** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

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**FORM 10-Q**

** **

**(MarkOne)**

**ý****        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

** **

**For the quarterly periodended June 30, 2005**

** **

**or**

** **

**o****        TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 1934**

** **

**For the transitionperiod from    to    **

** **

**Commission File Number:000-50938**

** **

**Fieldstone Investment Corporation**

(Exactname of registrant as specified in its charter)

 
| **Maryland**                                                    | ** ** | **74-2874689**                        |
|-----------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) |       | (I.R.S. Employer  Identification No.) |
|                                                            |       |                                  |
| **11000 Broken Land Parkway  Columbia, MD**                     | ** ** | **21044**                             |
| (Address of principal executive offices)                        |       | (Zip Code)                            |
|                                                            |       |                                  |
| **(410) 772-7200**                                              |
| (Registrant’s telephone number, including area code)       |

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe 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 such filing requirements for the past 90 days. |   | ý Yes o No |
|----------------------------------------------------------------------------------|--------|-----------------|

 

Indicateby check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Exchange Act)
|   |   | o Yes   ý No |
|--------|--------|-----------------------------|

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date. On August 12, 2005, the issuer had 48,835,876 shares of commonstock outstanding.

 

 

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**Tableof Contents**

 
| **Part I**  | FINANCIAL INFORMATION                                                                       | 3      |
|-------------|---------------------------------------------------------------------------------------------|--------|
| ** **  |                                                                                        |   |
| **Item 1.** | Financial Statements                                                                        | 3      |
| ** **  | Consolidated Statements of Condition                                                        | 3      |
| ** **  | Consolidated Statements of Operations                                                       | 4      |
| ** **  | Consolidated Statements of Cash Flows                                                       | 5      |
| ** **  | Notes to Consolidated Financial Statements                                                  | 6      |
| **Item 2.** | Management’s Discussion and Analysis of Financial Condition and  Results of Operations | 17     |
| ** **  | Executive Overview                                                                          | 18     |
| ** **  | Key Components of Financial Results of Operations                                           | 18     |
| ** **  | Critical Accounting Policies                                                                | 19     |
| ** **  | Results of Operations                                                                       | 22     |
| ** **  | Consolidated Statements of Condition                                                        | 29     |
| ** **  | Business Segment Results                                                                    | 33     |
| ** **  | Liquidity and Capital Resources                                                             | 38     |
| ** **  | Commitments and Contingencies                                                               | 40     |
| ** **  | REIT Taxable Income                                                                         | 41     |
| ** **  | Other Operational and Investment Portfolio Data                                             | 42     |
| ** **  | Impact of New Accounting Standards                                                          | 49     |
| ** **  | Effect of Inflation                                                                         | 50     |
| **Item 3**  | Quantitative and Qualitative Disclosures  About Market Risk                                 | 50     |
| **Item 4.** | Controls and Procedures                                                                     | 51     |
| ** **  |                                                                                        |   |
| **Part II** | OTHER INFORMATION                                                                           | 51     |
| ** **  |                                                                                        |   |
| **Item 1.** | Legal Proceedings                                                                           | 51     |
| **Item 2.** | Unregistered Sales of Equity Securities and  Use of Proceeds                                | 52     |
| **Item 3.** | Defaults Upon Senior Securities                                                             | 52     |
| **Item 4.** | Submission of Matters to a Vote of Security  Holders                                        | 52     |
| **Item 5.** | Other Information                                                                           | 52     |
| **Item 6.** | Exhibits                                                                                    | 53     |

 

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**PART I**

** **

**ITEM 1.       FINANCIALSTATEMENTS.**

** **

**FIELDSTONEINVESTMENT CORPORATION AND SUBSIDIARIES**

**Consolidated Statements of Condition**

**June 30,2005 and December 31, 2004(In thousands, except share and per share data)**

** **
| ** **                                                                                                                                                                              | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                                                                              | ** ** | **(Unaudited)**             | ** ** | ** **                      | ** ** |
| **Assets**                                                                                                                                                                              |       |                        |       |                            |       |
| Cash                                                                                                                                                                                    |       | $                           | 38,435     |                            | 61,681     |   |
| Restricted cash                                                                                                                                                                         |       | 5,946                       |       | 4,022                           |       |
| Mortgage loans held for sale, net                                                                                                                                                       |       | 548,446                     |       | 357,050                         |       |
|                                                                                                                                                                                    |       |                        |       |                            |       |
| Mortgage loans held for investment                                                                                                                                                      |       | 4,866,514                   |       | 4,774,756                       |       |
| Allowance for loan losses—loans held for  investment                                                                                                                               |       | (30,690                     | )          | (22,648                         | )          |
| Mortgage loans held for investment, net                                                                                                                                                 |       | 4,835,824                   |       | 4,752,108                       |       |
|                                                                                                                                                                                    |       |                        |       |                            |       |
| Accounts receivable                                                                                                                                                                     |       | 7,204                       |       | 9,326                           |       |
| Accrued interest receivable                                                                                                                                                             |       | 23,417                      |       | 22,420                          |       |
| Trustee receivable                                                                                                                                                                      |       | 95,561                      |       | 91,082                          |       |
| Prepaid expenses and other assets                                                                                                                                                       |       | 21,833                      |       | 20,172                          |       |
| Derivative assets, net                                                                                                                                                                  |       | 28,237                      |       | 20,161                          |       |
| Deferred tax asset, net                                                                                                                                                                 |       | 16,809                      |       | 15,880                          |       |
| Furniture and equipment, net                                                                                                                                                            |       | 9,205                       |       | 9,815                           |       |
| Total assets                                                                                                                                                                            |       | $                           | 5,630,917  |                            | 5,363,717  |   |
| ** **                                                                                                                                                                              |       |                        |       |                            |       |
| **Liabilities  and Shareholders’ Equity**                                                                                                                                          |       |                        |       |                            |       |
| Warehouse financing—loans held for sale                                                                                                                                            |       | $                           | 361,747    |                            | 188,496    |   |
| Warehouse financing—loans held for  investment                                                                                                                                     |       | 670,004                     |       | 521,506                         |       |
| Securitization financing                                                                                                                                                                |       | 3,968,008                   |       | 4,050,786                       |       |
| Reserve for losses—loans sold                                                                                                                                                      |       | 38,411                      |       | 33,302                          |       |
| Dividends payable                                                                                                                                                                       |       | —                      |       | 21,501                          |       |
| Accounts payable and accrued expenses                                                                                                                                                   |       | 23,551                      |       | 21,788                          |       |
| Total liabilities                                                                                                                                                                       |       | 5,061,721                   |       | 4,837,379                       |       |
|                                                                                                                                                                                    |       |                        |       |                            |       |
| Commitments and contingencies                                                                                                                                                           |       | —                      |       | —                          |       |
|                                                                                                                                                                                    |       |                        |       |                            |       |
| Shareholders’ equity:                                                                                                                                                              |       |                        |       |                            |       |
| Common stock $0.01 par value; 90,000,000  shares authorized; 48,835,876 and 48,855,876 shares issued and outstanding as  of June 30, 2005 and December 31, 2004, respectively |       | 488                         |       | 489                             |       |
| Paid-in capital                                                                                                                                                                         |       | 497,244                     |       | 497,147                         |       |
| Accumulated earnings                                                                                                                                                                    |       | 76,913                      |       | 34,687                          |       |
| Unearned compensation                                                                                                                                                                   |       | (5,449                      | )          | (5,985                          | )          |
| Total shareholders’ equity                                                                                                                                                         |       | 569,196                     |       | 526,338                         |       |
|                                                                                                                                                                                    |       |                        |       |                            |       |
| Total liabilities and shareholders’ equity                                                                                                                                         |       | $                           | 5,630,917  |                            | 5,363,717  |   |

 

See accompanying notes to consolidatedfinancial statements.

 

3

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**FIELDSTONEINVESTMENT CORPORATION AND SUBSIDIARIES**

**Consolidated Statements of Operations**

**Threeand Six Months Ended June 30, 2005 and 2004(Unaudited; in thousands, except share and per share data)**

** **
| ** **                                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                                 |       |                                  |       |                                |       |   |   |   |   |
| Interest income:                                          |       |                                  |       |                                |       |   |   |   |   |
| Loans held for investment                                 |       | $                                     | 80,574     |                                | 42,408     |   | 163,410 |   | 69,998 |   |
| Loans held for sale                                       |       | 14,226                                |       | 6,139                               |       | 19,598 |   | 12,591 |   |
| Total interest income                                     |       | 94,800                                |       | 48,547                              |       | 183,008 |   | 82,589 |   |
|                                                      |       |                                  |       |                                |       |   |   |   |   |
| Interest expense:                                         |       |                                  |       |                                |       |   |   |   |   |
| Loans held for investment                                 |       | 41,773                                |       | 11,266                              |       | 80,381 |   | 18,431 |   |
| Loans held for sale                                       |       | 6,276                                 |       | 1,318                               |       | 7,689 |   | 2,728 |   |
| Total interest expense                                    |       | 48,049                                |       | 12,584                              |       | 88,070 |   | 21,159 |   |
|                                                      |       |                                  |       |                                |       |   |   |   |   |
| Net interest income                                       |       | 46,751                                |       | 35,963                              |       | 94,938 |   | 61,430 |   |
|                                                      |       |                                  |       |                                |       |   |   |   |   |
| Provision for loan losses—loans held for  investment |       | 6,863                                 |       | 6,778                               |       | 11,357 |   | 8,957 |   |
|                                                      |       |                                  |       |                                |       |   |   |   |   |
| Net interest income after provision for  loan losses      |       | 39,888                                |       | 29,185                              |       | 83,581 |   | 52,473 |   |
|                                                      |       |                                  |       |                                |       |   |   |   |   |
| Gains on sales of mortgage loans, net                     |       | 27,254                                |       | 12,950                              |       | 36,923 |   | 27,118 |   |
| Other income (expense)—portfolio  derivatives        |       | (9,432                                | )          | 20,376                              |       | 10,910 |   | 10,544 |   |
| Fees and other income                                     |       | 144                                   |       | 988                                 |       | 537 |   | 1,831 |   |
| Total revenues                                            |       | 57,854                                |       | 63,499                              |       | 131,951 |   | 91,966 |   |
|                                                      |       |                                  |       |                                |       |   |   |   |   |
| Expenses:                                                 |       |                                  |       |                                |       |   |   |   |   |
| Salaries and employee benefits                            |       | 19,707                                |       | 20,665                              |       | 39,449 |   | 41,727 |   |
| Occupancy                                                 |       | 1,975                                 |       | 1,570                               |       | 3,770 |   | 3,067 |   |
| Depreciation and amortization                             |       | 828                                   |       | 609                                 |       | 1,623 |   | 1,128 |   |
| Servicing fees                                            |       | 1,743                                 |       | 1,272                               |       | 4,347 |   | 1,926 |   |
| General and administration                                |       | 7,792                                 |       | 7,948                               |       | 15,790 |   | 14,764 |   |
| Total expenses                                            |       | 32,045                                |       | 32,064                              |       | 64,979 |   | 62,612 |   |
|                                                      |       |                                  |       |                                |       |   |   |   |   |
| Income before income taxes                                |       | 25,809                                |       | 31,435                              |       | 66,972 |   | 29,354 |   |
|                                                      |       |                                  |       |                                |       |   |   |   |   |
| Provision for income tax expense                          |       | (2,734                                | )          | (1,312                              | )          | (1,793 | ) | (3,002 | ) |
|                                                      |       |                                  |       |                                |       |   |   |   |   |
| Net income                                                |       | $                                     | 23,075     |                                | 30,123     |   | 65,179 |   | 26,352 |   |
|                                                      |       |                                  |       |                                |       |   |   |   |   |
| Earnings per share of common stock:                       |       |                                  |       |                                |       |   |   |   |   |
| Basic                                                     |       | $                                     | 0.47       |                                | 0.62       |   | 1.34 |   | 0.54 |   |
| Diluted                                                   |       | $                                     | 0.47       |                                | 0.62       |   | 1.34 |   | 0.54 |   |
|                                                      |       |                                  |       |                                |       |   |   |   |   |   |
| Basic weighted average common shares  outstanding         |       | 48,462,126                            |       | 48,325,860                          |       | 48,462,057 |   | 48,325,860 |   |
| Diluted weighted average common shares  outstanding       |       | 48,462,126                            |       | 48,522,174                          |       | 48,462,057 |   | 48,554,060 |   |

 

See accompanying notes to consolidatedfinancial statements.

 

4

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**FIELDSTONEINVESTMENT CORPORATION AND SUBSIDIARIES**

**Consolidated Statements of Cash Flows**

**SixMonths Ended June 30, 2005 and 2004(Unaudited; in thousands)**

** **
| ** **                                                                             | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                             | ** ** | **2005**                            | ** ** | **2004** | ** ** |
| Cash flows from operating activities:                                                  |       |                                |       |   |   |
| Net income                                                                             |       | $                                   | 65,179     |   | 26,352 |   |
|                                                                                   |       |                                |       |   |   |
| Adjustments to reconcile net income to net  cash provided by operating activities:     |       |                                |       |   |   |
| Depreciation and amortization                                                          |       | 1,623                               |       | 1,128 |   |
| Amortization of deferred origination costs—loans  held for investment             |       | 10,786                              |       | 3,507 |   |
| Amortization of securitization issuance  costs                                         |       | 4,107                               |       | 1,066 |   |
| Amortization of bond discount                                                          |       | 148                                 |       | 230 |   |
| Provision for losses—loans sold                                                   |       | 6,128                               |       | 7,396 |   |
| Provision for loan losses—loans held for  investment                              |       | 11,357                              |       | 8,957 |   |
| (Increase) decrease in restricted cash                                                 |       | (1,924                              | )          | 3,153 |   |
| (Increase) decrease in accounts receivable                                             |       | 2,122                               |       | (3,875 | ) |
| Increase in accrued interest receivable                                                |       | (997                                | )          | (10,697 | ) |
| Increase in receivable due from trustee                                                |       | (4,479                              | )          | (8,022 | ) |
| Funding of mortgage loans held for sale                                                |       | (2,012,328                          | )          | (1,696,249 | ) |
| Proceeds from sales of mortgage loans held  for sale                                   |       | 2,350,536                           |       | 1,853,377 |   |
| Increase in prepaid expenses and other  assets                                         |       | (2,457                              | )          | (4,827 | ) |
| Increase in deferred tax asset, net                                                    |       | (929                                | )          | (1,532 | ) |
| Increase in derivative assets, net                                                     |       | (8,076                              | )          | (13,747 | ) |
| Increase (decrease) in accounts payable and  accrued expenses                          |       | 1,763                               |       | (8,282 | ) |
| Stock compensation expense                                                             |       | 1,017                               |       | 1,108 |   |
| Net cash provided by operating activities                                              |       | 423,576                             |       | 159,043 |   |
|                                                                                   |       |                                |       |   |   |
| Cash flows from investing activities:                                                  |       |                                |       |   |   |
| Funding of mortgage loans held for  investment                                         |       | (1,469,177                          | )          | (1,958,303 | ) |
| Payments of mortgage loans held for  investment                                        |       | 823,559                             |       | 121,228 |   |
| Purchase of furniture and equipment, net                                               |       | (1,013                              | )          | (4,322 | ) |
| Proceeds from sale of real estate owned                                                |       | 5,825                               |       | 1,189 |   |
| Net cash used in investing activities                                                  |       | (640,806                            | )          | (1,840,208 | ) |
|                                                                                   |       |                                |       |   |   |
| Cash flows from financing activities:                                                  |       |                                |       |   |   |
| Proceeds from warehouse financing—loans  held for sale                            |       | 2,184,318                           |       | 1,648,249 |   |
| Repayment of warehouse financing—loans held  for sale                             |       | (2,011,067                          | )          | (1,809,225 | ) |
| Proceeds from warehouse financing—loans  held for investment                      |       | 917,098                             |       | 2,246,664 |   |
| Repayment of warehouse financing—loans held  for investment                       |       | (768,600                            | )          | (1,915,354 | ) |
| Proceeds from securitization financing                                                 |       | 728,625                             |       | 1,496,864 |   |
| Repayment of securitization financing                                                  |       | (811,551                            | )          | (106,580 | ) |
| Dividends paid                                                                         |       | (44,454                             | )          | (3,420 | ) |
| Costs relating to the issuance of common stock                                         |       | (423                                | )          | — |   |
| Proceeds from exercise of stock options                                                |       | 38                                  |       | — |   |
| Net cash provided by financing activities                                              |       | 193,984                             |       | 1,557,198 |   |
| Net decrease in cash                                                                   |       | (23,246                             | )          | (123,967 | ) |
| Cash at the beginning of the period                                                    |       | 61,681                              |       | 158,254 |   |
| Cash at the end of the period                                                          |       | $                                   | 38,435     |   | 34,287 |   |
|                                                                                   |       |                                |       |   |   |
| Supplemental disclosures:                                                              |       |                                |       |   |   |
| Cash paid for interest                                                                 |       | $                                   | 87,290     |   | 27,810 |   |
| Cash paid (received) for taxes                                                         |       | (116                                | )          | 8,350 |   |
|                                                                                   |       |                                |       |   |   |
| Noncash investing and financing activities:                                            |       |                                |       |   |   |
| Transfer from mortgage loans held for sale  to real estate owned                       |       | 405                                 |       | 226 |   |
| Transfer from mortgage loans held for  investment to real estate owned                 |       | 12,558                              |       | — |   |
| Transfer from mortgage loans held for  investment to mortgage loans held for sale, net |       | 530,830                             |       | — |   |

 

See accompanying notes to consolidatedfinancial statements.

 

5

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**FIELDSTONEINVESTMENT CORPORATION AND SUBSIDIARIES**

**Notes to Consolidated Financial Statements**

**June 30,2005 and 2004**

** **

**(Unaudited)**

** **

**(1)    Organization**

** **

***(a)  Organization***

*** ***

Fieldstone Mortgage Company(FMC) was incorporated in the State of Maryland on April 27, 1995 underthe name Fieldstone Management Company. Fieldstone Investment Corporation (FIC)was incorporated in the State of Maryland on August 20, 2003, as a whollyowned subsidiary of Fieldstone Holdings Corp. (FHC). FHC was incorporated inthe State of Delaware in February 1998. In July 1998, FHC purchased100% of the shares of FMC. Prior to 2003, FHC operated as a taxable Ccorporation. Effective January 1, 2003, FHC elected to be taxed as an SCorporation.

 

In November 2003, FHCmerged with and into FIC, with FIC as the surviving entity, in a transactionthat was accounted for as a merger of entities under common control whereby thehistorical cost basis of the assets and liabilities was retained. Effectivewith the merger in November 2003, FIC elected to be taxed as a Real EstateInvestment Trust (REIT) for federal income tax purposes, and FMC, its whollyowned subsidiary, elected to be taxed as a Taxable REIT Subsidiary (TRS).

 

On February 3, 2004,FIC formed two wholly owned subsidiaries, Fieldstone Mortgage Ownership Corp.(FMOC) and Fieldstone Servicing Corp. (FSC), as Maryland corporations, whichare treated as qualified REIT subsidiaries. FMOC holds securities and ownershipinterests in owner trusts and other financing vehicles, including securitiesissued by FIC or on FIC’s behalf. FMOC holds the residual interest in FIC’ssecuritized pools of mortgage loans, as well as any derivatives designated aseconomic interest rate hedges related to securitized debt. FSC holds the rightsto direct the servicing of the mortgage loans held for investment.

 

During thesecond quarter of 2005, FIC formed two wholly owned, limited purpose financingsubsidiaries, Fieldstone Mortgage Investment Corporation (FMIC), a Marylandcorporation, and Fieldstone Investment Funding LLC (FIF), a Delaware limitedliability company, which are treated as qualified REIT subsidiaries.  FMIC was formed for the purpose offacilitating the financing and sale of mortgage loans and mortgage-relatedassets by issuing and selling securities secured primarily by, or evidencinginterests in, mortgage loans and mortgage-related assets.  FIF was formed for the purpose offacilitating the financing of mortgage loans through a conduit commercial paper facility.

 

FMC originates, purchases,and sells, non-conforming and conforming residential mortgage loans and engagesin other activities related to mortgage banking. FMC originates residentialmortgage loans through over 4,700 independent mortgage brokers serviced by 15regional wholesale operations centers and a network of retail branch officeslocated throughout the country.

 

The accompanying unauditedconsolidated financial statements include the accounts of Fieldstone InvestmentCorporation and its subsidiaries (together, the Company) and have been preparedin accordance with accounting principles generally accepted in the UnitedStates of America (GAAP) for interim financial information and with the instructionsto Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they donot include all of the information and footnotes required by GAAP for completefinancial statements. All significant intercompany balances and transactionshave been eliminated in consolidation. Certain amounts in the prior period’sunaudited consolidated financial statements have been reclassified to conformto the current period presentation.

 

In the opinion ofmanagement, the accompanying unaudited consolidated financial statementscontain all adjustments, consisting of normal recurring accruals, necessary fora fair presentation. The results of operations and other data for the three andsix months ended June 30, 2005 are not necessarily indicative of theresults that may be expected for any other interim periods or the fiscal yearending December 31, 2005. The unaudited consolidated

 

6

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financial statements presentedherein should be read in conjunction with the audited consolidated financialstatements and related notes thereto in the Company’s Annual Report on Form 10-Kfor the fiscal year ended December 31, 2004.

 

***(b)  Use of Estimates***

*** ***

The preparation ofconsolidated financial statements in conformity with GAAP requires management tomake estimates and assumptions that affect the reported amounts of assets andliabilities, disclosures of contingent assets and liabilities at the date ofthe financial statements and the reported amounts of revenues and expensesduring the reporting period.  Criticalestimates include (i) an estimate of the future loan prepayment rate ofmortgage loans held for investment, which is used in the calculation ofdeferred origination and bond issuance cost amortization; (ii) an estimate oflosses inherent in mortgage loans held for investment, which is used todetermine the related allowance for loan losses and realizable value of theCompany’s accrued interest receivable and (iii) an estimate of therepresentation and warranty liabilities related to the sale of mortgageloans.  Actual results could differ fromthose estimates. Amounts on the consolidated statements of operations mostaffected by the use of estimates are the reserve for losses—loans sold (whichis a component of gains on sales of mortgage loans, net), provision for loanlosses—loans held for investment, interest income – loans held for investment,derivative valuations (which are a component of other income(expense)—portfolio derivatives), stock-based compensation (which is acomponent of salaries and employee benefits) and deferred origination andissuance costs (which are components of net interest income after provision forloan losses for loans held for investment and gains on sales of mortgage loans,net, for loans held for sale).

 

**(2)    Mortgage Loans Held for Sale and Reserve forLosses—Loans Sold**

** **

Mortgage loans that theCompany acquires or originates with the intent to sell in the foreseeablefuture are initially recorded at cost including any premium paid or discountreceived, adjusted for the fair value change during the period in which theloan was an interest rate lock commitment. Loans held for sale are carried atthe lower of cost or market value calculated on an aggregate basis by type ofloan. Mortgage loans held for sale, net, as of June 30, 2005 and December 31,2004 are as follows (in thousands): 

 
| ** **                                  | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Mortgage loans held for sale                |       | $                       | 545,159    |                        | 356,408    |   |
| Net deferred origination costs              |       | 1,700                   |       | 1,031                       |       |
| Premium, net of discount                    |       | 2,445                   |       | 1,505                       |       |
| Allowance for lower of cost or market value |       | (858                    | )          | (1,894                      | )          |
| Total                                       |       | $                       | 548,446    |                        | 357,050    |   |

 

In April 2005,management determined that the forecasted rate of return on approximately $640million of loans held for investment but not yet securitized did not meet ourminimum return levels for investment of capital, and transferred these loansfrom held for investment to held for sale. Once classified as held for sale, on April 20, 2005, the TRS purchasedthese loans from the REIT at a gross price of 102.7%, which managementestimated to be the fair value of the loans on the transfer date as determinedby current market conditions and recent loan sale commitments.  The TRS, which is in the business of sellingpools of loans on a whole-loan basis, solicited third-party bids for thepurchase of a pool of non-conforming mortgage loans, including the loanspurchased from the REIT.  On April 21,2005, upon receipt and review of firm commitment bids, the TRS committed tosell a pool of approximately $1.0 billion of non-conforming mortgage loans to athird-party at a gross price of 103.5%. The third-party sale closed in May2005.

 

The Company maintains areserve for its representation and warranty liabilities related to the sale ofloans and for its contractual obligations to rebate a portion of any premiumpaid by an investor when a sold loan prepays within an agreed period. Thereserve, which is recorded as a liability on the consolidated statements ofcondition, is established when loans are sold, and is calculated as the fairvalue of liabilities reasonably estimated to occur during the life of therelated sold loans. The provision is recorded as a reduction of gains on salesof mortgage loans.  The adequacy of thisreserve for losses – loans sold is reviewed on a quarterly basis and adjusted,as necessary, based on this review.

 

The reserve for losses—loanssold is summarized as follows for the six months ended June 30, 2004 and2005 (in thousands):

 

7

----

 

| Balance at December 31, 2003 |   | $      | 31,965 |   |
|-----------------------------------|--------|--------|--------|--------|
| Provision                         |   | 7,396  |   |
| Realized losses                   |   | (4,162 | )      |
| Recoveries                        |   | 609    |   |
| Balance at June 30, 2004     |   | $      | 35,808 |   |
|                              |   |   |   |
| Balance at December 31, 2004 |   | $      | 33,302 |   |
| Provision                         |   | 6,128  |   |
| Realized losses                   |   | (1,102 | )      |
| Recoveries                        |   | 83     |   |
| Balance at June 30, 2005     |   | $      | 38,411 |   |

 

Historically,the Company has experienced substantially all of its representation andwarranty losses on loans sold during the first three years following the sale.The reserve for losses—loans sold as of June 30, 2005 and 2004 primarilyrelate to loan sales, which approximated $14.3 billion during the periodof July 1, 2002 through June 30, 2005 and $12.9 billion duringthe period July 1, 2001 through June 30, 2004, respectively.

