** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

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**FORM 10-Q**

**(Mark One)**

** **
| **x**                                             | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------|
| ** **                                        | ** ** | ** **                                                                                              |
| **For the  quarterly period ended June 30, 2006** |
| ** **                                        | ** ** | ** **                                                                                              |
| **o**                                             | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                        | ** ** | ** **                                                                                              |
| **Commission  File Number: 000-50938**            |

** **

**Fieldstone Investment Corporation**

(Exact name of registrant as specified in its charter)

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

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.     Yes x   Noo

Indicate by check mark whether the registrant is alarge accelerated filer, an accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act.

Large AcceleratedFiler o    AcceleratedFiler o    Non-accelerated Filer x

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act).  Yes  o   No x

Number of shares of Common Stock outstanding as ofAugust 1, 2006:  46,904,485

 

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**Tableof Contents**
|                  | ** ** | ** **                                                                                       | ** ** | **Page** |
|------------------|------------|--------------------------------------------------------------------------------------------------|------------|----------|
| **Part I**  |       | FINANCIAL INFORMATION                                                                            |       |     |
| ** **       |       |                                                                                             |       |     |
| **Item  1.**     |       | Financial  Statements                                                                            |       |     |
| ** **       |       | Condensed Consolidated Statements of Condition                                                   |       | 1        |
| ** **       |       | Condensed Consolidated Statements of Operations                                                  |       | 2        |
| ** **       |       | Condensed Consolidated Statements of Shareholders’  Equity                                  |       | 3        |
| ** **       |       | Condensed Consolidated Statements of Cash Flows                                                  |       | 4        |
| ** **       |       | Notes to Condensed Consolidated Financial Statements                                             |       | 5        |
| ** **       |       |                                                                                             |       |     |
| **Item 2.**      |       | Management’s Discussion and Analysis of Financial  Condition and Results of Operations |       |     |
|             |       | Executive  Overview                                                                              |       | 31       |
|             |       | Key Components of Financial Results of Operations                                                |       | 33       |
|             |       | Critical  Accounting Policies                                                                    |       | 34       |
|             |       | Results  of Operations                                                                           |       | 37       |
|             |       | Consolidated Statements of Condition                                                             |       | 45       |
|             |       | Business  Segment Results                                                                        |       | 50       |
|             |       | Liquidity and Capital Resources                                                                  |       | 55       |
|             |       | Commitments and Contingencies                                                                    |       | 59       |
|             |       | Other Operational and Investment Portfolio Data                                                  |       | 60       |
|             |       | Core  Financial Measures                                                                         |       | 64       |
|             |       | Recent Accounting Pronouncements                                                                 |       | 68       |
|             |       | Off-Balance Sheet Arrangements                                                                   |       | 70       |
|             |       | Effect  of Inflation                                                                             |       | 70       |
| ** **       |       |                                                                                             |       |     |
| **Item 3.**      |       | Quantitative and Qualitative Disclosures About Market  Risk                                      |       | 70       |
|             |       |                                                                                             |       |     |
| **Item 4.**      |       | Controls and Procedures                                                                          |       | 71       |
|             |       |                                                                                             |       |     |
| **Part II** |       | OTHER  INFORMATION                                                                               |       |     |
| ** **       |       |                                                                                             |       |     |
| **Item  1.**     |       | Legal  Proceedings                                                                               |       | 72       |
| ** **       |       |                                                                                             |       |     |
| **Item  1A.**    |       | Risk  Factors                                                                                    |       | 73       |
| ** **       |       |                                                                                             |       |     |
| **Item 2.**      |       | Unregistered Sales of Equity Securities and Use of  Proceeds                                     |       | 74       |
| ** **       |       |                                                                                             |       |     |
| **Item 3.**      |       | Defaults Upon Senior Securities                                                                  |       | 74       |
| ** **       |       |                                                                                             |       |     |
| **Item 4.**      |       | Submission of Matters to a Vote of Security Holders                                              |       | 74       |
| ** **       |       |                                                                                             |       |     |
| **Item  5.**     |       | Other  Information                                                                               |       | 75       |
| ** **       |       |                                                                                             |       |     |
| **Item 6.**      |       | Exhibits                                                                                         |       | 75       |
| ** **       |       | Signatures                                                                                       |       | 76       |
| ** **       |       | Exhibit Index                                                                                    |       | 77       |

 

i

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**PART I**

**ITEM 1.**                    FINANCIALSTATEMENTS.

**FIELDSTONEINVESTMENT CORPORATION AND SUBSIDIARIESCondensed Consolidated Statements of ConditionJune 30, 2006 and December 31, 2005(Unaudited; in thousands, except share data)**
| ** **                                                                                                                                                         | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                         | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **Assets**                                                                                                                                                         | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Cash                                                                                                                                                               |       | $                       | 31,638     |                        | $          | 33,536 |   |
| Restricted cash                                                                                                                                                    |       | 4,344                   |       | 7,888                       |       |
| Mortgage loans  held for sale, net                                                                                                                                 |       | 324,432                 |       | 594,269                     |       |
| Mortgage loans  held for investment                                                                                                                                |       | 5,732,263               |       | 5,570,415                   |       |
| Allowance for  loan losses—loans held for investment                                                                                                          |       | (44,749                 | )          | (44,122                     | )          |
| Mortgage loans held for investment, net                                                                                                                            |       | 5,687,514               |       | 5,526,293                   |       |
| Accounts  receivable                                                                                                                                               |       | 31,543                  |       | 7,201                       |       |
| Accrued interest  receivable                                                                                                                                       |       | 31,946                  |       | 29,940                      |       |
| Trustee  receivable                                                                                                                                                |       | 103,071                 |       | 130,237                     |       |
| Prepaid expenses  and other assets                                                                                                                                 |       | 13,085                  |       | 16,200                      |       |
| Real estate  owned                                                                                                                                                 |       | 34,786                  |       | 14,997                      |       |
| Derivative  assets                                                                                                                                                 |       | 36,740                  |       | 35,223                      |       |
| Deferred tax  asset                                                                                                                                                |       | 14,572                  |       | 17,679                      |       |
| Furniture and  equipment, net                                                                                                                                      |       | 8,909                   |       | 10,151                      |       |
| Total assets                                                                                                                                                       |       | $                       | 6,322,580  |                        | $          | 6,423,614 |   |
| **Liabilities  and Shareholders’ Equity**                                                                                                                     |       |                    |       |                        |       |
| Warehouse financing—loans  held for sale                                                                                                                      |       | $                       | 277,773    |                        | $          | 434,061 |   |
| Warehouse  financing—loans held for investment                                                                                                                |       | 874,788                 |       | 378,707                     |       |
| Securitization  financing                                                                                                                                          |       | 4,614,204               |       | 4,998,620                   |       |
| Reserve for  losses—loans sold                                                                                                                                |       | 28,028                  |       | 35,082                      |       |
| Dividends  payable                                                                                                                                                 |       | 20,638                  |       | 26,689                      |       |
| Accounts  payable, accrued expenses and other liabilities                                                                                                          |       | 23,453                  |       | 23,812                      |       |
| Total liabilities                                                                                                                                                  |       | 5,838,884               |       | 5,896,971                   |       |
|                                                                                                                                                               |       |                    |       |                        |       |
| Commitments and  contingencies (Note 11)                                                                                                                           |       | —                  |       | —                      |       |
|                                                                                                                                                               |       |                    |       |                        |       |
| Shareholders’ equity:                                                                                                                                         |       |                    |       |                        |       |
| Common stock $0.01 par value; 90,000,000 shares  authorized; 46,904,485 and 48,513,985 shares issued as of June 30, 2006 and  December 31, 2005, respectively |       | 469                     |       | 485                         |       |
| Paid-in capital                                                                                                                                                    |       | 473,270                 |       | 493,603                     |       |
| Accumulated earnings                                                                                                                                               |       | 9,957                   |       | 37,093                      |       |
| Unearned compensation                                                                                                                                              |       | —                  |       | (4,538                      | )          |
| Total shareholders’ equity                                                                                                                                    |       | 483,696                 |       | 526,643                     |       |
| Total  liabilities and shareholders’ equity                                                                                                                   |       | $                       | 6,322,580  |                        | $          | 6,423,614 |   |

 

See accompanying notes tocondensed consolidated financial statements.

1

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**FIELDSTONEINVESTMENT CORPORATION AND SUBSIDIARIESCondensed Consolidated Statements of OperationsThree and Six Months Ended June 30, 2006 and 2005(Unaudited; in thousands, except share and per share data)**
| ** **                                                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,**                | ** ** |
|--------------------------------------------------------------------|------------|-------------------------------------------------|------------|--------------------------------------------------------------|------------|
| ** **                                                         | ** ** | **2006**                                        | ** ** | **2005  (As restated - see  Note 1(g))** | ** ** | **2006** | ** ** | **2005  (As restated - see  Note 1(g))** | ** ** |
| Revenues:                                                          |       |                                            |       |                                                         |       |   |   |   |   |
| Interest income:                                                   |       |                                            |       |                                                         |       |   |   |   |   |
| Loans held for investment                                          |       | $                                               | 100,440    |                                                         | $          | 80,574 |   | $ | 195,553 |   | $ | 163,410 |   |
| Loans held for sale                                                |       | 6,991                                           |       | 12,846                                                       |       | 13,592 |   | 17,133 |   |
| Total interest income                                              |       | 107,431                                         |       | 93,420                                                       |       | 209,145 |   | 180,543 |   |
|                                                               |       |                                            |       |                                                         |       |   |   |   |   |
| Interest  expense:                                                 |       |                                            |       |                                                         |       |   |   |   |   |
| Loans held for investment                                          |       | 77,589                                          |       | 41,773                                                       |       | 146,505 |   | 80,381 |   |
| Loans held for sale                                                |       | 3,587                                           |       | 5,369                                                        |       | 6,192 |   | 6,361 |   |
| Total interest expense                                             |       | 81,176                                          |       | 47,142                                                       |       | 152,697 |   | 86,742 |   |
| Net interest income                                                |       | 26,255                                          |       | 46,278                                                       |       | 56,448 |   | 93,801 |   |
|                                                               |       |                                            |       |                                                         |       |   |   |   |   |
| Provision for  loan losses—loans held for investment          |       | 5,466                                           |       | 6,863                                                        |       | 10,859 |   | 11,357 |   |
| Net interest income after provision for loan losses                |       | 20,789                                          |       | 39,415                                                       |       | 45,589 |   | 82,444 |   |
|                                                               |       |                                            |       |                                                         |       |   |   |   |   |
| Gains on sales  of mortgage loans, net                             |       | 1,953                                           |       | 26,033                                                       |       | 12,248 |   | 34,502 |   |
| Other income  (expense)—portfolio derivatives                 |       | 10,821                                          |       | (9,432                                                       | )          | 22,979 |   | 10,910 |   |
| Fees and other  (expense) income                                   |       | (575                                            | )          | 9                                                            |       | (225 | ) | 295 |   |
| Total revenues                                                     |       | 32,988                                          |       | 56,025                                                       |       | 80,591 |   | 128,151 |   |
|                                                               |       |                                            |       |                                                         |       |   |   |   |   |
| Expenses:                                                          |       |                                            |       |                                                         |       |   |   |   |   |
| Salaries and employee benefits                                     |       | 19,166                                          |       | 17,719                                                       |       | 40,035 |   | 35,423 |   |
| Occupancy                                                          |       | 1,861                                           |       | 1,796                                                        |       | 3,684 |   | 3,295 |   |
| Depreciation and amortization                                      |       | 995                                             |       | 792                                                          |       | 1,930 |   | 1,552 |   |
| Servicing fees                                                     |       | 2,723                                           |       | 1,743                                                        |       | 5,292 |   | 4,347 |   |
| General and administration                                         |       | 7,742                                           |       | 7,000                                                        |       | 15,305 |   | 14,321 |   |
| Total expenses                                                     |       | 32,487                                          |       | 29,050                                                       |       | 66,246 |   | 58,938 |   |
|                                                               |       |                                            |       |                                                         |       |   |   |   |   |
| Income from continuing operations before income  taxes        |       | 501                                             |       | 26,975                                                       |       | 14,345 |   | 69,213 |   |
| Provision for  income tax benefit (expense)                        |       | 3,304                                           |       | (2,454                                                       | )          | 4,033 |   | (2,297 | ) |
| Income from continuing operations                                  |       | 3,805                                           |       | 24,521                                                       |       | 18,378 |   | 66,916 |   |
| Discontinued  operations, net of income tax (Note 7)               |       | —                                          |       | (695                                                         | )          | (1,645 | ) | (1,336 | ) |
| Net income                                                         |       | $                                               | 3,805      |                                                         | $          | 23,826 |   | $ | 16,733 |   | $ | 65,580 |   |
|                                                               |       |                                            |       |                                                         |       |   |   |   |   |
| Earnings per  share of common stock: basic and diluted             |       |                                            |       |                                                         |       |   |   |   |   |
| Continuing operations                                              |       | $                                               | 0.08       |                                                         | $          | 0.50 |   | $ | 0.38 |   | $ | 1.38 |   |
| Discontinued operations                                            |       | —                                          |       | (0.01                                                        | )          | (0.03 | ) | (0.03 | ) |
| Total                                                              |       | $                                               | 0.08       |                                                         | $          | 0.49 |   | $ | 0.35 |   | $ | 1.35 |   |
|                                                               |       |                                            |       |                                                         |       |   |   |   |   |
| Weighted average common  shares outstanding—basic and diluted |       | 47,677,853                                      |       | 48,462,126                                                   |       | 47,974,272 |   | 48,462,057 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

2

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**FIELDSTONEINVESTMENT CORPORATION AND SUBSIDIARIESCondensed Consolidated Statements of Shareholders’ EquitySix Months Ended June 30, 2006 and 2005(Unaudited; in thousands)**

 
| ** **                                                                                 | ** ** | **Common  shares  outstanding** | ** ** | **Common  stock** | ** ** | **Paid-in  capital** | ** ** | **Accumulated  earnings** | ** ** | **Unearned  compensation** | ** ** | **Total  shareholders’  equity** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------|------------|----------------------|------------|---------------------------|------------|----------------------------|------------|---------------------------------------|------------|
| Balance at  January 1, 2006                                                           |       | 48,514                          |       | $                 | 485        |                 | $          | 493,603                   |       | $                          | 37,093     |                                  | $          | (4,538 | ) | $ | 526,643 |   |
| Common shares  repurchased                                                                 |       | (1,632                          | )          | (16               | )          | (16,832              | )          | —                    |       | —                     |       | (16,848                               | )          |
| Restricted stock  issued                                                                   |       | 45                              |       | —            |       | —               |       | —                    |       | —                     |       | —                                |       |
| Restricted stock  forfeited                                                                |       | (23                             | )          | —            |       | —               |       | —                    |       | —                     |       | —                                |       |
| Restricted stock  compensation expense                                                     |       | —                          |       | —            |       | 897                  |       | —                    |       | —                     |       | 897                                   |       |
| Stock options  compensation expense                                                   |       | —                          |       | —            |       | 140                  |       | —                    |       | —                     |       | 140                                   |       |
| Reclass unearned  compensation to paid-in capital upon adoption of FASB Statement No. 123R |       | —                          |       | —            |       | (4,538               | )          | —                    |       | 4,538                      |       | —                                |       |
| Dividends  declared                                                                        |       | —                          |       | —            |       | —               |       | (43,869                   | )          | —                     |       | (43,869                               | )          |
| Net income                                                                                 |       | —                          |       | —            |       | —               |       | 16,733                    |       | —                     |       | 16,733                                |       |
| Balance at June  30, 2006                                                                  |       | 46,904                          |       | $                 | 469        |                 | $          | 473,270                   |       | $                          | 9,957      |                                  | $          | — |   | $ | 483,696 |   |
|                                                                                       |       |                            |       |              |       |                 |       |                      |       |                       |       |                                  |       |
| Balance at  January 1, 2005                                                           |       | 48,856                          |       | $                 | 489        |                 | $          | 497,147                   |       | $                          | 36,430     |                                  | $          | (5,985 | ) | $ | 528,081 |   |
|                                                                                       |       |                            |       |              |       |                 |       |                      |       |                       |       |                                  |       |
| Restricted stock  forfeited                                                                |       | (23                             | )          | (1                | )          | (337                 | )          | —                    |       | 338                        |       | —                                |       |
| Restricted stock  compensation expense                                                     |       | —                          |       | —            |       | —               |       | —                    |       | 905                        |       | 905                                   |       |
| Contingent  performance shares granted                                                     |       | —                          |       | —            |       | 707                  |       | —                    |       | (707                       | )          | —                                |       |
| Stock options  compensation expense                                                   |       | —                          |       | —            |       | 112                  |       | —                    |       | —                     |       | 112                                   |       |
| Stock options  exercised                                                                   |       | 3                               |       | —            |       | 38                   |       | —                    |       | —                     |       | 38                                    |       |
| Costs relating  to the equity registration                                                 |       | —                          |       | —            |       | (423                 | )          | —                    |       | —                     |       | (423                                  | )          |
| Dividends  declared                                                                        |       | —                          |       | —            |       | —               |       | (22,953                   | )          | —                     |       | (22,953                               | )          |
| Net income (As  restated—see Note 1(g))                                               |       | —                          |       | —            |       | —               |       | 65,580                    |       | —                     |       | 65,580                                |       |
| Balance at June 30,  2005 (As restated—  see Note 1(g))                               |       | 48,836                          |       | $                 | 488        |                 | $          | 497,244                   |       | $                          | 79,057     |                                  | $          | (5,449 | ) | $ | 571,340 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

** **

3

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**FIELDSTONEINVESTMENT CORPORATION AND SUBSIDIARIESCondensed Consolidated Statements of Cash FlowsSix Months Ended June 30, 2006 and 2005(Unaudited; in thousands)**
| ** **                                                                                                 | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2006**                                          | ** ** | **2005  (As restated - see  Note 1(g))** | ** ** |
| Cash flows from  operating activities:                                                                     |       |                                              |       |   |   |
| Net income                                                                                                 |       | $                                                 | 16,733     |   | $ | 65,580 |   |
| Adjustments to  reconcile income from continuing operations to net cash provided by operating  activities: |       |                                              |       |   |   |
| Depreciation and amortization                                                                              |       | 1,930                                             |       | 1,552 |   |
| Amortization of deferred origination costs—loans  held for investment                                 |       | 12,974                                            |       | 10,786 |   |
| Amortization of securitization issuance costs                                                              |       | 5,278                                             |       | 4,107 |   |
| Amortization of bond discount                                                                              |       | 57                                                |       | 148 |   |
| Provision for losses—loans sold                                                                       |       | 3,420                                             |       | 6,128 |   |
| Provision for loan losses—loans held for investment                                                   |       | 10,859                                            |       | 11,357 |   |
| Loss on disposal of discontinued operations                                                                |       | 904                                               |       | — |   |
| Loss from discontinued operations                                                                          |       | 741                                               |       | 1,336 |   |
| (Increase) decrease in accounts receivable                                                                 |       | (24,342                                           | )          | 2,122 |   |
| Increase in accrued interest receivable                                                                    |       | (2,006                                            | )          | (997 | ) |
| Decrease (increase) in trustee receivable                                                                  |       | 27,166                                            |       | (4,479 | ) |
| Funding of mortgage loans held for sale                                                                    |       | (1,120,371                                        | )          | (1,374,332 | ) |
| Proceeds from sales and payments of mortgage loans  held for sale                                          |       | 1,275,673                                         |       | 1,743,373 |   |
| Increase in prepaid expenses and other assets                                                              |       | (2,233                                            | )          | (2,457 | ) |
| Decrease (increase) in deferred tax asset, net                                                             |       | 3,107                                             |       | (1,330 | ) |
| Increase in fair market value of derivative  instruments                                                   |       | (2,082                                            | )          | (6,129 | ) |
| Increase (decrease) in accounts payable, accrued  expenses and other liabilities                           |       | 356                                               |       | (251 | ) |
| Stock compensation expense                                                                                 |       | 1,056                                             |       | 1,017 |   |
| Net cash provided by operating activities from  continuing operations                                      |       | 209,220                                           |       | 457,531 |   |
| Net cash provided by (used in) operating activities  from discontinued operations                          |       | 97,368                                            |       | (32,030 | ) |
| Net cash provided by operating activities                                                                  |       | 306,588                                           |       | 425,501 |   |
|                                                                                                       |       |                                              |       |   |   |
| Cash flows from  investing activities:                                                                     |       |                                              |       |   |   |
| Funding of mortgage loans held for investment                                                              |       | (1,357,635                                        | )          | (1,469,177 | ) |
| Payments of mortgage loans held for investment                                                             |       | 1,136,624                                         |       | 823,559 |   |
| Increase (decrease) in restricted cash                                                                     |       | 3,544                                             |       | (1,924 | ) |
| Purchase of furniture and equipment, net                                                                   |       | (974                                              | )          | (856 | ) |
| Proceeds from sale of real estate owned                                                                    |       | 21,320                                            |       | 5,825 |   |
| Net cash used in investing activities from  continuing operations                                          |       | (197,121                                          | )          | (642,573 | ) |
| Net cash provided by (used in) investing activities  from discontinued operations                          |       | 101                                               |       | (158 | ) |
| Net cash used in investing activities                                                                      |       | (197,020                                          | )          | (642,731 | ) |
|                                                                                                       |       |                                              |       |   |   |
| Cash flows from  financing activities:                                                                     |       |                                              |       |   |   |
| Proceeds from warehouse financing—loans held for  sale                                                |       | 906,650                                           |       | 1,710,788 |   |
| Repayment of warehouse financing—loans held for sale                                                  |       | (987,072                                          | )          | (1,585,424 | ) |
| Proceeds from warehouse financing—loans held for  investment                                          |       | 1,387,476                                         |       | 917,098 |   |
| Repayment of warehouse financing—loans held for  investment                                           |       | (891,395                                          | )          | (768,600 | ) |
| Proceeds from securitization financing                                                                     |       | 904,078                                           |       | 728,625 |   |
| Repayment of securitization financing                                                                      |       | (1,288,550                                        | )          | (811,551 | ) |
| Dividends paid                                                                                             |       | (49,939                                           | )          | (44,454 | ) |
| Costs relating to the equity registration                                                                  |       | —                                            |       | (423 | ) |
| Purchases of common stock                                                                                  |       | (16,848                                           | )          | — |   |
| Proceeds from exercise of stock options                                                                    |       | —                                            |       | 38 |   |
| Net cash (used in) provided by financing activities  from continuing operations                            |       | (35,600                                           | )          | 146,097 |   |
| Net cash (used in) provided by financing activities  from discontinued operations                          |       | (75,866                                           | )          | 47,887 |   |
| Net cash (used in) provided by financing activities                                                        |       | (111,466                                          | )          | 193,984 |   |
|                                                                                                       |       |                                              |       |   |   |
| Net decrease in cash                                                                                       |       | (1,898                                            | )          | (23,246 | ) |
| Cash at the  beginning of the period                                                                       |       | 33,536                                            |       | 61,681 |   |
| Cash at the end  of the period                                                                             |       | $                                                 | 31,638     |   | $ | 38,435 |   |
| Supplemental  disclosures:                                                                                 |       |                                              |       |   |   |
| Cash paid for interest                                                                                     |       | $                                                 | 150,862    |   | $ | 87,290 |   |
| Cash paid (received) for taxes                                                                             |       | 8,208                                             |       | (116 | ) |
| Non-cash  operating and investing activities:                                                              |       |                                              |       |   |   |
| Transfer from mortgage loans held for sale to real  estate owned                                           |       | 6,208                                             |       | 405 |   |
| Transfer from mortgage loans held for investment to  real estate owned                                     |       | 46,364                                            |       | 12,558 |   |
| Transfer from  mortgage loans held for investment to mortgage loans held for sale, net                     |       | $                                                 | —     |   | $ | 530,830 |   |

 

See accompanying notes to condensed consolidatedfinancial statements.

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**FIELDSTONEINVESTMENT CORPORATION AND SUBSIDIARIESNotes to Condensed Consolidated Financial StatementsJune 30, 2006(Unaudited; in thousands, except share and per share data)**

**(1)**            Organization andSummary of Significant Accounting Policies

***(a)   Organization***

Fieldstone Investment Corporation (FIC) wasincorporated 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 as a C Corporation. InJuly 1998, FHC purchased 100% of the shares of Fieldstone Mortgage Company(FMC), a Maryland corporation formed in 1995. Prior to 2003, FHC operated as ataxable C corporation. Effective January 1, 2003, FHC elected to be taxedas an S Corporation, and FMC was treated as a qualified sub-chapter Ssubsidiary.

In November 2003,FIC executed a reverse merger with FHC, with FIC as the surviving entity, in atransaction that was accounted for as a merger of entities under common controlwhereby the historical cost basis of the assets and liabilities was retained.In connection with the merger in November 2003, FIC elected to be taxed asa Real Estate Investment Trust (REIT), and FMC, its wholly owned subsidiary,elected to be taxed as a Taxable REIT Subsidiary (TRS).

In February of 2004, FIC formed two wholly ownedsubsidiaries, Fieldstone Mortgage Ownership Corp. (FMOC) and FieldstoneServicing Corp. (FSC), as Maryland corporations, which are treated as qualifiedREIT subsidiaries. FMOC holds securities and ownership interests in ownertrusts and other financing vehicles, including securities issued by FIC or onFIC’s behalf. FMOC holds the residual interest in FIC’s securitized pools, aswell as any derivatives designated as economic interest rate hedges related tosecuritized debt. FSC holds the rights to direct the servicing of the mortgageloans held for investment.

In May of 2005, FIC formed a wholly owned, limitedpurpose financing subsidiary, Fieldstone Mortgage Investment Corporation(FMIC), a Maryland corporation, which is treated as a qualified REITsubsidiary.  FMIC was formed for thepurpose of facilitating the financing and sale of mortgage loans andmortgage-related assets by issuing and selling securities secured primarily by,or evidencing interests in, mortgage loans and mortgage-related assets.

FMC originates, purchases, and sells non-conformingand conforming residential mortgage loans and engages in other activitiesrelated to mortgage banking. FMC originates mortgage loans through wholesaleand retail business channels through its network of independent mortgagebrokers serviced by regional wholesale operations centers and a network ofretail branch offices located throughout the country.

Non-conforming loans that are originated are underwrittenin accordance with FMC’s underwriting guidelines designed to evaluate aborrower’s credit history, capacity, willingness and ability to repay the loan,as well as the value and adequacy of the collateral. Conforming loans that areoriginated are loans that meet the underwriting criteria required for amortgage loan to be saleable to a Government Sponsored Entity (GSE), such asFannie Mae or Freddie Mac, or institutional investors.

A substantial portion of the non-conforming loansoriginated by FMC are closed by FMC using funds advanced by FIC, with asimultaneous assignment of the loans to FIC. These loans are held forinvestment and financed by warehouse debt and by issuing mortgage-backedsecurities secured by these loans. FMC sells the portion of the non-conformingloans not held for investment and all of the conforming loans that itoriginates on a whole-loan, servicing-released basis. FMC provides interimservicing on the loans held for sale from the time of funding until the timethe loans are transferred to the permanent servicer, which generally occursbetween 30 and 60 days after funding. With regard to the loans held forinvestment, the servicing rights are transferred to FSC. Pursuant to anagreement, JPMorgan Chase Bank, National Association acts as sub-servicer

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of the loans held forinvestment. The sub-servicer has primary responsibility for performing theservicing functions with respect to the loans, including all collection,advancing and loan level reporting obligations, maintenance of custodial andescrow accounts, maintenance of insurance and enforcement of foreclosureproceedings.

FMC is licensed or exemptfrom licensing requirements to originate residential mortgages in 50 states andthe District of Columbia. FIC is licensed or exempt from licensing requirementsto fund residential mortgage loans and acquire closed residential mortgageloans in all states in which it operates.

The accompanying unaudited condensed consolidatedfinancial statements include the accounts of FIC and its subsidiaries(together, the Company) and have been prepared in accordance with accountingprinciples generally accepted in the United States of America (GAAP) forinterim financial information and with the instructions to Form 10-Q and Rule10-01 of Regulation S-X.  Accordingly,they do not include all of the information and footnotes required by GAAP forcomplete financial statements.  Allintercompany balances and transactions have been eliminated in consolidation.

In the opinion ofmanagement, the accompanying unaudited condensed consolidated financialstatements contain all adjustments, consisting of normal recurring accruals,necessary for a fair presentation.  Theresults of operations and other data for the three and six months ended June30, 2006 are not necessarily indicative of the results that may be expected forthe fiscal year ending December 31, 2006. The unaudited condensed consolidated financial statements presentedherein should be read in conjunction with the audited consolidated financialstatements and related notes thereto in the Company’s Annual Report on Form10-K for the fiscal year ended December 31, 2005.

***(b)***   ***Discontinued Operations***

On January 13,2006, the Company’s Board of Directors approved a plan to sell, close orotherwise dispose of the assets of its conforming retail and conformingwholesale segments.  In February 2006,the assets pertaining to these segments’ headquarters, all wholesale offices,and certain of its retail offices were sold to third parties. The remainingassets of the conforming division, which include retail offices in Maryland andVirginia, have been combined with the Company’s non-conforming retail offices,which will offer a range of non-conforming and conforming loan products.

In accordance withthe provisions of Statement of Financial Accounting Standards No. 144, *“Accounting for the Impairment or Disposal of Long-Lived Assets”*(StatementNo. 144), the results of operations, net of income tax, and cash flowsassociated with the disposal of these conforming wholesale and conformingretail offices has been classified as discontinued operations and segregatedfrom the results of the Company’s continuing operations for all periodspresented.

***(c)   Use of Estimates***

The preparation of consolidated financial statementsin conformity with GAAP requires management to make estimates and assumptionsthat affect the reported amounts of assets and liabilities, disclosures ofcontingent assets and liabilities at the date of the financial statements, andthe reported amounts of revenues and expenses during the reporting period.  Critical estimates include (i) an estimate ofthe representation and warranty liabilities related to the sale of mortgageloans; (ii) an estimate of losses inherent in mortgage loans held forinvestment, which is used to determine the related allowance for loan lossesand realizable value of the Company’s accrued interest receivable; (iii) anestimate of the future loan prepayment rate of mortgage loans held forinvestment, which is used in the calculation of deferred origination and bondissuance cost amortization; (iv) the non-cash mark to market valuation of theinterest rate swaps which economically hedge the Company’s securitization debtand (v) the fair market value of equity compensation awards.  Actual results could differ from thoseestimates. Amounts on the consolidated statements of operations most affectedby the use of estimates are the reserve for losses—loans sold (which is acomponent 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 and bond

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issuance costs (which arecomponents of net interest income for loans held for investment and gains onsales of mortgage loans, net, for loans held for sale).

***(d)   Concentration of Credit Risk***

The non-conforming mortgage loans that the Companyoriginates primarily consist of adjustable-rate mortgage (ARM) loans, thepayments on which are adjustable from time to time as interest rates change,generally after an initial two year period during which the loans’ interestrates are fixed and do not change.  Afteran initial fixed rate period, generally two-years, the borrowers’ payments ontheir ARM loans adjust once every six months to a pre-determined margin over ameasure of market interest rates, generally the London InterBank Offered Rate(LIBOR) for one-month deposits. Many ARMS contain an “interest only” featurefor the first five years of the loan, so that the borrowers do not begin torepay the principal balance of the loans until after the fifth year of theloans.  After the fifth year, theborrowers’ payments increase to amortize the entire principal balance owed overthe remaining years of the loan.  For thethree and six months ended June 30, 2006, 40% and 41%, respectively, ofnon-conforming mortgage loan originations are “interest only”ARMs.  For both the three and six months ended June30, 2005, 56% of non-conforming mortgage loan originations were ARMs with an “interestonly” feature.

These loan features willlikely result in the borrowers’ payments increasing in the future. The interestadjustment feature generally will result in an increased payment after thesecond year of the loan and the interest only feature will result in anincreased payment after the fifth year of the loan. Since these features willincrease the debt service requirements of the borrowers, it may increase therisk of default on the Company’s investment portfolio of non-conforming loansthat remain outstanding at least two years (relative to the ARM feature) or forfive years (relative to the interest only feature).

For the three and sixmonths ended June 30, 2006, 59% and 58%, respectively, of non-conforming loanoriginations, were underwritten with little or no supporting documentation ofthe borrowers’ income, under the Company’s “stated income” loan programs and “bankstatement” programs.  The Companymitigates its risk on such loans by establishing minimum credit score standardsand otherwise evaluating the borrower’s income and cash flow. Based on its pastexperiences with similar loans and on industry performance data, the Companybelieves its strict underwriting guidelines relating to non-conforming loanshelp the Company to evaluate a borrower’s credit history, willingness andability to repay the loans, as well as the value and adequacy of the borrower’scollateral.  The Company’s underwritingguidelines are designed to balance the credit risk of the borrower with theloan-to-value (LTV) and interest rate of the loan.  For the three and six months ended June 30,2005, 53% and 55%, respectively, of non-conforming loan originations, wereunderwritten under “stated income” or “bank statement” loan programs.

For the three and six months ended June 30, 2006, 37%and 36%, respectively, of the non-conforming loan originations included loanssecured by properties located in California. The Company’s originations are concentrated heavily in Californiabecause it is the largest mortgage market in the U.S. and the Company believesthat its underwriting, product design, and pricing philosophies address thecharacteristics of California borrowers. The Company believes thesecharacteristics that address California borrowers to be non-standard creditprofiles, interest in low downpayment products, payment-focused mortgages, andhigher home values.  An overall declinein the economy or the residential real estate market or the occurrence of anatural disaster in California could adversely affect the value of themortgaged properties in that state and increase the risk of delinquency,foreclosure, bankruptcy, or loss on the these loans in the Company’s investment portfolio.  Non-conforming loan originations secured byproperty located in California comprised 41% of total non-conforming loanoriginations for both the three and six months ended June 30, 2005.

