 2004.

The focus in 2004 willcontinue to be loan quality.  As the loanbrokers become more desperate for production, Washtenaw will typically see anincrease in loans with misrepresentation in varying levels.  Management will continue to focus onimplementing procedures to improve asset quality and thereby reduce the costsassociated with loan repurchases.  Loanrepurchases are one of the greatest challenges management currently faces inimproving financial performance.

 

**CRITICAL ACCOUNTING POLICIES**

 

## **Theaccounting policies that have the greatest impact on The Washtenaw Group’sfinancial condition and results of operations and that requires the mostjudgment relate to its mortgage activities. The Washtenaw Group’s accounting policy for gain on sale of loans, MSRs,interest rate risk management activities and litigation and claims have not changedsince December 31, 2003.  Theseaccounting policies are described more fully in the annual report on Form 10-Kfor the year ended December 31, 2003.**

 

Beginning April 1,2004, Washtenaw’s interest rate risk management activities include the hedging ofMSR’s.  Washtenaw utilizes derivativesextensively in connection with its interest rate risk managementactivities.   Washtenaw is exposed tointerest rate risk on its MSRs.  Asmarket rates increase or decrease, the market value of MSRs will increase ordecline.  To offset this interest raterisk, Washtenaw enters into derivatives, including ten-year treasury futurescontracts and ten-year treasury put and call options.  In accordance with SFAS 133, all derivativeinstruments are recorded at fair value. Accordingly, ten-year treasury futures contracts and ten-year treasuryput 

 

9

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and call optionscontracts are carried at fair value, as determined by the amount payable orreceivable to/from the counterparty as if the derivatives were settled at thebalance sheet date.  The fair value isbased on the end of the period pricing from brokerage houses.  Changes in fair value are included in theMSRs valuation adjustment in the income statement.

 

## **EARNINGS PERFORMANCE**

 

The Washtenaw Group reported net loss of $2.3 million for the threemonths ended September 30, 2004 compared to net income of $3.8 million for thethree months ended September 30, 2003. Basic and diluted earnings per share was a loss of $0.50 per sharecompared to earnings of  $0.86 per sharefor the quarter ended September 30, 2004 and 2003 respectively. The WashtenawGroup reported net loss of $5.2 million for the nine months ended September 30,2004 compared to net income of $9.9 million for the nine months ended September30, 2003.  Basic and diluted earnings pershare was a loss of $1.17 per share compared to earnings of  $2.22 per share for the nine months endedSeptember 30, 2004 and 2003 respectively.

## ** **

## **RESULTS OF OPERATIONS**

 

Loan Production

 

Loan production was $212.3 million and $1.1 billion for the threemonths ended September 30, 2004 and 2003, respectively.  The volume of loans produced for the ninemonths ended September 30, 2004 totaled $990 million as compared to $3.2billion for the nine months ended September 30, 2003, a decrease of $2.2billion or 69%.  The decrease was theresult of a stable to rising interest rate environment during the nine monthsended September 30, 2004.

 

Noninterest Income

 

Noninterest income was $4.0 million and $13.9 million for the threemonths ended September 30, 2004 and 2003, respectively. Total noninterestincome for the nine months ended September 30, 2004 was $13.8 million, comparedto $44.4 million for the nine months ended September 30, 2003, a decrease of$30.6 million or 69%. This decrease was primarily due to an 84% decrease in thegain on sales of mortgage servicing rights and loans.  The decrease in gain on sale of MSRs andloans was primarily due to a decrease in the overall new loan origination volumein the first nine months of 2004.  Inaddition, the gains on sales of MSRs and loans was affected by reduced profitmargins on each new loan origination as a result of the current interest rateenvironment.

 

Loan Servicing

 

At September 30, 2004, Washtenaw serviced $2.5 billion of loanscompared to $2.7 billion at September 30, 2003, a 7% decrease.  Washtenaw has an agreement to sell theservicing rights related to mortgage loan production on a monthly basis.   This agreement expires in November 2004. Atthat time, Washtenaw will retain the majority of its servicing and sell theservicing rights in periodic bulk sales. During the nine months ended September30, 2004, Washtenaw was selling approximately 34% of its MSRs under thisagreement.  The remainder of the loanservicing rights created are retained in the mortgage loan servicing portfolio.