 

**(3)    Mortgage Loans Held for Investment andAllowance for Loan Losses**

** **

The Company originatesfixed-rate and adjustable-rate mortgage loans that have a contractual maturityof up to 30 years. These mortgage loans are initially recorded at costincluding any premium or discount and deferred loan fees and costs. Thesemortgage loans are financed with warehouse debt until they are pledged ascollateral for securitization financing. The Company is exposed to risk of lossfrom its mortgage loan portfolio and establishes an allowance for loan lossestaking into account a variety of criteria, including the contractualdelinquency status, market delinquency roll rates and market historical lossseverities. The adequacy of this allowance for loan loss is reviewed on aquarterly basis and adjusted, as necessary, based on this review.

 

The following is a detail ofthe mortgage loans held for investment, net as of June 30, 2005 and December 31,2004 (in thousands): 

 
| ** **                                                  | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Mortgage loans held for investment—securitized         |       | $                       | 4,082,938  |                        | 4,156,790  |   |
| Mortgage loans held for investment—warehouse  financed |       | 745,631                 |       | 578,273                     |       |
| Net deferred origination fees and costs                     |       | 37,945                  |       | 39,693                      |       |
| Mortgage loans held for investment                          |       | 4,866,514               |       | 4,774,756                   |       |
| Allowance for loan losses—loans held for  investment   |       | (30,690                 | )          | (22,648                     | )          |
| Mortgage loans held for investment, net                     |       | $                       | 4,835,824  |                        | 4,752,108  |   |

 

The allowance for loanlosses—loans held for investment is summarized as follows for the six monthsended June 30, 2004 and 2005 (in thousands): 

 

8

----

 

| Balance at December 31, 2003 |   | $      | 2,078  |   |
|-----------------------------------|--------|--------|--------|--------|
| Provision                         |   | 8,957  |   |
| Charge—offs                  |   | (1     | )      |
| Recoveries                        |   | — |   |
| Balance at June 30, 2004     |   | $      | 11,034 |   |
|                              |   |   |   |
| Balance at December 31, 2004 |   | $      | 22,648 |   |
| Provision                         |   | 11,357 |   |
| Charge—offs                  |   | (3,660 | )      |
| Recoveries                        |   | 345    |   |
| Balance at June 30, 2005     |   | $      | 30,690 |   |

 

Mortgage loans held forinvestment, which were on non-accrual status for interest income recognitiondue to delinquencies greater than 90 days, were $63.9 million,$40.6 million and $12.1 million as of June 30, 2005, December 31,2004 and June 30, 2004, respectively.

 

**(4)    Warehouse Financing, Loans Held for Sale andLoans Held for Investment**

** **

At June 30, 2005, theCompany had a total of $1.75 billion of committed warehouse lines of credit andrepurchase facilities with five financial entities.  At December 31, 2004, the Company had atotal of $1.9 billion of warehouse lines of credit and repurchasefacilities with six financial entities, of which $1.85 billion of the totalfunds available were committed facilities and $50.0 million wereuncommitted.  The facilities areaccounted for as short-term liabilities, secured by mortgage loans held forinvestment to be securitized, mortgage loans held for sale, the relatedinvestor commitments to purchase those loans held for sale, and all proceedsthereof.

 

Warehouse lines of creditand repurchase facilities consist of the following at June 30, 2005 and December 31,2004 (dollars in millions): 

 
| **Agreements as of June 30, 2005**          | ** ** | **Amount  Outstanding as of** | ** ** |
|---------------------------------------------|------------|-----------------------------------------|------------|
| **Lender**                                  | ** ** | **Amount  Available**                   | ** ** | **Maturity  Date** | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
| Countrywide Warehouse Lending               |       | $                                       | 100.0      |   | July 2005 |   | $ | 66.3 |   | 21.5 |   |
| Credit Suisse First Boston Mortgage Capital |       | 500.0                                   |       | February 2006 |   | 419.1 |   | 291.1 |   |
| Guaranty Bank Warehouse Facility            |       | 0.0                                     |       | Not renewed |   | 0.0 |   | 25.6 |   |
| JP Morgan Chase Bank                        |       | 150.0                                   |       | April 2006 |   | 123.1 |   | 77.3 |   |
| Lehman Brothers Bank                        |       | 500.0                                   |       | December 2005 |   | 329.1 |   | 228.0 |   |
| Merrill Lynch Bank USA                      |       | 500.0                                   |       | November 2005 |   | 94.2 |   | 66.5 |   |
| Total                                       |       | $                                       | 1,750.0    |   |   |   | $ | 1,031.8 |   | 710.0 |   |

 

The interest rates are basedon spreads to one month or overnight LIBOR, and are generally reset daily orweekly. The Company also pays facility fees based on the commitment amount andnon-use fees. A summary of coupon interest expense and facility fees, includedin total interest expense in the consolidated statements of operations, and theweighted average cost of funds of the warehouse lines of credit and repurchasefacilities for the three and six months ended June 30, 2005 and 2004 is asfollows (in thousands): 

 

| ** **              | ** ** | **Three Months Ended June 30,** | ** ** |
|-------------------------|------------|--------------------------------------|------------|
| ** **              | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **              | ** ** | **Amount**                           | ** ** | **Weighted  Average  Cost** | ** ** | **Amount** | ** ** | **Weighted  Average  Cost** | ** ** |
| Coupon interest expense |       | $                                    | 7,859      |   | 3.8 | % | $ | 3,969 |   | 2.0 | % |
| Facilities fees         |       | 798                                  |       | 0.4 | % | 943 |   | 0.4 | % |
| Total                   |       | $                                    | 8,657      |   | 4.2 | % | $ | 4,912 |   | 2.4 | % |

 

9

----

 

| ** **              | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------|------------|------------------------------------|------------|
| ** **              | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| ** **              | ** ** | **Amount**                         | ** ** | **Weighted  Average  Cost** | ** ** | **Amount** | ** ** | **Weighted  Average  Cost** | ** ** |
| Coupon interest expense |       | $                                  | 13,342     |   | 3.6 | % | $ | 7,686 |   | 1.9 | % |
| Facilities fees         |       | 1,632                              |       | 0.4 | % | 1,863 |   | 0.5 | % |
| Total                   |       | $                                  | 14,974     |   | 4.0 | % | $ | 9,549 |   | 2.4 | % |

 

The warehouse lines andrepurchase facilities generally have a term of 364 days or less.Management expects to renew these lines of credit prior to their respectivematurity dates. The Countrywide Warehouse Lending facility has been renewedthrough August 2006.  The creditfacilities are secured by substantially all of our unsecuritized mortgage loansand contain customary financial and operating covenants that require us tomaintain specified levels of liquidity and net worth, restrict indebtedness andinvestments and require compliance with applicable laws. The Company was incompliance with all of these covenants at June 30, 2005 and December 31,2004, respectively.

 

**(5)    Securitization Financing**

** **

During the six months ended June 30,2005, the Company issued $0.7 billion of additional mortgage-backed bondsthrough securitization trusts to finance the Company’s portfolio of loans heldfor investment. Interest rates on these bonds reset monthly and are indexed toone-month LIBOR. The bonds pay interest monthly based upon a spread over LIBOR.The estimated average life of the bonds is approximately 23 months, and isbased on assumptions made by management. The actual period from inception tomaturity may differ from expectations. The bonds are repaid from the cash flowsreceived from the mortgage loans pledged to the trust.

 

The following is a summaryof the securitization series issued during the six months ended June 30,2005 (dollars in millions):

 
| ** **                      | ** ** | **FMIT  2005-1** | ** ** |
|---------------------------------|------------|------------------|------------|
| Bonds issued                    |       | $                | 729        |   |
| Loans pledged                   |       | $                | 750        |   |
| Deferred bond issuance costs    |       | $                | 2.7        |   |
| Financing costs—LIBOR plus |       | 0.12-2.00        | %          |

 

The average securitizationfinancing outstanding was $4.2 billion for the three and six months ended June 30,2005, $1.7 billion and $1.3 billion for the three and six months ended June 30,2004 and $2.3 billion for the year ended December 31, 2004. Theunamortized bond issuance costs at June 30, 2005 and December 31,2004 were $11.0 million and $12.5 million, respectively.

 

A summary ofinterest expense, amortization of deferred issuance costs and original issuediscount, and the weighted average cost of funds of the securitizationfinancing for the three and six months ended June 30, 2005 and 2004 is asfollows (in thousands):

 
| ** **                                            | ** ** | **Three Months Ended June 30,** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **2005**                             | ** ** | **2004** | ** ** |
| ** **                                            | ** ** | **Amount**                           | ** ** | **Weighted  Average  Cost** | ** ** | **Amount** | ** ** | **Weighted  Average  Cost** | ** ** |
| Coupon interest expense                               |       | $                                    | 37,198     |   | 3.5 | % | $ | 6,850 |   | 1.5 | % |
| Amortization of deferred costs                        |       | 2,109                                |       | 0.2 | % | 700 |   | 0.2 | % |
| Amortization of bond discount                         |       | 85                                   |       | 0.0 | % | 122 |   | 0.0 | % |
| Total interest expense—securitization  financing |       | $                                    | 39,392     |   | 3.7 | % | $ | 7,672 |   | 1.7 | % |

 

10

----

 
| ** **                                            | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                            | ** ** | **2005**                           | ** ** | **2004** | ** ** |
| ** **                                            | ** ** | **Amount**                         | ** ** | **Weighted  Average  Cost** | ** ** | **Amount** | ** ** | **Weighted  Average  Cost** | ** ** |
| Coupon interest expense                               |       | $                                  | 68,841     |   | 3.3 | % | $ | 10,314 |   | 1.6 | % |
| Amortization of deferred costs                        |       | 4,107                              |       | 0.2 | % | 1,066 |   | 0.2 | % |
| Amortization of bond discount                         |       | 148                                |       | 0.0 | % | 230 |   | 0.0 | % |
| Total interest expense—securitization  financing |       | $                                  | 73,096     |   | 3.5 | % | $ | 11,610 |   | 1.8 | % |

 

Thefollowing is a summary of the outstanding securitization bond financing byseries as of June 30, 2005 and December 31, 2004 (in thousands):

 
| ** **                     | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|--------------------------------|------------|------------------------|------------|---------------------------------|------------|
| FMIT Series 2005-1        |       | $                      | 690,744    |                            | —     |   |
| FMIT Series 2004-5        |       | 768,013                |       | 861,403                         |       |
| FMIT Series 2004-4        |       | 692,985                |       | 816,527                         |       |
| FMIT Series 2004-3        |       | 714,969                |       | 879,659                         |       |
| FMIT Series 2004-2        |       | 502,954                |       | 692,854                         |       |
| FMIT Series 2004-1        |       | 353,117                |       | 484,025                         |       |
| FMIC Series 2003-1        |       | 245,578                |       | 316,817                         |       |
|                           |       | 3,968,360              |       | 4,051,285                       |       |
| Unamortized bond discount      |       | (352                   | )          | (499                            | )          |
| Total securitization financing |       | $                      | 3,968,008  |                            | 4,050,786  |   |

 

Thecurrent carrying amount of the mortgage loans pledged to the securitizationtrusts was $4.1 billion and $4.2 billion as of June 30, 2005 and December 31,2004, respectively.

 

**(6)    Segment Information**

** **

The information presentedbelow with respect to the Company’s reportable segments is consistent with thecontent of the business segment data provided to the Company’s management. Thissegment data uses a combination of business lines and channels to assessconsolidated results. The Company has six reportable segments, which includefour production segments, Non-Conforming Wholesale, Non-Conforming Retail,Conforming Wholesale, Conforming Retail, and two operating segments whichinclude Investment Portfolio, and Corporate.

 

The Company originates loansthrough two channels: a non-conforming channel and a conforming channel, eachof which operates both wholesale and retail divisions. The Investment Portfoliosegment primarily includes the net interest income earned by the loans held forinvestment. In addition, the Company has a Corporate segment that includes thetiming and other differences between revenues and costs recognized for GAAP ascompared to amounts allocated to the production segments. The Corporate segmentalso includes the effects of the deferral and capitalization of net originationcosts as required by FASB Statement No. 91, “*Accounting for Nonrefundable Fees and Costs Associated with Originatingor Acquiring Loans and Initial Direct Costs of Leases.*” Financialinformation by segment is evaluated regularly by management and used indecision-making relating to the allocation of resources and the assessment ofcompany performance. The Company manages the business on a pre-tax basis andtherefore all income tax expense or benefit is allocated to the Corporatesegment. For the purposes of segment information provided in the tables below,certain fees, origination costs, and other expenses recorded as a component ofgains on sale of mortgage loans, net, have been reflected in total revenues ortotal expenses consistent with intercompany allocations reported to the Company’smanagement. Also, gain on sale revenue is recognized at the time of funding bythe production segments as if all loans will be sold, and adjusted in theCorporate segment to reflect the actual gain on sale recognizable for GAAPrevenue reporting on the loans that are sold. In addition, net interest incomeis recognized on origination volume by the production segments and adjusted inthe Corporate segment for the actual net interest income earned. The Corporatesegment includes reconciling amounts necessary for the segment totals to agreeto the consolidated financial statements.

 

11

----

 

The assets of the Companythat are specifically identified to a segment include mortgage loans held forsale and investment, net, trustee receivable, derivative assets, net andfurniture and equipment, net. All other assets are attributed to the Corporatesegment. Total assets by segment at June 30, 2005 and December 31,2004 are summarized as follows (in thousands): 

 
| ** **                    | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|-------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Non-Conforming—wholesale |       | $                       | 372,492    |                        | 228,653    |   |
| Non-Conforming—retail    |       | 37,280                  |       | 27,014                      |       |
| Conforming—wholesale     |       | 101,418                 |       | 77,691                      |       |
| Conforming—retail        |       | 39,901                  |       | 27,104                      |       |
| Investment Portfolio          |       | 4,960,279               |       | 4,863,544                   |       |
| Corporate                     |       | 119,547                 |       | 139,711                     |       |
| Total                         |       | $                       | 5,630,917  |                        | 5,363,717  |   |

 

Operatingresults by business segment for the three months ending June 30, 2005 areas follows (in thousands):

 
| ** **                                                | ** ** | **Non-Conforming** | ** ** | **Conforming** | ** ** | **Investment** | ** ** | ** ** | ** ** | ** **    | ** ** |
|-----------------------------------------------------------|------------|--------------------|------------|----------------|------------|----------------|------------|------------|------------|---------------|------------|
| ** **                                                | ** ** | **Wholesale**      | ** ** | **Retail**     | ** ** | **Wholesale**  | ** ** | **Retail** | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidation** | ** ** |
| Revenues:                                                 |       |               |       |           |       |           |       |       |       |          |       |   |   |   |   |
| Interest income                                           |       | $                  | 8,928      |           | 1,058      |           | 1,075      |       | 429        |          | 80,574     |   | 2,736 |   | 94,800 |   |
| Interest expense                                          |       | 4,987              |       | 553            |       | 902            |       | 301        |       | 41,773        |       | (467 | ) | 48,049 |   |
| Net interest income                                       |       | 3,941              |       | 505            |       | 173            |       | 128        |       | 38,801        |       | 3,203 |   | 46,751 |   |
| Provision for loan losses—loans held for  investment |       | —             |       | —         |       | —         |       | —     |       | (6,863        | )          | — |   | (6,863 | ) |
| Gains on sales of mortgage loans, net                     |       | 33,792             |       | 8,545          |       | 1,648          |       | 2,052      |       | —        |       | (18,783 | ) | 27,254 |   |
| Other income (expense)—portfolio  derivatives        |       | —             |       | —         |       | —         |       | —     |       | (9,432        | )          | — |   | (9,432 | ) |
| Fee and other income                                      |       | —             |       | 163            |       | —         |       | 453        |       | (570          | )          | 98 |   | 144 |   |
| Total revenues                                            |       | 37,733             |       | 9,213          |       | 1,821          |       | 2,633      |       | 21,936        |       | (15,482 | ) | 57,854 |   |
| Total expenses                                            |       | 25,299             |       | 8,886          |       | 2,344          |       | 3,773      |       | 2,014         |       | (10,271 | ) | 32,045 |   |
| Income (loss) before income taxes                         |       | 12,434             |       | 327            |       | (523           | )          | (1,140     | )          | 19,922        |       | (5,211 | ) | 25,809 |   |
| Provision for income tax expense                          |       | N/A                |       | N/A            |       | N/A            |       | N/A        |       | N/A           |       | (2,734 | ) | (2,734 | ) |
| Net income (loss)                                         |       | $                  | 12,434     |           | 327        |           | (523       | )          | (1,140     | )             | 19,922     |   | (7,945 | ) | 23,075 |   |

 

12

----

 

Operatingresults by business segment for the three months ending June 30, 2004 areas follows (in thousands):

 
| ** **                                                | ** ** | **Non-Conforming** | ** ** | **Conforming** | ** ** | **Investment** | ** ** | ** ** | ** ** | ** **    | ** ** |
|-----------------------------------------------------------|------------|--------------------|------------|----------------|------------|----------------|------------|------------|------------|---------------|------------|
| ** **                                                | ** ** | **Wholesale**      | ** ** | **Retail**     | ** ** | **Wholesale**  | ** ** | **Retail** | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidation** | ** ** |
| Revenues:                                                 |       |               |       |           |       |           |       |       |       |          |       |   |   |   |   |
| Interest income                                           |       | $                  | 3,801      |           | 534        |           | 1,229      |       | 575        |          | 42,408     |   | — |   | 48,547 |   |
| Interest expense                                          |       | 653                |       | 92             |       | 405            |       | 168        |       | 11,266        |       | — |   | 12,584 |   |
| Net interest income                                       |       | 3,148              |       | 442            |       | 824            |       | 407        |       | 31,142        |       | — |   | 35,963 |   |
| Provision for loan losses—loans held for  investment |       | —             |       | —         |       | —         |       | —     |       | (6,778        | )          | — |   | (6,778 | ) |
| Gains on sales of mortgage loans, net                     |       | 36,407             |       | 9,774          |       | 1,382          |       | 3,211      |       | —        |       | (37,824 | ) | 12,950 |   |
| Other income (expense)—portfolio  derivatives        |       | —             |       | —         |       | —         |       | —     |       | 20,376        |       | — |   | 20,376 |   |
| Fee and other income                                      |       | —             |       | 176            |       | —         |       | 668        |       | —        |       | 144 |   | 988 |   |
| Total revenues                                            |       | 39,555             |       | 10,392         |       | 2,206          |       | 4,286      |       | 44,740        |       | (37,680 | ) | 63,499 |   |
| Total expenses                                            |       | 29,682             |       | 10,194         |       | 2,919          |       | 3,852      |       | 1,777         |       | (16,360 | ) | 32,064 |   |
| Income (loss) before income taxes                         |       | 9,873              |       | 198            |       | (713           | )          | 434        |       | 42,963        |       | (21,320 | ) | 31,435 |   |
| Provision for income tax expense                          |       | N/A                |       | N/A            |       | N/A            |       | N/A        |       | N/A           |       | (1,312 | ) | (1,312 | ) |
| Net income (loss)                                         |       | $                  | 9,873      |           | 198        |           | (713       | )          | 434        |          | 42,963     |   | (22,632 | ) | 30,123 |   |

 

Operatingresults by business segment for the six months ending June 30, 2005 are asfollows (in thousands):

 
| ** **                                                | ** ** | **Non-Conforming** | ** ** | **Conforming** | ** ** | **Investment** | ** ** | ** ** | ** ** | ** **    | ** ** |
|-----------------------------------------------------------|------------|--------------------|------------|----------------|------------|----------------|------------|------------|------------|---------------|------------|
| ** **                                                | ** ** | **Wholesale**      | ** ** | **Retail**     | ** ** | **Wholesale**  | ** ** | **Retail** | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidation** | ** ** |
| Revenues:                                                 |       |               |       |           |       |           |       |       |       |          |       |   |   |   |   |
| Interest income                                           |       | $                  | 14,946     |           | 1,868      |           | 2,150      |       | 777        |          | 163,410    |   | (143 | ) | 183,008 |   |
| Interest expense                                          |       | 8,062              |       | 943            |       | 1,766          |       | 555        |       | 80,381        |       | (3,637 | ) | 88,070 |   |
| Net interest income                                       |       | 6,884              |       | 925            |       | 384            |       | 222        |       | 83,029        |       | 3,494 |   | 94,938 |   |
| Provision for loan losses—loans held for  investment |       | —             |       | —         |       | —         |       | —     |       | (11,357       | )          | — |   | (11,357 | ) |
| Gains on sales of mortgage loans, net                     |       | 55,775             |       | 14,925         |       | 3,054          |       | 3,962      |       | —        |       | (40,793 | ) | 36,923 |   |
| Other income (expense)—portfolio  derivatives        |       | —             |       | —         |       | —         |       | —     |       | 10,910        |       | — |   | 10,910 |   |
| Fee and other income                                      |       | —             |       | 350            |       | —         |       | 809        |       | (771          | )          | 149 |   | 537 |   |
| Total revenues                                            |       | 62,659             |       | 16,200         |       | 3,438          |       | 4,993      |       | 81,811        |       | (37,150 | ) | 131,951 |   |
| Total expenses                                            |       | 46,449             |       | 17,308         |       | 4,644          |       | 7,122      |       | 4,998         |       | (15,542 | ) | 64,979 |   |
| Income (loss) before income taxes                         |       | 16,210             |       | (1,108         | )          | (1,206         | )          | (2,129     | )          | 76,813        |       | (21,608 | ) | 66,972 |   |
| Provision for income tax expense                          |       | N/A                |       | N/A            |       | N/A            |       | N/A        |       | N/A           |       | (1,793 | ) | (1,793 | ) |
| Net income (loss)                                         |       | $                  | 16,210     |           | (1,108     | )              | (1,206     | )          | (2,129     | )             | 76,813     |   | (23,401 | ) | 65,179 |   |

 

13

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Operatingresults by business segment for the six months ending June 30, 2004 are asfollows (in thousands):

 
| **`**                                                     | ** ** | **Non-Conforming** | ** ** | **Conforming** | ** ** | **Investment** | ** ** | ** ** | ** ** | ** **    | ** ** |
|-----------------------------------------------------------|------------|--------------------|------------|----------------|------------|----------------|------------|------------|------------|---------------|------------|
| ** **                                                | ** ** | **Wholesale**      | ** ** | **Retail**     | ** ** | **Wholesale**  | ** ** | **Retail** | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidation** | ** ** |
| Revenues:                                                 |       |               |       |           |       |           |       |       |       |          |       |   |   |   |   |
| Interest income                                           |       | $                  | 8,232      |           | 1,247      |           | 2,110      |       | 1,002      |          | 69,998     |   | — |   | 82,589 |   |
| Interest expense                                          |       | 1,531              |       | 228            |       | 677            |       | 292        |       | 18,431        |       | — |   | 21,159 |   |
| Net interest income                                       |       | 6,701              |       | 1,019          |       | 1,433          |       | 710        |       | 51,567        |       | — |   | 61,430 |   |
| Provision for loan losses—loans held for  investment |       | —             |       | —         |       | —         |       | —     |       | (8,957        | )          | — |   | (8,957 | ) |
| Gains on sales of mortgage loans, net                     |       | 65,010             |       | 19,644         |       | 2,785          |       | 6,382      |       | —        |       | (66,703 | ) | 27,118 |   |
| Other income (expense)—portfolio  derivatives        |       | —             |       | —         |       | —         |       | —     |       | 10,544        |       | — |   | 10,544 |   |
| Fee and other income                                      |       | —             |       | 355            |       | —         |       | 1,114      |       | —        |       | 362 |   | 1,831 |   |
| Total revenues                                            |       | 71,711             |       | 21,018         |       | 4,218          |       | 8,206      |       | 53,154        |       | (66,341 | ) | 91,966 |   |
| Total expenses                                            |       | 53,663             |       | 20,222         |       | 5,470          |       | 7,449      |       | 2,441         |       | (26,633 | ) | 62,612 |   |
| Income (loss) before income taxes                         |       | 18,048             |       | 796            |       | (1,252         | )          | 757        |       | 50,713        |       | (39,708 | ) | 29,354 |   |
| Provision for income tax expense                          |       | N/A                |       | N/A            |       | N/A            |       | N/A        |       | N/A           |       | (3,002 | ) | (3,002 | ) |
| Net income (loss)                                         |       | $                  | 18,048     |           | 796        |           | (1,252     | )          | 757        |          | 50,713     |   | (42,710 | ) | 26,352 |   |

 

**(7)   Stock-Based Compensation**

 

On May 6, 2005, the CompensationCommittee of the Board of Directors, pursuant to the Fieldstone InvestmentCorporation Equity Incentive Plan (the “Stock Plan”), granted to certain of ourkey officers and key employees, 138,400 non-qualified stock options with dividendequivalent rights (“Options with DERs”). The exercise price was $12.70, which was the closing price of theCompany’s common stock on the date of grant. One hundred percent of the options vest on March 31, 2009 with aterm expiring on March 31, 2012.  Whilethe option is unvested, dividend equivalents are earned based on the number ofoption shares held and are deemed invested in phantom shares of the Company’scommon stock at the closing price of the stock on the dividend paymentdate.  The phantom shares also will becredited with dividend equivalent rights at the same time and in the sameamount as cash dividends are paid on the Company’s common stock.  The total value of dividend equivalents,adjusted for the change in value of the phantom shares from date of issuancethrough vest date, will be paid in cash at the time the option vests.

 

In accordance with FASB Statement No. 123,*“Accounting for Stock-Based Compensation,”*the Company expenses its stock-based compensation by applying the fair valuemethod to stock-based compensation using the Black-Scholes option pricingmodel.  Compensation cost of $23.6thousand relating to the issuance of the stock options grant was recorded insalaries and employee benefits for the three months ending June 30, 2005.