***(e)   Recent Accounting Pronouncements***

In June 2006, the FASBissued FASB Interpretation No. 48 *“Accounting ForUncertainty in Income Taxes-an interpretation of FASB Statement No. 109,”*(FINNo. 48).  FIN No. 48 prescribes arecognition threshold and measurement attribute for the financial statementrecognition and measurement of a tax position taken or expected to be taken ina tax return. FIN No. 48 also provides guidance on derecognition,classification,

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interest and penalties,accounting in interim periods, disclosure, and transition. FIN No. 48 iseffective for fiscal years beginning after December 15, 2006.  The Company will adopt FIN No. 48, asapplicable, beginning in fiscal year 2007. Management is currently assessing the impact that the implementation ofFIN No. 48 may have on its results of operations, statements of condition orcash flows.

In March 2006, theFinancial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standards No. 156, *“Accounting For Servicingof Financial Assets-an amendment of FASB Statement No. 140,”*(StatementNo. 156).  Statement No. 156 amendsStatement of Financial Accounting Standards No. 140, *“Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities,”* (Statement No. 140),with respect to the accounting for separately recognized servicing rights.  Statement No. 156 requires an entity toinitially recognize, at fair value, a servicing asset or servicing liabilityeach time it undertakes an obligation to service a financial asset by enteringinto a servicing contract in certain situations.  In addition, Statement No. 156 permits thesubsequent measurement of servicing assets and servicing liabilities using thefair value method or the amortization method as prescribed under Statement No.140.  Statement No. 156 is effective asof the beginning of an entity’s first fiscal year that begins after September15, 2006.  The Company will adoptStatement No. 156, as applicable, beginning in fiscal year 2007.  Management believes that the implementationof Statement No. 156 will not have a material effect on its results ofoperations, statements of condition or cash flows.

In February 2006,the FASB issued Statement of Financial Accounting Standards No. 155, *“Accounting For Certain Hybrid Financial Instruments-an amendment ofFASB Statements No. 133 and 140,”*(Statement No. 155).  Statement No. 155 amends Statement No. 133 topermit fair value remeasurement for any hybrid financial instrument with anembedded derivative that otherwise would require bifurcation, provided that thewhole instrument is accounted for on a fair value basis.  Statement No. 155 amends Statement No. 140 toallow a qualifying special-purpose entity to hold a derivative financialinstrument that pertains to a beneficial interest other than another derivativefinancial instrument.  Statement No. 155is effective for all financial instruments acquired, issued or subject to aremeasurement (new basis) event occurring after the beginning of an entity’sfirst fiscal year that begins after September 15, 2006.  The Company will adopt Statement No. 155, asapplicable, beginning in fiscal year 2007. Management believes that the implementation of Statement No. 155 willnot have a material effect on its results of operations, statements ofcondition or cash flows.

In December 2005,the FASB issued Staff Position 94-6-1*, “Terms of Loan ProductsThat May Give Rise to a Concentration of Credit Risk,”* (FSP94-6-1).  FSP 94-6-1 clarifies that loanproducts that expose an originator, holder, investor, guarantor or servicer toan increased risk of non-payment or not realizing the full value of the loan,such as non-traditional loan products, may result in a concentration of creditrisk as defined in Statement of Financial Accounting Standards No. 107, *“Disclosures about Fair Value of Financial Instruments,”*(Statement No. 107).  FSP 94-6-1 alsoemphasizes the requirement to assess the adequacy of disclosures for alllending products (including both secured and unsecured loans) and the effect ofchanges in market or economic conditions on the adequacy of those disclosures.The guidance under FSP 94-6-1 is effective for interim and annual reportingperiods ending on or after December 19, 2005 and for loan products that aredetermined to represent a concentration of credit risk, disclosure requirementsof Statement No. 107 should be provided for all periods presented.  The adoption of FSP 94-6-1 has not had asignificant impact on the Company’s consolidated financial statements.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123R, “*ShareBased Payments*” (Statement No. 123R), requiring, among otherthings, that the compensation cost of stock options and other equity-basedcompensation issued to employees, which cost is based on the estimated fairvalue of the awards on the grant date, be reflected in the income statementover the requisite service period. In March 2005, the SEC staff issued StaffAccounting Bulletin No. 107 (SAB No. 107). SAB No. 107 expresses the views of the SEC regarding Statement No. 123Rand certain rules and regulations and provides the SEC’s view regarding thevaluation of share-based payment arrangements for public companies.  In April 2005, the SEC amended thecompliance dates for Statement No. 123R to the beginning of the nextfiscal year after June 15, 2005.  InNovember 2003, the Company adopted the fair value method of accounting forgrants of stock options and restricted stock as prescribed by Statement ofFinancial Accounting Standards No. 148,

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“*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 vestingperiod.  The Company adopted StatementNo. 123R and SAB No. 107 as of January 1, 2006, which resulted in a change inthe accounting for unearned compensation whereby the balance of unearnedcompensation as of December 31, 2005, and all subsequent unearned compensationtransactions were recorded to additional paid-in capital on the consolidatedstatements of condition. The implementation of Statement No. 123R and SAB No.107 has not had a material effect on the Company’s results of operations,statements of condition or cash flows.

***(f)   Reclassifications***

Certain prior period amounts have been reclassified toconform to the current period presentation. In accordance with Statement No. 144, the Company has reclassified theoperating results of the conforming wholesale and retail offices that weredisposed of in the first quarter of 2006 as discontinued operations in thecondensed consolidated statements of operations for the three and six monthsended June 30, 2005.  Also included inthese reclassifications is the reclassification of changes in restricted cashfrom cash flows from operating activities to cash flows from investingactivities in the amounts of $1.9 million for the six months ended June 30,2005.

***(g)   Restatement***

In preparing theCompany’s 2005 consolidated financial statements, the Company’s managementidentified errors in the accounting for income taxes related to the sale ofloans by FMC (the Company’s TRS) to FIC (which operates as a REIT) in the fourthquarter of 2003 and the second quarter of 2005. In each of these periods, the Company had previously recognized theentire income tax expense related to the gains on sales earned by FMC on thesesales of non-conforming loans to FIC for inclusion in its investmentportfolio.  However, the Companydetermined that it should have deferred the portion of the income tax expenserelated to the intercompany sale of those loans that remained on the Company’sconsolidated statements of condition at each period end.  Such deferred tax asset should have beenrecognized as expense over the life of the loans.  As a result, the Company has restated theaccompanying 2005 condensed consolidated financial statements.

A summary of thesignificant effects of the restatement on the accompanying condensedconsolidated financial statements is as follows:

CondensedConsolidated Statement of Condition:

|                         | ** ** | **June 30, 2005**           | ** ** |
|-------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | **Total  Shareholder’s  Equity** | ** ** |
| As previously  reported |       | $                                     | 569,196    |   |
| Income tax adjustment   |       | 2,144                                 |       |
| As restated             |       | $                                     | 571,340    |   |

 

CondensedConsolidated Statements of Operations:

|                                                                                       | ** ** | **Three Months Ended  June 30, 2005** | ** ** |
|---------------------------------------------------------------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **Income Tax  (Expense)  Benefit**                   | ** ** | **Net  Income** | ** ** | **Earnings  Per Share  (Diluted)** | ** ** |
| As previously reported                                                                |       | $                                                         | (2,734     | ) | $ | 23,075 |   | $ | 0.47 |   |
| Income tax restatement adjustment                                                     |       | 751                                                       |       | 751 |   | 0.02 |   |
| Reclassification of  income tax benefit included in loss from discontinued operations |       | (471                                                      | )          | — |   | — |   |
| As restated                                                                           |       | $                                                         | (2,454     | ) | $ | 23,826 |   | $ | 0.49 |   |

** **

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Condensed ConsolidatedStatements of Operations:

|                                                                                       | ** ** | **Six Months Ended  June 30, 2005** | ** ** |
|---------------------------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                                                                            | ** ** | **Income Tax  (Expense)  Benefit**                 | ** ** | **Net  Income** | ** ** | **Earnings  Per Share  (Diluted)** | ** ** |
| As previously reported                                                                |       | $                                                       | (1,793     | ) | $ | 65,179 |   | $ | 1.34 |   |
| Income tax restatement adjustment                                                     |       | 401                                                     |       | 401 |   | 0.01 |   |
| Reclassification of  income tax benefit included in loss from discontinued operations |       | (905                                                    | )          | — |   | — |   |
| As restated                                                                           |       | $                                                       | (2,297     | ) | $ | 65,580 |   | $ | 1.35 |   |

 

**(2)**            Mortgage Loans Held for Sale and Reservefor Losses—Sold Loans

Mortgage loans that theCompany acquires or originates with the intent to sell are initially recordedat cost, including any premium paid or discount received, and subsequentlyadjusted for the change in the fair value during the period in which the loanwas an interest rate lock commitment. Loans held for sale are carried on thebooks at the lower of cost or market value calculated on an aggregate basis bytype of loan. Mortgage loans held for sale, net, as of June 30, 2006 andDecember 31, 2005 are as follows:

|                                                  | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Mortgage loans  held for sale                    |       | $                       | 330,389    |                        | $          | 591,840 |   |
| Net deferred  origination costs                  |       | 571                     |       | 1,547                       |       |
| (Discount)  premium, net                         |       | (116                    | )          | 1,987                       |       |
| Allowance for  the lower of cost or market value |       | (6,412                  | )          | (1,105                      | )          |
| Total                                            |       | $                       | 324,432    |                        | $          | 594,269 |   |

 

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The Company maintains areserve for its representation and warranty liabilities related to the sale ofloans and its contractual obligations to rebate a portion of any premiumreceived when a sold loan prepays within an agreed period. The reserve, whichis recorded as a liability on the consolidated statements of condition, isestablished when loans are sold, and is calculated as the fair value ofliabilities reasonably estimated to occur during the life of the loans. Theprovision is recorded as a reduction of the gains on sale of loans.  At June 30, 2006 and December 31, 2005,mortgage loans held for sale included approximately $7.7 million and $1.7million, respectively, of loans repurchased pursuant to these contractualobligations, net of any related valuation allowance.  Realized losses on sold loans, primarilyrelated to early payment defaults, premium recaptures on early payoffs, andrepresentation and warranty liability, totaled $6.6 million and $10.5 million,or 1.04% and 0.69% of total loan sales, respectively, in the three and sixmonths ended June 30, 2006.  The netrealized losses on sold loans totaled $0.3 million and $1.0 million, or 0.02%and 0.04% of total loan sales, respectively, in the three and six months endedJune 30, 2005.

As of June 30, 2006, the Company had $11.8 million ofloans deemed to be unsaleable at standard sale premiums compared to $5.2million at December 31, 2005.  TheCompany recorded a valuation allowance of $1.9 million and $1.1 million, as ofJune 30, 2006 and December 31, 2005, respectively, for these loans.

The reserve forlosses—loans sold is summarized as follows for the three and six months endedJune 30, 2006 and 2005:
| Balance at March 31, 2006 |   | $       | 33,497 |            | Balance at March 31, 2005 |   | $ | 35,099 |
|---------------------------|--------|---------|--------|-----------------|---------------------------|--------|---|--------|
| Provision                 |   | 1,091   |   | Provision       |                      | 3,590  |
| Realized losses           |   | (6,876) |   | Realized losses |                      | (332)  |
| Recoveries                |   | 316     |   | Recoveries      |                      | 54     |
| Balance at June 30, 2006  |   | $       | 28,028 |            | Balance at June 30, 2005  |   | $ | 38,411 |

 
| Balance at December 31, 2005 |   | $        | 35,082 |            | Balance at December 31, 2004 |    | $ | 33,302 |
|-----------------------------------|--------|----------|--------|-----------------|-----------------------------------|---------|---|--------|
| Provision                         |   | 3,421    |   | Provision       |                              | 6,128   |
| Realized losses                   |   | (10,840) |   | Realized losses |                              | (1,094) |
| Recoveries                        |   | 365      |   | Recoveries      |                              | 75      |
| Balance at June 30, 2006          |   | $        | 28,028 |            | Balance at June 30, 2005          |    | $ | 38,411 |

 

Historically, theCompany has experienced substantially all of its representation and warrantylosses on loans sold during the first three years following the sale.  The reserve for losses—loans sold as of June30, 2006 relates to loan sales primarily during the period of July 1, 2003through June 30, 2006 of approximately $12.4 billion.

The market for second lien loans decreasedsignificantly during the second quarter of 2006 due to slowing home priceappreciation and an increased forecast of losses on second lien loans byprominent rating agencies.  As of June30, 2006, the Company determined that the market value of $130.7 million of itssecond lien loans held for sale as of that date was less than their carryingvalue.  Accordingly, the Company recordeda $4.5

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million pre-tax charge toreduce these loans to the lower of cost or market value as a reduction in thegain on sales of mortgage loans, net, in the accompanying condensedconsolidated financial statements.

**(3)**            Mortgage Loans Heldfor Investment and Allowance for Loan Losses

The Company originates fixed-rate and adjustable-ratemortgage loans that have a contractual maturity of up to 40 years. Thesemortgage loans are initially recorded at cost, including any premium ordiscount. These mortgage loans are financed with warehouse debt until they arepledged as collateral for securitization financing. The Company is exposed torisk of loss from its loan portfolio, and establishes an allowance for loanlosses taking into account a variety of criteria including the contractualdelinquency status, market delinquency roll rates, market historical lossseverities, and the Company’s historical loss experiences with similar loans.The adequacy of this allowance for loan losses is periodically evaluated andadjusted based on this review.

The following is adetail of the mortgage loans held for investment, net as of June 30, 2006 andDecember 31, 2005:

|                                                             | ** ** | **June 30,   2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------|------------|-------------------------------|------------|-----------------------------|------------|
| Securitized  mortgage loans held for investment             |       | $                             | 4,721,725  |                        | $          | 5,043,762 |   |
| Mortgage loans  held for investment—warehouse financed |       | 973,166                       |       | 486,454                     |       |
| Net deferred  origination fees and costs                    |       | 37,372                        |       | 40,199                      |       |
| Mortgage loans  held for investment                         |       | 5,732,263                     |       | 5,570,415                   |       |
| Allowance for  loan losses—loans held for investment   |       | (44,749                       | )          | (44,122                     | )          |
| Mortgage loans held for  investment, net                    |       | $                             | 5,687,514  |                        | $          | 5,526,293 |   |

 

The allowance forloan losses—loans held for investment for the three and six months ended June30, 2006 and 2005 is as follows:
| Balance at March 31, 2006 |   | $       | 45,744 |            | Balance at March 31, 2005 |    | $ | 26,379 |
|---------------------------|--------|---------|--------|-----------------|--------------------------------|---------|---|--------|
| Provision                 |   | 5,466   |   | Provision       |                           | 6,863   |
| Realized losses           |   | (6,461) |   | Realized losses |                           | (2,833) |
| Recoveries                |   | —  |   | Recoveries      |                           | 281     |
| Balance at June 30, 2006  |   | $       | 44,749 |            | Balance at June 30, 2005       |    | $ | 30,690 |

 
| Balance at December 31, 2005 |   | $        | 44,122 |            | Balance at December 31, 2004 |    | $ | 22,648 |
|-----------------------------------|--------|----------|--------|-----------------|-----------------------------------|---------|---|--------|
| Provision                         |   | 10,859   |   | Provision       |                              | 11,357  |
| Realized losses                   |   | (10,232) |   | Realized losses |                              | (3,660) |
| Recoveries                        |   | —   |   | Recoveries      |                              | 345     |
| Balance at June 30, 2006          |   | $        | 44,749 |            | Balance at June 30, 2005          |    | $ | 30,690 |

 

Mortgage loans held for investment are placed innon-accrual status for interest income recognition when they are past-dueninety days as to either principal or interest or when, in the opinion ofmanagement, the collection of principal and interest is in doubt. Loans heldfor investment on non-accrual status were $193.9 million and $77.6 millionas of June 30, 2006 and 2005, respectively, and $150.3 million as of December31, 2005.  The loans held on non-accrualstatus averaged $203.4 million and $63.9 million, respectively, for the sixmonths ended June 30, 2006 and 2005. During the three months ended June 30, 2006 and 2005, respectively, theCompany reversed previously accrued interest income relating to non-performingand delinquent loans, which would ordinarily have been recognized percontractual loan terms, of approximately $3.6 million and

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$1.3 million.  The Company reversed interest income relatedto the loans of approximately $5.8 million and $3.2 million during the six monthsended June 30, 2006 and 2005, respectively.

Prior to the second quarter of 2006, the Companyutilized industry loss assumptions for loans similar in credit, loan size, andproduct type in making estimates regarding the allowance for loan lossesbecause the Company had limited historical loss data on past originations, allof which were sold servicing-released prior to October 2003. Beginning in thesecond quarter of 2006, the Company began to blend its own historicaldelinquency experiences with industry averages in estimating the percentage ofloans that are delinquent 30+ days that will ultimately go to foreclosure. Thisresulted in an estimate that approximately 20% of the loans 30+ days delinquentwill ultimately go to foreclosure.  Alsoduring the second quarter of 2006, the Company began to utilize historical lossexperiences in estimating loss severity for pools for which it has significantrealized loss experiences. Applying this methodology individually to each poolyielded an estimated average loss severity of approximately 27% for 2003, 2004and first quarter 2005 vintage loans.  The Company continues to use industry loss severity estimates of 35% forsecond quarter 2005 and all 2006 pools for which significant realized lossexperience for its own loans is not available. These underlying assumptions and estimates are periodically evaluatedand updated to reflect management's current assessment of the value of theunderlying collateral, actual historical loss experience, and other relevantfactors impacting portfolio credit quality and inherent losses.

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

As of June 30, 2006, the Company had $1.875 billion ofwarehouse lines of credit with six financial entities. Committed facilitiescomprise $1.825 billion of the total available, with uncommittedfacilities totaling $50 million. The facilities are secured by mortgageloans held for investment to be securitized, mortgage loans held for sale, therelated investor commitments to purchase those loans held for sale, and allproceeds thereof.

Warehouse lines ofcredit and repurchase facilities consist of the following as of June 30, 2006and December 31, 2005:
| **(in millions)**                                            | ** ** | ** **           | ** ** | ** **       | ** **   | **Amount  Outstanding as of:** |
|--------------------------------------------------------------|------------|----------------------|------------|------------------|--------------|--------------------------------|
| **Lender**                                                   | ** ** | **Amount Available** | ** ** | **MaturityDate** | ** **   | **June 30,  2006**             | ** ** | **December 31,  2005** |
| Countrywide Warehouse  Lending                               |       | $                    | 75.0       |             | August  2006 |                           | $ | — |   | $ | 34.3 |
| Countrywide Early  Purchase Program                          |       | 50.0                 |       | Uncommitted      |         | —                         |   | — |
| Credit Suisse First  Boston Mortgage Capital                 |       | 400.0                |       | April  2007      |         | 245.4                          |   | 195.2 |
| Credit Suisse, New York  Branch Commercial Paper Facility(1) |       | 600.0                |       | July  2006       |         | 528.1                          |   | 415.8 |
| JPMorgan Chase Bank(1)                                       |       | 150.0                |       | July  2006       |         | 102.4                          |   | 53.9 |
| Lehman Brothers Bank                                         |       | 300.0                |       | December  2006   |         | 139.6                          |   | 51.7 |
| Merrill Lynch Bank USA                                       |       | 300.0                |       | November  2006   |         | 137.1                          |   | 61.9 |
| Total                                                        |       | $                    | 1,875.0    |             |         |                           | $ | 1,152.6 |   | $ | 812.8 |

----

(1)             During July 2006, the maturity date for thesefacilities were extended until July 2007.

The average outstanding amounts under these agreementswere $720.9 million and $745.1 million for the three and six months ended June30, 2006, respectively, and $825.1 million and $742.3 million for the three andsix months ended June 30, 2005, respectively. The maximum amount outstanding under these agreements at any month-endduring the six months ended June 30, 2006 and 2005 was $1.15 billion and $1.06billion, respectively.  The weightedaverage interest rate on June 30, 2006, December 31, 2005 and June 30, 2005 was5.6%, 4.7% and 4.2%, respectively.  Theinterest rates are based on spreads to one month or overnight LIBOR, and aregenerally reset daily or weekly. The Company also pays facility fees based onthe commitment amount and non-use fees.

13

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A summary ofcoupon interest expense and facilities fees included in total interest expensein the condensed consolidated statements of operations and the weighted averagecost of funds for the three and six months ended June 30, 2006 and 2005 is asfollows: 
| ** **              | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **              | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **              | ** ** | **Amount**                                          | ** ** | **Weighted  Average  Cost**                       | ** ** | **Amount** | ** ** | **Weighted  Average  Cost** | ** ** | **Amount** | ** ** | **Weighted  Average  Cost** | ** ** | **Amount** | ** ** | **Weighted  Average  Cost** | ** ** |
| Coupon interest expense |       | $                                                   | 9,965      |                                              | 5.5        | % | $ | 6,952 |   | 3.7 | % | $ | 18,325 |   | 5.0 | % | $ | 12,014 |   | 3.5 | % |
| Facilities fees         |       | 746                                                 |       | 0.4                                               | %          | 798 |   | 0.4 | % | 1,355 |   | 0.4 | % | 1,632 |   | 0.5 | % |
| Total                   |       | $                                                   | 10,711     |                                              | 5.9        | % | $ | 7,750 |   | 4.1 | % | $ | 19,680 |   | 5.4 | % | $ | 13,646 |   | 4.0 | % |

 

The warehouselines generally have a term of 364 days or less.  Management expects to renew these lines ofcredit prior to their respective maturity dates. The credit facilities aresecured by substantially all of the Company’s non-securitized mortgage loansand contain customary financial and operating covenants that require theCompany to maintain specified levels of liquidity and net worth, maintainspecified levels of profitability, restrict indebtedness and investments, andrequire compliance with applicable laws. The Company was in compliance with allof these covenants at June 30, 2006 and December 31, 2005.

**(5)**            SecuritizationFinancing

During the six months ended June 30, 2006, the Companyissued $0.9 billion of mortgage-backed bonds through a securitization trust tofinance the Company’s portfolio of loans held for investment. The bonds payinterest monthly based upon a weighted average spread over LIBOR. Interestrates reset monthly and are indexed to one-month LIBOR. The bonds are repaidfrom the cash flows derived from the mortgage loans pledged to the trust. Theestimated average life of the bonds is approximately 21 months, and is based onestimates and assumptions made by management. The actual period from inceptionto maturity may differ from management’s expectations. The Company retains theoption to repay the bonds when the remaining unpaid principal balance of theunderlying mortgages loans for each pool falls below specified levels. Thesecuritization financings include a step up stipulation which provides that thebond margin over LIBOR will increase 1.5 to 2.0 times the original margin ifthe option to repay the bonds is not exercised.

The following is asummary of the securitization issued by series during the six months ended June30, 2006:

|                                     | ** ** | **FMIT  2006-1** | ** ** |
|-------------------------------------|------------|------------------|------------|
| Bonds issued                        |       | $                | 904,000    |   |
| Loans pledged                       |       | 933,000          |       |
| Deferred bond  issuance costs       |       | $                | 3,100      |   |
| Weighted average  spread over LIBOR |       | 0.32             | %          |
| Financing costs—LIBOR  plus    |       | 0.08% - 2.30     | %          |

 

During the first quarterof 2006, the FMIT Series 2006-1 securitization included a pre-funding whereby aportion of the collateral pledged to the trust was delivered in April 2006,subsequent to the March 2006 bond closing date. Approximately $233.0 million of bond proceeds, which was notcollateralized at closing, was held in escrow by the trustee and reported as acomponent of restricted cash as of March 31, 2006.  As a result of the collateralization of theremaining bonds in April 2006, these proceeds were released from escrow.

The averagesecuritization financing outstanding was $5.0 billion and $4.9 billion for thethree and six months ended June 30, 2006, respectively, and $4.2 billion forthe three and six months ended June 30, 2005.

The unamortized bondissuance costs at June 30, 2006 and December 31, 2005 were $9.5 millionand $11.6 million, respectively.

14

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A summary of couponinterest expense, amortization of deferred issuance costs, and original issuediscount included in total interest expense in the consolidated statements ofoperations, and the weighted average cost of funds of the securitization financing,for the three and six months ended June 30, 2006 and 2005 is as follows:
| ** **                      | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                      | ** ** | **Amount**                                          | ** ** | **Weighted  Average  Cost**                       | ** ** | **Amount** | ** ** | **Weighted  Average  Cost** | ** ** | **Amount** | ** ** | **Weighted  Average  Cost** | ** ** | **Amount** | ** ** | **Weighted  Average  Cost** | ** ** |
| Coupon interest  expense        |       | $                                                   | 67,847     |                                              | 5.4        | % | $ | 37,198 |   | 3.5 | % | $ | 127,683 |   | 5.2 | % | $ | 68,841 |   | 3.3 | % |
| Amortization of  deferred costs |       | 2,593                                               |       | 0.2                                               | %          | 2,109 |   | 0.2 | % | 5,278 |   | 0.2 | % | 4,107 |   | 0.2 | % |
| Amortization of  bond discount  |       | 25                                                  |       | 0.0                                               | %          | 85 |   | 0.0 | % | 56 |   | 0.0 | % | 148 |   | 0.0 | % |
| Total                           |       | $                                                   | 70,465     |                                              | 5.6        | % | $ | 39,392 |   | 3.7 | % | $ | 133,017 |   | 5.4 | % | $ | 73,096 |   | 3.5 | % |

 

TheCompany also has the ability to finance the securities it retains insecuritizations through two repurchase facilities, each with an uncommitted amountof $200 million.  The first facility iswith Liquid Funding, Ltd., an affiliate of Bear Stearns Bank plc.  The second facility is with Lehman Brothers,Inc. and Lehman Brothers Commercial Paper Inc. Each facility bears interest at an annual rate of LIBOR plus anadditional percentage.

During March 2006,the unpaid principal balance of the loans collateralizing FMIT Series 2004-1fell below 20% of the original principal cut-off balance of the collateral,permitting Fieldstone Servicing Corporation to exercise its right of optionaltermination of the financing.  Management reviewed the performance ofmortgage loans in the financing trust and related cost of financing andsubsequently delivered notice in April 2006 to the FMIT Series 2004-1 trusteeand bondholders of the exercise of the Company’s option to purchase themortgage loans, REO property, and any other property remaining in the trust atthe next payment date. The Company paid $100.4 million to third-partybondholders on April 25, 2006.  The underlying collateral is included onthe consolidated statement of condition as unsecuritized loans held forinvestment.

Thefollowing is a summary of the outstanding securitization bond financing andweighted average interest rate by series as of June 30, 2006 andDecember 31, 2005:
| ** **                             | ** ** | **June 30, 2006** | ** ** | **December 31, 2005**           | ** ** |
|----------------------------------------|------------|-----------------------------|------------|-------------------------------------------|------------|
| **($ in 000s)**              | ** ** | **Amount  Outstanding**     | ** ** | **Weighted Avg  Interest Rate** | ** ** | **Amount  Outstanding** | ** ** | **Weighted Avg  Interest Rate** | ** ** |
| FMIT  Series 2006-1               |       | $                           | 880,309    |                                      | 5.6%       |   | $ | — — |   | —% |   |
| FMIT  Series 2005-3               |       | 1,005,713                   |       | 5.6%                                      |       | 1,089,820 |   | 4.7% |   |
| FMIT  Series 2005-2               |       | 759,846                     |       | 5.7%                                      |       | 872,455 |   | 4.7% |   |
| FMIT  Series 2005-1               |       | 437,230                     |       | 5.7%                                      |       | 555,650 |   | 4.7% |   |
| FMIT  Series 2004-5               |       | 476,753                     |       | 5.9%                                      |       | 595,481 |   | 4.9% |   |
| FMIT  Series 2004-4               |       | 423,947                     |       | 5.9%                                      |       | 518,283 |   | 4.9% |   |
| FMIT  Series 2004-3               |       | 350,493                     |       | 5.9%                                      |       | 523,296 |   | 4.9% |   |
| FMIT  Series 2004-2(1)            |       | 140,160                     |       | 6.4%                                      |       | 377,500 |   | 4.9% |   |
| FMIT  Series 2004-1               |       | —                      |       | —%                                   |       | 233,977 |   | 5.0% |   |
| FMIC  Series 2003-1               |       | 47,290                      |       | 7.7%                                      |       | 83,308 |   | 6.1% |   |
|                                   |       | 4,521,741                   |       | 5.7%                                      |       | 4,849,770 |   | 4.8% |   |
| Unamortized bond  discount             |       | (18                         | )          |                                      |       | (74 | ) |   |   |
| Subtotal securitization bond financing |       | 4,521,723                   |       |                                      |       | 4,849,696 |   |   |   |
|                                   |       |                        |       |                                      |       |   |   |   |   |
| Liquid Funding  repurchase facility    |       | 92,481                      |       |                                      |       | 86,079 |   |   |   |
| Lehman Brothers  repurchase facility   |       | —                      |       |                                      |       | 62,845 |   |   |   |
| Total  securitization financing        |       | $                           | 4,614,204  |                                      |       |   | $ | 4,998,620 |   |   |   |

----

(1)             Series 2004-2 was called in August 2006.  See Note 12.

15

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The current carrying amount of the mortgage loanspledged to the trusts was $4.7 billion and $5.0 billion as of June 30, 2006 andDecember 31, 2005, respectively.

**(6)**            Derivatives andHedging Activities

In conjunction with the financing of its portfolio ofloans held for investment, the Company entered into interest rate swapsdesigned to be economic hedges of the floating rate warehouse andsecuritization debt.  At June 30, 2006,the fair value of 29 interest rate swaps with positive fair values was $36.1million and the fair value of 3 swaps with negative fair values was $0.1million, for a net fair value of $35.9 million. At December 31, 2005, the fair value of 26 interest rate swaps withpositive fair values was $35.2 million and the fair value of 3 swaps withnegative fair values was $0.2 million, for a net fair value of $35.0million.  The swaps are not classified ascash flow hedges under Statement No. 133, and therefore, the mark tomarket valuation decreases of $1.0 million and $11.8 million have been includedin earnings during the three months ended June 30, 2006 and 2005,respectively.  Results of operationsinclude mark to market valuation increases of $0.9 million and $8.8 million duringthe six months ended June 30, 2006 and 2005, respectively.  The net cash settlements paid or received onthe interest rate swaps are also reported as a component of “Other income(expense)—portfolio derivatives” in the condensed consolidated statement ofoperations.

In conjunction with the Company’s FMIT Series 2003-1securitization, the Company purchased an interest rate cap agreement by payinga premium of $3.0 million, determined to be an economic hedge of thefloating rate debt of the security.  Markto market valuation decreases of $0.3 million and $0.2 million, respectively,have been included in earnings during the three and six months ended June 30,2005.  During the fourth quarter of 2005,the interest rate cap expired.

16

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The amounts ofcash settlements and non-cash changes in value that were included in “Otherincome (expense)—portfolio derivatives” is as follows for the three and sixmonths ended June 30, 2006 and 2005:
| ** **                                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Non-cash mark to  market valuation change          |       | $                                               | (1,024     | )                                             | $          | (12,087 | ) | $ | 870 |   | $ | 8,541 |   |
| Net cash  settlements on interest rate swaps       |       | 11,845                                          |       | 2,655                                         |       | 22,109 |   | 2,369 |   |
| Other income  (expense)—portfolio derivatives |       | $                                               | 10,821     |                                          | $          | (9,432 | ) | $ | 22,979 |   | $ | 10,910 |   |

 

**(7)**            DiscontinuedOperations

On January 13,2006, the Company’s Board of Directors approved a plan to sell, close orotherwise dispose of the assets of its conforming retail and conformingwholesale segments.  In February 2006,the assets pertaining to these segments’ headquarters, all wholesale offices,and certain of its retail offices were sold to third parties. The remainingassets of the conforming division, which include retail offices in Maryland andVirginia, have been combined with the Company’s non-conforming retail offices,which will offer a range of non-conforming and conforming loan products.  The pre-tax loss on disposal was $0.9 millionand is included in discontinued operations, net of income tax, in the condensedconsolidated statements of operations in the first quarter of 2006.

The provisions ofStatement No. 144 require the results of operations associated with theseconforming wholesale and conforming retail offices to be classified asdiscontinued operations, net of income tax, and segregated from the Company’scontinuing results of operations for all periods presented.

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Operating resultsof discontinued operations, net of income tax, included in the condensedconsolidated statements of operations are summarized as follows for the threeand six months ended June 30, 2006 and 2005:
| ** **                                  | ** ** | **Three months ended  June 30,** | ** ** | **Six months ended  June 30,** | ** ** |
|---------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                   |       |                                            |       |                                          |       |   |   |   |   |
| Interest income                             |       | $                                               | —     |                                          | $          | 1,380 |   | $ | 839 |   | $ | 2,465 |   |
| Interest expense                            |       | —                                          |       | 907                                           |       | 657 |   | 1,328 |   |
| Net interest income                         |       | —                                          |       | 473                                           |       | 182 |   | 1,137 |   |
| Gains on sales  of mortgage loans           |       | —                                          |       | 1,221                                         |       | (188 | ) | 2,421 |   |
| Fees and other  income                      |       | —                                          |       | 135                                           |       | 41 |   | 242 |   |
| Total revenues                              |       | —                                          |       | 1,829                                         |       | 35 |   | 3,800 |   |
|                                        |       |                                            |       |                                          |       |   |   |   |   |
| Expenses:                                   |       |                                            |       |                                          |       |   |   |   |   |
| Salaries and employee benefits              |       | —                                          |       | 1,988                                         |       | 1,692 |   | 4,026 |   |
| Occupancy                                   |       | —                                          |       | 179                                           |       | 272 |   | 475 |   |
| Depreciation and amortization               |       | —                                          |       | 36                                            |       | 104 |   | 71 |   |
| General and administration                  |       | —                                          |       | 792                                           |       | 727 |   | 1,469 |   |
| Total expenses                              |       | —                                          |       | 2,995                                         |       | 2,795 |   | 6,041 |   |
| Discontinued operations before income taxes |       | —                                          |       | (1,166                                        | )          | (2,760 | ) | (2,241 | ) |
| Income tax  benefit                         |       | —                                          |       | 471                                           |       | 1,115 |   | 905 |   |
| Discontinued  operations, net of income tax |       | $                                               | —     |                                          | $          | (695 | ) | $ | (1,645 | ) | $ | (1,336 | ) |

 

The impact ofdiscontinued operations on cash flows from operating, cash flows from investingand cash flows from financing activities are separately presented in thecondensed consolidated statements of cash flows for the six months ended June30, 2006 and 2005.

