**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


_____________________


**FORM
      10-Q**





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


or


o  Transition
      Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of
      1934


For
      the
      Transition Period from   to





Commission
      File Number **001-32447**


_____________________













**SAXON
      CAPITAL, INC.**


(Exact
      Name of Registrant as Specified in Its Charter)





**Maryland**
            **30-0228584**(State
                or Other Jurisdiction of Incorporation)
            (I.R.S.
                Employer Identification No.)**4860
                Cox Road**
              **Suite
                300**
              **Glen
                Allen, Virginia 23060**
            **23060**(Address
                of Principal Executive Offices)
            (Zip
                Code)





Registrant’s
      Telephone Number, Including Area Code: **(804)
      967-7400**.


_____________________





Indicate
      by check mark whether the registrant: (1) has filed all reports required to
      be
      filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
      the
      preceding 12 months (or for such shorter period that the registrant was required
      to file such reports) and (2) has been subject to such filing requirements
      for
      the past 90 days.





Yes
            x
            No
            o





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





Large
                accelerated filerx
            Accelerated
                filero
            Non-accelerated
                filero





Indicate
      by check mark whether the registrant is a shell company (as defined in Rule
      12b-2 of the Exchange Act).





Yes
            o
            No
            x





As
      of
      August 8, 2006 there were 50,080,215 shares of our common stock, par value
      $0.01 per share, outstanding.










**TABLE
                OF CONTENTS****Page****Part
                I**
            **Financial
                Information**Item
                1.
            Financial
                StatementsUnaudited
                Consolidated Balance Sheets at June 30, 2006 and December 31,
                2005
            1Unaudited
                Consolidated Statements of Operations for the three and six months
                ended
                June 30, 2006 and June 30, 2005
            2Unaudited
                Consolidated Statement of Shareholders’ Equity for the six months ended
                June 30, 2006 and June 30, 2005
            3Unaudited
                Consolidated Statements of Cash Flows for the six months ended June
                30,
                2006 and June 30, 2005
            4Notes
                to Unaudited Consolidated Financial Statements
            5Item
                2.
            Management’s
                Discussion and Analysis of Financial Condition and Results of
                Operations
            36Item
                3.
            Quantitative
                and Qualitative Disclosures About Market Risk
            79Item

                4.
            Controls
                and Procedures
            83**Part
                II**
            **Other
                Information**Item
                1.
            Legal
                Proceedings
            84Item
                1A.
            Risk
                Factors
            85Item
                2.
            Unregistered
                Sales of Equity Securities and Use of Proceeds
            85Item
                3.
            Defaults
                Upon Senior Securities
            85Item
                4.
            Submission
                of Matters to a Vote of Security Holders
            86Item
                5.
            Other
                Information
            87Item
                6.
            Exhibits
            87







i




**Part
      I.**  **Financial
      Information**


**Item
      1.**  **Financial
      Statements**





**Saxon
      Capital, Inc.**


**Consolidated
      Balance Sheets**


**(in
      thousands, except share data)**


**(unaudited)**





**June
                30, 2006**
            **December
                31, 2005****Assets:**Cash
            $13,344
            $6,053Trustee
                receivable
            139,937
            135,957Restricted
                cash
            6,005
            147,473Accrued
                interest receivable, net of allowance for past due interest of $14,671
                and
                $16,086 respectively
            43,055
            38,182Mortgage
                loan portfolio
            6,758,659
            6,444,872Allowance
                for loan losses
            (35,412)
            (36,639)Net
                mortgage loan portfolio
            6,723,247
            6,408,233Servicing
                related advances
            220,101
            185,297Mortgage
                servicing rights, net
            145,327
            129,742Real
                estate owned
            41,079
            38,933Derivative
                assets
            40,023
            19,954Deferred
                tax asset
            53,908
            53,724Other
                assets, net
            70,621
            68,530Total
                assets
            $7,496,647
            $7,232,078**Liabilities
                and shareholders’ equity:****Liabilities:**Accrued
                interest payable
            $10,588
            $8,357Dividends
                payable
            25,468
            32,539Warehouse
                financing
            245,979
            378,144Securitization
                financing
            6,434,332
            6,182,389Derivative
                liabilities
            21,022
            8,589Senior
                notes
            150,000
            —Other
                liabilities
            29,577
            28,925Total
                liabilities
            6,916,966
            6,638,943Commitments
                and contingencies - Note 10
            —
            —**Shareholders’
                equity:**Common
                stock, $0.01 par value per share, 100,000,000 shares authorized;
                shares
                issued and outstanding: 50,080,215 and 50,001,909 as of June 30,
                2006 and
                December 31, 2005, respectively
            501
            500Additional
                paid-in capital
            636,298
            634,023Accumulated
                other comprehensive loss, net of income tax of $(12) and $(16),
                respectively
            (277)
            (355)Accumulated
                deficit
            (56,841)
            (41,033)Total
                shareholders’ equity
            579,681
            593,135Total
                liabilities and shareholders’ equity
            $7,496,647
            $7,232,078




The
      accompanying notes are an integral part of these consolidated financial
      statements.







1




**Saxon
      Capital, Inc.**


**Consolidated
      Statements of Operations**


**(in
      thousands, except per share data)**


**(unaudited)**





**Three
                Months Ended June 30,**
            **Six
                Months Ended June 30,****2006**
            **2005**
            **2006**
            **2005****Revenues
                and Gains:**Interest
                income
            $124,114
            $111,077
            $245,394
            $223,499Interest
                expense
            (97,568)
            (61,487)
            (183,335)
            (116,478)Net
                interest income
            26,546
            49,590
            62,059
            107,021Provision
                for mortgage loan losses
            (13,410)
            (9,428)
            (13,987)
            (11,736)Net
                interest income after provision for mortgage loan losses
            13,136
            40,162
            48,072
            95,285Servicing
                income, net of amortization and impairment
            20,430
            17,224
            40,070
            30,790Derivative
                gains (losses)
            14,732
            (15,084)
            25,371
            6,150(Loss)
                gain on sale of assets
            (346)
            706
            (1,768)
            2,407Total
                net revenues and gains
            47,952
            43,008
            111,745
            134,632**Expenses:**Payroll
                and related expenses
            17,578
            16,255
            35,327
            38,006General
                and administrative expenses
            14,566
            15,339
            27,992
            31,359Depreciation
            1,761
            1,336
            3,528
            2,843Other
                expense, net
            1,016
            137
            2,556
            1,841Total
                operating expenses
            34,921
            33,067
            69,403
            74,049Income
                before taxes
            13,031
            9,941
            42,342
            60,583Income
                tax expense (benefit)
            4,385
            2,944
            7,297
            (383)**Income
                before cumulative effect of change in accounting
                principle**
            8,646
            6,997
            35,045
            60,966Cumulative
                effect of change in accounting principle
            —
            31
            —
            31**Net
                income**
            $8,646
            $7,028
            $35,045
            $60,997**Earnings
                per common share:**Weighted
                average common shares - basic
            50,055
            49,884
            50,035
            49,867Weighted
                average common shares - diluted
            51,045
            50,848
            51,086
            50,653Basic
                earnings per common share before cumulative effect of change in accounting
                principle
            $0.17
            $0.14
            $0.70
            $1.22Cumulative
                effect of change in accounting principle
            —
            —
            —
            —Basic
                earnings per common share
            $0.17
            $0.14
            $0.70
            $1.22Diluted
                earnings per common shares before cumulative effect of change in
                accounting principle
            $0.17
            $0.14
            $0.69
            $1.20Cumulative
                effect of change in accounting principle
            —
            —
            —
            —Diluted
                earnings per common share
            $0.17
            $0.14
            $0.69
            $1.20Dividends
                declared per common share
            $0.50
            $0.55
            $1.00
            $0.55







The
      accompanying notes are an integral part of these consolidated financial
      statements.




2




**Saxon
      Capital, Inc.**


**Consolidated
      Statements of Shareholders’ Equity**


**Six
      Months Ended June 30, 2006 and 2005**


**(in
      thousands, except share and per share amounts)**


**(unaudited)**





**Common
                Shares Outstanding**
            **Common**
              **Stock**
            **Additional**
              **Paid-in
                Capital**
            **Accumulated**
              **Other**
              **Comprehensive**
              **Loss**
            **Accumulated**
              **Deficit**
            **Total****Balance
                as of January 1, 2006**
            50,001,909
            $500
            $634,023
            $(355)
            $(41,033)
            $593,135Issuance
                of common stock
            78,306
            1
            543
            —
            —
            544Shared-based
                compensation expense
            —
            —
            1,699
            —
            —
            1,699Share
                based compensation tax benefit
            —
            —
            33
            —
            —
            33Dividends
                declared ($1.00 per common share)
            —
            —
            —
            —
            (50,853)
            (50,853)**Comprehensive
                income:**Net
                income
            —
            —
            —
            —
            35,045Mortgage
                bonds:Change
                in unrealized loss
            —
            —
            —
            85
            —Reclassification
                adjustment
            —
            —
            —
            (4)
            —Tax
                effect
            —
            —
            —
            (3)
            —**Total
                comprehensive income**
            —
            —
            —
            78
            35,045
            35,123**Balance
                as of June 30, 2006**
            50,080,215
            $501
            $636,298
            $(277)
            $(56,841)
            $579,681







**Common
                Shares Outstanding**
            **Common**
              **Stock**
            **Additional**
              **Paid-in
                Capital**
            **Accumulated**
              **Other**
              **Comprehensive**
              **Loss**
            **Accumulated
                Deficit**
            **Total****Balance
                as of January 1, 2005**
            49,849,386
            $498
            $625,123
            $(474)
            $(38,074)
            $587,073Issuance
                of common stock
            53,115
            1
            751
            —
            —
            752Shared-based
                compensation expense
            —
            —
            1,592
            —
            —
            1,592Share-based
                compensation tax benefit
            —
            —
            21
            —
            —
            21Cumulative
                effect of change in accounting principle
            —
            —
            (31)
            —
            —
            (31)Dividends
                declared ($0.55 per share)
            —
            —
            —
            —
            (27,883)
            (27,883)**Comprehensive
                income:**
              Net
                income
            —
            —
            —
            —
            60,997Mortgage
                bonds:Change
                in unrealized loss
            —
            —
            —
            (199)
            —Reclassification
                adjustment
            —
            —
            —
            343
            —Tax
                effect
            —
            —
            —
            (6)
            —**Total
                comprehensive income**
            —
            —
            —
            138
            60,997
            61,135**Balance
                as of June 30, 2005**
            49,902,501
            $499
            $627,456
            $(336)
            $(4,960)
            $622,659





The
        accompanying notes are an integral part of these consolidated financial
        statements.


The




3


**Saxon
      Capital, Inc.**


**Consolidated
      Statements of Cash Flows**


**(in
      thousands)**


**(unaudited)**




**Six
                Months Ended June 30,****2006**
            **2005****Operating
                Activities:**Net
                income
            $35,045
            $60,997Adjustments
                to reconcile net income to net cash provided by operating
                activities:Depreciation
                and amortization
            49,591
            34,401Deferred
                income tax benefit
            (184)
            (15,008)Impairment
                of assets
            3,452
            3,119Non
                cash change in fair value of derivative instruments
            (12,842)
            4,216Loss
                (gain) on sale of assets
            1,768
            (2,407)Provision
                for mortgage loan losses
            13,987
            11,736Provision
                for past due interest
            6,378
            6,663Compensation
                expense for share-based compensation plans
            1,699
            1,592Cumulative
                effect of change in accounting principle
            —
            (31)Increase
                in servicing related advances
            (34,804)
            (23,939)(Increase)
                decrease in accrued interest receivable
            (4,638)
            285Increase
                (decrease) in accrued interest payable
            2,231
            (1,136)Increase
                in trustee receivable
            (3,980)
            (23,362)Decrease
                in income tax receivable
            2,653
            29,729Proceeds
                from (purchases of) derivative instruments
            5,206
            (4,271)Net
                change in miscellaneous assets and liabilities
            (7,299)
            (5,917)Net
                cash provided by operating activities
            58,263
            76,667**Investing
                Activities:**Purchase
                and origination of mortgage loans
            (1,680,133)
            (1,614,182)Principal
                payments received on mortgage loan portfolio
            1,229,260
            1,181,764Proceeds
                from the sale of mortgage loans
            77,454
            216,396Proceeds
                from the sale of real estate owned
            27,259
            29,074Decrease
                (increase) in restricted cash
            141,468
            (203,316)Acquisition
                of mortgage servicing rights
            (43,588)
            (51,998)Capital
                expenditures
            (4,111)
            (5,888)Net
                cash used in investing activities
            (252,391)
            (448,150)**Financing
                Activities:**Proceeds
                from issuance of securitization financing-bonds
            1,478,029
            1,979,971Proceeds
                from issuance of securitization financing-certificates
            30,167
            40,824Proceeds
                received from issuance of senior notes
            150,000
            —Debt
                issuance costs
            (10,490)
            (6,340)Principal
                payments on securitization financing-bonds
            (1,253,224)
            (1,231,030)Principal
                payments on securitization financing-certificates
            (3,518)
            (18,264)Repayment
                of warehouse financing, net
            (132,165)
            (339,541)Proceeds
                received from issuance of stock
            544
            752Payment
                of dividends
            (57,924)
            (56,791)Net
                cash provided by financing activities
            201,419
            369,581Net
                increase (decrease) in cash
            7,291
            (1,902)Cash
                at beginning of period
            6,053
            12,852Cash
                at end of period
            $13,344
            $10,950**Supplemental
                Cash Flow Information:**Cash
                paid for interest
            $(176,030)
            $(119,443)Cash
                received for income taxes, net
            $4,797
            $15,118**Non-Cash
                Investing Activities:**Transfer
                of mortgage loans to real estate owned
            $46,698
            $40,517





The
      accompanying notes are an integral part of these consolidated financial
      statements.


4





**Notes
      to Consolidated Financial Statements**





**(1)**  **Organization
      and Summary of Significant Accounting Policies**




**(a)**  **The
      Company and Principles of Consolidation**




The
      accompanying unaudited consolidated financial statements have been prepared
      in
      conformity with the instructions to Form 10-Q and Article 10, Rule 10-01 of
      Regulation S-X for interim financial statements. Accordingly, they do not
      include all of the information and footnotes required by accounting principles
      generally accepted in the United States of America, or GAAP, for complete
      financial statements.





In
      the
      opinion of management, the accompanying unaudited consolidated financial
      statements contain all adjustments, consisting of normal recurring accruals,
      necessary for a fair presentation. The results of operations and other data
      for
      the three and six months ended June 30, 2006 are not necessarily indicative
      of
      the results that may be expected for any other interim periods or the entire
      year ending December 31, 2006. Certain information and footnote disclosures
      normally included in the audited consolidated financial statements prepared
      in
      accordance with GAAP have been omitted. The unaudited consolidated financial
      statements presented herein should be read in conjunction with the consolidated
      financial statements and related notes thereto included in Saxon Capital, Inc.’s
      Annual Report on Form 10-K for the year ended December 31, 2005, filed with
      the
      Securities and Exchange Commission. Use of the term “Company” throughout these
      Notes to Unaudited Consolidated Financial Statements shall be deemed to refer
      to
      or include the applicable subsidiaries of the Company. The unaudited
      consolidated financial statements of the Company include the accounts of all
      wholly-owned subsidiaries. All inter-company balances and transactions have
      been
      eliminated in consolidation.





Saxon
      Capital, Inc., a Delaware corporation (“Old Saxon”) was formed on April 23, 2001
      and acquired all of the issued and outstanding capital stock of SCI Services,
      Inc. from Dominion Capital, Inc., a wholly-owned subsidiary of Dominion
      Resources, Inc., on July 6, 2001. Saxon Capital, Inc., a Maryland corporation
      (formerly known as Saxon REIT, Inc.) (“New Saxon,” and together with Old Saxon,
      referred to herein as “Saxon” or the “Company”), was formed on February 5, 2004
      for the purpose of effecting Old Saxon’s conversion to a real estate investment
      trust, or REIT. The REIT conversion was completed on September 24,
      2004.





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




The
      preparation of financial statements in conformity with accounting principles
      generally accepted in the United States of America, or GAAP, requires management
      to make estimates and assumptions that affect the reported amounts of assets
      and
      liabilities and disclosure of contingent assets and liabilities at the date
      of
      the financial statements and the reported amount of revenues and expenses during
      the reporting period. Actual results could differ from those estimates. The
      recorded balances most affected by the use of estimates are allowance for loan
      losses and past due interest, valuation of mortgage servicing
      rights, deferral of certain direct loan origination costs, amortization of
      yield
      adjustments to net interest income, and income taxes.





5





****


**(c)**  **Stock
      Options**




The
      Company adopted Statement of Financial Accounting Standard, or SFAS, No. 123(R), *Share
      Based Payment,* on April
      1, 2005 to account for its two share-based compensation plans, namely its 2001
      Stock Incentive Plan and its 2004 Employee Stock Purchase Plan. The Company
      opted to utilize the modified prospective method of transition in adopting
      SFAS
      No. 123(R), thus prior periods were not restated. Prior to adopting SFAS No.
      123(R), the Company accounted for its share based payments in accordance with
      Accounting Principles Board, or APB, Opinion No. 25, *Accounting
      for Stock Issued to Employees* .




The
      following table illustrates that there would have been no effect on net income
      and earnings per share if the Company had applied the fair value method using
      the Black-Scholes option pricing model to options and restricted stock units
      granted to employees during the six months ended June 30, 2005. This is because
      all outstanding options were vested upon the Company’s conversion to REIT status
      in 2004, and restricted stock unit awards are accounted for similarly under
      either method.




**Six
                Months Ended**
              **June
                30,****2005**Net
                income
            $60,997Add:
                share-based compensation expense included in net income, net of related
                tax effects
            694Deduct:
                total share-based compensation expense determined under fair value
                based
                method for all awards, net of related tax effects
            (694)Pro
                forma net income
            $60,997Earnings
                per share:Basic
                - as restated
            $1.22Basic
                - pro forma
            $1.22Diluted
                - as restated
            $1.20Diluted
                - pro forma
            $1.20




(d) 
**Impaired
      Loans Acquired in a Transfer**




The
        Company periodically acquires mortgage loans that show evidence of deterioration
        of credit quality since the mortgage loans’ origination, and if it is probable
        that the Company will not be able to collect all amounts contractually due,
        the
        Company determines the excess of contractual amounts due on these mortgage
        loans
        over their fair value at the time of acquisition. The fair value of these
        credit
        impaired loans is based on historical prices received on the
        Company's delinquent loan sales to third parties. This excess amount is
        recorded as a nonaccretable difference that reduces the carrying value of
        the
        mortgage loans on the Company’s balance sheet. Statement of Position (SOP) 03-3,





6


*Accounting
        for Certain Loans or Debt Securities Acquired in a Transfer,* states
        that the nonaccretable difference should be calculated as the excess of
        contractual amounts due over the cash flows expected to be collected at the
        time
        of acquisition. The use of fair value provides a result similar to the use
        of
        cash flows expected to be collected at the time of acquisition. The excess
        of
        the fair value over the amount paid for these mortgage loans at the time
        of
        acquisition is recorded as an accretable difference, and accreted into interest
        income over the remaining life of the mortgage loans. On a quarterly basis,
        these mortgage loans are reevaluated to determine if there have been any
        subsequent increases in fair value, and if so, the Company adjusts the amount
        of
        accretable difference recognized on a prospective basis over the mortgage
        loan’s
        remaining life. Subsequent decreases in fair value due to further credit
        impairment are reserved for within the provision for mortgage loan
        losses.


**(e)**  **Recently
      Issued Accounting Pronouncements**





In
      February 2006, t he
      FASB
      issued SFAS No. 15 5, *Accounting
      for Certain Hybrid Instruments* ,
      which
      allows financial instruments that have embedded derivatives to be accounted
      for
      as a whole (eliminating the need to bifurcate the derivative from its host)
      if
      the holder elects to account for the whole instrument on a fair value basis.
      SFAS No. 155 is effective for all financial instruments acquired or issued
      after
      the beginning of an entity’s first fiscal year that begins after September 15,
      2006. The adoption of this statement is not anticipated to have a significant
      impact on the Company’s financial condition or results of
      operations.




In
      March
      2006, the FASB issued SFAS No. 156, *Accounting
      for Servicing of Financial Assets - An Amendment of FASB Statement No. 140.* This
      standard amends the guidance in FASB Statement No. 140, *Accounting
      for Transfers and Servicing of Financial Assets and Extinguishments of
      Liabilities.* Among
      other requirements, SFAS No. 156 requires an entity to recognize a servicing
      asset or servicing liability each time it undertakes an obligation to service
      a
      financial asset by entering into a servicing contract in any of the following
      situations: a transfer of the servicer’s financial assets that meets the
      requirements for sale accounting; a transfer of the servicer’s financial assets
      to a qualifying special-purpose entity in a guaranteed mortgage securitization
      in which the transferor retains all of the resulting securities and classifies
      them as either available-for-sale securities or trading securities; or an
      acquisition or assumption of an obligation to service a financial asset that
      does not relate to financial assets of the servicer or its consolidated
      affiliates. SFAS No. 156 is effective the beginning of the first fiscal year
      beginning after September 15, 2006. At this time, management has not yet
      completed its assessment of the impact of the implementation of this
      statement.




In
      July
      2006, the FASB issued FASB Interpretation No. 48, *Accounting
      for Uncertainty in Income Taxes* ,
      or FIN
      48 *.* This
      interpretation clarifies the accounting for uncertainty in income taxes
      recognized in an enterprise’s financial statements in accordance with FASB
      Statement No. 109, *Accounting
      for Income Taxes* .
      FIN 48
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return. FIN 48 also provides guidance on derecognition,
      classification, interest and penalties, accounting in interim periods,
      disclosure and transition. FIN 48 is effective for fiscal years beginning after
      December 15, 2006. At this time, management has not yet completed its assessment
      of the impact of this interpretation.







7





**(2)**  **Subsequent
      Events**




During
      the second quarter of 2006, the Company received a notice from the sponsor
      of a
      securitized mortgage loan pool that the Company services in its third-party
      servicing business. The notice demanded recovery of certain funds that the
      Company had previously claimed or did not remit, representing reimbursements
      made to borrowers of, or waivers of, prepayment penalties relating to loans
      claimed to have been made by a loan originator entitled to federal preemption
      of
      state restrictions on prepayment penalties. During the second quarter of 2006,
      this claim was neither probable nor estimable. However in July 2006, the Company
      agreed to reimburse the full amount of the claim. The Company accrued $1.4
      million in June 2006 based on these developments, and the amount is reflected
      in
      the consolidated statements of operations as a reduction in servicing
      income.





The
      Company entered into a new $300.0 million committed repurchase facility with
      DB
      Structured Products, Inc. effective July 19, 2006. The facility allows for
      the
      financing of mortgage loan purchases or originations as well as mortgage bonds
      and servicing advances required by the Company’s mortgage servicing contracts.
      The term of the facility expires on July 18, 2007.





The
      Company’s $300.0 million Bank of America, N.A. repurchase facility was
      terminated effective July 24, 2006.




On
        August
        9, 2006, the Company announced that it has entered into a definitive agreement
        with Morgan Stanley Mortgage Capital Inc. (“Morgan Stanley”) pursuant to which
        Morgan Stanley will acquire the Company for $14.10 per common share in cash,
        or
        approximately $706 million, through a merger between the Company and a
        wholly-owned subsidiary of Morgan Stanley. The transaction is expected to
        close
        in the fourth quarter of 2006, pending regulatory approval, approval by the
        Company’s shareholders and the satisfaction of other customary closing
        conditions. The impact on the Company's consolidated financial statements
        has
        not yet been determined
  **(3)**  **Earnings
      Per Share**




Basic
      earnings per share is based on the weighted average number of common shares
      outstanding, excluding any dilutive effects of options, warrants, or restricted
      stock units. Diluted earnings per share is based on the weighted average number
      of common shares, dilutive stock options, dilutive stock warrants, and dilutive
      restricted stock units outstanding during the year. Computations of earnings
      per
      share were as follows:




**Three
                Months Ended**
              **June
                30,**
            **Six
                Months Ended**
              **June
                30,****2006**
            **2005**
            **2006**
            **2005**(in
                thousands, except per share data)**Basic:**Net
                income
            $8,646
            $7,028
            $35,045
            $60,997Weighted
                average common shares outstanding
            50,055
            49,884
            50,035
            49,867Earnings
                per share
            $0.17
            $0.14
            $0.70
            $1.22**Diluted:**Net
                income
            $8,646
            $7,028
            $35,045
            $60,997Weighted
                average common shares outstanding
            50,055
            49,884
            50,035
            49,867Dilutive
                effect of stock options, warrants and restricted stock
                units
            990
            964
            1,051
            786Weighted
                average common shares outstanding - diluted
            51,045
            50,848
            51,086
            50,653Earnings
                per share
            $0.17
            $0.14
            $0.69
            $1.20










8





**(4)**  **Net
      Mortgage Loan Portfolio**




Mortgage
      loans reflected on the Company’s consolidated balance sheets as of June 30, 2006
      and December 31, 2005 were comprised of the following:








**June
                30, 2006**
            **December
                31, 2005**($
                in thousands)Securitized
                mortgage loans - principal balance
            $6,277,069
            $5,894,780Unsecuritized
                mortgage loans - principal balance
            369,557
            439,632Premiums,
                net of discounts
            99,820
            95,634Deferred
                origination costs, net
            11,195
            12,100Purchase
                accounting fair value adjustments
            2,307
            2,726Non-accretable
                differences
            (1,289)
            -Total
            6,758,659
            6,444,872Less
                allowance for loan losses
            (35,412)
            (36,639)Net
                mortgage loan portfolio
            $6,723,247
            $6,408,233




Non-accretable
        differences relate to mortgage loans the Company acquired during the six
        months
        ended June 30, 2006 that showed evidence of deterioration of credit quality
        since origination of the mortgage loans. This amount represents the excess
        of
        contractual amounts due at the time of acquisition over the fair value of
        the
        impaired mortgage loans at the time of acquisition, and is therefore not
        being
        accreted into interest income. The fair value and the estimated remaining
        contractual payments due on these mortgage loans at the time of acquisition
        were
        $0.7 million and $2.6 million, respectively. The outstanding principal balance
        and related carrying amount for these mortgage loans as of June 30, 2006
        were
        $2.1 million and $0.6 million, respectively. During the six months ended
        June
        30, 2006, $0.3 million of non-accretable differences was reclassified to
        accretable yield. This reclassification represents the amount of subsequent
        increases in fair value for some of these impaired mortgage loans and is
        accreted into interest income on a prospective basis over the mortgage loan’s
        remaining life. The following table summarizes activity relating to accretable
        yield on these impaired mortgage loans, which is included as a component
        of
        premiums, net of discounts for the six months ended June 30, 2006.
 
  9
  **June
                  30, 2006**($
                  in thousands)Balance,
                  beginning of period
              $ -Additions
              -Reclassification
              (306)Accretion
              -Disposals
              41Balance,
                  end of period
              $265
  During
          the six months ended June 30, 2006, $0.3 million of expense was recorded
          as a
          component of provision for mortgage loan losses related to some of these
          impaired mortgage loans, and represents the amount of subsequent decreases
          in
          fair value.




During
      the six months ended June 30, 2006, the Company completed the prefunding
      settlement of the Saxon Asset Securities Trust, or SAST, 2005-4 securitization
      of mortgage loans, totaling $140.4 million in principal balances and $1.6
      million in unamortized basis adjustments, and completed the issuances of SAST
      2006-1 and SAST 2006-2, totaling $500.0 million and $999.9 million in principal
      balances and $4.8 million and $7.3 million in unamortized basis adjustments,
      respectively.




The
      Company originates both fixed-rate and adjustable-rate fully-amortizing loans
      for periods up to 30 years. The Company originates balloon products - 50/30
      and
      40/30 fixed and adjustable rate first mortgage balloon loans and 30/20 fixed
      rate balloon loans on second liens. The underwriting guidelines for the
      Company’s fixed-rate and adjustable-rate fully-amortizing products allow
      loan-to-value ratios, or LTVs, and combined LTVs, or CLTVs, of up to 100%,
      and
      debt ratios of either 50% or 55% in circumstances where disposable income meets
      a specified threshold. No loans originated or purchased allow for negative
      amortization, nor does the Company offer a minimum payment option product that
      would result in a borrower’s monthly payment being less than the accrued
      interest amount or minimum principal and interest amount. Fixed-rate and
      adjustable-rate interest-only mortgage loans are also available to customers
      with credit scores in excess of 560. The interest-only period is for five years
      and debt ratios for interest-only products are restricted to a maximum of 50%.




The
      Company’s credit committee monitors the performance of each product originated
      and looks at characteristics of any loans that pose a concern from a performance
      standpoint. Adverse trends that share any common guideline characteristic are
      analyzed to determine if action needs to be taken from a guideline restriction
      or additional risk based pricing aspect. The Company also uses mortgage
      insurance to reduce its loss exposure in the event of borrower credit
      defaults.





10




The
      following table sets forth information about the Company’s mortgage loan
      portfolio composition based on product type as of June 30, 2006 and December
      31,
      2005.