 

The following table summarizes the weightedaverage fair value of the Options with DERs, determined using the Black-Scholesoption pricing model, and the assumptions used in their determination.

 

| Fair value, at date of grant   |   | $    | 4.56   |   |
|--------------------------------|--------|------|--------|--------|
| Expected life in years         |   | 5.5  |   |
| Annual risk-free interest rate |   | 4.03 | %      |
| Expected volatility            |   | 30   | %      |
| Expected forfeitures           |   | 20   | %      |
| Expected dividend yield        |   | 0.0  | %      |

 

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On June 22, 2005, the CompensationCommittee, pursuant to the Stock Plan, awarded a maximum of 65,040 shares ofrestricted stock to certain of our executive and senior officers subject tolevel of achievement of certain corporate performance objectives (the “performanceshares”).  The performance shares werevalued at $10.82 per share, with one hundred percent of the shares to vest on March 31,2009.  The performance shares are sharesof restricted stock that are subject to vesting requirements and can be earnedbased primarily on the Company’s achievement of certain return on equitytargets for the period April 1, 2005 through December 31, 2006.  Compensation cost of $6.6 thousand relatingto the issuance of the performance grant was recorded in salaries and employeebenefits for the three months ending June 30, 2005.

 

**(8)    Earnings Per Share**

** **

Informationrelating to the calculations of earnings per share (EPS) of common stock forthe three and six months ended June 30, 2005 and 2004 is summarized asfollows (in thousands, except per share data):

 
| ** **                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                             | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Basic earnings per share:                              |       |                                  |       |                                |       |   |   |   |   |
| Net income                                             |       | $                                     | 23,075     |                                | 30,123     |   | 65,179 |   | 26,352 |   |
| Dividends on unvested restricted stock                 |       | (176                                  | )          | (37                                 | )          | (176 | ) | (37 | ) |
| Adjusted net income used in EPS computation            |       | $                                     | 22,899     |                                | 30,086     |   | 65,003 |   | 26,315 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Weighted average shares outstanding                    |       | 48,462,126                            |       | 48,325,860                          |       | 48,462,057 |   | 48,325,860 |   |
| Earnings per share                                     |       | $                                     | 0.47       |                                | 0.62       |   | 1.34 |   | 0.54 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |   |
| Diluted earnings per share:                            |       |                                  |       |                                |       |   |   |   |   |
| Net income                                             |       | $                                     | 23,075     |                                | 30,123     |   | 65,179 |   | 26,352 |   |
| Dividends on unvested restricted stock                 |       | (176                                  | )          | —                              |       | (176 | ) | — |   |
| Adjusted net income used in EPS computation            |       | $                                     | 22,899     |                                | 30,123     |   | 65,003 |   | 26,352 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |   |
| Weighted average shares outstanding                    |       | 48,462,126                            |       | 48,325,860                          |       | 48,462,057 |   | 48,325,860 |   |
| Dilutive effect of stock options and  restricted stock |       | —                                |       | 196,314                             |       | — |   | 228,200 |   |
| Weighted average shares outstanding,  diluted          |       | 48,462,126                            |       | 48,522,174                          |       | 48,462,057 |   | 48,554,060 |   |
|                                                   |       |                                  |       |                                |       |   |   |   |   |
| Diluted earnings per share                             |       | $                                     | 0.47       |                                | 0.62       |   | 1.34 |   | 0.54 |   |

 

Effects of potentiallydilutive securities are presented only in periods in which they are dilutive.For the three and six months ended June 30, 2005, all outstanding stockcompensation awards were excluded from the calculation of diluted earnings pershare. For the three and six months ended June 30, 2004, 46,000 stockoptions granted in February 2004 were excluded from the calculation ofdiluted earnings per share.  These stockcompensation awards would have an antidilutive effect on earnings per share.

 

**(9)    Commitments and Contingencies**

** **

***(a)  Loan Commitments***

*** ***

AtJune 30, 2005 and December 31, 2004, the Company had originationcommitments outstanding to fund approximately $631 million and$422 million in mortgage loans, respectively. Fixed rate and hybrid ARMmortgages which are fixed for the initial two to three year term of the loancomprised 95.9% and 96.9%, respectively, of the outstanding originationcommitments at June 30, 2005 and December 31, 2004. The Company hadforward delivery commitments to sell approximately $1.4 billion and$0.4 billion of loans at June 30, 2005 and December 31, 2004,respectively, of which $76.0 million and $63.1 million, respectively,were mandatory sales of mortgage backed securities and investor whole loantrades. At June 30, 2005 and December 31, 2004, the Company had acommitment

 

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to sell $400 million and$40 million, respectively, of treasury note forward contracts, used toeconomically hedge the interest rate risk of its non-conforming loans.

 

***(b)  Legal Matters***

*** ***

In 2004, former shareholdersof the Company, whose shares were redeemed for approximately$188.1 million following the closing of the private placement offering in November 2003,filed an action alleging that they are entitled to an additional post-closingredemption price payment of approximately $19.0 million. Presently, theultimate outcome of this claim and the amount of liability, if any, that mayresult is not determinable, and no amounts have been accrued in the Company’sfinancial statements with respect to this claim. Regardless of the outcome, inthe opinion of management, the final resolution of this dispute will not have amaterial effect on the Company’s business, financial condition or results ofoperations. If the Company is unsuccessful in defending this matter, theCompany could be required to make a cash payment of approximately$19.0 million to the former shareholders. Any such payment would be accountedfor as an increase in the redemption price of the shares, and accordingly, willbe recorded as a reduction of paid in capital in the period in which thedispute is resolved, and will have no impact on the Company’s statements ofoperations. In addition, the Company could be required to pay interest orthird-party costs associated with the litigation, which, if payable as part ofa settlement, will be recorded to current period earnings.

 

We are subject to various legal proceedingsin the ordinary course of our business related to foreclosures, bankruptcies,condemnation and quiet title actions and alleged statutory and regulatoryviolations. Management believes that any liability with respect to these legalactions, individually or in the aggregate, will not have a material adverseeffect on our business, results of operations or financial position.

 

**(9)    Subsequent Event**

** **

***On July 27, 2005, FIC and FIFentered into a funding agreement with Credit Suisse, New York Branch, asFacility Agent, in which the Company may borrow funds under a conduitcommercial paper facility (the “facility”) in an aggregate amount not to exceed$800 million.  This facility will besecured principally by various mortgage loans and related assets, which are tobe purchased from time to time by FIF from FIC with amounts borrowed under thefacility.  The facility is scheduled toremain open until July 26, 2006.  Asof August 11, 2005, $188.6 billion was outstanding under this facility. Thisfacility bears interest at an annual rate depending upon the type of mortgageloans securing the advance of LIBOR plus an additional percentage, whichpercentage includes an administration fee on the average daily outstandingbalance of the facility.  This facility requiresFIC to maintain specified levels of liquidity and net worth, as well as tomaintain one or more committed loan facilities with an aggregate committedamount at least equal to $500 million. FIF is required to pay a non-use fee of 0.125% on unused amounts thatexceed certain thresholds relating to the average daily outstanding balance ofthe facility.***

 

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**ITEM 2.**                       MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

The following discussion andanalysis of our results of operations, financial condition and liquidity andcapital resources should be read in conjunction with our unaudited consolidatedfinancial statements and related notes contained in this Quarterly Report on Form 10-Q,as well as the audited financial statements and related notes for the fiscalyear ended December 31, 2004 and “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations,” contained in the our AnnualReport on Form 10-K, as amended, for the year ended December 31,2004.

 

**Safe Harbor for Forward-LookingStatements**

 

The Private SecuritiesLitigation Reform Act of 1995 provides a safe harbor for forward-lookingstatements as such term is defined under Section 21E of the SecuritiesExchange Act of 1934, as amended. Any written or oral statement, made by or onour behalf, using words such as “believes,” “expects,” “intends,” “estimates,” “projects,”“predicts,” “assumes,” “anticipates,” “plans,” “seeks,” and comparable terms,is a forward-looking statement. Forward-looking statements are not statementsof historical fact, but rather are based on our views and assumptions regardingfuture events and performance, taking into account all information currentlyavailable to us. Because we have a limited operating history, many statementsrelating to us and our business, including statements relating to ourcompetitive strengths and business strategies, may be forward-lookingstatements.

 

Allforward-looking statements (none of which is intended as a guarantee of performance)are subject to certain risks and uncertainties, known and unknown, that couldcause our actual results to differ materially from the expected resultsexpressed by the forward-looking statements. We believe that the factors thatmay affect future performance and the accuracy of forward-looking statementscontained in this Form 10-Q include, but are not limited to, thefollowing:

 

**•**      ourlimited operating history with building and managing an investment portfolio,which limits your ability to evaluate a key component of our business strategyand our growth prospects and increases your investment risk;

 

**•**      ourability to estimate future loan performance on our loans held for investment;

 

**•**      the availability, terms and deployment ofcapital;

 

**•**      thesuccess of our portfolio-based model of securitizations, which is subject tothe effects of interest rate fluctuations, margin calls and credit enhancementlevels;

 

**•**      ourability to execute successfully a hedging strategy to mitigate our risksassociated with changes in interest rates;

 

**•**      ourability to qualify or remain qualified as a REIT in any taxable year;

 

**•**      general volatility of the capital markets;

 

**•**      the degree and nature of our competition;

 

**•**      changes in government regulations thataffect our ability to originate and securitize mortgage loans; and

 

**•**      certain other factors set forth in ourfilings, from time to time, with the SEC, including our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2004.

 

All forward-looking statements should be read inconjunction with the other cautionary statements that are included in thisQuarterly Report on Form 10-Q. You are cautioned not to place unduereliance on the forward-looking statements contained in this Quarterly Reporton Form 10-Q, which speak only as of the date it is filed with the SEC. Weundertake no obligation to update publicly any forward-looking statement,whether as a result of new information, future events or otherwise.

 

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**Executive Overview**

 

We are a mortgage REIT thatinvests in non-conforming loans originated by our wholly owned subsidiary,Fieldstone Mortgage Company (Fieldstone Mortgage), which are financed withmortgage-backed securities. Fieldstone Mortgage originates loans through bothwholesale and retail origination channels. Through Fieldstone Mortgage, weoriginate, service and sell both non-conforming and conforming single familyresidential mortgage loans.

 

Currently, our primarysources of income are the net interest income on our loans held for investment,and the gains on sales of mortgage loans held for sale which are soldservicing-released. Our current strategy is to retain a portion of ournon-conforming loans in our REIT investment portfolio, to finance our portfolioof loans with mortgage-backed securities collateralized by those loans, and tocontinue to sell our conforming loans and the remainder of our non-conformingloans. The non-conforming loans that we retain meet our specific cash flow,credit and return requirements.

 

During the three monthsended June 30, 2005, our net income was $23.1 million. Our earnings duringthe second quarter benefited from the sale of $1.5 billion of mortgage loans,$557 million of which were previously held for investment as of March 31,2005, as well as increased net interest income on our growing portfolio ofmortgage loans. The quarter’s earnings were reduced by a $12.1 million non-cashmark to market valuation loss on the interest rate swap and cap agreements usedto economically hedge our variable rate debt financing the loans held forinvestment.

 

Our portfolio of loans heldfor investment, net, was $4.8 billion at June 30, 2005 and December 31,2004. At June 30, 2005, our financing debt on the loans held in ourportfolio was 8.1 times our equity. Based on the current size of our portfolioand management’s estimates and assumptions regarding expected futureorigination levels and market factors, in February 2005 we increased ourtarget debt to equity ratio on our portfolio to 13 times our equity from 11times our equity. We intend to continue to build our portfolio by retaining themajority of our non-conforming fundings; however, the percentage of loans weretain for the portfolio in any given period is likely to vary based upon thesize of the portfolio we hold, prepayments and the availability of loans whichmeet our cash flow, credit and return criteria.

 

We use interest rate swapsand caps to economically hedge the variable rate financing costs for the fixedrate period of our two and three year hybrid mortgage loans held forinvestment. Because these derivatives are not designated as cash flow hedgesunder Statement of Accounting Standards No. 133, “*Accounting for Derivative Instruments and HedgingActivities,*” changes in the fair market value of the swaps and capsare recognized in current period earnings and reported in our consolidatedstatement of operations in “Other income (expense)—portfolio derivatives.” Forexample, in the first quarter of 2005, we recognized a $20.6 million mark tomarket gain as interest rates increased during the quarter; however, asinterest rates declined slightly during the second quarter of 2005, werecognized a $12.1 million mark to market loss. We cannot predict the futurepath of interest rates, nor can we predict the magnitude by which these changesin the fair market value of our swaps and cap could cause our total revenue andnet income to increase or decrease significantly during periods of interestrate volatility.

 

**Key Components of Financial Results of Operations**

 

**Revenues**

 

The principal factors thataffect our revenues are interest rate volatility, origination volumes, salemargins on our loans held for sale, prepayment rates of our mortgage loans heldfor investment, and provision for loan losses on our investment portfolio.Rising interest rates may result in an increase in the mortgage rates we chargeon our loan originations, but also will increase our costs of borrowing tofinance the loans. Rising interest rates may lead to decreases in loanprepayments of our hybrid adjustable rate mortgages during the initial loanperiod in which our borrowers pay a fixed interest rate, generally during thefirst two years of the loan, but increase prepayments at or near the reset dateof the loan, when the coupon resets to a margin over six-month LIBOR. After thereset date of the loans, our margins are subject to less volatility because theloans and the related debt will be adjusting based on the same interest rateindex. In addition, rising interest rates generally will increase the fairvalue on the swaps and caps economically hedging our portfolio financing costs.

 

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**Expenses**

 

The principal factors whichlead to changes in our expenses are the current period funding volumes, thenumber of origination offices we operate, our staffing required to support ourorigination business, the balance of our investment portfolio incurringthird-party servicing fee expenses and the corporate overhead required tosupport a publicly- traded company. As loan volumes increase, we generallywould expect salaries, benefits and variable operating expenses to increase,net of deferred direct origination costs, including commissions. We also expectto incur incremental expenses in 2005 due to costs related to enhancedportfolio analytic tools, higher audit and legal fees, and increasedamortization expense as our new loan origination software becomes fullyoperational.

 

**Critical Accounting Policies**

 

We consider the policiesdiscussed below to be critical to an understanding of our financial statementsbecause their application places the most significant demands on the judgmentof our management, with financial reporting results relying on estimates andassumptions about the effects of matters that are inherently uncertain.Specific risks for these critical accounting policies are described in thefollowing paragraphs. While we believe that the estimates and assumptionsmanagement utilizes in preparing our financial statements are reasonable, suchestimates and assumptions routinely require periodic adjustment. Actual resultscould differ from our estimates, and these differences could be significant.

 

***Securitizations***

 

We must comply with theprovisions of Statement of Financial Accounting Standards No. 140 “*Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities*” (Statement No. 140)and Financial Interpretation Number 46R, “*Consolidationof Variable Interest Entities,*” (FIN 46R) relating to eachsecuritization. Depending on the structure of the securitization, it willeither be treated as a sale or secured financing for financial statementpurposes. We account for our securitizations of mortgage loans as securedfinancings, and accordingly, we include the securitized mortgage loans on ourbooks as mortgage loans held for investment. The loans are sold to a trustwhich is a wholly-owned special purpose entity for purposes of credit ratings;however, the securitizations are designed not to meet the qualifying specialpurpose entity criteria of Statement No. 140.

 

***Allowance for Loan Losses—Loans Heldfor Investment***

 

Because we maintain ourloans held for investment on the statements of condition for the life of theloans, we maintain an allowance for loan losses, based on our estimates of the principallosses inherent in the portfolio. This is a critical accounting policy becauseof the subjective nature of the estimates required and potential forimprecision. Two critical assumptions used in estimating the loss reserve arean assumed rate at which the loans go into foreclosure subsequent to initialdefault and an assumed loss severity rate, which represents the expected rateof realized loss upon disposition of the properties that have been foreclosed.Because we have limited historical loss data on our past originations, all ofwhich were sold servicing-released, we currently utilize industry lossassumptions for loans similar in credit, loan size and product type. Theseassumptions result in an estimate that approximately 24% of loans that aredelinquent 30+ days ultimately will default and experience an average principalbalance loss of 35%. These underlying assumptions and estimates are continuallyevaluated and updated to reflect management’s current assessment of the valueof the underlying collateral and other relevant factors impacting portfoliocredit quality and inherent losses. Provision for losses is charged to our consolidated statements of operationsas a reduction in net interest income. Losses incurred on mortgage loans held for investment are charged to theallowance at the time of liquidation or at the time the loan is transferred toreal estate owned.  Subsequent decreasesin net realizable value and losses at property disposal are recorded to gain(loss) on disposal of real estate owned, which is a component of “Fee and otherincome” on our consolidated statements of operation.

 

We define the beginning ofthe loss emergence period for a mortgage loan to be the occurrence of acontractual delinquency greater than 30 days. On a monthly basis, loansmeeting this criterion are included in a determination of the allowance forloan losses, which utilizes industry roll rate experience to assess thelikelihood and severity of portfolio losses. We do not assess loansindividually for impairment due to the homogeneous nature of the loans, whichare collectively evaluated for impairment. If actual results differ from our estimates,we may be required to

 

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adjust our provisionaccordingly. The use of different estimates or assumptions could producedifferent provisions for loan losses.

 

We place individual loans onnon-accrual status when they are past-due 90 days or when, in the opinionof management, the collection of principal and interest is in doubt. At thetime an individual loan is placed on non-accrual status, all previously accruedbut uncollectible interest is reversed against current period interest income.In addition, we reserve for interest income accrued on our pool of homogeneous30 and 60 day delinquent loans on the basis of the same industry loss roll rateassumptions, by estimating the interest due on our pool of homogeneous loanswhich will migrate to non-accrual status in the future.

 

***Amortization of Deferred LoanOrigination Costs and Deferred Debt Issuance Costs***

 

Interest income on ourmortgage loan portfolio is a combination of the accrual of interest based onthe outstanding balance and contractual terms of the mortgage loans, adjustedby the amortization of net deferred origination costs related to originationsin our investment portfolio, in accordance with Statement of FinancialAccounting Standards No. 91, “*Accountingfor Nonrefundable Fees and Costs Associated with Originating or Acquiring Loansand Initial Direct Costs of Leases*” (Statement No. 91). Our netdeferred origination costs consist primarily of premiums, discounts and othernet fees or costs directly associated with originating our mortgage loans. Forour loans held for investment, these net deferred costs are amortized asadjustments to interest income over the estimated lives of the loans using theinterest method. Because we hold a large number of similar loans for whichprepayments are probable and for which we can reasonably estimate the timing ofsuch prepayments, we use prepayment estimates in determining periodicamortization based on a model that considers actual prepayment experienceto-date as well as forecasted prepayments based on the contractual interestrate on the loans, loan age, loan type, prepayment fee coverage and a varietyof other factors. Mortgage prepayments are also affected by the terms andcredit grades of the loans, conditions in the housing and financial markets,relative levels of interest rates, and general economic conditions. Prepaymentassumptions are reviewed regularly to ensure that actual company experience aswell as industry data are supportive of prepayment assumptions used in ourmodel. Updates that are required to be made to these estimates are applied asif the revised estimates had been in place since the origination of the loansand may result in adjustments to the current period amortization recorded tointerest income.

 

Interest expense on ourwarehouse and securitization financing is a combination of the accrual ofinterest based on the contractual terms of the financing arrangements and theamortization of bond original issue discounts and issuance costs. Theamortization of bond original issue discounts and issuance costs also considersestimated prepayments and is calculated using the interest method. Theprincipal balance of the securitization financing is repaid as the relatedcollateral principal balance amortizes, either through receipt of monthlymortgage payments or any loan prepayment. The deferred issuance costs andoriginal issue discounts are amortized through interest expense over theestimated life of the outstanding balance of the securitization financing,utilizing the prepayment assumptions referenced above to estimate the averagelife of the related debt. Updates that are required to be made to theseestimates are applied as if the revised estimates had been in place since theissuance of the related debt and result in adjustments to the period amortizationrecorded to interest expense.

 

We have sought to partiallyoffset the impact to our net interest income of faster than anticipatedprepayment rates by originating mortgage loans with prepayment fees. These feestypically expire two years after origination of a loan. As of June 30,2005, approximately 87% of our mortgage loan portfolio had prepayment feefeatures. We anticipate that prepayment rates on our portfolio will increase asthese predominately adjustable rate loans reach their initial adjustmentsduring 2005 and 2006. The varying prepayment rate, referred to on an annualizedbasis as the constant prepayment rate, or CPR, currently used to project cashflows is based upon historical industry speeds for similar loan product and ouractual history to date. The forward-looking expected CPR used in our currentassumptions averages 23 CPR during the first 12 months, averages 41 CPRthrough month 24, and increases to 66 CPR during the months on and around thereset date, and declines to an average 42 CPR thereafter. If prepayment speedsincrease, our net interest margin would decrease due to the additional yieldadjustment amortization, which may be partially offset by an increase inprepayment fee income.

 

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***Hedging***

 

Hedging is a critical aspectof our business because of its interest rate sensitivity and the difficulty inestimating which interest rate locks will convert to closed loans as interestrates fluctuate. We use various financial instruments to hedge our exposure tochanges in interest rates. The financial instruments typically includemandatory delivery forward sale contracts of mortgage-backed securities,mandatory and best efforts whole-loan sales agreements and treasury noteforward sales contracts. These financial instruments are intended to mitigatethe interest rate risk inherent in providing interest rate lock commitments toprospective borrowers to finance one-to-four family homes and to hedge thevalue of our loans held for sale prior to entering fixed price sale contracts.

 

The interest rate locks forconforming loans and the mandatory forward sales, which are typically used tohedge the interest rate risk associated with these locks, are undesignatedderivatives and are marked to market through earnings. For interest rate lockcommitments related to conforming loans, mark to market adjustments arerecorded from inception of the interest rate lock through the funding date ofthe underlying loan. The funded loans have not been designated by us as aqualifying hedged asset in accordance with Statement of Financial AccountingStandards No. 133, “*Accounting forDerivative Instruments and Hedging Activities*” (Statement No. 133).We record the funded loans on the consolidated statements of condition at thelower of cost or market value. The mandatory forward sales, which generallyserve as an effective economic hedge from the inception of the interest ratelock through the time of the sale of the loans, remain subject to mark tomarket adjustments beyond the time the loan funds, and our reported earningsmay reflect some non-economic volatility as a result of this differingtreatment.

 

The interest rate lockcommitments associated with non-conforming loans held for sale and the treasurynote forward sales contracts typically used to hedge the interest rate riskassociated with these locks are also derivatives and are marked to marketthrough earnings. Similar to the conforming loans, the funded non-conformingloans have not been designated as a qualifying hedged asset in accordance withStatement No. 133, and, accordingly, we record them at the lower of cost ormarket value on the consolidated statements of condition. The treasury noteforward sales contracts, which do serve as an effective economic hedge prior tothe sale of some of our non-conforming loans, remain subject to mark to marketadjustments beyond the time the loans fund, and our reported earnings mayreflect some non-economic volatility as a result of this differing treatment.

 

We hedge the effect ofinterest rate changes on our cash flows relative to our loans held forinvestment as a result of changes in the benchmark interest rate, in this case,LIBOR, on which our interest payments on warehouse financing and securitizationfinancing are based. These derivatives are not classified as cash flow hedgesunder Statement No. 133. We enter into interest rate swap agreements to hedgethe financing on mortgage loans held for investment. The change in fair valueof the derivative during the hedge period is reported as a component of “Otherincome (expense)—portfolio derivatives.” The periodic net cash settlements andany gain or loss on terminated swaps are also reported as a component of “Otherincome (expense)—portfolio derivatives.” We also entered into an interest ratecap agreement to hedge interest rate changes relative to our firstsecuritization in the fourth quarter of 2003. The cap was not designated as acash flow hedge instrument, and as such, realized and unrealized changes in itsfair value are recognized as a component of “Other income (expense)-portfolioderivatives” during the period in which the changes occur.

 

Changes in interest ratesduring a reporting period will affect the mark to market valuations on ourundesignated derivatives. Increases in short-term interest rates will result ina non-cash credit being recognized in our statement of operations, whiledecreases in short-term rates will result in a non-cash charge being recognizedin our statement of operations.

 

***Stock-Based Compensation***

 

We  have adopted the fair value method ofaccounting for stock options and shares of restricted stock as prescribed byStatement of Financial Accounting Standards No. 148, *“Accountingfor Stock-Based Compensation-Transition and Disclosure”*(Statement No. 148) which amendsStatement of Financial Standards No. 123, *“Accountingfor Stock Based Compensation”* (Statement No. 123). Underthis method, compensation cost is measured at the grant date based on the fairvalue of the award and is recognized as expense on a straight-line basis overthe award’s vesting period. The fair value of awards of restricted stock isdetermined at the date of grant based on

 

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the market price of our commonstock on that date. For both the stock options and restricted stock, the amountof compensation cost is adjusted for estimated annual forfeitures. The fairvalue of the stock options is determined using the Black-Scholes option pricingmodel. Due to the subjective nature and estimates required under Statement No. 123,we consider this a critical accounting policy.

 

***Reserve for Losses—Loans Sold***

 

We maintain a reserve forour representation and warranty liabilities related to the sale of loans andfor our contractual obligation to rebate a portion of any premium paid by apurchaser when a borrower prepays a sold loan within an agreed period. Therepresentations and warranties generally relate to the accuracy andcompleteness of information related to the loans sold and to the collectibilityof the initial payments following the sale of the loan. The reserve, which isrecorded as a liability on our consolidated statements of condition, isestablished when loans are sold and is calculated as the fair value of lossesestimated to occur over the life of the loan. The reserve for losses isestablished through a provision for losses, which is reflected as a reductionof the gain on the loans sold at the time of sale. We forecast future losses oncurrent sales based on our analysis of our actual historical losses, stratifiedby type of loss, type of loan and year of sale. This analysis takes intoconsideration historical information regarding frequency and severity oflosses, organized by loan product and year of sale. We estimate losses due topremium recaptures on early loan prepayments by reviewing loan product andrate, borrower prepayment fee, if any, and estimates of future interest ratevolatility.