**(8)**            Segment Information

The information presented below with respect to theCompany’s reportable segments is consistent with the content of the businesssegment data provided to the Company’s management. This segment data uses acombination of business lines and channels to assess consolidated results. TheCompany has four reportable segments, which include two production segments,Wholesale and Retail, and two operating segments, which include InvestmentPortfolio and Corporate. Prior to the first quarter of 2006, the Companyreported two additional production segments referred to as its ConformingWholesale and Conforming Retail segments. In the first quarter of 2006, theCompany’s Board of Directors approved a plan to sell, close or otherwisedispose of the assets of the Conforming Wholesale and Conforming Retailsegments due to the decline in profitability of these segments.  In February 2006, the Company sold the assetspertaining to these divisions’ headquarters, all wholesale offices, and certainof its retail offices to third parties. The remaining assets of the conformingsegment, which included retail offices in Maryland and Virginia, have beencombined with the non-conforming

18

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retail offices and willbe reported as a component of the Company’s Retail segment. The followingdiscussion of results reflects the Company’s current segment structure, whilethe results of its former Conforming Wholesale and Conforming Retail segmentsare reported as discontinued operations.

The Company originates loans through two productionsegments: a Wholesale segment which originates non-conforming loans and aRetail segment, which originates non-conforming and conforming loans. TheInvestment Portfolio segment primarily includes the net interest income earnedby the loans held for investment and the direct costs, including third-partyservicing fees, incurred to manage the portfolio. In addition, the Company hasa Corporate segment that includes the timing and other differences betweenactual revenues and costs and amounts allocated to the production segments. TheCorporate segment also includes the effects of the deferral and capitalizationof net origination costs as required by Statement of Financial AccountingStandards No. 91, *“Accounting forNon-refundable Fees and Costs Associated with Originating or Acquiring Loansand Initial Direct Costs of Leases.”* Financial information bysegment is evaluated regularly by management and used in decision-makingrelating to the allocation of resources and the assessment of Companyperformance. For the purposes of segment information provided in the tablesbelow, certain fees, origination costs, and other expenses recorded as acomponent of gains on sale of mortgage loans, net, have been reflected in totalrevenues or total expenses consistent with intercompany allocations reported tothe Company’s management. Also, origination fees and gain on sale revenue arerecognized at the time of funding by the production segments, and adjusted inthe corporate segment to reflect the actual fees and gain on sale recognizablefor GAAP revenue reporting when the loans are sold. The Corporate segmentincludes reconciling amounts necessary for the segment totals to agree to thecondensed consolidated financial statements.

Theassets of the Company that are specifically identified to a segment includemortgage loans held for sale and investment, trustee receivable, derivativeassets, and furniture and equipment, net. All other assets are attributed tothe Corporate segment. Total assets by segment at June 30, 2006 andDecember 31, 2005 are summarized as follows:

|                              | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Production —  Wholesale |       | $                       | 277,111    |                        | $          | 526,914 |   |
| Production —  Retail    |       | 50,737                  |       | 70,632                      |       |
| Investment  Portfolio        |       | 5,826,658               |       | 5,691,744                   |       |
| Corporate                    |       | 168,074                 |       | 134,324                     |       |
| Total                        |       | $                       | 6,322,580  |                        | $          | 6,423,614 |   |

 

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Operatingresults by business segment for the three months ended June 30, 2006 are asfollows:
| ** **                                                | ** ** | **Production** | ** ** | **Investment** | ** ** | ** **    | ** ** | ** **    | ** ** |
|-----------------------------------------------------------|------------|----------------|------------|----------------|------------|---------------|------------|---------------|------------|
| ** **                                                | ** ** | **Wholesale**  | ** ** | **Retail**     | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidated** | ** ** |
| Revenues:                                                 |       |           |       |           |       |          |       |          |       |   |   |
| Interest income                                           |       | $              | 8,985      |           | $          | 1,277         |       | $             | 100,440    |   | $ | (3,271 | ) | $ | 107,431 |   |
| Interest expense                                          |       | 5,739          |       | 834            |       | 77,589        |       | (2,986        | )          | 81,176 |   |
| Net interest income                                       |       | 3,246          |       | 443            |       | 22,851        |       | (285          | )          | 26,255 |   |
| Provision for  loan losses—loans held for investment |       | —         |       | —         |       | (5,466        | )          | —        |       | (5,466 | ) |
| Gains (losses)  on sales of mortgage loans, net           |       | 24,924         |       | 8,463          |       | —        |       | (31,434       | )          | 1,953 |   |
| Other income  (expense)—portfolio derivatives        |       | —         |       | —         |       | 10,821        |       | —        |       | 10,821 |   |
| Fee and other  income                                     |       | —         |       | 409            |       | (1,344        | )          | 360           |       | (575 | ) |
| Total revenues                                            |       | 28,170         |       | 9,315          |       | 26,862        |       | (31,359       | )          | 32,988 |   |
| Direct expenses(1)                                        |       | 19,540         |       | 8,651          |       | 3,051         |       | 1,245         |       | 32,487 |   |
| Corporate  overhead allocation                            |       | 6,066          |       | 914            |       | —        |       | (6,980        | )          | — |   |
| Total expenses                                            |       | 25,606         |       | 9,565          |       | 3,051         |       | (5,735        | )          | 32,487 |   |
| Income from continuing operations before income  taxes    |       | 2,564          |       | (250           | )          | 23,811        |       | (25,624       | )          | 501 |   |
| Income tax  benefit                                       |       | —         |       | —         |       | —        |       | 3,304         |       | 3,304 |   |
| Net income  (loss)                                        |       | $              | 2,564      |           | $          | (250          | )          | $             | 23,811     |   | $ | (22,320 | ) | $ | 3,805 |   |

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***(1)***             Thedirect expenses of our Investment Porfolio include the allocation of corporateoverhead, which is assessed to that segment through the transfer pricing ofloans from the production segments.

 

20

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Operatingresults by business segment for the six months ended June 30, 2006 are asfollows:
| ** **                                                    | ** ** | **Production** | ** ** | **Investment** | ** ** | ** **    | ** ** | ** **    | ** ** |
|---------------------------------------------------------------|------------|----------------|------------|----------------|------------|---------------|------------|---------------|------------|
| ** **                                                    | ** ** | **Wholesale**  | ** ** | **Retail**     | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidated** | ** ** |
| Revenues:                                                     |       |           |       |           |       |          |       |          |       |   |   |
| Interest income                                               |       | $              | 15,049     |           | $          | 2,295         |       | $             | 195,553    |   | $ | (3,752 | ) | $ | 209,145 |   |
| Interest expense                                              |       | 9,004          |       | 1,399          |       | 146,505       |       | (4,211        | )          | 152,697 |   |
| Net interest income                                           |       | 6,045          |       | 896            |       | 49,048        |       | 459           |       | 56,448 |   |
| Provision for  loan losses—loans held for investment     |       | —         |       | —         |       | (10,859       | )          | —        |       | (10,859 | ) |
| Gains (losses)  on sales of mortgage loans, net               |       | 42,094         |       | 15,218         |       | —        |       | (45,064       | )          | 12,248 |   |
| Other income  (expense)—portfolio derivatives            |       | —         |       | —         |       | 22,979        |       | —        |       | 22,979 |   |
| Fee and other  income                                         |       | —         |       | 858            |       | (1,582        | )          | 499           |       | (225 | ) |
| Total revenues                                                |       | 48,139         |       | 16,972         |       | 59,586        |       | (44,106       | )          | 80,591 |   |
| Direct expenses(1)                                            |       | 37,295         |       | 17,563         |       | 5,950         |       | 5,438         |       | 66,246 |   |
| Corporate  overhead allocation                                |       | 10,266         |       | 1,642          |       | —        |       | (11,908       | )          | — |   |
| Total expenses                                                |       | 47,561         |       | 19,205         |       | 5,950         |       | (6,470        | )          | 66,246 |   |
| Income (loss) from continuing operations before  income taxes |       | 578            |       | (2,233         | )          | 53,636        |       | (37,636       | )          | 14,345 |   |
| Income tax  benefit                                           |       | —         |       | —         |       | —        |       | 4,033         |       | 4,033 |   |
| Income (loss) from continuing operations                      |       | $              | 578        |           | $          | (2,233        | )          | $             | 53,636     |   | $ | (33,603 | ) | 18,378 |   |
| Discontinued  operations, net of income tax                   |       |           |       |           |       |          |       |          |       | (1,645 | ) |
| Net income                                                    |       |           |       |           |       |          |       |          |       | $ | 16,733 |   |

----

***(1)***             Thedirect expenses of our Investment Porfolio include the allocation of corporateoverhead, which is assessed to that segment through the transfer pricing ofloans from the production segments.

 

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Operating results bybusiness segment for the three months ended June 30, 2005 are as follows:
| ** **                                                    | ** ** | **Production** | ** ** | **Investment** | ** ** | ** **    | ** ** | ** **    | ** ** |
|---------------------------------------------------------------|------------|----------------|------------|----------------|------------|---------------|------------|---------------|------------|
| ** **                                                    | ** ** | **Wholesale**  | ** ** | **Retail**     | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidated** | ** ** |
| Revenues:                                                     |       |           |       |           |       |          |       |          |       |   |   |
| Interest income                                               |       | $              | 8,928      |           | $          | 1,282         |       | $             | 80,574     |   | $ | 2,636 |   | $ | 93,420 |   |
| Interest expense                                              |       | 4,987          |       | 708            |       | 41,773        |       | (326          | )          | 47,142 |   |
| Net interest income                                           |       | 3,941          |       | 574            |       | 38,801        |       | 2,962         |       | 46,278 |   |
| Provision for  loan losses—loans held for investment     |       | —         |       | —         |       | (6,863        | )          | —        |       | (6,863 | ) |
| Gains (losses)  on sales of mortgage loans, net               |       | 33,792         |       | 9,639          |       | —        |       | (17,398       | )          | 26,033 |   |
| Other income  (expense)—portfolio derivatives            |       | —         |       | —         |       | (9,432        | )          | —        |       | (9,432 | ) |
| Fee and other  income                                         |       | —         |       | 491            |       | (569          | )          | 87            |       | 9 |   |
| Total revenues                                                |       | 37,733         |       | 10,704         |       | 21,937        |       | (14,349       | )          | 56,025 |   |
| Direct expenses(1)                                            |       | 19,203         |       | 9,622          |       | 2,014         |       | (1,789        | )          | 29,050 |   |
| Corporate  overhead allocation                                |       | 6,097          |       | 1,036          |       | —        |       | (7,133        | )          | — |   |
| Total expenses                                                |       | 25,300         |       | 10,658         |       | 2,014         |       | (8,922        | )          | 29,050 |   |
| Income (loss) from continuing operations before  income taxes |       | 12,433         |       | 46             |       | 19,923        |       | (5,427        | )          | 26,975 |   |
| Income tax  expense                                           |       | —         |       | —         |       | —        |       | (2,454        | )          | (2,454 | ) |
| Income (loss) from continuing operations                      |       | $              | 12,433     |           | $          | 46            |       | $             | 19,923     |   | $ | (7,881 | ) | 24,521 |   |
| Discontinued  operations, net of income tax                   |       |           |       |           |       |          |       |          |       | (695 | ) |
| Net income                                                    |       |           |       |           |       |          |       |          |       | $ | 23,826 |   |

----

***(1)***             Thedirect expenses of our Investment Porfolio include the allocation of corporateoverhead, which is assessed to that segment through the transfer pricing ofloans from the production segments.

 

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Operatingresults by business segment for the six months ended June 30, 2005 are asfollows:
| ** **                                                    | ** ** | **Production** | ** ** | **Investment** | ** ** | ** **    | ** ** | ** **    | ** ** |
|---------------------------------------------------------------|------------|----------------|------------|----------------|------------|---------------|------------|---------------|------------|
| ** **                                                    | ** ** | **Wholesale**  | ** ** | **Retail**     | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidated** | ** ** |
| Revenues:                                                     |       |           |       |           |       |          |       |          |       |   |   |
| Interest income                                               |       | $              | 14,946     |           | $          | 2,292         |       | $             | 163,410    |   | $ | (105 | ) | $ | 180,543 |   |
| Interest expense                                              |       | 8,062          |       | 1,241          |       | 80,381        |       | (2,942        | )          | 86,742 |   |
| Net interest income                                           |       | 6,884          |       | 1,051          |       | 83,029        |       | 2,837         |       | 93,801 |   |
| Provision for  loan losses—loans held for investment     |       | —         |       | —         |       | (11,357       | )          | —        |       | (11,357 | ) |
| Gains (losses)  on sales of mortgage loans, net               |       | 55,775         |       | 17,152         |       | —        |       | (38,425       | )          | 34,502 |   |
| Other income  (expense)—portfolio derivatives            |       | —         |       | —         |       | 10,910        |       | —        |       | 10,910 |   |
| Fee and other  income                                         |       | —         |       | 926            |       | (770          | )          | 139           |       | 295 |   |
| Total revenues                                                |       | 62,659         |       | 19,129         |       | 81,812        |       | (35,449       | )          | 128,151 |   |
| Direct  expenses(1)                                           |       | 36,030         |       | 18,766         |       | 4,999         |       | (857          | )          | 58,938 |   |
| Corporate  overhead allocation                                |       | 10,419         |       | 1,845          |       | —        |       | (12,264       | )          | — |   |
| Total expenses                                                |       | 46,449         |       | 20,611         |       | 4,999         |       | (13,121       | )          | 58,938 |   |
| Income (loss) from continuing operations before  income taxes |       | 16,210         |       | (1,482         | )          | 76,813        |       | (22,328       | )          | 69,213 |   |
| Income tax  expense                                           |       | —         |       | —         |       | —        |       | (2,297        | )          | (2,297 | ) |
| Income (loss) from continuing operations                      |       | $              | 16,210     |           | $          | (1,482        | )          | $             | 76,813     |   | $ | (24,625 | ) | 66,916 |   |
| Discontinued  operations, net of income tax                   |       |           |       |           |       |          |       |          |       | (1,336 | ) |
| Net income                                                    |       |           |       |           |       |          |       |          |       | $ | 65,580 |   |

----

***(1)***             Thedirect expenses of our Investment Porfolio include the allocation of corporateoverhead, which is assessed to that segment through the transfer pricing ofloans from the production segments.

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**(9)**            Earnings Per Share

Information relating tothe calculations of earnings per share of common stock for the three and sixmonths ended June 30, 2006 and 2005 is summarized as follows:
| ** **                                                          | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                          | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| *Earnings per share—basic and  diluted:*                       | * *   | * *                                        | * *   | * *                                      | * *   | * * | * * | * * | * * |
| Income from continuing operations                                   |       | $                                               | 3,805      |                                          | $          | 24,521 |   | $ | 18,378 |   | $ | 66,916 |   |
| Dividends on nonvested restricted stock                             |       | (97                                             | )          | (176                                          | )          | (175 | ) | (176 | ) |
| Income from continuing operations available to  common shareholders |       | 3,708                                           |       | 24,345                                        |       | 18,203 |   | 66,740 |   |
| Discontinued operations, net of income tax                          |       | —                                          |       | (695                                          | )          | (1,645 | ) | (1,336 | ) |
| Net income available to common shareholders                         |       | $                                               | 3,708      |                                          | $          | 23,650 |   | $ | 16,558 |   | $ | 65,404 |   |
| Weighted average shares outstanding                                 |       | 47,678                                          |       | 48,462                                        |       | 47,974 |   | 48,462 |   |
| Earnings per  share—basic and diluted:                         |       |                                            |       |                                          |       |   |   |   |   |
| Continuing operations                                               |       | $                                               | 0.08       |                                          | $          | 0.50 |   | $ | 0.38 |   | $ | 1.38 |   |
| Discontinued operations                                             |       | —                                          |       | (0.01                                         | )          | (0.03 | ) | (0.03 | ) |
| Total                                                               |       | $                                               | 0.08       |                                          | $          | 0.49 |   | $ | 0.35 |   | $ | 1.35 |   |

 

Effects of potentiallydilutive securities are presented only in periods in which they are dilutive.For the three and six months ended June 30, 2006 and 2005, all stock options(with strike prices of  $11.60 to $19.25)and all shares of nonvested restricted stock were excluded from the calculationof diluted earnings per share as their effect was anti-dilutive.

**(10)**     Stock-Based Compensation

Under the Company’s Equity Incentive Plan (the “StockPlan”) approved by the Board of Directors and shareholders inNovember 2003, an aggregate of 2.7 million of share options or shares of theCompany’s stock may be awarded to employees, outside directors and consultants,and to any other individual whose participation in the plan is determined to bein the best interests of the Company by the Compensation Committee of FIC’sBoard of Directors. Awards of common stock will be made with currentlyauthorized but unissued common stock.

As of January 1, 2006,the Company adopted Statement of Financial Accounting Standards No. 123R, *“Share-Based Payment,”*(Statement No. 123R).  In accordance with Statement No. 123R, theCompany expenses its stock-based compensation by applying the fair value methodto stock-based compensation.  Prior tothe adoption of Statement No. 123R, the Company elected to expense its stock-basedcompensation by applying the fair value method to stock-based compensation inaccordance with Financial Accounting Standards No. 123, *“Accountingfor Stock-Based Compensation”*(Statement No. 123).  The adoption of Statement No. 123R did nothave a material effect on the Company’s consolidated statements of operationsor cash flows.  In accordance withStatement No. 123R, the balance of unearned compensation that was included inthe Company’s consolidated statements of condition as of January 1, 2006 hasbeen reclassified as a reduction of paid-in capital.

***(a)  Stock Options***

Under the Stock Plan, the exercise price of each stockoption may not be less than 100% of the fair market value of the common stockon the date of grant.  Stock optionstypically vest ratably over a four-year period with a term fixed by theCompensation Committee of the Board of Directors  (Compensation Committee) not to exceedten years from the date of grant. Stock options with accompanying dividend equivalent rights (Options withDERs) typically cliff vest approximately four years from the date of grant witha term fixed by the compensation committee not to exceed seven years from thedate of grant.  The fair value of eachoption award is estimated on the date of grant using the Black-Scholes optionpricing model, which takes into account

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the exercise price andexpected life of the option, the underlying stock’s expected volatility andexpected dividends, and the risk-free interest rate for the expected term ofthe option.

In February 2006, the Compensation Committee granted atotal of 162,000 non-qualified stock options with accompanying dividendequivalent rights to certain key officers and employees pursuant to the StockPlan.  The exercise price of the grantswas $11.90 and $11.60 as of February 16, 2006 and February 21, 2006,respectively, which was the closing price of the Company’s common stock on thedate of each grant.  All of the optionsvest on March 31, 2010 with a term expiring on March 31, 2013.  While the option is nonvested, dividendequivalents are earned based on the number of option shares held and are deemedinvested in phantom shares of the Company’s common stock at the closing priceof the stock on the dividend payment date. The phantom shares also will be credited with dividend equivalent rightsat the same time and in the same amount as cash dividends are paid on theCompany’s common stock.  The total valueof dividend equivalents, adjusted for the change in value of the phantom sharesfrom date of issuance through vest date, will be paid in cash at the time theoption vests.

The followingtable summarizes the weighted average fair value of the Options with DERsgranted in 2006 and the assumptions used in applying the Black-Scholes optionpricing model.

|                                 | ** ** | **2006** | ** ** |
|---------------------------------|------------|----------|------------|
| Fair value at  date of grant    |       | $        | 4.71       |   |
| Expected life in  years         |       | 5.5      |       |
| Annual risk-free  interest rate |       | 4.6      | %          |
| Expected  volatility            |       | 35       | %          |
| Expected forfeitures            |       | 20       | %          |
|                                 |            |          |            |  |

 

Thefollowing tables summarize stock option activity for the three and six monthsended June 30, 2006:
| **Options**                   | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual Term** | ** ** | **Aggregate  Fair  Value** | ** ** |
|-------------------------------|------------|------------|------------|--------------------------------------------|------------|---------------------------------------------------------|------------|----------------------------|------------|
| Outstanding at  April 1, 2006 |       | 959,000    |       | $                                          | 14.31      |                                                    | 8.4        |                       |       |   |
| Granted                       |       | —     |       | —                                     |       | —                                                  |       |                       |       |
| Exercised                     |       | —     |       | —                                     |       | —                                                  |       |                       |       |
| Forfeited or  expired         |       | (33,000    | )          | $                                          | 14.55      |                                                    | 7.2        |                       |       |   |
| Outstanding at  June 30, 2006 |       | 926,000    |       | $                                          | 14.30      |                                                    | 7.1        |                       | $          | 2,531 |   |
| Exercisable at June 30,  2006 |       | 386,600    |       | $                                          | 15.26      |                                                    | 7.4        |                       | $          | 716 |   |

 
| **Options**                     | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** | **Weighted  Average  Remaining  Contractual Term** | ** ** | **Aggregate  Fair  Value** | ** ** |
|---------------------------------|------------|------------|------------|--------------------------------------------|------------|---------------------------------------------------------|------------|----------------------------|------------|
| Outstanding at  January 1, 2006 |       | 826,500    |       | $                                          | 14.86      |                                                    | 8.0        |                       |       |   |
| Granted                         |       | 162,000    |       | 11.63                                      |       | 6.8                                                     |       |                       |       |
| Exercised                       |       | —     |       | —                                     |       | —                                                  |       |                       |       |
| Forfeited or  expired           |       | (62,500    | )          | $                                          | 14.67      |                                                    | 7.2        |                       |       |   |
| Outstanding at  June 30, 2006   |       | 926,000    |       | $                                          | 14.30      |                                                    | 7.1        |                       | $          | 2,531 |   |
| Exercisable at June 30,  2006   |       | 386,600    |       | $                                          | 15.26      |                                                    | 7.4        |                       | $          | 716 |   |

 

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The weighted averageexercise price of options granted during both the three and six months endedJune 30, 2006 was $11.63. During both the three and six months ended June 30,2005, 138,400 options were granted with a weighted average exercise price of$12.70.

Total compensationexpense relating to nonvested stock options of $25 thousand and $0.1million, respectively, were recorded in salaries and employee benefits expensefor the three and six months ended June 30, 2006.  For the three and six months ended June 30,2005, $0.1 million and $0.1 million, respectively, of total compensationexpense relating to nonvested stock options were recorded in salaries andemployee benefits expense.  As of June30, 2006, there was no unrecognized compensation cost related to nonvestedstock options granted under the Stock Plan.

In accordance withStatement No. 123R, the Company estimates the forfeitures of nonvested optionsthat are expected to occur, and recognizes compensation expense based on thefair value of the options that are expected to vest.  Previous to the second quarter of 2006, theCompany had estimated that 20% of all options issued would be forfeited priorto vesting.  Actual forfeitures have beentracked against this estimate.  Duringthe second quarter, the number of options actually forfeited exceeded theCompany’s original estimate of 20%. Based on this review of actual forfeitures to date, the Company hasrevised its estimate and now estimates that 30% of all options granted will beforfeited prior to vesting.  Thisrevision in estimate reduces the total expected amount of compensation expenseto be recorded for stock options that have been granted by $0.3 million.  The impact of this revision in theaccompanying consolidated statement of operations is a $0.1 millionreduction in compensation expense for both the three and six months ended June30, 2006.

***(b) Restricted Stock***

On February 16,2006, the Compensation Committee of the Board of Directors, pursuant to theStock Plan, granted 45,000 shares of restricted stock to the Company’s newlyappointed chief financial officer, valued at $11.90 per share.  The restricted stock vests ratably over afour-year period beginning December 31, 2006.

On February 21,2006, the Compensation Committee of the Board of Directors awarded a maximum of83,400 shares of restricted stock to certain of the Company’s senior officerspursuant to the Stock Plan.  These sharesare subject to the achievement of certain corporate performance objectives (theperformance shares).  The performanceshares were valued at $8.35 per share, with any earned performance shares tovest on March 31, 2010.  The performanceshares are shares of restricted stock that are subject to vesting requirementsand can be earned based primarily on the Company’s achievement of certainreturn on equity targets for the period January 1, 2006 through December 31,2007.

**All ofthe restricted stock awards are expensed on a straight-line method over thescheduled vesting period. Total compensation expense of $0.4 million and $0.9million, respectively, was recorded in salaries and employee benefits expensefor the three and six months ended June 30, 2006, respectively, relating to thenonvested restricted stock.  Compensationexpense of $0.5 million and $0.9 million, respectively, was recorded insalaries and employee benefits expense for the three and six months ended June30, 2005, respectively, relating to the nonvested restricted stock.  As of June 30, 2006, there was $4.0 millionof total unrecognized compensation cost related to nonvested restricted stockgranted under the Stock Plan, which is expected to be recognized over a periodof four years.**

There was no activity related to nonvested restrictedstock for the three months ended June 30, 2006.

A summary of the Company’s nonvested restricted stockand changes during the six months ended June 30, 2006 is presented below:                

| Nonvested Restricted Stock | ** ** | **Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|--------------------------------------|------------|------------|------------|-------------------------------------------------------------|------------|
| Outstanding at  January 1, 2006      |       | 240,000    |       | $                                                           | 15.18      |   |
| Granted                              |       | 45,000     |       | 11.90                                                       |       |
| Vested                               |       | —     |       | —                                                      |       |
| Forfeited                            |       | (22,500    | )          | 15.00                                                       |       |
| Outstanding at June 30,  2006        |       | 262,500    |       | $                                                           | 14.64      |   |

** **

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**(11)**     Commitments and Contingencies

***(a) Loan Commitments***

As of June 30, 2006 and December 31, 2005, theCompany had origination commitments outstanding to fund approximately $468million and $422 million in mortgage loans, respectively. Fixed rate andhybrid ARM mortgages which are fixed for the initial two to three year term ofthe loan, comprised 99.8% and 97.0%, respectively, of the outstandingorigination commitments. The Company had forward delivery commitments to sellapproximately $0.7 billion and $1.3 billion of loans and forward contractsat June 30, 2006 and December 31, 2005, respectively, of which $21.8 millionand $26.6 million, respectively, were mandatory sales of mortgage-backedsecurities and mandatory investor whole loan trades. At June 30, 2006 andDecember 31, 2005, the Company had a commitment to sell $460 million and$580 million, respectively, of treasury note forward contracts, used toeconomically hedge the interest rate risk of its non-conforming loans.

***(b) Legal Matters***

Because the nature of the Company’s business involvesthe collection of numerous accounts, the validity of liens and compliance withvarious state and federal lending and consumer protection laws, the Company issubject to various legal proceedings in the ordinary course of business relatedto foreclosures, bankruptcies, condemnation and quiet title actions and allegedstatutory and regulatory violations. The Company is also subject to other legalproceedings in the ordinary course of business related to employee matters. Allof these ordinary course proceedings, individually or taken as a whole, are notexpected to have a material adverse effect on the Company’s business, financialcondition or results of operations.

***Bass Litigation:***

On May 24, 2004, all of the former shareholders whoseshares were redeemed following the closing of the 144A Offering (the “FormerShareholders”), filed an action in the District Court of Tarrant County, Texas,against the Company, Fieldstone Mortgage and KPMG LLP (KPMG), alleging that theFormer Shareholders whose shares were redeemed for approximately$188.1 million, are entitled to an additional post-closing redemptionprice payment of approximately $19.0 million. On September 9, 2004, KPMGserved its response to plaintiffs’ request for disclosure, stating, among otherthings, that KPMG has determined that the deferred tax asset, which isreflected in the December 31, 2003 audited financial statements, shouldhave been reflected in the Company’s financial statements as ofNovember 13, 2003, the day immediately prior to the closing of the 144AOffering. At the present time, the ultimate outcome of this claim and theamount of liability, if any, that may result is not determinable, and noamounts have been accrued in the financial statements with respect to this claim. On October 28, 2005, the Company served a cross claim against KPMG.The cross claim asserts, among other claims, that KPMG’s withdrawal of itsaudit report on the November 13, 2003 balance sheet was improper and thatthe Company suffered damages due to this improper withdrawal.  Inaddition, the cross claim asserts that in the event the Former Shareholdersprevail in their suit, KPMG negligently advised the Company regarding theNovember 13, 2003 balance sheet giving rise to this dispute. The crossclaim seeks a judgment against KPMG in an amount in excess of $1 million, plusprejudgment interest for the attorneys fees and costs incurred in thislawsuit.  On June 26, 2006, the FormerShareholders filed their Third Amended Petition in which they assert an alternativeclaim against KPMG for damages.  Thislitigation is still in the discovery stage. A trial date is currently set for October 9, 2006.

The Companyintends to vigorously defend against the claim made by the Former Shareholders.If the Company is ultimately unsuccessful in defending this matter, it could berequired to make a cash payment of up to $19.0 million to the FormerShareholders, plus potential interest and third-party costs associated with thelitigation.  The impact of any payment onthe Company’s financial statements will be dependent upon the actual facts andcircumstances surrounding such an outcome.

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***Arredondo Litigation:***

*Arredondo,et al. v. Fieldstone Investment, et al.,*is an action filedon August 3, 2004 in the United States District Court for the District ofArizona by nine former employees of Fieldstone Mortgage Company alleging thattheir supervisors and co-workers created a hostile work environment resultingfrom gender discrimination, racial discrimination and retaliation in theworkplace pursuant to Title VII of the Civil Rights Act of 1964, 42 U.S.C.§2000e, and the Civil Rights Act of 1866, 42 U.S.C. §1981, as amended by theCivil Rights Act of 1991, 42 U.S.C. §1981(a). Plaintiffs claim that they areentitled to money damages in the form of back pay and front pay and nominal,compensatory and punitive damages, costs and attorney fees and equitablerelief. The Company filed its answer denying all relevant claims onAugust 25, 2004. In addition, the Company filed a variety of motionsseeking to have some of the plaintiffs dismissed from the lawsuit for failureto exhaust their administrative remedies, to dismiss other claims as not beingpermitted under the statute, and finally to sever the plaintiffs for trialpurposes. Plaintiffs filed a response to the motion to dismiss, sever or in thealternative, bifurcate, and on April 18, 2005, the motion to dismiss wasdenied.  On December 27, 2005, oneof the named Plaintiffs, Berinda Arredondo, requested and was dismissed fromthe litigation.  The discovery cutoffdate was May 31, 2006.

Due to the uncertain nature of this litigationat this time, the Company is unable to estimate the probable outcome of thismatter.  The plaintiffs in this matterhave not specified damages sought and therefore the Company is unable toestimate the Company’s potential exposure.

***Rhodes Litigation:***

On January 9,2006, a class action lawsuit was filed naming Fieldstone Mortgage in theNorthern District of Illinois (Eastern Division) alleging violations of theFair Credit Reporting Act (FCRA).  The class action is entitled Rhodes v.Fieldstone Mortgage Company. Plaintiff alleges that Fieldstone Mortgageviolated the firm offer of credit guidelines encapsulated in 15 U.S.C.§1681 et seq. during its mail marketing campaign in or around April 2005.Specifically, Plaintiff alleges that Fieldstone Mortgage did not comply withthe statutory guidelines for providing a firm offer of credit to the potentialconsumer. Pursuant to 15 U.S.C. §1681 et seq., statutory damages can rangefrom $100 to $1,000 per mailing in the event that the violation is deemedwillful.  In July 2006, Plaintiff filed amotion for class certification.  Thisaction is currently in the discovery stage.

Due to theuncertain nature of the litigation at this time, the Company is unable toestimate the probable outcome of this matter. While the Company intends to continue to vigorously defend this claimand believe it has meritorious defenses available, there can be no assurancethe Company will prevail and that an adverse outcome would not have a materialeffect on the Company’s results of operations.

***Hill Litigation:***

*Hill,et al. v. Fieldstone Mortgage Company, et al.* is a classaction filed on January 16, 2002 in the Circuit Court for Baltimore Cityby plaintiffs, who are two individuals who obtained a second mortgage loan fromFieldstone Mortgage in 1998, in the amount of $28,000, secured by theirresidence, against Fieldstone Mortgage and ten other mortgage lenders thatplaintiffs contend are or were the assignees of second mortgage loans inMaryland made by Fieldstone Mortgage. The lawsuit alleges, among other things,that (i) the defendants violated the Maryland Second Mortgage Loan Law, orSMLL, by failing to obtain the necessary license to provide a second mortgageloan and by charging fees unauthorized by the SMLL, and (ii) thedefendants violated the Maryland Consumer Protection Act by engaging in conductcontrary to the provisions of the SMLL. The plaintiffs seek a declaratoryjudgment that their mortgage contract is illegal and, therefore, that they donot need to honor their obligation to repay the second mortgage loan. Theplaintiffs also seek monetary damages in the amount of $300,000. FieldstoneMortgage, and each of the other defendants, filed motions to dismiss assertingthat, among other things, the plaintiffs’ claims are barred by the applicablethree-year statute of limitations, the plaintiffs’ failed to properly plead aclaim under the Maryland Consumer Protection Act, and the plaintiffs’ requestfor a judicial declaration that their mortgage contract is illegal is not aremedy available under either Maryland statutory or common law. The circuitcourt heard oral arguments on the motions to dismiss in January 2003. Todate, the court has not ruled on this motion. This lawsuit was consolidatedwith 14 other class actions with identical claims against other mortgagelenders. No motion for class certification has yet been filed in this case. OnMarch 30, 2006, the court held a status conference with regard to thismatter. The court requested supplemental briefings on the outstanding issuesfrom the parties.  Oral argument on theoutstanding issues was heard on July 26, 2006.

28

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Due to theinherent uncertainties of the judicial process, the Company is unable topredict the outcome of this matter. While the Company intends to continue to vigorously defend this claimand believe it has meritorious defenses available, there can be no assurancethe Company will prevail.

There have been noother material changes to the legal proceedings as described in our AnnualReport on Form 10-K, as amended, for the fiscal year ended December 31, 2005.