 

At September 30, 2004 and 2003, with the exception of servicing relatedto loans held for sale in Washtenaw’s loan portfolio and servicing sold but notyet delivered, all loan servicing was performed for others.  Service fee income, net of amortization was$91,000 and $174,000 for the three months ended and $782,000 and $966,000 forthe nine months ended September 30, 2004 and 2003 respectively.  Servicing income increased $279,000 and $1.5million due to the increase in the servicing portfolio; however, the increasein amortization of mortgage servicing rights more than offset the increase inincome.  The increase in amortization isrelated to the effect of the low interest rate environment, which has increasedactual and expected prepayment rates used to determine amortization rates.

 

Noninterest Expense

 

Noninterest expense was $7.5 million and $10.1 million for the threemonths ended September 30, 2004 and 2003, respectively. Total noninterestexpense for the nine months ended September 30, 2004 was $22.5 million,compared 

 

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to $34.9 million for the same period in 2003, a decrease of $12.4million, or 35%.  For the three monthsending September 30, the decrease was primarily due to the decrease in employeecompensation and benefits expenses and a decrease in the loss and provision forloss on loan repurchases and other real estate, offset by an increase in the mortgageservicing rights valuation adjustment and the amortization of mortgageservicing rights.  For the nine monthsended September 30, the decrease was primarily due to the decrease in employeecompensation and benefits and a favorable MSRs valuation, offset by theincrease in amortization of MSRs. The decrease in employee compensation andbenefits was the result of a decrease in operations staff due to attrition,layoffs, closing the operations center in California, a reduction in overtimeexpense, a reduction in commission compensation paid to the sales staff and thereduction in management bonus compensation. The unfavorable MSRs valuationadjustment for the quarter was due to a decrease in mortgage interest ratesduring the period, resulting in increases in expected prepayment speeds, whichproject the expected runoff of the mortgage loan servicing portfolio based oncomparing the interest rates of the loans in the portfolio against currentmarket interest rates.  However, the yearto date MSRs valuation adjustment is positive which reflects the overallincrease in mortgage interest rates during the year. The increase inamortization of MSRs is the result of the increase in mortgage loan servicingportfolio and the increased speed in which the asset is being amortized due tothe higher prepayment speeds when the servicing asset was created.

 

The loss and provision for loss on loan repurchases and other realestate continues to be a significant component of  noninterest expense. Washtenaw determines itsexpected loss on repurchase requests as a result of historical experience whenthe actual amount of the loss is not available. Typically, loans requested to be repurchased are non-performing.  Washtenaw reviews repurchase requests andprovides a rebuttal, if applicable, on a loan-by-loan basis.   The liability is established based onhistorical repurchase experience and current repurchase requests.  Also, Washtenaw establishes a liability forrepurchases based on mortgage loan production. For the periods ended September 30, 2004 and December 31, 2003, thepending possible repurchases totaled 61 and 80 loans with a total principalbalance of $5.6 million and $6.7 million.  The liability for future loan repurchases at the periods ended September30, 2004 and December 31, 2003 was $3.2 million and $3.7 million.

 

**BALANCE SHEET ANALYSIS**

 

The following is a discussion of the consolidated balance sheet of TheWashtenaw Group.

 

## **ASSETS**

 

At September 30, 2004, total assets of The Washtenaw Group equaled$67.6 million as compared to $131.2 million at December 31, 2003, a decrease of$63.6 million or 48%. The decrease is primarily due to the decrease in loansheld for sale and mortgage servicing rights.

 

 

Loans Held for Sale

 

Loans held for sale were $36.0 million at September30, 2004 compared to $97.7 million at December 31, 2003.  This decrease of $61.7 million or 63% was theresult of a decrease in mortgage loan production.

 

Mortgage Servicing Rights

 

Mortgage servicing rights were $19.0 million at September 30, 2004, adecrease of $5.6 million or 23% from $24.6 million at December 31, 2003.  This is the result of two bulk servicingsales of $649 million in the nine months ended September 30, 2004.  The MSR asset was decreased by $6.9 millionas a result of the sales.  In addition$6.0 million of amortization was recorded for the nine months ended September30, 2004. These decreases were offset by Washtenaw retaining a portion ofcurrent loan production and the $941,000 favorable MSRs valuationadjustment.  In general, servicing rightvalues tend to decline in a falling interest rate environment and increase in arising interest rate environment. Management cannot predict future market interest rate levels or themagnitude of future servicing valuation adjustments; however, the potential forfurther impairment charges exist depending on the mortgage interest rateenvironment.