 

**Results of Operations**

 

**Three and Six Months Ended June 30,2005 Compared to Three and Six Months Ended June 30, 2004**

 

**Net Income**

 

Net income decreased$7.0 million, to $23.1 million, for the three months ended June 30,2005, from $30.1 million for the three months ended June 30, 2004.  This decrease was primarily the result of a$12.1 million non-cash mark to market valuation loss on interest rate swap andcap agreements in the second quarter of 2005 compared to the $22.2 millionnon-cash mark to market gain in the second quarter of 2004. The decrease in theending valuation of the swaps and cap resulted from a decline in the two yearswap rate at the end of the quarter due to a market flattening of the forwardyield curve during the second quarter of 2005, as compared to an increase inthe level of the two year swap during the comparable period in 2004. Ourinterest rate swaps and cap are not designated as cash flow hedges and,therefore, the change in the periodic mark to market of the future value of theinterest rate swaps and cap is reported in current period earnings. Thenon-cash valuation decrease was partially offset by increases in both netinterest income on our loans held for investment and gain on sale of mortgageloans, net.

 

Net income increased $38.8million, to $65.2 million, for the six months ended June 30, 2005 from$26.4 million for the six months ended June 30, 2004, primarily due toincreased net interest income on our growing portfolio of loans held forinvestment. Our average balance of loans held for investment was$4.7 billion for the six months ended June 30, 2005 as compared to$2.1 billion for the six months ended June 30, 2004. Gains on salesof mortgage loans, net, through June 30, 2005 also exceeded gains on salesthrough June 30, 2004, because we sold 26.6% more loans at higher salemargins in the six months ended June 30, 2005 as compared to the sameperiod in 2004.

 

**Revenues**

 

***Net Interest Income after Provisionfor Loan Losses***

 

The following are thecomponents of net interest income after provision for loan losses for the threeand six months ended June 30, 2005 and 2004 (in thousands): 

 

22

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| ** **                                                | ** ** | **Three Months  Ended  June 30,** | ** ** | **Six Months  Ended  June 30,** | ** ** |
|-----------------------------------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|
| ** **                                                | ** ** | **2005**                               | ** ** | **2004**                             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Interest income:                                          |       |                                   |       |                                 |       |   |   |   |   |
| Coupon interest income on loans held for  investment      |       | $                                      | 77,125     |                                 | 42,990     |   | 158,676 |   | 71,565 |   |
| Coupon interest income on loans held for  sale            |       | 14,226                                 |       | 6,139                                |       | 19,598 |   | 12,591 |   |
| Amortization of deferred origination costs                |       | (5,282                                 | )          | (2,094                               | )          | (10,786 | ) | (3,507 | ) |
| Prepayment fees                                           |       | 8,731                                  |       | 1,512                                |       | 15,520 |   | 1,940 |   |
| Total interest income                                     |       | 94,800                                 |       | 48,547                               |       | 183,008 |   | 82,589 |   |
|                                                      |       |                                   |       |                                 |       |   |   |   |   |
| Interest expense:                                         |       |                                   |       |                                 |       |   |   |   |   |
| Financing interest expense on loans held  for investment  |       | 39,579                                 |       | 10,444                               |       | 76,126 |   | 17,135 |   |
| Financing interest expense on loans held  for sale        |       | 6,276                                  |       | 1,318                                |       | 7,689 |   | 2,728 |   |
| Amortization of deferred bond issuance  costs             |       | 2,194                                  |       | 822                                  |       | 4,255 |   | 1,296 |   |
| Total interest expense                                    |       | 48,049                                 |       | 12,584                               |       | 88,070 |   | 21,159 |   |
|                                                      |       |                                   |       |                                 |       |   |   |   |   |
| Net interest income                                       |       | 46,751                                 |       | 35,963                               |       | 94,938 |   | 61,430 |   |
| Provision for loan losses—loans held for  investment |       | 6,863                                  |       | 6,778                                |       | 11,357 |   | 8,957 |   |
| Net interest income after provision for  loan losses      |       | $                                      | 39,888     |                                 | 29,185     |   | 83,581 |   | 52,473 |   |

 

23

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The following table presentsthe average balances for our loans held for investment and loans held for saleand our warehouse and securitization financing, with the correspondingannualized yields for the three and six months ended June 30, 2005 and2004 (in thousands). 

 
| ** **                                                                                                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                      | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Average balances:                                                                                               |       |                                  |       |                                |       |   |   |   |   |
| Mortgage loans held for investment                                                                              |       | $                                     | 4,590,662  |                                | 2,553,929  |   | 4,736,675 |   | 2,106,152 |   |
| Securitization financing—loans held for  investment                                                        |       | 4,242,147                             |       | 1,747,666                           |       | 4,215,218 |   | 1,293,750 |   |
| Warehouse financing—loans held for  investment                                                             |       | 223,368                               |       | 559,012                             |       | 370,294 |   | 561,105 |   |
|                                                                                                            |       |                                  |       |                                |       |   |   |   |   |
| Yield analysis—loans held for investment:                                                                  |       |                                  |       |                                |       |   |   |   |   |
| Coupon interest income on loans held for  investment                                                            |       | 6.7                                   | %          | 6.7                                 | %          | 6.7 | % | 6.7 | % |
| Amortization of deferred origination costs                                                                      |       | (0.5                                  | )%         | (0.3                                | )%         | (0.5 | )% | (0.3 | )% |
| Prepayment fees                                                                                                 |       | 0.7                                   | %          | 0.2                                 | %          | 0.7 | % | 0.2 | % |
| Yield on loans held for investment (1)                                                                          |       | 6.9                                   | %          | 6.6                                 | %          | 6.9 | % | 6.6 | % |
|                                                                                                            |       |                                  |       |                                |       |   |   |   |   |
| Interest expense securitization financing –  loans held for investment                                     |       | 3.5                                   | %          | 1.6                                 | %          | 3.3 | % | 1.6 | % |
| Interest expense warehouse financing –  loans held for investment                                          |       | 4.2                                   | %          | 2.5                                 | %          | 3.9 | % | 2.4 | % |
| Amortization—deferred bond issuance costs  and issue discount                                              |       | 0.2                                   | %          | 0.2                                 | %          | 0.2 | % | 0.2 | % |
| Cost of financing for loans held for  investment (2)                                                            |       | 3.7                                   | %          | 1.9                                 | %          | 3.5 | % | 2.0 | % |
|                                                                                                            |       |                                  |       |                                |       |   |   |   |   |
| Net yield on loans held for investment (3)                                                                      |       | 3.4                                   | %          | 4.8                                 | %          | 3.5 | % | 4.8 | % |
| Provision for loan losses                                                                                       |       | (0.6                                  | )%         | (1.0                                | )%         | (0.5 | )% | (0.8 | )% |
| Net yield on loans held for investment  after provision for loan losses                                         |       | 2.8                                   | %          | 3.8                                 | %          | 3.0 | % | 4.0 | % |
|                                                                                                            |       |                                  |       |                                |       |   |   |   |   |
| Average balances:                                                                                               |       |                                  |       |                                |       |   |   |   |   |
| Mortgage loans held for sale                                                                                    |       | $                                     | 811,753    |                                | 354,493    |   | 559,418 |   | 353,019 |   |
| Warehouse financing—loans held for sale                                                                    |       | 601,742                               |       | 235,788                             |       | 371,968 |   | 224,795 |   |
|                                                                                                            |       |                                  |       |                                |       |   |   |   |   |
| Yield analysis—loans held for sale:                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Yield on loans held for sale (1)                                                                                |       | 6.9                                   | %          | 6.9                                 | %          | 7.0 | % | 7.1 | % |
| Cost of financing for loans held for sale  (2)                                                                  |       | 4.1                                   | %          | 2.2                                 | %          | 4.1 | % | 2.4 | % |
| Net yield on loans held for sale (3)                                                                            |       | 3.9                                   | %          | 5.4                                 | %          | 4.2 | % | 5.5 | % |
|                                                                                                            |       |                                  |       |                                |       |   |   |   |   |
| Yield analysis – loans held for investment  and loans held for sale:                                       |       |                                  |       |                                |       |   |   |   |   |
| Yield-net interest income on loans held for  sale and loans held for investment after provision for loan losses |       | 2.9                                   | %          | 4.0                                 | %          | 3.1 | % | 4.2 | % |

 

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| (1)    |   | Calculated as the annualized interest income divided  by the average daily balance of the mortgage loans.                                                                                                                                                                                |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                     |
| (2)    |   | Calculated as the annualized interest expense divided by the average  daily balance of the debt related to mortgage loans.                                                                                                                                                               |
|   |   |                                                                                                                                                                                                                                                                                     |
| (3)    |   | Calculated as the annualized net interest income divided by the  average daily balance of mortgage loans. The net yield on loans will not  equal the difference between the yield on loans and the cost of financing due  to the difference in the denominators of the two calculations. |

 

The increase in our netinterest income after provision for loan losses in the three and six monthsended June 30, 2005 compared to the same periods in 2004 was attributableprimarily to the increase in our portfolio of loans held for investment,partially offset by the increase in interest expense on the highersecuritization debt financing the portfolio combined with rising interest ratesthroughout 2004 and 2005. We expect net interest income to increase throughout

 

24

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the remainder of 2005 as wecontinue to build the portfolio. Prepayment fee income collected in 2005 waspartially offset by the amortization of deferred origination costs on theloans. We expect prepayment fee income will continue to increase in 2005, asthe portfolio continues to grow and mature. The decrease in the net yield onloans held for investment after provision for loan losses during the three andsix months ended June 30, 2005 compared to the same period in 2004,reflects the increase in the cost of financing the warehouse and securitizationdebt due to rising interest rates.

 

The following table recaps the 2 Year Swap index asof the following quarter end dates:

 
| ** **       | ** ** | **2004**          | ** ** | **2005**         | ** ** |
|------------------|------------|-------------------|------------|------------------|------------|
| ** **       | ** ** | **March 31** | ** ** | **June 30** | ** ** | **Sept 30** | ** ** | **Dec 31** | ** ** | **March 31** | ** ** | **June 30** | ** ** |
| 2Year Swap Index |       | 1.88              | %          | 3.09             | %          | 2.94 | % | 3.45 | % | 4.19 | % | 3.98 | % |

 

Source: Bloomberg L.P.

 

We anticipate that interestexpense related to both warehouse and securitization financing will continue toincrease in 2005 as we continue to finance our investment portfolio growth withmortgage-backed securities indexed to a LIBOR-based rate. Interest expense willalso increase both notionally and as a percentage cost of financing due to theprepayment of older loans financed with lower-rate debt, compared to newmortgage fundings financed with higher cost debt.

 

Provision for loan lossesincreased in 2005, consistent with expectations, due to the increase indelinquent loans in our portfolio as the portfolio continues to season.

 

The net interest incomeafter provision for loan losses excludes the net cash settlementsreceived/(paid) of $2.7 million and ($1.8) million, in the threemonths ending June 30, 2005 and June 30, 2004, respectively, and the$2.4 million, and ($5.4) million in the six months ended June 30, 2005 and2004, respectively, under the terms of the swap and cap agreements used toeconomically hedge the financing costs of our investment portfolio. The regularmonthly swap and cap settlement amounts, plus any cash paid or received attermination of the agreements prior to maturity, are included in the line item “Otherincome (expense)—portfolio derivatives.” We expect that net interest incomeafter provision for loan losses will continue to increase in 2005, reflectingthe anticipated growth in our portfolio of loans held for investment. Thisincrease will be partially offset by margin decreases as our portfoliofinancing costs rise due to current as well as continued anticipated increasesin the LIBOR interest rate to which they are indexed.

 

***Gains on Sales of Mortgage Loans,net***

 

The components of the gainson sale of mortgage loans, net, are illustrated in the following table for thethree and six months ended June 30, 2005 and 2004 (in millions)*:

 

25

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| ** **                                                         | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                         | ** ** | **2005**                             | ** ** | **% of  Sales  Volume**            | ** ** | **2004** | ** ** | **% of  Sales  Volume** | ** ** | **2005** | ** ** | **% of  Sales  Volume** | ** ** | **2004** | ** ** | **% of  Sales  Volume** | ** ** |
| Gross premiums - whole loan sales, net of  hedging gains or losses |       | $                                    | 45.9       |                               | 3.0        | % | $ | 23.9 |   | 2.6 | % | $ | 65.4 |   | 2.8 | % | $ | 49.8 |   | 2.7 | % |
| Loan fees collected(1)                                             |       | 9.2                                  |       | 0.6                                | %          | 5.4 |   | 0.6 | % | 13.4 |   | 0.6 | % | 11.5 |   | 0.6 | % |
| Premiums paid(2)                                                   |       | (13.9                                | )          | (0.9                               | )%         | (6.6 | ) | (0.7 | )% | (20.3 | ) | (0.9 | )% | (13.5 | ) | (0.7 | )% |
| Subtotal                                                           |       | 41.2                                 |       | 2.7                                | %          | 22.7 |   | 2.5 | % | 58.5 |   | 2.5 | % | 47.8 |   | 2.6 | % |
| Provision for losses—sold loans                               |       | (3.6                                 | )          | (0.2                               | )%         | (3.3 | ) | (0.4 | )% | (6.1 | ) | (0.3 | )% | (7.4 | ) | (0.4 | )% |
| Direct origination costs(3)                                        |       | (10.3                                | )          | (0.7                               | )%         | (6.5 | ) | (0.7 | )% | (15.5 | ) | (0.6 | )% | (13.3 | ) | (0.7 | )% |
| Gains on sales of mortgage loans, net                              |       | $                                    | 27.3       |                               | 1.8        | % | $ | 12.9 |   | 1.4 | % | $ | 36.9 |   | 1.6 | % | $ | 27.1 |   | 1.5 | % |
| Loan sales volume                                                  |       | $                                    | 1,536.7    |                               |       |   | $ | 905.5 |   |   |   | $ | 2,339.4 |   |   |   | $ | 1,847.3 |   |   |   |

 

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*              Loan fees collected, premiums paid and directorigination costs are deferred at funding and recognized at loan sale.

 

(1)           Loan fees collected represent pointsand fees collected from borrowers.

 

(2)           Premiums paid represent fees paid tobrokers for wholesale loan originations.

 

(3)           Direct origination costs primarilyare commissions and direct salary costs.

 

The increase in gains onsale of mortgage loans, net, for the three and six months ended June 30,2005 compared to the same periods in 2004, is primarily due to the increase in2005 sales volume, as well as higher non-conforming sale margins. Theperiod-over-period increase in gain on sale margin reflects the strong demandfor mortgages from the whole loan purchase sector of the industry during 2005,combined with the sale of a relatively greater component of first liennon-conforming mortgages at relatively higher sales premiums in the secondquarter of 2005, than first lien conforming and second lien mortgages.

 

In April 2005, managementdetermined that the forecasted rate of return on approximately $640 million ofloans held for investment but not yet securitized did not meet our minimumreturn levels for investment of capital, and transferred these loans from heldfor investment to held for sale.  Onceclassified as held for sale, on April 20, 2005, the TRS purchased these loansfrom the REIT at a gross price of 102.7%, which management estimated to be thefair value of the loans on the transfer date as determined by current marketconditions and recent loan sale commitments. The TRS, which is in the business of selling pools of loans on awhole-loan basis, solicited third-party bids for the purchase of a pool ofnon-conforming mortgage loans, including the loans purchased from theREIT.  On April 21, 2005, upon receiptand review of firm commitment bids, the TRS committed to sell a pool ofapproximately $1.0 billion of non-conforming mortgage loans to a third-party ata gross price of 103.5%.  Theinter-company gain on sale between the REIT and the TRS has been eliminatedfrom our consolidated financial statements; however, the TRS has recordedapproximately $5.0 million of taxable income, which includes the differencebetween the purchase price of the loans purchased from the REIT and thesubsequent sale by the TRS to a third-party purchaser.

 

Provision for losses—loanssold as a percent of sales volume decreased in three and six months ended June 30,2005 from the three and six months ended June 30, 2004 levels because 2005loan sales were comprised of a higher percentage of first lien non-conformingloans, which incur lower representation and warranty losses than second liennon-conforming loans.

 

***Other Income (Expense)—PortfolioDerivatives***

 

We use interest rate swapand cap agreements to economically hedge the variable rate debt financing of ourportfolio of non-conforming mortgage loans held for investment. Changes in thefair value of these agreements, which reflect the potential future cashsettlements over the remaining lives of the agreements according to the market’schanging projections of interest rates, are recognized in the line item “Otherincome (expense)—portfolio derivatives”

 

26

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in the consolidatedstatements of operations. This single line item includes both the actual cashsettlements related to the agreements that occurred during the period andrecognition of the non-cash changes in the fair value of the agreements overthe period. The cash settlements include regular monthly payments or receiptsunder the terms of the swap agreements and cash paid or received to terminatethe agreements prior to maturity. The amounts of cash settlements and non-cashchanges in value that were included in “Other income (expense)—portfolioderivatives” are as follows for the three and six months ended June 30,2005 and 2004 (in thousands): 

 
| ** **                                                                             | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                             | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Non-cash changes in fair value                                                         |       | $                                     | (12,087    | )                                   | 22,158     |   | 8,541 |   | 15,896 |   |
| Net cash settlements paid on existing  derivatives                                     |       | 2,726                                 |       | (2,684                              | )          | 1,431 |   | (4,368 | ) |
| Net cash settlements received (paid) to  terminate derivatives prior to final maturity |       | (71                                   | )          | 902                                 |       | 938 |   | (984 | ) |
| Other income (expense)—portfolio  derivatives                                     |       | $                                     | (9,432     | )                                   | 20,376     |   | 10,910 |   | 10,544 |   |

 

Our portfolio derivativesallow us to stabilize the expected financing costs of our investment portfolioover a future contractual time period. At June 30, 2005 and June 30,2004, the notional balance of our interest rate swaps and cap agreements was$4.4 billion and $2.1 billion, respectively.

 

The following tablesummarizes the average notional balance and the future weighted average fixedpayment interest rate of our interest rate swaps and cap in effect as of June 30,2005, for the  six and twelve monthsending December 31, 2005 and 2006, respectively  (in thousands): 

 
| ** **          | ** ** | **Six Months Ended**           | ** ** | **Twelve Months Ended**              | ** ** |
|---------------------|------------|--------------------------------|------------|--------------------------------------|------------|
| ** **          | ** ** | **December 31, 2005**     | ** ** | **December 31, 2006**           | ** ** |
| ** **          | ** ** | **Average  Notional  Balance** | ** ** | **Weighted  Average  Pay Rate** | ** ** | **Average  Notional  Balance** | ** ** | **Weighted  Average  Pay Rate** | ** ** |
| Interest rate swaps |       | $                              | 3,767,572  |                                 | 2.93       | % | $ | 2,006,161 |   | 3.34 | % |
| Interest rate cap   |       | $                              | 320,956    | *                                    | 3.16       | % | — |   | — |   |
|                     |            |                                |            |                                      |            |  |  |  |  |  |  |

 

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*  Cap expiration date is September 25, 2005

 

Other income(expense)—portfolio derivatives will vary as the market’s expectation of futurechanges to the LIBOR interest rate vary throughout the period. Generally,rising interest rates will increase the fair value of our derivatives and ournet cash settlements on existing derivatives. We cannot predict the net effectof interest rate volatility in future periods to our other income(expense)—portfolio derivatives.

 

**Expenses**

 

The following is a summaryof total expenses and the percentage change from the prior period, for thethree and six months ended June 30, 2005 and 2004 (in thousands): 

 
| ** **                          | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                          | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Salaries and employee benefits *    |       | $                                     | 19,707     |                                | 20,665     |   | 39,449 |   | 41,727 |   |
| Occupancy                           |       | 1,975                                 |       | 1,570                               |       | 3,770 |   | 3,067 |   |
| Depreciation and amortization       |       | 828                                   |       | 609                                 |       | 1,623 |   | 1,128 |   |
| Servicing fees                      |       | 1,743                                 |       | 1,272                               |       | 4,347 |   | 1,926 |   |
| General and administration          |       | 7,792                                 |       | 7,948                               |       | 15,790 |   | 14,764 |   |
| Total expenses                      |       | $                                     | 32,045     |                                | 32,064     |   | 64,979 |   | 62,612 |   |
| Percentage change from prior period |       | 0.1                                   | %          | N/A                                 |       | 3.8 | % | N/A |   |

 

----

* Does not includecommissions which are required by Statement No. 91 to be capitalized asdeferred origination costs.

 

***Total Expenses.***  Total expenses remainedsubstantially unchanged during the three months ended June 30, 2005compared to the three months ended June 30, 2004 reflecting flatorigination volumes, and increased servicing expense attributable to ourgrowing portfolio of loans held for investment, offset by lower salaries andbenefit expense. The increase in total expenses during the six

 

27

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months ended June 30,2005 as compared to the six months ended June 30, 2004 is also primarilydue to the increased servicing fees offset by lower  salaries and employee benefits, including a$1.5 million employee benefit cost savings as a result of our self-insurancehealth plan, implemented in the third quarter of 2004. We expect total expensesfor the remainder of 2005 to increase over levels in the first six months of2005, primarily due to expected increases in third-party portfolio servicingfees related to portfolio growth,  andthe amortization and maintenance expenses related to placing a new loanorigination software system fully in service.

 

We are currently replacingour two separate loan origination software systems with a single, integratedsystem to support both conforming and non-conforming originations and fundings.The project involves purchasing, developing, installing, training andsupporting the new system. Additionally, we have upgraded “Fieldscore,” ourpre-approval and credit gathering engine. The initial “Fieldscore” upgrade wascomplete as of December 31, 2004, and we anticipate the originationcomponents will be fully implemented by the end of 2005. We expectamortization, licensing and maintenance expenses to increase in 2005 as wecomplete development of the software and place the system fully into service.

 

***Salaries and Employee Benefits.*** Salaries and employee benefits decreasedfrom the three and six months ended June 30, 2004 to the three and sixmonths ended June 30, 2005 primarily due to a $1.3 million and $2.3million decrease, respectively, in employee benefit expense, combined withorigination process improvement initiatives which reduced staffing levels inthe production support area.  In July 2004,we adopted a self-insurance health plan which has reduced health insurancepremium expense approximately $0.2 million monthly. We expect salaries andemployee benefits, net of deferred direct origination costs, to increasethroughout the remainder of 2005 primarily due to the additional personnelrequired to support a higher level of loan originations, the growth of our REITportfolio, and additional information technology personnel to support plannedenhancements in access and security controls.

 

***Servicing Fees.*** Servicing fees for the loans in our portfolio increased for the threeand six months ended June 30, 2005 compared to three and six months ended June 30,2004 due to the growth of the investment portfolio. Currently, all of our loansheld for investment are serviced by a third-party servicer effective with thefirst mortgage payment due after loan funding. We expect to incur servicingfees, net of compensating interest received from our third-party servicer, ofapproximately 0.21% of the average balance of our held for investment portfoliothroughout the remainder of  2005.Servicing fees for the three and six months ended June 30, 2005 have beenreduced by approximately $0.9 million related to compensatory interest receivedfrom the sub-servicer, including $0.8 million related to periods prior to thesecond quarter of 2005, based on an analysis of information received from thesub-servicer in the second quarter of 2005.

 

***General and Administration Expenses.*** General and administration expensesdecreased in the three months ended June 30, 2005 from the three monthsended June 30, 2004 primarily due to a reduction in marketing costs in thenon-conforming retail division, as the division restructured its salesinitiatives. General and administration expenses increased in the six monthsended June 30, 2005 from the same period in 2004 due to increased costsassociated with quality control and due diligence programs, audit, legal andinsurance fees related to operation as a public company, and maintenance andequipment costs associated with the development of a new loan originationsystem. We expect general and administrative expenses to increase in the secondhalf of 2005 relative to the first six months primarily due to costs incurredfor the implementation of Sarbanes-Oxley Act compliance measures, and theincrease in amortization, licensing and maintenance expenses as we put intoservice our new loan origination software system.

 

***Provision for Income Tax Expense.*** We elected to be taxed as a REIT, effectivein the fourth quarter of 2003, and we elected to treat our loan origination andsale subsidiary, Fieldstone Mortgage Company (FMC), as a taxable REIT subsidiary(TRS). We recognized income tax expense of $2.7 million for the threemonths ended June 30, 2005 related to the $7.7 million pretax net incomeof FMC compared to income tax expense of $1.3 million for the three monthsended June 30, 2004 related to FMC’s $3.3 million pretax net incomein that period. We recognized income tax expense of $1.8 million for thesix months ended June 30, 2005 related to the $5.3 million pretax netincome of FMC compared to income tax expense of $3.0 million for the sixmonths ended June 30, 2004 related to FMC’s $7.4 million pretax netincome in that period.

 

28

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On April 21, 2005, theTRS committed to sell a pool of non-conforming mortgage loans at a price of103.5%, which included approximately $640 million of loans purchased on April 20,2005 from the REIT at a price of 102.7%, which was determined to be the fairvalue of the inter-company sold loans as of April 20, 2005. The TRS hasincluded in taxable income and recorded a tax provision on the differencebetween the purchase price of the $640 million of loans from the REIT and thesubsequent sale to the third-party purchaser, which resulted in approximately$5.0 million of taxable income to the TRS.

 

In May 2005, the TRSsold approximately $110 million of non-conforming mortgage loans to the REIT,at a price of 103.6%, and recognized in gain on sale the difference between thebook basis in the loans, and the gross sales price received from the REIT,which resulted in approximately $2.7 million of taxable income to the TRS.