**(12)**     Subsequent Events

***(a)  Securitization Financing***

On July 6, 2006, the Company issued $779.2 million ofmortgage-backed bonds (FMIT Series 2006-2) through a securitization trust tofinance the Company’s portfolio of loans held for investment. The bonds containsimilar provisions to the Company’s previous securitizations, which aredetailed in Note 5 above.  The bonds bearinterest at rates between LIBOR plus 0.09% to LIBOR plus 1.90%.

The aggregate sales priceof the bonds was $779.2 million, and the Company expects to incur issuancecosts of approximately $2.6 million that will be deferred and amortized overthe estimated life of the bonds.

FMIT Series 2006-2included a pre-funding, whereby a portion of the collateral pledged to thetrust was delivered at the time of the offering, with the remaining collateralto be delivered prior to September 29, 2006. Approximately $200 million of bond proceeds, which were notcollateralized at closing, will be held in escrow by the trustee. According tothe terms of the offering, these proceeds held in escrow will be used topurchase qualifying mortgage loans, which will then be used to collateralizethe remaining bonds prior to September 29, 2006.  Concurrent with the closing of the offering,the Company collateralized the bonds with loans held for investment with an aggregateoutstanding principal balance of approximately $600 million.

***(b)  Reclassification of Second Lien Loans Heldfor Sale***

In July 2006,management determined that the total economic return on certain of the secondlien loans held for sale as of June 30, 2006 could be improved by retaining theloans in its held for investment portfolio. Accordingly, approximately $100 million of second liens previously heldfor sale were transferred to held for investment at the lower of cost or marketvalue.

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***(c)  Call of FMIT Series 2004-2***

During July 2006,the unpaid principal balance of the loans collateralizing FMIT Series 2004-2fell below 20% of the original principal cut-off balance of the collateral,permitting Fieldstone Servicing Corp. to exercise its right of optionaltermination of the financing.  Management reviewed the performance ofmortgage loans in the financing trust and related cost of financing andsubsequently delivered notice in August 2006 to the FMIT Series 2004-2 trusteeand bondholders of the exercise of the Company’s option to purchase themortgage loans, REO property, and any other property remaining in the trust atthe next payment date. The underlying collateral will remain on theconsolidated statement of condition as unsecuritized loans held for investment.

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

The following discussion and analysis of our resultsof operations, financial condition and liquidity and capital resources shouldbe read in conjunction with our unaudited condensed consolidated financialstatements and related notes contained in this Quarterly Report on Form 10-Q,as well as the audited consolidated financial statements and related notes forthe fiscal year ended December 31, 2005 and in the section titled “Management’sDiscussion and Analysis of Financial Condition and Results of Operations,” eachcontained in our Annual Report on Form 10-K for the fiscal year ended December31, 2005.

**SafeHarbor for Forward-Looking Statements**

Statements contained in this Form 10-Qwhich are not historical facts may be forward-looking statements within themeaning of Section 21E of the Securities Exchange Act of 1934, as amended(Exchange Act). We intend such forward-looking statements to be covered by thesafe harbor provisions for forward-looking statements contained inSection 21E of the Exchange Act. Readers are cautioned not to place unduereliance on these forward-looking statements, which speak only as of the datethis Form 10-Q is filed with the SEC.

The forward-lookingstatements are based on our beliefs, assumptions, and expectations of ourfuture performance, taking into account all information currently available tous. These beliefs, assumptions and expectations can change as a result of manypossible events or factors, not all of which are known to us or are within ourcontrol. If a change occurs, our business, financial condition and results ofoperations may vary materially from those expressed in our forward-lookingstatements. These statements (none of which is intended as a guarantee ofperformance) are subject to certain risks and uncertainties which could causeour actual future results, achievements or transactions to differ materiallyfrom those projected or anticipated. Some of the important factors that couldcause our actual results, performance or financial condition to differmaterially from expectations are:

·       our ability to successfullyimplement or change aspects of our portfolio strategy;

·       interest rate volatilityand the level of interest rates generally;

·       the sustainability of loanorigination volumes and levels of origination costs;

·       continued availability ofcredit facilities for the origination of mortgage loans;

·       the ability to sell orsecuritize mortgage loans on favorable economic terms;

·       deterioration in the creditquality of our loan portfolio;

·       the nature and amount ofcompetition;

·       the impact of changes tothe fair value of our interest rate swaps on our net income, which will varybased upon changes in interest rates and could cause net income to varysignificantly from quarter to quarter; and

·       the other factors set forthin our filings with the SEC, including in this Report and in the Annual Reporton Form 10-K for the fiscal year ended December 31, 2005.

**Executive Overview**

We are a mortgage real estate investment trust (REIT)that invests in non-conforming loans originated by our wholly owned subsidiary,Fieldstone Mortgage Company (FMC), which we finance by issuing mortgage-backedsecurities. Through FMC, we originate, service, and sell non-conformingsingle-family residential mortgage loans through our wholesale originationchannel and both non-conforming and conforming single-family residentialmortgage loans through our retail origination channel.

Our primary sources of income are the interest incomeon our loans held for investment, net of the interest expense of financingthose loans, the cash gains on sales of mortgage loans that we choose not tohold

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forinvestment which include originations fees collected at funding, and the netinterest income on loans held for sale during the period from origination todate of sale.

During the three and six months ended June 30, 2006,our net income was $3.8 million and $16.7 million, respectively, as compared to$23.8 million and $65.6 million in the three and six months ended June 30,2005.  The decrease in net income forboth the three and six month periods is due primarily to decreases in our net gainson sale, net and interest income due to a decline in our net interest margin onloans originated in 2006.  In addition,we recognized a $4.5 million pre-tax charge as of June 30, 2006 to reduce our secondlien loans held for sale to the lower of cost or market value as demand forsecond lien mortgages declined and a $0.9 million pre-tax loss on the disposalof our discontinued operations during the first quarter of 2006.  Our net interest income decreased to $20.8million and $45.6 million in the three and six months ended June 30, 2006,respectively, from $39.4 million and $82.4 million, respectively, in the sameperiods in 2005.  These decreases weredue primarily to a decrease in our average interest spread, which is thedifference between the coupon interest rate on our loans to borrowers and theinterest rate we incur for the debt financing the loan, which was partiallyoffset by a higher average portfolio balance. Net interest margin, including the net cash received on our swaps,declined to 2.4% and 2.5%, respectively, in the three and six months ended June30, 2006 from 3.6% in each of the comparable periods last year.  The cost of financing for loans held forinvestment increased as our weighted average swap rate increased as older,lower rate swaps expired during the second quarter and were replaced with newswaps at current market rates, resulting in an increase in our weighted averageswap rate to 3.85% in the second quarter of 2006 from 3.52% in the precedingquarter.  Consequently, the spreadsavailable on new loans narrowed, as intense market competition for new loansdid not permit coupons on new originations to increase at the same rate as theincrease in our financing costs for the loans.

Gains on sales of mortgage loans, net decreased to$2.0 million in the second quarter of 2006, compared with $10.3 million for theprior quarter of 2006 due primarily to a significant decline in the marketvalue of certain second lien products. The market decline was due to slowinghome price appreciation, increased defaults on these loans industry-wide, andan increase in the forecast of losses on pools of second lien loans byprominent rating agencies.  As of June30, 2006, we determined that the market value of $130.7 million of our secondlien loans held for sale as of that date was less than their carryingvalue.  Accordingly, we recorded a $4.5million pre-tax charge to reduce these loans to the lower of cost or marketvalue as a reduction in the gains on sales of mortgage loans, net.

Our portfolio of loansheld for investment, net, was $5.7 billion as of June 30, 2006, an increase of$200.8 million during the quarter as the amount of new loans added to theportfolio during the quarter exceeded loan repayments. We intend to continue tobuild our portfolio by retaining the majority of our non-conformingfundings.  The percentage of loans weretain for the portfolio in any given period will vary based upon the size ofthe portfolio we hold, prepayments during the quarter, and the availability ofloans which meet our cash flow, credit, and projected return criteria.  As of June 30, 2006, our financing debt onthe loans held in our portfolio was 11.4 times our equity. Based on the currentsize of our portfolio and management’s estimates, we believe we can achieve byyear end our target portfolio debt to equity ratio on our portfolio of at least13 times our equity, adjusted for the non-cash mark to market of our portfolioderivatives.

We use interest rate swaps and caps to economicallyhedge the variable rate financing costs for the fixed rate period of our twoand three year hybrid ARM mortgage loans held for investment. Because thesederivatives are not designated as cash flow hedges under Statement of FinancialAccounting Standards No. 133, “*Accountingfor Derivative Instruments and Hedging Activities,”*(Statement No. 133) changes in thefair market value of the swaps and caps are recognized in current periodearnings and reported in our consolidated statement of operations in “Otherincome (expense)—portfolio derivatives.” We cannot predict the future path of interest rates, nor can we predictin a definitive manner the magnitude by which these changes in the fair marketvalue of our swaps and cap could cause our total revenue and net income toincrease or decrease during periods of interest rate volatility.

Our continuing operations originated $1.5 billion ofmortgage loans during the three months ended June 30, 2006, a 13% reductionfrom the $1.7 billion originated by our continuing operations during the sameperiod in 2005.  Our origination volumesdeclined in 2006 as a result of intense competition for new loan

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originations on bothprice and credit, which has been exacerbated by the industry-wide reduction intotal mortgage loan originations.  TheMortgage Bankers Association of America forecasted that total mortgageoriginations in 2006 would be approximately 18% lower than in 2005. In responseto these current market conditions, we are implementing a number of newinitiatives which we believe will increase our level of originations, includingthe introduction of new products, the continued expansion of new originationchannels, the expansion of our geographical footprint, the improvement of ourtechnology throughout the origination cycle, and an increase in pricingtransparency.

Net cost to produce forour continuing operations was 2.6% and 3.0% of total loan originations,respectively, in the three and six months ended June 30, 2006, compared to 2.4%and 2.7%, in the three and six months ended June 30, 2005, respectively.  The increase in cost to produce as a percentageof loan fundings is due primarily to the changes in funding volumes betweenquarters.  Our fixed production expenseshave increased in 2006, due primarily to increased sales personnel salaries andbenefits, as a result of our initiatives to maintain market share in anincreasingly competitive market. To mitigate these increases, we haveidentified and begun to execute a number of cost management initiatives,including pricing and commission changes to reduce the level of premiums paid,increased use of technology, including the rollout of our new loan originationsystem and incentives for on-line submissions, consolidation of our operationscenters, as appropriate, and vendor re-structuring.

 

In the first quarter of 2006, our Board of Directorsapproved a plan to sell, close or otherwise dispose of the assets of itsconforming retail and conforming wholesale segments.  In February 2006, the assets pertaining tothese segments’ headquarters, all wholesale offices, and certain of its retailoffices were sold to third parties. The remaining assets of the conformingdivision, which include retail offices in Maryland and Virginia, have beencombined with our non-conforming retail offices, which will offer a range ofnon-conforming and conforming loan products. The pre-tax loss on disposal was $0.9 million and is included indiscontinued operations, net of income tax, in the Condensed ConsolidatedStatements of Operations in the first quarter of 2006.

**Restatement of Condensed ConsolidatedFinancial Statements**

The followingdiscussion contained in “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” gives effect to the restatement discussedin Note 1(g) to the condensed consolidated financial statements included inthis report.

**Key Components ofFinancial Results of Operations**

**Revenues**

Our revenues are based primarily on the spread betweenthe interest income we receive from the loans we fund for investment and theinterest expense on the debt financing these loans, sale margins on our loansheld for sale, prepayments on our mortgage loans held for investment, creditlosses on our investment portfolio, and origination volumes. During periods ofrising interest rates, such as now, we would generally increase the mortgageinterest rates we charge on our loan originations, but we will also experiencean increase in our costs of borrowing to finance the loans. If the rise inborrowing costs is greater than the increase in the coupon on new originationsof loans held for investment, which we have experienced in the first six monthsof 2006, net interest income spread will be lower on new loans which replaceolder loans originated at higher spreads that have prepaid. Rising interestrates may lead to decreases in loan prepayments of our hybrid adjustable-ratemortgages during the initial loan period in which our borrowers pay a fixedinterest rate, generally during the first two to three years of the loan, butincrease prepayments at or near the reset date of the loan, when the couponresets to a six-month LIBOR-based ARM reflecting the higher market rates.Decreases in prepayment speeds result in lower prepayment fee income, but offerhigher net interest income and potential expense reductions in the form ofdecreases to the rate of amortization of deferred origination costs and bondissuance costs, which are recorded as a reduction in yield.

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**Expenses**

The principal factors which lead to changes in ourexpenses are funding volumes, the number of production facilities we operate,the staffing required to support our origination platform, the balance of ourinvestment portfolio incurring third-party servicing fees, and the corporateoverhead required to support a public company. As loan volumes increase, wegenerally would expect salaries, employee benefit expenses, and variable loanrelated expenses to increase. As a public company, we have also experiencedincreased costs related to compliance with the Sarbanes-Oxley Act of 2002, SECreporting, and professional services fees. We have also incurred increasedexpenses in 2006 related to the implementation of our new loan originationsoftware system.

**Critical Accounting Policies**

We consider the policies discussed below to becritical to an understanding of our financial statements because theirapplication places the most significant demands on the judgment of ourmanagement, 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.

***Allowance for LoanLosses—Loans Held for Investment***

Because we maintain our loans held for investment onthe statements of condition for the life of the loans, we maintain an allowancefor loan principal losses based on our estimates of the losses inherent in theportfolio. This is a critical accounting policy because of the subjectivenature of the estimates required and potential for imprecision.   Twocritical assumptions used in estimating the loss reserve are an assumed rate atwhich the loans go into foreclosure subsequent to initial default and anassumed loss severity rate, which represents the expected rate of realized lossupon disposition of the properties that have been foreclosed.  Prior to the second quarter of 2006, weutilized industry loss assumptions for loans similar in credit, loan size, andproduct type in making these estimates regarding losses because we had limitedhistorical loss data on our past originations, all of which were soldservicing-released prior to October 2003. Beginning in the second quarter of2006, we began to blend our own historical delinquency experiences withindustry averages in estimating the percentage of loans that are delinquent 30+days that will ultimately go to foreclosure. This resulted in an estimate thatapproximately 20% of the loans 30+ days delinquent will ultimately go toforeclosure.  Also during the secondquarter of 2006, we began to utilize historical loss experiences in estimatingloss severity for pools for which we have significant realized lossexperiences. Applying this methodology individually to each pool yielded anestimated average loss severity of approximately 27% for 2003, 2004 and firstquarter 2005 vintage loans.   We continueto use industry loss severity estimates of 35% for second quarter 2005 and all2006 pools for which significant realized loss experience for our own loans isnot available.  These underlyingassumptions and estimates are periodically evaluated and updated to reflect ourcurrent assessment of the value of the underlying collateral, actual historicalloss experience, and other relevant factors impacting portfolio credit qualityand inherent losses.

We define the beginning of the loss emergence periodfor a mortgage loan to be the occurrence of a contractual delinquency greaterthan 30 days. On a monthly basis, loans meeting this criterion areincluded in a determination of the allowance for loan losses based on roll rateand loss severity estimates. We assess homogenous groups of loans collectivelyfor impairment. If actual results differ from our estimates, we may be requiredto adjust our provision accordingly. The use of different estimates orassumptions could produce different provisions for loan losses.

The provision for losses is charged to ourconsolidated statements of operations.  Lossesincurred on mortgage loans held for investment are charged to the allowance atthe earlier of the time of liquidation or at the time the loan is transferredto real estate owned.  Subsequent gainsor losses at property disposal are recorded as a component of “Fees and otherincome” on our consolidated statements of operation.

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We place individual loans on non-accrual status whenthey are 90 days or more past-due or when, in the opinion of management, thecollection of principal and interest is in doubt. At the time an individualloan is placed on non-accrual status, all previously accrued but uncollectibleinterest is reversed against current period interest income. In addition, wereserve for interest income accrued on our pool of homogeneous 30 and 60 daydelinquent loans by estimating the interest due on the pool of loans thatmigrate to non-accrual status in the future on the basis of the same industryloss roll rate assumptions.

***Reserve forLosses—Loans Sold***

We maintain a reserve for our representation andwarranty liabilities related to the sale of loans and for our contractualobligation to rebate a portion of any premium paid by a purchaser when aborrower prepays a sold loan within an agreed period. The representations andwarranties generally relate to the accuracy and completeness of informationrelated to the loans sold and to the collectibility of the initial paymentsfollowing the sale of the loan. The reserve, which is recorded as a liabilityon our consolidated statements of condition, is established when loans are soldand is calculated as the fair value of losses estimated to occur over the lifeof the loan. The reserve for losses is established through a provision forlosses, which is reflected as a reduction of the gain on the loans sold at thetime of sale. We forecast future losses on current sales based on our analysisof our actual historical losses, stratified by type of loss, type of loan, lienposition, collateral location, and year of sale. This analysis takes intoconsideration historical information regarding frequency and severity of lossesand compares economic and real estate market trends which may have affectedhistorical losses and the potential impact of these trends to losses on currentloans sold. We estimate losses due to premium recapture on early loanprepayments by reviewing historical experience for similar product and rateclasses, borrower prepayment fees, if any, and estimates of future interestrate volatility. We will adjust the provision expense if the actual loss trendon loans sold varies compared to the loss provision previously forecast.

***Lower of Cost orMarket Value Adjustment—Loans Sold***

Mortgage loans held for sale are to be stated at thelower of (1) their historical cost or (2) their market value according to theprovisions of Statement of Financial Accounting Standards No. 65 “*Accounting for Certain Mortgage Banking Activities*”(Statement No. 65).  As of June 30, 2006,we determined that the market value of certain second lien loans held for salewas less than their cost based on quoted prices of similar loans.  Accordingly, we established an allowance toreduce the carrying value of these loans to their estimated lower of cost ormarket value.  The charge to establishthe allowance was recorded as a reduction in “Gain on sales of mortgage loans,net.”  We routinely evaluate estimatedlower of cost or market value for all of our loans and update the allowance asnecessary.

***Amortization ofDeferred Loan Origination Costs and Deferred Debt Issuance Costs***

Interest income on our mortgage loan portfolio is acombination of the accrual of interest based on the outstanding balance andcontractual terms of the mortgage loans, adjusted by the amortization of netdeferred origination costs related to originations in our investment portfolio,in accordance with Statement of Financial Accounting Standards No. 91, “*Accounting for Nonrefundable Fees and CostsAssociated with Originating or Acquiring Loans and Initial Direct Costs ofLeases*” (Statement No. 91). Our net deferred origination costsconsist primarily of premiums, discounts, and other net fees or costs directlyassociated with originating our mortgage loans, including commissions paid onclosed loans. For our loans held for investment, these net deferred costs areamortized as adjustments to interest income over the estimated lives of theloans using the effective interest rate method. Because we hold a large numberof similar loans for which prepayments are probable and for which we canreasonably estimate the timing of such prepayments, we use prepayment estimatesin determining periodic amortization based on a model that considers actualprepayment experience to date as well as forecasted prepayments based on thecontractual interest rate on the loans, loan age, loan type, prepayment feecoverage, and a variety of other factors. Mortgage prepayment forecasts arealso affected by the terms and credit grades of the loans, conditions in thehousing and financial markets, relative levels of interest rates, and generaleconomic conditions. Prepayment assumptions are reviewed regularly to ensurethat our actual experience and industry data are supportive of the assumptionsused in our model. Updates that are required to be made to these estimates areapplied as if the revised estimates had been in place since the

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originationof the loans and may result in adjustments to the current period amortizationrecorded to interest income.

Interest expense on our warehouse and securitizationfinancing is a combination of the accrual of interest based on the contractualterms of the financing arrangements and the amortization of bond discounts andother issuance costs. The amortization of bond discounts and issuance costsalso considers estimated prepayments and is calculated using the effectiveinterest rate method. The principal balance of the securitization financing isrepaid as the related collateral principal balance amortizes, either throughreceipt of monthly mortgage payments or any loan prepayment. The deferredissuance costs and original issue discounts are amortized through interestexpense over the estimated life of the outstanding balance of thesecuritization financing utilizing the prepayment assumptions referenced aboveto estimate the average life of the related debt. Updates that are required tobe made to these estimates are applied as if the revised estimates had been inplace since the issuance of the related debt and result in adjustments to thecurrent period amortization recorded to interest expense.

We have sought to partially offset the impact to ournet interest income of faster than anticipated prepayment rates by originatingmortgage loans with prepayment fees. These fees typically expire two yearsafter origination of a loan. Approximately 86.0% of our mortgage loan portfoliohad prepayment fee features as of both June 30, 2006 and December 31, 2005. Ourexperience is that prepayment rates on our portfolio increase as thesepredominately adjustable-rate loans reach their initial adjustments, typicallytwo to three years after funding the loans. The varying prepayment rate,referred to on an annualized basis as the constant prepayment rate (CPR) isreforecast each quarter to project cash flows based upon historical industrydata for similar loan products in the context of the current markets and ouractual history to date. The forward-looking expected CPR used in our currentassumptions averages 26 CPR during the first 12 months, averages 38 CPRthrough month 21, and increases to an average of 82 CPR during the monthsimmediately before and after the reset date, declining to an average 32 CPRthereafter.  If prepayment speedsincrease, our net interest margin would decrease due the reduction inoutstanding principle and the additional cost amortization, which may bepartially offset by an increase in prepayment fee income.

***Derivatives***

The economic hedging of our interest rate risk relatedto our loans held for sale is a critical accouting policy related to ourbusiness 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 economically hedge ourexposure to changes in interest rates. The financial instruments typicallyinclude mandatory delivery forward sale contracts of mortgage-backedsecurities, mandatory and best efforts whole-loan sale agreements, and treasurynote forward sales contracts. These financial instruments are intended tomitigate the interest rate risk inherent in providing interest rate lockcommitments to prospective borrowers to finance one-to-four family homes and toeconomically hedge the value of our loans held for sale prior to entering fixedprice sale contracts.

The interest rate locks for conforming loans and themandatory forward sales of mortgage backed securities, which are typically usedto economically hedge the interest rate risk associated with these locks, areundesignated derivatives and are marked to market through earnings. For interestrate lock commitments related to conforming loans, mark to market adjustmentsare recorded from inception of the interest rate lock through the funding dateof the 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 atthe lower 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 non-cash mark to market valuations of both our interest ratelock commitments and derivative instruments is reported as a component of gainson sales of mortgage loans, net.

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The interest rate lock commitments associated withnon-conforming loans held for sale and the treasury note forward salescontracts used to hedge the risk associated with these locks are alsoderivatives and are marked to market through earnings. Similar to theconforming loans, the funded non-conforming loans have not been designated as aqualifying hedged asset in accordance with Statement No. 133, and accordingly,we record them at the lower of cost or market value on the consolidatedstatements of condition. The treasury note forward sales contracts, which doserve as an effective economic hedge prior to the sale of some of ournon-conforming loans, remain subject to mark to market adjustments beyond thetime the loans fund, and our reported earnings may reflect some non-economicvolatility as a result of this differing treatment.

We economically hedge against unfavorable changes inthe benchmark interest rate for our cost of financing during the period thatthe coupon interest rate on the related loans to our borrowers is fixed. Thesederivatives are not classified as cash flow hedges under Statement No. 133. Weenter into interest rate swap agreements to economically hedge the financing onmortgage loans held for investment. The change in fair value of the derivativeduring the hedge period is reported as a component of “Other income(expense)—portfolio derivatives.” The periodic net cash settlements and anygain 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 economically 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.   The interest rate cap expired in 2005.

Changes in interest rates during a reporting periodwill affect the mark to market valuations on our undesignated derivatives.Increases in short-term interest rates will result in a non-cash credit beingrecognized in our consolidated statements of operations, while decreases inshort-term rates will result in a non-cash charge being recognized in ourconsolidated statements of operations.

***Stock-BasedCompensation***

We have adopted the fair value method of accountingfor stock options and shares of restricted stock as prescribed by Statement ofFinancial Accounting Standards No. 123R, *“Share-BasedPayments”*(Statement No.123R). Under Statement No. 123R, compensation cost is measured at thegrant date based on the fair value of the award and is recognized as expense ona straight-line basis over the award’s vesting period. The fair value of awardsof restricted stock is determined at the date of grant based on the marketprice of our common stock on that date. For both the stock options andrestricted stock, the amount of compensation cost is adjusted for estimatedannual forfeitures. The fair value of the stock options is determined using theBlack-Scholes option pricing model. Due to the subjective nature and estimatesrequired under Statement No. 123R, we consider this a critical accountingpolicy.

Prior to the second quarter of 2006, we had previouslyestimated that 80% of the options granted to employees would ultimately vest,and we recognized expense based on the fair value of these options.  During the second quarter of 2006, based onactual forfeiture experience to date, we revised our estimate of forfeitures.We currently estimate 70% of the options granted will ultimately vest, and weadjusted stock compensation expense accordingly.  This revision in estimate resulted in adecrease in stock compensation expense of $0.1 million during the three and sixmonths ended June 30, 2006.

**Results of Operations**

**Three and Six Months Ended June 30, 2006 Compared tothe Three and Six Months Ended June 30, 2005**

**Net Income**

Net income was $3.8 million for the three months endedJune 30, 2006 compared to $23.8 million for the three months ended June30, 2005, a decrease of $20.0 million, or 84%. For the six months ended June30, 2006, net income was $16.7 million compared to $65.6 million for thesix months ended June 30, 2005, a decrease of $48.8 million, or 75%. 

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Net incomedecreased in the three and six months ended June 30, 2006 compared to the sameperiods of the prior year due primarily to decreased sales premiums on loansheld for sale, a charge recorded in 2006 to reduce second lien loans held forsale to the lower of cost or market value, and decreased net yield after theprovision for loan losses on loans held for investment.  The decrease in sales premiums on loans heldfor sale was due to the decline in the net interest margin on loans originatedin 2006. This narrower net interest spread also contributed to the decrease innet yield after the provision for loan losses on our loans held for investment,as our financing costs increased at a greater rate than the rise in couponinterest rates on new loans. Intense competition for new originations haslimited the increase in coupon rates on new originations.  The charge to reduce second lien loans to thelower of cost or market value was due to the decline in the demand for secondlien loan products in light of the mortgage industry’s present uncertaintyregarding future loan performance. These decreases in net income were partiallyoffset by the performance of our derivative contracts in 2006 compared to 2005,particularly related to the mark to market valuation change for our interestrate swap agreements.

In addition, net incomefor the six months ended June 30, 2006 includes the recognition of a $0.9million pre-tax loss on the disposal of our discontinued operations thatoccurred in the first quarter of 2006.

**Revenues**

***Net InterestIncome After Provision for Loan Losses***

The following arethe components of net interest income after provision for loan losses for thethree and six months ended June 30, 2006 and 2005:
| **($ in 000s)**                                        | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                       | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Interest income:                                                 |       |                                                |       |                                              |       |   |   |   |   |
| Coupon interest income on loans held for investment              |       | $                                                   | 101,368    |                                              | $          | 77,130 |   | $ | 197,791 |   | $ | 158,669 |   |
| Coupon interest income on loans held for sale                    |       | 6,991                                               |       | 12,846                                            |       | 13,592 |   | 17,133 |   |
| Amortization of deferred origination costs                       |       | (6,114                                              | )          | (5,287                                            | )          | (12,975 | ) | (10,779 | ) |
| Prepayment fees                                                  |       | 5,186                                               |       | 8,731                                             |       | 10,737 |   | 15,520 |   |
| Total interest income                                            |       | 107,431                                             |       | 93,420                                            |       | 209,145 |   | 180,543 |   |
|                                                             |       |                                                |       |                                              |       |   |   |   |   |
| Interest  expense:                                               |       |                                                |       |                                              |       |   |   |   |   |
| Financing interest expense on loans held for  investment(1)      |       | 74,972                                              |       | 39,580                                            |       | 141,170 |   | 76,126 |   |
| Financing interest expense on loans held for sale                |       | 3,587                                               |       | 5,369                                             |       | 6,192 |   | 6,361 |   |
| Amortization of deferred bond issuance costs and  issue discount |       | 2,617                                               |       | 2,193                                             |       | 5,335 |   | 4,255 |   |
| Total interest expense(1)                                        |       | 81,176                                              |       | 47,142                                            |       | 152,697 |   | 86,742 |   |
| Net interest income(1)                                           |       | 26,255                                              |       | 46,278                                            |       | 56,448 |   | 93,801 |   |
| Provision for  loan losses—loans held for investment        |       | 5,466                                               |       | 6,863                                             |       | 10,859 |   | 11,357 |   |
| Net interest  income after provision for loan losses(1)          |       | $                                                   | 20,789     |                                              | $          | 39,415 |   | $ | 45,589 |   | $ | 82,444 |   |

----

(1)             Does not include the effects of our interestrate hedges.

38

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Thefollowing table presents the average balances of our loans held for investment,loans held for sale, and our warehouse and securitization financing, with thecorresponding annualized yields for the three and six months ended June 30,2006 and 2005: 
| **($ in 000s)**                                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                 | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Average balances:                                                          |       |                                            |       |                                          |       |   |   |   |   |
| Mortgage loans held for investment                                         |       | $                                               | 5,564,433  |                                          | $          | 4,590,662 |   | $ | 5,509,484 |   | $ | 4,736,675 |   |
| Securitization financing—loans held for investment                    |       | 4,975,958                                       |       | 4,242,147                                     |       | 4,900,994 |   | 4,215,218 |   |
| Warehouse financing—loans held for investment                         |       | 477,987                                         |       | 223,368                                       |       | 494,336 |   | 370,294 |   |
|                                                                       |       |                                            |       |                                          |       |   |   |   |   |
| Yield analysis—loans  held for investment:                            |       |                                            |       |                                          |       |   |   |   |   |
| Coupon interest income on loans held for investment                        |       | 7.21                                            | %          | 6.65                                          | %          | 7.14 | % | 6.66 | % |
| Amortization of deferred origination costs                                 |       | (0.44                                           | )%         | (0.46                                         | )%         | (0.47 | )% | (0.45 | )% |
| Prepayment fees                                                            |       | 0.37                                            | %          | 0.75                                          | %          | 0.39 | % | 0.65 | % |
| Yield on loans held for investment                                         |       | 7.14                                            | %          | 6.94                                          | %          | 7.06 | % | 6.86 | % |
| Interest expense securitization financing(1)                               |       | 5.39                                            | %          | 3.47                                          | %          | 5.18 | % | 3.25 | % |
| Interest expense warehouse financing                                       |       | 5.90                                            | %          | 4.22                                          | %          | 5.43 | % | 3.91 | % |
| Amortization—deferred bond issuance costs and  issue discount    |       | 0.21                                            | %          | 0.20                                          | %          | 0.22 | % | 0.20 | % |
| Cost of financing for loans held for investment(1)                         |       | 5.63                                            | %          | 3.70                                          | %          | 5.40 | % | 3.48 | % |
| Net yield on loans held for investment(2)                                  |       | 1.63                                            | %          | 3.34                                          | %          | 1.77 | % | 3.49 | % |
| Provision for loan losses as% of average loan  balance                     |       | (0.39                                           | )%         | (0.59                                         | )%         | (0.39 | )% | (0.48 | )% |
| Net yield on  loans held for investment after provision for loan losses(1) |       | 1.24                                            | %          | 2.75                                          | %          | 1.38 | % | 3.01 | % |
|                                                                            |            |                                                 |            |                                               |            |  |  |  |  |  |  |  |  |

 
| **($ in 000s)**                                                                                              | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                             | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Average  balances:                                                                                                     |       |                                            |       |                                          |       |   |   |   |   |
| Mortgage loans held for sale                                                                                           |       | $                                               | 324,336    |                                          | $          | 701,022 |   | $ | 327,190 |   | $ | 458,903 |   |
| Warehouse financing—loans held for sale                                                                           |       | 242,929                                         |       | 516,843                                       |       | 227,543 |   | 307,528 |   |
|                                                                                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Yield  analysis—loans held for sale:                                                                              |       |                                            |       |                                          |       |   |   |   |   |
| Yield on loans held for sale                                                                                           |       | 8.53                                            | %          | 7.25                                          | %          | 8.26 | % | 7.43 | % |
| Cost of financing for loans held for sale                                                                              |       | 5.84                                            | %          | 4.11                                          | %          | 5.41 | % | 4.11 | % |
| Net yield on loans held for sale(2)                                                                                    |       | 4.15                                            | %          | 4.22                                          | %          | 4.50 | % | 4.67 | % |
|                                                                                                                   |       |                                            |       |                                          |       |   |   |   |   |
| Combined yield—net  interest income after provision for loan losses, loans held for investment  and held for sale |       | 1.40                                            | %          | 3.15                                          | %          | .56 | % | 3.25 | % |
|                                                                                                                        |            |                                                 |            |                                               |            |  |  |  |  |  |  |  |  |

----

(1)             Does not include the effect of our interestrate hedges.

(2)             Calculated as the annualized net interest incomedivided by the average daily balance of mortgage loans. The net yield on loanswill not equal the difference between the yield on loans and the cost offinancing due to the difference in the denominators of the two calculations.

39

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***Net Interest Income AfterProvision for Loan Losses Earned on Loans Held for Investment***

Interest income on loans held for investment was$100.4 million and $195.6 million, respectively, for the three and six monthsended June 30, 2006 compared to $80.6 million and $163.4 million for thethree and six months ended June 30, 2005, respectively.  The increase in both the three and six monthperiods ending June 30, 2006 were primarily the result of higher coupon ratesand an increase in the average portfolio balance in 2006.  Our average portfolio balance increasedapproximately $1.0 billion and $0.8 billion for both the three and six monthsended June 30, 2006, respectively, compared to the same periods of the prioryear.

Yield on loans held forinvestment increased to 7.14% and 7.06%, respectively, in the three and sixmonths ended June 30, 2006 from 6.94% and 6.86%, respectively, in the sameperiods in 2005.  This change reflectsthe increase in the coupon on the loans that reached their note resets fromfixed to adjustable rates during the period combined with higher yields on newloans added to the portfolio.