 

In April 2004, Washtenaw began hedging a portion of its mortgage loanservicing portfolio.  During the quarter,management has used ten-year treasury futures contracts and ten-year treasuryput and call options to hedge against the reduction in the value of the MSRsdue to a decline in mortgage interest rates. The derivative instruments were 

 

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purchased to protect between 20% and 25% of the servicing rights thatcan be hedged against declining interest rates. All fixed rate loan servicing may be hedged, while arms and balloons arenot.  For the three months endedSeptember 30, 2004, Washtenaw incurred a $1.1 million unfavorable MSR valuationadjustment.  During the same period,Washtenaw recognized a $1.0 million favorable adjustment on MSRs hedgingactivity.  The MSR valuation adjustmentfor the nine months ended September 30, 2004, Washtenaw recognized a favorableMSRs valuation adjustment of $395,000. During the same period, Washtenaw recognized a $554,000 favorableadjustment on MSRs hedging activity.

 

Washtenaw intends to sell approximately $300 to $700 million in MSRsduring the quarter ended December 31, 2004. Management anticipates this will reduce the mortgage servicing rightsasset by approximately $3.0 to $7.0 million at the sale date.  At the time of the sale, management willreduce its hedge position accordingly in an effort to hedge the same overallpercentage of the MSRs.

## ** **

## **LIABILITIES**

 

At September 30, 2004, the total liabilities of The Washtenaw Groupwere $50.6 million as compared to $109.0 million at December 31, 2003, adecrease of $58.4 million or 54%. This decrease was primarily due to decreasesin repurchase agreements, notes payable, due to bank and other liabilities.

 

Due to Bank

 

Due to bank represents drafts issued for specific loan closings thathave not cleared the bank.  At September30, 2004 due to bank was $7.0 million compared to $11.1 million at December 31,2003.  The decrease is the result of thedecrease in loan production.

 

Notes Payable

 

Notes payable was $19.3 million at September 30, 2004 compared to $33.2million at December 31, 2003.  Thisdecrease of $13.9 million, or 42% was primarily caused by the significantdecrease in loan originations during the quarter ended September 30, 2004.  The notes payable represent the warehouseline of credit that Washtenaw uses to fund its loan production until such timethat the loans are sold to the secondary market.

 

Repurchase Agreements

 

Repurchase agreements were $8.1 million at September 30, 2004 comparedto $43.9 million at December 31, 2003. This decrease of $35.8 million, or 82%, was primarily the result ofdecreased loan originations during the quarter ended September 30, 2004.  Also, Washtenaw is selling more loans toinvestors that do not allow the transfer to repurchase agreements.  The use of the repurchase agreements islimited to loans sold to the Federal National Mortgage Association (“FNMA”).

 

Other Liabilities

 

Other liabilities also decreased from $12.2 million at December 31,2003 to $9.5 million or 28% as of September 30, 2004.  This decrease was primarily due to a decreasein accrued salaries and fees on loans due FNMA. Accrued salaries decreased from $1.2 million due to the reduction inmanagement bonuses earned during the year. At December 31, 2003, a portion of bonuses earned related to the 2003performance of Washtenaw had not been paid. At September 30, 2004 no bonuses were accrued as none were earned due tothe losses incurred.  The fees on loansdue FNMA decreased $1.3 million as a result of the decrease in loanproduction.  FNMA charges Washtenawvarious fees at the loan level for certain type of loans based on the riskcharacteristics of the particular loan.

 

 

LIQUIDITY AND CAPITAL RESOURCES

 

Liquidity Management

 

The objective of liquidity management is to ensure the availability ofsufficient resources to meet all financial commitments and to capitalize onopportunities for business expansion. Liquidity management addresses the ability 

 

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to meet deposit withdrawals either on demand or by contractualmaturity, to repay other borrowings as they mature and to make new loans andinvestments as opportunities arise.