 

**Consolidated Statements of Condition at June 30,2005 and December 31, 2004**

 

***Mortgage Loans Held for Investment***

 

The following tablesummarizes the principal balance of our investment portfolio for the six monthsended June 30, 2005 and for the year ended December 31, 2004 (inthousands): 

 
| ** **                                              | ** ** | **Six Months  Ended  June 30,** | ** ** | **Year Ended  December 31,** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|
| ** **                                              | ** ** | **2005**                             | ** ** | **2004**                          | ** ** |
| Beginning  principal balance                            |       | $                                    | 4,735,063  |                              | 1,319,123  |   |
| Loan fundings                                           |       | 1,460,139                            |       | 4,112,190                         |       |
| Payoffs and  principal reductions                       |       | (823,245                             | )          | (690,037                          | )          |
| Transfers to  mortgage loans held for sale, net         |       | (530,830                             | )          | —                            |       |
| Transfers to  real estate owned                         |       | (12,558                              | )          | (6,213                            | )          |
| Ending principal  balance                               |       | 4,828,569                            |       | 4,735,063                         |       |
| Net deferred  loan origination (fees)/costs             |       | 37,945                               |       | 39,693                            |       |
| Ending balance mortgage  loans held for investment      |       | 4,866,514                            |       | 4,774,756                         |       |
| Allowance for  loan losses                              |       | (30,690                              | )          | (22,648                           | )          |
| Ending balance mortgage  loans held for investment, net |       | $                                    | 4,835,824  |                              | 4,752,108  |   |

 

Our investment portfoliowas  $4.8 billion as of June 30,2005 and generated $83.0 million of net interest income before provision forloans losses for the six months ended June 30, 2005. During the year endedDecember 31, 2004, our portfolio of loans held for investment increased to$4.8 billion and generated $137.4 million of net interest incomebefore provision for loan losses. A provision for loan losses of $11.4 millionwas recorded in the six months ended June 30, 2005 and $3.3 millionof net charge-offs were incurred, resulting in an allowance for loan losses of$30.7 million as of June 30, 2005. A provision for loan losses of$21.6 million was recorded and $1.0 million of charge-offs wereincurred during the year ended December 31, 2004, resulting in anallowance for loan losses of $22.6 million as of December 31, 2004.

 

The increasein payoffs and principal reductions as our portfolio seasons is consistent withour expectations. Because we sold all of the loans we originated prior to thethird quarter of 2003, we do not have comprehensive performance data on ourloans sold to investors relative to either prepayments or credit losses. Weestimate prepayment rates and credit losses based on historical industry datafor similar loan products and actual history to date. These assumptions forprepayment curves indicate an average loan life of approximately 26 months.There can be no assurance that this industry data will be reflective of ouractual results.

 

Early in thesecond quarter of 2005, management determined that the projected return onassets and return on equity to be generated by approximately $640 million ofloans yet to be securitized held by the REIT, including $557 million ofnon-securitized loans held for investment as of March 31, 2005, haddeclined to levels below our targeted investment return. The projected declinein net interest margin was the result of an increase in the cost of financingover the prior four-month period, which was not offset by an increase in couponrate by originators.  Due to theprojected returns, management decided to transfer the loans from held forinvestment to held for sale.

 

29

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Thenon-securitized portfolio was not examined at loan level in any attempt toselect only the most adverse returning assets, but the entire non-securitizedportion of the portfolio was transferred to held for sale, with the exceptionof delinquent loans.  The transfer andsubsequent sale of these loans was due primarily to an unforeseen andsignificant business need in circumstances where market conditions wereevolving, is not expected to be a recurring event, and, therefore, the transferand subsequent sale should not be treated as a “prohibited transaction” forpurposes of Section 857(b)(6)(A) of the Internal Revenue Code.  In May 2005, management implementedadditional policies and procedures to ensure that, prior to the designation ofloans as held for investment, the loans funded by the REIT will achieve ourminimum portfolio rate of return threshold.

 

***Allowance for Loan Losses—Loans Heldfor Investment***

 

The following tablesummarizes the allowance for loan loss activity of our investment portfolio forthe six months ended June 30, 2005 and the year ended December 31,2004 (in thousands): 

 
| ** **                                                    | ** ** | **Six Months  Ended  June 30,** | ** ** | **Year Ended  December 31,** | ** ** |
|---------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|
| ** **                                                    | ** ** | **2005**                             | ** ** | **2004**                          | ** ** |
| Beginning  balance allowance for loan losses                  |       | $                                    | 22,648     |                              | 2,078      |   |
| Provision                                                     |       | 11,357                               |       | 21,556                            |       |
| Charge-offs                                                   |       | (3,660                               | )          | (986                              | )          |
| Recoveries                                                    |       | 345                                  |       | —                            |       |
| Ending balance  allowance for loan losses                     |       | $                                    | 30,690     |                              | 22,648     |   |
| Ending principal  balance, mortgage loans held for investment |       | $                                    | 4,828,569  |                              | $          | 4,735,063 |   |
| Ending allowance  balance as % of ending principal balance    |       | 0.6                                  | %          | 0.5                               | %          |
|                                                               |            |                                      |            |                                   |            |  |  |

 

The delinquency status ofour loans held for investment as of June 30, 2005 and December 31,2004 was as follows (in thousands):

 
| ** **                                                                                                                   | ** ** | **June 30, 2005** | ** ** | **December 31, 2004** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                   | ** ** | **Principal Balance**  | ** ** | **Percentage of Total**    | ** ** | **Principal Balance** | ** ** | **Percentage of Total** | ** ** |
| Current                                                                                                                      |       | $                      | 4,467,490  |                            | 92.5       | % | $ | 4,424,418 |   | 93.4 | % |
| 30 days past due                                                                                                             |       | 226,477                |       | 4.7                             | %          | 230,787 |   | 4.9 | % |
| 60 days past due                                                                                                             |       | 55,685                 |       | 1.1                             | %          | 38,713 |   | 0.8 | % |
| 90+ days past  due                                                                                                           |       | 32,642                 |       | 0.7                             | %          | 15,487 |   | 0.3 | % |
| In process of  foreclosure                                                                                                   |       | 46,275                 |       | 1.0                             | %          | 25,658 |   | 0.6 | % |
| Total                                                                                                                        |       | $                      | 4,828,569  |                            | 100.0      | % | $ | 4,735,063 |   | 100.0 | % |
|                                                                                                                         |       |                   |       |                            |       |   |   |   |   |
| Allowance for  loan losses                                                                                                   |       | $                      | 30,690     |                            |       |   | $ | 22,648 |   |   |   |
|                                                                                                                         |       |                   |       |                            |       |   |   |   |   |
| Allowance for  loan losses as a % of total delinquent loans (30+ days past due and loans in  the process of foreclosure)     |       | $                      | 361,079    |                            | 8.5        | % | $ | 310,645 |   | 7.3 | % |
|                                                                                                                         |       |                   |       |                            |       |   |   |   |   |
| Allowance for  loan losses as a % of seriously delinquent loans (60+ days past due and loans  in the process of foreclosure) |       | $                      | 134,602    |                            | 22.8       | % | $ | 79,858 |   | 28.4 | % |
|                                                                                                                              |            |                        |            |                                 |            |  |  |  |  |  |  |  |

 

Delinquency and life to dateloss status of our loans held for investment by securitization pool as of June 30,2005 and December 31, 2004 was as follows (in thousands):

 

30

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| ** **                                   | ** ** | **As of June 30, 2005** | ** ** |
|----------------------------------------------|------------|----------------------------------------|------------|
| ** **                                   | ** ** | **Current  Principal  Balance**        | ** ** | **% of  Principal  Balance  60+ Days  Delinquent** | ** ** | **Original Principal Pledged** | ** ** | **% of  Realized  Losses*** | ** ** | **Avg. Age  of Loans  from  Funding  (months)** | ** ** |
| Loans held for  investment-securitized:      |       |                                   |       |   |   |   |   |   |   |   |   |
| FMIC  Series 2003-1                     |       | $                                      | 249,497    |   | 4.9 | % | $ | 498,844 |   | 0.16 | % | 23 |   |
| FMIT  Series 2004-1                     |       | 369,749                                |       | 4.5 | % | 680,858 |   | 0.11 | % | 19 |   |
| FMIT  Series 2004-2                     |       | 519,876                                |       | 4.6 | % | 879,325 |   | 0.17 | % | 16 |   |
| FMIT  Series 2004-3                     |       | 744,458                                |       | 3.1 | % | 999,865 |   | 0.04 | % | 14 |   |
| FMIT  Series 2004-4                     |       | 707,542                                |       | 3.8 | % | 879,604 |   | 0.05 | % | 11 |   |
| FMIT Series 2004-5                      |       | 789,499                                |       | 2.1 | % | 900,000 |   | 0.01 | % | 9 |   |
| FMIT  Series 2005-1                     |       | 702,317                                |       | 2.0 | % | 749,999 |   | 0.01 | % | 7 |   |
| Total                                        |       | 4,082,938                              |       | 3.3 | % | 5,588,495 |   | 0.07 | % |   |   |
| Loans held for  investment-to be securitized |       | 745,631                                |       | 0.1 | % | 745,728 |   | 0.02 | % | 2 |   |
| Total loans held  for investment             |       | $                                      | 4,828,569  |   | 2.8 | % | $ | 6,334,223 |   | 0.06 | % | 11 |   |
|                                              |            |                                        |            |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                   | ** ** | **As of December 31, 2004** | ** ** |
|----------------------------------------------|------------|-------------------------------------------------|------------|
| ** **                                   | ** ** | **Current Principal   Balance**            | ** ** | **% of Principal   Balance 60+ Days   Delinquent** | ** ** | **Original Principal   Pledged** | ** ** | **% of Realized   Losses*** | ** ** | **Avg. Age of Loans   from  Funding  (months)** | ** ** |
| Loans held for  investment-securitized:      |       |                                            |       |   |   |   |   |   |   |   |   |
| FMIC  Series 2003-1                     |       | $                                               | 308,758    |   | 3.4 | % | $ | 498,844 |   | 0.07 | % | 17 |   |
| FMIT  Series 2004-1                     |       | 490,043                                         |       | 3.2 | % | 680,858 |   | 0.04 | % | 13 |   |
| FMIT  Series 2004-2                     |       | 709,909                                         |       | 3.3 | % | 879,325 |   | 0.04 | % | 10 |   |
| FMIT Series 2004-3                      |       | 913,253                                         |       | 1.6 | % | 999,865 |   | 0.00 | % | 8 |   |
| FMIT  Series 2004-4                     |       | 842,340                                         |       | 1.3 | % | 879,604 |   | 0.00 | % | 5 |   |
| FMIT  Series 2004-5                     |       | 892,488                                         |       | 0.5 | % | 900,000 |   | 0.00 | % | 3 |   |
| Total                                        |       | 4,156,791                                       |       | 1.9 | % | 4,838,496 |   | 0.02 | % |   |   |
| Loans held for  investment-to be securitized |       | 578,272                                         |       | 0.2 | % | 578,312 |   | 0.00 | % | 1 |   |
| Total loans held  for investment             |       | $                                               | 4,735,063  |   | 1.7 | % | $ | 5,416,808 |   | 0.02 | % | 7 |   |

 

----

*                    Realized losses include charge-offs to theallowance for loan losses—loans held for investment related to loan principalbalances and do not include previously accrued but uncollected interest, whichis reversed against current period interest income.

 

The increase in allowancefor loan losses as of June 30, 2005 and December 31, 2004 reflectsour estimate of losses inherent in the loan portfolio, and is based upon lossassumptions which take into account the contractual delinquency status, marketdelinquency roll rates and market historical loss severities. We currentlyestimate an average loss severity of 35%, not including past due interest whichis reversed against current period interest income when the loan is placed onnon-accrual status or deemed otherwise uncollectible. Due to the short timespan from our initial securitization through June 30, 2005, we have onlylimited actual loss experience from our investment portfolio.

 

We anticipate thatdelinquent loans will continue to increase in principal balance and as apercentage of the portfolio, consistent with industry expectations, as theportfolio grows and the loans continue to season.

 

Real estate owned is acomponent of “Prepaid expenses and other assets” on the consolidated statementsof condition and is reported at its estimated net realizable value. At thetime a loan is foreclosed and transferred to real estate owned, any reductionin value from its previous carrying balance is charged to the allowance forloan losses – 

 

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loans held forinvestment.  Subsequent decreases in netrealizable value, and losses at disposal of the property, are recorded to gain(loss) on disposal of real estate owned, which is a component of “Fee and otherincome” on the consolidated statements of operations. Recoveries of amountspreviously charged off at date of foreclosure are recorded as an increase tothe allowance for loan losses. The following is a summary of real estate ownedas of June 30, 2005 and December 31, 2004 (in thousands): 

 
| ** **                                         | ** ** | **Six Months  Ended  June 30,** | ** ** | **Year Ended  December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------------------------|------------|-----------------------------------|------------|
| ** **                                         | ** ** | **2005**                             | ** ** | **2004**                          | ** ** |
| Beginning  balance real estate owned               |       | $                                    | 4,374      |                              | 1,805      |   |
| Plus: Transfers  from mortgage loans held for sale |       | 405                                  |       | 998                               |       |
| Transfers from  mortgage loans held for investment |       | 12,558                               |       | 6,213                             |       |
| Less:  Charge-offs                                 |       | (3,049                               | )          | (1,438                            | )          |
| Real estate sold                                   |       | (6,603                               | )          | (3,204                            | )          |
| Ending balance  real estate owned *                |       | $                                    | 7,685      |                              | 4,374      |   |

 

----

*       Includes properties previously securing loansheld for sale of $0.4 million and $0.3 million, as of June 30,2005 and December 31, 2004, respectively.

 

We sold 61 real estate ownedproperties formerly collateralizing loans held for investment in the six monthsended June 30, 2005 with an average aggregate principal net charge-off of27%, which includes both the initial charge-off at transfer to real estateowned, if any, and the final gain or loss on disposal of the property. As wedispose of sufficient properties to determine a loss severity trend in ourportfolio, we will review our loss assumptions and update our estimates asrequired.

 

***Mortgage Loans Held for Sale andRelated Warehouse Financing—Loans Held for Sale***

 

The following tablesprovides a summary of the mortgage loans held for sale, net and warehousefinancing—loans held for sale as of June 30, 2005 and December 31,2004 (in thousands):

 
| ** **                                             | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Mortgage loans  held for sale, net:                    |       |                    |       |                        |       |
| Non-Conforming                                         |       | $                       | 407,499    |                        | 252,620    |   |
| Conforming                                             |       | 140,947                 |       | 104,430                     |       |
| Total mortgage  loans held for sale, net               |       | $                       | 548,446    |                        | 357,050    |   |
| Warehouse  financing—mortgage loans held for sale |       | $                       | 361,747    |                        | 188,496    |   |
| Percentage  financed—mortgage loans held for sale |       | 66                      | %          | 53                          | %          |

 

The increase in mortgageloans held for sale, net, at June 30, 2005 compared to December 31,2004 reflects the increase in non-conforming loan origination volumes in thetwo months ended June 30, 2005 compared to the two months ended December 31,2004. We typically retain loans held for sale for approximately 60 daysprior to investor purchase. We had $4.2 million and $6.6 million ofloans deemed to be unsaleable at standard sale premiums as of June 30,2005 and December 31, 2004, respectively, for which we had recorded avaluation allowance of $0.9 million and $1.9 million, respectively.

 

Warehouse financing—loansheld for sale increased as of June 30, 2005 compared to December 31,2004 reflecting our increased level of mortgage loans held for sale at June 30,2005. We expect the balance of warehouse financing to increase relative to thebalance of loans held for sale, as we deploy the remaining equity offeringproceeds.

 

***Trustee Receivable***

 

Trustee receivable increasedto $95.6 million at June 30, 2005, from $91.1 million at December 31,2004. The increase reflects higher principal payments and prepaid loan paymentsreceived after the cut-off date for the current month bond payments from ourseven securitized mortgage pools outstanding as of June 30, 2005, comparedto six securitized pools outstanding as of December 31, 2004. Trusteereceivable includes principal and interest

 

32

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prepayments received afterthe 15th day prior to the end of the reporting period from loanssecuritized in pools FMIT Series 2004-1 through pools FMIT Series 2005-1,and prepayments received by the trustee after the last day of the month priorto the end of the reporting period from loans in pool FMIC Series 2003-1.The funds are retained by the trustee until the following month’s disbursementdate.

 

***Derivative Assets, Net***

 

Derivative assets, netincreased to $28.2 million at June 30, 2005, from $20.2 millionat December 31, 2004. The increase primarily relates to the $8.5 millionincrease in the fair value of the interest rate swap and cap agreements overthe period, reflecting an increase in the two year swap rate as of the end ofthe second quarter of 2005.

 

***Securitization Financing***

 

The following is a summaryof the outstanding securitization bond financing by series as of June 30,2005 and December 31, 2004 (in thousands): 

 
| ** **                      | ** ** | ** **        | ** ** | **Balance as of**       | ** ** |
|---------------------------------|------------|-------------------|------------|-------------------------|------------|
| ** **                      | ** ** | **Bonds  Issued** | ** ** | **June 30,  2005** | ** ** | **December 31,  2004** | ** ** |
| FMIT  Series 2005-1        |       | $                 | 728,625    |                    | 690,744    |   | — |   |
| FMIT  Series 2004-5        |       | 863,550           |       | 768,013                 |       | 861,403 |   |
| FMIT  Series 2004-4        |       | 845,283           |       | 692,985                 |       | 816,527 |   |
| FMIT  Series 2004-3        |       | 949,000           |       | 714,969                 |       | 879,659 |   |
| FMIT  Series 2004-2        |       | 843,920           |       | 502,954                 |       | 692,854 |   |
| FMIT  Series 2004-1        |       | 652,944           |       | 353,117                 |       | 484,025 |   |
| FMIC  Series 2003-1        |       | 488,923           |       | 245,578                 |       | 316,817 |   |
|                            |       | 5,372,245         |       | 3,968,360               |       | 4,051,285 |   |
| Unamortized bond  discount      |       | (1,130            | )          | (352                    | )          | (499 | ) |
| Total  securitization financing |       | $                 | 5,371,115  |                    | 3,968,008  |   | 4,050,786 |   |

 

During the six months ended June 30,2005 and the year ended December 31, 2004, we issued $0.7 billion and$4.2 billion, respectively, of mortgage-backed bonds throughsecuritization trusts to finance the Company’s portfolio of loans held forinvestment. Interest rates reset monthly and are indexed to one-month LIBOR.The bonds pay interest monthly based upon a spread over LIBOR. The estimatedaverage months to maturity is based on estimates and assumptions made bymanagement. The actual maturity may differ from expectations. We retain theoption to repay the bonds when the remaining unpaid principal balance of theunderlying mortgages loans for each pool falls below 20% of the originalprincipal balance, with the exception of FMIC Series 2003-1, which may berepaid when the principalbalance falls below 10% of the original collateralized amount. The repayment ofthe bonds is secured by pledging mortgage loans to the trust.

 

As of June 30, 2005 andDecember 31, 2004, the outstanding bonds were over-collateralized by$217.8 million and $194.8 million, respectively. The collateral includesmortgage loans and trustee receivables. We enter into interest rate swap or capagreements to hedge the bond costs and protect against rising interest rates.

 

***Total Shareholders’ Equity***

 

Our total shareholders’equity increased to $569.2 million at June 30, 2005, from$526.3 million at December 31, 2004. The change in shareholders’equity primarily reflects an increase in accumulated earnings of$65.2 million from net income for the six months ended June 30, 2005,partially offset by the $23.0 million in dividends paid in April 2005.

 

**Business Segment Results**

 

We have a total of sixreportable business segments, which include four production segments and twooperating segments. We originate loans through our production segments, whichinclude the Non-Conforming Wholesale, Non-Conforming Retail, ConformingWholesale, and Conforming Retail segments. The results of operations of ourproduction segments primarily include a net interest income allocation forfunded loans, direct expenses and an

 

33

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allocation of corporateoverhead expenses. In addition, revenues include an allocation method wherebythe production segments are credited with a pro forma value for net gain onsale of loan production as if all fundings were sold servicing-released,concurrent with funding, at standard investor premium margins.

 

The operating segmentsinclude the Investment Portfolio and Corporate segments. The results ofoperations of the Investment Portfolio segment primarily include the netinterest income after provision for loan losses for the loans held in ourinvestment portfolio, changes in the fair value and actual cash settlementsrelating to our portfolio derivatives, and direct expenses, includingthird-party servicing fees paid related to our loans held for investment. Theresults of operations of the Corporate segment primarily include directexpenses of the corporate home office, income tax expense related to the TRSoperating results, and the elimination of the corporate overhead allocated tothe production segments. The Corporate segment also includes amounts recordedto reconcile the internal revenue and expenses allocated to the productionsegments’ with the revenue and expense recognition in our consolidated statementof operations which complies with GAAP reporting under Statement No. 91.

 

The results of operationsreported per segment differ materially from consolidated results due to timingdifferences in net gain on sale recognition at time of cash settlement of thesale compared to loan funding, the actual sale prices compared to the pro formavalues, the actual net interest margin earned on loans, and the holding forinvestment of a substantial portion of our non-conforming loans for whichactual revenue will consist of net interest income rather than net gain onsale.

 

The following is a summaryof net income by production segments and operating segments for the three andsix months ended June 30, 2005 and 2004 (in thousands): 

 
| ** **                                   | ** ** | **Production  Segments** | ** ** | **Operating  Segments** | ** ** | **Total** | ** ** |
|----------------------------------------------|------------|--------------------------|------------|-------------------------|------------|-----------|------------|
| ***Three  Months Ended June 30, 2005*** |       |                     |       |                    |       |      |       |
| Total revenues                               |       | $                        | 51,400     |                    | 6,454      |      | 57,854     |   |
| Total expenses                               |       | 40,302                   |       | (8,257                  | )          | 32,045    |       |
| Income before  income taxes                  |       | 11,098                   |       | 14,711                  |       | 25,809    |       |
| Provision for  income tax expense            |       | —                   |       | (2,734                  | )          | (2,734    | )          |
| Net income                                   |       | $                        | 11,098     |                    | 11,977     |      | 23,075     |   |
|                                         |       |                     |       |                    |       |      |       |
| ***Three  Months Ended June 30, 2004*** |       |                     |       |                    |       |      |       |
| Total revenues                               |       | $                        | 56,439     |                    | 7,060      |      | 63,499     |   |
| Total expenses                               |       | 46,647                   |       | (14,583                 | )          | 32,064    |       |
| Income before  income taxes                  |       | 9,792                    |       | 21,643                  |       | 31,435    |       |
| Provision for  income tax expense            |       | —                   |       | (1,312                  | )          | (1,312    | )          |
| Net income                                   |       | $                        | 9,792      |                    | 20,331     |      | 30,123     |   |
|                                         |       |                     |       |                    |       |      |       |
| ***Six  Months Ended June 30, 2005***   |       |                     |       |                    |       |      |       |
| Total revenues                               |       | $                        | 87,290     |                    | 44,661     |      | 131,951    |   |
| Total expenses                               |       | 75,523                   |       | (10,544                 | )          | 64,979    |       |
| Income before  income taxes                  |       | 11,767                   |       | 55,205                  |       | 66,972    |       |
| Provision for  income tax expense            |       | —                   |       | (1,793                  | )          | (1,793    | )          |
| Net income                                   |       | $                        | 11,767     |                    | 53,412     |      | 65,179     |   |
|                                         |       |                     |       |                    |       |      |       |
| ***Six  Months Ended June 30, 2004***   |       |                     |       |                    |       |      |       |
| Total revenues                               |       | $                        | 105,153    |                    | (13,187    | )         | 91,966     |   |
| Total expenses                               |       | 86,804                   |       | (24,192                 | )          | 62,612    |       |
| Income before  income taxes                  |       | 18,349                   |       | 11,005                  |       | 29,354    |       |
| Provision for  income tax expense            |       | —                   |       | (3,002                  | )          | (3,002    | )          |
| Net income                                   |       | $                        | 18,349     |                    | 8,003      |      | 26,352     |   |

 

34

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***ProductionSegment Results***

 

The following tablessummarize our production segment results for the three and six months ended June 30,2005 and 2004 (in thousands): 

 
| ** **                                   | ** ** | **Non-Conforming** | ** ** | **Conforming** | ** ** | **Total**     | ** ** |
|----------------------------------------------|------------|--------------------|------------|----------------|------------|---------------|------------|
| ** **                                   | ** ** | **Wholesale**      | ** ** | **Retail**     | ** ** | **Wholesale** | ** ** | **Retail** | ** ** | **Production** | ** ** |
| ***Three  Months Ended June 30, 2005*** |       |               |       |           |       |          |       |   |   |   |   |
| Revenues                                     |       | $                  | 37,733     |           | 9,213      |          | 1,821      |   | 2,633 |   | 51,400 |   |
| Direct expenses                              |       | 19,203             |       | 7,918          |       | 1,992         |       | 3,566 |   | 32,679 |   |
| Segment  contribution                        |       | 18,530             |       | 1,295          |       | (171          | )          | (933 | ) | 18,721 |   |
| Corporate  overhead allocation               |       | 6,096              |       | 968            |       | 352           |       | 207 |   | 7,623 |   |
| Net income  (loss)                           |       | $                  | 12,434     |           | 327        |          | (523       | ) | (1,140 | ) | 11,098 |   |
| Funding volume                               |       | $                  | 1,468,308  |           | 165,305    |          | 286,368    |   | 95,026 |   | 2,015,007 |   |
| Segment  contribution as a % of volume       |       | 1.26               | %          | 0.78           | %          | (0.06         | )%         | (0.98 | )% | 0.93 | % |
|                                         |       |               |       |           |       |          |       |   |   |   |   |
| ***Three  Months Ended June 30, 2004*** |       |               |       |           |       |          |       |   |   |   |   |
| Revenues                                     |       | $                  | 39,555     |           | 10,392     |          | 2,206      |   | 4,286 |   | 56,439 |   |
| Direct expenses                              |       | 21,678             |       | 9,083          |       | 2,663         |       | 3,745 |   | 37,169 |   |
| Segment  contribution                        |       | 17,877             |       | 1,309          |       | (457          | )          | 541 |   | 19,270 |   |
| Corporate  overhead allocation               |       | 8,004              |       | 1,111          |       | 256           |       | 107 |   | 9,478 |   |
| Net income  (loss)                           |       | $                  | 9,873      |           | 198        |          | (713       | ) | 434 |   | 9,792 |   |
| Funding volume                               |       | $                  | 1,506,251  |           | 169,603    |          | 256,325    |   | 109,520 |   | 2,041,699 |   |
| Segment  contribution as a % of volume       |       | 1.19               | %          | 0.77           | %          | (0.18         | )%         | 0.49 | % | 0.94 | % |
|                                         |       |               |       |           |       |          |       |   |   |   |   |
| ***Six  Months Ended June 30, 2005***   |       |               |       |           |       |          |       |   |   |   |   |
| Revenues                                     |       | $                  | 62,659     |           | 16,200     |          | 3,438      |   | 4,993 |   | 87,290 |   |
| Direct expenses                              |       | 36,030             |       | 15,594         |       | 4,014         |       | 6,784 |   | 62,422 |   |
| Segment  contribution                        |       | 26,629             |       | 606            |       | (576          | )          | (1,791 | ) | 24,868 |   |
| Corporate  overhead allocation               |       | 10,419             |       | 1,714          |       | 630           |       | 338 |   | 13,101 |   |
| Net income  (loss)                           |       | $                  | 16,210     |           | (1,108     | )             | (1,206     | ) | (2,129 | ) | 11,767 |   |
| Funding volume                               |       | $                  | 2,444,212  |           | 293,082    |          | 560,978    |   | 172,587 |   | 3,470,859 |   |
| Segment  contribution as a % of volume       |       | 1.09               | %          | 0.21           | %          | (0.10         | )%         | (1.04 | )% | 0.72 | % |
|                                         |       |               |       |           |       |          |       |   |   |   |   |
| ***Six  Months Ended June 30, 2004***   |       |               |       |           |       |          |       |   |   |   |   |
| Revenues                                     |       | $                  | 71,711     |           | 21,018     |          | 4,218      |   | 8,206 |   | 105,153 |   |
| Direct expenses                              |       | 39,451             |       | 18,121         |       | 5,043         |       | 7,258 |   | 69,873 |   |
| Segment  contribution                        |       | 32,260             |       | 2,897          |       | (825          | )          | 948 |   | 35,280 |   |
| Corporate  overhead allocation               |       | 14,212             |       | 2,101          |       | 427           |       | 191 |   | 16,931 |   |
| Net income  (loss)                           |       | $                  | 18,048     |           | 796        |          | (1,252     | ) | 757 |   | 18,349 |   |
| Funding volume                               |       | $                  | 2,628,222  |           | 332,741    |          | 472,185    |   | 203,110 |   | 3,636,258 |   |
| Segment  contribution as a % of volume       |       | 1.23               | %          | 0.87           | %          | (0.17         | )%         | 0.47 | % | 0.97 | % |

 

Production segment netincome increased during the three months ended June 30, 2005 compared tothe same period in 2004, primarily due to lower origination costs and corporateoverhead allocation per loan in our non-conforming wholesale and retail segments,with origination volumes relatively unchanged. Production segment net incomedecreased during the first half of 2005 compared to the first half of 2004 dueto lower funding volumes and increased competitive pressures. In response toindustry-wide margin compression on new loan originations, as interest ratesincreased, our revenues per loan decreased in all production segments. Weexpect margins to remain at these compressed levels throughout the remainder of2005 as the industry adjusts rates on new loan originations to mirror changesin the yield curve. To address the market revenue compression and increasesegment contribution from each of our production segments to meet or exceed2004 levels, we are focusing on expansion opportunities in favorable geographiclocations, hiring additional account executives and loan officers andimplementing cost efficiency initiatives, including savings generated as weimplement our new loan origination system.