Interest expense for both warehouse and securitizationfinancings rose in the three and six months ended June 30, 2006 as compared tothe same periods in 2005. We expect interest expense to continue to increasethroughout the remainder of 2006 both notionally and as a percentage of thecost of financing.  Our average cost offinancing for loans held for investment increased to 5.63% and 5.40%,respectively, for the three and six months ended June 30, 2006, compared to3.70% and 3.48%, respectively, for the three and six months ended June 30,2005.

As discussed above, our cost of financing new loanshas increased more rapidly than the coupon rates have increased, and as aresult our margins have declined.  Weexpect this to continue throughout the remainder of 2006 due to the intensecompetition for new loan originations. 

Prepayment fee income, which constitutes a portion ofthe net interest margin earned by our portfolio, has declined to 0.39% of ourportfolio balance throughout the first half of 2006 compared to 0.65% in thesame period of 2005. In the current rising interest rate environment, borrowersare increasingly deferring the prepayment of their loan until after theexpiration of their prepay fee period. We expect prepay fee income to increaseslightly throughout the remainder of 2006 due to the higher notional balance ofloans expected to prepay through year end, as they reach the reset of theirinitial fixed rate coupon period to a higher adjustable interest coupon.

The $22.9 million and $49.0 million of net interestincome before provision for loan losses earned on loans held for investment inthe three and six months ended June 30, 2006, respectively, does not includethe $11.8 million and $22.1 million, respectively, of net cash settlementsreceived in 2006 under the terms of the swap agreements used to economicallyhedge the financing costs of our loans held for investment, which is includedin the line item “Other income (expense)—portfolio derivatives” in thecondensed consolidated statement of operations.

Provision for loan lossesdecreased in the three and six months ended June 30, 2006 compared to the sameperiods in 2005 due primarily to a reduction in our loan loss estimatesrelative to 2003 and 2004 vintage loans, as indicated by lower actual life todate loss experience. Our realized losses on 2003 and 2004 originations werelower than initial expectations due to strong home price appreciation in 2003through 2005, and faster than anticipated prepayment speeds. We expect the provisionfor losses to increase throughout the remainder of 2006 due to (i) higheramounts of delinquent loans due to slower prepayment speeds, (ii) morenormalized losses on foreclosure due to flattening home price appreciation and(iii) higher levels of delinquencies due to the increases in borrowers’ monthlypayments as loans from 2004 continue to reach their initial reset period from afixed to an adjustable interest rate.

***Net Interest Income Earned onLoans Held for Sale***

Net interest incomeearned on loans held for sale includes the net interest spread on our loans heldfor sale during the period from funding to sale date. Our loans held for salegenerated net interest income of $3.4 million and $7.4 million, respectively,in the three and six months ended June 30, 2006 compared to $7.5 million and$10.8 million, respectively, in the same periods in 2005.  The decreases in net interest income are dueto the decrease in the average balance of loans held for sale and the declinein net interest income yield to 4.15% and 4.50%, respectively, in the three andsix months ended June 30, 2006 compared to 4.22% and 4.67%, respectively, inthe same periods of 2005.  The decline inyield reflects the decrease in the net interest spread available on new loansdue to rising market rates in the first six months of 2006 and intensecompetition for new originations, which we expect to continue through 2006.

40

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

The components of the gains on sale of mortgage loans,net are as follows for the three and six months ended June 30, 2006 and 2005:******
| ** **                                                            | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|-----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **($ in 000s)**                                             | ** ** | **2006**                                            | ** ** | **% of  Sales  Volume**                      | ** ** | **2005** | ** ** | **% of  Sales  Volume** | ** ** | **2006** | ** ** | **% of  Sales  Volume** | ** ** | **2005** | ** ** | **% of  Sales  Volume** | ** ** |
| Gross premiums—whole loan sales, net of hedging gains  or losses |       | $                                                   | 10,679     |                                              | 1.69       | % | $ | 38,949 |   | 3.23 | % | $ | 26,223 |   | 2.04 | % | $ | 52,640 |   | 3.03 | % |
| Loan fees collected(1)                                                |       | 3,916                                               |       | 0.62                                              | %          | 8,140 |   | 0.67 | % | 7,892 |   | 0.61 | % | 11,561 |   | 0.67 | % |
| Premiums paid(1)                                                      |       | (2,460                                              | )          | (0.39                                             | )%         | (8,603 | ) | (0.71 | )% | (5,222 | ) | (0.41 | )% | (10,723 | ) | (0.62 | )% |
| Subtotal                                                              |       | 12,135                                              |       | 1.93                                              | %          | 38,486 |   | 3.19 | % | 28,893 |   | 2.25 | % | 53,478 |   | 3.08 | % |
| Provision for losses—sold loans                                  |       | (5,639                                              | )          | (0.89                                             | )%         | (3,195 | ) | (0.26 | )% | (7651 | ) | (0.60 | )% | (5,406 | ) | (0.31 | )% |
| Direct origination costs(1)                                           |       | (4,543                                              | )          | (0.72                                             | )%         | (9,258 | ) | (0.77 | )% | (8,994 | ) | (0.70 | )% | (13,570 | ) | (0.78 | )% |
| Gains on sales of mortgage loans, net                                 |       | $                                                   | 1,953      |                                              | 0.31       | % | $ | 26,033 |   | 2.16 | % | $ | 12,248 |   | 0.95 | % | $ | 34,502 |   | 1.99 | % |
| Loan sales volume                                                     |       | $                                                   | 630,091    |                                              |       |   | $ | 1,206,195 |   |   |   | $ | 1,284,641 |   |   |   | $ | 1,735,746 |   |   |   |

----

(1)             Loan fees collected, premiums paid anddirect origination costs are deferred at funding and recognized on settlementof the loan sale.

(2)             The market for second lien loans declinedsignificantly during the second quarter of 2006.  This allowance was recorded to reduce oursecond lien loans held for sale as of June 30, 2006, and relates to the $134.3million of second lien loans held for sale as of that date.

The gross premiumson whole loan sales, net of hedging gains or losses, for first and second lienloans sold in the three and six months ended June 30, 2006 and June 30, 2005,respectively were as follows:
| ** **                                                       | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| **($ in 000,000s)**                                    | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| Gross whole loan sale  premiums, net of hedging gains or losses: |       |                                                |       |                                              |       |   |   |   |   |
| First lien mortgage  loans                                       |       | 2.1                                                 | %          | 3.0                                               | %          | 2.6 | % | 3.2 | % |
| Second lien mortgage  loans                                      |       | (0.7                                                | )%         | 1.5                                               | %          | 0.3 | % | 2.1 | % |
| Total                                                            |       | 1.7                                                 | %          | 3.3                                               | %          | 2.0 | % | 3.1 | % |
|                                                             |       |                                                |       |                                              |       |   |   |   |   |

 

The gains on sales of mortgage loans, net, decreasedfor the three and six months ended June 30, 2006 compared to the same periodsin 2005 due primarily to lower sales volumes combined with a significantdecline in the market value of certain second lien products late in the secondquarter of 2006 and lower premiums on the sale of first mortgages throughout2006.  As a result of industry concernsregarding a potential increase in second lien losses in the current environmentof flattening home price appreciation and rising interest rates, the marketvalue of our second liens held for sale as of June 30, 2006 declined below parvalue. We recognized a $4.5 million pre-tax charge to gains on sales of loansto reduce certain of our second lien loan inventory at period end to theirlower of cost or market value. In response to this value decline at the end ofthe second quarter, we discontinued the origination of lower FICO second lienproducts whose market value had been the most severely affected, and willcontinue to evaluate our product offerings to maximize sale premiums. Salespremiums earned on first lien mortgages declined to 2.1% in the second quarterof 2006 from 3.0% in the second quarter of 2005, as a result of themarket-driven reduction in the net interest spread on new loans sold.

The year over year decrease in sales volumes was dueto decreased originations in 2006 and a larger proportion of the loansoriginated in 2006 meeting the credit and coupon filters for our held forinvestment portfolio. Gross whole loan sales premiums declined as narrowerinterest spreads compressed sale premiums to 1.69% and 2.04% in the three andsix months ended June 30, 2006, from 3.23% and 3.03% in the three and sixmonths ended June 30, 2005, respectively. We expect gross sale premiums tocontinue at lower levels than 2005 as the industry responds to increasedcompetition, triggered in part by a decline in the overall mortgage market, byoffering coupon rates on new originations which are not increasing at the samerate as the increase in the cost of financing the loans.

In July 2006, approximately $100 million of secondliens previously held for sale were transferred to held for investment at theirlower market value based on the projected return on the loans, includingcurrent rating agency loss forecasts. 

We maintained a $1.9million valuation allowance on $11.8 million of unsaleable loans withdocumentation deficiencies or serious delinquency histories as of June 30,2006.

***Other Income(Expense)—Portfolio Derivatives***

We use interest rate swap and cap agreements to createeconomic hedges of the variable rate debt financing of our portfolio ofnon-conforming mortgages held for investment.

During the period that our loans have a fixed interestrate, generally the first two to three years of the loan, an increase ininterest rates will increase our cost of financing for the debt related tothose loans without a corresponding increase in the interest income we receivefrom borrowers.  Fieldstone mitigates therisk of adverse effects of changes in interest rates during this period usinginterest rate swaps.  Under these swapagreements, which are generally for a period of two years, we contract to pay afixed interest rate on a notional balance to the counterparty in exchange forreceiving from them the actual LIBOR rate on the notional

41

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balance.  We economically hedge approximately 90% ofour debt related to the fixed interest rate period of the loans.  We do not economically hedge any debt thathas a floating interest rate, as any impact of a change in interest rates wouldhave offsetting increases on both our cost of financing and our interestincome.

Changes in the fair value of these agreements, whichreflect the potential future cash settlements over the remaining lives of theagreements according to the market’s changing projections of interest rates,are recognized in the line item “Other income (expense)—portfolio derivatives”in the condensed consolidated statements of operations. This line item includesboth the actual cash settlements and recognition of the non-cash changes in thefair value of the agreements over the period.

The amount of cash settlements and non-cash changes invalue that were included in “Other income (expense)—portfolio derivatives” isas follows for the three and six months ended June 30, 2006 and 2005:
| **($ in 000s)**                          | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                         | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Non-cash changes  in fair value                    |       | $                                               | (1,024     | )                                             | $          | (12,087 | ) | $ | 870 |   | $ | 8,541 |   |
| Net cash  settlements paid on existing derivatives |       | 11,845                                          |       | 2,655                                         |       | 22,109 |   | 2,369 |   |
| Other income (expense)—portfolio  derivatives |       | $                                               | 10,821     |                                          | $          | (9,432 | ) | $ | 22,979 |   | $ | 10,910 |   |

 

Our portfolio derivatives allow us to “lock-in” theexpected financing costs of our investment portfolio over a future contractualtime period. At June 30, 2006 and December 31, 2005, the notional balance ofour interest rate swaps was $4.4 billion and $5.0 billion, respectively.

We have multiple interest rate swap agreements thataggregate to provide our total hedge coverage, and our interest expense duringany given period will be impacted by the weighted average interest rate of theexisting swap agreements.  Our older,lower rate swaps have begun to expire and are being replaced by swap agreementsthat bear higher interest rates, as interest rates have consistently risenthroughout 2005 and the first half of 2006. The rise in our weighted average swap rate has been partially offset byincreased coupon rates on our loans as a result of the rising interest rates.

The following chart illustrates the weighted averageinterest rate of our swap agreements for the periods presented:

**WeightedAvg. Interest Rate**

42

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Thefollowing table summarizes the average notional balance and the weighted averageinterest rate of our interest rate swaps that had been executed as of June 30,2006 for the six months ending December 31, 2006 and the year endingDecember 31, 2007:

| ($ in 000s) | ** ** | **Period Ending December 31,** | ** ** |
|-----------------------|------------|-----------------------------------------------|------------|
| ** **            | ** ** | **2006**                                      | ** ** | **2007** | ** ** |
| ** **            | ** ** | **Average  Notional  Balance**                | ** ** | **Weighted  Average  Pay Rate** | ** ** | **Average  Notional  Balance** | ** ** | **Weighted  Average  Pay Rate** | ** ** |
| Interest rate  swaps  |       | $                                             | 3,582,228  |   | 4.38% |   | $ | 1,768,408 |   | 4.81% |   |
|                       |            |                                               |            |  |  |  |  |  |  |  |  |

 

Other income(expense)—portfolio derivatives will vary due to movements in the LIBORinterest rate during the period. Generally, rising interest rates will increasethe fair value of our derivatives and our net cash settlements on existingderivatives. We cannot predict the net effect of interest rate volatility infuture periods on our other income (expense)—portfolio derivatives.

**Expenses**

Total expenses forthe three and six months ended June 30, 2006 and 2005 are as follows:
| **($ in 000s)**            | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                           | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| Salaries and employee  benefits      |       | $                                               | 19,166     |                                          | $          | 17,719 |   | $ | 40,035 |   | $ | 35,423 |   |
| Occupancy                            |       | 1,861                                           |       | 1,796                                         |       | 3,684 |   | 3,295 |   |
| Depreciation and  amortization       |       | 995                                             |       | 792                                           |       | 1,930 |   | 1,552 |   |
| Servicing fees                       |       | 2,723                                           |       | 1,743                                         |       | 5,292 |   | 4,347 |   |
| General and  administration          |       | 7,742                                           |       | 7,000                                         |       | 15,305 |   | 14,321 |   |
| Total expenses                       |       | $                                               | 32,487     |                                          | $          | 29,050 |   | $ | 66,246 |   | $ | 58,938 |   |
| Percentage change from  prior period |       | 11.8                                            | %          |                                          |       | 12.4 | % |   |   |

 

***Total Expenses. ***Total expenses increased during the three and six months ended June 30,2006 compared to the same periods in 2005 due primarily to higher compensationexpenses and costs related to the growth of our loan portfolio. We expect totalexpenses throughout the remainder of 2006 to continue to be higher thancomparable periods in 2005 due primarily to increased third-party servicingfees on the higher average balance of our loan portfolio, the addition of salespersonnel to maintain our market share of loan originations and additionalcosts to support initiatives related to information technology improvements. Tomitigate these increased costs, we are implementing various cost managementinitiatives throughout the Company, and we expect a decrease in productioncosts as a percent of origination volume in the second half of 2006.

We have partially replacedour two non-integrated conforming and non-conforming origination softwaresystems with a single, integrated system to serve as both the conforming andnon-conforming origination and funding support system, and upgraded “Fieldscore,”our pre-approval and credit gathering engine. The project involves purchasing,developing, installing, training and supporting the new system, which we expectto be completed by the end of 2006. The “Fieldscore” upgrade is complete, theconforming component has been placed in service, and we have begun implementingthe non-conforming component.  Costsrelated to these initiatives include maintenance, depreciation, andamortization for these technological initiatives, as well as increasedpersonnel costs due to increased technology staffing levels during the upgrade.We have capitalized $5.5 million to date for these hardware and softwaredevelopment initiatives, and expensed approximately $0.4 million and $0.7million for

43

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the three and six monthsended June 30, 2006, respectively.  Weexpect our expenses to increase in 2006 as we complete development of thesoftware and place the system fully into service.

***Salaries andEmployee Benefits.**** * The increases in salaries and employeebenefits, net of deferred direct origination costs, in the three and six monthsended June 30, 2006 compared to the same periods in 2005 are due to theadditional sales personnel hired to maintain our loan origination volume in adeclining mortgage market, the legal, finance, and internal staffingrequirements of operating as a public company, including compliance with the Sarbanes-OxleyAct, and additional information technology personnel to support our ongoingtechnological enhancements in access and security controls.  We have also experienced increased employeebenefit expenses related to our self-insurance health plan in the current year.

***Servicing Fees*.**   Servicing fees paid to our third-partyservicer of the loans in our portfolio increased for the three and six monthsended June 30, 2006 compared to the same periods in the prior year.  Servicing fees vary with the number of loansheld for investment, and all of our loans held for investment are currentlyserviced by a third-party servicer beginning with the loan’s first mortgagepayment due after funding.  The increasein servicing fees in 2006 is due primarily to an increase in the averagebalance of our portfolio. In addition, in the second quarter of 2005,approximately $0.9 million of compensatory interest received from thesub-servicer was netted against service fee expense, including $0.8 millionrelated to periods prior to the second quarter of 2005.  These year over year increases were partiallyoffset by lower servicing rates negotiated with our third-party servicer onrecently issued securitization deals.

***General and Administration.*** General and administration expensesincreased in the three and six months ended June 30, 2006 compared to the sameperiods in 2005 due primarily to increased audit fees for our re-audit offinancial results for the years ended December 31, 2004 and 2003 and thedepreciation and amortization of our new loan origination software system,which began in late 2005.  The re-auditwas completed in the first quarter of 2006. We are in the process of implementing several cost-management initiatives,including office consolidation, credit reporting efficiencies, and improvedvendor sourcing.  We do not expectgeneral and administration expenses to increase significantly during theremainder of 2006, as the planned cost efficiencies are expected to substantiallyoffset variable loan related costs, which we anticipate may rise with anyorigination volume increases, and the incremental expenses related to our newloan origination software system.

***Income Tax Benefit.****  *Wequalified to be taxed as a REIT, effective beginning in the fourth quarter of2003, and we elected to treat our loan origination and sale subsidiary, FMC, asa taxable REIT subsidiary (TRS).  A TRSis a corporation that is permitted to engage in non-qualifying REIT activities.Taxable income of our TRS is subject to federal, state, and local income taxes.Income tax expense reflects the following effective tax rates:
| **($ in 000s)**         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                        | ** ** | **2005**                                      | ** ** | **2006** | ** ** | **2005** | ** ** |
| FMC pre-tax net  (loss) income(1) |       | $                                               | (9,197     | )                                             | $          | 7,718 |   | $ | (14,447 | ) | $ | 5,253 |   |
| Effective tax  rate               |       | 35.9                                            | %          | 35.4                                          | %          | 35.6 | % | 34.1 | % |
|                                   |            |                                                 |            |                                               |            |  |  |  |  |  |  |  |  |

----

(1)             Includesloss from discontinued operations for the six months ended June 30, 2006 andthe three and six months ended June 30, 2005.

The effective tax rate includes the amortization of adeferred tax asset related to prior year inter-company loan sales.

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**Consolidated Statements of Condition as of June 30,2006 and December 31, 2005**

***Mortgage LoansHeld for Investment***

The followingtable summarizes the principle balance of our investment portfolio for the sixmonths ended June 30, 2006 and the year ended December 31, 2005:

| ($ in 000s)                          | ** ** | **Six Months Ended  June 30,  2006** | ** ** | **Year Ended  December 31,  2005** | ** ** |
|------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------|------------|
| Beginning  principal balance                   |       | $                                                   | 5,530,216  |                                         | $          | 4,735,063 |   |
| Loan fundings                                  |       | 1,347,488                                           |       | 3,341,911                                    |       |
| Payoffs and principal reductions               |       | (1,136,449                                          | )          | (1,981,866                                   | )          |
| Transfers to mortgage loans held for sale, net |       | —                                              |       | (530,830                                     | )          |
| Transfers to real estate owned                 |       | (46,364                                             | )          | (34,062                                      | )          |
| Ending principal  balance                      |       | 5,694,891                                           |       | 5,530,216                                    |       |
| Net deferred loan origination costs            |       | 37,372                                              |       | 40,199                                       |       |
| Ending balance  loans held for investment      |       | 5,732,263                                           |       | 5,570,415                                    |       |
| Allowance for loan losses                      |       | (44,749                                             | )          | (44,122                                      | )          |
| Ending balance loans  held for investment, net |       | $                                                   | 5,687,514  |                                         | $          | 5,526,293 |   |

 

During the six monthsended June 30, 2006, we originated $1.35 billion in new loans for theportfolio. The increase in the portfolio balance is the result of new fundingsexceeding payoffs during the first half of 2006. The portfolio generated$49.0 million of net interest income before provision for loan losses.

We estimate prepaymentspeeds based upon historical industry data for similar loan products and actualhistory to date, which are adjusted for current market assumptions regardingfuture economic conditions such as home price appreciation and interest rate forecasts.These assumptions for prepayment speeds indicate an average loan life ofapproximately 24 months. There can be no assurance that this industry data willbe reflective of our actual results.

***Allowance for LoanLosses—Loans Held for Investment***

The followingtable summarizes the allowance for loan loss activity of our investmentportfolio for the six months ended June 30, 2006 and the year endedDecember 31, 2005:

| ($ in 000s)                                           | ** ** | **Six Months Ended  June 30,  2006** | ** ** | **Year Ended  December 31,  2005** | ** ** |
|-----------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------|------------|
| Beginning  balance allowance for loan losses                    |       | $                                                   | 44,122     |                                         | $          | 22,648 |   |
| Provision                                                       |       | 10,859                                              |       | 30,065                                       |       |
| Charge-offs                                                     |       | (10,232                                             | )          | (8,591                                       | )          |
| Ending balance  allowance for loan losses                       |       | $                                                   | 44,749     |                                         | $          | 44,122 |   |
| Ending principal  balance, mortgage loans held for investment   |       | $                                                   | 5,694,891  |                                         | $          | 5,530,216 |   |
| Ending allowance  balance as % of ending principal balance |       | 0.79                                                | %          | 0.79                                         | %          |

 

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The delinquencystatus of our loans held for investment as of June 30, 2006 andDecember 31, 2005 was as follows:
| **($ in 000s)**                                                                                               | ** ** | **June 30, 2006** | ** ** | **December 31, 2005** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|---------------------------------|------------|
| ** **                                                                                                              | ** ** | **Principal  Balance**      | ** ** | **Percentage  of Total**   | ** ** | **Principal  Balance** | ** ** | **Percentage  of Total** | ** ** |
| Current                                                                                                                 |       | $                           | 4,965,056  |                            | 87.2%      |   | $ | 4,925,656 |   | 89.1% |   |
| 30 days past due                                                                                                        |       | 411,390                     |       | 7.2%                            |       | 359,074 |   | 6.5% |   |
| 60 days past due                                                                                                        |       | 117,641                     |       | 2.1%                            |       | 93,663 |   | 1.7% |   |
| 90+ days past  due                                                                                                      |       | 60,972                      |       | 1.1%                            |       | 65,810 |   | 1.2% |   |
| In process of  foreclosure                                                                                              |       | 139,832                     |       | 2.4%                            |       | 86,013 |   | 1.5% |   |
| Total                                                                                                                   |       | $                           | 5,694,891  |                            | 100.0%     |   | $ | 5,530,216 |   | 100.0% |   |
|                                                                                                                    |       |                        |       |                            |       |   |   |   |   |
| Allowance for loan losses                                                                                               |       | $                           | 44,749     |                            |       |   | $ | 44,122 |   |   |   |
|                                                                                                                    |       |                        |       |                            |       |   |   |   |   |
| Allowance for loan  losses as a% of total delinquent loans (30+ days past due and loans in the  process of foreclosure) |       | 6.1                         | %          |                            |       | 7.3 | % |   |   |

 

Delinquency, life to dateloss experience, and weighted average coupon rate of our loans held forinvestment by securitization pool as of June 30, 2006 and December 31,2005 were as follows:
| ** **                                             | ** ** | **As of June 30, 2006** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------|------------|
| **($ in 000s)**                              | ** ** | **Current  Principal  Balance**             | ** ** | **Current  Balance as  Factor of  Original  Principal** | ** ** | **% of  Principal  Balance  Seriously  Delinquent(1)** | ** ** | **% of  Cumulative   Realized  Losses(2)** | ** ** | **Weighted   Avg. Coupon** | ** ** | **Avg. Age  of Loans  from  Funding  (months)** | ** ** |
| Loans held for  investment-securitized:                |       |                                        |       |   |   |   |   |   |   |   |   |   |   |
| FMIC Series 2003-1                                |       | $                                           | 54,554     |   | 11% |   | 20.1% |   | 0.44% |   | 9.16% |   | 35 |   |
| FMIT Series 2004-2(3)                             |       | 162,908                                     |       | 19% |   | 17.3% |   | 0.40% |   | 9.18% |   | 28 |   |
| FMIT Series 2004-3                                |       | 356,568                                     |       | 36% |   | 9.3% |   | 0.36% |   | 8.01% |   | 26 |   |
| FMIT Series 2004-4                                |       | 439,922                                     |       | 50% |   | 8.4% |   | 0.34% |   | 7.00% |   | 23 |   |
| FMIT Series 2004-5                                |       | 496,756                                     |       | 55% |   | 7.3% |   | 0.31% |   | 6.77% |   | 21 |   |
| FMIT Series 2005-1                                |       | 445,933                                     |       | 59% |   | 6.6% |   | 0.27% |   | 6.89% |   | 19 |   |
| FMIT Series 2005-2                                |       | 795,841                                     |       | 82% |   | 5.9% |   | 0.16% |   | 7.11% |   | 13 |   |
| FMIT Series 2005-3                                |       | 1,066,675                                   |       | 92% |   | 4.7% |   | 0.05% |   | 7.31% |   | 9 |   |
| FMIT Series 2006-1                                |       | 902,567                                     |       | 97% |   | 3.5% |   | 0.00% |   | 7.93% |   | 6 |   |
| Total                                                  |       | 4,721,724                                   |       | 59% |   | 6.4% |   | 0.25% |   |   |   | 15 |   |
| Loans held for  investment—to be securitized      |       | 889,613                                     |       | 100% |   | 1.6% |   | 0.00% |   |   |   | 2 |   |
| Loans held for  investment—previously securitized |       | 83,554                                      |       | 12% |   | 18.3% |   | 0.39% |   |   |   | 31 |   |
| Total loans held for  investment                       |       | $                                           | 5,694,891  |   | 64% |   | 5.6% |   | 0.24% |   | 7.61% |   | 12 |   |

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| ** **                                        | ** ** | **As of December 31, 2005** | ** ** |
|---------------------------------------------------|------------|-------------------------------------------------|------------|
| **($ in 000s)**                         | ** ** | **Current  Principal  Balance**                 | ** ** | **Current  Balance as  Factor of  Original  Principal** | ** ** | **% of  Principal  Balance  Seriously  Delinquent(1)** | ** ** | **% of  Cumulative   Realized  Losses(2)** | ** ** | **Weighted  Avg. Coupon** | ** ** | **Avg. Age  of Loans  from  Funding  (months)** | ** ** |
| Loans held for  investment-securitized:           |       |                                            |       |   |   |   |   |   |   |   |   |   |   |
| FMIC Series 2003-1                           |       | $                                               | 83,201     |   | 17% |   | 17.1% |   | 0.31% |   | 8.79% |   | 29 |   |
| FMIT Series 2004-1(4)                        |       | 221,352                                         |       | 33% |   | 9.1% |   | 0.22% |   | 8.48% |   | 25 |   |
| FMIT Series 2004-2(3)                        |       | 398,754                                         |       | 45% |   | 7.0% |   | 0.30% |   | 6.83% |   | 22 |   |
| FMIT Series 2004-3                           |       | 556,056                                         |       | 56% |   | 6.9% |   | 0.18% |   | 6.46% |   | 20 |   |
| FMIT Series 2004-4                           |       | 535,681                                         |       | 61% |   | 7.5% |   | 0.20% |   | 6.97% |   | 17 |   |
| FMIT Series 2004-5                           |       | 610,985                                         |       | 68% |   | 6.7% |   | 0.07% |   | 6.80% |   | 15 |   |
| FMIT Series 2005-1                           |       | 562,331                                         |       | 75% |   | 4.9% |   | 0.11% |   | 6.92% |   | 13 |   |
| FMIT Series 2005-2                           |       | 918,831                                         |       | 95% |   | 3.0% |   | 0.00% |   | 7.14% |   | 7 |   |
| FMIT Series 2005-3                           |       | 1,156,571                                       |       | 99% |   | 0.7% |   | 0.00% |   | 7.34% |   | 3 |   |
| Total                                             |       | 5,043,762                                       |       | 65% |   | 4.9% |   | 0.14% |   |   |   | 13 |   |
| Loans held for  investment—to be securitized |       | 486,454                                         |       | 100% |   | 0.1% |   | 0.00% |   |   |   | 1 |   |
| Total loans held for  investment                  |       | $                                               | 5,530,216  |   | 67% |   | 4.4% |   | 0.13% |   | 7.13% |   | 12 |   |

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(1)             Seriouslydelinquent is defined as a mortgage loan that is 60 + days past due or in theprocess of foreclosure.

(2)             Doesnot include previously accrued but uncollected interest, which is reversedagainst current period interest income.

(3)             Series2004-2 was called in August 2006.  SeeNote 12 to the unaudited consolidated financial statements included inthis  report.

(4)             Series2004-1 was called and paid in full in April 2006.  As of June 30, 2006, the remaining loans frompool 2004-1 were being classified as held for investment.

The allowance for loan losses was $44.7 million as ofJune 30, 2006 compared to $44.1 million as of December 31, 2005, reflecting theportfolio growth and seasoning of the underlying loans as well as theflattening of home price appreciation, partially offset by lower than expectedrealized losses on loans originated in 2003 and 2004.

Prior to the second quarter of 2006, we utilizedindustry loss assumptions for loans similar in credit quality, loan size, andproduct type in making these estimates regarding losses because we had limitedhistorical loss data on our past originations, all of which were soldservicing-released prior to October 2003. Beginning in the second quarter of2006, we began to blend our own historical delinquency experiences withindustry averages in estimating the percentage of loans that are delinquent 30+days that will ultimately go to foreclosure. This resulted in an estimate thatapproximately 20% of the loans 30+ days delinquent will ultimately go toforeclosure. Also during the second quarter of 2006, we began to utilizehistorical loss experiences in estimating loss severity for pools for which wehave significant realized loss experiences. Applying this methodologyindividually to each pool yielded an estimated average loss severity ofapproximately 27% for 2003, 2004 and first quarter 2005 vintage loans. Wecontinue to use industry loss severity estimates of 35% for second quarter 2005and all 2006 pools for which significant realized loss experience for our own loansis not available. These underlying assumptions and estimates are periodicallyevaluated and updated to reflect our current assessment of the value of theunderlying collateral, actual historical loss experience, and other relevantfactors impacting portfolio credit quality and inherent losses.  

During the six months ended June 30, 2006, we soldapproximately 200 real estate owned properties previously collateralizing loansheld for investment with an average aggregate principal charge-off of 25.3%,which includes the initial charge-off at transfer to real estate owned, thesubsequent decrease in net realizable value, if any, and the final gain or losson disposal of the property.  At thistime, we believe our estimated average loss severity rates are supported by acombination of industry data, our disposal history, and the risk that lossseverity may increase as the loans continue to season and economic factors mayslow the increases in property values. We will continue to review our lossassumptions and update our estimates as required.

At June 30, 2006, $318.4 million, or 5.6%, of loansheld for investment were seriously delinquent (defined as 60+ days past due orin the process of foreclosure), compared to $245.5 million, or 4.4%, atDecember 31, 2005. This is consistent with industry trends andexpectations of increased delinquencies as the portfolio grows,

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loans further season, andhome price appreciation declines.  Thisrise in delinquencies has also led to an increase in the balance of the loansplaced on non-accrual status for interest income recognition as of June 30,2006 and a related increase in the amount of accrued interest income that wassubsequently reversed. We anticipate that our level of delinquencies willincrease as the portfolio continues to age and borrowers reach the reset periodof their loan from lower fixed interest rates to higher adjustable coupons.While our portfolio delinquency and loss rates continue to be lower thanindustry averages, many lenders, including us, have reported an increase in earlypayment defaults on more recent originations to levels approximating historicalnorms, which may increase industry-wide losses. 

***Real Estate Owned***

Real estate owned is reported at the lower of cost ormarket value on the condensed consolidated statements of condition. At thetime a loan held for investment is foreclosed and the underlying collateral istransferred to real estate owned, any reduction in value from the loan’sprevious carrying balance is charged to the allowance for loan losses — loansheld for investment.  We record gains andlosses at disposal of the property to gain (loss) on disposal of real estateowned, a component of “Fees and other income” on the condensed consolidatedstatements of operations.

The following is a summary of real estate owned as ofJune 30, 2006 and December 31, 2005:

| ($ in 000s)                                                                              | ** ** | **Six Months Ended  June 30,  2006** | ** ** | **Year Ended  December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------|------------|
| Beginning  balance real estate owned                                                               |       | $                                                   | 14,997     |                                         | $          | 4,374 |   |
| Plus: Transfers  from mortgage loans held for sale                                                 |       | 6,208                                               |       | 867                                          |       |
|         Transfers  from mortgage loans held for investment |       | 46,364                                              |       | 34,062                                       |       |
| Less:  Charge-offs                                                                                 |       | (10,824                                             | )          | (7,634                                       | )          |
|          Real  estate sold                            |       | (21,959                                             | )          | (16,672                                      | )          |
| Ending balance real  estate owned                                                                  |       | $                                                   | 34,786     |                                         | $          | 14,997 |   |

 

***Mortgage Loans Held for Sale and Related WarehouseFinancing—Loans Held for Sale***

The followingtable provides a summary of the mortgage loans held for sale, net and warehousefinancing—loans held for sale as of June 30, 2006 and December 31, 2005:

| ($ in 000s)                                  | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Total mortgage  loans held for sale, net               |       | $                       | 324,432    |                        | $          | 594,269 |   |
| Warehouse  financing—mortgage loans held for sale |       | $                       | 277,773    |                        | $          | 434,061 |   |
| Percentage  financed—mortgage loans held for sale |       | 86                      | %          | 73                          | %          |

 

The decrease in mortgage loans held for sale, net, atJune 30, 2006 compared to December 31, 2005 reflects lower funding of loansheld for sale in the two months preceding June 30, 2006 than in the two monthspreceding December 31, 2005, decreased overall funding volumes in 2006, and theincreased proportion of our loans funded for investment in 2006.  The balance of loans held for sale as ofDecember 31, 2005 includes approximately $149 million of loans whose sale wasrescheduled until the first quarter of 2006 to take advantage of a higher salesprice, which also contributed to the decrease as of June 30, 2006.  We typically retain loans held for sale forapproximately 60 to 90 days prior to investor purchase.

At June 30, 2006, we had $11.8 million of loans heldfor sale deemed to be unsaleable at standard sale premiums compared to $5.2million at December 31, 2005.  We haverecorded a valuation allowance of $1.9 million and $1.1 million as of June 30,2006 and December 31, 2005, respectively, for these loans.