**June
                30, 2006 (1)**
            **December
                31, 2005 (1)**Floating
                adjustable rate mortgage loans
            0.24%
            0.27%Interest-only
                adjustable rate mortgage loans
            24.51%
            26.21%Two
                - five year hybrids (2)
            36.25%
            39.62%40/30
                and 50/30 adjustable rate mortgage loans (3)
            6.65%
            2.32%Total
                adjustable rate mortgage loans
            67.65%
            68.42%15
                and 30 year fixed rate mortgage loans
            25.05%
            24.49%Interest-only
                fixed rate mortgage loans
            1.60%
            1.75%Balloons
                and other (4)
            4.40%
            4.84%40/30
                and 50/30 fixed rate mortgage loans (3)
            1.30%
            0.50%Total
                fixed rate mortgage loans
            32.35%
            31.58%


_______________


(1)
            Excludes
                loans funded but not transmitted to the servicing system as of June
                30,
                2006 and December 31, 2005 of $232.5 million and $110.7 million,
                respectively.


(2)
            Hybrid
                loans are loans that have a fixed interest rate for the initial two
                to
                five years and after that specified time period, become adjustable
                rate
                loans.


(3)
            40/30
                and 50/30 mortgage loans are loans with payments calculated according
                to a
                40-year or 50-year amortization schedule, but which require the entire
                unpaid principal and accrued interest to be paid in full on a specified
                date that is 30 years after
                origination.


(4)
            Balloon
                loans are loans with payments calculated according to a 30-year
                amortization schedule, but which require the entire unpaid principal
                and
                accrued interest to be paid in full on a specified date that is less
                than
                30 years after origination.





***Loan
      Sales***





From
      time
      to time, the Company’s subsidiaries may choose to sell certain mortgage loans
      rather than securitize them. The Company retains the servicing rights with
      respect to sales of conforming first lien mortgage loans, and releases the
      servicing on all other loan sales.





The
      following table summarizes the Company’s activity with respect to conforming
      mortgage loans sold during the periods presented.





**Conforming
                      mortgage loans sold (1)**
                  **Three
                      Months Ended**
                    **June
                      30,**
                  **Six
                      Months Ended**
                    **June
                      30,****2006**
                  **2005**
                  **2006**
                  **2005**($
                      in thousands)Performing
                      first lien mortgage loans
                  $20,484
                  $20,599
                  $45,797
                  $40,086Plus:
                      basis adjustments
                  (455)
                  (127)
                  (1,023)
                  (225)Less:
                      cash received
                  20,516
                  20,849
                  45,995
                  40,285Gain
                      on sale of conforming mortgage loans
                  $487
                  $377
                  $1,221
                  $424


___________


(1)
            Conforming
                mortgage loans are loans that generally meet the underwriting guidelines
                of one of the government-sponsored entities such as Freddie Mac or
                Fannie
                Mae.





11








The
      following table summarizes the Company’s activity with respect to non-conforming
      mortgage loans sold during the periods presented.




**Non-conforming
                    mortgage loans sold**
                **Three
                    Months Ended**
                  **June
                    30,**
                **Six
                    Months Ended**
                  **June
                    30,****2006**
                **2005**
                **2006**
                **2005**($
                    in thousands)Performing
                    first lien mortgage loans
                $
                    -
                $ 
                    -
                $ 
                    -
                $98,786Performing
                    second lien mortgage loans
                15,055
                20,829
                31,995
                64,235Delinquent
                    mortgage loans (1)
                -
                8,812
                -
                8,812Total
                    mortgage loans sold
                15,055
                29,641
                31,995
                171,833Plus:
                    basis adjustments
                629
                (357)
                2,453
                2,318Less:
                    cash received
                14,851
                29,590
                31,459
                176,111(Loss)
                    gain on sale of non-conforming mortgage loans
                $(833)
                $306
                $(2,989)
                $1,960


___________


(1)
            Includes
                real estate owned, or REO, loans that were part of a delinquent loan
                sale.





***Concentrations
      of Risk***




Properties
      securing the mortgage loans in the Company’s mortgage loan portfolio are
      geographically dispersed throughout the Unites States. At June 30, 2006, 30%,
      18%, and 18% of the unpaid principal balance of mortgage loans in the Company’s
      mortgage loan portfolio were secured by properties located in the Southern
      region, California region, and Mid-Atlantic region, respectively. At December
      31, 2005, 30%, 19%, and 16% of the unpaid principal balances were secured by
      properties located in these same regions, respectively. The remaining properties
      securing mortgage loans did not exceed 15% in any other region at either period
      end.





In
      recent
      years, mortgage loan production was also geographically concentrated in the
      Southern, Mid-Atlantic, and California regions. During the first six months
      of
      2006, these regions accounted for 30%, 26%, and 14%, respectively, of the
      Company’s collateral for mortgage loan production. During the first six months
      of 2005, these regions accounted for 27%, 21%, and 24%, respectively, of the
      Company’s collateral for mortgage loan production.








** **(5)**  **Allowance
      for Loan Losses and Past Due Interest**




The
      Company is exposed to risk of loss from its mortgage loan portfolio and
      establishes the allowance for loan losses and past due interest taking into
      account a variety of criteria including contractual delinquency status,
      historical loss experience, and catastrophic environmental influences or natural
      disasters. The allowance for loan losses and past due interest is evaluated
      monthly and adjusted based on this evaluation.





Activity
      related to the allowance for loan losses and past due interest for the mortgage
      loan portfolio is as follows:





12








**June
                30, 2006**
            **December
                31, 2005**($
                in thousands)Allowance
                for loan losses (1)
            $35,412
            $36,639Allowance
                for past due interest (2)
            14,671
            16,086Total
                allowance for loan losses and past due interest
            $50,083
            $52,725








**Three
                Months****Ended**
              **June
                30,**
            **Six
                Months****Ended**
              **June
                30,****2006**
            **2005**
            **2006**
            **2005**($
                in thousands)Beginning
                balance
            $45,584
            $33,580
            $52,725
            $37,310Provision
                for loan losses (1)
            13,410
            9,428
            13,987
            11,736Provision
                for past due interest (3)
            2,618
            2,131
            5,183
            4,586Charge-offs
            (11,529)
            (8,861)
            (21,812)
            (17,354)Ending
                balance
            $50,083
            $36,278
            $50,083
            $36,278


_________


(1)
            During
                the three and six months ended June 30, 2006, $1.3 million and $1.5
                million, respectively, of the Company’s allowance for loan losses was
                reversed relating to Hurricane Katrina due to the Company receiving
                additional inspection reports and due to liquidation of certain mortgage
                loans, which left a remaining allowance for probable losses related
                to
                Hurricane Katrina of $3.0 million.




(2)
            Provided for within accrued interest receivable
              on the
              consolidated balance sheets.




(3)
            Recorded
                as a component within interest income on the consolidated statements
                of
                operations and represents the reversal of interest income on loans
                delinquent for 90 days or more.





An
      internally developed roll rate analysis, static pool analysis and historical
      losses are the primary tools used in analyzing the Company’s allowance for loan
      losses and past due interest. The Company’s roll rate analysis is defined as the
      historical progression of loans through the various delinquency categories.
      The
      Company’s static pool analysis provides data on individual pools of loans based
      on year of origination. These tools take into consideration historical
      information regarding delinquency and loss severity experience and apply that
      information to the portfolio and the portfolio’s basis adjustments. Loss
      severity, as a percentage, is defined as the total loss amount divided by the
      actual unpaid principal balance at the time of liquidation. Total loss amounts
      include all accrued interest, fees, principal balances, all costs of
      liquidating, and all other servicing advances for taxes, property insurance,
      and
      other servicing costs incurred and invoiced to the Company within 90 days
      following the liquidation date. As of June 30, 2006, the Company is experiencing
      an 18-month average loss severity of 40% on its owned portfolio, and this is
      the
      assumption currently used in the loan loss allowance model. The 40% loss
      severity includes the following loss components: 13% for principal, 13% for
      past
      due interest, and 14% for advances and other costs. This average loss severity
      has increased over time because loss severities typically increase as a
      portfolio gets older.











13





**(6)**  **Mortgage
      Servicing Rights**





As
      of
      June 30, 2006, the fair value of the mortgage servicing rights, or MSRs, in
      total was $170.2 million compared to $156.1 million as of December 31, 2005.
      The
      fair value is estimated by discounting estimated future cash flows from the
      servicing assets using discount rates that approximate current market rates.
      The
      fair value as of June 30, 2006 was determined using prepayment assumptions
      ranging from 21% to 52% and discount rates ranging from 11% to 18%. The fair
      value as of December 31, 2005 was determined using prepayment assumptions
      ranging from 20% to 45% and discount rates ranging from 11% to 18%. The
      following table summarizes activity in mortgage servicing rights for the three
      and six months ended June 30, 2006 and 2005:





**Three
                Months****Ended**
              **June
                30,**
            **Six
                Months****Ended**
              **June
                30,****2006**
            **2005**
            **2006**
            **2005**($
                in thousands)Beginning
                balance of MSRs, gross
            $153,895
            $118,045
            $138,370
            $106,619Purchased
                (1)
            16,822
            30,201
            47,549
            51,998Amortization
            (15,894)
            (11,333)
            (31,096)
            (20,521)Permanent
                impairment
            —
            (1,791)
            —
            (2,974)Ending
                balance of MSRs, gross
            $154,823
            135,122
            $154,823
            135,122Beginning
                balance of valuation allowance
            $(10,147)
            (7,945)
            $(8,628)
            (7,624)Recovery
                (impairment)
            651
            72
            (868)
            (1,432)Permanent
                impairment
            —
            1,791
            —
            2,974Ending
                balance of valuation allowance
            (9,496)
            (6,082)
            (9,496)
            (6,082)MSRs,
                net
            $145,327
            $129,040
            $145,327
            $129,040


_________


(1)
            The
                Company acquired approximately $4.0 million of servicing rights on
                June
                30, 2006 for which payment was made subsequent to that date. This
                payment
                was accrued in other liabilities in the Company’s consolidated balance
                sheet as of June 30, 2006.




As
      of
      June 30, 2006, the following table summarizes the remaining estimated projected
      amortization expense for the carrying value of the MSRs for each of the five
      succeeding years and thereafter:




**Years
                Ending December 31,**($
                in thousands)July
                2006 through December 2006
            $31,7362007
            51,2992008
            30,2432009
            16,9362010
            10,003Thereafter
            14,606Total
            $154,823










14





**(7)**  **Warehouse
      Financing, Securitization Financing and Senior Notes**




A
      summary
      of the amounts outstanding under these agreements as of June 30, 2006 and
      December 31, 2005 is as follows:





**June
                30, 2006**
            **December
                31, 2005**($
                in thousands)**Debt
                Outstanding**Warehouse
                financing - loans
            $111,832
            $154,339Repurchase
                agreements - loans
            125,976
            215,158Repurchase
                agreements - retained bond (1)
            8,171
            8,383Repurchase
                agreements - mortgage bonds
            —
            264Total
                warehouse financing
            $245,979
            $378,144Securitization
                financing - servicing advances
            $222,579
            $195,929Securitization
                financing - loans and real estate owned
            6,211,753
            5,986,460Total
                securitization financing
            $6,434,332
            $6,182,389Senior
                notes
            $150,000
            $—Total
            $6,830,311
            $6,560,533


___________________




(1)
            Class
                B-4 of the 2005-3 securitization was retained by the Company rather
                than
                being sold to third-party investors. The purchase price of the retained
                bond was financed using borrowing availability from the Company’s
                Greenwich repurchase agreement.





On
      May 4,
      2006, the Company closed a private offering of $150 million of 12% senior notes
      due 2014. The notes bear interest at a fixed rate of 12% per annum, commencing
      on May 4, 2006, and will mature on May 1, 2014. Interest on the notes will
      be
      payable on May 1 and November 1 of each year, beginning November 1, 2006. The
      notes are guaranteed by certain of our subsidiaries. The Company is using the
      net proceeds from the offering for general corporate purposes, principally
      the
      acquisition of additional third-party mortgage servicing rights and whole loans
      in bulk. The notes are general, unsecured, senior obligations and rank senior
      to
      all of our future debt that is expressly subordinated in right of payment to
      the
      notes.





The
      following table provides an estimate of the contractual due dates for the
      principal amounts of the Company’s outstanding debt obligations as of June 30,
      2006:





15








**As
                of June 30, 2006**
            **Total**
            **2006**
            **2007**
            **2008**
            **2009**
            **2010**
            **Thereafter**($
                in thousands)Warehouse
                financing - loans
            $111,832
            $111,832
            $—
            $—
            $—
            $—
            $—Repurchase
                agreements - loans, retained bond and mortgage bonds (1)
            134,147
            134,147
            —
            —
            —
            —
            —Securitization
                financing - servicing advances
            222,579
            137,579
            —
            85,000
            —
            —
            —Securitization
                financing - loans and real estate owned (2)
            6,211,753
            2,534,651
            1,624,026
            1,035,480
            657,184
            348,092
            12,320Senior
                notes
            150,000
            —
            —
            —
            —
            —
            150,000Total
                outstanding debt obligations
            $6,830,311
            $2,918,209
            $1,624,026
            $1,120,480
            $657,184
            $348,092
            $162,320


________________


(1)
            Repurchase
                agreements are included as part of warehouse financing on the consolidated
                balance sheets.




(2)
            Amounts
                shown are estimated bond payments based on anticipated receipt of
                principal and interest on underlying mortgage loan collateral using
                historical prepayment speeds.




Interest
      on the warehouse financing and repurchase facilities is based on a margin over
      the London Interbank Offered Rate, or LIBOR, with the margin above LIBOR varying
      by facility and depending on the type of asset that is being financed.  As
      of June 30, 2006, these margins ranged from 0.6% to 1.0%. The weighted average
      interest rate on these borrowings outstanding at June 30, 2006 and December
      31,
      2005 was 5.95% and 5.10%, respectively. Interest on the securitization financing
      is either based on a fixed rate or is based on a margin above LIBOR varying
      by
      securitization deal and the type of asset that is being financed. As of June
      30,
      2006, these fixed rates ranged from 3.5% to 6.7% and these margins above LIBOR
      ranged from 0.03% to 4.0%. As of December 31, 2005, these fixed rates ranged
      from 3.5% to 6.7% and these margins above LIBOR ranged from 0.09% to
      4.0%.







16


A
      summary
      of interest expense and the weighted average cost of funds 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**($
                in thousands)**Interest
                Expense**Warehouse
                financing - loans
            $596
            $1,015
            $1,511
            $2,181Warehouse
                financing - servicing rights
            61
            —
            113
            —Repurchase
                agreements
            7,834
            2,350
            13,537
            4,099Securitization
                financing
            84,575
            57,013
            162,416
            108,094Senior
                notes
            2,920
            —
            2,920
            —Other
                (1)
            1,582
            1,109
            2,838
            2,104Total
            $97,568
            $61,487
            $183,335
            $116,478**Weighted
                Average Cost of Funds**


Warehouse
                financing - loans
            1.48%
            2.11%
            1.67%
            2.40%Warehouse
                financing - servicing rights
            2.58%
            —
            2.51%
            —Repurchase
                agreements
            5.61%
            3.74%
            5.47%
            3.52%Securitization
                financing
            5.69%
            4.01%
            5.46%
            3.79%Senior
                notes
            12.30%
            —
            12.30%
            —Other
            —
            —
            —
            —Total
            5.77%
            4.02%
            5.49%
            3.80%


________________


(1)
            Represents
                primarily facility, commitment, and non-use fees as well as lender
                paid
                private mortgage insurance.





17


Under
      its
      borrowing agreements, the Company is subject to certain debt covenants and
      is
      required to maintain or satisfy specified financial ratios and tests, as well
      as
      other customary covenants, representations and warranties. In the event of
      default, the Company may be prohibited from paying dividends and making
      distributions under certain of its financing facilities without the prior
      approval of its lenders. As of June 30, 2006, the Company was in compliance
      with
      all of its covenants under the respective borrowing agreements.




**(8)**  **Derivatives**





The
      Company may use a variety of financial instruments to manage the exposure to
      changes in interest rates. The Company may enter into interest rate swap
      agreements, interest rate cap agreements, interest rate floor agreements,
      financial forwards, financial futures, and options on financial instruments
      (collectively referred to as “Interest Rate Agreements”) to manage the
      sensitivity to changes in market interest rates. The Interest Rate Agreements
      used have an active secondary market, and none are obtained for speculation.
      The
      Company accounts for all of its derivative financial instruments as undesignated
      derivative instruments. The maximum term over which the Company is currently
      managing its exposure for forecasted transactions is 69 months. The Company
      has
      classified cash activity associated with derivatives as an operating activity
      in
      the consolidated statements of cash flows. Derivative gains (losses) totaled
      $14.7 million and $(15.1) million for the three months ended June 30, 2006
      and
      2005, respectively, and derivative gains totaled $25.4 million and $6.2 million
      for the six months ended June 30, 2006 and 2005, respectively. The components
      of
      these derivative gains consist of the following:




**Three
                Months Ended June 30,**
            **Six
                Months Ended June 30,****2006**
            **2005**
            **2006**
            **2005**($
                in thousands)Non
                cash fair value gain (loss)
            $7,839
            $(13,288)
            $12,842
            $(4,216)Cash
                settlements, net
            7,112
            (1,718)
            12,859
            10,618Broker
                commissions
            (200)
            (97)
            (290)
            (291)Interest
                on margin, net
            (19)
            19
            (40)
            39Total
            $14,732
            $(15,084)
            $25,371
            $6,150





**(9)**  **Share-Based
      Compensation Plans**





18





Compensation
      cost charged against income for the Company’s share-based compensation plans was
      $0.9 million and $0.9 million for the three months ended June 30, 2006 and
      2005,
      respectively, and $1.8 million and $1.6 million for the six months ended June
      30, 2006 and 2005, respectively.




*Stock
      Options -* The
      following table summarizes the transactions relating to the Company’s stock
      options for the six months ended June 30, 2006:




**Number
                of Options**
            **Weighted
                Average Exercise**
              **Price
                Per Share**Options
                outstanding, January 1, 2006 (includes 6,000 exercisable options
                with a
                remaining contractual life of 5.8 years outstanding under the Stock
                Incentive Plan)
            6,000
            $10.10Options
                granted
            —
            —Options
                exercised
            (3,000)
            $10.10Options
                cancelled / forfeited
            —
            —Options
                outstanding, June 30, 2006 (includes 3,000 exercisable options with
                a
                remaining contractual life of 5.3 years outstanding under the Stock
                Incentive Plan)
            3,000
            $10.10





No
      options were exercised during the three months ended June 30, 2006. Cash
      received from options exercised under all share-based payment arrangements
      for
      the three months ended June 30, 2005, and for the six months ended June 30,
      2006
      and June 30, 2005 was $50.5 thousand, $30.3 thousand and $50.5 thousand,
      respectively. The actual tax benefit realized for the tax deductions from option
      exercises under share-based payment arrangements was immaterial for the three
      and six months ended June 30, 2006 and 2005. The total intrinsic value of
      options exercised during the three months ended June 30, 2005 and during the
      six
      months ended June 30, 2006 and June 30, 2005 was $34.5 thousand, $0.4 thousand
      and $34.7 thousand, respectively. The total intrinsic value of options
      outstanding and exercisable as of June 30, 2006 was $4.0 thousand.




*Restricted
      Stock Units -* The
      Company recognizes compensation expense for outstanding restricted stock units
      over their vesting periods for an amount equal to the fair value of the
      restricted stock units at grant date. Fair value is determined by the price
      of
      the common shares underlying the restricted stock units on the grant date.
      As of
      June 30, 2006, there was $11.2 million of total unrecognized compensation cost
      related to nonvested restricted stock units granted under the Stock Incentive
      Plan. That cost is expected to be recognized over a weighted-average period
      of
      3.6 years.




A
      summary
      of the status of the Company’s nonvested restricted stock units as of June 30,
      2006, and changes during the six months ended June 30, 2006, is presented
      below:




**Number
                of Restricted**
              **Stock
                Units**
            **Weighted
                Average Grant-Date Fair Value**Nonvested
                at January 1, 2006
            840,000
            $20.19Granted
            55,000
            $10.81Vested
            (20,000)
            $20.29


Forfeited
            (20,000)
            $21.50Nonvested
                at June 30, 2006
            855,000
            $19.56







19


*Employee
      Stock Purchase Plan* - The
      Company recognizes compensation expense for its Employee Stock Purchase Plan
      for
      an amount equal to the difference between the fair value and the sales price
      of
      the shares on the date of purchase. As a result, the Company incurred $44.6
      thousand and $47.3 thousand of expense during the three months ended June 30,
      2006 and 2005, respectively, and incurred $90.5 thousand and $47.3 thousand
      of
      expense during the six months ended June 30, 2006 and 2005, respectively. The
      Company issued 26.0 thousand shares of common stock at $9.72 per share for
      a
      total of $252.9 thousand in proceeds during the second quarter of 2006.




**(10)**  **Commitments
      and Contingencies**




***Mortgage
      Loans***




As
      of
      June 30, 2006 and December 31, 2005, the Company’s subsidiaries had commitments
      to fund mortgage loans with agreed-upon rates of $445.4 million and $262.6
      million, respectively. These amounts do not necessarily represent future cash
      requirements, as some portion of the commitments are likely to expire without
      being drawn upon or may be subsequently declined for credit or other reasons.





From
      May
      1996 to July 5, 2001, the Company securitized its mortgage loans in off balance
      sheet transactions, of which $325.0 million are still outstanding as of June
      30,
      2006. In connection with these mortgage loans as well as in connection with
      the
      sales of mortgage loans to nonaffiliated parties, the Company’s subsidiaries
      made representations and warranties about certain characteristics of the loans,
      the borrowers, and the underlying properties. In the event of a breach of these
      representations and warranties, those subsidiaries may be required to remove
      loans from a securitization and replace them with cash or substitute loans,
      and
      to indemnify parties for any losses or expenses related to such breach. As
      of
      June 30, 2006 those subsidiaries did not have any material obligation to remove
      any such loans, or to provide any such indemnification.





In
      the
      normal course of business, the Company is subject to indemnification obligations
      related to the sale of residential mortgage loans. Under these obligations,
      the
      Company is required to repurchase certain mortgage loans that fail to meet
      the
      standard representations and warranties included in the sales contracts. The
      Company accrues an estimate for the fair value of those obligations. The
      Company’s subsidiaries are also subject to premium recapture expenses and early
      payment default in connection with the sale of residential mortgage loans.
      Premium recapture expenses represent repayment of a portion of certain loan
      sale
      premiums to investors on previously sold loans that are repaid within six months
      of the loan sale. The Company accrues an estimate of the potential refunds
      of
      premium received on loan sales based upon historical experience. As of June
      30,
      2006 and December 31, 2005, the liability recorded for premium recapture expense
      and for obligations to repurchase mortgage loans was $0.4 million and $0.4
      million, respectively and the associated expense was recorded within (loss)
      gain
      on sale of assets in the consolidated statements of operations.





20







***Mortgage
      Servicing Rights***




The
      Company is committed to purchasing third party servicing rights for an
      additional $1.1 billion unpaid principal balance of third party mortgage loans
      during the third quarter of 2006, none of which have been purchased as of July
      31, 2006.





***Legal
      Matters***




Because
      the Company is subject to many laws and regulations, including but not limited
      to federal and state consumer protection laws, we are regularly involved in
      numerous lawsuits filed against us, some of which seek certification as class
      action lawsuits on behalf of similarly situated individuals. With respect to
      each matter in which class action status has been asserted, in the event class
      action status is certified, if there is an adverse outcome or we do not
      otherwise prevail in each of the following matters, we could suffer material
      losses, although we intend to vigorously defend each of these lawsuits. The
      following is a summary of litigation matters that could be significant. Unless
      otherwise noted, the Company cannot predict the outcome of these matters.
      Accordingly, no amounts have been accrued in the accompanying consolidated
      financial statements, except as noted below.





Bauer,
      et al., v. Saxon Mortgage Services, Inc., et al. is a
      matter filed on December 1, 2004 in the Civil District Court for the Parish
      of
      Orleans, State of Louisiana, Case No. 2004-17015. On January 26, 2005, the
      plaintiffs filed a motion to dismiss the case without prejudice, and the court
      entered an order dismissing the case on January 31, 2005. On February 17, 2005,
      the plaintiffs re-filed the case as two separate class action lawsuits, Bauer,
      et al., v. Dean Morris, et al., filed as
      Case No. 05-2173 in the Civil District Court for the Parish of Orleans, State
      of
      Louisiana, and Patterson,
      et al., v. Dean Morris, et al., filed as
      Case No. 05-2174 in the Civil District Court for the Parish of Orleans, State
      of
      Louisiana. In the Bauer case, the Company is not a named defendant but may
      owe
      defense and indemnification to Deutsche Bank Trust Company Americas, N.A.,
      as
      custodian of a mortgage loan for which one named plaintiff is mortgagor. A
      subsidiary, Saxon Mortgage Services, Inc., is a named defendant in the Patterson
      case. In both cases, the named plaintiffs allege misrepresentation, fraud,
      conversion and unjust enrichment on the part of the lender defendants and law
      firm hired by a number of defendants, including Saxon Mortgage Services, Inc.,
      to enforce mortgage loan obligations against borrowers who had become delinquent
      pursuant to the terms of their mortgage loan documents. Specifically, the
      plaintiffs alleged that the law firm quoted inflated court costs and sheriff’s
      fees on reinstatement proposals to the plaintiffs. In both cases, the Plaintiffs
      seek certification as a class action, compensatory damages, pre-judgment
      interest, attorneys’ fees, litigation costs, and other unspecified general,
      special and equitable relief. On January 24, 2006, the United States District
      Court for the Eastern District of Louisiana granted the Company’s motion to
      compel arbitration and stayed the court proceedings as to named plaintiffs
      Keenan and Karen Duckworth in Bauer,
      et al., v. Dean Morris, et al., filed as
      Case No. 05-2173 in the Civil District Court





21





for
      the
      Parish of Orleans, State of Louisiana. On January 25, 2006, the United States
      District Court for the Eastern District of Louisiana granted the Company’s
      motion to compel arbitration and stayed the court proceedings as to named
      plaintiff Debra Herron in Patterson,
      et al., v. Dean Morris, et al., filed as
      Case No. 05-2174 in the Civil District Court for the Parish of Orleans, State
      of
      Louisiana. The court subsequently remanded the underlying court proceedings
      in
      both the Bauer and Patterson cases to
      the Civil District Court for the Parish of Orleans, State of Louisiana. There
      were no significant developments in this matter during the quarter ended June
      30, 2006.





Cechini,
      et al., v. America’s MoneyLine, Inc .
      is a
      matter filed on August 10, 2005 in the United States District Court for the
      Northern District of Illinois, Eastern Division, as Case No. 05C 4570. The
      plaintiff filed the case as a class action, alleging violation of the Fair
      Credit Reporting Act in connection with the use of pre-approved offers of credit
      by the Company’s subsidiary, America’s MoneyLine, Inc. The parties reached a
      settlement, pending court approval and entry into a mutually acceptable
      settlement agreement, on June 19, 2006, pursuant to which the Company would
      pay
      an aggregate amount of approximately $0.5 million and incur approximately $10
      thousand in settlement administration costs in exchange for a release of claims.
      The Company accrued $0.5 million in June 2006 based on these
      developments.





Jumar
      Hooks and Diane Felder, et al., v. Saxon Mortgage, Inc. is a
      matter filed on October 12, 2005 in the Common Pleas Court for Cuyahoga County,
      Ohio as Case No. CV 05 574577. The plaintiffs filed this case as a class action,
      on behalf of themselves and similarly situated Ohio borrowers, alleging that
      the
      Company’s subsidiary engaged in unlawful practices in originating and servicing
      the plaintiffs’ loans. The plaintiffs sought certification as a class and a
      judgment in favor of the plaintiffs for money damages, costs, attorneys’ fees,
      and other relief deemed appropriate by the court. During the second quarter
      of
      2006, the court granted the Company’s motion to compel individual arbitration as
      to each of the two named plaintiffs and
      stayed the court proceedings with no class having been certified.





Brian
      Harris, et al., v. Capital Mortgage Company, et al .,
      is a
      matter filed in the Circuit Court of Cook County, County Department-Chancery
      Division, Illinois as Case No. 05CH 22369. The Company’s subsidiary, Saxon
      Mortgage Services, was served with a summons and complaint on March 1, 2006.
      The
      plaintiffs included a class action claim, alleging, on behalf of themselves
      and
      those similarly situated, that Saxon Mortgage Services and other named
      defendants engaged in unfair and deceptive acts and violated the Illinois
      Consumer Fraud Act in connection with originating and servicing the plaintiffs’
loans. The plaintiffs seek certification as a class and a judgment in favor
      of
      the plaintiffs for money damages, costs, attorneys’ fees, and other relief
      deemed appropriate by the court. There
      were no significant developments in this matter during the quarter ended June
      30, 2006.





**(11)**
            **Segments**




The
        operating segments reported below are the segments of the Company for which
        separate financial information is available and for which amounts are evaluated
        regularly by management in deciding how to allocate resources and in assessing
        performance. The Company’s segment information for the three and six months
        ended June 30, 2005 has been restated to reflect a change in the presentation
        of
        certain intercompany transactions within its reportable segments.