 

To date The Washtenaw Group has conducted no business other thanmanaging its investments in Washtenaw. The Washtenaw Group’s source of funds is dividends paid by Washtenaw.Washtenaw’s sources of funds include cash from gains on sales of mortgage loansand servicing, net interest income, servicing fees and borrowings. Washtenawsells its mortgage loans generally on a monthly basis to generate cash foroperations. Washtenaw’s uses of cash in the short-term include the funding ofmortgage loan purchases and originations and purchases of mortgage servicingrights, payment of interest, repayment of amounts borrowed pursuant towarehouse lines of credit, operating and administrative expenses, income taxesand capital expenditures.  Long-term usesof cash may also include the funding of securitization activities or portfoliosof loan or servicing assets.

 

Washtenaw funds its business through the use of a warehouse line ofcredit and the use of agreements to repurchase. The agreements to repurchase typically have terms of less than 90 daysand are treated as a source of financing. The warehouse line of credit has a limit of $100 million, of which $13.0million represents a sublimit for servicing under contract for sale, and $7.2million represents a working capital sublimit. Borrowing pursuant to the warehouse line of credit totaled $19.3 millionat September 30, 2004 and $33.2 million at December 31, 2003.  Included in the total warehouse lineborrowing at September 30, 2004 and December 31, 2003 was $6.4 million and zerounder the sublimit for servicing under contract for sale. The interest rate onthe warehouse line of credit is the Federal Funds Rate plus 1.50% resulting inan effective rate of 3.25% at September 30, 2004 and 2.50% at December 31,2003.  The effective interest rate on theagreements to repurchase was 2.65% at September 30, 2004 and 1.90% at December31, 2003.

 

Washtenaw intends to sell approximately $300 to $700 million in MSRsduring the quarter ended December 31, 2004. Management anticipates this will generate approximately $3.0 to $7.0million in cash depending on the sales price. A portion of the proceeds will be received at the sale date while theremainder is received upon transfer of the loans, typically 30 to 90 dayslater.

 

Washtenaw purchases its loans either by wiring funds to the closingagent or sending a draft.  The decisionis based on the requirements of the state where the loan is beingpurchased.  When a draft is used,Washtenaw begins earning interest on the day the draft is issued but does notincur any cost of funds until the draft is presented to the bank.  When the draft clears the bank, Washtenawwill either borrow money on its warehouse line of credit or through itsagreements to repurchase depending on the type of loan.  Outstanding drafts totaled $7.0 million atSeptember 30, 2004 and $11.1 million at December 31, 2003.

 

The Washtenaw Group’sability to continue to purchase loans and MSRs and to originate new loans isdependent in large part upon its ability to sell the mortgage loans at par orfor a premium or to sell the MSRs in the secondary market in order to generatecash proceeds to repay borrowings pursuant to the warehouse facility, thereby creatingborrowing capacity to fund new purchases and originations.  The value of and market for The WashtenawGroup’s loans and mortgage servicing rights are dependent upon a number offactors, including the borrower credit risk classification, loan-to-valueratios and interest rates, general economic conditions, warehouse facilityinterest rates and governmental regulations.

 

Washtenaw generally grants commitments to fund mortgage loans for up to30 days at a specified term and interest rate. The commitments are commonly known as rate-lock commitments.  At September 30, 2004, Washtenaw hadoutstanding rate-lock commitments to lend $63.3 million for mortgageloans.  Because these commitments mayexpire without being drawn upon, they do not necessarily represent future cashcommitments.  Also, as of September 30,2004, Washtenaw had outstanding commitments to sell $53.2 million of mortgageloans.  These commitments usually arefunded within 90 days.

 

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Item 3:  Quantitative and Qualitative Disclosure AboutMarket Risk

 

For a discussion of The Washtenaw Group’s asset/liability managementpolicies as well as the potential impact of interest rate changes upon themarket value of The Washtenaw Group’s portfolio, see The Washtenaw Group’sAnnual Report to Shareholders on Form 10-K. Management believes that there has been no material change in TheWashtenaw Group’s asset/liability position or the market value of The WashtenawGroup’s portfolio since December 31, 2003.