Warehouse financing—loans held for sale decreased$156.3 million as of June 30, 2006 compared to December 31, 2005reflecting our decreased level of mortgage loans held for sale at June 30,2006.

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***Trustee Receivable***

Trustee receivable decreased to$103.1 million at June 30, 2006 from $130.2 million at December 31,2005.  The decrease reflects lowerprincipal payments and prepaid loan payments received after the cut-off datefor the current month bond payments from our nine securitized mortgage poolsoutstanding as of June 30, 2006 compared to December 31, 2005. The trusteeretains funds received after the cut-off date until the following month’sdisbursement date. The decrease in the trustee receivable was also attributableto the decreased number of securitized pools outstanding following the call ofFMIT Series 2004-1 in April 2006.

***Derivative Assets and DerivativeLiabilities***

Derivative assetsincreased to $36.7 million at June 30, 2006 from $35.2 million at December 31,2005.  Derivative liabilities, includedin “Accounts payable, accrued expenses and other liabilities” in the condensedconsolidated statements of condition, decreased to $0.2 million at June 30,2006 from $0.9 million at December 31, 2005. The change in derivative assetsand liabilities primarily relates to the $0.9 million increase in the fairvalue of the interest rate swap and cap agreements over the period, reflectingan increase in the two year swap rate as of June 30, 2006 compared to December31, 2005.

*** Securitization Financing***

Thefollowing is a summary of the outstanding securitization financing by series asof June 30, 2006 and December 31, 2005:

| ($ in 000s)                   | ** ** | ** **        | ** ** | **Balance as of** | ** ** |
|-----------------------------------------|------------|-------------------|------------|-----------------------------|------------|
| ** **                              | ** ** | **Bonds  Issued** | ** ** | **June 30,  2006**     | ** ** | **December 31,  2005** | ** ** |
| FMIT  Series 2006-1                |       | $                 | 904,078    |                        | $          | 880,309 |   | $ | — |   |
| FMIT  Series 2005-3                |       | 1,094,246         |       | 1,005,713                   |       | 1,089,820 |   |
| FMIT Series 2005-2                 |       | 911,081           |       | 759,846                     |       | 872,455 |   |
| FMIT Series 2005-1                 |       | 728,625           |       | 437,230                     |       | 555,650 |   |
| FMIT Series 2004-5                 |       | 863,550           |       | 476,753                     |       | 595,481 |   |
| FMIT Series 2004-4                 |       | 845,283           |       | 423,947                     |       | 518,283 |   |
| FMIT Series 2004-3                 |       | 949,000           |       | 350,493                     |       | 523,296 |   |
| FMIT Series 2004-2(2)              |       | 843,920           |       | 140,160                     |       | 377,500 |   |
| FMIT  Series 2004-1(1)             |       | 652,944           |       | —                      |       | 233,977 |   |
| FMIC Series 2003-1                 |       | 488,923           |       | 47,290                      |       | 83,308 |   |
|                                    |       | 8,281,650         |       | 4,521,741                   |       | 4,849,770 |   |
| Unamortized bond  discount              |       | (1,130            | )          | (18                         | )          | (74 | ) |
| Subtotal  securitization bond financing |       | 8,280,520         |       | 4,521,723                   |       | 4,849,696 |   |
| Liquid Funding  repurchase facility     |       | —            |       | 92,481                      |       | 86,079 |   |
| Lehman Brothers repurchase  facility    |       | —            |       | —                      |       | 62,845 |   |
| Total securitization  financing         |       | $                 | 8,280,520  |                        | $          | 4,614,204 |   | $ | 4,998,620 |   |

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(1)             Series2004-1 was called and paid in full in April 2006.

(2)             Series2004-2 was called in August 2006.  SeeNote 12 to the condensed consolidated financial statements included in thisreport.

During the sixmonths ended June 30, 2006 and the year ended December 31, 2005, we issued$0.9 billion and $2.7 billion, respectively, of mortgage-backed bonds throughsecuritization trusts to finance our portfolio of loans held forinvestment.  Interest rates reset monthlyand are indexed to one-month LIBOR. The bonds pay interest monthly based upon aspread over LIBOR. We retain the option to repay the bonds when the remainingunpaid principal balance of the underlying mortgage loans for each pool fallsbelow set thresholds of the original principal balance.

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During March 2006, the current principal balance as apercentage of the original principal balance of the underlying mortgage loanscollateralizing FMIT Series 2004-1 fell below 20%, permitting us to exerciseits option to repay the relating bonds. Management reviewed the economic factors relating to this potentialcall, and subsequently delivered notice in April 2006 to FMIT Series 2004-1bondholders to repay the bonds at the next payment date.

As of June 30, 2006 andDecember 31, 2005, the outstanding bonds were over-collateralized by$245.6 million and $189.8 million, respectively. The collateral includesmortgage loans, trustee receivables, real estate owned and proceeds from bondpre-fundings which are designated as restricted cash until the mortgage loancollateral is delivered to the trust. Weenter into interest rate swap or cap agreements to economically hedge theinterest expense associated with the bonds, as described above under “CriticalAccounting Policies.”

***Total Shareholders’ Equity***

Total shareholders’ equity decreased to $483.7 millionat June 30, 2006, from $526.6 million at December 31, 2005.  The change in shareholders’ equity primarilyreflects the $43.9 million in dividends declared in 2006 and the $16.8 millionvalue of the shares of common stock repurchased during the period, which werepartially offset by net income for the six months ended June 30, 2006 of$16.7 million.

Dividends werepaid from our operating cash flows. Dividends declared are based on our REIT taxable income, which differsfrom our net income as described below under “REIT Taxable Income.”  The following is a summary of the dividendsdeclared per share for the six months ended June 30, 2006:

| Declaration Date | ** ** | **Record Date** | ** ** | **Payment Date** | ** ** | **Dividend** |
|-----------------------|------------|----------------------|------------|-----------------------|------------|--------------|
| March 17, 2006        |       | March  31, 2006      |       | April  28, 2006       |       | $0.48        |
| June 16, 2006         |       | June 30, 2006        |       | July 31, 2006         |       | $0.44        |

 

**Business Segment Results**

Fieldstone reports on atotal of four business segments, which include two production segments and twooperating segments. Our production segments include our Wholesale segment,previously designated as Non-conforming Wholesale, and our Retail segment,previously designated as Non-conforming Retail. Our Wholesale segmentoriginates non-conforming loans, while our Retail segment originates bothconforming and non-conforming mortgages, in order to provide a complete rangeof mortgage options to our retail borrowers. Prior to the first quarter of 2006, we reported two additional productionsegments referred to as our Conforming Wholesale and Conforming Retailsegments. In the first quarter of 2006, our Board of Directors approved a planto dispose of the assets of the Conforming Wholesale and Conforming Retailsegments due to the decline in profitability of these segments.  In February 2006, the assets pertaining tothese divisions’ headquarters, all wholesale offices, and certain of its retailoffices were sold to third parties. The remaining assets of the conformingdivision, which include retail offices in Maryland and Virginia, have beencombined with our non-conforming retail offices, which offer a range ofnon-conforming and conforming loan products. The following discussion of results reflects our current segmentstructure, and the results of our former Conforming Wholesale and ConformingRetail segments are reported as discontinued operations.

The results of operationsof our production segments primarily include an allocation of net interestincome for funded loans, direct expenses, and a corporate overhead expense allocation.In addition, segment revenues include an allocation which credits theproduction segments with the pro forma current value of the net gain on sale ofloan production as if all of the segments’ fundings were sold servicing-releasedconcurrent with funding, even though a significant portion of the loansoriginated will be held for investment. Loans held for investment generate revenue over the life of loan, whichcurrently averages two years, and is recorded as part of our InvestmentPortfolio segment.

Our 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 our loans held forinvestment, changes in the fair value and cash settlements relating to ourportfolio derivatives, and direct expenses, including third-party servicingfees, related to our loans held for investment. The results of operations ofthe

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Corporate segmentprimarily include direct expenses of the corporate home office, the eliminationof the corporate overhead allocated to the production segments, and the incometax provision related to FMC, our taxable REIT subsidiary. The Corporatesegment also includes various reconciling amounts necessary to adjust for theretention of a substantial portion of our non-conforming loans to be held forinvestment, and to convert the production segments’ allocated revenue andexpenses to comply 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 the time of cash settlement ofthe sale compared to the revenue allocation which each segment receives at thetime of loan funding, the actual whole loan sales prices compared to the proforma values, the actual net interest margin earned on loans prior to theirsale, and the holding for investment of a substantial portion of ournon-conforming loans for which actual revenue will consist of net interestincome generated over the life of the loan rather than net gain on salerecognized one-time as of the sale date.

Operating results by business segment for the threemonths ended June 30, 2006 are as follows:
| ** **                                                | ** ** | **Production** | ** ** | **Investment** | ** ** | ** **    | ** ** | ** **    | ** ** |
|-----------------------------------------------------------|------------|----------------|------------|----------------|------------|---------------|------------|---------------|------------|
| ** **                                                | ** ** | **Wholesale**  | ** ** | **Retail**     | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidated** | ** ** |
| Revenues:                                                 |       |           |       |           |       |          |       |          |       |   |   |
| Interest income                                           |       | $              | 8,985      |           | $          | 1,277         |       | $             | 100,440    |   | $ | (3,271 | ) | $ | 107,431 |   |
| Interest expense                                          |       | 5,739          |       | 834            |       | 77,589        |       | (2,986        | )          | 81,176 |   |
| Net interest income                                       |       | 3,246          |       | 443            |       | 22,851        |       | (285          | )          | 26,255 |   |
| Provision for  loan losses—loans held for investment |       | —         |       | —         |       | (5,466        | )          | —        |       | (5,466 | ) |
| Gains (losses)  on sales of mortgage loans, net           |       | 24,924         |       | 8,463          |       | —        |       | (31,434       | )          | 1,953 |   |
| Other income  (expense)—portfolio derivatives        |       | —         |       | —         |       | 10,821        |       | —        |       | 10,821 |   |
| Fee and other  income                                     |       | —         |       | 409            |       | (1,344        | )          | 360           |       | (575 | ) |
| Total revenues                                            |       | 28,170         |       | 9,315          |       | 26,862        |       | (31,359       | )          | 32,988 |   |
| Direct expenses(1)                                        |       | 19,540         |       | 8,651          |       | 3,051         |       | 1,245         |       | 32,487 |   |
| Corporate  overhead allocation                            |       | 6,066          |       | 914            |       | —        |       | (6,980        | )          | — |   |
| Total expenses                                            |       | 25,606         |       | 9,565          |       | 3,051         |       | (5,735        | )          | 32,487 |   |
| Income from continuing operations before income  taxes    |       | 2,564          |       | (250           | )          | 23,811        |       | (25,624       | )          | 501 |   |
| Income tax  benefit                                       |       | —         |       | —         |       | —        |       | 3,304         |       | 3,304 |   |
| Net income  (loss)                                        |       | $              | 2,564      |           | $          | (250          | )          | $             | 23,811     |   | $ | (22,320 | ) | $ | 3,805 |   |

 

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Operating results by business segment for the sixmonths ended June 30, 2006 are as follows:
| ** **                                                    | ** ** | **Production** | ** ** | **Investment** | ** ** | ** **    | ** ** | ** **    | ** ** |
|---------------------------------------------------------------|------------|----------------|------------|----------------|------------|---------------|------------|---------------|------------|
| ** **                                                    | ** ** | **Wholesale**  | ** ** | **Retail**     | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidated** | ** ** |
| Revenues:                                                     |       |           |       |           |       |          |       |          |       |   |   |
| Interest income                                               |       | $              | 15,049     |           | $          | 2,295         |       | $             | 195,553    |   | $ | (3,752 | ) | $ | 209,145 |   |
| Interest expense                                              |       | 9,004          |       | 1,399          |       | 146,505       |       | (4,211        | )          | 152,697 |   |
| Net interest income                                           |       | 6,045          |       | 896            |       | 49,048        |       | 459           |       | 56,448 |   |
| Provision for  loan losses—loans held for investment     |       | —         |       | —         |       | (10,859       | )          | —        |       | (10,859 | ) |
| Gains (losses)  on sales of mortgage loans, net               |       | 42,094         |       | 15,218         |       | —        |       | (45,064       | )          | 12,248 |   |
| Other income  (expense)—portfolio derivatives            |       | —         |       | —         |       | 22,979        |       | —        |       | 22,979 |   |
| Fee and other  income                                         |       | —         |       | 858            |       | (1,582        | )          | 499           |       | (225 | ) |
| Total revenues                                                |       | 48,139         |       | 16,972         |       | 59,586        |       | (44,106       | )          | 80,591 |   |
| Direct expenses(1)                                            |       | 37,295         |       | 17,563         |       | 5,950         |       | 5,438         |       | 66,246 |   |
| Corporate  overhead allocation                                |       | 10,266         |       | 1,642          |       | —        |       | (11,908       | )          | — |   |
| Total expenses                                                |       | 47,561         |       | 19,205         |       | 5,950         |       | (6,470        | )          | 66,246 |   |
| Income (loss) from continuing operations before  income taxes |       | 578            |       | (2,233         | )          | 53,636        |       | (37,636       | )          | 14,345 |   |
| Income tax  benefit                                           |       | —         |       | —         |       | —        |       | 4,033         |       | 4,033 |   |
| Income (loss) from continuing operations                      |       | $              | 578        |           | $          | (2,233        | )          | $             | 53,636     |   | $ | (33,603 | ) | 18,378 |   |
| Discontinued  operations, net of income tax                   |       |           |       |           |       |          |       |          |       | (1,645 | ) |
| Net income                                                    |       |           |       |           |       |          |       |          |       | $ | 16,733 |   |

 

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Operating results bybusiness segment for the three months ended June 30, 2005 are as follows:
| ** **                                                    | ** ** | **Production** | ** ** | **Investment** | ** ** | ** **    | ** ** | ** **    | ** ** |
|---------------------------------------------------------------|------------|----------------|------------|----------------|------------|---------------|------------|---------------|------------|
| ** **                                                    | ** ** | **Wholesale**  | ** ** | **Retail**     | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidated** | ** ** |
| Revenues:                                                     |       |           |       |           |       |          |       |          |       |   |   |
| Interest income                                               |       | $              | 8,928      |           | $          | 1,282         |       | $             | 80,574     |   | $ | 2,636 |   | $ | 93,420 |   |
| Interest expense                                              |       | 4,987          |       | 708            |       | 41,773        |       | (326          | )          | 47,142 |   |
| Net interest income                                           |       | 3,941          |       | 574            |       | 38,801        |       | 2,962         |       | 46,278 |   |
| Provision for  loan losses—loans held for investment     |       | —         |       | —         |       | (6,863        | )          | —        |       | (6,863 | ) |
| Gains (losses)  on sales of mortgage loans, net               |       | 33,792         |       | 9,639          |       | —        |       | (17,398       | )          | 26,033 |   |
| Other income  (expense)—portfolio derivatives            |       | —         |       | —         |       | (9,432        | )          | —        |       | (9,432 | ) |
| Fee and other  income                                         |       | —         |       | 491            |       | (569          | )          | 87            |       | 9 |   |
| Total revenues                                                |       | 37,733         |       | 10,704         |       | 21,937        |       | (14,349       | )          | 56,025 |   |
| Direct expenses(1)                                            |       | 19,203         |       | 9,622          |       | 2,014         |       | (1,789        | )          | 29,050 |   |
| Corporate  overhead allocation                                |       | 6,097          |       | 1,036          |       | —        |       | (7,133        | )          | — |   |
| Total expenses                                                |       | 25,300         |       | 10,658         |       | 2,014         |       | (8,922        | )          | 29,050 |   |
| Income (loss) from continuing operations before  income taxes |       | 12,433         |       | 46             |       | 19,923        |       | (5,427        | )          | 26,975 |   |
| Income tax expense                                            |       | —         |       | —         |       | —        |       | (2,454        | )          | (2,454 | ) |
| Income (loss) from continuing operations                      |       | $              | 12,433     |           | $          | 46            |       | $             | 19,923     |   | $ | (7,881 | ) | 24,521 |   |
| Discontinued  operations, net of income tax                   |       |           |       |           |       |          |       |          |       | (695 | ) |
| Net income                                                    |       |           |       |           |       |          |       |          |       | $ | 23,826 |   |

 

Operatingresults by business segment for the six months ended June 30, 2005 are asfollows: 
| ** **                                                    | ** ** | **Production** | ** ** | **Investment** | ** ** | ** **    | ** ** | ** **    | ** ** |
|---------------------------------------------------------------|------------|----------------|------------|----------------|------------|---------------|------------|---------------|------------|
| ** **                                                    | ** ** | **Wholesale**  | ** ** | **Retail**     | ** ** | **Portfolio** | ** ** | **Corporate** | ** ** | **Consolidated** | ** ** |
| Revenues:                                                     |       |           |       |           |       |          |       |          |       |   |   |
| Interest income                                               |       | $              | 14,946     |           | $          | 2,292         |       | $             | 163,410    |   | $ | (105 | ) | $ | 180,543 |   |
| Interest expense                                              |       | 8,062          |       | 1,241          |       | 80,381        |       | (2,942        | )          | 86,742 |   |
| Net interest income                                           |       | 6,884          |       | 1,051          |       | 83,029        |       | 2,837         |       | 93,801 |   |
| Provision for  loan losses—loans held for investment     |       | —         |       | —         |       | (11,357       | )          | —        |       | (11,357 | ) |
| Gains (losses)  on sales of mortgage loans, net               |       | 55,775         |       | 17,152         |       | —        |       | (38,425       | )          | 34,502 |   |
| Other income  (expense)—portfolio derivatives            |       | —         |       | —         |       | 10,910        |       | —        |       | 10,910 |   |
| Fee and other  income                                         |       | —         |       | 926            |       | (770          | )          | 139           |       | 295 |   |
| Total revenues                                                |       | 62,659         |       | 19,129         |       | 81,812        |       | (35,449       | )          | 128,151 |   |
| Direct expenses(1)                                            |       | 36,030         |       | 18,766         |       | 4,999         |       | (857          | )          | 58,938 |   |
| Corporate  overhead allocation                                |       | 10,419         |       | 1,845          |       | —        |       | (12,264       | )          | — |   |
| Total expenses                                                |       | 46,449         |       | 20,611         |       | 4,999         |       | (13,121       | )          | 58,938 |   |
| Income (loss) from continuing operations before  income taxes |       | 16,210         |       | (1,482         | )          | 76,813        |       | (22,328       | )          | 69,213 |   |
| Income tax  expense                                           |       | —         |       | —         |       | —        |       | (2,297        | )          | (2,297 | ) |
| Income (loss) from continuing operations                      |       | $              | 16,210     |           | $          | (1,482        | )          | $             | 76,813     |   | $ | (24,625 | ) | 66,916 |   |
| Discontinued  operations, net of income tax                   |       |           |       |           |       |          |       |          |       | (1,336 | ) |
| Net income                                                    |       |           |       |           |       |          |       |          |       | $ | 65,580 |   |

----

(1)             Thedirect costs of our Investment Porfolio includes the allocation of corporateoverhead, which is assessed to that segment through the transfer pricing ofloans from the production segments.

53

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***Production Segments***

Segment contribution from our production segmentsdecreased in the three and six months ended June 30, 2006 compared to the sameperiods in 2005, due primarily to 13.4% and 12.8% decreases, respectively, inloan originations and a reduction in the gain on sale revenue allocation perfunding dollar, as narrowing interest margins in 2006 contributed to reducedsales premiums.  

As interest rates increased during 2005 and the firsthalf of 2006, the margin compression on new loan originations resulted in adecrease in allocated revenues per loan to our production segments. We expectmargins to remain at these compressed levels in the near-term future as theindustry adjusts rates on new loan originations to mirror changes in the yieldcurve.  To address the market revenuecompression in order to increase segment contribution, we are introducing newproducts, continuing the expansion of new origination channels and ourgeographical footprint, improving our technology throughout the originationcycle, and increasing our pricing transparency with our brokers and we are continuingto implement cost management measures, including pricing and commission changesto reduce the level of premiums paid; increased use of technology including therollout of our new loan origination system and incentives for on-linesubmissions; consolidation of our operations centers, as appropriate, andvendor re-structuring.

***Wholesale Segment.  ***Ourwholesale segment contribution decreased in the three and six months ended June30, 2006 compared to the same periods of 2005 due to reduced sales margins and 13.9% and 13.1%reductions in origination volumes for the three and six months endedJune 30, 2006.  The industry responded tocompetitive pressures in an increasing interest rate environment by originatingloans with narrower net interest income spreads, which earn reduced salepremiums. Direct expenses increased in the three and six months ended June 30,2006 to 69.4% and 77.5%, respectively, of total revenue, compared to 50.9% and57.5% in the same periods in 2005, and reflect higher salary costs related toadditional account executives hired to sustain funding volumes in a reducedoverall mortgage marketplace. These increased fixed costs are also being spreadover a reduced funding volume in 2006. Higher base salary expenses are partially offset by lower variable loancosts including commissions, as our commission plan was restructured to reducecompensation for narrower margins in the current lending environment.

***Retail Segment.  ***Our retail segmentcontribution decreased in the three and six months ended June 30, 2006 comparedto the same periods in 2005, reflecting 9.5% and 10.7% reductions inorigination volumes, respectively.  These decreases resulted from a lower proportion of second lienoriginations, which typically earn lower sale premiums, as a result ofour decision to discontinue the origination of certain second lien productswhose market value had been the most severely affected during the secondquarter of 2006 as discussed above under “Results of Operations.”  Direct expenses increased in the three andsix months ended June 30, 2006 to

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92.9% and 103.5%,respectively, of total revenue, compared to 89.9% and 98.1% in the same periodsin 2005, and reflect higher salary costs and a lower volume of originationsover which to spread fixed costs, partially offset by cost savings fromstreamlined marketing initiatives and new management to support our initiativesto improve cost efficiencies within the production centers.

***Operating Segments***

***Investment Portfolio***.  The Investment Portfolio contribution increased in the three months ended June30, 2006 compared to the same period in 2005 due to the gains recognized on ourderivative contracts in 2006.  For thethree months ended June 30, 2006, the impact of our derivatives was $20.3million more favorable than the comparable period of 2005, which offset thedecrease in net interest income after provision for losses earned by ourportfolio of loans held for investment.

The Investment Portfolio contribution decreased in thesix months ended June 30, 2006 compared to the same period in 2005 due to thedecrease in net interest income after provision for losses earned by ourportfolio of loans held for investment. The decline is due primarily to adecrease in our average 2006 net interest income margin, partially offset by ahigher portfolio balance.

Net interest margin decreased in the three and sixmonths ended June 30, 2006 compared to the same periods of 2005 as our older,higher margin loans prepaid and new loans were added to the portfolio at lowermargins.  The margins available on newloans narrowed, as intense market competition for new loans did not permitcoupons on new originations to increase at the same rate as the increase infinancing costs for these loans, which are indexed to rising market interestrates.

We anticipate decreased contribution from ourInvestment Portfolio segment for the remainder of 2006 compared to 2005 due tonarrower net interest margins on the loans to be originated in 2006 compared tooutstanding portfolio loans expected to prepay, partially offset by forecastedgrowth of our portfolio to approximately $6.0 billion by the end of 2006.

***Corporate***.   Thedirect expenses reported under our corporate segment rose in the three and sixmonths ended June 30, 2006 compared to the same periods in 2005.  The increase in 2006 expenses relate to theimplementation of Sarbanes-Oxley Act compliance measures, increasedprofessional service fees, and incremental expenses related to our new loanorigination system.

**Liquidity and Capital Resources**

As a mortgagelending company, we borrow substantial sums of money to fund the mortgage loanswe originate. After funding, our primary operating subsidiary, FMC, holds allof the conforming loans and some of the non-conforming loans that it originatesin inventory (warehouse) prior to sale. We hold the remainder of thenon-conforming loans for investment in our portfolio. Our primary cashrequirements include:

·       funding mortgages;

·       premiums paid in connectionwith loans originated in the wholesale channel;

·       interest expense on ourcredit facilities and securitization financings;

·       ongoing general andadministration expenses;

·       derivative transactions;and

·       REIT stockholderdistributions — as a REIT, we are required to distribute at least 90% of ourREIT taxable income to our shareholders.

Our primary cashsources include:

·       borrowings from our creditfacilities secured by mortgage loans held in inventory and the securities weretain from our securitizations;

·       proceeds from the issuanceof securities collateralized by the loans in our portfolio;

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·       proceeds from whole loansales;

·       principal and interestcollections relative to the mortgage loans held in inventory; and

·       points andfees collected from the origination of retail and wholesale loans.

We rely on our securitizations as a primary source ofliquidity. As of June 30, 2006, we have completed ten securitizations, issuingan aggregate of $8.3 billion of mortgage-backed securities.

The following is asummary of the securitizations issued by series during the year endedDecember 31, 2005 and the six months ended June 30, 2006:
| ** **                                  | ** ** | **FMIT  2005-1**    | ** ** | **FMIT  2005-2**    | ** ** | **FMIT  2005-3**    | ** ** | **FMIT  2006-1**    | ** ** |
|---------------------------------------------|------------|---------------------|------------|---------------------|------------|---------------------|------------|---------------------|------------|
| Issue date                                  |       | Feb  2005           |       | Aug  2005           |       | Nov  2005           |       | Mar  2006           |       |
| Bonds issued                                |       | $729,000            |       | $911,000            |       | $1,094,000          |       | $904,000            |       |
| Loans pledged                               |       | $750,000            |       | $967,000            |       | $1,165,000          |       | $933,000            |       |
| Bond  ratings—Standard and Poor’s |       | AAA–BBB-       |       | AAA–A+         |       | AAA–A+         |       | AAA–BBB        |       |
| Bond ratings—Moody’s              |       | Aaa–Baa3       |       | Aaa–Baa2       |       | Aaa–Baa2       |       | Aaa–Baa3       |       |
| Financing  costs—LIBOR plus            |       | 0.12%  – 2.00% |       | 0.12%  – 1.35% |       | 0.12%  – 1.45% |       | 0.08%  – 2.30% |       |
| Weighted average  spread over LIBOR         |       | 0.40%               |       | 0.38%               |       | 0.37%               |       | 0.32%               |       |
| Transaction fees                            |       | 0.36%               |       | 0.33%               |       | 0.30%               |       | 0.32%               |       |

 

On July 6, 2006, we completed our eleventhsecuritization and issued $779.2 million of mortgage-backed bonds, FMIT Series2006-2. The non-retained bonds contain similar provisions to our previoussecuritizations, with Standard and Poor’s ratings between AAA—BBB and Moody’sratings between Aaa—Baa3.  The bonds bearinterest at rates between LIBOR plus 0.09% to LIBOR plus 1.90%.  We expect to incur issuance costs for FMIT Series2006-2 of approximately $2.6 million that will be deferred and amortized overthe estimated life of the bonds.  FMITSeries 2006-2 included a pre-funding, whereby a portion of the collateralpledged to the trust was delivered at the time of the offering, with theremaining collateral to be delivered prior to September 29, 2006.  Approximately $200 million of bond proceeds,which were not collateralized at closing, will be held in escrow by thetrustee. According to the terms of the offering, these proceeds held in escrowwill be used to purchase qualifying mortgage loans, which will then be used tocollateralize the remaining bonds prior to September 29, 2006.  Concurrent with the closing of the offering,we collateralized the bonds with loans held for investment with an aggregateoutstanding principle balance of approximately $600 million.

We use our various credit facilities to fundsubstantially all of our loan originations. Fieldstone Mortgage sells themortgage loans it holds within two or three months of origination and pays downthese facilities with the proceeds. We issue mortgage-backed securitiesto pay down those facilities financing our loans held for investment.

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The material terms and features of these creditfacilities as of June 30, 2006 (in millions): 
| **Lender**                                                   | ** ** | ** ** | ** ** | **Committed** | ** ** | **Uncommitted** | ** **  | **Maturity  Date** | ** **     | **Range of  Allowable  Advances** | ** ** | **Minimum  Consolidated  Tangible  Net Worth** | ** ** | **Maximum  Ratio of  Indebtedness  To Adjusted  Tangible  Net Worth** | ** ** | **Minimum  Liquidity** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|---------------|------------|-----------------|-------------|--------------------|----------------|----------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|------------------------|------------|
| Countrywide Warehouse Lending                                |       | $          | 75.0       |          | —     |            | August 2006 |               | 95%–99.5% |                                   | $          | 250.0                                               |       | 17:1                                                                                 |       | $                      | N/A        |   |
| Countrywide Early Purchase Program                           |       | —     |       | 50.0          |       | Uncommitted     |        | N/A                |           | N/A                                    |       | N/A                                                 |       | N/A                                                                                  |       |
| Credit Suisse First Boston Mortgage Capital                  |       | 400.0      |       | —        |       | April 2007      |        | 91%–95%       |           | 400.0                                  |       | 16:1                                                |       | 15.0                                                                                 |       |
| Credit Suisse, New York Branch Commercial Paper  Facility(2) |       | 600.0      |       | —        |       | July 2006       |        | 92.5%              |           | 400.0                                  |       | 16:1                                                |       | 15.0                                                                                 |       |
| JPMorgan Chase Bank(2)                                       |       | 150.0      |       | —        |       | July 2006       |        | 95%–97%       |           | 400.0                                  |       | 16:1                                                |       | 20.0                                                                                 |       |
| Lehman Brothers Bank                                         |       | 300.0      |       | —        |       | December 2006   |        | 91.5%–94.5%   |           | 250.0                                  |       | 16:1                                                |       | 15.0                                                                                 |       |
| Merrill Lynch Bank USA                                       |       | 300.0      |       | —        |       | November 2006   |        | 91%–95%       |           | 250.0                                  |       | 17:1                                                |       | N/A                                                                                  |       |
| Subtotal                                                     |       | 1,825.0    |       | 50.0          |       |            |        |               |           |                                   |       |                                                |       |                                                                                 |       |
| Liquid Fundings(1)                                           |       | —     |       | 200.0         |       | Uncommitted     |        | N/A                |           | N/A                                    |       | N/A                                                 |       | N/A                                                                                  |       |
| Lehman Brothers(1)                                           |       | —     |       | 200.0         |       | Uncommitted     |        | N/A                |           | N/A                                    |       | N/A                                                 |       | N/A                                                                                  |       |
| Total                                                        |       | $          | 1,825.0    |          | 450.0      |            |        |               |           |                                   |       |                                                |       |                                                                                 |       |                   |
|                                                              |            |            |            |               |            |                 |             |                    |                |                                        |            |                                                     |            |                                                                                      |            |                        |            |  |  |  |

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(1)             Facilities remain open indefinitely, but may beterminated by either party at any time.

(2)             During July 2006, the maturity date forthese facilities were extended until July 2007

Under our warehouse lines and repurchase facilities,interest is payable monthly in arrears and outstanding principal is payableupon receipt of loan sale proceeds or transfer of a loan into a securitizationtrust. Outstanding principal is also repayable upon the occurrence of certaindisqualifying events, which include a mortgage loan in default for a period oftime, a repaid mortgage loan, a mortgage loan obtained with fraudulentinformation or the failure to cure a defect in a mortgage loan’s documentation.Outstanding principal is repayable if the mortgage loan does not close, but hadbeen pledged and funds were advanced. Our warehouse lines and repurchasefacilities contain terms mandating principal repayment if a loan remains on theline after a contractual time period from date of funding, or on the maturitydate of the facility.  Under thesefacilities, advances bear interest at annual rates of LIBOR plus an additionalpercentage that vary depending upon the type of mortgage loans securing theadvance. We are also required to pay non-use fees on unused amounts whichexceed certain thresholds relating to the average outstanding balance of thefacility.  The credit facilities aresecured by substantially all of our non-securitized mortgage loans and containcustomary financial and operating covenants that require us to maintain specifiedlevels of liquidity and net worth, maintain specified levels of profitability,restrict indebtedness and investments except in certain limited circumstances,restrict our ability to engage in certain mergers, consolidations orsubstantially change our business, and require compliance with applicable laws.We were in compliance with all of these covenants at June 30, 2006 and December31, 2005.

 

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***In addition to our traditional warehouse lines and creditfacilities, in October 2005 one of our wholly owned subsidiaries, FieldstoneMortgage Ownership Corp. (FMOC), which holds the securities we retain in oursecuritizations (Retained Securities), entered into two repurchase facilities,each with the uncommitted amount of $200 million and each secured by FMOC’spledge of the Retained Securities.  Thefacilities are with Liquid Funding, Ltd. (Liquid Funding), an affiliate of BearStearns Bank plc, and Lehman Brothers Inc. and Lehman Commercial Paper Inc.(together, Lehman Brothers) and remains open indefinitely, but may beterminated by either party at any time, and bear interest at an annual rate ofLIBOR plus an additional percentage.  Asof June 30, 2006 and December 31, 2005, there was $92.5 million and $148.9million, respectively, of collective borrowings outstanding under thesefacilities.***

A primary component of our liquidity strategy is tofinance our mortgage loans (prior to issuing securities collateralized by theloans held for investment) through a diverse group of lending counterpartiesand to schedule frequent sales or securitizations of loans so that the averageholding period of our inventory of loans generally does not exceed60 days.

We use our excess cash from operations to reduce theadvances on our warehouse lines or repurchase facilities. This process reducesour debt outstanding and the corresponding interest expense incurred, andresults in a pool of highly liquid mortgage collateral available to secureborrowings to meet our working capital needs. This pool of available collateraltotaled approximately $155 million and $199 million as of June 30, 2006and December 31, 2005, respectively. We expect to continue to invest ourworking capital in our portfolio of loans held for investment.

The Board of Directors authorized the repurchase of upto $40 million of outstanding common shares under a stock repurchase programannounced on November 28, 2005. As of June 30, 2006, we had repurchasedapproximately $20.1 million of shares under the plan.