 

***Non-Conforming Wholesale Segment.***  Our non-conforming wholesale segment continued to report a positivesegment contribution before corporate allocation in the three and six monthsended June 30, 2005, although the 

 

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contribution was reducedthrough six months ended June 30, 2005 from levels in the same period in2004, primarily due to lower origination volume and thinning interest and salemargins as interest rates increased throughout 2004 and the first six months of2005. The decrease in direct expenses in three and six months ended June 30,2005 compared to the three and six months ended June 30, 2004 reflectslower variable loan costs including commissions, related to the decrease inloan production quarter over quarter and year over year.

 

***Non-Conforming Retail Segment.***  The increase in our non-conforming retail segment contribution in thethree months ended June 30, 2005 from the three months ended June 30,2004 reflects a decrease in direct origination expenses quarter over quarter,as new divisional management restructured operations support costs andmarketing initiatives. The decrease in segment contribution in the six monthsended June 30, 2005 compared to the same period in 2004 reflects areduction in origination volume and revenue per loan year over year, dueprimarily to increased pricing competition and a higher percentage in 2005 ofsecond lien originations, which generate lower fee income. Our non-conformingretail direct expenses decreased in 2005 due to a reduction in marketinginitiatives and the salary expenses associated with cost efficiency measuresimplemented within the production centers in 2005. We have reduced our totalmarketing budget for 2005 and appointed new management to support our model ofincreasing volume, reducing costs and continuing to report a positive segmentcontribution throughout the remainder of 2005.

 

***Conforming Wholesale Segment.***  The conforming wholesale segment negative contribution reported in thethree and six months ended June 30, 2005, while improved from contributionlevels in the same periods in 2004, continues to reflect thinner interest andsale margins, partially offset by direct production cost decreases due to thedownsizing of production operations. In the second half of 2004, we evaluatedeach conforming wholesale branch for profitability and closed those brancheswith negative contributions. Management is performing a review of the potentialprofitability of the conforming wholesale operation, and expects to determinewithin the third quarter of 2005 if future volume expectations of this segmentare sufficient to achieve profitability despite continued competition anddepressed margins, or if an alternate action plan for the resources used tosupport this segment should be considered.

 

***Conforming Retail Segment.***  Thedecrease in our conforming retail segment contribution in the three and sixmonths ended June 30, 2005 from the three and six months ended June 30,2004 reflects a 13% decrease in loan funding volume quarter over quarter, a 15%decrease year over year, combined with additional salaries and office expensesincurred to expand our offices in the Colorado region. During the first sixmonths of 2005, we opened 6 new branches, primarily in the Midwest region,which have incurred substantial operating start-up costs.  In concert with our review of the conformingwholesale segment, we are currently examining each conforming retail branchoffice for near-term profitability, to determine whether additional resourcesshould be deployed to support under-performing branches until the branch volumeis sufficient to produce positive income contributions.

 

***Operating SegmentResults***

 

The following tablesummarizes our operating segment results for the three and six months ended June 30,2005 and 2004 (in thousands): 

 

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| ** **                                   | ** ** | ** **                | ** ** | **Corporate**        | ** ** | ** **                        | ** ** |
|----------------------------------------------|------------|---------------------------|------------|----------------------|------------|-----------------------------------|------------|
| ** **                                   | ** ** | **Investment  Portfolio** | ** ** | **Segment  Results** | ** ** | **Reconciliations  to GAAP** | ** ** | **Total  Corporate** | ** ** | **Total  Operating** | ** ** |
| ***Three  Months Ended June 30, 2005*** |       |                      |       |                 |       |                              |       |   |   |   |   |
| Revenues                                     |       | $                         | 21,936     |                 | 82         |                              | (15,564    | ) | (15,482 | ) | 6,454 |   |
| Direct expenses                              |       | 2,014                     |       | 10,054               |       | (12,702                           | )          | (2,648 | ) | (634 | ) |
| Segment  contribution                        |       | 19,922                    |       | (9,972               | )          | (2,862                            | )          | (12,834 | ) | 7,088 |   |
| Corporate  overhead allocation               |       | —                    |       | (7,623               | )          | —                            |       | (7,623 | ) | (7,623 | ) |
| Income (loss)  before income taxes           |       | 19,922                    |       | (2,349               | )          | (2,862                            | )          | (5,211 | ) | 14,711 |   |
| Provision for  income tax expense            |       | —                    |       | (2,734               | )          | —                            |       | (2,734 | ) | (2,734 | ) |
| Net income  (loss)                           |       | $                         | 19,922     |                 | (5,083     | )                                 | (2,862     | ) | (7,945 | ) | 11,977 |   |
|                                         |       |                      |       |                 |       |                              |       |   |   |   |   |
| ***Three  Months Ended June 30, 2004*** |       |                      |       |                 |       |                              |       |   |   |   |   |
| Revenues                                     |       | $                         | 44,740     |                 | 76         |                              | (37,756    | ) | (37,680 | ) | 7,060 |   |
| Direct expenses                              |       | 1,777                     |       | 7,628                |       | (14,510                           | )          | (6,882 | ) | (5,105 | ) |
| Segment  contribution                        |       | 42,963                    |       | (7,552               | )          | (23,246                           | )          | (30,798 | ) | 12,165 |   |
| Corporate  overhead allocation               |       | —                    |       | (9,478               | )          | —                            |       | (9,478 | ) | (9,478 | ) |
| Income (loss)  before income taxes           |       | 42,963                    |       | 1,926                |       | (23,246                           | )          | (21,320 | ) | 21,643 |   |
| Provision for  income tax expense            |       | —                    |       | (1,312               | )          | —                            |       | (1,312 | ) | (1,312 | ) |
| Net income  (loss)                           |       | $                         | 42,963     |                 | 614        |                              | (23,246    | ) | (22,632 | ) | 20,331 |   |
|                                         |       |                      |       |                 |       |                              |       |   |   |   |   |
| ***Six  Months Ended June 30, 2005***   |       |                      |       |                 |       |                              |       |   |   |   |   |
| Revenues                                     |       | $                         | 81,811     |                 | 118        |                              | (37,268    | ) | (37,150 | ) | 44,661 |   |
| Direct expenses                              |       | 4,998                     |       | 19,240               |       | (21,680                           | )          | (2,440 | ) | 2,558 |   |
| Segment  contribution                        |       | 76,813                    |       | (19,122              | )          | (15,588                           | )          | (34,710 | ) | 42,103 |   |
| Corporate  overhead allocation               |       | —                    |       | (13,102              | )          | —                            |       | (13,102 | ) | (13,102 | ) |
| Income (loss)  before income taxes           |       | 76,813                    |       | (6,020               | )          | (15,588                           | )          | (21,608 | ) | 55,205 |   |
| Provision for  income tax expense            |       | —                    |       | (1,793               | )          | —                            |       | (1,793 | ) | (1,793 | ) |
| Net income  (loss)                           |       | $                         | 76,813     |                 | (7,813     | )                                 | (15,588    | ) | (23,401 | ) | 53,412 |   |
|                                         |       |                      |       |                 |       |                              |       |   |   |   |   |
| ***Six  Months Ended June 30, 2004***   |       |                      |       |                 |       |                              |       |   |   |   |   |
| Revenues                                     |       | $                         | 53,154     |                 | 322        |                              | (66,663    | ) | (66,341 | ) | (13,187 | ) |
| Direct expenses                              |       | 2,441                     |       | 15,670               |       | (25,370                           | )          | (9,700 | ) | (7,259 | ) |
| Segment  contribution                        |       | 50,713                    |       | (15,348              | )          | (41,293                           | )          | (56,641 | ) | (5,928 | ) |
| Corporate overhead  allocation               |       | —                    |       | (16,933              | )          | —                            |       | (16,933 | ) | (16,933 | ) |
| Income (loss)  before income taxes           |       | 50,713                    |       | 1,585                |       | (41,293                           | )          | (39,708 | ) | 11,005 |   |
| Provision for  income tax expense            |       | —                    |       | (3,002               | )          | —                            |       | (3,002 | ) | (3,002 | ) |
| Net income  (loss)                           |       | $                         | 50,713     |                 | (1,417     | )                                 | (41,293    | ) | (42,710 | ) | 8,003 |   |

 

***Investment Portfolio.***  Segment contribution decreased $23.0 million in thethree months ended June 30, 2005 as compared to the three months ended June 30,2004 due to the $12.1 million non-cash mark to market valuation loss oninterest rate swap and cap agreements in the second quarter of 2005 compared tothe $22.2 million non-cash mark to market valuation gain in the second quarterof 2004. The decrease in the ending valuation of the swaps and cap resultedfrom a flattening of the forward yield curve during the second quarter of 2005as compared to an increasing curve during the comparable period in 2004. Ourinterest rate swaps and cap are not designated as cash flow hedges and,therefore, the change in the periodic mark to market of the future value of theinterest rate swaps and cap is reported in current period earnings. Thenon-cash valuation decrease was partially offset by increased net interestincome on our loans held for investment as our average portfolio grew to $4.6 billion in the second quarter of2005 from $2.6 billion during the second quarter of 2004.

 

Segment contributionincreased $26.1 million in the six months ended June 30, 2005compared to the six months ended June 30, 2004 primarily due to theincrease in net interest income after provision for loan loss of$29.1 million, as a result of the growth of our portfolio of loans heldfor investment. During the six months ended June 30, 2005, our averageportfolio of loans held for investment increased to $4.7 billion from$2.1 billion for the six months ended June 30, 2004. The $2.6 millionincrease in direct expenses for the six months ended June 30, 2005compared to the same period in 2004 primarily reflects a $2.4 million increasein third-party servicing expense

 

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relating to our loanportfolio.  We anticipate a continuedincrease in investment segment contribution in 2005, primarily due to continuedincreases in net interest income on our growing investment portfolio, offset byincreasing third-party servicing fees, portfolio management personnel andanalytical technology costs.

 

***Corporate.***    Directexpenses increased from the three and six months ended June 30, 2004 to June 30,2005 due to staffing increases in the second half of 2004 primarily to supportour legal, accounting and information technology departments. The increase in2005 direct expenses also includes increases in professional costs related tooperating as a public company. We expect direct expenses to increase in 2005reflecting costs to be incurred for the implementation of Sarbanes-Oxley Actcompliance measures and additional amortization, licensing and maintenanceexpenses related to placing our new loan origination software system fully intoservice.

 

**Liquidity and Capital Resources**

 

As a mortgage lendingcompany, we borrow substantial sums of money to fund the mortgage loans weoriginate. After funding, our primary operating subsidiary, Fieldstone MortgageCompany, holds all of the conforming loans and some of the non-conforming loansthat it originates in inventory (warehouse) prior to sale. We hold theremainder of the non-conforming loans for investment in our portfolio. Ourprimary cash requirements include:

 

• mortgage origination funding;

 

• premiums paid in connection with loans originated in the wholesalechannel;

 

• interest expense on our warehouse lines and repurchase facilities andsecuritization financings;

 

• ongoing general and administrative expenses;

 

• hedge transactions; and

 

•  REIT stockholder distributions – as a REIT,we are required to distribute at least 90% of our REIT taxable income to ourstockholders.

 

Our primary cash sourcesinclude:

 

•  borrowings from our warehouse lines andrepurchase facilities secured by mortgage loans held in inventory;

 

• proceeds from the issuance of securities collateralized by the loans inour portfolio;

 

• proceeds of whole loan sales;

 

• principal and interest collections relative to the mortgage loans heldin inventory; and

 

• points and fees collected from the origination of retail and wholesaleloans.

 

We rely on oursecuritizations as a primary source of liquidity. As of June 30, 2005, wehave completed seven  securitizations,issuing an aggregate of $5.4 billion of mortgage-backed securities.

 

The following is a summaryof the securitizations issued by series during the year ended December 31,2004 and the six months ended June 30, 2005 (in millions):

 

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| ** **                                  | ** ** | **FMIT  2004-1** | ** ** | **FMIT  2004-2** | ** ** | **FMIT  2004-3** | ** ** | **FMIT  2004-4** | ** ** | **FMIT  2004-5** | ** ** | **FMIT  2005-1** | ** ** |
|---------------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|------------------|------------|------------------|------------|------------------|------------|
| Issue date                                  |       | Feb 2004         |       | Apr 2004         |       | Jul 2004         |       | Oct 2004         |       | Nov 2004         |       | Feb 2005         |       |
| Bonds issued                                |       | $                | 652        |             | $          | 844              |       | $                | 949        |             | $          | 845              |       | $ | 864 |   | $ | 729 |   |
| Loans pledged                               |       | $                | 681        |             | $          | 880              |       | $                | 1,000      |             | $          | 879              |       | $ | 900 |   | $ | 750 |   |
| Bond ratings—Standard  and Poor’s |       | AAA–BBB     |       | AAA–BBB     |       | AAA–BBB     |       | AAA–BBB     |       | AAA–BBB     |       | AAA-BBB–    |       |
| Bond ratings—Moody’s              |       | Aaa–Baa     |       | Aaa–Baa     |       | Aaa–Baa2    |       | Aaa–Baa2    |       | Aaa–Baa2    |       | Aaa–Baa3    |       |
| Financing costs—LIBOR  plus            |       | 0.29 – 1.8  | %          | 0.24 – 2.15 | %          | 0.27 – 2.15 | %          | 0.33 – 1.80 | %          | 0.24 – 1.85 | %          | 0.12-2.0         | %          |
| Weighted average  spread over LIBOR         |       | 0.55             | %          | 0.47             | %          | 0.48             | %          | 0.51             | %          | 0.53             | %          | 0.40             | %          |
| Weighted average  life of loans             |       | 2.5 years        |       | 2.5 years        |       | 2.5 years        |       | 2.5 years        |       | 2.5 years        |       | 2.5 years        |       |
| Transaction fees                            |       | 0.36             | %          | 0.32             | %          | 0.34             | %          | 0.35             | %          | 0.32             | %          | 0.36             | %          |

 

We use our various warehouselines and repurchase facilities to fund substantially all of our loanoriginations. Fieldstone Mortgage sells the mortgage loans it holds within twoor three months of origination and pays down these facilities with the saleproceeds. We issue mortgage-backed securities to pay down the portion of thosefacilities financing our loans held for investment.

 

The material terms andfeatures of these secured warehouse lines and repurchase facilities as of June 30,2005 are as follows (in millions): 

 
| **Lender**                                        | ** ** | **Committed** | ** ** | **Maturity  Date** | ** **     | **Range of  Allowable  Advances** | ** ** | **Minimum Consolidated   Tangible Net   Worth** | ** ** | **Ratio of Indebtedness   To Adjusted Tangible   Net  Worth** | ** ** | **Minimum  Liquidity** | ** ** |
|---------------------------------------------------|------------|---------------|------------|--------------------|----------------|----------------------------------------|------------|-----------------------------------------------------------|------------|-----------------------------------------------------------------------------------|------------|------------------------|------------|
| Countrywide  Warehouse Lending(1)                 |       | $             | 100.0      |               | July 2005 |                                   | 95%-99.5   | %                                                         | $          | 250.0                                                                             |       | 17:1                   |       | $ | N/A |   |
| Credit Suisse  First Boston Mortgage Capital |       | 500.0         |       | February 2006 |           | 95%-99                                 | %          | 400.0                                                     |       | 16:1                                                                              |       |                   | 15.0       |   |
| JP Morgan Chase  Bank                             |       | 150.0         |       | April 2006    |           | 95%-97                                 | %          | 400.0                                                     |       | 16:1                                                                              |       | 20.0                   |       |
| Lehman Brothers  Bank                             |       | 500.0         |       | December 2005 |           | 95.5%-98.5                             | %          | 250.0                                                     |       | 16:1                                                                              |       | 15.0                   |       |
| Merrill Lynch  Bank USA                           |       | 500.0         |       | November 2005 |           | 93%-98                                 | %          | 250.0                                                     |       | 17:1                                                                              |       | N/A                    |       |
|                                              |       | $             | 1,750.0    |               |           |                                   |       |                                                      |       |                                                                              |       |                   |       |   |
|                                                   |            |               |            |                    |                |                                        |            |                                                           |            |                                                                                   |            |                        |            |  |  |  |

 

----

(1) During the thirdquarter of 2005, the Countrywide Warehouse Lending facility was renewed throughAugust 2006. There were no material amendments to the therms of thisfacility.

 

Under our warehouse linesand repurchase facilities, interest is payable monthly in arrears andoutstanding principal is payable upon receipt of loan sale proceeds or transferof a loan into a securitization trust. Outstanding principal is also repayableupon the occurrence of certain disqualifying events, which include a mortgageloan in default for a period of time, a repaid mortgage loan, a mortgage loan obtainedwith fraudulent information or the failure to cure a defect in a mortgage loan’sdocumentation. Outstanding principal also is repayable if the mortgage loandoes not close, but had been pledged and funds were advanced. Our warehouselines and repurchase facilities contain terms mandating principal repayment ifa loan remains on the line after a contractual time period from date offunding, or on the maturity date of the facility.

 

A primary component of ourliquidity strategy is to finance our mortgage loans held for sale and our loansheld for investment (prior to issuing securities collateralized by those loans)through a diverse group of lending counterparties and to schedule frequentsales or securitizations of loans so that the average holding period of ourinventory of loans generally does not exceed 60 days.

 

We use our excess cash fromoperations and our capital to reduce the advances on our warehouse lines orrepurchase facilities. This process reduces our debt outstanding and thecorresponding interest expense incurred and results in excess mortgagecollateral available to secure borrowings in an amount required to meet ourworking capital needs. This pool of available collateral totaled approximately$223 million and $190 million as of June 30, 2005 and December 31,2004, respectively. We plan to deploy a portion of this working capital tofinance the continued growth of our investment portfolio. Depending upon theprojected incremental returns available through new loan

 

39

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originations and our stockprice, our Board of Directors may consider authorizing us to repurchase alimited amount of our common stock. Any repurchase of our common stock woulddecrease our capital base, but could increase our overall return on remainingequity. If we did decrease our capital base with a share repurchase, we wouldreduce our target portfolio balance while maintaining our current 13:1 leveragetarget.

 

The warehouse lines andrepurchase facilities are secured by substantially all of our non-securitizedmortgage loans and contain customary financial and operating covenants that,among other things, require us to maintain specified levels of liquidity andnet worth, restrict indebtedness other than in the ordinary course of business,restrict investments in other entities except in certain limited circumstances,restrict our ability to engage in mergers, consolidations or substantiallychange the nature or character of our business and require compliance with applicablelaws. We were in compliance with all of these covenants at June 30, 2005and December 31, 2004.

 

For our warehouse lines andrepurchase facilities, advances bear interest at annual rates that varydepending upon the type of mortgage loans securing the advance of LIBOR or the30-day Eurodollar rate plus an additional percentage which ranges from 0.70% to3.25%. We are required to pay facilities fees ranging from 0.10% to 0.15% ofthe committed amount of the facility. We are also required to pay non-use feeson some of the warehouse lines and repurchase facilities of  0.125% on unused amounts which exceed certainthresholds relating to the average outstanding balance of the facility.

 

On July 27,2005, FIC and FIF entered into a funding agreement with Credit Suisse, New YorkBranch, as Facility Agent, in which the Company may borrow funds under arevolving credit facility (the “facility”) in an aggregate amount not to exceed$800 million.  The facility will besecured principally by various mortgage loans and related assets, which are tobe purchased from time to time by FIF from FIC with amounts borrowed under thefacility.  The facility is scheduled toremain open until July 26, 2006.  Asof August 11, 2005, $188.6 billion was outstanding under this facility. Thisfacility bears interest at an annual rate depending upon the type of mortgageloans securing the advance of LIBOR plus an additional percentage, whichpercentage includes an administration fee on the average daily outstandingbalance of the facility.  This facilityrequires FIC to maintain specified levels of liquidity and net worth, as wellas to maintain one or more committed loan facilities with an aggregatecommitted amount at least equal to $500 million.  FIF is required to pay a non-use fee of0.125% on unused amounts that exceed certain thresholds relating to the averagedaily outstanding balance of the facility.

 

**Cash Flows**

 

For the six months ended June 30,2005, our cash flow from operations was $423.6 million as compared tooperating cash flows of $159.0 million for the six months ended June 30,2004. This increase in operating cash flows is primarily due to increasedproceeds from the higher volume of mortgage loan sales in the first half of2005 compared to the first half of 2004.

 

Our cash used in investingactivities was $640.8 million and $1.8 billion for the six months ended June 30,2005 and 2004, respectively. The decrease in investing activities primarilyrelates to the lower funding volume of loans to be held for investment, asmanagement determined to sell $640 million of loans initially designated asheld for investment due to market conditions which significantly decreaseinterest margins. Higher principal repayments in 2005 of our loans held forinvestment due to the continued seasoning of our portfolio of loans held forinvestment, also contributed to the decrease in investing activity. Ourinvesting cash flows are negative as presented in our consolidated statementsof cash flows, because they exclude the net proceeds from mortgage warehousefinancing and securitization financing used to support the increase in ourinvestment in mortgage loans. We are required to present the net proceeds from,or repayments of, mortgage financing in our consolidated statements of cash flowsas cash flow from financing activities and not as investing cash flow. Our cashflows from financing activities were $194.0 million and $1.6 billionfor the six months ended June 30, 2005 and 2004, respectively.

 

**Commitments and Contingencies**

 

We had commitments to fundapproximately $631 million and $422 million of mortgage loans at June 30,2005 and December 31, 2004, respectively. Interest rate lock commitmentsare considered derivatives under Statement No. 133, and as such, have beenrecorded at fair value in the consolidated statements of condition as acomponent of derivative assets, net. This does not necessarily represent futurecash requirements, as some of the commitments are likely to expire withoutbeing drawn upon or may be subsequently declined for credit or other reasons.

 

We had forward deliverycommitments to sell approximately $1.4 billion and $0.4 billion ofloans at June 30, 2005 and December 31, 2004, respectively, of which$76.0 million and $63.1 million, respectively, were mandatory

 

40

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sales of mortgage-backedsecurities and investor whole loan trades, and $400 million and $40 million, respectively, were treasury noteforward contracts, which we used to economically hedge the interest rate riskof our non-conforming loans.