22








The
      portfolio segment uses the Company’s equity capital and borrowed funds to invest
      in its mortgage loan portfolio, thereby producing net interest income. The
      portfolio segment also records servicing expense associated with the cost of
      servicing its mortgage loan portfolio. The mortgage loan production segment
      purchases and originates non-conforming residential mortgage loans through
      relationships with various mortgage companies, mortgage brokers, and
      correspondent lenders, and directly to borrowers through its eight branch
      offices. The mortgage loan production segment also records interest income,
      interest expense, servicing expense, and provision for mortgage loan losses
      on
      the mortgage loans it holds prior to selling its loans to the portfolio segment.
      This segment also collects revenues such as origination and underwriting fees
      and certain nonrefundable fees that are deferred and recognized over the life
      of
      the loan as an adjustment to interest income recorded in the portfolio segments.
      The production segment is also the legal entity named as master servicer for
      some third party loans, and as such, records fees received for these services
      as
      servicing income. The servicing segment services loans the production segment
      originates or purchases as well as third party loans, seeking to ensure that
      loans are repaid in accordance with their terms. The data presented below for
      “Gain (loss) on sale of mortgage assets” includes third party sales as well as
      intercompany gains (losses) on sales of mortgage assets such as loans and
      servicing advances. The intercompany gains (losses) are eliminated at the
      consolidated level.




**Three
                Months Ended June 30, 2006****Portfolio**
            **Mortgage
                Loan**
              **Production**
            **Servicing**
            **Eliminations**
            **Total**($
                in thousands)Interest
                income
            $110,731
            $19,992
            $649
            $(7,258)
            $124,114Interest
                expense
            (89,473)
            (13,707)
            (614)
            6,226
            (97,568)Net
                interest income
            21,258
            6,285
            35
            (1,032)
            26,546Provision
                for mortgage loan losses
            (13,074)
            (336)
            —
            —
            (13,410)Net
                interest income after provision for mortgage loan losses
            8,184
            5,949
            35
            (1,032)
            13,136Servicing
                income, net of amortization and impairment
            —
            1,174
            27,023
            (7,767)
            20,430Derivative
                gains
            14,732
            —
            —
            —
            14,732Gain
                (loss) on sale of mortgage assets
            —
            6,555
            (7,366)
            465
            (346)Total
                net revenues and gains
            22,916
            13,678
            19,692
            (8,334)
            47,952Payroll
                and general and administrative expenses
            10,396
            22,013
            11,144
            (11,409)
            32,144DepreciationOperating
                expenses
            66
            1,164
            531
            —
            1,761Other
                expense (income), netOperating
                expenses
            1,242
            (5,674)
            (443)
            5,891
            1,016Total
                operating expenses
            11,704
            17,503
            11,232
            (5,518)
            34,921Income
                (loss) before taxes
            11,212
            (3,825)
            8,460
            (2,816)
            13,031Income
                tax expense (benefit)
            587
            (3,069)
            6,941
            (74)
            4,385**Net
                income (loss)**
            $10,625
            $(756)
            $1,519
            $(2,742)
            $8,646







23


**Three
                Months Ended June 30, 2005****Portfolio**
            **Mortgage
                Loan**
              **Production**
            **Servicing**
            **Eliminations**
            **Total**($
                in thousands)Interest
                income
            $92,302
            $13,600
            $482
            $4,693
            $111,077Interest
                expense
            (57,568)
            (7,738)
            (663)
            4,482
            (61,487)Net
                interest income
            34,734
            5,862
            (181)
            9,175
            49,590Provision
                for mortgage loan losses
            (9,914)
            486
            —
            —
            (9,428)Net
                interest income afterprovision
                for mortgage
              loan losses
            24,820
            6,348
            (181)
            9,175
            40,162Servicing
                income, net of amortizationand
                impairment
            —
            688
            23,565
            (7,029)
            17,224Derivative
                losses
            (15,084)
            —
            —
            —
            (15,084)Gain
                (loss) on sale of mortgage assets
            —
            20,275
            (4,200)
            (15,369)
            706Total
                net revenues and gains
            9,736
            27,311
            19,184
            (13,223)
            43,008Payroll
                and general and administrativeexpenses
            10,852
            23,716
            10,810
            (13,784)
            31,594Depreciation
            —
            879
            457
            —
            1,336Other
                expense (income), net
            290
            (5,745)
            196
            5,396
            137Total
                operating expenses
            11,142
            18,850
            11,463
            (8,388)
            33,067Income
                (loss) before taxes
            (1,406)
            8,461
            7,721
            (4,835)
            9,941Income
                tax expense (benefit)
            (52)
            3,348
            3,056
            (3,408)
            2,944**Income
                (loss) before cumulative effect of change in accounting
                principle**
            (1,354)
            5,113
            4,665
            (1,427)
            $6,997Cumulative
                effect of change inaccounting
                principle
            31
            —
            —
            —
            31**Net
                income (loss)**
            $(1,323)
            $5,113
            $4,665
            $(1,427)
            $7,028





24











**Six
                Months Ended June 30, 2006****Portfolio**
            **Mortgage
                Loan**
              **Production**
            **Servicing**
            **Eliminations**
            **Total**($
                in thousands)Interest
                income
            $221,966
            $36,589
            $970
            $(14,131)
            $245,394Interest
                expense
            (169,214)
            (24,495)
            (1,070)
            11,444
            (183,335)Net
                interest income
            52,752
            12,094
            (100)
            (2,687)
            62,059Provision
                for mortgage loan losses
            (13,237)
            (750)
            —
            —
            (13,987)Net
                interest income after provision for mortgage loan losses
            39,515
            11,344
            (100)
            (2,687)
            48,072Servicing
                income, net of amortization and impairment
            —
            1,926
            53,998
            (15,854)
            40,070Derivative
                gains
            25,371
            —
            —
            —
            25,371Gain
                (loss) on sale of mortgage assets
            —
            3,691
            (14,686)
            9,227
            (1,768)Total
                net revenues and gains
            64,886
            16,961
            39,212
            (9,314)
            111,745Payroll
                and general and administrative expenses
            21,614
            41,902
            22,375
            (22,572)
            63,319Depreciation
            156
            2,297
            1,075
            —
            3,528Other
                expense (income), net
            2,365
            (10,254)
            (27)
            10,472
            2,556Total
                operating expenses
            24,135
            33,945
            23,423
            (12,100)
            69,403Income
                (loss) before taxes
            40,751
            (16,984)
            15,789
            2,786
            42,342Income
                tax expense (benefit)
            1,716
            (6,896)
            9,780
            2,697
            7,297**Net
                income (loss)**
            $39,035
            $(10,088)
            $6,009
            $89
            $35,045







25




**Six
                Months Ended June 30, 2005****Portfolio**
            **Mortgage
                Loan**
              **Production**
            **Servicing**
            **Eliminations**
            **Total**($
                in thousands)Interest
                income
            $194,318
            $26,364
            $930
            $1,887
            $223,499Interest
                expense
            (110,161)
            (14,390)
            (1,033)
            9,106
            (116,478)Net
                interest income
            84,157
            11,974
            (103)
            10,993
            107,021Provision
                for mortgage loan losses
            (11,289)
            (447)
            —
            —
            (11,736)Net
                interest income afterprovision
                for mortgage loan losses
            72,868
            11,527
            (103)
            10,993
            95,285Servicing
                income, net of amortizationand
                impairment
            —
            1,514
            42,765
            (13,489)
            30,790Derivative
                gains
            6,150
            —
            —
            —
            6,150Gain
                (loss) on sale of mortgage assets
            —
            37,703
            (7,442)
            (27,854)
            2,407Total
                net revenues and gains
            79,018
            50,744
            35,220
            (30,350)
            134,632Payroll
                and general and administrative expenses
            21,112
            52,465
            21,937
            (26,149)
            69,365Depreciation
            —
            1,936
            907
            —
            2,843Other
                expense (income), net
            1,398
            (10,792)
            315
            10,920
            1,841Total
                operating expenses
            22,510
            43,609
            23,159
            (15,229)
            74,049Income
                before taxes
            56,508
            7,135
            12,061
            (15,121)
            60,583Income
                tax expense
            2,068
            2,823
            4,773
            (10,047)
            (383)Income
                before cumulative effect of change in accounting principle
            54,440
            4,312
            7,288
            (5,074)
            60,966Cumulative
                effect of change inaccounting
                principle
            31
            —
            —
            —
            31**Net
                income**
            $54,471
            $4,312
            $7,288
            $(5,074)
            $60,997





26











Management
      evaluates assets only for the servicing and portfolio segments. Assets not
      identifiable to an individual segment are corporate assets, which are comprised
      of cash and other assets.





**June
                30, 2006**
            **December
                31, 2005****Segment
                Assets:**Portfolio
            $6,953,323
            $6,768,778Servicing
            365,428
            315,039Total
                segment assets
            $7,318,751
            7,083,817Corporate
                assets
            177,896
            148,261Total
                assets
            $7,496,647
            $7,232,078





**(12)**  **Non-guarantor
      / Guarantor** **Financial Data**





The
      Company issued
      $150.0 million in aggregate principal amount of its 12% senior notes due 2014
      in
      an offering that closed May 4, 2006. The notes are fully and unconditionally
      guaranteed on a joint and several basis by Saxon Funding Management, Inc.,
      Saxon
      Capital Holdings, Inc., SCI Services, Inc., Saxon Mortgage Services, Inc.,
      Saxon
      Mortgage, Inc. and Saxon Holding, Inc., each of which is a direct or indirect
      wholly-owned subsidiary of the Company, or sub-guarantors. All of the
      sub-guarantors are taxable REIT subsidiaries except for Saxon Funding
      Management, Inc., which is a qualified REIT subsidiary. One non-guarantor is
      a
      taxable REIT subsidiary and the other non-guarantors are qualified REIT
      subsidiaries. The financing facilities to which the Company and certain of
      its
      subsidiaries are party prohibit distributions to the Company in the event of
      default thereunder. In addition, the ability of the Company and the
      sub-guarantors to obtain funds from their subsidiaries by dividend or loan
      may
      be limited by legal restrictions and regulatory and rating agency considerations
      applicable to such subsidiaries.





The
      following tables present the financial condition, results of operations, and
      cash flows for the Company, its sub-guarantors, and its non-guarantors as of
      June 30, 2006 and December 31, 2005 and for the three and six months ended
      June
      30, 2006 and 2005.





27




**Consolidating
                Balance Sheet**
              **As
                of June 30, 2006****Saxon
                Capital, Inc. (Parent)**
            **Sub-guarantors**
            **Non-guarantors**
            **Eliminations**
            **Total**($
                in thousands)**Assets:**Cash
            $641
            $3,310
            $9,393
            $—
            $13,344Accrued
                interest receivable, net
            —
            10,800
            13,816
            18,439
            43,055Trustee
                receivable
            —
            13,919
            8,282
            117,736
            139,937Mortgage
                loan portfolio
            —
            1,935,902
            5,041,056
            (218,299)
            6,758,659Allowance
                for loan losses
            —
            (2,780)
            (32,632)
            —
            (35,412)Net
                mortgage loan portfolio
            —
            1,933,122
            5,008,424
            (218,299)
            6,723,247Restricted
                cash
            —
            3,779
            2,226
            —
            6,005Servicing
                related advances
            —
            18,117
            224,897
            (22,913)
            220,101Mortgage
                servicing rights, net
            —
            145,327
            —
            —
            145,327Real
                estate owned
            —
            5,538
            35,541
            —
            41,079Derivative
                assets
            —
            24,852
            15,171
            —
            40,023Deferred
                tax asset
            —
            25,536
            2,358
            26,014
            53,908Investment
                in subsidiaries
            439,701
            157,546
            (2,528)
            (594,719)
            —Other
                assets, net
            7,518
            50,561
            12,542
            —
            70,621Total
                assets
            $447,860
            $2,392,407
            $5,330,122
            $(673,742)
            $7,496,647**Liabilities
                and shareholders’ equity:****Liabilities:**Accrued
                interest payable
            2,850
            3,790
            5,957
            (2,009)
            10,588Dividends
                payable
            25,468
            —
            —
            —
            25,468Warehouse
                financing
            —
            237,808
            8,171
            —
            245,979Securitization
                financing
            —
            1,571,650
            4,862,682
            —
            6,434,332Senior
                notes
            150,000
            —
            —
            —
            150,000Derivative
                liabilities
            —
            21,022
            —
            —
            21,022Due
                to (from) affiliates
            1,282
            (541)
            (741)
            —
            —Other
                liabilities
            —
            29,025
            552
            —
            29,577Total
                liabilities
            179,600
            1,862,754
            4,876,621
            (2,009)
            6,916,966**Shareholders’
                equity:**Common
                stock
            501
            353
            2
            (355)
            501Preferred
                stock
            —
            10
            —
            (10)
            —Additional
                paid-in capital
            632,867
            854,453
            353,863
            (1,204,885)
            636,298Accumulated
                other comprehensive loss, net of tax of $(12)
            —
            —
            (277)
            —
            (277)Net
                accumulated (deficit) earnings
            (365,108)
            (325,163)
            99,913
            533,517
            (56,841)Total
                shareholders’ equity
            268,260
            529,653
            453,501
            (671,733)
            579,681Total
                liabilities and shareholders’ equity
            $447,860
            $2,392,407
            $5,330,122
            $(673,742)
            $7,496,647








28


**Consolidating
                Balance Sheet**
              **As
                of December 31, 2005****Saxon
                Capital, Inc. (Parent)**
            **Sub-guarantors**
            **Non-guarantors**
            **Eliminations**
            **Total**($
                in thousands)**Assets:**Cash
            $222
            $4,054
            $5,255
            $(3,478)
            $6,053Accrued
                interest receivable, net
            —
            4,636
            15,134
            18,412
            38,182Trustee
                receivable
            —
            1,219
            6,204
            128,534
            135,957Mortgage
                loan portfolio
            —
            952,263
            5,722,105
            (229,496)
            6,444,872Allowance
                for loan losses
            —
            (211)
            (36,428)
            —
            (36,639)Net
                mortgage loan portfolio
            —
            952,052
            5,685,677
            (229,496)
            6,408,233Restricted
                cash
            —
            145,513
            1,960
            —
            147,473Servicing
                related advances
            —
            10,591
            199,667
            (24,961)
            185,297Mortgage
                servicing rights, net
            —
            129,742
            —
            —
            129,742Real
                estate owned
            —
            6,149
            32,784
            —
            38,933Derivative
                assets
            —
            5,471
            14,483
            —
            19,954Deferred
                tax asset
            —
            25,789
            2,341
            25,594
            53,724Investment
                in subsidiaries
            339,704
            127,090
            (4,742)
            (462,052)
            —Other
                assets, net
            10,688
            38,069
            19,773
            —
            68,530Total
                assets
            $350,614
            $1,450,375
            $5,978,536
            $(547,447)
            $7,232,078**Liabilities
                and shareholders’ equity:****Liabilities:**Accrued
                interest payable
            —
            1,978
            6,379
            —
            8,357Dividends
                payable
            32,539
            —
            —
            —
            32,539Warehouse
                financing
            —
            369,496
            8,648
            —
            378,144Securitization
                financing
            —
            645,262
            5,537,127
            —
            6,182,389Derivative
                liabilities
            —
            8,589
            —
            —
            8,589Due
                (from) to affiliates
            (1,563)
            (27,504)
            29,067
            —
            —Other
                liabilities
            —
            29,777
            2,627
            (3,479)
            28,925Total
                liabilities
            $30,976
            $1,027,598
            $5,583,848
            $(3,479)
            $6,638,943**Shareholders’
                equity:**Common
                stock
            500
            353
            2
            (355)
            500Preferred
                stock
            —
            10
            —
            (10)
            —Additional
                paid-in capital
            630,592
            740,707
            296,941
            (1,034,217)
            634,023Accumulated
                other comprehensive income (loss), net of tax of $(16)
            —
            24
            (379)
            —
            (355)Net
                accumulated (deficit) earnings
            (311,454)
            (318,317)
            98,124
            490,614
            (41,033)Total
                shareholders’ equity
            319,638
            422,777
            394,688
            (543,968)
            593,135Total
                liabilities and shareholders’ equity
            $350,614
            $1,450,375
            $5,978,536
            (547,447)
            $7,232,078








29








**Consolidating
                Statement of Operations**
              **For
                the three months ended June 30, 2006****Saxon
                Capital, Inc. (Parent)**
            **Sub-guarantors**
            **Non-guarantors**
            **Eliminations**
            **Total**($
                in thousands)**Revenues
                and Gains:**Interest
                income
            $—
            $34,357
            $92,798
            $(3,041)
            $124,114Interest
                expense
            (2,920)
            (23,244)
            (73,413)
            2,009
            (97,568)Intercompany
                interest
            13
            4,634
            (5,113)
            466
            —Net
                interest income
            (2,907)
            15,747
            14,272
            (566)
            26,546Provision
                for mortgage loan losses
            —
            (2,222)
            (11,188)
            —
            (13,410)Net
                interest income after provision for mortgage loan losses
            (2,907)
            13,525
            3,084
            (566)
            13,136Servicing
                income, net of amortization and impairment
            —
            21,069
            (639)
            —
            20,430Derivative
                gains
            —
            4,137
            10,595
            —
            14,732Loss
                on sale of assets
            —
            (346)
            —
            —
            (346)Total
                net revenues and gains
            (2,907)
            38,385
            13,040
            (566)
            47,952**Expenses:**Payroll
                and related expenses
            —
            17,551
            —
            27
            17,578General
                and administrative expenses
            22
            14,539
            5
            —
            14,566Depreciation
            —
            1,761
            —
            —
            1,761Other
                (income) expense, net
            —
            (207)
            1,241
            (18)
            1,016Total
                operating expenses
            22
            33,644
            1,246
            9
            34,921(Loss)
                income before taxes
            (2,929)
            4,741
            11,794
            (575)
            13,031Income
                tax (benefit) expense
            (119)
            6,168
            491
            (2,155)
            4,385**Net
                (loss) income**
            $(2,810)
            $(1,427)
            $11,303
            $1,580
            $8,646








30








**Consolidating
                Statement of Operations**
              **For
                the three months ended June 30, 2005****Saxon
                Capital, Inc. (Parent)**
            **Sub-guarantors**
            **Non-guarantors**
            **Eliminations**
            **Total**($
                in thousands)**Revenues
                and Gains:**Interest
                income
            $—
            $10,739
            $93,008
            $7,330
            $111,077Interest
                expense
            —
            (4,157)
            (57,330)
            —
            (61,487)Intercompany
                interest
            9
            16,159
            (798)
            (15,370)
            —Net
                interest income
            9
            22,741
            34,880
            (8,040)
            49,590Provision
                for mortgage loan losses
            —
            486
            (9,914)
            —
            (9,428)Net
                interest income after provision for mortgage loan losses
            9
            23,227
            24,966
            (8,040)
            40,162Servicing
                income, net of amortization and impairment
            —
            19,886
            (2,662)
            —
            17,224Derivative
                gains (losses)
            —
            2,126
            (17,210)
            —
            (15,084)Gain
                on sale of assets
            —
            680
            26
            —
            706Total
                net revenues and gains
            9
            45,919
            5,120
            (8,040)
            43,008**Expenses:**Payroll
                and related expenses
            —
            11,119
            5,925
            (789)
            16,255General
                and administrative expenses
            8
            8,921
            6,487
            (77)
            15,339Depreciation
            —
            1,218
            118
            —
            1,336Other
                expense (income), net
            —
            3,049
            (3,769)
            857
            137Total
                operating expenses
            8
            24,307
            8,761
            (9)
            33,067Income
                (loss) before taxes
            1
            21,612
            (3,641)
            (8,031)
            9,941Income
                tax expense (benefit)
            —
            9,650
            (2,152)
            (4,554)
            2,944**Income
                (loss) before cumulative effect of change in accounting
                principle**
            1
            11,962
            (1,489)
            (3,477)
            6,997Cumulative
                effect of change in accounting principle
            —
            31
            —
            —
            31**Net
                income (loss)**
            $1
            $11,993
            $(1,489)
            $(3,477)
            $7,028








31








**Consolidating
                Statement of Operations**
              **For
                the six months ended June 30, 2006****Saxon
                Capital, Inc. (Parent)**
            **Sub-guarantors**
            **Non-guarantors**
            **Eliminations**
            **Total**($
                in thousands)**Revenues
                and Gains:**Interest
                income
            $—
            $61,266
            $190,826
            $(6,698)
            $245,394Interest
                expense
            (2,920)
            (38,428)
            (143,996)
            2,009
            (183,335)Intercompany
                interest
            21
            1,456
            (10,705)
            9,228
            —Net
                interest income
            (2,899)
            24,294
            36,125
            4,539
            62,059Provision
                for mortgage loan losses
            —
            (3,663)
            (10,324)
            —
            (13,987)Net
                interest income after provision for mortgage loan losses
            (2,899)
            20,631
            25,801
            4,539
            48,072Servicing
                income, net of amortization and impairment
            —
            41,379
            (1,309)
            —
            40,070Derivative
                gains (losses)
            —
            5,998
            19,373
            —
            25,371Loss
                on sale of assets
            —
            (1,768)
            —
            —
            (1,768)Total
                net revenues and gains
            (2,899)
            66,240
            43,865
            4,539
            111,745**Expenses:**Payroll
                and related expenses
            —
            35,058
            —
            269
            35,327General
                and administrative expenses
            22
            27,960
            10
            —
            27,992Depreciation
            —
            3,528
            —
            —
            3,528Other
                expense (income), net
            —
            405
            2,365
            (214)
            2,556Total
                operating expenses
            22
            66,951
            2,375
            55
            69,403(Loss)
                income before taxes
            (2,921)
            (711)
            41,490
            4,484
            42,342Income
                tax (benefit) expense
            (119)
            6,134
            1,702
            (420)
            7,297**Net
                (loss) income**
            $(2,802)
            $(6,845)
            $39,788
            $4,904
            $35,045








32








**Consolidating
                Statement of Operations**
              **For
                the six months ended June 30, 2005****Saxon
                Capital, Inc. (Parent)**
            **Sub-guarantors**
            **Non-guarantors**
            **Eliminations**
            **Total**($
                in thousands)**Revenues
                and Gains:**Interest
                income
            $—
            $20,891
            $192,630
            $9,978
            $223,499Interest
                expense
            —
            (7,801)
            (108,677)
            —
            (116,478)Intercompany
                interest
            24
            24,385
            3,445
            (27,854)
            —Net
                interest income
            24
            37,475
            87,398
            (17,876)
            107,021Provision
                for mortgage loan losses
            —
            (447)
            (11,289)
            —
            (11,736)Net
                interest income after provision for mortgage loan losses
            24
            37,028
            76,109
            (17,876)
            95,285Servicing
                income, net of amortization and impairment
            —
            39,503
            (8,713)
            —
            30,790Derivative
                gains
            —
            143
            6,007
            —
            6,150Gain
                on sale of assets
            —
            2,381
            26
            —
            2,407Total
                net revenues and gains
            24
            79,055
            73,429
            (17,876)
            134,632**Expenses:**Payroll
                and related expenses
            —
            25,526
            13,269
            (789)
            38,006General
                and administrative expenses
            15
            16,920
            14,501
            (77)
            31,359Depreciation
            —
            2,556
            287
            —
            2,843Other
                expense (income), net
            —
            7,860
            (6,876)
            857
            1,841Total
                operating expenses
            15
            52,862
            21,181
            (9)
            74,049Income
                (loss) before taxes
            9
            26,193
            52,248
            (17,867)
            60,583Income
                tax expense (benefit)
            —
            11,831
            (2,704)
            (9,510)
            (383)**Income
                (loss) before cumulative effect of change in accounting
                principle**
            9
            14,362
            54,952
            (8,357)
            60,966Cumulative
                effect of change in accounting principle
            —
            31
            —
            —
            31**Net
                income (loss)**
            $9
            $14,393
            $54,952
            $(8,357)
            $60,997





33





**Consolidating
                Statement of Cash Flows**
              **For
                the six months ended June 30, 2006****Saxon
                Capital, Inc. (Parent)**
            **Sub-guarantors**
            **Non-guarantors**
            **Eliminations**
            **Total**($
                in thousands)**Operating
                Activities:**Net
                (loss) income
            $(2,802)
            $(6,845)
            $39,788
            $4,904
            $35,045Adjustments
                to reconcile net (loss) income to net cash provided by (used in)
                operating
                activities:Depreciation
                and amortization
            70
            36,395
            13,131
            (5)
            49,591Intercompany
                amortization
            —
            (2,178)
            (2,516)
            4,694
            —Deferred
                income tax provision (benefit)
            —
            253
            (17)
            (420)
            (184)Impairment
                of assets
            —
            1,087
            2,365
            —
            3,452Non
                cash derivative gains
            —
            (6,942)
            (5,900)
            —
            (12,842)Loss
                from sale of assets
            —
            1,768
            —
            —
            1,768Intercompany
                loss (gain) from sale of loans and advances
            —
            9,228
            —
            (9,228)
            —Provision
                for mortgage loan losses
            —
            3,663
            10,324
            —
            13,987Provision
                for advanced interest
            —
            88
            6,290
            —
            6,378Compensation
                expense for share-based compensationplans
            —
            1,699
            —
            —
            1,699(Increase)
                decrease in servicing related advances
            —
            (428,102)
            380,660
            12,638
            (34,804)(Increase)
                decrease in accrued interest receivable
            —
            (7,055)
            2,444
            (27)
            (4,638)Increase
                (decrease) in accrued interest payable
            2,850
            1,812
            (422)
            (2,009)
            2,231(Increase)
                decrease in trustee receivable
            —
            (12,700)
            (2,078)
            10,798
            (3,980)Decrease
                (increase) in income tax receivable
            8,922
            (11,754)
            5,485
            —
            2,653(Purchases
                of) proceeds from derivative instruments
            —
            (5)
            5,211
            —
            5,206Net
                change in miscellaneous assets and liabilities
            1,695
            1,993
            3,045
            (14,032)
            (7,299)Net
                cash provided by (used in) operating activities
            10,735
            (417,595)
            457,810
            7,313
            58,263**Investing
                Activities:**Purchase
                and origination of mortgage loans
            —
            (1,677,267)
            (9,355)
            6,489
            (1,680,133)Principal
                payments received on mortgage loan portfolio
            —
            113,156
            1,126,426
            (10,322)
            1,229,260Proceeds
                from the sale of mortgage loans
            —
            77,454
            —
            —
            77,454Proceeds
                received from (paid for) the intercompany sale of loans
            —
            905,864
            (905,864)
            —
            —Proceeds
                from the sale of real estate owned
            —
            1,760
            25,499
            —
            27,259Decrease
                (increase) in restricted cash
            —
            141,734
            (266)
            —
            141,468Acquisition
                of mortgage servicing rights
            —
            (43,588)
            —
            —
            (43,588)Capital
                expenditures
            —
            (4,111)
            —
            —
            (4,111)Capital
                contributions (to) from affiliates
            (99,995)
            83,288
            16,709
            (2)
            —Net
                cash (used in) provided by investing activities
            (99,995)
            (401,710)
            253,149
            (3,835)
            (252,391)**Financing
                Activities:**Proceeds
                from issuance of securitization financing-bonds
            —
            1,013,495
            464,534
            —
            1,478,029Proceeds
                from issuance of securitization financing-certificates
            —
            —
            30,167
            —
            30,167Proceeds
                received from issuance of senior notes
            150,000
            —
            —
            —
            150,000Debt
                issuance costs
            (5,786)
            (2,960)
            (1,744)
            —
            (10,490)Principal
                payments on securitization financing-bonds
            —
            (87,249)
            (1,165,975)
            —
            (1,253,224)Principal
                payments on securitization financing-certificates
            —
            —
            (3,518)
            —
            (3,518)Repayment
                of warehouse financing, net
            —
            (131,688)
            (477)
            —
            (132,165)Proceeds
                received from issuance of stock
            544
            —
            —
            —
            544Payment
                of dividends
            (57,924)
            —
            —
            —
            (57,924)Due
                from (to) affiliates
            2,845
            26,963
            (29,808)
            —
            —Net
                cash provided by (used in) financing activities
            89,679
            818,561
            (706,821)
            —
            201,419Net
                increase (decrease) in cash
            419
            (744)
            4,138
            3,478
            7,291Cash
                at beginning of year
            222
            4,054
            5,255
            (3,478)
            6,053Cash
                at end of year
            $641
            $3,310
            $9,393
            $—
            $13,344