**Cash Flows**

For the six monthsended June 30, 2006, our operations provided $306.6 million in cash compared to$425.5 million for the six months ended June 30, 2005. The decrease inoperating cash flows in 2006 as compared to 2005 is due primarily to thedecrease in loans sold in the second quarter of 2006 compared to the secondquarter of 2005.  Cash used in investingactivities was $197.0 million and $642.7 million for the six months ended June30, 2006 and 2005, respectively. The decrease in cash used in investingactivities in 2006 compared to 2005 primarily relates to the lower volume ofloans funded for investment and a larger amount of principal repaymentsreceived on loans held for investment as a result of the increase in theportfolio balance in 2006. Investing cash flows, as presented in our condensedconsolidated statements of cash flows, will typically be a use of cash becausethey exclude the net proceeds from mortgage warehouse financing andsecuritization financing used to support the increase in our investment in mortgageloans. We are required to show the net proceeds from, or repayments of,mortgage financing in our consolidated statements of cash flows as cash flowfrom financing activities and not as investing cash flow. Cash flows used infinancing activities was $111.5 million in the six months ended June 30, 2006compared to a source of $194.0 million of cash in the same period of 2005.  The increased use of cash in financingactivities in 2006 is due primarily to increased repayments on our securitizedfinancings, including calling FMIT series 2004-1.

**REIT Taxable Income**

To maintain ourstatus as a REIT, we are required to distribute at least 90% of our REITtaxable income each year to our shareholders. Federal tax rules calculateREIT taxable income in a manner that, in certain

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respects,differs from the calculation of consolidated net income pursuant to GAAP. Ourconsolidated GAAP net income will differ from our REIT taxable income primarilyfor the following reasons:

·       the provision for loan lossexpense recognized for GAAP purposes is based upon our estimate of probableloan losses inherent in our current portfolio of loans held for investment, forwhich we have not yet recorded a charge-off (tax accounting rules allow adeduction for loan losses only in the period when a charge-off occurs);

·       the mark to marketvaluation changes to our interest rate swap derivatives recognized for GAAPpurposes are not recognized for tax accounting;

·       the differences betweenGAAP and tax methodologies for capitalization of origination expenses; and

·       income of a TRS is includedin the REIT’s earnings for consolidated GAAP purposes; tax rules for REITtaxable income do not provide for a REIT to recognize income of the TRS until aTRS pays a dividend to the REIT.

Our REIT taxable income will continue to differ fromour GAAP consolidated income, particularly during the period in which we buildour investment portfolio.

REIT taxable income is a non-GAAP financial measurewithin the meaning of Regulation G promulgated by the SEC. Management believesthat the presentation of REIT taxable income provides useful information toinvestors regarding the estimated annual distributions to our investors. Thepresentation of REIT taxable income is not meant to be considered in isolationor as a substitute for financial results prepared in accordance with GAAP.

The followingtable is a reconciliation of GAAP net income to REIT taxable net income for thesix months ended June 30, 2006 and the year ended December 31, 2005:
| **($ in 000s)**                                  | ** ** | **Six Months Ended  June 30,  2006** | ** ** | **Year Ended  December 31,  2005** | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------|------------|----------------------------------------------|------------|
| Consolidated  GAAP pre-tax net income                      |       | $                                                   | 12.7       |                                         | $          | 102.9 |   |
| Plus:                                                      |       |                                                |       |                                         |       |
| Provision for  loan losses in excess of actual charge-offs |       | 0.5                                                 |       | 21.5                                         |       |
| Variance in  recognition of net origination expenses       |       | (0.2                                                | )          | 6.4                                          |       |
| Less:                                                      |       |                                                |       |                                         |       |
| Taxable REIT  subsidiary pre-tax net loss (income)         |       | 12.0                                                |       | (9.6                                         | )          |
| Mark to market  valuation changes on derivatives           |       | (0.7                                                | )          | (9.0                                         | )          |
| Miscellaneous  other                                       |       | 0.7                                                 |       | (7.2                                         | )          |
| Estimated REIT taxable  income                             |       | $                                                   | 25.0       |                                         | $          | 105.0 |   |

 

Estimated REIT taxableincome for the six months ended June 30, 2006 and the year ended December 31,2005 is subject to change until we file our REIT federal tax return.

We have experienced negativetreads during the first six months of 2006 of net interest margins on newloans, prepayment fees received on older vintage loans and delinquencies andlosses on loans originated in more recent vintages in 2005 and 2006 which couldnegatively affect our REIT taxable income.

**Commitments and Contingencies**

***(a)***      Loan Commitments

At June 30, 2006 and December 31, 2005, we hadorigination commitments outstanding to fund approximately $468 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 loan,comprised 99.8% and 97.0%,

59

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respectively, of theoutstanding origination commitments. We had forward delivery commitments tosell approximately $0.7 billion and $1.3 billion of loans and forwardcontracts at June 30, 2006 and December 31, 2005, respectively, of which $21.8 millionand $26.6 million, respectively, were mandatory sales of mortgage-backedsecurities and mandatory investor whole loan trades. At June 30, 2006 andDecember 31, 2005, we had a commitment to sell $460 million and $580million, respectively, of treasury note forward contracts, used to economicallyhedge the interest rate risk of its non-conforming loans.

***(b)***      Legal Matters

For a discussion ofcertain material legal proceedings that we are involved in, see Part II, Item1of this Quarterly Report on Form 10-Q. Because the nature of our business involves the collection of numerousaccounts, the validity of liens and compliance with various state and federallending and consumer protection laws, we are subject to various legalproceedings in the ordinary course of our business related to foreclosures,bankruptcies, condemnation and quiet title actions and alleged statutory andregulatory violations. We are also subject to other legal proceedings in theordinary course of business related to employee matters. All of these ordinarycourse proceedings, individually and taken as a whole, are not expected to havea material adverse effect on our business, financial condition or results ofoperations.

**Other Operational andInvestment Portfolio Data**

***LoanFundings***

The following tableindicates our total loan fundings of loans held for investment and loans heldfor sale for the three and six months ended June 30, 2006 and 2005:
| **($ in 000s)** | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------|------------|-----------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                | ** ** | **2006**                                            | ** ** | **2005**                                          | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                | ** ** | **Fundings**                                        | ** ** | **% of  Total**                              | ** ** | **Fundings** | ** ** | **% of  Total** | ** ** | **Fundings** | ** ** | **% of   Total** | ** ** | **Fundings** | ** ** | **% of   Total** | ** ** |
| Mortgage Loan Fundings:   |       |                                                |       |                                              |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Wholesale                 |       | $                                                   | 1,263,911  |                                              | 87%        |   | $ | 1,468,307 |   | 73% |   | $ | 2,124,434 |   | 82% |   | $ | 2,444,212 |   | 70% |   |
| Retail                    |       | 196,106                                             |       | 13%                                               |       | 216,695 |   | 11% |   | 346,902 |   | 13% |   | 388,651 |   | 11% |   |
| Discontinued operations   |       | —                                              |       | —                                            |       | 330,005 |   | 16% |   | 127,797 |   | 5% |   | 637,996 |   | 19% |   |
| Total Fundings            |       | $                                                   | 1,460,017  |                                              | 100%       |   | $ | 2,015,007 |   | 100% |   | $ | 2,599,133 |   | 100% |   | $ | 3,470,859 |   | 100% |   |

 

Loan fundings decreasedto $1.5 billion and $2.6 billion, respectively, in the three and six monthsended June 30, 2006 compared to $2.0 billion and $3.5 billion, respectively,for the three and six months ended June 30, 2005. The decrease in loan fundingswas due primarily to a rising interest rate environment and mortgage originatorprice and credit competition, triggered in part by a decline in the overallmortgage market.  In 2006, we expectnon-conforming fundings to be approximately $5.0 billion to $6.0 billion.

60

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***OriginatedNon-Conforming Loan Characteristics***

The following tables provide a summary of thecharacteristics of our total non-conforming loan originations for the threemonths ended June 30, 2006:

*IncomeDocumentation*
| ** **                   | ** ** | **Aggregate  Principal  Balance** | ** ** | **Percent  of  Originations** | ** ** | **Weighted  Average  Coupon** | ** ** | **Weighted  Average  Credit  Score** | ** ** | **Average  Principal  Balance** | ** ** | **Weighted  Average  LTV** | ** ** | **Weighted  Average  CLTV** | ** ** |
|------------------------------|------------|-----------------------------------|------------|-------------------------------|------------|-------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|----------------------------|------------|-----------------------------|------------|
| Full  Documentation          |       | $                                 | 572,643    |                          | 40.4%      |                          | 8.4%       |                                 | 620        |                            | $          | 116                        |       | 85.6%                       |       | 94.0% |   |
| Stated Income Wage  Earner   |       | 407,748                           |       | 28.8%                         |       | 8.7%                          |       | 678                                  |       | 170                             |       | 87.1%                      |       | 96.7%                       |       |
| Stated Income  Self Employed |       | 268,095                           |       | 18.9%                         |       | 8.7%                          |       | 666                                  |       | 195                             |       | 86.0%                      |       | 95.4%                       |       |
| 24 Month Bank  Statements    |       | 30,774                            |       | 2.2%                          |       | 8.2%                          |       | 631                                  |       | 176                             |       | 85.6%                      |       | 93.8%                       |       |
| 12 Month Bank  Statements    |       | 133,984                           |       | 9.4%                          |       | 8.4%                          |       | 638                                  |       | 188                             |       | 86.6%                      |       | 96.1%                       |       |
| Limited  Documentation       |       | 3,558                             |       | 0.3%                          |       | 8.5%                          |       | 616                                  |       | 187                             |       | 81.7%                      |       | 87.1%                       |       |
| Total                        |       | $                                 | 1,416,802  |                          | 100.0%     |                          |       |                                 |       |                            |       |                       |       |                        |       |   |
| Weighted  Average/Average    |       |                              |       |                          |       | 8.5%                          |       | 647                                  |       | $                               | 148        |                       | 86.2%      |                        | 95.2%      |   |

 

*Credit Score*
| ** **                | ** ** | **Aggregate  Principal  Balance** | ** ** | **Percent  of  Originations** | ** ** | **Weighted  Average  Coupon** | ** ** | **Weighted  Average  Credit  Score** | ** ** | **Average  Principal  Balance** | ** ** | **Weighted  Average  LTV** | ** ** | **Weighted  Average  CLTV** | ** ** | **Percent Full  Documentation** | ** ** |
|---------------------------|------------|-----------------------------------|------------|-------------------------------|------------|-------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|----------------------------|------------|-----------------------------|------------|--------------------------------------|------------|
| 500 – 549            |       | $                                 | 30,367     |                          | 2.1%       |                          | 9.8%       |                                 | 535        |                            | $          | 141                        |       | 78.5%                       |       | 81.1%                                |       | 80.4% |   |
| 550 – 599            |       | 214,658                           |       | 15.2%                         |       | 8.8%                          |       | 582                                  |       | 120                             |       | 84.9%                      |       | 91.8%                       |       | 79.1%                                |       |
| 600 – 649            |       | 526,825                           |       | 37.2%                         |       | 8.5%                          |       | 627                                  |       | 136                             |       | 85.7%                      |       | 95.5%                       |       | 49.3%                                |       |
| 650 – 699            |       | 441,563                           |       | 31.2%                         |       | 8.4%                          |       | 672                                  |       | 166                             |       | 87.1%                      |       | 96.8%                       |       | 19.8%                                |       |
| 700 or greater            |       | 203,389                           |       | 14.3%                         |       | 8.3%                          |       | 731                                  |       | 188                             |       | 88.0%                      |       | 96.9%                       |       | 15.6%                                |       |
| Total                     |       | $                                 | 1,416,802  |                          | 100.0%     |                          |       |                                 |       |                            |       |                       |       |                        |       |                                 |       |   |
| Weighted  Average/Average |       |                              |       |                          |       | 8.5%                          |       | 647                                  |       | $                               | 148        |                       | 86.2%      |                        | 95.2%      |                                 | 40.4%      |   |

 

*Product Type*
| ** **                | ** ** | **Aggregate  Principal  Balance** | ** ** | **Percent  of  Originations** | ** ** | **Weighted  Average  Coupon** | ** ** | **Weighted  Average  Credit  Score** | ** ** | **Average  Principal  Balance** | ** ** | **Weighted  Average  LTV** | ** ** | **Weighted  Average  CLTV** | ** ** | **Percent Full  Documentation** | ** ** |
|---------------------------|------------|-----------------------------------|------------|-------------------------------|------------|-------------------------------|------------|--------------------------------------|------------|---------------------------------|------------|----------------------------|------------|-----------------------------|------------|--------------------------------------|------------|
| 2/28 LIBOR ARM            |       | $                                 | 335,276    |                          | 23.7%      |                          | 8.7%       |                                 | 624        |                            | 151        |                       | 84.2%      |                        | 93.2%      |                                 | 51.5%      |   |
| 2/28 LIBOR ARM IO         |       | 507,652                           |       | 35.8%                         |       | 8.0%                          |       | 669                                  |       | 324                             |       | 86.0%                      |       | 97.3%                       |       | 20.4%                                |       |
| 3/27 LIBOR ARM            |       | 13,103                            |       | 0.9%                          |       | 8.2%                          |       | 633                                  |       | 139                             |       | 82.6%                      |       | 90.1%                       |       | 74.9%                                |       |
| 3/27 LIBOR ARM IO         |       | 31,633                            |       | 2.2%                          |       | 7.6%                          |       | 666                                  |       | 310                             |       | 85.0%                      |       | 95.8%                       |       | 47.8%                                |       |
| 5/25 Treasury ARM IO      |       | 17,502                            |       | 1.2%                          |       | 7.7%                          |       | 668                                  |       | 330                             |       | 84.7%                      |       | 93.4%                       |       | 43.4%                                |       |
| 5/25 Treasury ARM         |       | 6,642                             |       | 0.5%                          |       | 7.9%                          |       | 634                                  |       | 180                             |       | 80.9%                      |       | 87.7%                       |       | 64.0%                                |       |
| Fixed Rate                |       | 127,658                           |       | 9.0%                          |       | 8.1%                          |       | 642                                  |       | 135                             |       | 80.8%                      |       | 89.2%                       |       | 70.9%                                |       |
| Fixed Rate IO             |       | 10,602                            |       | 0.8%                          |       | 8.1%                          |       | 654                                  |       | 272                             |       | 83.0%                      |       | 94.6%                       |       | 63.5%                                |       |
| 6 month LIBOR ARM         |       | 1,027                             |       | 0.1%                          |       | 8.7%                          |       | 691                                  |       | 205                             |       | 83.1%                      |       | 94.1%                       |       | 11.8%                                |       |
| 6 month LIBOR ARM IO      |       | 1,241                             |       | 0.1%                          |       | 8.5%                          |       | 643                                  |       | 310                             |       | 79.9%                      |       | 88.3%                       |       | 0.0%                                 |       |
| 2nd Liens                 |       | 149,191                           |       | 10.5%                         |       | 11.1%                         |       | 653                                  |       | 42                              |       | 99.3%                      |       | 99.3%                       |       | 37.7%                                |       |
| 2/38 LIBOR ARM            |       | 207,267                           |       | 14.6%                         |       | 8.3%                          |       | 626                                  |       | 219                             |       | 84.8%                      |       | 95.1%                       |       | 49.1%                                |       |
| 3/37 LIBOR ARM            |       | 8,008                             |       | 0.6%                          |       | 8.5%                          |       | 639                                  |       | 195                             |       | 86.1%                      |       | 94.8%                       |       | 55.3%                                |       |
| Total                     |       | $                                 | 1,416,802  |                          | 100.0%     |                          |       |                                 |       |                            |       |                       |       |                        |       |                                 |       |   |
| Weighted  Average/Average |       |                              |       |                          |       | 8.5%                          |       | 647                                  |       | $                               | 148        |                       | 86.2%      |                        | 95.2%      |                                 | 40.4%      |   |
|                           |            |                                   |            |                               |            |                               |            |                                      |            |                                 |            |                            |            |                             |            |                                      |            |  |  |

** **

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***Cost to Produce***

Cost to produce is a non-GAAP financial measure withinthe meaning of Regulation G promulgated by the SEC. Management believes thatthe presentation of cost to produce provides useful information to investorsregarding financial performance because this measure includes additional coststo originate mortgage loans, both recognized when incurred and deferred costs,which are not included in total expenses under GAAP. In addition, theproduction segments’ cost to produce includes the allocation of the directexpenses of the operating segments, which include corporate home office costsand investment portfolio management costs. The presentation of cost to produceis not meant to be considered in isolation or as a substitute for financialresults prepared in accordance with GAAP. The following discussion includes the cost to produce from ourWholesale, Retail, Corporate and Investment Portfolio segments, and excludesthe results of our discontinued conforming segments.

As required byRegulation G, a reconciliation of cost to produce to the most directlycomparable measure under GAAP, which is total expenses, is provided below forthe three and six months ended June 30, 2006 and 2005:
| **($ in 000s)**                                     | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                    | ** ** | **2006**                                              | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Total expenses                                                |       | $                                                     | 32,487     |                                                | $          | 29,050 |   | $ | 66,246 |   | $ | 58,938 |   |
| Deferred origination costs                                    |       | 9,774                                                 |       | 11,632                                              |       | 16,280 |   | 19,694 |   |
| Servicing costs—internal and external                    |       | (3,312                                                | )          | (2,505                                              | )          | (6,567 | ) | (5,823 | ) |
| Total operating costs                                         |       | 38,949                                                |       | 38,177                                              |       | 75,959 |   | 72,809 |   |
| Premiums paid, net of fees collected                          |       | (1,330                                                | )          | 1,596                                               |       | (2,728 | ) | 2,188 |   |
| Cost to produce*                                              |       | $                                                     | 37,619     |                                                | 39,773     |   | 73,231 |   | 74,997 |   |
|                                                          |       |                                                  |       |                                                |       |   |   |   |   |
| Mortgage loan  fundings:                                      |       |                                                  |       |                                                |       |   |   |   |   |
| Wholesale                                                     |       | $                                                     | 1,263,911  |                                                | $          | 1,468,307 |   | $ | 2,124,434 |   | $ | 2,444,212 |   |
| Retail                                                        |       | 196,106                                               |       | 216,695                                             |       | 346,902 |   | 388,651 |   |
| Mortgage loan fundings*                                       |       | $                                                     | 1,460,017  |                                                | $          | 1,685,002 |   | $ | 2,471,336 |   | $ | 2,832,863 |   |
|                                                          |       |                                                  |       |                                                |       |   |   |   |   |
| Cost to produce  as % of mortgage loan fundings:         |       |                                                  |       |                                                |       |   |   |   |   |
| Total expenses                                                |       | 2.23                                                  | %          | 1.72                                                | %          | 2.68 | % | 2.08 | % |
| Deferred  origination costs                                   |       | 0.67                                                  | %          | 0.69                                                | %          | 0.66 | % | 0.70 | % |
| Servicing  costs—internal and external                   |       | (0.23                                                 | )%         | (0.14                                               | )%         | (0.27 | )% | (0.21 | )% |
| Total operating  costs                                        |       | 2.67                                                  | %          | 2.27                                                | %          | 3.07 | % | 2.57 | % |
| Premiums paid,  net of fees collected                         |       | (0.09                                                 | )%         | 0.09                                                | %          | (0.11 | )% | 0.08 | % |
| Cost to produce  as % of mortgage loan fundings          |       | 2.58                                                  | %          | 2.36                                                | %          | 2.96 | % | 2.65 | % |
|                                                          |       |                                                  |       |                                                |       |   |   |   |   |
| Segment cost to  produce as % of mortgage loan fundings: |       |                                                  |       |                                                |       |   |   |   |   |
| Wholesale                                                     |       | 2.49                                                  | %          | 2.28                                                | %          | 2.83 | % | 2.52 | % |
| Retail                                                        |       | 3.32                                                  | %          | 3.03                                                | %          | 3.90 | % | 3.52 | % |

----

*       Excludes costto produce and mortgage loan fundings relating to discontinued operations.

Our cost to produce increased in the three and sixmonths ended June 30, 2006 from the same period in the prior year due primarilyto (i) an increased allocation of fixed costs as a result of lower fundingvolumes, (ii) an increase in home office costs as a percent of volume due tothe disposal of the conforming division in the six months ended June 30, 2006and the related reduction in 2006 total loan volume, (iii) increased salariesrelated to additional account executives and loan officers hired to maintainmarket share and non-conforming

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loan origination volumein a flat origination environment, and (iv) the cost of implementing our newloan origination system.

Theseincreases were partially offset by a lower commission structure in response tonarrower market interest spreads, combined with cost reductions realizedthrough aggressive vendor sourcing.  Weexpect our cost to produce to decrease throughout the remainder of 2006 dueprimarily to expected higher loan origination volume, and our cost managementprogram.  Key components of the costmanagement program include:

·                  Branch consolidation:consolidation of operations centers, as appropriate, while maintaininggeographic market coverage;

·                  Roll-out of newloan origination software: Resulting efficiencies in the staffing levelsrequired to process, underwrite, and fund loans;

·                  Pricing andcommission initiatives to reduce the level of premiums paid and maximizerevenue;

·                  Focus ontechnology: Expand development of on-line submissions, virtual offices, and “paperless”transactions; and 

·      Vendor re-structuring.

***Investment Portfolio***

The following tables provide a summary of thecharacteristics of the principal balance of our portfolio of loans held forinvestment as of June 30, 2006:

*Income Documentation*
| **($ in 000s)**    | ** ** | **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          |       | $                                 | 2,559,551  |                                | 44.9%      |                          | 7.6%       |                                 | 618        |                            | $          | 154                        |       | 82.3%                       |       | 91.7 | % |
| Stated Income  Wage Earner   |       | 1,210,927                         |       | 21.3%                               |       | 7.7%                          |       | 676                                  |       | 224                             |       | 80.8%                      |       | 94.0                        | %          |
| Stated Income  Self Employed |       | 1,359,711                         |       | 23.9%                               |       | 7.6%                          |       | 686                                  |       | 211                             |       | 80.6%                      |       | 95.0                        | %          |
| 24 Month Bank  Statements    |       | 178,214                           |       | 3.1%                                |       | 7.5%                          |       | 626                                  |       | 226                             |       | 83.8%                      |       | 91.4                        | %          |
| 12 Month Bank  Statements    |       | 362,987                           |       | 6.4%                                |       | 7.7%                          |       | 632                                  |       | 221                             |       | 82.8%                      |       | 93.1                        | %          |
| Limited  Documentation       |       | 23,501                            |       | 0.4%                                |       | 7.6%                          |       | 637                                  |       | 193                             |       | 80.0%                      |       | 93.3                        | %          |
| Total                        |       | $                                 | 5,694,891  |                                | 100.0%     |                          |       |                                 |       |                            |       |                       |       |                        |       |   |
| Weighted  Average/Average    |       |                              |       |                                |       | 7.6%                          |       | 648                                  |       | $                               | 184        |                       | 81.6%      |                        | 93.1       | % |

 

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*Credit Score*
| **($ in 000s)** | ** ** | **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            |       | $                                 | 269,833    |                                | 4.7%       |                          | 8.9%       |                                 | 532        |                            | $          | 129                        |       | 79.9%                       |       | 81.3%                            |       | 82.6% |   |
| 550 – 599            |       | 905,477                           |       | 15.9%                               |       | 8.1%                          |       | 578                                  |       | 150                             |       | 81.7%                      |       | 87.3%                       |       | 76.0%                            |       |
| 600 – 649            |       | 1,663,538                         |       | 29.2%                               |       | 7.5%                          |       | 625                                  |       | 182                             |       | 82.1%                      |       | 92.3%                       |       | 63.3%                            |       |
| 650 – 699            |       | 1,857,679                         |       | 32.7%                               |       | 7.4%                          |       | 673                                  |       | 214                             |       | 81.8%                      |       | 96.0%                       |       | 23.3%                            |       |
| 700 or greater            |       | 998,364                           |       | 17.5%                               |       | 7.4%                          |       | 730                                  |       | 195                             |       | 80.9%                      |       | 97.2%                       |       | 16.2%                            |       |
| Total                     |       | $                                 | 5,694,891  |                                | 100.0%     |                          |       |                                 |       |                            |       |                       |       |                        |       |                             |       |   |
| Weighted  Average/Average |       |                              |       |                                |       | 7.6%                          |       | 648                                  |       | $                               | 184        |                       | 81.6%      |                        | 93.1%      |                             | 44.9%      |   |

 

*Product Type*
| **($ in 000s)** | ** ** | **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            |       | $                                 | 1,850,880  |                                | 32.5%      |                          | 8.1%       |                                 | 619        |                            | $          | 142                        |       | 81.9%                       |       | 91.2%                            |       | 56.5% |   |
| 2/28 LIBOR ARM IO         |       | 2,773,662                         |       | 48.7%                               |       | 7.3%                          |       | 665                                  |       | 260                             |       | 82.5%                      |       | 94.9%                       |       | 34.2%                            |       |
| 3/27 LIBOR ARM            |       | 197,978                           |       | 3.5%                                |       | 7.5%                          |       | 624                                  |       | 131                             |       | 82.0%                      |       | 90.4%                       |       | 64.6%                            |       |
| 3/27 LIBOR ARM IO         |       | 332,886                           |       | 5.8%                                |       | 7.0%                          |       | 662                                  |       | 239                             |       | 81.9%                      |       | 92.6%                       |       | 45.0%                            |       |
| 5/25 Treasury ARM         |       | 25,845                            |       | 0.4%                                |       | 6.9%                          |       | 649                                  |       | 172                             |       | 78.4%                      |       | 84.9%                       |       | 65.8%                            |       |
| 5/25 Treasury ARM IO      |       | 72,020                            |       | 1.2%                                |       | 6.7%                          |       | 671                                  |       | 277                             |       | 81.8%                      |       | 90.3%                       |       | 60.2%                            |       |
| Fixed Rate                |       | 242,968                           |       | 4.3%                                |       | 7.9%                          |       | 633                                  |       | 134                             |       | 79.1%                      |       | 89.2%                       |       | 70.5%                            |       |
| Fixed Rate IO             |       | 38,505                            |       | 0.7%                                |       | 7.5%                          |       | 662                                  |       | 239                             |       | 81.1%                      |       | 92.0%                       |       | 57.8%                            |       |
| 6 Month LIBOR ARM         |       | 428                               |       | 0.0%                                |       | 8.6%                          |       | 689                                  |       | 143                             |       | 80.0%                      |       | 83.7%                       |       | 44.0%                            |       |
| 6 Month LIBOR ARM IO      |       | 4,000                             |       | 0.1%                                |       | 8.0%                          |       | 683                                  |       | 200                             |       | 80.9%                      |       | 93.5%                       |       | 15.2%                            |       |
| 2nd Liens                 |       | 86,453                            |       | 1.5%                                |       | 10.2%                         |       | 719                                  |       | 51                              |       | 53.6%                      |       | 99.5%                       |       | 10.8%                            |       |
| 2/38 LIBOR ARM            |       | 61,955                            |       | 1.1%                                |       | 8.4%                          |       | 649                                  |       | 248                             |       | 82.9%                      |       | 91.7%                       |       | 29.8%                            |       |
| 3/37 LIBOR ARM            |       | 3,679                             |       | 0.1%                                |       | 9.4%                          |       | 642                                  |       | 230                             |       | 85.6%                      |       | 93.5%                       |       | 52.9%                            |       |
| 40 Year Fixed             |       | 3,632                             |       | 0.1%                                |       | 8.4%                          |       | 610                                  |       | 145                             |       | 78.2%                      |       | 87.5%                       |       | 87.0%                            |       |
| Total                     |       | $                                 | 5,694,891  |                                | 100.0%     |                          |       |                                 |       |                            |       |                       |       |                        |       |                             |       |   |
| Weighted  Average/Average |       |                              |       |                                |       | 7.6%                          |       | 648                                  |       | $                               | 184        |                       | 81.6%      |                        | 93.1%      |                             | 44.9%      |   |

** **

**Core Financial Measures**

***Core Net Income and Core Earnings Per Share***

Core net income and core earnings per share arenon-GAAP financial measures within the meaning of Regulation G promulgatedby the SEC. Management believes that the presentation of core net income andcore earnings per share 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 is not meant to be considered in isolationor as a substitute for financial results prepared in accordance with GAAP.

As required by Regulation G, a reconciliation ofnet income and earnings per share in the condensed consolidated statements ofoperations, presented in accordance with GAAP, to core net income and coreearnings per share is provided below for the three and six months ended June30, 2006 and 2005:

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| **($ in 000s)**                                                                                                               | ** **   | **Three Months Ended  June 30,**                                                              | ** **   | **Six Months Ended  June 30,**                                                                | ** **   |
|-----------------------------------------------------------------------------------------------------------------------------------------|--------------|--------------------------------------------------------------------------------------------------------------|--------------|--------------------------------------------------------------------------------------------------------------|--------------|
| ** **                                                                                                                              | ** **   | **2006**                                                                                                     | ** **   | **2005**                                                                                                     | ** **   | **2006** | ** ** | **2005** | ** ** |
| ***Core  net income:***                                                                                                                 | *** *** |                    | *** *** |                    | *** *** |                    | *** *** |                    | *** *** |
| Net income                                                                                                                              |         | $                                                                                                            | 3,805        |                                                                                                         | $            | 23,826 |   | $ | 16,733 |   | $ | 65,580 |   |
| Less: Mark to market  (gain) loss on portfolio derivatives included in “Other income (expense) —  portfolio derivatives” |         |                                                                                                         |         |                                                                                                         |         |   |   |   |   |
| Mark to market interest rate swaps                                                                                                      |         | 1,024                                                                                                        |         | 11,788                                                                                                       |         | (870 | ) | (8,770 | ) |
| Mark to market interest rate cap                                                                                                        |         | —                                                                                                       |         | 299                                                                                                          |         | — |   | 229 |   |
| Total mark to market on portfolio derivatives                                                                                           |         | 1,024                                                                                                        |         | 12,087                                                                                                       |         | (870 | ) | (8,541 | ) |
| Less:  Amortization of interest rate swap buydown payments                                                                              |         | (781                                                                                                         | )            | —                                                                                                       |         | (1,648 | ) | — |   |
| Core net income                                                                                                                         |         | $                                                                                                            | 4,048        |                                                                                                         | $            | 35,913 |   | $ | 14,215 |   | $ | 57,039 |   |

 
| **($ in 000s)**                                                              | ** ** | **Three Months Ended   June 30,** | ** ** | **Six Months Ended   June 30,** | ** ** |
|----------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                                             | ** ** | **2006**                                              | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| ***Core  earnings per share:***                                                        |       |                                                  |       |                                                |       |   |   |   |   |
| Net income                                                                             |       | $                                                     | 3,805      |                                                | $          | 23,826 |   | $ | 16,733 |   | $ | 65,580 |   |
| Nonvested restricted  stock dividends                                                  |       | (97                                                   | )          | (176                                                | )          | (175 | ) | (176 | ) |
| Net income available to common shareholders                                            |       | 3,708                                                 |       | 23,650                                              |       | 16,558 |   | 65,404 |   |
| Less: Mark to  market (gain) loss on portfolio derivatives                             |       | 1,024                                                 |       | 12,087                                              |       | (870 | ) | (8,541 | ) |
| Amortization of interest rate swap buydown payments                                    |       | (781                                                  | )          | —                                              |       | (1,648 | ) | — |   |
| Core net income available to common shareholders                                       |       | $                                                     | 3,951      |                                                | $          | 35,737 |   | $ | 14,040 |   | $ | 56,863 |   |
|                                                                                   |       |                                                  |       |                                                |       |   |   |   |   |
| Earnings per  share — basic and diluted                                           |       | $                                                     | 0.08       |                                                | $          | 0.49 |   | $ | 0.35 |   | $ | 1.35 |   |
| Core earnings  per share — basic and diluted                                      |       | $                                                     | 0.08       |                                                | $          | 0.74 |   | $ | 0.29 |   | $ | 1.17 |   |
|                                                                                   |       |                                                  |       |                                                |       |   |   |   |   |
| Weighted average common  shares outstanding — basic and diluted    |       | 47,677,853                                            |       | 48,462,126                                          |       | 47,974,272 |   | 48,462,057 |   |

 

The decrease in core net income during the three andsix months ended June 30, 2006 compared to the same periods in 2005 was dueprimarily to decreased funding volumes, decreased sales premiums due todecreased net interest spread available on new loans, decreased core netinterest income on loans held for investment as higher margin portfolio loansprepaid and new loans were added to the portfolio at lower margins, and thecharge to reduce second lien loans held for sale to the lower of cost or marketvalue as of June 30, 2006.