 

Because the nature of ourbusiness involves the collection of numerous accounts, the validity of liensand compliance with various state and federal lending and consumer protectionlaws, we are subject to various legal proceedings in the ordinary course of ourbusiness related to foreclosures, bankruptcies, condemnation and quiet titleactions and alleged statutory and regulatory violations. We are also subject toother legal proceedings in the ordinary course of business related to employeematters. All of these ordinary course proceedings, taken as a whole, are notexpected to have a material adverse effect on our business, financial conditionor results of operations.

 

In addition, on May 24,2004, our former shareholders whose shares were redeemed for approximately$188.1 million following the closing of our private offering in November 2003,filed an action in the District Court of Tarrant County, Texas, against us,Fieldstone Mortgage and KPMG LLP. The lawsuit alleges that the formershareholders are entitled to an additional post-closing redemption pricepayment of approximately $19.0 million because, according to plaintiffs,our November 13, 2003 balance sheet should have included a deferred taxasset that, if included, would have increased the redemption price. At thepresent time, the ultimate outcome of this claim and the amount of liability,if any, that may result is not determinable, and no amounts have been accruedin our financial statements with respect to this claim. We intend to vigorouslydefend against this claim. Regardless of the outcome, in the opinion ofmanagement, the final resolution of this dispute will not have a materialeffect on our business, financial condition or results of operations. If weultimately are unsuccessful in defending this matter, we could be required tomake a cash payment of up to $19.0 million to the redeemed shareholders,plus potential interest and third-party costs associated with the litigation.Excluding interest or third-party costs, which may be payable as part of asettlement, the potential payment will be an increase in the redemption priceof the shares and recorded as a reduction of our paid in capital in the periodin which the dispute is resolved and will not be reflected in our incomestatement.

 

**REIT Taxable Income**

 

To maintain our status as aREIT, we are required to distribute at least 90% of our REIT taxable incomeeach year to our shareholders. Federal tax rules calculate REIT taxableincome in a manner that, in certain respects, differs from the calculation ofconsolidated net income pursuant to GAAP. Our consolidated GAAP net income willdiffer from our REIT taxable income primarily for the following reasons:

 

•  the provision for loan loss expense recognizedfor GAAP purposes is based upon our estimate of probable loan losses inherentin our current portfolio of loans held for investment, for which we have notyet recorded a charge-off (tax accounting rules allow a deduction for loanlosses only in the period when a charge-off occurs);

 

•  the mark-to-market valuation changes to ourinterest rate swap derivatives recognized for GAAP purposes are not recognizedfor tax accounting;

 

•  there are differences between GAAP and taxmethodologies for capitalization of origination expenses; and

 

•  income of the TRS is included in the REIT’searnings for consolidated GAAP purposes, but is recognized in REIT taxableincome.

 

Our REIT taxable income willcontinue to differ from our GAAP consolidated income, particularly during theperiod in which we build our investment portfolio.

 

REIT taxable income is anon-GAAP financial measure within the meaning of Regulation G promulgatedby the Securities and Exchange Commission (SEC). Management believes that thepresentation of REIT taxable income provides useful information to investorsregarding the estimated annual distributions to our investors. The presentationof REIT taxable income is not meant to be considered in isolation or as asubstitute for financial results prepared in accordance with GAAP.

 

41

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The following table is areconciliation of GAAP net income to estimated REIT taxable net income for thesix months ended June 30, 2005 and the year ended December 31, 2004(in thousands): 

 
| ** **                                                 | ** ** | **Six Months  Ended  June 30,  2005** | ** ** | **Year Ended   December 31,  2004** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------|------------|-----------------------------------------------|------------|
| Consolidated  GAAP pre-tax net income                      |       | $                                          | 66,972     |                                          | 69,530     |   |
| Plus:                                                      |       |                                       |       |                                          |       |
| Provision for  loan losses in excess of actual charge-offs |       | 8,042                                      |       | 21,056                                        |       |
| Variance in  recognition of net origination expenses       |       | 6,589                                      |       | 9,922                                         |       |
| Less:                                                      |       |                                       |       |                                          |       |
| Taxable REIT  subsidiary pre-tax net income                |       | (5,253                                     | )          | (10,091                                       | )          |
| Mark-to-market  valuation changes on derivatives           |       | (8,541                                     | )          | (22,079                                       | )          |
| Miscellaneous  other                                       |       | 665                                        |       | (4,972                                        | )          |
| Estimated REIT  taxable income                             |       | $                                          | 68,474     |                                          | 63,366     |   |

 

REIT taxable income for thesix months ended June 30, 2005 and the year ended December 31, 2004is an estimate only, and is subject to change until we file the 2004 and 2005REIT federal tax returns.

 

On July 6, 2005, aquarterly cash dividend of $0.50 per share was declared for the second quarterof 2005. The dividend was paid on July 29, 2005 to stockholders of recordat the close of business on July 20, 2005. We currently intend todistribute approximately 85% of our 2005 REIT taxable income, as well as theportion of the 2004 REIT taxable income that was not distributed in 2004.

 

**Other Operational and Investment Portfolio Data**

 

***Loan Fundings***

 

The following tableindicates our total fundings of loans held for investment and loans held forsale for the three and six months ended June 30, 2005 and 2004 (inthousands)*: 

 
| ** **                 | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                 | ** ** | **2005**                             | ** ** | **2004**                           | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                 | ** ** | **Fundings**                         | ** ** | **% of  Total**               | ** ** | **Fundings** | ** ** | **% of  Total** | ** ** | **Fundings** | ** ** | **% of  Total** | ** ** | **Fundings** | ** ** | **% of  Total** | ** ** |
| Non-Conforming:            |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans held for  investment |       | $                                    | 755,288    |                               | 46         | % | $ | 1,105,395 |   | 66 | % | $ | 929,309 |   | 34 | % | $ | 1,939,041 |   | 65 | % |
| Loans held for  sale       |       | 878,325                              |       | 54                                 | %          | 570,459 |   | 34 | % | 1,807,985 |   | 66 | % | 1,021,922 |   | 35 | % |
| Total Non-Conforming       |       | 1,633,613                            |       | 100                                | %          | 1,675,854 |   | 100 | % | 2,737,294 |   | 100 | % | 2,960,963 |   | 100 | % |
|                       |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Conforming:                |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans held for  sale       |       | 381,394                              |       | 100                                | %          | 365,845 |   | 100 | % | 733,565 |   | 100 | % | 675,295 |   | 100 | % |
| Total Fundings             |       | $                                    | 2,015,007  |                               |       |   | $ | 2,041,699 |   |   |   | $ | 3,470,859 |   |   |   | $ | 3,636,258 |   |   |   |

 

----

*                    Data for the three and six months ended June 30,2005 reflects the second quarter of 2005 net transfer of mortgage loans heldfor investment to mortgage loans held for sale

 

The decrease in loan fundingsin three and six months ended June 30, 2005 compared to the three and sixmonths ended June 30, 2004 was the result of a 2.5% decrease in ournon-conforming fundings quarter over quarter and 7.6% decrease year over yearas we responded to rising interest rates and narrower interest margins byincreasing the interest rate on new originations to a greater degree than manyof our industry competitors. The decision of our competitors to accept narrowernet interest margins rather than increase new origination interest ratesreduced our competitive position and reduced our origination volume. In March 2005,we evaluated our year to date gain on sale margins and adjusted the coupon onnew loan originations to more closely reflect market pricing. The quarter overquarter decrease in non-conforming volume was partially offset by a 4.3%increase in our conforming fundings, as new retail branches opened in thesecond half of 2004 contributed to the higher fundings volume. We expectfunding volumes to grow approximately 4% in 2005 from 2004 volumes, as we hireadditional account executives and loan officers in both our new and existingproduction centers and continue our geographic expansion. We expect interest

 

42

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margins to improve modestlyover the remainder of 2005, but we do not expect that these margins will returnto 2003 or 2004 levels because competitive pressures likely will prevent awidening of the margins.

 

The following tables providea summary of the characteristics of our total non-conforming loan originationsfor the three months ended June 30, 2005 (in thousands):

 

*IncomeDocumentation*

 
| ** **                   | ** ** | **Aggregate Principal   Balance** | ** ** | **Percent of Mortgage   Pool** | ** ** | **Weighted Average   Coupon** | ** ** | **Weighted Average   Credit Score** | ** ** | **Average Principal   Balance** | ** ** | **Weighted Average   LTV** | ** ** | **Weighted Average   CLTV** | ** ** |
|------------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|------------------------------------|------------|-----------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|
| Full  Documentation          |       | $                                      | 758,648    |                                     | 46.4       | %                                  | 7.2        | %                                             | 631        |                                 | $          | 131                             |       | 84.6                             | %          | 92.9 | % |
| Stated Income  Wage Earner   |       | 433,936                                |       | 26.6                                     | %          | 7.5                                | %          | 682                                           |       | 172                                  |       | 83.5                            | %          | 95.3                             | %          |
| Stated Income  Self Employed |       | 252,408                                |       | 15.4                                     | %          | 7.5                                | %          | 674                                           |       | 183                                  |       | 83.0                            | %          | 93.5                             | %          |
| 24 Month Bank  Statements    |       | 58,619                                 |       | 3.6                                      | %          | 7.2                                | %          | 640                                           |       | 195                                  |       | 85.5                            | %          | 92.7                             | %          |
| 12 Month Bank  Statements    |       | 120,935                                |       | 7.4                                      | %          | 7.3                                | %          | 645                                           |       | 181                                  |       | 84.5                            | %          | 94.5                             | %          |
| Limited  Documentation       |       | 9,067                                  |       | 0.6                                      | %          | 7.6                                | %          | 648                                           |       | 189                                  |       | 81.2                            | %          | 92.0                             | %          |
| Total                        |       | $                                      | 1,633,613  |                                     | 100.0      | %                                  |       |                                          |       |                                 |       |                            |       |                             |       |   |
| Weighted  Average/Average    |       |                                   |       |                                     |       | 7.3                                | %          | 653                                           |       | $                                    | 153        |                            | 84.1       | %                                | 93.7       | % |

* *

*CreditScore*

 
| ** **                | ** ** | **Aggregate Principal   Balance** | ** ** | **Percent of Mortgage   Pool** | ** ** | **Weighted Average   Coupon** | ** ** | **Weighted Average   Credit  Score** | ** ** | **Average Principal   Balance** | ** ** | **Weighted Average   LTV** | ** ** | **Weighted Average   CLTV** | ** ** | **Percent Full   Documentation** | ** ** |
|---------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|------------------------------------|------------|-------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|---------------------------------------|------------|
| 500 – 549            |       | $                                      | 43,070     |                                     | 2.6        | %                                  | 8.6        | %                                         | 535        |                                 | $          | 150                             |       | 79.7                             | %          | 80.9                                  | %          | 84.2 | % |
| 550 – 599            |       | 218,471                                |       | 13.4                                     | %          | 7.7                                | %          | 580                                       |       | 136                                  |       | 83.1                            | %          | 88.5                             | %          | 77.6                                  | %          |
| 600 – 649            |       | 497,181                                |       | 30.4                                     | %          | 7.3                                | %          | 627                                       |       | 144                                  |       | 84.5                            | %          | 93.7                             | %          | 61.9                                  | %          |
| 650 – 699            |       | 589,639                                |       | 36.1                                     | %          | 7.3                                | %          | 671                                       |       | 161                                  |       | 84.4                            | %          | 96.0                             | %          | 29.4                                  | %          |
| 700 or greater            |       | 285,252                                |       | 17.5                                     | %          | 7.2                                | %          | 733                                       |       | 168                                  |       | 83.9                            | %          | 95.2                             | %          | 25.2                                  | %          |
| Total                     |       | $                                      | 1,633,613  |                                     | 100.0      | %                                  |       |                                      |       |                                 |       |                            |       |                             |       |                                  |       |   |
| Weighted  Average/Average |       |                                   |       |                                     |       | 7.3                                | %          | 653                                       |       | $                                    | 153        |                            | 84.1       | %                                | 93.7       | %                                     | 46.5       | % |

* *

*ProductType*

* *
| ** **                | ** ** | **Aggregate Principal   Balance** | ** ** | **Percent of Mortgage   Pool** | ** ** | **Weighted Average   Coupon** | ** ** | **Weighted Average   Credit  Score** | ** ** | **Average Principal   Balance** | ** ** | **Weighted Average   LTV** | ** ** | **Weighted Average   CLTV** | ** ** | **Percent Full   Documentation** | ** ** |
|---------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|------------------------------------|------------|-------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|---------------------------------------|------------|
| 2/28 LIBOR ARM            |       | $                                      | 300,878    |                                     | 18.4       | %                                  | 7.4        | %                                         | 623        |                                 | $          | 148                             |       | 83.6                             | %          | 93.1                                  | %          | 59.2 | % |
| 2/28 LIBOR ARM  IO        |       | 682,115                                |       | 41.7                                     | %          | 6.8                                | %          | 663                                       |       | 278                                  |       | 81.8                            | %          | 94.6                             | %          | 34.9                                  | %          |
| 3/27 LIBOR ARM            |       | 126,245                                |       | 7.7                                      | %          | 7.4                                | %          | 627                                       |       | 149                                  |       | 82.7                            | %          | 91.2                             | %          | 64.9                                  | %          |
| 3/27 LIBOR ARM  IO        |       | 206,336                                |       | 12.6                                     | %          | 6.8                                | %          | 661                                       |       | 265                                  |       | 82.1                            | %          | 93.0                             | %          | 50.3                                  | %          |
| 5/25 Treasury  ARM        |       | 3,197                                  |       | 0.2                                      | %          | 7.2                                | %          | 672                                       |       | 178                                  |       | 80.8                            | %          | 90.2                             | %          | 68.3                                  | %          |
| 5/25 Treasury  ARM IO     |       | 20,833                                 |       | 1.3                                      | %          | 6.5                                | %          | 687                                       |       | 302                                  |       | 77.9                            | %          | 87.3                             | %          | 55.2                                  | %          |
| Fixed Rate                |       | 89,760                                 |       | 5.5                                      | %          | 7.1                                | %          | 658                                       |       | 139                                  |       | 79.5                            | %          | 85.0                             | %          | 71.4                                  | %          |
| Fixed Rate IO             |       | 10,887                                 |       | 0.7                                      | %          | 6.9                                | %          | 662                                       |       | 259                                  |       | 79.6                            | %          | 91.5                             | %          | 46.3                                  | %          |
| 6 Month ARM IO            |       | 2,978                                  |       | 0.2                                      | %          | 6.7                                | %          | 669                                       |       | 331                                  |       | 81.0                            | %          | 92.4                             | %          | 0.0                                   | %          |
| 2nd Liens                 |       | 190,384                                |       | 11.7                                     | %          | 10.0                               | %          | 665                                       |       | 50                                   |       | 99.0                            | %          | 99.0                             | %          | 39.1                                  | %          |
| Total                     |       | $                                      | 1,633,613  |                                     | 100.0      | %                                  |       |                                      |       |                                 |       |                            |       |                             |       |                                  |       |   |
| Weighted  Average/Average |       |                                   |       |                                     |       | 7.3                                | %          | 653                                       |       | $                                    | 153        |                            | 84.1       | %                                | 93.7       | %                                     | 46.5       | % |

 

43

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***Cost to Produce***

 

Cost to produce is anon-GAAP financial measure within the meaning of Regulation G promulgatedby the SEC. Management believes that the presentation of cost to produceprovides useful information to investors regarding financial performancebecause this measure includes additional costs to originate mortgage loans,both recognized when incurred and deferred costs, which are not all included intotal expenses under GAAP. In addition, the production segments’ cost toproduce includes the allocation of the direct expenses of the operatingsegments, which include corporate home office costs and investment portfoliomanagement costs. The presentation of cost to produce is not meant to beconsidered in isolation or as a substitute for financial results prepared inaccordance with GAAP.

 

As required by Regulation G,a reconciliation of cost to produce to the most directly comparable measureunder GAAP, which is total expenses, is provided below for the three and sixmonths ended June 30, 2005 and 2004 (in thousands): 

 
| ** **                                                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                  | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Total expenses                                                              |       | $                                     | 32,045     |                                | 32,064     |   | 64,979 |   | 62,612 |   |
| Deferred  origination costs                                                 |       | 12,703                                |       | 14,510                              |       | 21,681 |   | 25,371 |   |
| Servicing costs—internal  and external                                 |       | (2,504                                | )          | (1,968                              | )          | (5,823 | ) | (3,396 | ) |
| Total general  and administrative costs                                     |       | 42,244                                |       | 44,606                              |       | 80,837 |   | 84,587 |   |
| Premiums paid,  net of fees collected                                       |       | 5,568                                 |       | 3,336                               |       | 10,133 |   | 6,521 |   |
| Cost to produce                                                             |       | $                                     | 47,812     |                                | 47,942     |   | 90,970 |   | 91,108 |   |
|                                                                        |       |                                  |       |                                |       |   |   |   |   |   |
| Fundings:                                                                   |       |                                  |       |                                |       |   |   |   |   |
| Non-Conforming  wholesale                                                   |       | $                                     | 1,468,308  |                                | 1,506,251  |   | 2,444,212 |   | 2,628,222 |   |
| Non-Conforming  retail                                                      |       | 165,305                               |       | 169,603                             |       | 293,082 |   | 332,741 |   |
| Conforming  wholesale                                                       |       | 286,368                               |       | 256,325                             |       | 560,978 |   | 472,185 |   |
| Conforming  retail                                                          |       | 95,026                                |       | 109,520                             |       | 172,587 |   | 203,110 |   |
| Total mortgage  fundings                                                    |       | $                                     | 2,015,007  |                                | 2,041,699  |   | 3,470,859 |   | 3,636,258 |   |
|                                                                        |       |                                  |       |                                |       |   |   |   |   |   |
| Cost to produce  as % of total mortgage loan fundings                       |       | 2.37                                  | %          | 2.35                                | %          | 2.62 | % | 2.51 | % |
| Total general  and administrative costs as% of total mortgage loan fundings |       | 2.10                                  | %          | 2.18                                | %          | 2.33 | % | 2.33 | % |
|                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Segment cost to  produce as % of mortgage loan fundings:                    |       |                                  |       |                                |       |   |   |   |   |
| Non-Conforming  wholesale                                                   |       | 2.24                                  | %          | 2.29                                | %          | 2.49 | % | 2.43 | % |
| Non-Conforming  retail                                                      |       | 3.37                                  | %          | 3.49                                | %          | 3.99 | % | 3.62 | % |
| Conforming  wholesale                                                       |       | 2.37                                  | %          | 2.08                                | %          | 2.40 | % | 2.26 | % |
| Conforming  retail                                                          |       | 2.66                                  | %          | 2.02                                | %          | 2.85 | % | 2.23 | % |

 

Our cost to produceincreased in the three and six months ended June 30, 2005 from the prioryear level in the same period, primarily due to the level of conforming segmentfixed expenses in 2005, including branch personnel and facilities, whichsupported a lower origination volume in 2005 as compared to 2004. The increase also was attributable toadditional expenses related to our portfolio of loans held for investment,including portfolio management personnel and increased accounting and legalcosts. We expect our cost to produce as a percentage of total mortgage loanfundings to decrease throughout the remainder of 2005 based upon theimprovement of our funding volumes during the quarter, our forecast ofrelatively flat fixed costs supporting an increase in origination volume, andour continued focus on improving cost efficiencies within the productionsegments.

 

***Non-Conforming Wholesale Segment. ***Our non-conforming wholesale segment net costto produce decreased in the second quarter of 2005 from the second quarter of2004, primarily due to a  decrease inpremiums paid to brokers in the three months ended June 30, 2005. Net costto produce increased in the first half of 2005 compared to the same period in2004 due to a 7% decrease in loan fundings year over year, while total costsremained at 2004 levels.

 

***Non-Conforming Retail Segment. ***The increase in our non-conforming retailsegment cost to produce reflects a lower origination volume, a reduction in thefees collected due mainly to increased pricing competition, and a higher

 

44

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percentage in 2005 of secondlien originations, which generate lower fee income. We expect the segment’scost to produce to improve throughout the remainder of 2005 due to reductionsin marketing expenses combined with an increase in origination volumes as weexpand our relationship-based and affinity-lending programs.

 

***Conforming Wholesale Segment. ***Our conforming wholesale segment cost toproduce decreased in the three and six months ended June 30, 2005 from thethree and six months ended June 30, 2004, primarily due to a decrease infixed expenses in 2005 combined with a 11.7% increase in loan fundings in thesecond quarter of 2005 and a 18.8% increase in loan fundings in the six monthsended June 30, 2005 as compared to the same periods in 2004. In the secondhalf of 2004, we evaluated each conforming wholesale branch for profitabilityand closed those branches with negative contributions. Cost to produce isexpected to continue to improve throughout 2005 due to continued operationalefficiency initiatives, including the implementation of our new loanorigination system.

 

***Conforming Retail Segment.***  The decrease in the cost to produce of our conformingretail segment in the three months ended June 30, 2005, primarily reflectsa 10% reduction in direct costs supporting a 3% reduction in loan fundings. Netcost to produce rose during the six months ended June 30, 2005 compared tothe same period in 2004 primarily due to a decrease in fees revenue due tomarket price competition and a decrease in revenue from loans brokered toother  mortgage companies.

 

***I******nvestmentPortfolio***

 

The following tables providea summary of the characteristics of the principal balance of our portfolio ofloans held for investment as of June 30, 2005 (in thousands):

 

*IncomeDocumentation*

 
| ** **                   | ** ** | **Aggregate  Principal  Balance** | ** ** | **Percent of Mortgage  Pool** | ** ** | **Weighted  Average  Coupon** | ** ** | **Weighted  Average  Credit  Score** | ** ** | **Average  Principal  Balance** | ** ** | **Weighted  Average  LTV** | ** ** | **Weighted  Average  CLTV** | ** ** |
|------------------------------|------------|-----------------------------------|------------|------------------------------------|------------|-------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| Full  Documentation          |       | $                                 | 2,232,290  |                               | 46.3       | %                             | 6.9        | %                                    | 622        |                            | $          | 167                        |       | 83.3                        | %          | 90.9 | % |
| Stated Income  Wage Earner   |       | 1,380,962                         |       | 28.6                               | %          | 6.8                           | %          | 690                                  |       | 216                             |       | 81.1                       | %          | 95.1                        | %          |
| Stated Income  Self Employed |       | 745,068                           |       | 15.4                               | %          | 7.0                           | %          | 671                                  |       | 219                             |       | 80.5                       | %          | 93.4                        | %          |
| 24 Month Bank  Statements    |       | 197,582                           |       | 4.1                                | %          | 6.8                           | %          | 628                                  |       | 229                             |       | 83.8                       | %          | 91.3                        | %          |
| 12 Month Bank  Statements    |       | 247,213                           |       | 5.1                                | %          | 6.9                           | %          | 639                                  |       | 218                             |       | 83.1                       | %          | 91.7                        | %          |
| Limited  Documentation       |       | 25,454                            |       | 0.5                                | %          | 7.0                           | %          | 632                                  |       | 210                             |       | 80.8                       | %          | 92.5                        | %          |
| Total                        |       | $                                 | 4,828,569  |                               | 100.0      | %                             |       |                                 |       |                            |       |                       |       |                        |       |   |
| Weighted  Average/Average    |       |                              |       |                               |       | 6.9                           | %          | 650                                  |       | $                               | 191        |                       | 82.2       | %                           | 92.6       | % |

 

45

----

 

*CreditScore*

 
| ** **                | ** ** | **Aggregate Principal   Balance** | ** ** | **Percent of Mortgage   Pool** | ** ** | **Weighted Average   Coupon** | ** ** | **Weighted Average   Credit  Score** | ** ** | **Average Principal   Balance** | ** ** | **Weighted Average   LTV** | ** ** | **Weighted Average   CLTV** | ** ** | **Percent Full   Documentation** | ** ** |
|---------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|------------------------------------|------------|-------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|---------------------------------------|------------|
| 500 – 549            |       | $                                      | 331,095    |                                     | 6.9        | %                                  | 7.9        | %                                         | 531        |                                 | $          | 139                             |       | 80.3                             | %          | 81.5                                  | %          | 82.2 | % |
| 550 – 599            |       | 692,756                                |       | 14.4                                     | %          | 7.4                                | %          | 576                                       |       | 161                                  |       | 82.6                            | %          | 85.6                             | %          | 75.5                                  | %          |
| 600 – 649            |       | 1,207,715                              |       | 25.0                                     | %          | 6.8                                | %          | 627                                       |       | 192                                  |       | 82.5                            | %          | 91.4                             | %          | 63.8                                  | %          |
| 650 – 699            |       | 1,624,859                              |       | 33.6                                     | %          | 6.7                                | %          | 674                                       |       | 210                                  |       | 82.1                            | %          | 96.0                             | %          | 27.8                                  | %          |
| 700 or greater            |       | 972,144                                |       | 20.1                                     | %          | 6.5                                | %          | 734                                       |       | 214                                  |       | 82.4                            | %          | 97.2                             | %          | 22.2                                  | %          |
| Total                     |       | $                                      | 4,828,569  |                                     | 100.0      | %                                  |       |                                      |       |                                 |       |                            |       |                             |       |                                  |       |   |
| Weighted  Average/Average |       |                                   |       |                                     |       | 6.9                                | %          | 650                                       |       | $                                    | 191        |                            | 82.2       | %                                | 92.6       | %                                     | 46.2       | % |

 

*ProductType*

 
| ** **                | ** ** | **Aggregate Principal   Balance** | ** ** | **Percent of Mortgage   Pool** | ** ** | **Weighted Average   Coupon** | ** ** | **Weighted Average   Credit  Score** | ** ** | **Average Principal   Balance** | ** ** | **Weighted Average   LTV** | ** ** | **Weighted Average   CLTV** | ** ** | **Percent Full   Documentation** | ** ** |
|---------------------------|------------|----------------------------------------|------------|------------------------------------------|------------|------------------------------------|------------|-------------------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|----------------------------------|------------|---------------------------------------|------------|
| 2/28 LIBOR ARM            |       | $                                      | 1,619,275  |                                     | 33.5       | %                                  | 7.2        | %                                         | 627        |                                 | $          | 143                             |       | 82.3                             | %          | 90.7                                  | %          | 53.4 | % |
| 2/28 LIBOR ARM  IO        |       | 2,621,123                              |       | 54.3                                     | %          | 6.6                                | %          | 664                                       |       | 249                                  |       | 82.3                            | %          | 94.2                             | %          | 39.9                                  | %          |
| 3/27 LIBOR ARM            |       | 161,603                                |       | 3.3                                      | %          | 7.3                                | %          | 624                                       |       | 147                                  |       | 81.8                            | %          | 89.7                             | %          | 62.7                                  | %          |
| 3/27 LIBOR ARM  IO        |       | 237,202                                |       | 4.9                                      | %          | 6.7                                | %          | 660                                       |       | 249                                  |       | 81.2                            | %          | 91.3                             | %          | 48.8                                  | %          |
| 5/25 Treasury  ARM        |       | 24,687                                 |       | 0.5                                      | %          | 6.4                                | %          | 656                                       |       | 167                                  |       | 79.0                            | %          | 86.0                             | %          | 61.1                                  | %          |
| 5/25 Treasury  ARM IO     |       | 66,635                                 |       | 1.4                                      | %          | 6.2                                | %          | 674                                       |       | 263                                  |       | 81.1                            | %          | 90.1                             | %          | 65.7                                  | %          |
| Fixed Rate                |       | 80,689                                 |       | 1.7                                      | %          | 8.2                                | %          | 680                                       |       | 97                                   |       | 84.6                            | %          | 89.4                             | %          | 48.9                                  | %          |
| Fixed Rate IO             |       | 12,184                                 |       | 0.3                                      | %          | 6.9                                | %          | 680                                       |       | 214                                  |       | 79.6                            | %          | 91.2                             | %          | 52.1                                  | %          |
| 6 Month ARM IO            |       | 5,171                                  |       | 0.1                                      | %          | 6.6                                | %          | 687                                       |       | 225                                  |       | 80.7                            | %          | 93.6                             | %          | 23.5                                  | %          |
| Total                     |       | $                                      | 4,828,569  |                                     | 100.0      | %                                  |       |                                      |       |                                 |       |                            |       |                             |       |                                  |       |   |
| Weighted  Average/Average |       |                                   |       |                                     |       | 6.9                                | %          | 650                                       |       | $                                    | 191        |                            | 82.2       | %                                | 92.6       | %                                     | 46.2       | % |

 

***Core FinancialMeasures***

 

***Core Net Income and Core EarningsPer Share (Diluted)***

 

Core net income and coreearnings per share (diluted) are non-GAAP financial measures within the meaningof Regulation G promulgated by the Securities and Exchange Commission.Management believes that the presentation of core net income and core earningsper share (diluted) provides useful information to investors regardingfinancial performance because this measure excludes the non-cash mark to marketgains or losses on interest rate swap and cap agreements. The presentation ofcore net income and core earnings per share (diluted) is not meant to beconsidered in isolation or as a substitute for financial results prepared inaccordance with GAAP.