34


**Consolidating
                Statement of Cash Flows**
              **For
                the six months ended June 30, 2005****Saxon
                Capital, Inc. (Parent)**
            **Sub-guarantors**
            **Non-guarantors**
            **Eliminations**
            **Total**($
                in thousands)**Operating
                Activities:**Net
                income (loss)
            $9
            $14,393
            $54,952
            $(8,357)
            $60,997Adjustments
                to reconcile net income (loss) to net cash provided by operating
                activities:Depreciation
                and amortization
            —
            22,368
            12,308
            (275)
            34,401Intercompany
                amortization
            —
            419
            9,284
            (9,703)
            —Deferred
                income tax benefit
            —
            (7,228)
            (7)
            (7,773)
            (15,008)Impairment
                of assets
            —
            1,720
            1,399
            —
            3,119Non
                cash derivative (gains) losses
            —
            (395)
            4,611
            —
            4,216Gain
                from sale of assets
            —
            (2,381)
            (26)
            —
            (2,407)Intercompany
                (gain) loss from sale of loans and advances
            —
            (21,926)
            (5,928)
            27,854
            —Provision
                for mortgage loan losses
            —
            447
            11,289
            —
            11,736Provision
                for advanced interest
            —
            —
            6,663
            —
            6,663Compensation
                expense for share-based compensationplans
            —
            1,592
            —
            —
            1,592Cumulative
                effect of change in accounting principle
            —
            (31)
            —
            —
            (31)(Increase)
                decrease in servicing related advances
            —
            (265,037)
            235,156
            5,942
            (23,939)Decrease
                (increase) in accrued interest receivable
            —
            2,276
            (2,842)
            851
            285Decrease
                in accrued interest payable
            —
            (376)
            (760)
            —
            (1,136)Increase
                in trustee receivable
            —
            (1,782)
            (183)
            (21,397)
            (23,362)(Increase)
                decrease in income tax receivable
            (1,245)
            35,365
            (2,656)
            (1,735)
            29,729Purchases
                of derivative instruments
            —
            —
            (4,271)
            —
            (4,271)Net
                change in miscellaneous assets and liabilities
            1,595
            25,158
            (5,701)
            (26,969)
            (5,917)Net
                cash provided by (used in) operating activities
            359
            (195,418)
            313,288
            (41,562)
            76,667**Investing
                Activities:**Purchase
                and origination of mortgage loans
            —
            (1,191,199)
            (444,839)
            21,856
            (1,614,182)Principal
                payments received on mortgage loan portfolio
            —
            13,803
            1,146,713
            21,248
            1,181,764Proceeds
                from the sale of mortgage loans
            —
            216,396
            —
            —
            216,396Proceeds
                received from (paid for) the intercompany sale of loans
            —
            1,650,092
            (1,650,092)
            —
            —Proceeds
                from the sale of real estate owned
            —
            1,565
            27,509
            —
            29,074Increase
                in restricted cash
            —
            —
            (203,316)
            —
            (203,316)Acquisition
                of mortgage servicing rights
            —
            (51,998)
            —
            —
            (51,998)Capital
                expenditures
            —
            (5,888)
            —
            —
            (5,888)Capital
                contributions from (to) affiliates
            60,298
            (24,773)
            (33,983)
            (1,542)
            —Net
                cash provided by (used in) investing activities
            60,298
            607,998
            (1,158,008)
            41,562
            (448,150)**Financing
                Activities:**Proceeds
                from issuance of securitization financing-bonds
            —
            —
            1,979,971
            —
            1,979,971Proceeds
                from issuance of securitization financing-certificates
            —
            —
            40,824
            —
            40,824Debt
                issuance costs
            —
            —
            (6,340)
            —
            (6,340)Principal
                payments on securitization financing-bonds
            —
            —
            (1,231,030)
            —
            (1,231,030)Principal
                payments on securitization financing-certificates
            —
            —
            (18,264)
            —
            (18,264)Repayment
                of warehouse financing, net
            —
            (339,461)
            (80)
            —
            (339,541)Proceeds
                received from issuance of stock
            752
            —
            —
            —
            752Payment
                of dividends
            (56,791)
            —
            —
            —
            (56,791)Due
                (to) from affiliates
            (5,198)
            (78,770)
            83,968
            —
            —Net
                cash (used in) provided by financing activities
            (61,237)
            (418,231)
            849,049
            —
            369,581Net
                (decrease) increase in cash
            (580)
            (5,651)
            4,329
            —
            (1,902)Cash
                at beginning of year
            743
            8,998
            3,111
            —
            12,852Cash
                at end of year
            $163
            $3,347
            $7,440
            $—
            $10,950






35




**Item
      2. Management’s Discussion and Analysis of Financial Condition and Results of
      Operations**





This
      discussion should be read in conjunction with the unaudited consolidated
      financial statements, notes and tables included elsewhere in this report and
      in
      the Saxon Capital, Inc. Annual Report on Form 10-K for the year ended December
      31, 2005, or the 2005 Form 10-K, filed with the Securities and Exchange
      Commission. Certain information contained in this report constitutes
      forward-looking statements within the meaning of Section 27A of the Securities
      Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Generally,
      forward-looking statements can be identified by the use of forward-looking
      terminology including, but not limited to, “may,” “expect,” “intend,” “should,”
“anticipate,” “estimate,” “is likely to,” “could,” “are confident that,” or
“believe” or comparable terminology. All statements contained in this item as
      well as those discussed elsewhere in this Report addressing our operating
      performance, events, or developments that we expect or anticipate will occur
      in
      the future, including statements relating to net interest income growth,
      earnings or earnings per share growth, and market share, as well as statements
      expressing optimism or pessimism about future operating results, are
      forward-looking statements. The forward-looking statements are based upon
      management’s views and assumptions as of the date of this Report, regarding
      future events and operating performance and are applicable only as of the dates
      of such statements. By their nature, all forward-looking statements involve
      risk
      and uncertainties. Actual results may differ materially from those contemplated
      by the forward-looking statements for a number of reasons, including, but not
      limited to, those addressed in “Part II - Item 1A. Risk Factors” in our
      quarterly report on Form 10-Q for the period ended March 31, 2006 and those
      included in the 2005 Form 10-K, and the following summary of risks and
      uncertainties:





·
            decreases
                in residential real estate values, which could reduce both the credit
                quality of our mortgage loan portfolio and the ability of borrowers
                to use
                their home equity to obtain cash through mortgage loan refinancings,
                which
                would adversely impact our ability to produce new mortgage
                loans;





·
            changes
                in overall regional or local economic conditions or changes in interest
                rates, particularly those conditions that affect demand for new housing,
                housing resales or the value of
                houses;





·
            our
                ability to successfully implement our growth strategy throughout
                the
                various cycles experienced by our
                industry;





·
            greater
                than expected declines in consumer demand for residential mortgage
                loans,
                particularly sub-prime, non-conforming
                loans;





·
            our
                ability to sustain loan production growth at historical
                levels;





·
            continued
                availability of financing facilities and access to the securitization
                markets or other funding sources;





·
            our
                ability to securitize our loans at favorable financing
                rates;





·
            deterioration
                in the credit quality of our loan portfolio and the loan portfolios
                of
                others serviced by us;






36


·
            lack
                of access to the capital markets for additional funding if our existing
                sources of funding become
                unavailable;





·
            challenges
                in successfully expanding our servicing platform and technological
                capabilities;





·
            our
                ability to maintain our current servicer
                ratings;





·
            difficulty
                in satisfying complex rules in order for us to maintain qualification
                as a
                real estate investment trust, or REIT, for federal income tax
                purposes;





·
            the
                ability of certain of our subsidiaries to continue to qualify as
                qualified
                REIT subsidiaries for federal income tax
                purposes;





·
            our
                ability and the ability of our subsidiaries to operate effectively
                within
                the limitations imposed by the federal income tax laws and regulations
                applicable to REITs;





·
            changes
                in federal income tax laws and regulations applicable to
                REITs;





·
            changes
                in mortgage loan prepayment speeds;





·
            decreased
                valuations of our mortgage loan portfolio and mortgage servicing
                rights,
                or MSRs, due to a variety of factors, including catastrophic environmental
                influences or natural disasters such as hurricanes, tornados and
                earthquakes;





·
            future
                litigation developments or regulatory or enforcement actions;
                and





·
            increased
                competitive conditions or changes in the legal and regulatory environment
                in our industry.




These
        risks and uncertainties should be considered in evaluating forward-looking
        statements, and undue reliance should not be placed on such statements. We
        undertake no obligation to update publicly any of these statements in light
        of
        future events except as required in subsequent periodic reports we file with
        the
        Securities and Exchange Commission.


37





The
      following sets forth the table of contents for this management’s discussion and
      analysis of financial condition and results of operations.




**Table
                of Contents**
            **Page**Executive
                Summary
            38Description
                of Other Data
            40Second
                Quarter 2006 Events and Outlook
            42Critical
                Accounting Policies
            43Consolidated
                Results
            48Business
                Segment Results
            63Financial
                Condition
            68Liquidity
                and Capital Resources
            70Off
                Balance Sheet Items and Contractual Obligations
            76Other
                Matters
            77







**Executive
      Summary**




***Company
      Overview***




We
      are in
      the business of originating, purchasing, securitizing, and servicing
      non-conforming residential mortgage loans that are primarily sub-prime. We
      operate through three business segments. These segments are:





·  Mortgage
      loan production;





·  Portfolio;
      and





·  Mortgage
      loan servicing;





Through
      our taxable REIT subsidiary, Saxon Capital Holdings, Inc., and its subsidiaries,
      which we refer to collectively as our taxable REIT subsidiaries, we originate
      or
      purchase mortgage loans for our portfolio segment through our wholesale,
      correspondent and retail channels, which we refer to collectively as our
“mortgage loan production segment”. We earn most of our revenues from the net
      interest income generated by those mortgage loans through our portfolio segment
      and from servicing loans for other companies through our mortgage loan servicing
      segment. We also earn revenues through whole loan sales of some of our mortgage
      loans. We pay interest to finance our mortgage loan portfolio, servicing rights
      and servicing advances and incur general and administrative expenses to operate
      our business. We maintain a provision for mortgage loan losses that may occur
      from impaired mortgage loans that are in our portfolio. We initially fund our
      mortgage loan originations and purchases through short-term warehouse lines
      of
      credit and through repurchase facilities, as well as with the amounts borrowed
      under our senior notes, which are replaced by permanent financing when we
      securitize the loans. We structure our securitization transactions as financing
      transactions, with the mortgage loans and related debt to finance those loans
      remaining on our balance sheet.




38


We
      access
      the asset-backed securitization market to provide long-term financing for our
      mortgage loans. We finance the loans initially using one of several different
      secured and committed warehouse lines of credit and repurchase agreement
      facilities. These loans are subsequently financed using asset-backed securities
      issued through securitization trusts. From May 1996 to June 30, 2006, we
      securitized $24.0 billion in mortgage loans. Since July 6, 2001, we have
      structured our securitizations as financing transactions for financial reporting
      purposes under accounting principles generally accepted in the United States
      of
      America, or GAAP. Accordingly, following a securitization: (1) the mortgage
      loans we produce remain on our consolidated balance sheet; (2) the
      securitization indebtedness replaces the warehouse and repurchase debt
      associated with the securitized mortgage loans; and (3) we record interest
      income on the mortgage loans and interest expense on the securities issued
      in
      the securitization over the life of the securitization, instead of recognizing
      a
      gain or loss upon completion of the securitization. This accounting treatment
      more closely matches the recognition of income with the receipt of cash payments
      on the individual loans than does gain on sale accounting, which we used prior
      to July 6, 2001.




***Industry
      Overview and Prospective Trends***






Described
      below are some of the marketplace conditions and prospective trends that may
      impact our future results of operations.




According
      to the Board of Governors of the Federal Reserve System, or FRB, the residential
      mortgage loan market is the largest consumer finance market in the United
      States. According to the Mortgage Bankers Association of America, or MBAA,
      website as of July 12, 2006, lenders in the United States originated more than
      $2.9 trillion in one-to-four family mortgage loans in 2005. A substantial
      portion of the loan originations in 2005 was attributable to mortgage loan
      refinancings, and we believe this was a result of customers taking advantage
      of
      strong housing appreciation and increased mortgage product offerings in the
      marketplace. Additionally, customers benefited from the increased competition
      within the mortgage loan industry which kept interest rates low in spite of
      a
      slightly rising interest rate environment. According to the MBAA website as
      of
      July 12, 2006, lenders are expected to originate $2.4 trillion in single-family
      mortgage loans in 2006, reflecting an anticipated decrease in refinancing
      activity. Generally, we believe sub-prime borrowers are not solely motivated
      by
      fluctuations in interest rates.




Generally,
      the mortgage loan industry is segmented by the size of the mortgage loans and
      the credit characteristics of the borrowers. Mortgage loans that conform to
      the
      guidelines of GSEs, such as Fannie Mae or Freddie Mac, which have guidelines
      for
      both size and credit characteristics, are called conforming mortgage loans.
      Most
      of our mortgage loans are considered non-conforming mortgage loans because
      of
      the size of the loans (generally referred to as jumbo mortgage loans), or the
      credit profiles of the borrowers (generally referred to as sub-prime mortgage
      loans), or both. We believe the mortgage loan originators in the non-conforming
      segment of the mortgage industry provide credit to a broad range of consumers
      who are underserved by the conforming mortgage loan market. In addition, we
      believe that many sub-prime mortgage loan products that have very low initial
      interest rates for a period of one or two years continue to present borrowers
      with economic incentives to refinance their existing mortgage loans when the
      low
      interest rate period expires, regardless of interest rate movements; therefore,
      we do not expect the same level of decline in loan demand in the non-conforming
      mortgage loan market as would be expected in the overall mortgage loan market
      as
      interest rates rise.




39


Over
      the
      last several years, the housing price index has increased faster than the
      consumer price index and growth in personal income. We expect that this trend
      will slow in the coming years. Over the long term, however, we anticipate that
      housing appreciation will be positively correlated with both consumer price
      inflation and growth in personal income. Rising housing values point to healthy
      demand for purchase-money mortgage financing, increased average loan balances
      and a reduction in the risk of loss on sale of foreclosed real estate in the
      event a loan defaults. However, as housing values appreciate, prepayments of
      existing mortgage loans tend to increase as borrowers look to realize the
      additional equity in their homes. If our forecasts are incorrect and housing
      prices fall dramatically, our future results of operations would be adversely
      affected by lower production and higher credit losses.




**Description
      of Other Data**






In
      this
      Management's Discussion and Analysis of Financial Condition and Results of
      Operations, we present certain data that we consider helpful in understanding
      our financial condition and results of operations, and our calculations of
      these
      data may be calculated differently than other registrants. These measures have
      limitations as analytical tools, and you should not consider them in isolation
      or as a substitute for analysis of our results as reported under GAAP. These
      measures should be used only supplementally. See our consolidated financial
      statements and related notes included elsewhere in this report and see
“Consolidated Results” for the reconciliations of these financial measures to
      GAAP. Descriptions of these financial measures are set forth below.




*Net
      interest margin.* Net
      interest margin is calculated as the difference between our interest income
      and
      interest expense divided by our average interest-earning assets. Average
      interest-earning assets are calculated using a daily average balance over the
      time period indicated.




*Reconciliation
      of securitization net losses on liquidated loans to
      charge-offs.* Securitization net losses on liquidated loans is a non-GAAP financial measure
      within the meaning of Regulation G promulgated by the Securities and Exchange
      Commission. We present a reconciliation of securitization net losses on
      liquidated loans to charge-offs, which are recognized in our financial
      statements in accordance with GAAP, because management believes that it is
      useful to show both measures of losses to evaluate securitization net losses
      on
      liquidated loans and the information is provided on a monthly basis to the
      investors in each securitization. GAAP requires losses to be recognized
      immediately upon a loan being transferred to REO, whereas securitization net
      losses on liquidated loans do not recognize a loss on REO until the loan is
      sold. This causes a timing difference between charge-offs and securitization
      net
      losses on liquidated loans. In addition, securitization net losses on liquidated
      loans exclude losses resulting from delinquent loan sales.




40


*Working
      capital.* It is
      common business practice to define working capital as current assets less
      current liabilities. We do not have a classified balance sheet and therefore
      calculate our working capital using our own internally defined formula, which
      is
      generally calculated as unrestricted cash and investments as well as
      unencumbered assets that can be pledged against existing committed facilities
      and converted to cash in five days or less.





*Reconciliation
      of GAAP net income to estimated REIT taxable net income.* To
      maintain our status as a REIT, we are required to distribute at least 90% of
      our
      REIT taxable income each year to our shareholders. REIT taxable income is
      calculated under federal tax laws in a manner that, in certain respects, differs
      from the calculation of consolidated net income pursuant to GAAP. We expect
      that
      our consolidated GAAP net income may differ from our REIT taxable income for
      many reasons, including the following:





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





·
            there
                are several differences between GAAP and tax methodologies for
                capitalization of origination
                expenses





·
            there
                are differences between GAAP and tax related to the timing of recognition
                of income (loss) from derivative instruments;
                and





·
            income
                of a taxable REIT subsidiary is generally included in the REIT’s earnings
                for consolidated GAAP purposes, but is not recognized in REIT taxable
                income.




We
        expect
        that our REIT taxable income will continue to differ from our GAAP consolidated
        income, particularly during the period in which we build our mortgage loan
        portfolio.
  Estimated
        REIT taxable income is a non-GAAP financial measure within the meaning of
        Regulation G promulgated by the Securities and Exchange Commission. Management
        believes that the presentation of estimated REIT taxable income provides
        useful
        information to investors regarding our estimated annual distributions to
        our
        investors. The presentation of estimated REIT taxable income is not to be
        considered in isolation or as a substitute for financial results prepared
        in
        accordance with GAAP.


41




Descriptions
      of certain components of our revenues and expenses are set forth in more detail
      in our 2005 Form 10-K.





**Second
      Quarter** **2006
      Events and Outlook**




On
        August
        9, 2006, we announced that we had entered into a definitive agreement with
        Morgan Stanley Mortgage Capital Inc. (“Morgan Stanley”) pursuant to which Morgan
        Stanley will acquire our company for $14.10 per common share in cash, or
        approximately $706 million, through a merger between us and a wholly-owned
        subsidary of Morgan Stanley. The transaction is expected to close in the
        fourth
        quarter of 2006, pending regulatory approval, approval by our shareholders
        and
        the satisfaction of other customary closing conditions. The impact on our
        consolidated financial statements has not yet been
        determined.




The
      non-conforming, residential mortgage industry has become increasingly
      competitive in recent years. Today, the industry is dominated by a small number
      of large companies. This market share domination has led to intense competition
      within the industry and has negatively impacted our profitability. Specifically,
      lenders in the industry have not raised interest rates in line with increases
      in
      market interest rates, which has reduced our net interest margin and negatively
      impacted our liquidity. Toward the end of 2005 and at the beginning of the
      first
      quarter of 2006, lenders began to raise interest rates marginally; but not
      commensurate with market interest rates and for the latter half of the first
      quarter of 2006, lenders began decreasing their rates. For the majority of
      the
      second quarter of 2006, lenders either marginally increased rates or left their
      rates unchanged while borrowing costs continued to increase. As a result, we
      expect to continue to experience margin compression in 2006. To compete
      effectively, we will be required to achieve and maintain a high level of
      operational, technological and managerial expertise and efficiencies, as well
      as
      an ability to attract capital at a competitive cost.





Throughout
      the first six months of 2006, we experienced an increase in short-term borrowing
      interest rates and a continued increase in competitiveness of pricing within
      our
      industry. We also experienced a reduction in our prepayment penalty income
      as a
      result of fewer loans in our portfolio containing prepayment features and a
      decrease in prepayment penalty fees collected per loan during the first six
      months of 2006 as compared to the first six months of 2005. This resulted in
      a
      substantial reduction in the net interest margin including prepayment penalty
      income on our mortgage loan portfolio. During the first six months of 2006,
      we
      experienced an increase in the 2/3 year swap curve and six-month LIBOR curve,
      which positively impacted the fair value of our derivatives and increased our
      derivative gains.




During
        the first six months of 2006, we purchased the rights to service $5.9 billion
        of
        mortgage loans at a cost of $47.5 million. We have generally seen prices
        of
        mortgage servicing rights increase in the marketplace due to an anticipated
        decrease in prepayment speeds, and thus an increase in the lives of servicing
        assets resulting in an increase in servicing fees.
 
 During
        the second quarter of 2006, we completed the issuances of SAST 2006-1 and
        SAST
        2006-2, totaling $500.0 million and $999.9 million in principal balances,
        respectively.
 
 On
        May 4,
        2006, we closed a private offering of $150 million of 12% senior notes due
        2014.
        The notes bear interest at a fixed rate of 12% per annum. The Company is
        using
        the net proceeds from the offering for general corporate purposes, principally
        the acquisition of additional third-party mortgage servicing rights and whole
        loans in bulk.


42




We
      have
      also made significant progress in implementing our 2006 strategic initiatives
      during the second quarter of 2006. Specifically, we saw decreased total
      operating expenses during the first six months of 2006 due to management’s
      continued focus on maximizing operating efficiencies, reducing production costs,
      and enhancing profitability. We also successfully completed our first conduit
      loan pool purchase of $119.4 million. Finally, we completed the implementation
      of our new web-based loan production system in May 2006.





In
      summary, our production levels during the second quarter of 2006 were above
      our
      second quarter of 2005 production. In 2006, we expect to increase our mortgage
      loan production over levels achieved in 2005 through a more efficient process
      as
      a result of having adjusted to our new centralized loan production structure,
      the investments we have made in technology and our focus on controlling our
      general and administrative expenses. We also intend to continue to grow our
      mortgage loan portfolio and servicing portfolio in order to produce higher
      levels of net interest income and servicing income. However, we also expect
      short-term market interest rates to rise and competitive pressures to remain
      intense during 2006.





**Critical
      Accounting Policies**




Management’s
      Discussion and Analysis of Financial Condition and Results of Operations
      discusses our consolidated financial statements, which have been prepared in
      accordance with GAAP. The preparation of these consolidated financial statements
      requires management to make estimates and assumptions that affect the reported
      amounts of assets and liabilities and the disclosure of contingent assets and
      liabilities as of the date of the consolidated financial statements and the
      reported amounts of revenues and expenses during the reporting period. On an
      ongoing basis, management evaluates its estimates and judgments. Management
      bases its estimates and judgments on historical experience and on various other
      factors that it believes to be reasonable under the circumstances, the results
      of which form the basis for making judgments about the carrying values of assets
      and liabilities that are not readily apparent from other sources. Actual results
      may differ from these estimates and the estimates will change under different
      assumptions or conditions.





Critical
      accounting estimates are defined as those that reflect significant judgments
      and
      uncertainties and potentially result in materially different outcomes under
      different assumptions and conditions. Our critical accounting estimates are
      discussed below and consist of:





·
            amortization
                of yield adjustments to net interest
                income;




·
            allowance
                for loan losses and past due
                interest;




·
            mortgage
                servicing rights;




·
            deferral
                of direct loan origination costs;
                and




·
            accounting
                for income taxes.








43


*Amortization
      of Yield Adjustments to Net Interest Income*




Net
      interest income is calculated as the difference between our interest income
      and
      interest expense. Interest income on our mortgage loan portfolio is a
      combination of accruing interest based on the outstanding balance and
      contractual terms of the mortgage loans and the amortization of yield
      adjustments using the interest method, principally the amortization of premiums,
      discounts, and other net capitalized fees or costs associated with originating
      our mortgage loans. These yield adjustments are amortized against interest
      income over the lives of the assets using the interest method adjusted for
      the
      effects of estimated prepayments. Management does not currently use the payment
      terms required by each loan contract in the calculation of amortization. Because
      we hold a large number of similar loans for which prepayments are probable,
      we
      currently use a prepayment model to project loan prepayment activity based
      upon
      loan age, loan type and remaining prepayment penalty coverage. Estimating
      prepayments and estimating the remaining lives of our mortgage loan portfolio
      requires management judgment, which involves consideration of possible future
      interest rate environments and an estimate of how borrowers will behave in
      those
      environments. Reasonableness tests are performed against past history, mortgage
      asset pool specific events, current economic outlook and loan age to verify
      the
      overall prepayment projection. If these mortgage loans prepay at an actual
      speed
      that differs from the projections used in our estimates, GAAP requires us to
      adjust the remaining capitalized yield adjustments accordingly on a prospective
      and retrospective basis. The projections used in our interest method
      calculations are based on six-month LIBOR.




Mortgage
      loan prepayments generally increase on our adjustable rate mortgage loans when
      fixed mortgage interest rates fall below the then-current interest rates on
      outstanding adjustable rate mortgage loans. Prepayments on mortgage loans are
      also affected by the terms and credit grades of the loans, conditions in the
      housing and financial markets and general economic conditions. We have sought
      to
      minimize the effects caused by faster than anticipated prepayment rates by
      lowering premiums paid to acquire mortgage loans, which decreases the balance
      of
      premiums to be amortized, and by purchasing and originating mortgage loans
      with
      prepayment penalties. The majority of our penalties expire two to three years
      from origination. As of June 30, 2006, 71% of our mortgage loan portfolio had
      active prepayment penalty features. We anticipate that prepayment rates on
      a
      significant portion of our adjustable rate mortgage loan portfolio will increase
      as these adjustable rate mortgage loans reach their initial adjustments during
      2006 and 2007, due to the high concentration of two to three year hybrid loans
      we originated or purchased during 2003 and 2004. The constant prepayment rate,
      or CPR, currently used to project cash flows is 36% over twelve months.




Interest
      expense on our warehouse, repurchase and securitization financings, as well
      as
      our senior notes is a combination of accruing interest based on the contractual
      terms of the financing arrangements and the amortization/accretion of premiums,
      discounts, and debt issuance costs. These yield adjustments are amortized
      against interest expense over the life of the debt in a manner similar to that
      described above for interest income, using the interest method adjusted for
      the
      effects of the estimated payments on the debt.




*Allowance
      for Loan Losses and Past Due Interest*





The
      allowance for loan losses is established through the provision for mortgage
      loan
      losses, which is charged to earnings on a monthly basis. The allowance for
      past
      due interest is charged to earnings through interest income. The accounting
      estimate of the allowance for loan losses and past due interest is considered
      critical as significant changes in the mortgage loan portfolio, which includes
      both securitized and unsecuritized mortgage loans, and/or economic conditions
      may affect the allowance for loan losses and past due interest and our results
      of operations. The assumptions used by management regarding these key estimates
      involve a great deal of judgment.





44


Provisions
      are made to the allowance for loan losses and past due interest for currently
      impaired loans in the outstanding mortgage loan portfolio. We define a mortgage
      loan as impaired at the time the loan becomes 30 days delinquent under its
      payment terms. Charge-offs to the allowance are recorded at the time of
      liquidation or at the time the loan is transferred to REO status. The allowance
      for loan losses and past due interest is regularly evaluated by management
      for
      propriety by taking into consideration factors such as: changes in the nature
      and volume of the loan portfolio; trends in actual and forecasted portfolio
      performance and credit quality, including delinquency, charge-off and bankruptcy
      rates; and current economic conditions that may affect a borrower’s ability to
      pay as well as the underlying value of the collateral. An internally developed
      roll rate analysis, static pool analysis and historical losses are the primary
      tools used in analyzing our allowance for loan losses and past due interest.
      Our
      roll rate analysis is defined as the historical progression of our loans through
      the various delinquency categories. Our static pool analysis provides data
      on
      individual pools of loans based on year of origination. These tools take into
      consideration historical information regarding delinquency and loss severity
      experience and apply that information to the portfolio and the portfolio’s basis
      adjustments. Loss severity, as a percentage, is defined as the total loss amount
      divided by the actual unpaid principal balance at the time of liquidation.
      Total
      loss amounts include all accrued interest, fees, principal balances, all costs
      of liquidating and all other servicing advances for taxes, property insurance,
      and other servicing costs incurred and invoiced to us within 90 days following
      the liquidation date. If actual results differ from our estimates, we will
      adjust our provision accordingly. Likewise, the use of different estimates
      or
      assumptions could produce different provisions for loan losses.




The
      allowance for loan losses and past due interest was impacted in the first six
      months of 2006 primarily by a decrease in overall delinquencies since December
      31, 2005. We are currently experiencing an 18-month average loss severity of
      40%
      on our owned portfolio, and this is the assumption currently used in our loan
      loss allowance model. We did not make any significant changes in our reserve
      methodologies or assumptions during the second quarter of 2006.





*Mortgage
      Servicing Rights*





The
      valuation of MSRs requires that we make estimates of numerous market
      assumptions. Interest rates, prepayment speeds, servicing costs, discount rates,
      and the payment performance of the underlying loans significantly affect the
      fair value and the rate of amortization of MSRs. Increasing prepayments
      attributable to increased mortgage refinancing activity result in a decline
      in
      the value of MSRs.





The
      carrying values of the MSRs are amortized in proportion to, and over the period
      of, the anticipated net servicing income. MSRs are assessed periodically to
      determine if there has been any impairment to the carrying value, based on
      the
      fair value as of the date of the assessment and by stratifying the MSRs based
      on
      underlying loan characteristics, including the date of the related
      securitization. We obtain quarterly independent valuations for our MSRs.