 

Item 4: Controls and Procedures

 

The Washtenaw Group, under the supervision and with the participationof its management, including its principal executive officer and principalfinancial officer, evaluated the effectiveness of the design and operation ofits disclosure controls and procedures as of the end of the period covered bythis report.  Based on this evaluation,the principal executive officer and principal financial officer concluded thatThe Washtenaw Group’s disclosure controls and procedures are effective inreaching a reasonable level of assurance that information required to bedisclosed by The Washtenaw Group in the reports that it files or submits underthe Securities Exchange Act of 1934 is recorded, processed, summarized andreported within the time period specified in the Securities and ExchangeCommission’s rules and forms.

 

The principal executive officer and principal financial officer alsoconducted an evaluation of internal control over financial reporting (“InternalControl”) to determine whether any changes in Internal Control occurred duringthe fiscal quarter that have materially affected or which are reasonably likelyto materially affect Internal Control. Based on that evaluation, there has been no such change during the quartercovered by this report.

 

A control system, no matter how well conceived and operated, canprovide only reasonable, not absolute, assurance that the objectives of thecontrol system are met.  Further, thedesign of a control system must reflect the fact that there are resourceconstraints, and the benefits of controls must be considered relative to theircosts.  Because of the inherentlimitations in all control systems, no evaluation of controls can provideabsolute assurance that all control issues and instances of fraud, if any,within Washtenaw have been detected. Because of the inherent limitations in a cost-effective control system,misstatements due to error or fraud may occur and not be detected.  The Washtenaw Group conducts periodicevaluations to enhance, where necessary, its procedures and controls.

 

 

Part II. OtherInformation

 

Item 1.   Legal Proceedings

 

*Webb, et al. v. Washtenaw Mortgage Co.*, Case No. 01C38.  The litigation, pending in West Virginiastate court, asserts that Washtenaw and others conspired to take advantage ofborrowers through predatory lending practices such as inflating appraisals, notproperly disclosing fees and charges, etc. The proposed class is fairly narrow and limited: it is said to consistof persons who obtained loans from Washtenaw in West Virginia during thefive-year period preceding the filing of the complaint, which loans werearranged by a broker, First Security, closed on documents prepared byWashtenaw, and then sold to Chase Manhattan Mortgage Corp.   The state court has never certified anyclass in the litigation.  During thequarter ended September 30, 2004, the Webbs and one of the other defendants inthe lawsuit entered into a partial settlement of the litigation, which theyhave asked the court to approve.  Thecourt has scheduled a December 2004 hearing on the request to approve thesettlement.  The Webbs and thatparticular defendant have requested that the court certify a class for thelimited purpose of approving the settlement, which those parties havereached.  There is presently no existingrequest to certify any class in connection with the plaintiffs’ claims againstWashtenaw.  At this time, managementcannot express an opinion on the impact of this case or the ultimate outcome ofthis matter, and no liability has been established.

 

Other than described above, there have been no material changes to thepending legal proceedings to which The Washtenaw Group is a party since thefiling of the registrant’s Form 10-K, nor have there been any material legalproceedings to which The Washtenaw Group is a party instituted since that date.

 

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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

(a)   Not Applicable

(b)   Not Applicable

(c)   Not Applicable

 

Item 3.  Defaults Upon Senior Securities

 

Not Applicable.

 

Item 4.  Submission of Matters to a Vote of Security Holders

 

None

 

Item 5.   Other Information

 

None

 

Item 6.  Exhibits and Reports on Form 8-K

 

(a)          Exhibits

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

 

 (b)      Reportson Form 8-K

 

August 4, 2004 to announce the financial results ofthe quarter ended June 30, 2004.

 

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**The Washtenaw Group, Inc. andSubsidiary**

**Signatures**

** **

Under the requirements of the Securities Exchange Act of 1934, theRegistrant has duly caused this Report to be signed on its behalf by theundersigned thereunto duly authorized.

 

 
| Date: November 12, 2004 | /s/ Charles C. Huffman                       |
|-------------------------|----------------------------------------------|
|                    | Charles C. Huffman                           |
|                    | President and Chief Executive Officer        |
|                    |                                         |
| Date: November 12, 2004 | /s/ Howard M. Nathan                         |
|                    | Howard M. Nathan                             |
|                    | Vice President and Chief Financial Officer   |
|                    | (Principal Financial and Accounting Officer) |

 

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