 

As required byRegulation G, a reconciliation of net income and earnings per share(diluted) in the consolidated statements of operations, presented in accordancewith GAAP, to core net income and core earnings per share (diluted) is providedbelow for the three months ended June 30, 2005 and 2004 (in thousands):

 

46

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| ** **                                                                                                                        | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                        | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| ***Core  net income:***                                                                                                           |       |                                  |       |                                |       |   |   |   |   |
| Net income.                                                                                                                       |       | $                                     | 23,075     |                                | 30,123     |   | 65,179 |   | 26,352 |   |
| Less: Mark to  market (gain) loss on portfolio derivatives included in “Other income  (expense) – portfolio derivatives |       |                                  |       |                                |       |   |   |   |   |
| Mark to market  interest rate swaps.                                                                                              |       | 11,788                                |       | (21,074                             | )          | (8,770 | ) | (16,319 | ) |
| Mark to market  interest rate cap                                                                                                 |       | 299                                   |       | (1,084                              | )          | 229 |   | 423 |   |
| Total mark to  market on portfolio derivatives                                                                                    |       | 12,087                                |       | (22,158                             | )          | (8,541 | ) | (15,896 | ) |
| Core net income                                                                                                                   |       | $                                     | 35,162     |                                | 7,965      |   | 56,638 |   | 10,456 |   |
|                                                                                                                              |       |                                  |       |                                |       |   |   |   |   |
| ***Core  earnings per share (diluted):***                                                                                         |       |                                  |       |                                |       |   |   |   |   |
| Net income  available to common shareholders                                                                                      |       | $                                     | 23,075     |                                | 30,123     |   | 65,179 |   | 26,352 |   |
| Less: Mark to  market (gain) loss on portfolio derivatives                                                                        |       | 12,087                                |       | (22,158                             | )          | (8,541 | ) | (15,896 | ) |
| Unvested  restricted stock dividends                                                                                              |       | (176                                  | )          | (37                                 | )          | (176 | ) | (37 | ) |
| Core net income  available to common shareholders                                                                                 |       | $                                     | 34,986     |                                | 7,928      |   | 56,462 |   | 10,419 |   |
|                                                                                                                              |       |                                  |       |                                |       |   |   |   |   |
| Earnings per  share – diluted                                                                                                |       | $                                     | 0.47       |                                | 0.62       |   | 1.34 |   | 0.54 |   |
| Core earnings  per share – diluted                                                                                           |       | $                                     | 0.72       |                                | 0.16       |   | 1.17 |   | 0.24 |   |
|                                                                                                                              |       |                                  |       |                                |       |   |   |   |   |
| Diluted weighted  average common shares outstanding                                                                               |       | 48,462,126                            |       | 48,522,174                          |       | 48,462,057 |   | 48,554,060 |   |

 

Core net income for thethree months ended June 30, 2005 was $35.2 million, or core earningsper share (diluted) of $0.72, an increase of $27.2 million from the$8.0 million core net income, or core earnings per share (diluted) of$0.16 for the second quarter of 2004. Core net income for the six months ended June 30,2005 was $56.6 million, or core earnings per share (diluted) of $1.17, anincrease of $46.1 million from the $10.5 million core net income, orcore earnings per share (diluted) of $0.24 for the six months ended June 30,2004.  Core net income in the three andsix months ended June 30, 2005 was higher that the three and six monthsended June 30, 2004 due to the growth of the investment portfolio.

 

***Core Net Interest Income and Margin***

 

Core net interest incomeafter provision for loan losses is a non-GAAP financial measure within themeaning of Regulation G promulgated by the Securities and ExchangeCommission. Management believes that the presentation of core net interestincome after provision for loan losses provides useful information to investorsbecause this measure includes the effect of the net cash settlements on theexisting interest rate swap and cap agreements economically hedging thevariable rate debt financing the portfolio of mortgage loans and the net cashsettlements incurred or paid to terminate those derivatives prior to maturity.Core net interest income after provision for loan losses does not include thenet cash settlements incurred or paid to terminate swaps or caps related toloans ultimately

 

47

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sold. The presentation of core net interest income after provision forloan losses is not meant to be considered in isolation or as a substitute forfinancial results prepared in accordance with GAAP.

 

As required byRegulation G, a reconciliation of net interest income after provision forloan losses in the consolidated statements of operations, presented inaccordance with GAAP, to core net interest income after provision for loanlosses is provided below for the three and six months ended June 30, 2005and 2004 (in thousands): 

 
| ** **                                                                                                                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **2005**                              | ** ** | **2004**                            | ** ** | **2005** | ** ** | **2004** | ** ** |
| Core net  interest income after provision for loan losses:                                                                                  |       |                                  |       |                                |       |   |   |   |   |
| Net interest  income after provision for loan losses                                                                                        |       | $                                     | 39,888     |                                | 29,185     |   | 83,581 |   | 52,473 |   |
| Plus: Net cash  settlements received (paid) on portfolio derivatives included in “Other  income (expense) – portfolio derivatives |       | 2,655                                 |       | (1,782                              | )          | 2,369 |   | (5,352 | ) |
| Core net  interest income after provision for loan losses                                                                                   |       | $                                     | 42,543     |                                | 27,403     |   | 85,950 |   | 47,121 |   |
|                                                                                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Interest income  loans held for investment                                                                                                  |       | $                                     | 80,574     |                                | 42,408     |   | 163,410 |   | 69,998 |   |
|                                                                                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Interest expense  loans held for investment                                                                                                 |       | 41,773                                |       | 11,266                              |       | 80,381 |   | 18,431 |   |
| Plus: Net cash  settlements received (paid) on portfolio derivatives                                                                        |       | (2,655                                | )          | 1,782                               |       | (2,369 | ) | 5,352 |   |
| Core interest  expense – loans held for investment                                                                                     |       | 39,118                                |       | 13,048                              |       | 78,012 |   | 23,783 |   |
| Core net  interest income loans held for investment                                                                                         |       | 41,456                                |       | 29,360                              |       | 85,398 |   | 46,215 |   |
| Provision for  loan losses loans held for investment                                                                                        |       | 6,863                                 |       | 6,778                               |       | 11,357 |   | 8,957 |   |
| Core net  interest income loans held for investment after provision for loan losses                                                         |       | 34,593                                |       | 22,582                              |       | 74,041 |   | 37,258 |   |
|                                                                                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Net interest  income loans held for sale                                                                                                    |       | 7,950                                 |       | 4,821                               |       | 11,909 |   | 9,863 |   |
| Core net interest  income after provision for loan losses                                                                                   |       | $                                     | 42,543     |                                | 27,403     |   | 85,950 |   | 47,121 |   |
|                                                                                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Core Yield  Analysis:                                                                                                                       |       |                                  |       |                                |       |   |   |   |   |
| Core yield  analysis – loans held for investment:                                                                                      |       |                                  |       |                                |       |   |   |   |   |
| Yield on loans  held for investment                                                                                                         |       | 6.9                                   | %          | 6.6                                 | %          | 6.9 | % | 6.6 | % |
|                                                                                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Cost of  financing for loans held for investment                                                                                            |       | 3.7                                   | %          | 1.9                                 | %          | 3.5 | % | 2.0 | % |
| Net cash  settlements (received) paid on portfolio derivatives                                                                              |       | (0.2                                  | )%         | 0.3                                 | %          | (0.1 | )% | 0.5 | % |
| Core cost of  financing for loans held for investment                                                                                       |       | 3.5                                   | %          | 2.2                                 | %          | 3.4 | % | 2.5 | % |
|                                                                                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Net yield on  loans held for investment                                                                                                     |       | 3.4                                   | %          | 4.8                                 | %          | 3.5 | % | 4.8 | % |
| Net cash  settlements received (paid) on portfolio derivatives                                                                              |       | 0.2                                   | %          | (0.3                                | )%         | 0.1 | % | (0.5 | )% |
| Core net yield  on loans held for investment                                                                                                |       | 3.6                                   | %          | 4.5                                 | %          | 3.6 | % | 4.3 | % |
| Provision for  loan losses – loans held for investment                                                                                 |       | (0.6                                  | )%         | (1.0                                | )%         | (0.5 | )% | (0.8 | )% |
| Core yield on  loans held for investment after provision for loan losses                                                                    |       | 3.0                                   | %          | 3.5                                 | %          | 3.1 | % | 3.5 | % |
|                                                                                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Core yield  analysis – loans held for sale:                                                                                            |       |                                  |       |                                |       |   |   |   |   |
| Yield on loans  held for sale                                                                                                               |       | 6.9                                   | %          | 6.9                                 | %          | 7.0 | % | 7.1 | % |
| Cost of  financing for loans held for sale                                                                                                  |       | 4.1                                   | %          | 2.2                                 | %          | 4.1 | % | 2.4 | % |
| Net yield on  loans held for sale                                                                                                           |       | 3.9                                   | %          | 5.4                                 | %          | 4.2 | % | 5.5 | % |
|                                                                                                                                        |       |                                  |       |                                |       |   |   |   |   |
| Core yield  analysis – loans held for investment and loans held for sale:                                                              |       |                                  |       |                                |       |   |   |   |   |
| Yield– net  interest income on loans held for sale and loans held for investment after  provision for loan losses                      |       | 2.9                                   | %          | 4.0                                 | %          | 3.1 | % | 4.2 | % |
| Net cash  settlements received (paid) on portfolio derivatives                                                                              |       | 0.2                                   | %          | (0.3                                | )%         | 0.1 | % | (0.4 | )% |
| Core yield – net  interest income on loans held for sale and loans held for investment after  provision for loan losses                |       | 3.1                                   | %          | 3.7                                 | %          | 3.2 | % | 3.8 | % |

 

48

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Core net interest incomeafter provision for loan losses was $42.5 million for the three monthsended June 30, 2005, a 3.1% core net interest margin, an increase of$15.1 million compared to $27.4 million for the three months ended June 30,2004, a 3.7% core net interest margin. Core net interest income after provisionfor loan losses was $86.0 million for the six months ended June 30,2005, a 3.2% core net interest margin, an increase of $38.9 millioncompared to $47.1 million for the six months ended June 30, 2004, a 3.8%core net interest margin.  Core netinterest margin in the three and six months ended June 30, 2005 is lowerthan the same periods in 2004 due to the generally lower net interest marginsavailable on newer loans added to the portfolio as older loans financed withlower rate debt and swaps are replaced with loans supported by debt and swapsindexed to the rising LIBOR interest rate.

 

**Impact of New Accounting Standards**

 

In May 2005,the FASB issued Statement of Financial Accounting Standards No. 154, *“Accounting Changes and Error Corrections,”*(Statement No. 154).  This Statement replaces APB Opinion No. 20,*“Accounting Changes,”* (APB No. 20)**and FASB Statement No. 3, *“ReportingAccounting Changes in Interim Financial Statements.” *Statement No. 154 carriesforward the guidance contained in APB No. 20 for reporting the correctionof an error in previously issued financial statements and a change inaccounting estimate.  However, Statement No. 154changes the requirements for the accounting for and reporting a change inaccounting principle and requires retrospective application to prior periods’financial statements, unless it is impracticable.  It also applies to changes required by anaccounting pronouncement in the unusual instance that the pronouncement doesnot include specific transition provisions. Statement No. 154 is effective for accounting changes andcorrections of errors made in fiscal years beginning after December 15,2005, although earlier application is permitted for accounting changes andcorrections of errors made in fiscal years beginning after June 1,2005.  Management believes that theimplementation of Statement No. 154 will not have a material effect on ourresults of operations or statements of condition.

 

49

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In December 2004, the FASBissued Statement of Financial Accounting Standards No. 123R, “*Share Based Payments*” (Statement No. 123R),requiring, among other things, that the compensation cost of stock options andother equity-based compensation issued to employees, which cost is based on theestimated fair value of the awards on the grant date, be reflected in theincome statement over the requisite service period. Statement No. 123R iseffective for interim or annual reporting periods beginning after June 15,2005. In March 2005, the SEC staff issued Staff Accounting Bulletin No. 107(SAB No. 107).  SAB No. 107expresses the views of the SEC regarding Statement No. 123R and certain rules andregulations and provides the SEC’s view regarding the valuation of share-basedpayment arrangements for public companies. In April 2005, the SEC amended the compliance dates for Statement No. 123Rto the beginning of the next fiscal year after June 15, 2005.  We have adopted the fair value method ofaccounting for our grants of stock options and restricted stock as prescribedby Statement of Financial Accounting Standards No. 148, “*Accounting for Stock-Based Compensation-Transition and Disclosure.”*  Under this method, compensation cost ismeasured at the grant date based on the fair value of the award and isrecognized as expense on a straight-line basis over the award’s vesting period.Management believes that the implementation of Statement No. 123R and SAB No. 107will not have a material effect on our results of operations or statements of condition.

 

**Effect of Inflation**

 

Inflation affects us mostsignificantly in the effect it has on interest rates and real estate values.Our level of loan originations is affected by the level and trends of interestrates. Interest rates normally increase during periods of high inflation (or inperiods when the Federal Reserve Bank raises short-term interest rates in anattempt to prevent inflation) and decrease during periods of low inflation. Inaddition, inflation of real estate values increases the equity homeowners havein their homes and increases the volume of refinancing loans we can originateas borrowers draw down on the increased equity in their homes. We believe thatreal estate inflation will improve the performance of the loans originated byus in the past, reducing delinquencies and defaults, as borrowers protect orborrow against the equity in their homes.

 

**ITEM 3.       QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK.**

** **

**General**

 

Wecarry interest-sensitive assets on our balance sheet that are financed byinterest-sensitive liabilities. We are subject to interest rate risk becausethe interval for re-pricing of the assets and liabilities is not matched. Anincrease or decrease in interest rates would affect our net interest income andthe fair value of our mortgage loans held for investment and held for sale aswell as the related financing. We employ hedging strategies to manage theinterest-rate risk inherent in our assets and liabilities. These strategies aredesigned to create gains when movements in interest rates would cause our cashflows or the value of our assets to decline and to result in losses whenmovements in interest rates cause our cash flows and/or the value of our assetsto increase.

 

Theinterest rates on our hybrid ARM loans held for investment are fixed for thefirst two to three years of the loan, after which the interest rates resetevery six months to the then-current market rate. The interest rates on thebonds financing these loans reset to current market rates each month during theentire term of the loan. During the period we are receiving fixed rate paymentson our loans, we use interest rate swaps to pay fixed to the swapcounter-party, and receive variable interest rate payments which match theinterest rates on our financing interest costs. The swap of “variable for fixed”rates allows us to match fund our loans during the fixed period of the loans.

 

Therehave not been any significant changes in our interest rate risk profile and ourstrategies to manage interest rate risk from December 31, 2004 to June 30,2005. For further information on our interest rate risk profile, refer to Item7A, “Quantitative and Qualitative Disclosures about Market Risk” contained inour 2004 Form 10-K.

 

**Effectsof interest rate volatility**

 

Changesin interest rates impact our earnings and cash flows in several ways. Interestrate changes can affect our net interest income on our hybrid mortgages heldfor investment (net of the cost of financing these assets). We

 

50

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estimate the duration of our hybrid loans in our investment portfolioand our policy is to hedge the financing of the loans during the period inwhich the loans are paying a fixed coupon, while being financed with floatingrate debt indexed to LIBOR. During an increasing interest rate environment, ourassets may prepay slower than expected, requiring us to finance a higher amountof fixed assets with floating rate debt than originally anticipated, at a timewhen interest rates may be higher, resulting in a decline in our net return. Inorder to manage our exposure to changes in the prepayment speed of our hybridloan assets, we regularly monitor the portfolio balance, revise the amountsanticipated to be outstanding in future periods and adjust the notional balanceof our hedging derivatives to mitigate this risk.

 

Duringa rising interest rate environment, there may be less total loan originationand refinance activity. At the same time, a rising interest rate environmentmay result in a larger percentage of ARM products being originated, mitigatingthe impact of lower overall loan origination and refinance activity.Conversely, during a declining interest rate environment, consumers, ingeneral, may favor fixed rate mortgage products over ARM and hybrid products.

 

Ifinterest rates decline, the rate of prepayment on our mortgage assets mayincrease during the two to three year initial life of our loans held forinvestment. Increased prepayments would cause us to amortize the deferredorigination costs of our mortgage assets faster, resulting in a reduced yieldon our mortgage assets. Additionally, to the extent proceeds of prepaymentscannot be reinvested at a rate of interest at least equal to the ratepreviously earned on such mortgage assets, our earnings may be adverselyaffected. Conversely, if interest rates rise, the rate of prepayment on ourmortgage assets during the initial fixed pay period of the assets’ life maydecrease. Decreased prepayments would cause us to amortize the deferredorigination costs of our ARM assets over a longer time period, resulting in anincreased yield on our mortgage assets.

 

**ITEM 4.      CONTROLSAND PROCEDURES.**

** **

**Evaluation of Disclosure Controls and Procedures**

 

Ourprincipal executive officer, Michael J. Sonnenfeld, and our principal financialand accounting officer, Robert G. Partlow, evaluated as of June 30, 2005,the effectiveness of the design and operation of our disclosure controls andprocedures that are designed to ensure that information required to bedisclosed by us in the reports that we file with or submit to the SEC under theSecurities Exchange Act of 1934, as amended, is recorded, processed, summarizedand reported within the time periods specified in the SEC’s rules andregulations.  As a result of thisevaluation, these executive officers have concluded that, as of such date, thedesign and operation of our disclosure controls and procedures were effective.

 

**Changes in Internal Controls**

 

Inconnection with the evaluation described above, our principal executive officerand principal financial and accounting officer identified no change in ourinternal control over financial reporting that occurred during the three monthsended June 30, 2005, and that has materially affected, or is reasonablylikely to materially affect, our internal control over financial reporting.

 

**PART II**

** **

**ITEM 1.       LEGALPROCEEDINGS.**

** **

Therehave been no material legal proceedings initiated or terminated during thequarter ended June 30, 2005, and there have been no material developmentsin ongoing material legal proceedings during the quarter ended June 30,2005.  For information on material legalproceedings, see our Annual Report on Form 10-K for the fiscal year ended December 31,2004, as filed with the SEC on March 24, 2005.

 

We aresubject to various legal proceedings in the ordinary course of our businessrelated to foreclosures, bankruptcies, condemnation and quiet title actions andalleged statutory and regulatory violations. Management believes that anyliability with respect to these legal actions, individually or in theaggregate, will not have a material adverse effect on our business, results ofoperations or financial position.

 

51

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**ITEM 2.       UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS.**

** **

On May 6,2005, the Compensation Committee of the Board of Directors, pursuant to theFieldstone Investment Corporation Equity Incentive Plan (the “Stock Plan”),granted to certain of our officers and key employees 138,400 non-qualifiedstock options with dividend equivalent rights (“Options with DERs”).  The exercise price  was $12.70, which was the closing price ofour common stock, as reported on the NASDAQ Stock Market, on May 6, 2005,the grant date. The Options with DERs vest on March 31,2009 and arecontingent on continued employment. While the option is unvested, dividend equivalents are earned based onthe number of option shares held and are deemed invested in phantom shares ofour common stock at the closing price of the stock on the dividend paymentdate.  The phantom shares also will becredited with dividend equivalent rights at the same time and in the sameamount as cash dividends are paid on our common stock.  The total value of dividend equivalents willbe paid in cash at the time the option vests.

 

On June 22,2005, the Compensation Committee, pursuant to the Stock Plan, awarded a maximumof 65,040 shares of restricted stock to certain of our executive and seniorofficers subject to the level of achievement of certain corporate performanceobjectives (the “Performance Shares”). The Performance Shares are shares ofrestricted stock that are subject to vesting requirements and can be earnedbased primarily on our achievement of certain return on equity targets.

 

Thegrant of the Options with DERs and the award of the Performance Shares were notregistered under the Securities Act of 1933, as amended because thesetransactions either did not involve an offer or sale for purposes of Section 2(a)(3) ofthe Securities Act of 1933, as amended, in reliance on the fact that thesecurities were granted for no consideration or were offered and sold intransactions not involving a public offering, exempt from registration under Section 4(2) ofthe Securities Act.

 

**ITEM 3.       DEFAULTS UPON SENIOR SECURITIES.**

** **

None.

 

**ITEM 4.       SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS.**

** **

Atthe Annual Meeting of Stockholders held on May 3, 2005, the shareholderstook the following actions:

 

1.  Elected the persons named below to the Boardof Directors by the following votes:

 
| **Name of Nominee**   | ** ** | **Number of  Votes Cast For** | ** ** | **Number of  Votes Withheld** | ** ** |
|-----------------------|------------|-------------------------------|------------|-------------------------------|------------|
| Thomas D. Eckert      |       | 40,751,380                    |       | 40,925                        |       |
| David S.  Engelman    |       | 40,751,380                    |       | 40,925                        |       |
| Celia V. Martin       |       | 40,715,680                    |       | 76,625                        |       |
| Jonathan E. Michael   |       | 40,751,380                    |       | 40,925                        |       |
| David A.  Schoenholz  |       | 40,751,380                    |       | 40,925                        |       |
| Jeffrey R.  Springer  |       | 40,751,380                    |       | 40,925                        |       |
| Michael J. Sonnenfeld |       | 40,751,380                    |       | 40,925                        |       |

 

2.    Ratified the appointment of KPMG LLP as theCompany’s independent registered public accounting firm for the fiscal yearending December 31, 2005 by a vote of 39,938,110 FOR; 846,870 AGAINST; and7,325 ABSTENTIONS.

 

**ITEM 5.      OTHERINFORMATION.**

** **

None.

 

52

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**ITEM6.       EXHIBITS.**

** **

Theexhibits required by this Item are set forth on the Exhibit Index attachedhereto.

 

53

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**SIGNATURES**

** **

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

 
|                  | FIELDSTONE INVESTMENT CORPORATION |
|-----------------------|-----------------------------------|
|                  | (registrant)                      |
|                  |                              |   |
| Date: August 12, 2005 | By:                               | /s/ MICHAEL J. SONNENFELD |   |
|                  |                              | Michael J. Sonnenfeld |
|                  |                              | *President and Chief Executive Officer* |
|                  |                              |   |
| Date: August 12, 2005 | By:                               | /s/ ROBERT G. PARTLOW |   |
|                  |                              | Robert G. Partlow |
|                  |                              | *Senior Vice President and Chief Financial Officer* | * * |

54

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**EXHIBIT INDEX**

** **
| **Exhibit** | ** ** | ** **                                                                                                                                                                                             |
|-------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Description**                                                                                                                                                                                        |
| 31.1        |       | Certification of Chief  Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange  Act of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002 (filed herewith) |
| 31.2        |       | Certification of Chief  Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act  of 1934 as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002  (filed herewith) |
| 32.1        |       | Certification of Chief  Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section  1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002  (filed herewith)       |

 

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