45


Due
      to
      subsequent changes in economic and other relevant conditions, the actual rates
      of prepayments and defaults and the value of collateral may differ from our
      initial estimates, and these differences may be material. If actual prepayment
      and default rates were higher than those assumed, we would earn less mortgage
      servicing income, which would adversely affect the value of the MSRs.
      Significant changes in prepayment speeds, delinquencies, and losses may result
      in impairment of our MSRs. We perform an impairment analysis using independent
      valuations that we obtain each quarter. We consider estimates of numerous market
      assumptions, changes in interest rates, prepayment speeds, servicing costs,
      discount rates, and the payment performance of the underlying mortgage loans,
      all of which could significantly affect the fair value and the rate of
      amortization of MSRs. If we determine that a pool of MSRs is impaired, we
      analyze certain attributes of that pool, such as prepayments, to assess whether
      the impairment is temporary or permanent. If we conclude that the impairment
      is
      temporary, we establish a valuation allowance and record an expense. In the
      event the impairment is subsequently reversed, the related allowance amount
      is
      recognized in our income; however, reversals of impairment may not be reversed
      passed the amount of the original fair value recorded. When the Company
      determines that a portion of the mortgage servicing rights are not recoverable,
      the related mortgage servicing rights and the previously established valuation
      allowance are correspondingly reduced to reflect the permanent impairment.





As
      a
      result of increased actual prepayment speeds and future prepayment speed
      assumptions applied to certain aged third party servicing portfolios, we
      recorded a temporary impairment of $0.9 million on our MSRs for the first six
      months of 2006. It is possible that we may experience, in whole or in part,
      a
      reversal of the temporary impairment if actual future prepayments are lower
      than
      our future prepayment speed assumptions. Every quarter we value the third-party
      portion of our loan servicing portfolio using a prepayment speed assumption
      which management believes is appropriate given the product mix of the
      third-party servicing portfolio. The prepayment speed assumption used to value
      the servicing rights is an average of the CPR over the remaining life of the
      servicing rights and is therefore re-evaluated every quarter.





*Deferral
      of Direct Loan Origination Costs*





We
      incur
      certain direct loan origination costs in connection with our loan origination
      activities. Such amounts are recognized over the life of the related loans
      as an
      adjustment of yield, as discussed above in the section relating to our critical
      accounting policy with respect to accounting for net interest
      income.





We
      determine the amount of direct loan origination costs to be deferred based
      on an
      estimate of the standard cost per loan originated. The standard cost per loan
      is
      based on the amount of time spent and costs incurred by loan origination
      personnel in the performance of certain activities directly related to the
      origination of funded mortgage loans. These activities include evaluating the
      prospective borrower’s financial condition, evaluating and recording collateral
      and security arrangements, negotiating loan terms, processing loan documents
      and
      closing the loan. Management believes these estimates reflect an accurate cost
      estimate related to successful loan origination efforts for the three months
      ended June 30, 2006 based on existing facts and circumstances. Management
      evaluates its time and cost estimates quarterly to determine if updates and
      refinements to the deferral amounts are necessary. Updates will be necessary
      if
      it is determined that the time spent and/or costs incurred related to performing
      the above activities have significantly changed from the previous period. This
      estimate is made for all loans originated in our wholesale and retail channels.
      Correspondent production is not included, as we purchase these loans as closed
      loans and therefore, loan origination costs related to these purchases are
      expensed as incurred. In the second quarter of 2006, we deferred $5.7 million
      in
      costs associated with originating loans and $5.9 million in nonrefundable fees
      related to mortgage loan originations. We also recorded net amortization of
      these deferred loan origination costs and fees of $0.8 million.




46


*Accounting
      for Income Taxes*




Significant
      management judgment is required in developing our provision for income taxes,
      including the determination of deferred tax assets and liabilities and any
      valuation allowances that might be required against the deferred tax asset.
      As
      of June 30, 2006, we recorded $18.8 thousand as a valuation allowance on our
      deferred tax assets for capital losses incurred by a qualified REIT subsidiary
      during the first six months of 2006 based on management’s belief that it is more
      likely than not that capital gains will not be generated within the next five
      years by the qualified REIT subsidiary to realize the benefit of this asset.
      The
      evaluation of the need for a valuation allowance takes into consideration our
      taxable income, current tax position, and estimates of taxable income in the
      near term. The tax character (ordinary versus capital) and the carryforward
      periods of certain tax attributes such as capital losses and tax credits must
      also be considered. Significant judgment is required in considering the relative
      impact of negative and positive evidence related to the ability to realize
      deferred tax assets. In the event that actual results differ from these
      estimates or if our current trend of positive taxable income changes, we may
      be
      required to record additional valuation allowances on our deferred tax assets,
      which could have a material adverse effect on our consolidated financial
      condition and results of operations. We recognize deferred tax assets if we
      believe that it is more likely than not, given all available evidence, that
      all
      of the benefits of the carryforward losses and other deferred tax assets will
      be
      realized. Management believes that, based on the available evidence, it is
      more
      likely than not that we will realize the benefit from the remainder of our
      deferred tax assets.





We
      believe we have complied with the REIT provisions of the Internal Revenue Code
      for the three months ended June 30, 2006 and currently intend to continue to
      comply with such provisions in the future. Accordingly, we do not expect to
      be
      subject to federal or state income tax on net income that is distributed to
      shareholders as long as we continue to comply with the requirements necessary
      to
      maintain our qualification as a REIT. In the event that we do not qualify as
      a
      REIT in any year, we will be subject to federal and state income tax as a
      domestic corporation, and the amount of our after-tax cash available for
      distribution to our shareholders will be reduced. However, our taxable REIT
      subsidiaries are subject to federal and state income tax and we intend to
      continue to employ the accounting policy described above with respect to our
      taxable REIT subsidiaries.





47


For
      further information about our critical accounting policies, refer to our 2005
      Form 10-K.




**Consolidated
      Results**





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





*Overview.* Net
      income increased $1.6 million, or 23%, to $8.6 million for the three months
      ended June 30, 2006 from $7.0 million for the three months ended June 30, 2005.
      This increase consisted of: (1) an increase in our servicing income of $3.2
      million, related to our acquisition of significant amounts of servicing rights
      for third-party mortgage loans; and (2) an increase in our derivative gains
      of
      $29.8 million. Offsetting these increases, we experienced: (1) a decrease of
      $23.0 million in net interest income due primarily to an increase in the cost
      of
      our borrowings; (2) an increase in provision for mortgage loan losses of $4.0
      million due to an increase in our delinquencies since June 30, 2005; (3) an
      increase in our loss on sale of assets of $1.1 million primarily due to the
      repurchase of mortgage loans previously sold due to early payment default;
      (4)
      an increase in our total operating expenses of $1.9 million; and (5) an increase
      in our income tax expense of $1.4 million. Net income decreased $26.0 million,
      or 43%, to $35.0 million for the six months ended June 30, 2006 from $61.0
      million for the six months ended June 30, 2005. This decrease was primarily
      the
      result of: (1) a decrease of $45.0 million in net interest income due primarily
      to an increase in the cost of our borrowings; (2) an increase in provision
      for
      mortgage loan losses of $2.3 million due to an increase in our delinquencies
      since June 30, 2005; (3) an increase in our loss on sale of assets of $4.2
      million primarily due to the repurchase of mortgage loans previously sold that
      had early payment defaults; and (4) an increase in our income tax expense of
      $7.7 million. These decreases were offset by: (1) an increase in our servicing
      income of $9.3 million, related to our acquisition of significant amounts of
      servicing rights for third-party mortgage loans; (2) an increase in our
      derivative gains of $19.2 million; and (3) a decrease in our total operating
      expenses of $4.6 million. The two most influential factors currently affecting
      our net income in 2006 are the rising interest rate environment, which causes
      our interest expense to increase significantly, and intense competitive pricing
      within our industry which causes the interest rates we charge on our new loan
      production to be substantially lower in relation to our cost of funds than
      has
      historically been the case. These two factors compressed interest margins
      compared to the more favorable interest margins that we had experienced in
      prior
      years.




48


**Revenues**





*Total
      Net Revenues and Gains.* Total
      net
      revenues and gains increased $5.0 million, or 12%, to $48.0 million for the
      three months ended June 30, 2006 from $43.0 million for the three months ended
      June 30, 2005. Total net revenues and gains decreased $22.9 million, or 17%,
      to
      $111.7 million for the six months ended June 30, 2006 from $134.6 million for
      the six months ended June 30, 2005. The decrease in total net revenues and
      gains
      was primarily attributable to an increase in the cost of our borrowings as
      well
      as to increases in our losses on sale of assets, offset by increases in our
      servicing income and derivative gains.





*Interest
      Income.* Interest
      income increased $13.0 million, or 12%, to $124.1 million for the three months
      ended June 30, 2006 from $111.1 million for the three months ended June 30,
      2005. Interest income increased $21.9 million, or 10%, to $245.4 million for
      the
      six months ended June 30, 2006 from $223.5 million for the six months ended
      June
      30, 2005. The increase in interest income was due primarily to the growth in
      our
      securitized mortgage loan portfolio and an increase of 23 basis points and
      17
      basis points in the weighted average coupons on our mortgage loan portfolio
      for
      the three and six months ended June 30, 2006 as compared to the three and six
      months ended June 30, 2005, respectively.





As
      shown
      in the table below, for the three and six months ended June 30, 2006 compared
      to
      the three and six months ended June 30, 2005, our interest income increased
      $9.2
      million and $16.8 million, respectively, due to an increase in the size of
      our
      mortgage loan portfolio, and increased $6.2 million and $8.4 million,
      respectively, as a result of higher interest rates earned on our mortgage loan
      portfolio.







*Rate/Volume
      Table For the Three and Six Months Ended June 30, 2006 Compared to the Three
      and
      Six Months Ended June 30, 2005*




**Three
                Months Ended June 30, 2006 Compared to**
              **Three
                Months Ended June 30, 2005**
            **Six
                Months Ended June 30, 2006 Compared to**
              **Six
                Months Ended June 30, 2005******
            **Change
                in Rate**
            **Change
                in Volume**
            **Total
                Change in Interest Income**
            **Change
                in Rate**
            **Change
                in Volume**
            **Total
                Change in Interest Income**(in
                thousands)Securitized
                loans
            $5,495
            $4,006
            $9,501
            $6,937
            $8,660
            $15,597Loans
                funded by warehouse and repurchase financing
            682
            5,182
            5,864
            1,407
            8,124
            9,531Mortgage
                bonds
            (3)
            (6)
            (9)
            90
            (9)
            81Other
            —
            (1)
            (1)
            —
            (8)
            (8)Total
            $6,174
            $9,181
            $15,355
            $8,434
            $16,767
            $25,201Prepayment
                penalty income
            
            
            (2,318)
            
            
            (3,306)$13,037
            
            
            $21,895








49


*Interest
      Income Yield Analysis For the Three and Six Months Ended June 30, 2006 and
      2005*




The
      following table presents the average yield on our interest-earning assets for
      the three and six months ended June 30, 2006 and 2005.







**Three
                Months Ended June 30, 2006**
            **Three
                Months Ended June 30, 2005******
            **Average**
              **Balance**
            **Interest**
              **Income**
            **Average**
              **Yield**
            **Average**
              **Balance**
            **Interest**
              **Income**
            **Average**
              **Yield**($
                in thousands)Gross
            $6,537,554
            $123,413
            7.55%
            $6,051,182
            $110,765
            7.32%Less
                amortization of yield adjustments (1)
            —
            (5,557)
            (0.34)%
            —
            (8,264)
            (0.55)%6,537,554
            117,856
            7.21%
            $6,051,182
            $102,501
            6.77%Add
                prepayment penalty income
            —
            6,258
            0.38%
            —
            8,576
            0.57%**Total
                interest-earning assets**
            $6,537,554
            $124,114
            7.59%
            $6,051,182
            $111,077
            7.34%







**Six
                Months Ended June 30, 2006**
            **Six
                Months Ended June 30, 2005******
            **Average**
              **Balance**
            **Interest**
              **Income**
            **Average**
              **Yield**
            **Average**
              **Balance**
            **Interest**
              **Income**
            **Average**
              **Yield**($
                in thousands)Gross
            $6,488,643
            $243,001
            7.49%
            $6,038,543
            $221,023
            7.32%Less
                amortization of yield adjustments (1)
            —
            (9,641)
            (0.30)%
            —
            (12,864)
            (0.43)%6,488,643
            233,360
            7.19%
            $6,038,543
            208,159
            6.89%Add
                prepayment penalty income
            —
            12,034
            0.37%
            —
            15,340
            0.51%**Total
                interest-earning assets**
            $6,488,643
            $245,394
            7.56%
            $6,038,543
            $223,499
            7.40%


_______________


(1)
            Yield
                adjustments include premiums, discounts, net deferred origination
                costs
                and nonrefundable fees.





50


The
      increase in interest income correlated with the growth of our mortgage loan
      portfolio; however, it did not increase at the same rate as the increases in
      LIBOR as competitive pricing pressures were constraining us from charging higher
      interest rates on our mortgage loan production. Our net mortgage loan portfolio
      increased $0.3 billion, or 5%, to $6.7 billion as of June 30, 2006 from $6.4
      billion as of December 31, 2005. We anticipate that our interest income in
      dollars will continue to grow as our mortgage loan portfolio grows if interest
      rates rise. We also expect that our interest income may increase in 2006 if
      market-weighted average coupons increase.





Amortization
      expense of yield adjustments decreased $2.7 million, or 33%, to $5.6 million
      for
      the three months ended June 30, 2006 from $8.3 million for the three months
      ended June 30, 2005. Amortization expense of yield adjustments decreased $3.3
      million, or 26%, to $9.6 million for the six months ended June 30, 2006 from
      $12.9 million for the six months ended June 30, 2005. This decrease was
      predominantly caused by an increase in the projected six-month LIBOR curve,
      which increases cash flows in the future as adjustable rate mortgage loans,
      or
      ARMs, enter their reset period. An increase in cash flows positively affects
      the
      retrospective adjustment component of our level yield amortization by increasing
      the internal rate of return used to calculate our net investment in the
      underlying mortgage loans.





Prepayment
      penalty income decreased $2.3 million, or 27%, to $6.3 million for the three
      months ended June 30, 2006 from $8.6 million for the three months ended June
      30,
      2005. This decrease was primarily related to an 11% decline in the number of
      loans paying off in our portfolio which contained prepayment penalty features
      as
      well as a 4% decline in the average size of the prepayment penalty fees we
      collected. Prepayment penalty income decreased $3.3 million, or 22%, to $12.0
      million for the six months ended June 30, 2006 from $15.3 million for the six
      months ended June 30, 2005. This decrease was primarily related to an 8% decline
      in the number of loans paying off in our portfolio which contained prepayment
      penalty features as well as a 3% decline in the average size of the prepayment
      penalty fees we collected. Prepayment penalty income in 2006 was also negatively
      affected by amendments to government regulations related to the Alternative
      Mortgage Transactions Parity Act, which became effective July 1, 2003. These
      amendments eliminated federal preemption of state restrictions on prepayment
      penalties on certain types of mortgage loans. Management expects that these
      amendments will continue to reduce our prepayment penalty income in future
      periods.





*Securitized
      Mortgage Loan Coupon and Prepayment Penalty Coverage*





Our
      securitized loan principal balance was composed of 68% adjustable rate mortgage
      loans and 32% fixed rate loans at June 30, 2006. The aggregate unpaid principal
      balances of our adjustable rate loans in their reset period was $524.8 million,
      or 12.2% of our portfolio, at June 30, 2006. As shown in the following tables,
      the weighted average coupon, or WAC, on the ARM portion of our securitizations
      increased as of June 30, 2006 compared to December 31, 2005, while the WAC
      on
      the fixed rate mortgage, or FRM, portion of our securitizations decreased
      slightly or remained constant as of June 30, 2006 compared to December 31,
      2005.
      The following tables set forth information about our securitized mortgage loan
      portfolio, by Saxon Asset Securities Trust, or SAST, transaction, including
      those loans associated with our securitized REO properties as of June 30, 2006
      and December 31, 2005.





51


**Issue
                date**
            **Original
                aggregate loan principal balance**
            **Current
                aggregate loan principal balance**
            **Fixed
                current aggregate loan principal balance**
            **ARM
                current aggregate loan principal balance**
            **Percentage
                of portfolio**
            **Percentage
                of original remaining**
            **Current
                WAC fixed**
            **Current**
              **WAC
                ARM**($
                in thousands)June
                30, 2006SAST
                2001-2
            8/2/2001
            $650,410
            $81,653
            $59,129
            $22,524
            1%
            13%
            9.12%
            10.86%SAST
                2001-3
            10/11/2001
            699,999
            67,184
            31,496
            35,688
            1%
            10%
            9.91%
            10.46%SAST
                2002-1
            3/14/2002
            899,995
            118,127
            70,224
            47,903
            2%
            13%
            8.83%
            10.27%SAST
                2002-2
            7/10/2002
            605,000
            81,951
            38,216
            43,735
            1%
            14%
            8.97%
            10.44%SAST
                2002-3
            11/8/2002
            999,999
            149,596
            75,171
            74,425
            2%
            15%
            8.35%
            10.08%SAST
                2003-1
            3/6/2003
            749,996
            147,870
            102,609
            45,261
            2%
            20%
            7.37%
            9.59%SAST
                2003-2
            5/29/2003
            599,989
            122,067
            76,693
            45,374
            2%
            20%
            7.21%
            9.14%SAST
                2003-3
            9/16/2003
            1,000,000
            270,749
            170,196
            100,553
            4%
            27%
            7.12%
            8.60%SAST
                2004-1
            2/19/2004
            1,099,999
            322,260
            134,242
            188,018
            5%
            29%
            7.81%
            8.98%SAST
                2004-2
            7/27/2004
            1,199,994
            557,252
            336,855
            220,397
            9%
            46%
            6.93%
            7.49%SAST
                2004-3
            10/27/2004
            899,956
            470,497
            91,404
            379,093
            7%
            52%
            7.77%
            7.11%SAST
                2005-1
            1/25/2005
            999,972
            572,929
            91,523
            481,406
            9%
            57%
            7.40%
            6.77%SAST
                2005-2
            6//07/2005
            979,990
            638,486
            119,784
            518,702
            10%
            65%
            7.50%
            7.13%SAST
                2005-3
            9/29/2005
            899,999
            715,098
            160,214
            554,884
            11%
            79%
            7.29%
            7.20%SAST
                2005-4
            12/21/2005
            639,994
            561,855
            127,160
            434,695
            9%
            88%
            7.71%
            7.70%SAST
                2006-1
            5/2/2006
            499,973
            465,137
            98,298
            366,839
            7%
            93%
            8.22%
            8.24%SAST
                2006-2
            6/7/2006
            999,949
            985,740
            247,102
            738,638
            16%
            99%
            8.19%
            8.42%Total
            
            $14,425,214
            $6,328,451
            $2,030,316
            $4,298,135Less:
                unpaid principal balance of securitized
              REO
                properties
            (51,382)Total
                securitized loans
            $6,277,069December
                31, 2005SAST
                2001-2
            8/2/2001
            $650,410
            $96,608
            $68,777
            27,831
            2%
            15%
            9.18%
            10.34%SAST
                2001-3
            10/11/2001
            699,999
            84,561
            37,340
            47,221
            1%
            12%
            9.93%
            9.98%SAST
                2002-1
            3/14/2002
            899,995
            142,946
            79,862
            63,084
            2%
            16%
            8.87%
            9.61%SAST
                2002-2
            7/10/2002
            605,000
            102,646
            45,899
            56,747
            2%
            17%
            8.97%
            9.76%SAST
                2002-3
            11/8/2002
            999,999
            189,019
            88,057
            100,961
            3%
            19%
            8.37%
            9.28%SAST
                2003-1
            3/6/2003
            749,996
            194,274
            122,268
            72,006
            3%
            26%
            7.38%
            8.79%SAST
                2003-2
            5/29/2003
            599,989
            160,949
            89,336
            71,613
            3%
            27%
            7.21%
            8.27%SAST
                2003-3
            9/16/2003
            1,000,000
            344,009
            192,094
            151,915
            6%
            34%
            7.17%
            8.14%SAST
                2004-1
            2/19/2004
            1,099,999
            477,122
            156,521
            320,601
            8%
            43%
            7.82%
            7.73%SAST
                2004-2
            7/27/2004
            1,199,994
            710,671
            384,640
            326,031
            12%
            59%
            6.95%
            6.68%SAST
                2004-3
            10/27/2004
            899,956
            563,859
            103,023
            460,836
            9%
            63%
            7.80%
            7.07%SAST
                2005-1
            1/25/2005
            999,972
            711,372
            106,440
            604,932
            12%
            71%
            7.40%
            6.77%SAST
                2005-2
            6//07/2005
            979,990
            808,742
            132,692
            676,050
            14%
            83%
            7.49%
            7.16%SAST
                2005-3
            9/29/2005
            899,999
            857,855
            175,798
            682,057
            14%
            95%
            7.29%
            7.22%SAST
                2005-4
            12/21/2005
            499,625
            496,839
            111,207
            385,633
            8%
            99%
            7.70%
            7.68%Total
            $12,784,923
            $5,941,472
            $1,893,954
            $4,047,518Less:
                unpaid principal balance of securitized
              REO
                properties
            (46,692)Total
                securitized loans
            $5,894,780




Borrowers
      who accept a prepayment penalty receive a lower interest rate on their mortgage
      loan. A number of states restrict our ability to charge prepayment penalties
      on
      mortgage loans made to borrowers in such states. Borrowers always retain the
      right to refinance their loan, but may have to pay a fee of up to six months
      of
      interest on 80% of the remaining principal when prepaying their loans. If the
      mortgage loan prepays within the prepayment penalty coverage period, we will
      record revenue from collection of a prepayment penalty. We report prepayment
      penalties when we collect such fees as part of interest income on our
      consolidated statements of operations. In addition, if a loan prepays we fully
      expense any related deferred costs for that loan upon prepayment. We also
      reflect the amortization of these deferred costs as part of interest income
      on
      our consolidated statement of operations.





52


We
      experienced a decrease in prepayments of our mortgage loans and a decrease
      in
      our prepayment penalty income during the second quarter of 2006 compared to
      the
      second quarter of 2005. This was due to a decline in the size of the average
      prepayment penalty as well as decreases in the percentage of mortgage loans
      in
      our portfolio having prepayment penalty features. Additionally, we have
      experienced a decline in production of loans with prepayment penalties since
      amendments to the Alternative Mortgage Transactions Parity Act, which became
      effective on July 1, 2003, eliminated our ability to rely on federal preemption
      of state restrictions on prepayment penalties on certain types of mortgage
      loans. We expect our prepayment speeds to continue to decrease in future periods
      if interest rates continue to rise and housing prices begin to decline.





**12
                Month Constant Prepayment Rate (Annual Percent)**
            **Life-to-date
                Constant Prepayment Rate (Annual Percent)******
            **Issue
                Date**
            **Percent
                with Prepayment Penalty**
            **Fixed**
            **Arm**
            **Fixed**
            **Arm**June
                30, 2006SAST
                2001-2
            8/2/2001
            36.20%
            26.80%
            33.16%
            29.87%
            40.65%SAST
                2001-3
            10/11/2001
            34.97%
            28.32%
            45.58%
            33.72%
            43.51%SAST
                2002-1
            3/14/2002
            40.65%
            24.24%
            44.42%
            30.39%
            43.64%SAST
                2002-2
            7/10/2002
            16.37%
            34.96%
            49.17%
            33.62%
            43.51%SAST
                2002-3
            11/8/2002
            1.20%
            31.70%
            53.08%
            30.97%
            45.81%SAST
                2003-1
            3/6/2003
            3.42%
            29.57%
            54.04%
            28.25%
            48.96%SAST
                2003-2
            5/29/2003
            16.13%
            26.95%
            59.25%
            27.78%
            49.76%SAST
                2003-3
            9/16/2003
            55.38%
            26.09%
            58.12%
            23.71%
            46.00%SAST
                2004-1
            2/19/2004
            33.85%
            28.96%
            57.56%
            26.03%
            46.75%SAST
                2004-2
            7/27/2004
            59.87%
            26.22%
            48.10%
            23.35%
            41.09%SAST
                2004-3
            10/27/2004
            60.30%
            23.71%
            38.76%
            20.42%
            34.78%SAST
                2005-1
            1/25/2005
            62.38%
            23.82%
            38.92%
            20.29%
            34.99%SAST
                2005-2
            6/07/2005
            60.52%
            16.88%
            36.87%
            15.55%
            35.88%SAST
                2005-3
            9/29/2005
            58.09%
            —
            —
            13.97%
            29.77%SAST
                2005-4
            12/21/2005
            61.29%
            —
            —
            19.12%
            24.10%SAST
                2006-1
            5/2/2006
            51.26%
            —
            —
            35.10%
            49.70%SAST
                2006-2
            6/7/2006
            59.39%
            —
            —
            9.62%
            16.03%December
                31, 2005SAST
                2001-2
            8/2/2001
            51.36%
            28.82%
            36.73%
            30.34%
            41.58%SAST
                2001-3
            10/11/2001
            30.33%
            29.52%
            45.52%
            34.30%
            43.45%SAST
                2002-1
            3/14/2002
            37.03%
            32.32%
            51.35%
            31.59%
            44.02%SAST
                2002-2
            7/10/2002
            14.15%
            36.81%
            51.72%
            34.13%
            43.72%SAST
                2002-3
            11/8/2002
            14.81%
            33.0%
            52.65%
            31.39%
            45.12%SAST
                2003-1
            3/6/2003
            59.40%
            30.08%
            56.22%
            28.05%
            46.60%SAST
                2003-2
            5/29/2003
            57.73%
            32.01%
            59.97%
            28.44%
            47.53%SAST
                2003-3
            9/16/2003
            51.60%
            30.59%
            54.33%
            24.49%
            44.19%SAST
                2004-1
            2/19/2004
            57.64%
            29.80%
            45.96%
            25.35%
            39.91%SAST
                2004-2
            7/27/2004
            63.00%
            25.99%
            41.89%
            22.81%
            37.58%SAST
                2004-3
            10/27/2004
            58.56%
            21.63%
            37.56%
            19.21%
            35.58%SAST
                2005-1
            1/25/2005
            61.53%
            —
            —
            16.78%
            33.40%SAST
                2005-2
            6/07/2005
            58.70%
            —
            —
            13.44%
            31.24%SAST
                2005-3
            9/29/2005
            56.23%
            —
            —
            8.87%
            22.95%SAST
                2005-4
            12/21/2005
            58.65%
            —
            —
            —
            —





53


*Interest
      Expense.* Interest
      expense increased $36.1 million, or 59%, to $97.6 million for the three months
      ended June 30, 2006 from $61.5 million for the three months ended June 30,
      2005.
      Interest expense increased $66.8 million, or 57%, to $183.3 million for the
      six
      months ended June 30, 2006 from $116.5 million for the six months ended June
      30,
      2005. The table below presents the total change in interest expense for the
      three and six months ended June 30, 2006 compared to the three and six months
      ended June 30, 2005, and the amount of the total change that was attributable
      to
      increasing interest rates and an increase in our outstanding debt. Our interest
      expense increased $26.2 million and $52.1 million for the three and six months
      ended June 30, 2006 compared to the three and six months ended June 30, 2005
      as
      a result of higher interest rates on our interest-bearing liabilities and
      increased $9.9 million and $14.7 million for the three and six months ended
      June
      30, 2006 compared to the three and six months ended June 30, 2005 due to an
      increase in our borrowings.





*Rate/Volume
      Table For the Three and Six Months Ended June 30, 2006 Compared to the Three
      and
      Six Months Ended June 30, 2005*




**Three
                Months Ended June 30, 2006 Compared to**
              **Three
                Months Ended June 30, 2005**
            **Six
                Months Ended June 30, 2006 Compared to**
              **Six
                Months Ended June 30, 2005******
            **Change
                in Rate**
            **Change
                in Volume**
            **Total
                Change in Interest Expense**
            **Change
                in Rate**
            **Change
                in Volume**
            **Total
                Change in Interest Expense**(in
                thousands)Securitization
                financing
            $24,843
            $2,719
            $27,562
            $49,668
            $4,654
            $54,322Warehouse
                and repurchase financing:Lines
                of credit
            (251)
            (107)
            (358)
            (649)
            92
            (557)Repurchase
                agreements
            1,596
            3,888
            5,484
            3,104
            6,334
            9,438Senior
                notes
            —
            2,920
            2,920
            —
            2,920
            2,920Other
            —
            473
            473
            —
            734
            734Total
            $26,188
            $9,893
            $36,081
            $52,123
            $14,734
            $66,857





As
      seen
      in the table below, our average balance of borrowings increased $0.7 billion,
      or
      11%, to $6.8 billion for the three months ended June 30, 2006 from $6.1 billion
      for the three months ended June 30, 2005 and increased $0.6 billion, or 10%,
      to
      $6.7 billion for the six months ended June 30, 2006 from $6.1 billion for the
      six months ended June 30, 2005 as a result of the growth in our mortgage loan
      portfolio. Compensating balance credits increased $1.1 million, or 122%, to
      $2.0
      million for the three months ended June 30, 2006 from $0.9 million for the
      three
      months ended June 30, 2005 and increased $2.7 million, or 208%, to $4.0 million
      for the six months ended June 30, 2006 from $1.3 million for the six months
      ended June 30, 2005 as a result of increases in the underlying escrow balances
      and an increase in the LIBOR index rate, both of which served to increase the
      compensating balance credits. Additionally, our yield adjustments increased
      $1.9
      million, or 475%, to $2.3 million amortization for the three months ended June
      30, 2006 from $0.4 million amortization for the three months ended June 30,
      2005
      and increased $6.8 million, or 378%, to $5.0 million amortization for the six
      months ended June 30, 2006 from $1.8 million accretion for the six months ended
      June 30, 2005. This increase was due primarily to a decrease of $7.4 million
      in
      the accretion of bond premium on the interest only classes of some of our bonds,
      offset by a $0.3 million decrease in our amortization of bond issuance costs
      and
      a $0.3 million decrease in our amortization of bond discount on other classes
      of
      our bonds.