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

Core net interest income after provision for loanlosses is a non-GAAP financial measure within the meaning of Regulation Gpromulgated by the SEC. Management believes that the presentation of core netinterest income after provision for loan losses provides useful information toinvestors because this measure includes the effect of the net cash settlementson existing derivative agreements economically hedging the variable rate debtfinancing the portfolio of mortgage loans and the net cash settlements to terminatethose derivatives prior to maturity. Core net interest income after provisionfor loan losses does not include the net cash settlements to terminatederivative agreements related to loans ultimately sold. The presentation ofcore net interest income after provision for loan losses 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 ofnet interest income after provision for loan losses in the condensedconsolidated statements of operations, presented in accordance with GAAP, tocore net interest income after provision for loan losses is provided below forthe three and six months ended June 30, 2006 and 2005:

 
| **($ in 000s)**                                                                                                                   | ** **   | **2006**     | ** **   | **2005**     | ** **   | **2006**     | ** **   | **2005**     | ** **   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------------|--------------|--------------|--------------|--------------|--------------|--------------|--------------|--------------|
| ***Core  net interest income after provision for loan losses:***                                                                            | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| Net interest  income after provision for loan losses                                                                                        |         | $            | 20,789       |         | $            | 39,415       |         | $            | 45,589       |   | $ | 82,444 |   |
| Plus: Net cash  settlements received (paid) on portfolio derivatives included in “Other  income (expense) — portfolio derivatives |         | 11,845       |         | 2,655        |         | 22,109       |         | 2,369        |         |
| Less:  Amortization of interest rate swap buydown payments                                                                                  |         | (781         | )            | —       |         | (1,648       | )            | —       |         |
| Core net  interest income after provision for loan losses                                                                                   |         | $            | 31,853       |         | $            | 42,070       |         | $            | 66,050       |   | $ | 84,813 |   |
|                                                                                                                                        |         |         |         |         |         |         |         |         |         |
| Interest income  loans held for investment                                                                                                  |         | $            | 100,440      |         | $            | 80,574       |         | $            | 195,553      |   | $ | 163,410 |   |
|                                                                                                                                        |         |         |         |         |         |         |         |         |         |
| Interest expense  loans held for investment                                                                                                 |         | 77,589       |         | 41,773       |         | 146,505      |         | 80,381       |         |
| Plus: Net cash  settlements received (paid) on portfolio derivatives                                                                        |         | (11,845      | )            | (2,655       | )            | (22,109      | )            | (2,369       | )            |
| Plus:  Amortization of interest rate swap buydown payments                                                                                  |         | 781          |         | —       |         | 1,648        |         | —       |         |
| Core interest  expense — loans held for investment                                                                                     |         | 66,525       |         | 39,118       |         | 126,044      |         | 78,012       |         |
| Core net  interest income loans held for investment                                                                                         |         | 33,915       |         | 41,456       |         | 69,509       |         | 85,398       |         |
| Provision for  loan losses loans held for investment                                                                                        |         | 5,466        |         | 6,863        |         | 10,859       |         | 11,357       |         |
| Core net  interest income loans held for investment after provision for  loan losses                                                        |         | 28,449       |         | 34,593       |         | 58,650       |         | 74,041       |         |
|                                                                                                                                        |         |         |         |         |         |         |         |         |         |
| Net interest  income loans held for sale                                                                                                    |         | 3,404        |         | 7,477        |         | 7,400        |         | 10,772       |         |
| Core net interest  income after provision for loan losses                                                                                   |         | $            | 31,853       |         | $            | 42,070       |         | $            | 66,050       |   | $ | 84,813 |   |

*** ***

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*** ***
| ** **                                                                                                                   | ** **   | **2006**     | ** **   | **2005**     | ** **   | **2006**     | ** **   | **2005**     | ** **   |
|------------------------------------------------------------------------------------------------------------------------------|--------------|--------------|--------------|--------------|--------------|--------------|--------------|--------------|--------------|
| ***Core  yield analysis:***                                                                                                  | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| ***Core  yield analysis — loans held for investment:***                                                                 | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| Coupon interest  income on loans held for investment                                                                         |         | 7.21         | %            | 6.65         | %            | 7.14         | %            | 6.66         | %            |
| Amortization of  deferred origination costs                                                                                  |         | (0.44        | )%           | (0.46        | )%           | (0.47        | )%           | (0.45        | )%           |
| Prepayment fees                                                                                                              |         | 0.37         | %            | 0.75         | %            | 0.39         | %            | 0.65         | %            |
| Yield on loans  held for investment                                                                                          |         | 7.14         | %            | 6.94         | %            | 7.06         | %            | 6.86         | %            |
|                                                                                                                         |         |         |         |         |         |         |         |         |         |
| Cost of  financing for loans held for investment                                                                             |         | 5.63         | %            | 3.70         | %            | 5.40         | %            | 3.48         | %            |
| Net cash  settlements (received) paid on portfolio derivatives                                                               |         | (0.86        | )%           | (0.23        | )%           | (0.81        | )%           | (0.10        | )%           |
| Amortization of  interest rate swap buydown payments                                                                         |         | 0.06         | %            | 0.00         | %            | 0.06         | %            | 0.00         | %            |
| Core cost of  financing for loans held for investment                                                                        |         | 4.83         | %            | 3.47         | %            | 4.65         | %            | 3.38         | %            |
|                                                                                                                         |         |         |         |         |         |         |         |         |         |
| Net yield on  loans held for investment                                                                                      |         | 1.63         | %            | 3.34         | %            | 1.77         | %            | 3.49         | %            |
| Net cash settlements  received (paid) on portfolio derivatives                                                               |         | 0.84         | %            | 0.23         | %            | 0.80         | %            | 0.10         | %            |
| Amortization of  interest rate swap buydown payments                                                                         |         | (0.06        | )%           | 0.00         | %            | (0.06        | )%           | 0.00         | %            |
| Core net yield  on loans held for investment                                                                                 |         | 2.41         | %            | 3.57         | %            | 2.51         | %            | 3.59         | %            |
| Provision for  loan losses — loans held for investment                                                                  |         | (0.39        | )%           | (0.59        | )%           | (0.39        | )%           | (0.48        | )%           |
| Core yield on  loans held for investment after provision for loan losses                                                     |         | 2.02         | %            | 2.98         | %            | 2.12         | %            | 3.11         | %            |
|                                                                                                                         |         |         |         |         |         |         |         |         |         |
| ***Core  yield analysis — loans held for sale:***                                                                       | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| Yield on loans  held for sale                                                                                                |         | 8.53         | %            | 7.25         | %            | 8.26         | %            | 7.43         | %            |
| Cost of  financing for loans held for sale                                                                                   |         | 5.84         | %            | 4.11         | %            | 5.41         | %            | 4.11         | %            |
| Net yield on  loans held for sale                                                                                            |         | 4.15         | %            | 4.22         | %            | 4.50         | %            | 4.67         | %            |
|                                                                                                                         |         |         |         |         |         |         |         |         |         |
| ***Total  core yield analysis***                                                                                             | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** | *** *** |
| Total yield — net  interest income after provision for loan losses                                                      |         | 1.40         | %            | 2.95         | %            | 1.56         | %            | 3.16         | %            |
| Net cash  settlements received (paid) on portfolio derivatives                                                               |         | 0.79         | %            | 0.20         | %            | 0.75         | %            | 0.09         | %            |
| Amortization of  interest rate swap buydown payments                                                                         |         | (0.05        | )%           | 0.00         | %            | (0.06        | )%           | 0.00         | %            |
| Core yield — net  interest income on loans held for sale and loans held for investment after  provision for loan losses |         | 2.14         | %            | 3.15         | %            | 2.25         | %            | 3.25         | %            |

*** ***

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***Core net interest margin in the three and six months endedJune 30, 2006 was lower than the same periods in 2005 due to the lower netinterest spreads available on new loans added to the portfolio throughout thetwelve months ended June 30, 2006, as older loans economically hedged withlower rate swaps prepaid and were replaced with new loans with coupons that hadnot increased to the same extent as the increase in our financing costs,including the higher than current interest rate swaps.***

***Core Equity and Core Portfolio Leverage***

Core equity and core portfolio leverage are non-GAAPfinancial measures within the meaning of Regulation G promulgated by theSEC. Management believes that the presentation of core equity and coreportfolio leverage provide useful information to investors because thesemeasures exclude the cumulative non-cash mark to market gains or losses oninterest rate swap and cap agreements economically hedging the variable ratedebt financing the portfolio of mortgage loans and include the cumulativeamortization of interest rate swap buydown payments. The presentation of coreequity and core portfolio leverage are not meant to be considered in isolationor as a substitute for financial results prepared in accordance with GAAP.

As required by Regulation G, a reconciliation ofequity and portfolio leverage, presented in accordance with GAAP, to coreequity and core portfolio leverage are provided below as of June 30, 2006 andDecember 31, 2005:

 
| **($ in 000s)**                                                                                                                          | ** **   | **June 30,   2006** | ** **   | ** December 31,   2005** | ** **   |
|----------------------------------------------------------------------------------------------------------------------------------------------------|--------------|-------------------------------|--------------|-----------------------------------------|--------------|
| ***Core  equity:***                                                                                                                                | *** *** | *** ***                  | *** *** | *** ***                            | *** *** |
| Equity balance  at period end                                                                                                                      |         | $                             | 483,696      |                                    | $            | 526,643 |   |
| Less: Cumulative  mark to market (gain) loss on portfolio derivatives included in “Other income  (expense) — portfolio derivatives” |         | (26,983                       | )            | (26,113                                 | )            |
| Less: Cumulative  amortization of interest rate swap buydown payments                                                                              |         | (2,402                        | )            | (755                                    | )            |
| Core equity balance at period end                                                                                                                  |         | $                             | 454,311      |                                    | $            | 499,775 |   |
|                                                                                                                                               |         |                          |         |                                    |         |
| Portfolio debt  (warehouse financing — loans held for investment and securitization  financing)                           |         | $                             | 5,488,992    |                                    | $            | 5,377,327 |   |
| Portfolio  leverage (portfolio debt to equity)                                                                                                     |         | 11.3:1                        |         | 10.2:1                                  |         |
| Core portfolio leverage  (portfolio debt to core equity)                                                                                           |         | 12.1:1                        |         | 10.8:1                                  |         |

 

**Recent AccountingPronouncements**

In June 2006, the FASB issued FASB Interpretation No.48 *“Accounting For Uncertainty in Income Taxes-aninterpretation of FASB Statement No. 109,”*(FIN No. 48).  FIN No. 48 prescribes a recognition thresholdand measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN No. 48 also provides guidance on derecognition, classification, interestand penalties, accounting in interim periods, disclosure, and transition. FINNo. 48 is effective for fiscal years beginning after December 15, 2006.  We will adopt FIN No. 48, as applicable,beginning in fiscal

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year 2007.  Management is currently assessing the impactthat the implementation of FIN No. 48 may have on its results of operations,statements of condition or cash flows.

In March 2006, the Financial Accounting StandardsBoard (FASB) issued Statement of Financial Accounting Standards No. 156, *“Accounting For Servicing of Financial Assets — an amendment of FASBStatement No. 140,”*(Statement No. 156).  Statement No. 156 amends Statement ofFinancial Accounting Standards No. 140, *“Accounting for Transfers and Servicing ofFinancial Assets and Extinguishments of Liabilities,”* (StatementNo. 140), with respect to the accounting for separately recognizedservicing rights.  Statement No. 156requires an entity to initially recognize, at fair value, a servicing asset orservicing liability each time it undertakes an obligation to service afinancial asset by entering into a servicing contract in certainsituations.  In addition, Statement No.156 permits the subsequent measurement of servicing assets and servicingliabilities using the fair value method or the amortization method asprescribed under Statement No. 140. Statement No. 156 is effective as of the beginning of an entity’s firstfiscal year that begins after September 15, 2006.  We will adopt Statement No. 156, asapplicable, beginning in fiscal year 2007. Management believes that the implementation of Statement No. 156 willnot have a material effect on its results of operations, statements ofcondition or cash flows.

In February 2006,the FASB issued Statement of Financial Accounting Standards No. 155, *“Accounting For Certain Hybrid Financial Instruments-an amendment ofFASB Statements No. 133 and 140,”*(Statement No. 155).  Statement No. 155 amends Statement No. 133,to permit fair value remeasurement for any hybrid financial instrument with anembedded derivative that otherwise would require bifurcation, provided that thewhole instrument is accounted for on a fair value basis.  Statement No. 155 amends Statement No. 140 toallow a qualifying special-purpose entity to hold a derivative financial instrumentthat pertains to a beneficial interest other than another derivative financialinstrument.  Statement No. 155 iseffective for all financial instruments acquired, issued or subject to aremeasurement (new basis) event occurring after the beginning of an entity’sfirst fiscal year that begins after September 15, 2006.  We will adopt Statement No. 155, asapplicable, beginning in fiscal year 2007. Management believes that the implementation of Statement No. 155 willnot have a material effect on its results of operations, statements ofcondition or cash flows.

In December 2005,the FASB issued Staff Position 94-6-1*, “Terms of Loan ProductsThat May Give Rise to a Concentration of Credit Risk,”* (FSP94-6-1).  FSP 94-6-1 clarifies that loanproducts that expose an originator, holder, investor, guarantor or servicer toan increased risk of non-payment or not realizing the full value of the loan,such as non-traditional loan products, may result in a concentration of creditrisk as defined in Statement of Financial Accounting Standards No. 107, *“Disclosures about Fair Value of Financial Instruments,”*(Statement No. 107).  FSP 94-6-1 alsoemphasizes the requirement to assess the adequacy of disclosures for alllending products (including both secured and unsecured loans) and the effect ofchanges in market or economic conditions on the adequacy of those disclosures.The guidance under FSP 94-6-1 is effective for interim and annual reportingperiods ending on or after December 19, 2005 and for loan products that aredetermined to represent a concentration of credit risk, disclosure requirementsof Statement No. 107 should be provided for all periods presented.  The adoption of FSP 94-6-1 has not had asignificant impact on our consolidated financial statements.

In December 2004, the FASB issued Statement ofFinancial Accounting Standards No. 123R, “*ShareBased Payments*” (Statement No. 123R), requiring, among otherthings, that the compensation cost of stock options and other equity-basedcompensation issued to employees, which cost is based on the estimated fairvalue of the awards on the grant date, be reflected in the income statementover the requisite service period. In March 2005, the SEC staff issued StaffAccounting Bulletin No. 107 (SAB No. 107). SAB No. 107 expresses the views of the SEC regarding Statement No. 123Rand certain rules and regulations and provides the SEC’s view regarding thevaluation of share-based payment arrangements for public companies.  In April 2005, the SEC amended thecompliance dates for Statement No. 123R to the beginning of the nextfiscal year after June 15, 2005.  InNovember 2003, we adopted the fair value method of accounting for grants ofstock options and restricted stock as prescribed by Statement of FinancialAccounting Standards No. 148, “*Accounting for Stock-BasedCompensation — Transition and Disclosure.”*  Under this method, compensation cost ismeasured at

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thegrant date based on the fair value of the award and is recognized as expense ona straight-line basis over the award’s vesting period.  We adopted Statement No. 123R and SAB No. 107as of January 1, 2006, which resulted in a change in the accounting forunearned compensation whereby the balance of unearned compensation as of December31, 2005, and all subsequent unearned compensation transactions were recordedto additional paid-in capital on the consolidated statements of condition. Theimplementation of Statement No. 123R and SAB No. 107 has not had a materialeffect on our results of operations, statements of condition or cash flows.

**Off-BalanceSheet Arrangements**

As of June 30, 2006, wewere not a party to any off-balance sheet arrangements.

**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, such as now, when the Federal Reserve Bank raises short-term interestrates in an attempt to prevent inflation) and decrease during periods of lowinflation. In addition, inflation of real estate values increases the equityhomeowners have in their homes and increases the volume of refinancing loans wecan originate as borrowers draw down on the increased equity in their homes. Webelieve that real estate inflation will improve the performance of the loansoriginated by us in the past, reducing delinquencies and defaults, as borrowersprotect or borrow against the equity in their homes.

**ITEM3.**                    QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

***General***

The market risk discussions and timing of re-pricingof our interest rate sensitive assets and liabilities are forward-lookingstatements that assume that certain market conditions occur. Actual results maydiffer materially from these forecasts due to changes in our held for saleportfolio and borrowings mix and due to developments in the finance and realestate markets, including the likelihood of changing interest rates and the impactof these changes on our net interest margin, cost of funds and cash flows. Themethods we utilize to assess and mitigate these market risks should not beconsidered projections of future events or operating performance.

We carry interest-sensitive assets on ourbalance sheet that are financed by interest-sensitive liabilities. We aresubject to interest rate risk because the interval for re-pricing of the assetsand liabilities is not matched. An increase or decrease in interest rates wouldaffect our net interest income and the fair value of our mortgage loans as wellas 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.

The interest rates on our hybrid ARM loans held for investmentare fixed for the first two to three years of the loan, after which theinterest rates reset every six months to the then-current market rate. Theinterest rates on the bonds financing these loans reset to current market rateseach month during the entire term of the loan. During the period we arereceiving fixed rate payments on our loans, we use interest rate swaps to payfixed rate payments to the swap counter-party, and receive variable interestrate payments which match the interest rates on our financing interest costs.The swap of “variable for fixed” rates allows us to match fund our loans duringthe fixed period of the loans.

***Effects of Interest Rate Volatility***

Changes in interest rates impact our earnings and cashflows in several ways. Interest rate changes can affect our net interest incomeon our hybrid mortgages held for investment (net of the cost of financing theseassets). We estimate the duration of our hybrid loans in our investmentportfolio and our policy is to

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economically hedge thefinancing of the loans during the period in which the loans are paying a fixedcoupon, while being financed with floating rate debt indexed to LIBOR. Duringan increasing interest rate environment, our assets may prepay more slowly thanexpected, requiring us to finance a higher amount of fixed assets with floatingrate debt at higher interest rates than originally anticipated, resulting in adecline in our net return. In order to manage our exposure to changes in theprepayment speed of our hybrid loan assets, we regularly monitor the portfoliobalance, revise the amounts anticipated to be outstanding in future periods,and adjust the notional balance of our hedging derivatives to mitigate thisrisk.

During a rising interest rate environment, there maybe lower total loan origination and refinance activity. At the same time, arising interest rate environment may result in a larger percentage of ARMproducts being originated, mitigating the impact of lower overall loanorigination and refinance activity. Conversely, during a declining interestrate environment, consumers, in general, may favor fixed-rate mortgage productsover ARM and hybrid products.  A flat orinverted yield curve may shift borrower preference from an ARM mortgage loan toa fixed mortgage loan.

If interest rates decline, the rate of prepayment onour mortgage assets may increase during the expected two to three year initiallife of our loans held for investment. Increased prepayments would cause us toamortize the deferred origination costs of our mortgage assets faster,resulting in a reduced yield on our mortgage assets. Additionally, to theextent proceeds of prepayments cannot be reinvested at a rate of interest atleast equal to the rate previously earned on such mortgage assets, our earningsmay be adversely affected.

Conversely, if interest rates rise, the rate ofprepayment on our mortgage assets during the initial fixed pay period of theassets’ life may decrease. Decreased prepayments would cause us to amortize thedeferred origination costs of our ARM assets over a longer time period,resulting in an increased yield on our mortgage assets.

**ITEM 4.**                   CONTROLS ANDPROCEDURES.

**Disclosure Controls and Procedures**

Under thesupervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we conducted anevaluation of the effectiveness as of June 30, 2006 of our disclosure controlsand procedures, as such term is defined under Rule 13(a)-15(e) underthe Securities Exchange Act of 1934, as amended. Based on this evaluation,our principal executive officer and principal financial officer have concludedthat our system of disclosure controls and procedures were effective as of June30, 2006.

**Changes in Internal Control overFinancial Reporting**

There were nochanges to our system of internal control over financial reporting during thethree month period ended June 30, 2006 that had a material effect or couldmaterially affect the internal control over financial reporting.

 

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**PART II — OTHER INFORMAITON**

**ITEM1.**                    LEGALPROCEEDINGS.

In addition to theproceedings discussed below, we are subject to various legal proceedings in theordinary course of our business related to foreclosures, bankruptcies,condemnation and quiet title actions and alleged statutory and regulatoryviolations. Our management believes that any liability with respect to thesevarious legal actions, individually or in the aggregate, will not have amaterial adverse effect on the Company’s business, results of operations orfinancial position.

***Rhodes Litigation:***

On January 9,2006, a class action lawsuit was filed naming Fieldstone Mortgage in theNorthern District of Illinois (Eastern Division) alleging violations of theFair Credit Reporting Act (“FCRA”).  The class action is entitled Rhodesv. Fieldstone Mortgage Company. Plaintiff alleges that Fieldstone Mortgageviolated the firm offer of credit guidelines encapsulated in 15 U.S.C.§1681 et seq. during its mail marketing campaign in or around April 2005.Specifically, Plaintiff alleges that Fieldstone Mortgage did not comply withthe statutory guidelines for providing a firm offer of credit to the potentialconsumer. Pursuant to 15 U.S.C. §1681 et seq., statutory damages can rangefrom $100 to $1,000 per mailing in the event that the violation is deemedwillful.  In July 2006, Plaintiff filed amotion for class certification.  Thisaction is currently in the discovery stage.

Due to theuncertain nature of the litigation at this time, we are unable to estimate theprobable outcome of this matter.  Whilewe intend to continue to vigorously defend this claim and believe we havemeritorious defenses available, there can be no assurance the Company willprevail and that an adverse outcome would not have a material effect on theCompany’s results of operations.

***Arredondo Litigation:***

*Arredondo,et al. v. Fieldstone Investment, et al.,*is an action filedon August 3, 2004 in the United States District Court for the District ofArizona by nine former employees of Fieldstone Mortgage Company alleging thattheir supervisors and co-workers created a hostile work environment resultingfrom gender discrimination, racial discrimination and retaliation in theworkplace pursuant to Title VII of the Civil Rights Act of 1964, 42 U.S.C.§2000e, and the Civil Rights Act of 1866, 42 U.S.C. §1981, as amended by theCivil Rights Act of 1991, 42 U.S.C. §1981(a). Plaintiffs claim that they areentitled to money damages in the form of back pay and front pay and nominal,compensatory and punitive damages, costs and attorney fees and equitablerelief. We filed our answer denying all relevant claims on August 25,2004. In addition, we filed a variety of motions seeking to have some of theplaintiffs dismissed from the lawsuit for failure to exhaust theiradministrative remedies, to dismiss other claims as not being permitted underthe statute, and finally to sever the plaintiffs for trial purposes. Plaintiffsfiled a response to our motion to dismiss, sever or in the alternative,bifurcate, and on April 18, 2005, our motion to dismiss was denied.  On December 27, 2005, one of the namedPlaintiffs, Berinda Arredondo, requested and was dismissed from thelitigation.  The discovery cutoff datewas May 31, 2006.

Due to theuncertain nature of this litigation at this time, we are unable to estimate theprobable outcome of this matter.  Theplaintiffs in this matter have not specified damages sought and therefore weare unable to estimate potential exposure.

***Bass Litigation:***

On May 24, 2004, all of our former shareholderswhose shares were redeemed following the closing of the 144A Offering (the “FormerShareholders”), filed an action in the District Court of Tarrant County, Texas,against us, Fieldstone Mortgage and KPMG LLP (KPMG), alleging that the FormerShareholders whose shares were redeemed for approximately $188.1 million,are entitled to an additional post-closing redemption price payment ofapproximately $19.0 million. On September 9, 2004, KPMG served itsresponse to plaintiffs’ request for disclosure, stating, among other things,that KPMG has determined that the deferred tax asset, which is reflected in ourDecember 31, 2003 audited financial statements, should have been reflectedin our financial statements as of November 13, 2003, the day immediatelyprior to the closing of the 144A Offering. At the present time, the ultimateoutcome of this claim and the amount of liability, if any, that may result isnot determinable, and no amounts have been accrued in our financial statementswith respect to this claim.  On October 28, 2005, we served a crossclaim against KPMG. Our cross claim asserts, among other claims, that KPMG’swithdrawal of its audit report on the

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November 13, 2003 balance sheet was improper andthat due to this improper withdrawal we suffered damages.  In addition,the cross claim asserts that in the event the Former Shareholders prevail intheir suit, KPMG negligently advised us regarding the November 13, 2003balance sheet giving rise to this dispute. The cross claim seeks a judgmentagainst KPMG in an amount in excess of $1 million, plus prejudgment interestfor the attorneys fees and costs incurred in this lawsuit.  On June 26, 2006, the Former Shareholdersfiled their Third Amended Petition in which they assert an alternative claimagainst KPMG for damages.  Thislitigation is still in the discovery stage. A trial date is currently set for October 9, 2006.

We intend tovigorously defend against the claim made by the Former Shareholders. If weultimately are unsuccessful in defending this matter, we could be required tomake a cash payment of up to $19.0 million to the Former Shareholders,plus potential interest and third-party costs associated with thelitigation.  The impact of any payment onthe Company’s financial statements will be dependent upon the actual facts andcircumstances surrounding such an outcome.

***Hill Litigation:***

*Hill,et al. v. Fieldstone Mortgage Company, et al.* is a classaction filed on January 16, 2002 in the Circuit Court for Baltimore Cityby plaintiffs, who are two individuals who obtained a second mortgage loan fromFieldstone Mortgage in 1998, in the amount of $28,000, secured by theirresidence, against Fieldstone Mortgage and ten other mortgage lenders thatplaintiffs contend are or were the assignees of second mortgage loans inMaryland made by Fieldstone Mortgage. The lawsuit alleges, among other things,that (i) the defendants violated the Maryland Second Mortgage Loan Law, orSMLL, by failing to obtain the necessary license to provide a second mortgageloan and by charging fees unauthorized by the SMLL, and (ii) thedefendants violated the Maryland Consumer Protection Act by engaging in conductcontrary to the provisions of the SMLL. The plaintiffs seek a declaratoryjudgment that their mortgage contract is illegal and, therefore, that they donot need to honor their obligation to repay the second mortgage loan. Theplaintiffs also seek monetary damages in the amount of $300,000. FieldstoneMortgage, and each of the other defendants, filed motions to dismiss assertingthat, among other things, the plaintiffs’ claims are barred by the applicablethree-year statute of limitations, the plaintiffs’ failed to properly plead aclaim under the Maryland Consumer Protection Act, and the plaintiffs’ requestfor a judicial declaration that their mortgage contract is illegal is not aremedy available under either Maryland statutory or common law. The circuitcourt heard oral arguments on the motions to dismiss in January 2003. Todate, the court has not ruled on this motion. This lawsuit was consolidatedwith 14 other class actions with identical claims against other mortgagelenders. No motion for class certification has yet been filed in this case. OnMarch 30, 2006, the court held a status conference with regard to thismatter. The court requested supplemental briefings on the outstanding issuesfrom the parties.  Oral argument on theoutstanding issues was heard on July 26, 2006.

Due to theinherent uncertainties of the judicial process, we are unable to predict theoutcome of this matter.  While we intendto continue to vigorously defend this claim and believe we have meritoriousdefenses available to us, there can be no assurance we will prevail.

For moreinformation on our other material legal proceedings, see our Annual Report onForm 10-K, as amended, for the fiscal year ended December 31, 2005 and ourQuarterly Report on Form 10-Q for the period ended March 31, 2006.

**ITEM1A.**            RISKFACTORS.

There have been nomaterial changes to the risk factors previously disclosed in our Annual Reporton Form 10-K for the fiscal year ended December 31, 2005, except as follows:

**The failure to prevail in ourlitigation with our former shareholders could have a negative effect on ourliquidity.**

On May 24, 2004, certainof our former shareholders prior to the closing of the 144A Offering, filed alawsuit against us alleging that they are entitled to an additionalpost-closing redemption price payment of between $15.8 million and $19.8million. These shareholders’shares were redeemed following the closing of the144A Offering, for approximately $186.3 million. On June 14, 2004, we filed ouranswer generally denying all of the allegations in the complaint. TheRedemption Agreement between the redeemed shareholders and us required us toadjust the

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redemption price we paidto the redeemed shareholders based on our November 13, 2003 balance sheet, asaudited by KPMG LLP (KPMG). On January 12, 2004, KPMG issued an independentauditors’ report of our November 13, 2003 balance sheet. Based on the November13, 2003 balance sheet and the terms of the Redemption Agreement, we paid anadditional $1.8 million to the redeemed shareholders on February 18, 2004, fora total adjusted redemption price of $188.1 million. The lawsuit alleges thatour November 13, 2003 balance sheet should have included a deferred tax assetthat, if included, would have increased our net worth on November 13, 2003. Thelawsuit also alleges that the redeemed shareholders are entitled to an increasein the redemption price if our November 13, 2003 balance sheet is revised toinclude the deferred tax asset. On April 20, 2004, following notification bythe redeemed shareholders of their dispute concerning our November 13, 2003balance sheet, KPMG advised that their January 12, 2004 independent auditors’report of our November 13, 2003 balance sheet should no longer be relied upon.On September 9, 2004, in its response to a request for disclosure from theplaintiffs, KPMG stated, among other things, that it had determined that thedeferred tax asset, which is reflected in our December 31, 2003 auditedfinancial statements, should have been reflected in our November 13, 2003balance sheet. On October 28, 2005, we served a cross claim against KPMGasserting, among other claims, that KPMG’s withdrawal of its audit report onthe November 13, 2003 balance sheet was improper and that due to this improperwithdrawal we suffered damages. On June 26, 2006, the former shareholders filedtheir Third Amended Petition in which they assert an alternative claim againstKPMG for damages.   If we ultimately are unsuccessful defending theshareholder suit, we could be required to pay to the redeemed shareholders anamount in excess of $19.0 million, plus any potential interest orthird-party costs associated with the litigation, which at such timecould have an adverse effect on our liquidity. The impact of any payment on ourfinancial statements will be dependent upon the actual facts and circumstancessurrounding such an outcome.

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

**IssuerPurchases of Equity Securities**

The following table sets forth information withrespect to purchases made by us or on our behalf of our common stock during thesecond quarter of 2006 (dollars in thousands, except per share data): 
| **Period(1)**              | ** ** | **Total  Number of  Shares  Purchased** | ** ** | **Average  Price  Paid per  Share** | ** ** | **Total Number of  Shares Purchased  as Part of  Publicly Announced  Program(2)** | ** ** | **Approximate  Dollar Value of  Shares that May  Yet Be Purchased  Under the Program** | ** ** |
|----------------------------|------------|----------------------------------------------|------------|------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                 | ** ** | ** **                                   | ** ** | ** **                               | ** ** | ** **                                                                                                      | ** ** | ** **                                                                                                                     | ** ** |
| May 1 – May 31,  2006 |       | 1,632,000                                    |       | $10.28                                   |       | 1,632,000                                                                                                       |       | $19,877                                                                                                                        |       |

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(1)             Noshares were repurchased during the months of April and June 2006.

(2)             TheBoard of Directors authorized the repurchase of up to $40 million ofoutstanding common shares under a stock repurchase program announced onNovember 28, 2005. Subject to applicable federal and state securities lawsand Maryland General Corporation Law, purchase decisions will be taken basedupon market conditions and other factors. Purchases may be made from time totime through December 31, 2006 in the open market at prevailing marketprices or through negotiated private transactions, at management’s discretion,subject to our standard policies on trading periods, including “black-out”periods related to the public announcement of earnings.

**ITEM 3.**                    DEFAULTS UPONSENIOR SECURITIES.

Not applicable.

**ITEM 4.**                    SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS.

At the Annual Meeting of Stockholders held on June 1,2006, the stockholders voted on the following matters:

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1.  Elected the persons named below to the Boardof Directors by the following votes (representing all members of our Board ofDirectors):

| Name of Nominee       | ** ** | **Number of  Votes Cast For** | ** ** | **Number of  Votes Withheld** |
|-----------------------|------------|-------------------------------|------------|-------------------------------|
| Thomas D. Eckert      |       | 42,651,851                    |       | 2,547,719                     |
| David S. Engelman     |       | 42,665,541                    |       | 2,534,029                     |
| Celia V. Martin       |       | 42,577,276                    |       | 2,622,294                     |
| Jonathan E. Michael   |       | 41,397,733                    |       | 3,801,837                     |
| David A. Schoenholz   |       | 42,659,081                    |       | 2,540,489                     |
| Michael J. Sonnenfeld |       | 42,623,682                    |       | 2,575,888                     |
| Jeffrey R. Springer   |       | 42,656,249                    |       | 2,543,321                     |

 

2.   Ratified the appointment of Deloitte & Touche LLP as the Company’sindependent registered public accounting firm for the fiscal year endingDecember 31, 2006 by a vote of 45,057,363 FOR; 113,794 AGAINST; and 28,313ABSTENTIONS.

**ITEM 5.**                    OTHERINFORMATION.

Not applicable.

**ITEM 6.**                    EXHIBITS.

See the ExhibitIndex for list of exhibits filed with this report.

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**SIGNATURES**

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of1934, as amended, the registrant has duly caused this report to be signed onits behalf by the undersigned, thereunto duly authorized.
|                       |   | FIELDSTONE INVESTMENT CORPORATION |
|-----------------------|--------|-----------------------------------|
|                  |   | (registrant)                      |
|                  |   |                              |   |   |
|                  |   |                              |   |   |
| Dated August 14, 2006 |   | By:                               |   | /s/ Michael J. Sonnenfeld |
|                  |   |                              |   | Michael J. Sonnenfeld |
|                  |   |                              |   | *President and Chief Executive Officer* |
|                  |   |                              |   | * * |
|                  |   |                              |   | * * |
| Dated August 14, 2006 |   | By:                               |   | /s/ Nayan V. Kisnadwala |
|                  |   |                              |   | Nayan V. Kisnadwala*Executive Vice President and Chief Financial Officer* |

 

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**EXHIBITINDEX**
| Exhibit  Number | ** ** | **Description**                                                                                                                                                                                                                                                                           |
|-----------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |       |                                                                                                                                                                                                                                                                                      |
| 10.1(1)         |       | Amendment No. 2 dated as of April 10, 2006 by  and among Fieldstone Investment Corporation, Fieldstone Mortgage Company and  JPMorgan Chase Bank, N.A. to 4/04 Amended and Restated Senior Secured Credit  Agreement dated as of April 21, 2004, as amended.                         |
|            |       |                                                                                                                                                                                                                                                                                      |
| 10.2(2)         |       | Amendment No. 6 dated as of April 24, 2006 by  and among Fieldstone Investment Corporation, Fieldstone Mortgage Company and  Merrill Lynch Bank USA to that certain Master Repurchase Agreement dated as  of November 12, 2004, as amended.                                          |
|            |       |                                                                                                                                                                                                                                                                                      |
| 10.3(2)         |       | Amendment No. 3 dated as of April 27, 2006 by  and among Fieldstone Investment Corporation, Fieldstone Mortgage Company and  Credit Suisse First Boston Mortgage Capital LLC to the Second Amended and  Restated Master Repurchase Agreement dated as of March 31, 2005, as amended. |
|            |       |                                                                                                                                                                                                                                                                                      |
| 10.4(3)         |       | Amendment No. 3 dated as of June 13, 2006 by  and among Fieldstone Investment Corporation, Fieldstone Mortgage Company and  JPMorgan Chase Bank, N.A. to 4/04 Amended and Restated Senior Secured Credit  Agreement dated as of April 21, 2004, as amended.                          |
|            |       |                                                                                                                                                                                                                                                                                      |
| 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. (Furnished herewith)                                                                            |

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(1)             Incorporatedby reference to the registrant’s Form 8-K filed with the SEC on April 13,2006.

(2)             Incorporatedby reference to the registrant’s Form 8-K filed with the SEC on April 28,2006.

(3)             Incorporatedby reference to the registrant’s Form 8-K filed with the SEC on June 15,2006.

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