54


*Interest
      Expense Yield Analysis For the Three and Six Months Ended June 30, 2006 and
      For
      the Three and Six Months Ended June 30, 2005*





**Three
                Months Ended June 30, 2006**
            **Three
                Months Ended June 30, 2005******
            **Average**
              **Balance**
            **Interest**
              **Expense**
            **Average**
              **Yield**
            **Average**
              **Balance**
            **Interest**
              **Expense**
            **Average**
              **Yield**($
                in thousands)**Warehouse
                financing - loans**
            $158,895
            $2,496
            6.21%
            $190,034
            $1,880
            3.91%Less
                compensating balance credits (1)
            —
            (1,900)
            (4.73)%
            —
            (865)
            (1.80%)**Net
                warehouse financing**
            $158,895
            $596
            1.48%
            $190,034
            $1,015
            2.11%**Warehouse
                financing - servicing rights**
            $9,419
            $165
            6.93%
            —
            —
            —Less
                compensating balance credits (1)
            —
            (104)
            (4.35)%
            —
            —
            —**Net
                warehouse financing - servicing rights**
            $9,419
            $61
            2.58%
            —
            —
            —**Repurchase
                agreements**
            552,391
            7,834
            5.61%
            248,761
            2,350
            3.74%**Securitization
                financing:**Gross
            $5,945,840
            $82,236
            5.53%
            $5,685,408
            $56,608
            3.98%Add
                amortization of yield adjustments (2)
            —
            2,339
            0.16%
            —
            405
            0.03%**Net
                securitization financing:**
            $5,945,840
            $84,575
            5.69%
            $5,685,408
            $57,013
            4.01%**Senior
                notes:**Gross
            $95,000
            $2,850
            12.00%
            —
            —
            —Add
                amortization of yield adjustments (2)
            —
            70
            0.30%
            —
            —
            —**Net
                senior notes**
            $95,000
            $2,920
            12.30%
            —
            —
            —**Other
                expenses**
            —
            1,582
            —
            —
            1,109
            —**Total
                interest-bearing liabilities**
            $6,761,545
            $97,568
            5.77%
            $6,124,203
            $61,487
            4.02%






55




**Six
                Months Ended June 30, 2006**
            **Six
                Months Ended June 30, 2005******
            **Average**
              **Balance**
            **Interest**
              **Expense**
            **Average**
              **Yield**
            **Average**
              **Balance**
            **Interest**
              **Expense**
            **Average**
              **Yield**($
                in thousands)**Warehouse
                financing - loans**
            $180,054
            $5,337
            5.90%
            $181,063
            $3,496
            3.84%Less
                compensating balance credits (1)
            —
            (3,826)
            (4.23)%
            —
            (1,315)
            (1.44)%**Net
                warehouse financing**
            $180,054
            $1,511
            1.67%
            $181,063
            $2,181
            2.40%**Warehouse
                financing - servicing rights**
            $8,947
            $302
            6.72%
            —
            —
            —Less
                compensating balance credits (1)
            —
            (189)
            (4.21)%
            —
            —
            —**Net
                warehouse financing - servicing rights**
            $8,947
            $113
            2.51%
            —
            —
            —**Repurchase
                agreements**
            $492,297
            $13,537
            5.47%
            $231,428
            $4,099
            3.52%**Securitization
                financing:**Gross
            $5,952,874
            $157,412
            5.29%
            $5,715,750
            109,922
            3.85%Add(subtract)
                net amortization (accretion) of yield adjustments (2)
            —
            5,004
            0.17%
            —
            (1,828)
            (0.06)%**Net
                securitization financing:**
            $5,952,874
            $162,416
            5.46%
            $5,715,750
            $108,094
            3.79%**Senior
                notes:**Gross
            $47,500
            $2,850
            12.00%
            —
            —
            —Add
                amortization of yield adjustments (2)
            —
            70
            0.30%
            —
            —
            —**Net
                senior notes**
            $47,500
            $2,920
            12.30%
            —
            —
            —**Other
                expenses**
            —
            2,838
            —
            —
            2,104
            —**Total
                interest-bearing liabilities**
            $6,681,672
            $183,335
            5.49%
            $6,128,241
            $116,478
            3.80%


_____________


(1)
            Compensating
                balance credits represent the amount of credits against interest
                expense
                placed on the value of balances held by our financial
                institutions.




(2)
            Yield
                adjustments include premiums, discounts, and debt issuance costs
                related
                to our bonds and senior notes.




56


*Net
      Interest Margin.* Our
      net
      interest margin decreased to 1.6% for the three months ended June 30, 2006
      from
      3.3% for the three months ended June 30, 2005. Our net interest margin decreased
      to 1.9% for the six months ended June 30, 2006 from 3.5% for the six months
      ended June 30, 2005. The decline in our net interest margin was primarily
      attributable to an increase in the cost of our borrowings due to an increase
      of
      201 basis points in one-month LIBOR from the second quarter of 2005 to the
      second quarter of 2006. At the same time, competitive pricing pressures were
      constraining us from charging higher interest rates on our mortgage loan
      production. We use derivative instruments to manage our exposure to changes
      in
      interest rates. Changes in one-month LIBOR may have an immediate impact on
      our
      borrowing costs and our net interest margin, while the impact of such changes
      on
      derivative instruments is reflected in derivative gains (losses), which is
      not a
      component of net interest margin. Over the term of the debt, we believe the
      derivatives should effectively protect our net revenues. Therefore, we expect,
      based on the current interest rate environment, that our derivatives will
      positively impact our net revenues throughout the remainder of
      2006.





*Provision
      for Mortgage Loan Losses.* Provision
      for mortgage loan losses increased $4.0 million, or 43%, to $13.4 million for
      the three months ended June 30, 2006 from $9.4 million for the three months
      ended June 30, 2005. Provision for mortgage loan losses increased $2.3 million,
      or 20%, to $14.0 million for the six months ended June 30, 2006 from $11.7
      million for the six months ended June 30, 2005. Total delinquencies,
      bankruptcies, and foreclosures for the second quarter of 2006 were 17% higher
      at
      $784.2 million than total delinquencies, bankruptcies, and foreclosures for
      the
      second quarter of 2005 at $669.6 million. Total delinquencies, bankruptcies,
      and
      foreclosures as a percentage of our owned portfolio were 12% as of June 30,
      2006
      while total delinquencies, bankruptcies, and foreclosures as a percentage of
      our
      owned portfolio were 11% as of June 30, 2005.





We
      saw an
      overall increase in delinquency rates and loan loss experience in our owned
      servicing portfolio as of June 30, 2006 compared to delinquency rates and loan
      loss experience in our owned servicing portfolio as of June 30, 2005. This
      rise
      in delinquency levels in our owned servicing portfolio was due primarily to
      the
      seasoning of our assets. We saw an increase in loss severities in the second
      quarter 2006 from the second quarter of 2005 primarily as a result of the
      flattening in the housing market causing an increase in the severity of losses
      on liquidated properties.





Two
      widely accepted methodologies of reporting delinquency data are the Mortgage
      Bankers Association, or MBA, and the Office of Thrift Supervision, or OTS,
      methods. The MBA methodology reports delinquencies as of month-end while the
      OTS
      methodology reports delinquencies as of the first day of the following month
      after payment is due. We believe the MBA method is more commonly used in
      conforming and jumbo mortgage markets while the OTS method is more commonly
      used
      in non-conforming and sub-prime mortgage markets. Reporting delinquencies as of
      the first of the month makes OTS reported loans appear one delinquency category
      better than the MBA method of reporting delinquencies as of month-end;
      therefore, we consider the MBA method to be a more conservative approach. The
      following table sets forth information about the delinquency and loss experience
      of our owned servicing portfolio using the MBA method and is followed by a
      reconciliation of securitization net losses on liquidated loans to charge-offs.
      (See footnote (4) below the table for disclosure of seriously delinquent data
      using the OTS method.)





57


*Delinquency
      and Loss Experience Of Our Owned Portfolio*




**June
                30,******
            **2006**
            **2005****Total
                Delinquencies and Loss Experience**
            ($
                in thousands)Total
                outstanding principal balance (at period end)
            $6,699,633
            $6,104,889Delinquency
                (at period end):30-59
                days:Principal
                balance
            $370,309
            $307,766Delinquency
                percentage
            5.53%
            5.04%60-89
                days:Principal
                balance
            $92,635
            $83,148Delinquency
                percentage
            1.38%
            1.36%90
                days or more:Principal
                balance
            $72,494
            $46,542Delinquency
                percentage
            1.08%
            0.76%Bankruptcies
                (1):Principal
                balance
            $121,559
            $126,391Delinquency
                percentage
            1.81%
            2.07%Foreclosures:Principal
                balance
            $127,185
            $105,782Delinquency
                percentage
            1.90%
            1.73%Real
                estate owned (2):Principal
                balance
            $53,234
            $41,972Delinquency
                percentage
            0.79%
            0.69%Total
                seriously delinquent including real estate owned (3) (4)
            $435,268
            $367,013Total
                seriously delinquent including real estate owned (3) (4)
            6.50%
            6.01%Total
                seriously delinquent excluding real estate owned (4)
            $382,033
            $325,041Total
                seriously delinquent excluding real estate owned (4)
            5.70%
            5.32%Securitization
                net losses on liquidated loans - quarter ended
            $11,578
            $13,074Percentage
                of securitization net losses on liquidated loans (5)
            0.69%
            0.86%Loss
                severity on liquidated loans for the quarter (6)
            41.69%
            37.18%Charge-offs
                - quarter ended(7)
            $11,529
            $8,861Percentage
                of charge-offs (5)
            0.69%
            0.58%


________________




(1)
            Bankruptcies
                include both non-performing and performing loans in which the related
                borrower is in bankruptcy. Amounts included for contractually current
                bankruptcies for the owned portfolio as of June 30, 2006 and 2005
                are
                $23.8 million and $29.7 million, respectively.


(2)
            When
                a loan is deemed to be uncollectible and the property is foreclosed,
                it is
                transferred to REO at net realizable value and periodically evaluated
                for
                additional impairments. Net realizable value is defined as the property’s
                fair value less estimated costs to sell. Costs of holding this real
                estate
                and related gains and losses on disposition are credited or charged
                to
                operations as incurred; and therefore, are not included as part of
                our
                allowance for loan losses and past due
                interest.


(3)
            Seriously
                delinquent is defined as loans that are 60 or more days delinquent,
                foreclosed, REO, or held by a borrower who has declared bankruptcy
                and is
                60 or more days contractually
                delinquent.


(4)
            Total
                seriously delinquent including REO using the OTS method would be
                $336.6
                million, or 5.02% as of June 30, 2006, and $283.4 million, or 4.64%,
                as of
                June 30, 2005. Total seriously delinquent excluding REO using the
                OTS
                method would be $283.3 million, or 4.23% as of June 30, 2006 and
                $241.5
                million, or 3.96% as of June 30,
                2005.


(5)
            Annualized.


(6)
            Loss
                severity, as a percentage, is defined as the total loss amount divided
                by
                the actual unpaid principal balance at the time of liquidation. Total
                loss
                amounts include all accrued interest and interest advances, fees,
                principal balances, all costs of liquidating and all other servicing
                advances for taxes, property insurance, and other servicing costs
                incurred
                and invoiced to us within 90 days following the liquidation date.


(7)
            Charge-offs
                represent the losses recognized in our financial statements in accordance
                with GAAP. See reconciliation of securitization net losses on liquidated
                loans to charge-offs below.




58




*Reconciliation
      of Securitization Net Losses on Liquidated Loans to
      Charge-offs*





**Three
                Months Ended June 30,******
            **2006**
            **2005**(in
                thousands)Securitization
                net losses on liquidated loans
            $11,578
            $13,074Loan
                transfers to real estate owned
            9,696
            8,432Realized
                losses on real estate owned
            (8,932)
            (10,581)Timing
                differences between liquidation and claims processing
            (262)
            (338)Interest
                not advanced on warehouse loans
            (68)
            (220)Other
            (483)
            (1,506)Charge-offs
                (1)
            $11,529
            $8,861


_______________


_


(1)
            Charge-offs
                represent the losses recognized in our financial statements in accordance
                with GAAP.







*Servicing
      Income, Net of Amortization and Impairment.* Servicing
      income, net of amortization and impairment, increased $3.2 million, or 19%,
      to
      $20.4 million for the three months ended June 30, 2006 from $17.2 million for
      the three months ended June 30, 2005. Servicing income, net of amortization
      and
      impairment, increased $9.3 million, or 30%, to $40.1 million for the six months
      ended June 30, 2006 from $30.8 million for the six months ended June 30, 2005.
      The increase in gross servicing income was primarily the result of the
      acquisition of additional third-party servicing rights as well as a higher
      average total servicing portfolio due to the continued growth in our owned
      portfolio, which generates servicing income in the form of ancillary fees.
      As
      our total servicing portfolio grew and LIBOR increased during the second quarter
      of 2006 as compared to the second quarter of 2005, interest earned on the
      associated escrow balances increased $4.5 million, or 115%, to $8.4 million
      for
      the three months ended June 30, 2006 from $3.9 million for the three months
      ended June 30, 2005 and increased $8.6 million, or 132%, to $15.1 million for
      the six months ended June 30, 2006 from $6.5 million for the six months ended
      June 30, 2005. These increases were offset by an increase of $4.0 million and
      $10.0 million of amortization and impairment expense of MSRs for the three
      and
      six months ended June 30, 2006 compared to the three and six months ended June
      30, 2005, respectively. The increase in amortization and impairment expenses
      was
      due to increased prepayment speeds on certain aged third-party servicing
      portfolios during the three months ended June 30, 2006 compared to the three
      months ended June 30, 2005 as well as growth in our servicing portfolio.
      Servicing income was also negatively affected during the second quarter of
      2006
      as a result of the $1.4 million accrual to reimburse a sponsor of a securitized
      mortgage loan pool that we service in our third-party servicing business for
      funds representing prepayment penalties that we had waived or reimbursed to
      borrowers. These prepayment penalties related to loans made by a lender that
      claimed to be entitled to federal preemption of state restrictions on prepayment
      penalties.





59


We
      expect
      our servicing income, net of amortization and impairment, to increase as we
      grow
      our third-party servicing portfolio. To the extent prepayment speeds on mortgage
      loans in our servicing portfolio decline in the future, as anticipated; we
      would
      also anticipate a decline in our amortization and impairment expense assuming
      a
      constant level in our mortgage loan servicing portfolio. Information relating
      to
      our servicing income is shown in the table below:




*Servicing
      Income For the Three and Six Months Ended June 30, 2006 Compared to the Three
      and Six Months Ended June 30, 2005*




**Three
                Months Ended June 30,**
            **Six
                Months Ended June 30,******
            **2006**
            **2005**
            **Variance**
            **2006**
            **2005**
            **Variance**($
                in thousands)
            ($
                in thousands)Average
                third-party servicing portfolio
            $19,508,933
            $18,174,942
            7%
            $19,729,152
            $16,326,701
            21%Average
                owned portfolio
            $6,421,709
            $6,008,245
            7%
            $6,386,405
            $5,983,996
            7%Average
                total servicing portfolio
            $25,930,642
            $24,183,187
            7%
            $26,115,557
            $22,310,697
            17%Gross
                servicing income
            $35,673
            $28,484
            25%
            $72,035
            $52,742
            37%Amortization
                and impairment
            $15,243
            $11,261
            35%
            $31,965
            $21,953
            46%Servicing
                fees - third-party portfolio (1)(2)
            50
            52
            
            50
            53Amortization
                and impairment- third-party portfolio(1)
            32
            25
            
            33
            27Other
                servicing income - total servicing portfolio(1)(3)
            17
            8
            
            17
            8Servicing
                income - total servicing portfolio(1)
            55
            47
            
            55
            47


___________




(1)
            In
                basis points.


(2)
            Includes
                master servicing fees.


(3)
            Includes
                primarily late fees, electronic processing fees, and tax service
                fee
                expense. Ancillary fees are collected and recorded within other servicing
                income for both the third-party portfolio as well as the owned portfolio.




*Derivative
        gains (losses).* Derivative
        gains increased $29.8 million, or 197%, to $14.7 million for the three months
        ended June 30, 2006 from a loss of $(15.1) million for the three months ended
        June 30, 2005. Derivative gains increased $19.2 million, or 310%, to $25.4
        million for the six months ended June 30, 2006 from $6.2 million for the
        six
        months ended June 30, 2005. This increase was primarily due to an increase
        of
        $17.1 million in the fair value of our derivative instruments as well as
        a $2.2
        million increase in cash settlements. These two components increased primarily
        as a result of an increase in the notional amount of derivative instruments
        held
        during the first six months of 2006 compared to the first six months of 2005
        as
        well as increases in the 2/3 year swap curve and six-month LIBOR curve, both
        of
        which positively impacted the fair value of our derivatives.
 
 We
        expect
        that accounting for the derivative instruments as undesignated derivatives
        will
        result in increased volatility in our results of operations, as fluctuations
        in
        the market price of the derivative instruments will result in changes in
        the
        fair value of the derivatives being recorded in our consolidated statements
        of
        operations.





60





*(Loss)
      gain on sale of assets.* (Loss)
      gain on sale of assets decreased $1.0 million, or 14%, to a loss of $(0.3)
      million for the three months ended June 30, 2006 from a gain of $0.7 million
      for
      the three months ended June 30, 2005. (Loss) gain on sale of assets decreased
      $4.2 million, or 175%, to a loss of $(1.8) million for the six months ended
      June
      30, 2006 from a gain of $2.4 million for the six months ended June 30, 2005.
      This decrease was primarily due to repurchases of $1.8 million of loans
      previously sold due to early payment default as well as the sale of $32.0
      million in principal balances of second lien mortgage loans, which resulted
      in
      additional losses of $1.0 million.





**Operating
      expenses**





During
      the first six months of 2006, we made significant progress in reducing our
      operating expenses and increasing our efficiencies due to management’s continued
      focus in this area. Total operating expenses increased slightly by $1.8 million,
      or 5%, to $34.9 million for the three months ended June 30, 2006 from $33.1
      million for the three months ended June 30, 2005 but decreased $4.6 million,
      or
      6%, to $69.4 million for the six months ended June 30, 2006 from $74.0 million
      for the six months ended June 30, 2005.





*Payroll
      and Related Expenses.* Payroll
      and related expenses increased $1.3 million, or 8%, to $17.6 million for the
      three months ended June 30, 2006 from $16.3 million for the three months ended
      June 30, 2005. Payroll and related expenses decreased $2.7 million, or 7%,
      to
      $35.3 million for the six months ended June 30, 2006 from $38.0 million for
      the
      six months ended June 30, 2005. Specifically:




·
              Salary
                  and overtime expense and associated payroll taxes and benefits
                  decreased
                  $0.6 million, or 4%, to $15.6 million for the three months ended
                  June 30,
                  2006 from $16.2 million for the three months ended June 30, 2005,
                  and
                  decreased $2.3 million, or 7%, to $31.5 million for the six months
                  ended
                  June 30, 2006 from $33.8 million for the six months ended June
                  30, 2005.
                  These decreases were primarily due to a 10% decline in average
                  headcount
                  from 1,242 employees for the period ended June 30, 2005 to 1,118
                  employees
                  for the period ended June 30, 2006.
 ·
              Bonus
                  expense increased $0.6 million, or 60%, to $1.6 million for the
                  three
                  months ended June 30, 2006 from $1.0 million for the three months
                  ended
                  June 30, 2005. This increase was the result of a $1.4 million reduction
                  in
                     bonus expense made during the second quarter of 2005 after it
                  was
                  determined that we were not on track to meet some of our 2005 bonus
                  objectives. Bonus expense decreased $0.4 million, or 11%, to $3.4
                  million
                  for the six months ended June 30, 2006 from $3.8 million for the
                  six
                  months ended June 30, 2005. The decrease during the first six months
                  of
                  2006 was primarily due to our decline in headcount and our revised
                  bonus
                  structure.
 ·
              Commission
                  expense increased $0.1 million, or 2%, to $4.9 million for the
                  three
                  months ended June 30, 2006 from $4.8 million for the three months
                  ended
                  June 30, 2005, and decreased $1.8 million, or 17%, to $8.8 million
                  for the
                  six months ended June 30, 2006 from $10.6 million for the six months
                  ended
                  June 30, 2005. The significant decrease during the six months of
                  2006 was
                  primarily due to revisions to our commission plan structure, offset
                  by
                  increased mortgage loan production.
 ·
              Severance
                  expense decreased $0.2 million, or 95%, to $11.2 thousand for the
                  three
                  months ended June 30, 2006 from $0.2 million for the three months
                  ended
                  June 30, 2005, and decreased $0.5 million, or 83%, to $0.1 million
                  for the
                  six months ended June 30, 2006 from $0.6 million for the six months
                  ended
                  June 30, 2005.
 ·
              Deferred
                  payroll and related expenses, as they related to direct loan origination
                  costs, decreased $1.5 million, or 21%, to $5.5 million for the
                  three
                  months ended June 30, 2006 from $7.0 million for the three months
                  ended
                  June 30, 2005, and decreased $2.5 million, or 19%, to $10.4 million
                  for
                  the six months ended June 30, 2006 from $12.9 million for the six
                  months
                  ended June 30, 2005. These decreases were primarily due to significant
                  decreases in our operating expenses that can be deferred as it
                  now costs
                  us less to produce mortgage loans, and as a result, there are fewer
                  expenses to defer.
 
 *General
        and Administrative Expenses.* General
        and administrative expenses decreased $0.7 million, or 5%, to $14.6 million
        for
        the three months ended June 30, 2006, from $15.3 million for the three months
        ended June 30, 2005, and decreased $3.4 million, or 11%, to $28.0 million
        for
        the six months ended June 30, 2006 from $31.4 for the six months ended June
        30,
        2005. These decreases were primarily due to our continued efforts to reduce
        our
        operating expenses.





61







The
      decrease in general and administrative expenses for the three months ended
      June
      30, 2006 compared to the three months ended June 30, 2005 consisted of:





·
            a
                $0.6 million decrease in consulting fees;


·
            a
                $0.5 million decrease in credit report and appraisal fee expenses
                primarily due to our policy change to begin collecting these amounts
                from
                the borrowers;


·
            a
                $0.5 million decrease in employee relations / training expense and
                travel
                / entertainment expense; and


·
            a
                $0.3 million decrease in temporary office assistance expense and
                advertising expense.





These
      decreases were partially offset by a $0.4 million increase in legal and
      accounting fees, a $0.4 million decrease in our deferred loan origination costs,
      and a $0.3 million increase in lease equipment expense.




The
        decrease in general and administrative expenses for the six months ended
        June
        30, 2006 compared to the six months ended June 30, 2005 consisted of:
 
 ·
              a
                  $1.7 million decrease in advertising expense because we had fewer
                  retail
                  branches during the six months ended June 30,
                  2006;
 ·
              a
                  $1.0 million decrease in consulting
                  fees;
 ·
              a
                  $0.9 million decrease in credit report and appraisal fee expenses
                  primarily due to our policy change to begin collecting these amounts
                  from
                  the borrowers;
 ·
              a
                  $0.5 million decrease in temporary office assistance expense;
 ·
              a
                  $1.2 million decrease in employee relations / training expense,
                  travel /
                  entertainment expense, and conference
                  expense;
 ·
              a
                  $0.3 million decrease in investor relations expense due to additional
                  expenses incurred in 2005 related to our listing on the NYSE;
                  and
 ·
              a
                  $0.4 million decrease in dues and subscription expense and insurance
                  expense.
 
 These
        decreases were partially offset by a $0.5 million increase in litigation
        expenses, a $0.5 million increase in accounting fees relating to the restatement
        of our financial statements, a $0.8 million decrease in our deferred loan
        origination costs, and a $0.7 million increase in lease equipment
        expense.
 
 *Income
        Tax Expense.* We
        recorded a $4.4 million tax expense during the three months ended June 30,
        2006,
        and a $7.3 million tax expense during the six months ended June 30, 2006.
         The primary drivers of this expense include 1) the impact of intercompany
        activity between the taxable REIT subsidiaries and the qualified REIT
        subsidiaries, 2) the provision for taxes on the income earned in our taxable
        REIT subsidiaries, and 3) a write down of our deferred tax assets of
        approximately $2.5 million due to the enactment of new tax legislation in
        the
        state of Texas.
 
 *Reconciliation
        of GAAP Net Income to Estimated REIT Taxable Net Income*
 
 The
        following table is a reconciliation of GAAP net income to estimated REIT
        taxable
        net income for the three and six months ended June 30,
        2006:


62







**Three
                months ended**
              **June
                30, 2006**
            **Six
                months ended**
              **J****une
                30, 2006**($
                in thousands)Consolidated
                GAAP income before taxes
            $13,031
            $42,342Estimated
                tax adjustments:Plus:Provision
                for losses - REIT portfolio
            13,410
            13,987Provision
                for advanced interest - REIT portfolio
            2,618
            5,183Elimination
                of intercompany pre tax net income (loss)
            575
            —Miscellaneous
            562
            1,493Less:Taxable
                REIT subsidiary pre-tax net income (loss)
            9,931
            10,697Elimination
                of intercompany pre-tax net income loss
            —
            4,333Hedging
                income (1)
            4,425
            7,418Securitized
                loan adjustments for tax
            5,863
            6,850Estimated
                Qualified REIT taxable income
            $9,977
            $33,707Estimated
                Qualified REIT taxable income per basic common share
            $0.20
            $0.67


____________ ____


(1)
            Although
                we have eliminated the use of hedge accounting under SFAS No. 133
                for
                financial purposes, we continue to account for certain of our derivative
                instruments as hedges for tax
                purposes.





The
      estimated REIT taxable income for the three and six months ended June 30, 2006
      set forth in the table above is an estimate only and is subject to change until
      we file our 2006 REIT federal tax returns.





**Business
      Segment Results**





We
      operate our business through three core business segments: mortgage loan
      production, portfolio and mortgage loan servicing. All segments except the
      portfolio segment are operated by our taxable REIT subsidiaries. In this
      section, we discuss performance and results of our business segments for the
      three and six months ended June 30, 2006 and for the three and six months ended
      June 30, 2005. See Note 11 to our unaudited consolidated financial statements
      for additional information about the results of our business
      segments.





63


***Portfolio
      Segment***




In
      our
      portfolio segment, we use our equity capital and borrowed funds to invest in
      our
      mortgage loan portfolio to produce net interest income. We conduct certain
      mortgage loan table funding activities through our qualified REIT subsidiary
      in
      our portfolio segment. We also record servicing expense associated with
      servicing our mortgage loan portfolio in our portfolio segment. We evaluate
      the
      performance of our portfolio segment based on total net revenues and gains.
      Total net revenues and gains for the portfolio segment increased $13.2 million,
      or 136%, to $22.9 million for the three months ended June 30, 2006 from $9.7
      million for the three months ended June 30, 2005. Total net revenues and gains
      for the portfolio segment decreased $14.1 million, or 18%, to $64.9 million
      for
      the six months ended June 30, 2006 from $79.0 for the six months ended June
      30,
      2005. The fluctuation in total net revenues and gains was primarily due to
      the
      increase in our borrowing costs as well as volatility in derivative gains
      (losses) during those periods.





***Mortgage
      Loan Servicing Segment***




We
      service mortgage loans in our mortgage loan servicing segment, seeking to ensure
      that loans are repaid in accordance with their terms. We evaluate the
      performance of our servicing segment based on servicing income, net of
      amortization and impairment; cost to service a loan; and delinquency levels.
      We
      believe these measures assist investors by allowing them to evaluate the
      performance of our servicing segment. The following discussion highlights
      changes in our servicing segment for the periods indicated.





*Our
      Mortgage Loan Servicing Portfolio*





In
      addition to servicing mortgage loans that we originate or purchase through
      our
      taxable REIT subsidiaries and retain in our portfolio, we also service mortgage
      loans for other lenders and investors. Our mortgage loan servicing portfolio,
      including loans recorded on our consolidated balance sheets, increased $1.6
      billion, or 6.5%, to $26.4 billion as of June 30, 2006 from $24.8 billion as
      of
      December 31, 2005. As of June 30, 2006, we serviced 121,353 loans with a
      principal balance of $19.7 billion for third-parties and 44,442 loans with
      a
      principal balance of $6.7 billion related to our owned portfolio. As of December
      31, 2005, we serviced 119,311 loans with a principal balance of $18.4 billion
      for third-parties and 43,636 loans with a principal balance of $6.4 billion
      related to our owned portfolio. The increase during the first six months of
      2006
      was due primarily to the acquisition of servicing rights related to $5.9 billion
      of mortgage loans owned by non-affiliated companies a well as the origination
      and purchase of $1.7 billion of mortgage loans. This increase was partially
      offset by reductions due to payments totaling $5.8 billion during the six months
      ended June 30, 2006.




We
      believe we can continue to grow our mortgage loan servicing portfolio because
      the non-conforming mortgage loan industry has been adversely affected by limited
      access to capital, lower than anticipated performance of seasoned portfolios,
      and industry consolidation. Competitors with limited access to capital have
      shifted their operations to selling loans, along with the related servicing
      rights, or have entered into strategic alliances with investment banks to
      increase their liquidity and access to the capital markets. We believe this
      has
      resulted in an increasing number of asset-backed securities being issued by
      entities that do not perform servicing, which presents opportunities for us
      to
      increase the size of our portfolio of loans serviced for third parties. We
      anticipate purchasing third-party servicing rights for an additional $1.1
      billion of mortgage loans during the third quarter of 2006, none of which have
      been purchased as of July 31, 2006.





*Our
      Delinquency and Loss Experience - Total Servicing Portfolio*




We
      experienced an increase in seriously delinquent accounts for our total servicing
      portfolio to 7.95% as of June 30, 2006 from 5.46% as of June 30, 2005. In the
      first six months of 2006, we saw a rise in delinquency levels in our total
      servicing portfolio due primarily to the aging of the portfolio. Higher
      delinquencies on our third-party servicing portfolio will negatively impact
      our
      servicing income and the fair value of our MSRs and will cause us to pay more
      in
      servicing advances. The following tables set forth information about the
      delinquency and loss experience of the total mortgage loan portfolio we service
      for the periods indicated using the MBA method. (See footnote (4) below the
      table for disclosure of seriously delinquent data using the OTS
      method.)





64


**June
                30,******
            **2006**
            **2005****Total
                Delinquencies and Loss Experience (1)**
            **Total
                Servicing Portfolio**($
                in thousands)Total
                outstanding principal balance (at period end)
            $26,355,210
            $24,730,615Delinquency
                (at period end):30-59
                days:Principal
                balance
            $1,524,292
            $1,262,124Delinquency
                percentage
            5.78%
            5.10%60-89
                days:Principal
                balance
            $438,648
            $348,432Delinquency
                percentage
            1.66%
            1.41%90
                days or more:Principal
                balance
            $383,615
            $285,741Delinquency
                percentage
            1.46%
            1.16%Bankruptcies
                (2):Principal
                balance
            $408,298
            $358,906Delinquency
                percentage
            1.55%
            1.45%Foreclosures:Principal
                balance
            $661,585
            $346,306Delinquency
                percentage
            2.51%
            1.40%Real
                estate owned:Principal
                balance
            $305,213
            $121,455Delinquency
                percentage
            1.16%
            0.49%Total
                seriously delinquent including real estate owned (3)(4)
            $2,094,399
            $1,351,039Total
                seriously delinquent including real estate owned (3)(4)
            7.95%
            5.46%Total
                seriously delinquent excluding real estate owned(3)(4)
            $1,789,185
            $1,229,584Total
                seriously delinquent excluding real estate owned(3)(4)
            6.79%
            4.97%Securitization
                net losses on liquidated loans - quarter ended
            $55,465
            $27,579Percentage
                of securitization net losses on liquidated loans (5)
            0.84%
            0.45%Loss
                severity on liquidated loans for the quarter (6)
            38.86%
            33.81%


________________


(1)
            Includes
                all loans we service.


(2)
            Bankruptcies
                include both non-performing and performing loans in which the related
                borrower is in bankruptcy. Amounts included for contractually current
                bankruptcies for the total servicing portfolio as of June 30, 2006
                and
                June 30, 2005 are $79.4 million and $89.6 million, respectively.


(3)
            Seriously
                delinquent is defined as loans that are 60 or more days delinquent,
                foreclosed, REO, or held by a borrower who has declared bankruptcy
                and is
                60 or more days contractually delinquent.


(4)
            Total
                seriously delinquent including REO using the OTS method would be
                $1.6
                billion, or 6.22%, as of June 30, 2006 and $1.0 billion, or 4.02%,
                as of
                June 30, 2005. Total seriously delinquent excluding REO using the
                OTS
                method would be $1.3 billion, or 5.06%, as of June 30, 2006 and $0.9
                billion, or 3.53%, as of June 30, 2005.


(5)
            Annualized.


(6)
            Loss
                severity, as a percentage, is defined as the total loss amount divided
                by
                the actual unpaid principal balance at the time of liquidation. Total
                loss
                amounts include all accrued interest and interest advances, fees,
                principal balances, all costs of liquidating and all other servicing
                advances for taxes, property insurance, and other servicing costs
                incurred
                and invoiced to us within 90 days following the liquidation
                date.






65






*Losses
      by Year Funded* (1)
      (2)




**Year**
            **Original
                Balance**
            **BalanceOutstanding**
            **Percentage
                of Original Remaining**
            **Cumulative
                Loss**
              **Percentage
                (3)**
            **Loss
                Severity (4) (5)**($
                in thousands)Pre-divestiture:1996
            $741,645
            $7,964
            1.07%
            1.94%
            31.31%1997
            $1,769,538
            $32,762
            1.85%
            3.24%
            38.89%1998
            $2,084,718
            $70,120
            3.36%
            4.14%
            39.65%1999
            $2,381,387
            $144,058
            6.05%
            5.24%
            42.08%2000
            $2,078,637
            $152,488
            7.34%
            5.87%
            44.48%2001
            $499,879
            $46,137
            9.23%
            4.00%
            45.80%Post-divestiture:2001
            $1,833,357
            $190,669
            10.40%
            4.07%
            42.16%2002
            $2,484,074
            $323,819
            13.04%
            1.87%
            37.44%2003
            $2,842,942
            $615,895
            21.66%
            0.67%
            29.46%2004
            $3,764,628
            $1,547,074
            41.10%
            0.24%
            28.39%2005
            $3,349,035
            $2,327,606
            69.50%
            0.04%
            23.08%2006
            $1,666,343
            $1,337,874
            80.29%
            —
            —


_________________


(1)
            Includes loans originated or purchased
              by our predecessor and us.(2)
            As of June 30, 2006.(3)
            Includes securitization losses and
              losses incurred from loan repurchases, delinquent loan sales, and
              unsecuritized loans. Excludes losses on called loans.(4)
            Loss severity, as a percentage, is
              defined as the total loss amount divided by the actual unpaid principal
              balance at the time of liquidation. Total loss amounts include all
              accrued
              interest and interest advances, fees, principal balances, all costs
              of
              liquidating and all other servicing advances for taxes, property
              insurance, and other servicing costs incurred and invoiced to us within
              90
              days following the liquidation date.(5)
            Loss severity amounts are cumulative
              for each respective funded year. Excludes loss severity amounts on
              called
              loans.






66




***Mortgage
      Loan Production Segment***




We
      evaluate the performance of our mortgage loan production segment based on the
      production levels of our three business channels. We believe that information
      about the characteristics and level of mortgage loan production assists
      investors by allowing them to evaluate performance of our mortgage loan
      production segment. Our mortgage loan production segment is composed of our
      wholesale, correspondent and retail business channels. We characterize our
      wholesale and correspondent channels as indirect lending sources and our retail
      channel as a direct lending source. Through our mortgage loan production
      segment, we originate and purchase non-conforming residential mortgage loans
      through relationships with various approved mortgage companies, mortgage
      brokers, and lenders; and we originate non-conforming residential mortgage
      loans
      directly to borrowers through our retail sales centers. We record interest
      income, interest expense, servicing expense and provision for mortgage loan
      losses on the mortgage loans held in our mortgage loan production segment prior
      to the sale of those loans to the portfolio segment. We also collect revenues
      in
      our mortgage loan production segment, such as origination and underwriting
      fees
      and certain other non-refundable fees, which are deferred and recognized over
      the life of the loan as an adjustment to interest income recorded in the
      portfolio segment. With our continued investment in technology in our mortgage
      loan production segment, as well as the reorganization of our wholesale and
      retail back-end operations into three centralized lending facilities and
      strategically-located retail sales center locations, we expect to see continued
      improvements in our loan production efficiency in 2006, although we cannot
      be
      certain that we will.





Mortgage
      loan production was $920.0 million for the three months ended June 30, 2006,
      which represents a 17% increase from our production of $787.8 million for the
      three months ended June 30, 2005. Mortgage loan production was $1.7 billion
      for
      the six months ended June 30, 2006, which represents a 6% increase from our
      production of $1.6 billion for the six months ended June 30, 2005.





Our
      wholesale mortgage loan production was $436.9 million for the three months
      ended
      June 30, 2006, an increase of 16% from the three months ended June 30, 2005.
      Our
      wholesale mortgage loan production was $800.6 million for the six months ended
      June 30, 2006, an increase of 11% from the six months ended June 30, 2005.





Our
      retail mortgage loan production was $171.8 million for the three months ended
      June 30, 2006, a decrease of 4% from the three months ended June 30, 2005.
      Our
      retail mortgage loan production was $310.3 million for the six months ended
      June
      30, 2006, a decrease of 18% from the six months ended June 30, 2005.





Our
      correspondent flow mortgage loan production was $191.9 million for the three
      months ended June 30, 2006, a decrease of 4% from the three months ended June
      30, 2005. Our correspondent flow mortgage loan production was $418.0 million
      for
      the six months ended June 30, 2006, a decrease of 1% from the six months ended
      June 30, 2005.


We
      had no
      correspondent bulk mortgage loan production for the three months ended June
      30,
      2006, as compared to $33.2 million of correspondent bulk mortgage loan
      production for the three months ended June 30, 2005. Our correspondent bulk
      mortgage loan production was $18.1 million for the six months ended June 30,
      2006, a decrease of 75% from the six months ended June 30, 2005.





67


During
      the second quarter of 2006, we completed our first conduit mortgage loan
      purchase of $119.4 million. We apply our conduit bulk purchase process to
      selected pools of loans from sellers that we consider qualified based on factors
      that include our assessment of the correspondent seller's financial strength,
      management, industry experience, and quality of loan underwriting guidelines
      and
      procedures. The primary differences between our traditional bulk purchase
      process and our conduit bulk purchase process are that: (a) pools of loans
      purchased through the conduit bulk purchase process may be underwritten in
      accordance with the underwriting guidelines of the seller, not our underwriting
      guidelines; and (b) pools of loans purchased through the conduit bulk purchase
      process may be reviewed either by us or by third parties hired by us on a sample
      basis to determine that the loans were underwritten in accordance with the
      applicable underwriting guidelines, whereas under our traditional bulk purchase
      process, we re-underwrite each loan in a pool under our underwriting guidelines.
      We distinguish loans purchased through our traditional bulk purchase process
      from loans purchased through our conduit bulk purchase process on our systems,
      for management reporting purposes as well to ensure that we clearly identify
      loans purchased through the conduit bulk purchase process in connection with
      each pool of loans that we pledge, sell, or securitize. Generally, we expect
      to
      securitize the loans we purchase through our conduit bulk purchase process
      separately from the other loans we produce. We intend to continue to engage
      in
      conduit bulk purchase transactions only where we believe the net interest income
      generated by the loans we purchase will offset the potential for higher credit
      losses and funding costs resulting from our not re-underwriting each loan and
      where we believe it will provide us with attractive risk-adjusted returns.





**Financial
      Condition**




*June
      30, 2006 Compared to December 31, 2005*





*Net
      Mortgage Loan Portfolio.* Our
      net
      mortgage loan portfolio increased $0.3 billion, or 5%, to $6.7 billion as of
      June 30, 2006 from $6.4 billion as of December 31, 2005. This increase was
      the
      result of the origination and purchase of $1.7 billion of mortgage loans offset
      by principal payments of $1.3 billion and loan sales of $77.8
      million.





*Allowance
      for Loan Losses.* Allowance
      for loan losses decreased $1.2 million, or 3%, to $35.4 million as of June
      30,
      2006 from $36.6 million as of December 31, 2005. This decrease was due to a
      3%
      decrease in total delinquencies, bankruptcies, and foreclosures since December
      31, 2005.





*Mortgage
      Servicing Rights, Net.* Mortgage
      servicing rights (MSRs), net increased $15.6 million, or 12%, to $145.3 million
      as of June 30, 2006 from $129.7 million as of December 31, 2005. This increase
      was primarily due to purchases of $47.5 million of rights to service $5.9
      billion of mortgage loans during the six months ended June 30, 2006. The
      increase in MSRs was partially offset by amortization of servicing rights of
      $31.1 million during the first six months of 2006, which was higher than the
      amortization of servicing rights in the first six months of 2005 of $20.5
      million due to growth in our servicing portfolio. Also, a temporary impairment
      of $0.9 million in the first six months of 2006 further offset the increase.
      The
      impairment of MSRs was primarily the result of increased prepayment speeds
      on
      mortgage loans in certain aged third-party servicing portfolios. We have sought
      to strategically position ourselves to take advantage of the increased supply
      of
      servicing assets in the marketplace and have been able to purchase servicing
      assets at what we believe to be favorable prices.





*Servicing
      Related Advances.* Servicing related advances increased $34.8 million, or 19%, to $220.1 million
      as
      of June 30, 2006 from $185.3 million as of December 31, 2005. The increase
      was
      primarily due to the increase in our third-party servicing balances.





68


*Trustee
      Receivable.* Trustee
      receivable increased $3.9 million, or 3%, to $139.9 million as of June 30,
      2006
      from $136.0 million as of December 31, 2005. On each payment date, the trust
      distributes securitization loan payments to the related bondholders. These
      loan
      payments are collected by the trust before the cut-off date, which is typically
      the 17 th of each
      month. Therefore, all principal payments received after the cut-off date are
      recorded as a trustee receivable and reduce our mortgage loan portfolio on
      our
      consolidated balance sheet. The trustee retains these principal payments until
      the following payment date. As we continue to securitize mortgage loans, we
      anticipate our trustee receivable balance to increase.





*Other
      Assets.* Other
      assets increased $2.1 million, or 3%, to $70.6 million as of June 30, 2006
      from
      $68.5 million as of December 31, 2005. The increase in other assets was
      primarily due to an increase in deferred issuance costs of $5.9 million
      primarily relating to the issuance of our senior notes. This increase was offset
      by a decrease of $2.7 million in current tax receivable relating to our receipt
      of tax refunds for prior periods offset by our accrual of current period tax
      expense. Additionally, there was a decrease of $0.4 million in margin
      receivables on derivatives.





*Warehouse
      Financing.* Warehouse financing, which includes borrowings under our warehouse lines of
      credit and repurchase agreement facilities, decreased $132.1 million, or 35%,
      to
      $246.0 million as of June 30, 2006 from $378.1 million as of December 31, 2005,
      primarily because we used proceeds from our June issuance of a $984.5 million
      asset-backed securitization as well as proceeds from our senior notes offering
      to temporarily pay down our outstanding debt. We expect our warehouse financing
      to continue to fluctuate from one reporting period to the next as a result
      of
      the timing of our securitizations, as a result of the deployment of our senior
      notes offering proceeds, and in relation to our mortgage loan production
      volumes.





*Securitization
      Financing.* Securitization financing increased $0.2 billion, or 3%, to $6.4 billion as
      of
      June 30, 2006 from $6.2 billion as of December 31, 2005. This increase during
      the first six months of 2006 resulted primarily from the issuances of two
      asset-backed securitizations totaling $1.5 billion, offset by bond principal
      payments of $1.3 billion. In general, we expect increases in our securitization
      financing as we experience increases in mortgage loan production and continue
      to
      securitize our mortgage loans.





*Senior
      Notes.* Senior
      notes increased to $150.0 million as of June 30, 2006 as a result of our private
      offering that closed on May 4, 2006.





*Shareholders’
      Equity.* Shareholders’
      equity decreased $13.4 million, or 2%, to $579.7 million as of June 30, 2006
      from $593.1 million as of December 31, 2005. The decrease in shareholders’
equity was due primarily to the declaration of $50.9 million in dividends offset
      by net income of $35.0 million, additional issuances of common stock of $0.5
      million, and compensation expense related to restricted stock units of $1.7
      million.





We
      expect
      to continue making quarterly distributions to shareholders totaling at least
      90%
      of our annual REIT taxable income (determined without regard to the deduction
      for dividends paid and by excluding any net capital gain). The actual amount
      and
      timing of dividends will be declared by our Board of Directors and will depend
      on our financial condition and earnings. While we expect our shareholders’
equity to increase in the future due to continued growth in our net income,
      we
      anticipate shareholders’ equity to grow relatively slowly because we expect to
      make regular quarterly distributions.




69


**Liquidity
      and Capital Resources**




Cash
      increased by $7.3 million for the six months ended June 30, 2006 and decreased
      $1.9 million for the six months ended June 30, 2005. The overall change in
      cash
      consisted of the following:





**For
                the Six Months Ended June 30,******
            **2006**
            **2005**(in
                thousands)Cash
                provided by operating activities
            $58,263
            $76,667Cash
                used in investing activities
            (252,391)
            (448,150)Cash
                provided by financing activities
            201,419
            369,581Increase
                (decrease) in cash
            $7,291
            $(1,902)





*Operating
      Activities* .
      Cash
      provided by operating activities decreased $18.4 million, or 24%, to $58.3
      million for the six months ended June 30, 2006 from $76.7 million for the six
      months ended June 30, 2005. This change was the result of decreased net income
      from operations adjusted for non-cash items such as depreciation and
      amortization, deferred income taxes, non-cash changes in the fair value of
      derivative instruments, and provision for mortgage loan losses. Our earnings
      are
      primarily from net interest income, servicing income, and derivative gains,
      offset by general and administrative expenses, derivative losses and income
      tax
      expense. Further details are discussed in “-- Consolidated
      Results.”





*Investing
      Activities* .
      Cash
      used in investing activities decreased $195.8 million, or 44%, to $252.4 million
      for the six months ended June 30, 2006 from $448.2 million for the six months
      ended June 30, 2005. Investing activities consist principally of the origination
      and purchase of mortgage loans as well as the acquisition of MSRs. The
      origination and purchase of mortgage loans including premiums totaled $1.7
      billion for the six months ended June 30, 2006. In addition, cash payments
      of
      $43.6 million had been made for MSRs purchased during the first six months
      of
      2006. These decreases to cash were partially offset by principal payments
      received on our mortgage loan portfolio of $1.2 billion and mortgage loan and
      REO sales to third parties of $77.5 million and $27.3 million, respectively.
      Capital expenditures during the six months ended June 30, 2006 were $4.1 million
      and related primarily to computer equipment and leasehold improvements as well
      as various information technology enhancements.





70


Restricted
      cash decreased $141.5 million to $6.0 million at June 30, 2006 from $147.5
      million at December 31, 2005 due to the timing of the receipt of cash related
      to
      prefunded securitizations. Prefunded amounts are held in a SAST trust account
      and made available once all required mortgage loans have been included in the
      securitization. During the first six months of 2006, the prefunding settlement
      for the SAST 2005-4 securitization was closed, decreasing our restricted cash
      balance.




*Financing
      Activities* .
      Cash
      provided by financing activities decreased $168.2 million, or 46%, to $201.4
      million for the six months ended June 30, 2006 from $369.6 million for the
      six
      months ended June 30, 2005. Cash provided by financing activities primarily
      consisted of $1.5 billion from the securitization of mortgage loans and
      servicing advances and $150.0 million in proceeds from the issuance of senior
      notes during the second quarter of 2006, offset by $1.3 billion related to
      principal payments on securitization financing and $132.2 million in payments
      on
      warehouse and repurchase financing facilities. Fluctuations in warehouse,
      repurchase and securitization financing from period to period can occur due
      to
      the timing of securitizations and the related repayment of the warehouse and
      repurchase financings.




*Dividends.* During
      the second quarter of 2006, our Board of Directors declared a regular dividend
      in the amount of $0.50 per share payable on July 13, 2006 to shareholders of
      record at July 3, 2006. The regular and special dividends declared in the fourth
      quarter of 2005, in the aggregate amount of $32.5 million, were paid on January
      11, 2006. The regular dividend declared in the first quarter of 2006, in the
      aggregate amount of $25.4 million, was paid on April 28, 2006. Due to our
      election to be treated as a REIT, we expect to continue making quarterly
      distributions to shareholders, the amount and timing of which will be determined
      by our Board of Directors.





*Trends* .
      At this
      time, we see no material negative trends that we believe would affect our access
      to long-term borrowings, short-term borrowings or bank credit lines sufficient
      to maintain our current operations or that would likely cause us to be in danger
      of any debt covenant default or that would inhibit our ability to fund
      operations and capital commitments for the next 12 months and
      beyond.





***Working
      Capital***




We
      would
      use working capital to fund the cash flow needs of our operations in the event
      we were unable to generate sufficient cash flows from operations to cover our
      operating requirements. Under the commonly defined working capital definition,
      which is current assets less current liabilities, we calculated our working
      capital as of June 30, 2006 to be $507.0million. Using our definition of working
      capital, we calculated our working capital as of June 30, 2006 to be $225.4
      million. A reconciliation between our working capital calculation and the common
      definition of working capital is provided below. Management focuses on our
      internally defined calculations of working capital rather than the commonly
      used
      definition of working capital because management believes our definition
      provides a better indication of how much liquidity we have available to conduct
      business at the time of the calculation.







71




**Working
                  Capital Reconciliation - June 30, 2006**
              **Saxon
                  Defined**
                **Working
                  Capital**
              **Commonly
                  Defined**
                **Working
                  Capital**($
                  in thousands)Unrestricted
                  cash
              $13,344
              $13,344Trustee
                  receivable
              —
              139,937Accrued
                  interest receivable
              —
              43,055Current
                  tax payable
              —
              10,419Accrued
                  interest payable
              —
              (10,588)Other
                  current liabilities
              —
              (28,047)Unsecuritized
                  mortgage loans, MSRs, & mortgage bonds - payments less than one year
              323,919
              463,972Warehouse
                  financing - payments less than one year
              (111,832)
              (111,832)Repurchase
                  financing - payments less than one year
              —
              (134,147)Servicing
                  advances
              —
              220,101Financed
                  advances - payments less than one year
              —
              (137,579)Securitized
                  loans - payments less than one year
              —
              2,572,989Securitized
                  financing - payments less than one year
              —
              (2,534,651)Total
              $225,431
              $506,973







***Financing
      Facilities***





We
      need
      to borrow substantial sums of money each quarter to originate and purchase
      mortgage loans, as well as to acquire servicing rights and fund a portion of
      our
      servicing advances. We rely upon several counterparties to provide us with
      financing facilities for these purposes. Our ability to fund current operations
      and accumulate loans for securitization depends upon our ability to secure
      these
      types of short-term financing on acceptable terms.





To
      accumulate loans for securitization, we borrow money on a short-term basis
      through secured warehouse lines of credit and repurchase agreements. In addition
      to funding loans prior to securitization, some of our facilities allow us to
      finance advances that are required by our mortgage servicing contracts, mortgage
      bonds and mortgage servicing rights.





72


Under
      certain of our warehouse lines of credit and repurchase facilities, we obtain
      advances of less than 100% of the principal balance of the mortgage loans,
      requiring us to use working capital to fund the remaining portion of the
      principal balance of the mortgage loans. Some of our warehouse lines of credit
      and repurchase facilities contain sub-limits that provide us with the ability
      to
      finance assets such as non-performing loans, mortgage bonds, mortgage servicing
      rights, advances that are required by our mortgage servicing contracts and
“wet”
loans. “Wet” loans are mortgage loans for which the collateral custodian has not
      yet received the related loan documentation.





Under
      our
      warehouse lines of credit and repurchase facilities, interest is payable monthly
      in arrears and outstanding principal is payable upon receipt of loan sale
      proceeds or transfer of a loan into a securitization trust. Outstanding
      principal is also repayable upon the occurrence of certain events, such as
      a
      mortgage loan which is in default for a period of time, a repaid mortgage loan,
      a mortgage loan obtained with fraudulent information or the failure to cure
      a
      defect in a mortgage loan’s documentation. In addition, our facilities contain
      terms requiring principal repayment if a loan remains funded by the facilities
      longer than a contractual period of time from the date of funding or on the
      maturity date of the facility.





Interest
      on our warehouse lines of credit and repurchase facilities is based on a margin
      over the London Interbank Offered Rate, or LIBOR, with the margin above LIBOR
      varying by facility and depending on the type of asset that is being financed.
      Dry funded loans carry the lowest rate and mortgage servicing rights carry
      the
      highest rate.





Loans,
      mortgage bonds and mortgage servicing rights financed under our warehouse lines
      of credit and repurchase facilities are subject to changes in market valuation
      and margin calls. The market value of our loans, mortgage bonds and mortgage
      servicing rights depends on a variety of economic conditions, including interest
      rates and demand for our asset-backed securities. To the extent the value of
      the
      loans, mortgage bonds or mortgage servicing rights declines significantly,
      we
      would be required to repay portions of the amounts we have
      borrowed.





There
      were several changes to our revolving warehouse and repurchase facilities during
      the second quarter of 2006.





·
            Our
                $300.0 million Credit Suisse First Boston Mortgage Capital LLC repurchase
                facility was amended on April 26, 2006, extending the termination
                date of
                the facility to April 25, 2007.





·
            Our
                $375.0 million syndicated warehouse facility with JPMorgan Chase
                Bank was
                amended effective May 25, 2006, extending the termination date of
                the
                facility to August 23, 2006.





·
            Our
                $300.0 million repurchase facility with Bank of America, N.A. was
                amended
                effective June 7, 2006, extending the termination date of the facility
                to
                July 24, 2006. This repurchase facility was terminated effective
                July 24,
                2006.





·
            Our
                $300.0 million repurchase facility with Greenwich Capital Financial
                Products, Inc. was amended effective June 15, 2006. The amendment
                added
                $1.0 billion in uncommitted capacity to the existing
                facility.





73


In
      addition, in July 2006, we entered into a new $300.0 million committed
      repurchase facility with DB Structured Products, Inc. effective July 19, 2006.
      The facility allows for the financing of mortgage loan purchases or originations
      as well as mortgage bonds and servicing advances required by our mortgage
      servicing contracts. The facility terminates on July 18, 2007.





As
      of
      June 30, 2006, we had revolving warehouse and repurchase facilities in the
      amount of $2.8 billion, of which $1.7 billion and $1.1 billion were committed
      and uncommitted, respectively. The table below summarizes our facilities and
      their expiration dates as of June 30, 2006. We believe this level of financing
      will allow us flexibility to execute our asset-backed securitizations in
      accordance with our business plans.





**Lender**
            **Committed**
              **Facility
                Amount**
            **Uncommitted**
              **Facility
                Amount**
            **Expiration
                Date**($
                in thousands)JPMorgan
                Chase Bank, N.A.
            $375,000
            $—
            August
                23, 2006Greenwich
                Capital Financial Products, Inc.
            300,000
            1,000,000
            September
                28, 2006Bank
                of America, N.A.
            300,000
            —
            July
                24, 2006CS
                First Boston Mortgage Capital, LLC
            300,000
            —
            April
                25, 2007Merrill
                Lynch Bank USA
            400,000
            100,000
            November
                20, 2006Total
            $1,675,000
            $1,100,000




The
      amount we have outstanding on our committed facilities at any quarter end
      generally is a function of the pace of mortgage loan purchases and originations
      relative to the timing of our securitizations. Although we expect to issue
      asset-backed securities on a quarterly basis, our intention is to maintain
      committed financing facilities equal to approximately six months of mortgage
      production to provide us with flexibility in timing our securitizations.





We
      had
      $246.0 million of warehouse and repurchase borrowings collateralized by
      residential mortgage loans and mortgage bonds outstanding as of June 30, 2006.
      As we complete securitization transactions, a portion of the proceeds from
      the
      long-term debt issued in the securitization will be used to pay down our
      short-term borrowings. Therefore, the amount of short-term borrowings will
      fluctuate from quarter to quarter, and could be significantly higher or lower
      than the $246.0 million we had outstanding as of June 30, 2006, as our mortgage
      production and securitization programs continue.





Our
      financing facilities require us to comply with various customary operating
      and
      financial covenants, including, without limitation, tests relating to our
      tangible net worth and liquidity, leverage requirements and restrictions on
      guarantees and the granting of liens. In addition, some of the facilities may
      subject us to cross default features. In the event of default, we may be
      prohibited from paying dividends and making distributions under certain of
      our
      financing facilities without the prior approval of our lenders. We do not
      believe that these existing financial covenants currently restrict our
      operations or growth. To the extent that we fail to comply with the covenants
      contained in our financing agreements or are otherwise found to be in default
      under the terms of such agreements, we could be restricted from paying dividends
      or from engaging in other transactions that are necessary for us to maintain
      our
      REIT status. Our failure to qualify as a REIT could reduce materially the value
      of our common stock. We were in compliance with all covenants under the
      agreements as of and for the six months ended June 30, 2006.





74


***Senior
      Notes***





On
      May 4,
      2006, we closed a private offering of $150 million of 12% senior notes due
      2014.
      The notes bear interest at a fixed rate of 12% per annum, commencing on May
      4,
      2006, and will mature on May 1, 2014. Interest on the notes will be payable
      on
      May 1 and November 1 of each year, beginning November 1, 2006. The notes are
      guaranteed by certain of our subsidiaries (the “Guarantees”). We began using the
      net proceeds from the sale of the notes for general corporate purposes,
      principally the acquisition of additional third-party mortgage servicing rights
      and whole loans in bulk. Initially, we used the net proceeds to temporarily
      reduce outstanding debt under one or more of our warehouse and repurchase
      facilities. The notes are general, unsecured, senior obligations and rank senior
      to all of our future debt that is expressly subordinated in right of payment
      to
      the notes.





We
      may
      redeem some or all of the notes at any time at a price equal to 100% of the
      aggregate principal amount thereof plus accrued and unpaid interest and a
      make-whole premium. We may also redeem at any time up to May 1, 2009 (which
      may
      be more than once) up to 35% of the aggregate principal amount of the notes
      using the proceeds of certain equity offerings at a redemption price of 112%
      of
      the principal amount outstanding plus accrued and unpaid interest. We must
      offer
      to purchase the notes at a purchase price of 101% of the principal amount plus
      accrued and unpaid interest to the date of purchase if we experience certain
      specific kinds of changes of control. We must offer to purchase the notes at
      a
      purchase price of 100% of the principal amount plus accrued and unpaid interest
      to the date of purchase if we sell assets under certain circumstances. We also
      must offer to repurchase up to $10 million in aggregate principal amount of
      notes at a purchase price of 100% of the principal amount plus accrued and
      unpaid interest to the date of purchase if we have Excess Cash Flow (as defined
      in the indenture governing the notes) for the six months ended March 31, 2007,
      and each six-month period thereafter.





The
      indenture governing the notes contains certain covenants that restrict the
      ability of our company and certain subsidiaries to, among other things: incur
      additional indebtedness; make certain distributions, investments, and certain
      other payments; sell certain assets; agree to restrictions on the ability of
      certain subsidiaries from making payments to us; create certain liens; merge,
      consolidate, or sell substantially all of our assets; and enter into certain
      transactions with affiliates. In addition, the indenture includes a covenant
      relating to the maintenance of unencumbered assets. The indenture also contains
      certain exceptions from and qualifications to such covenants; it does not
      restrict the ability to incur Funding Indebtedness (as defined in the
      indenture); and it does not restrict us from paying dividends on our common
      stock to the extent necessary to maintain our status as a REIT absent a default
      with respect to the notes. The indenture also contains customary default
      provisions.





***Securitization
      Financing***





*Mortgage
      Loan Securitization Facilities.* We have
      historically financed, and expect to continue to finance, our mortgage loan
      portfolio on a long-term basis by issuing asset-backed securities. We believe
      that issuing asset backed securities provides us with a low cost method of
      financing our mortgage loan portfolio. In addition, it allows us to reduce
      our
      interest rate risk on our fixed rate loans by securitizing them. Our ability
      to
      issue asset backed securities depends on the overall performance of our assets,
      as well as the continued general demand for securities backed by non-conforming
      mortgage loans and home equity loans.





Generally,
      we are not legally obligated to make payments to the holders of the asset-backed
      securities issued as part of our securitizations. Instead, the holders of the
      asset-backed securities can look for repayment only from the cash flows relating
      to the assets specifically collateralizing the debt.





75


*Servicing
      Advance Facility.* As of
      June 30, 2006 we had $222.6 million of borrowings outstanding and an additional
      $62.4 million of available borrowing capacity under a facility that allows
      for
      the issuance of notes to finance principal, interest and other servicing
      advances that we are required to make for our owned portfolio as well as those
      related to certain third-party servicing contracts.





Our
      servicing advance facility contains two series of notes, the Series 2004-1
      Notes
      and the Series 2005-A Notes. The Series 2004-1 Notes have one remaining class
      of
      term notes outstanding with a face value of $55.0 million. The Series 2005-A
      Notes include a class of term notes with a face value of $85.0 million and
      a
      class of variable funding notes with a maximum face value of $145.0 million.
      The
      total borrowing capacity of our servicing advance facility is $285.0
      million.





Our
      servicing advance facility requires us to comply with various customary
      operating covenants and performance tests on the underlying receivables related
      to payment rates and minimum balance. In the event of a breach, the notes issued
      by the servicing advance facility may begin to amortize earlier than scheduled.
      We do not believe that these existing covenants and performance tests will
      restrict our operations or growth. We were in compliance with all covenants
      and
      performance tests under the servicing advance facility as of and for the six
      months ended June 30, 2006.





As
      of
      June 30, 2006, securitization financing related to mortgage loans and servicing
      advances on our consolidated balance sheet was $6.4 billion.





**Off-Balance
      Sheet Items and Contractual Obligations**





***Off-Balance
      Sheet Items***





Prior
      to
      July 6, 2001, our predecessor sold mortgage loans, while retaining certain
      residual interests, through securitizations structured as sales, with a
      corresponding one-time recognition of gain or loss, under GAAP. All such
      residual interests were retained by Dominion Capital in connection with our
      July
      6, 2001 acquisition of the issued and outstanding shares of capital stock of
      our
      predecessor from Dominion Capital. Mortgage loans that were securitized in
      off-balance sheet transactions by our predecessor from May 1996 to July 5,
      2001
      were still outstanding with an aggregate unpaid principal balance of $325.0
      million as of June 30, 2006. In connection with those loans and in connection
      with the sales of mortgage loans to nonaffiliated parties, our subsidiaries
      have
      made representations and warranties about certain characteristics of the loans,
      the borrowers, and the underlying properties. In the event of a breach of these
      representations and warranties, our subsidiaries may be required to remove
      loans
      from a securitization and replace them with cash or substitute loans, and to
      indemnify parties for any losses or expenses related to such breach. As of
      June
      30, 2006 our subsidiaries neither had nor expected to incur any material
      obligation to remove any loans from any securitizations, or to provide any
      such
      indemnification to any party.





76


In
      the
      normal course of business, we are subject to indemnification obligations related
      to the sale of residential mortgage loans. Under these obligations, we are
      required to repurchase certain mortgage loans that fail to meet the standard
      representations and warranties included in the sales contracts. We accrue an
      estimate for the fair value of those obligations, which includes premium
      recapture expenses and early payment defaults. Our subsidiaries are also subject
      to these obligations in connection with the sale of residential mortgage loans.
      Premium recapture expenses represent repayment of a portion of certain loan
      sale
      premiums to investors on previously sold loans that are repaid within six months
      of the loan sale. We accrue an estimate of the potential refunds of premium
      received on loan sales based upon historical experience. As of June 30, 2006
      and
      December 31, 2005, the liability recorded for premium recapture expenses and
      for
      obligations to repurchase mortgage loans was $0.4 million and $0.4 million,
      respectively and the associated expense was recorded within (loss) gain on
      sale
      of assets in the consolidated statements of operations.





Our
      subsidiaries had commitments to fund mortgage loans with agreed upon rates
      of
      $445.4 million and $262.6 million as of June 30, 2006 and December 31, 2005,
      respectively. These commitments do not necessarily represent future cash
      requirements, as some portion of the commitments are likely to expire without
      being drawn upon or may be subsequently declined for credit or other
      reasons.





***Contractual
      Obligations and Commitments***





Our
      subsidiaries are obligated under non-cancelable operating leases for property
      and equipment. Future minimum rental payments for all of our operating leases
      as
      of June 30, 2006 and December 31, 2005 totaled $61.6 million and $67.5 million,
      respectively. We have one capital lease for equipment with total future minimum
      rental payments of $1.8 million as of June 30, 2006.





We
      are
      committed to purchasing third-party servicing rights of an additional $1.1
      billion unpaid principal balance of third-party mortgage loans during the third
      quarter of 2006, none of which have been purchased as of July 31, 2006.





**Other
      Matters**





***Related
      Party Transactions***





On
      June
      16, 2005, we purchased the home of W. Michael Head, our former Vice President
      and Director of Human Capital, and his wife for $0.5 million, in connection
      with
      Mr. Head’s hiring by us and relocation to Richmond, Virginia. We determined the
      purchase price based on the lower of the price at which the property was listed
      for sale, and the market value as determined by a licensed appraiser, which
      determination was approved by senior management at the time. At March 31, 2006,
      the home was for sale at a listing price of $0.4 million, and was recorded
      at
      its net realizable value of $0.4 million on our consolidated balance sheets.
      On
      April 28, 2006, we entered into a contract to sell the home for $0.4 million,
      which sale contract closed on May 16, 2006.





77


***Impact
      of New Accounting Pronouncements*** ****





In
      February 2006, t he
      FASB
      issued SFAS No. 15 5, *Accounting
      for Certain Hybrid Instruments* ,
      which
      allows financial instruments that have embedded derivatives to be accounted
      for
      as a whole (eliminating the need to bifurcate the derivative from its host)
      if
      the holder elects to account for the whole instrument on a fair value basis.
      SFAS No. 155 is effective for all financial instruments acquired or issued
      after
      the beginning of an entity’s first fiscal year that begins after September 15,
      2006. The adoption of this statement is not anticipated to have a significant
      impact on our financial condition or results of operations.




In
      March
      2006, the FASB issued SFAS No. 156, *Accounting
      for Servicing of Financial Assets - An Amendment of FASB Statement No. 140.* This
      standard amends the guidance in SFAS No. 140, *Accounting
      for Transfers and Servicing of Financial Assets and Extinguishments of
      Liabilities.* Among
      other requirements, SFAS No. 156 requires an entity to recognize a servicing
      asset or servicing liability each time it undertakes an obligation to service
      a
      financial asset by entering into a servicing contract in any of the following
      situations: a transfer of the servicer’s financial assets that meets the
      requirements for sale accounting; a transfer of the servicer’s financial assets
      to a qualifying special-purpose entity in a guaranteed mortgage securitization
      in which the transferor retains all of the resulting securities and classifies
      them as either available-for-sale securities or trading securities; or an
      acquisition or assumption of an obligation to service a financial asset that
      does not relate to financial assets of the servicer or its consolidated
      affiliates. SFAS No. 156 is effective the beginning of the first fiscal year
      beginning after September 15, 2006. At this time, management has not yet
      completed its’ assessment of the impact of the implementation of this
      statement.




In
      July
      2006, the FASB issued FASB Interpretation No. 48, *Accounting
      for Uncertainty in Income Taxes* ,
      or FIN
      48 *.* This
      interpretation clarifies the accounting for uncertainty in income taxes
      recognized in an enterprise’s financial statements in accordance with FASB
      Statement No. 109, *Accounting
      for Income Taxes* .
      FIN 48
      prescribes a recognition threshold and measurement attribute for the financial
      statement recognition and measurement of a tax position taken or expected to
      be
      taken in a tax return. FIN 48 also provides guidance on derecognition,
      classification, interest and penalties, accounting in interim periods,
      disclosure and transition. FIN 48 is effective for fiscal years beginning after
      December 15, 2006. At this time, management has not yet completed its assessment
      of the impact of this interpretation.







78





**Item
      3. Quantitative and Qualitative Disclosures About Market
      Risk**




We
      define
      market risk as the sensitivity of income to changes in interest rates. Changes
      in prevailing market interest rates may have two general effects on our
      business. Firstly, any general increase in mortgage loan interest rates may
      tend
      to reduce customer demand for new mortgage loans, which can negatively impact
      our future production volume and our projected income. Secondly, increases
      or
      decreases in interest rates can cause changes in net interest income on the
      mortgage loans that we own or are committed to fund, and as a result, cause
      changes in our future earnings. We refer to this second type of risk as our
      “managed interest rate risk”. Substantially all of our managed interest rate
      risk arises from debt related to the financing of our mortgage loan portfolio.




Interest
      rate risk is managed within an overall asset/liability management framework.
      The
      principal objective of asset/liability management is to manage the sensitivity
      of net income to changing interest rates.




***Maturity
      and Repricing Information*** **




As
      shown
      in the tables below, there was a slight increase in our derivative activity
      at
      June 30, 2006 compared to December 31, 2005 due to additional existing and
      forecasted debt and the belief that interest rates will continue to increase
      in
      the near future. The following tables summarize the notional amounts, expected
      maturities and weighted average strike rates for interest rate floors, caps,
      swaps, options and futures that we held as of June 30, 2006 and December 31,
      2005.




**As
                of June 30, 2006******
            **2006**
            **2007**
            **2008**
            **2009**
            **2010**
            **Thereafter**($
                in thousands)Caps
                bought - notional:
            $1,141,000
            $18,167
            —
            —
            —
            —Weighted
                average rate
            3.90
            3.25
            —
            —
            —
            —Caps
                sold - notional:
            $1,141,000
            $18,167
            —
            —
            —
            —Weighted
                average rate
            4.70
            5.00
            —
            —
            —
            —Futures
                sold - notional:
            $152,000
            $303,250
            $352,250
            $42,500
            $20,000
            $4,231Weighted
                average rate
            5.35
            5.08
            4.87
            5.43
            5.54
            5.69Swaps
                bought - notional:
            $986,269
            $1,607,580
            $488,712
            $187,501
            $32,192
            —Weighted
                average rate
            5.27
            4.86
            5.28
            5.28
            5.31
            —Puts
                bought - notional:
            $2,500,000
            $875,000
            —
            —
            —
            —Weighted
                average rate
            5.55
            5.75
            —
            —
            —
            —Puts
                sold - notional:
            —
            $500,000
            $875,000
            —
            —
            —Weighted
                average rate
            —
            6.25
            6.50
            —
            —
            —Total
                notional activity:
            $5,920,269
            $3,322,164
            $1,715,962
            $230,001
            $52,192
            $4,231




79







**As
                of December 31, 2005******
            **2006**
            **2007**
            **2008**
            **2009**
            **2010**
            **Thereafter**($
                in thousands)Caps
                bought - notional:
            $1,186,583
            $18,167
            —
            —
            —
            —Weighted
                average rate
            3.86%
            3.25%
            —
            —
            —
            —Caps
                sold - notional:
            1,186,583
            18,167
            —
            —
            —
            —Weighted
                average rate
            4.69%
            5.00%
            —
            —
            —
            —Futures
                bought - notional:
            30,250
            —
            —
            —
            —
            —Weighted
                average rate
            3.75%
            —
            —
            —
            —
            —Futures
                sold - notional:
            118,750
            293,750
            103,750
            —
            —
            —Weighted
                average rate
            4.49%
            4.38%
            4.49%
            —
            —
            —Swaps
                bought - notional:
            —
            600,000
            —
            —
            —
            —Weighted
                average rate
            —
            4.17%
            —
            —
            —
            —Puts
                bought - notional:
            4,487,500
            —
            —
            —
            —
            —Weighted
                average rate
            5.22%
            —
            —
            —
            —
            —Puts
                sold - notional:
            58,250
            —
            —
            —
            —
            —Weighted
                average rate
            3.75%
            —
            —
            —
            —
            —Total
                notional activity:
            $7,067,916
            $930,084
            $103,750
            $—
            $—
            $—




*Analyzing
      Rate Shifts*




In
      our
      method of analyzing the potential effect of interest rate changes, we study
      the
      published forward yield curves for applicable interest rates and instruments,
      and we then develop various interest rate scenarios for those yield curves
      based
      on assumptions concerning economic growth rates, market conditions, and
      inflation rates, as well as the timing, duration, and amount of corresponding
      FRB responses, in order to determine hypothetical impacts on relevant interest
      rates. We use this method of analysis as a means of valuation to manage our
      interest rate risk on our mortgage loan financing over the term of the
      liabilities. The table below represents the change in our interest expense
      as
      determined by changes in our debt costs and offsetting values of derivative
      instruments under the four different analysis scenarios that we used as of
      June
      30, 2006 and the four scenarios that we used as of December 31, 2005. The change
      in values represented under each of the scenarios depicts value improvements,
      or
      declines, relative to the rate scenario depicted by the forward curve. If the
      forward curve at the end of the period depicts two potential rate increases
      by
      the FRB and the scenario only depicts one increase, the cost in forward
      liabilities may actually decline while interest rates are going up.  The
      change from June 30, 2006 to December 31, 2005 represents our change in
      forecasted transactions, changes in forward rates during the period, and
      assumptions for each scenario as described below.




80


**Effect
                on Interest Expense of Assumed Changes in Interest Rates Over a Three
                Year
                Period******
            **June
                30, 2006**
            **December
                31, 2005******
            **Scenario
                1**
            **Scenario
                2**
            **Scenario
                3**
            **Scenario
                4**
            **Scenario
                1**
            **Scenario
                2**
            **Scenario
                3**
            **Scenario
                4**(in
                thousands)Change
                in interest expense
            $42,853
            $10,486
            $(10,044)
            $(35,827)
            $22,620
            $(1,170)
            $(25,519)
            $12,665Impact
                from derivative instruments:Futures
            (3,484)
            (1,090)
            218
            4,951
            (2,292)
            (990)
            1,655
            (165)Swaps
            (16,803)
            (4,072)
            3,286
            13,773
            (2,740)
            (1,084)
            2,064
            (203)Puts
            (3,659)
            (98)
            1,464
            (1,405)
            (661)
            265
            428
            (1,699)Caps
            (7)
            (9)
            10
            (9)
            (1,117)
            949
            1,036
            (990)Total
                impact from derivative instruments
            $(23,953)
            $(5,269)
            $4,978
            $17,310
            $(6,810)
            $(860)
            $5,183
            $(3,057)Net
                change
            $18,900
            $5,217
            $(5,066)
            $(18,517)
            $15,810
            $(2,030)
            $(20,336)
            $9,608




Each
      scenario is more fully discussed below, and tables of the hypothetical yield
      curves are included below.




Scenario
      1 - Under this scenario we show liability costs and derivative valuations based
      upon an assumed aggressive response from the Board of Governors of the FRB
      with
      the assumption that the economy is growing at a pace inconsistent with the
      FRB
      desire to maintain a stable or declining inflation environment. Under this
      scenario, we assumed a hypothetical interest rate increase of 75 basis points
      over a five-month period. Such an increase provides us with a view of the
      interest expense changes assuming a comparable rise in financing rates. Making
      these assumptions as of June 30, 2006, we estimated that our interest expense
      would increase by $42.9 million. However, we estimated that this amount would
      be
      partially offset by the impact of our derivative instruments of $24.0 million.
      The net effect of this scenario would be a potential decrease of $18.9 million
      in our net revenues. At December 31, 2005, assuming a hypothetical interest
      rate
      increase of 75 basis points over a five-month period, we estimated at that
      time
      that our net revenues would decrease by $15.8 million.




Scenario
      2 - In this scenario we assumed a slightly less severe hypothetical rise in
      interest rates compared to Scenario 1. Under this scenario, we assumed that
      interest rates have the potential to rise 25 basis points over a three-month
      period. Making these assumptions as of June 30, 2006, we estimated that our
      interest expense would increase by $10.5 million offset by the impact of our
      derivative instruments of $5.3 million, for a net decrease of $5.2 million
      in
      our net revenues. At December 31, 2005, assuming interest rates had the
      potential to rise 50 basis points over a three-month period, we estimated at
      that time that our net revenues would decrease by $2.0 million.






81


Scenario
      3 - In this scenario we assumed relatively stable hypothetical short-term rates.
      This scenario assumed that the FRB pauses its increasing rate scenario to assess
      the lagging impact of previous rate increases on the domestic and global
      economy. Given these assumptions as of June 30, 2006, we estimated that our
      interest expense would decrease by $10.0 million. However, we estimated that
      this amount would be partially offset by the impact of our derivative
      instruments of $4.9 million. The net effect of this scenario would be a
      potential increase of $5.1 million in our net revenues. As of December 31,
      2005,
      assuming interest rates remained relatively stable, we estimated at that time
      that our net revenues would decline by $20.3 million.




Scenario
      4 -This scenario assumed that the FRB continues to increase rates in an effort
      to avert continued growth in inflation by increasing rates 50 basis points
      over
      the next five months. The scenario further assumed that, by the fourth quarter
      of 2006, signs of a slowing economy alert the FRB that it increased rates too
      dramatically and, as a result, the FRB lowers rates 125 basis points over the
      following nine months. Given these assumptions, at June 30, 2006, we estimated
      that our interest expense would decrease by $35.8 million, which would be
      partially offset by the impact of derivative instruments of $17.3 million,
      for a
      total potential increase in net revenues of $18.5 million. At December 31,
      2005,
      assuming interest rates increased 125 basis points over an eight-month period,
      and then decreased 100 basis points over the following six months, we estimated
      at that time that our net revenues would increase by $9.6 million.




The
      hypothetical yield curve data for each scenario at June 30, 2006 and December
      31, 2005 are as follows:




**June
                30, 2006****Month**
            **Current
                Market (1)**
            **Scenario
                1**
            **Scenario
                2**
            **Scenario
                3**
            **Scenario
                4**July-06
            5.44
            5.51
            5.51
            5.39
            5.52Sep-06
            5.58
            5.90
            5.65
            5.39
            5.65Dec-06
            5.60
            6.15
            5.65
            5.40
            5.66Mar-07
            5.56
            6.16
            5.66
            5.40
            5.43Jun-07
            5.51
            6.17
            5.67
            5.41
            4.81Sep-07
            5.47
            6.18
            5.68
            5.41
            4.44Dec-07
            5.46
            6.19
            5.69
            5.42
            4.33Mar-08
            5.45
            6.19
            5.69
            5.42
            4.44Jun-08
            5.47
            6.20
            5.70
            5.43
            4.45Sept-08
            5.49
            6.21
            5.71
            5.43
            4.47Dec-08
            5.53
            6.22
            5.72
            5.44
            4.48Mar-09
            5.54
            6.23
            5.73
            5.44
            4.49Jun-09
            5.57
            6.24
            5.74
            5.45
            4.50


________________


(1)  
      Current market is depicted using the forward Eurodollar Futures curve. The
      Eurodollar Future curve is the series of benchmark rates of Libor with a 3-month
      maturity. The series of 3 month rates depicted represent the current market
      expectations of Libor spot rates in the future based on expectations of economic
      activity.











82







**December
                31, 2005****Month**
            **Current
                Market (1)**
            **Scenario
                1**
            **Scenario
                2**
            **Scenario
                3**
            **Scenario
                4**Jan-06
            4.49
            4.52
            4.39
            4.39
            4.51Mar-06
            4.78
            4.90
            4.52
            4.39
            4.89Jun-06
            4.85
            5.16
            4.65
            4.40
            5.40Sep-06
            4.84
            5.18
            4.79
            4.40
            5.53Dec-06
            4.80
            5.19
            4.92
            4.41
            5.13Mar-07
            4.75
            5.20
            4.93
            4.41
            4.76Jun-07
            4.74
            5.21
            4.94
            4.42
            4.64Sep-07
            4.74
            5.22
            4.94
            4.42
            4.64Dec-07
            4.75
            5.23
            4.95
            4.43
            4.65Mar-08
            4.75
            5.25
            4.96
            4.43
            4.65Jun-08
            4.77
            5.26
            4.97
            4.44
            4.66Sept-08
            4.79
            5.27
            4.98
            4.44
            4.66Dec-08
            4.83
            5.28
            4.99
            4.45
            4.67


________________


(1)
            Current
                market is depicted using the forward Eurodollar Futures curve. The
                Eurodollar Future curve is the series of benchmark rates of Libor
                with a
                3-month maturity. The series of 3 month rates depicted represent
                the
                current market expectations of Libor spot rates in the future based
                on
                expectations of economic activity.






These
      scenarios are provided for illustrative purposes only and are intended to assist
      in the understanding of our sensitivity to changes in interest rates. While
      these scenarios are developed based on current economic and market conditions,
      we cannot make any assurances as to the predictive nature of assumptions made
      in
      this analysis.






**Item
      4. Controls and Procedures**




***Conclusion
      Regarding the Effectiveness of Disclosure Controls and
      Procedures***




We
      carried out an evaluation, as required by Exchange Act Rule 13a-15(b), under
      the
      supervision and with the participation of our management, including our Chief
      Executive Officer and Chief Financial Officer, of the effectiveness of the
      design and operation of our disclosure controls and procedures as of the end
      of
      the period covered by this report. Based upon that evaluation, our Chief
      Executive Officer and Chief Financial Officer concluded that, as of the end
      of
      the period covered by this report, our disclosure controls and procedures were
      effective in ensuring that information required to be disclosed by us in the
      reports that we file or submit under the Exchange Act is recorded, processed,
      summarized and reported within the time periods specified in the Securities
      and
      Exchange Commission’s rules and forms, and accumulated and communicated to our
      management to allow timely decisions regarding disclosure required to be
      included in the periodic reports we are required to file and submit to the
      Securities and Exchange Commission under the Exchange Act.




Our
      management, including our Chief Executive Officer and Chief Financial Officer,
      has determined that there have been no changes in our internal control over
      financial reporting during the quarter ended June 30, 2006 that have materially
      affected, or are likely to materially affect, our internal control over
      financial reporting, except for the successful completion of our first conduit
      bulk purchase. These controls have been tested and are operating effectively.
      Changes to internal controls over financial reporting related to implementing
      the conduit bulk purchase program were limited to the addition of key controls
      inherent in that process.




83


**PART
      II**







**Item
      1. Legal Proceedings**





Because
      we are subject to many laws and regulations, including but not limited to
      federal and state consumer protection laws, we are regularly involved in
      numerous lawsuits filed against us, some of which seek certification as class
      action lawsuits on behalf of similarly situated individuals. With respect to
      each matter in which class action status has been asserted, in the event class
      action status is certified, if there is an adverse outcome or we do not
      otherwise prevail in each of the following matters, we could suffer material
      losses, although we intend to vigorously defend each of these lawsuits. The
      following is a summary of litigation matters that could be significant. Unless
      otherwise noted, we cannot predict the outcome of these matters. Accordingly,
      no
      amounts have been accrued in our accompanying consolidated financial statements,
      except as noted below.





Bauer,
      et al., v. Saxon Mortgage Services, Inc., et al. is a
      matter filed on December 1, 2004 in the Civil District Court for the Parish
      of
      Orleans, State of Louisiana, Case No. 2004-17015. On January 26, 2005, the
      plaintiffs filed a motion to dismiss the case without prejudice, and the court
      entered an order dismissing the case on January 31, 2005. On February 17, 2005,
      the plaintiffs re-filed the case as two separate class action lawsuits, Bauer,
      et al., v. Dean Morris, et al., filed as
      Case No. 05-2173 in the Civil District Court for the Parish of Orleans, State
      of
      Louisiana, and Patterson,
      et al., v. Dean Morris, et al., filed as
      Case No. 05-2174 in the Civil District Court for the Parish of Orleans, State
      of
      Louisiana. In the Bauer case, we are not a named defendant but may owe defense
      and indemnification to Deutsche Bank Trust Company Americas, N.A., as custodian
      of a mortgage loan for which one named plaintiff is mortgagor. Our subsidiary,
      Saxon Mortgage Services, is a named defendant in the Patterson case. In both
      cases, the named plaintiffs allege misrepresentation, fraud, conversion and
      unjust enrichment on the part of the lender defendants and a law firm hired
      by a
      number of defendants, including our subsidiary, Saxon Mortgage Services, to
      enforce mortgage loan obligations against borrowers who had become delinquent
      pursuant to the terms of their mortgage loan documents. Specifically, the
      plaintiffs alleged that the law firm quoted inflated court costs and sheriff’s
      fees on reinstatement proposals to the plaintiffs. In both cases, the plaintiffs
      seek certification as a class action, compensatory damages, pre-judgment
      interest, attorneys’ fees, litigation costs, and other unspecified general,
      special and equitable relief. On January 24, 2006, the United States District
      Court for the Eastern District of Louisiana granted our motion to compel
      arbitration and stayed the court proceedings as to named plaintiffs Keenan
      and
      Karen Duckworth in Bauer,
      et al., v. Dean Morris, et al., filed as
      Case No. 05-2173 in the Civil District Court for the Parish of Orleans, State
      of
      Louisiana. On January 25, 2006, the United States District Court for the Eastern
      District of Louisiana granted our motion to compel arbitration and stayed the
      court proceedings as to named plaintiff Debra Herron in Patterson,
      et al., v. Dean Morris, et al., filed as
      Case No. 05-2174 in the Civil District Court for the Parish of Orleans, State
      of
      Louisiana. The court subsequently remanded the underlying court proceedings
      in
      both the Bauer and Patterson cases to
      the Civil District Court for the Parish of Orleans, State of Louisiana. There
      were no significant developments in this matter during the quarter ended June
      30, 2006.





Cechini,
      et al., v. America’s MoneyLine, Inc .
      is a
      matter filed on August 10, 2005 in the United States District Court for the
      Northern District of Illinois, Eastern Division, as Case No. 05C 4570. The
      plaintiff filed the case as a class action, alleging violation of the Fair
      Credit Reporting Act in connection with the use of pre-approved offers of credit
      by our subsidiary, America’s MoneyLine, Inc. The parties reached a settlement,
      pending court approval and entry into a mutually acceptable settlement
      agreement, on June 19, 2006, pursuant to which we would pay an aggregate amount
      of approximately $0.5 million and incur approximately $10 thousand in settlement
      administration costs in exchange for a release of claims. We accrued $0.5
      million in June 2006 based on these developments.





84


Jumar
      Hooks and Diane Felder, et al., v. Saxon Mortgage, Inc. is a matter filed
      o n
      October
      12, 2005 in the Common Pleas Court for Cuyahoga County, Ohio as Case No. CV
      05
      574577. The plaintiffs filed this case as a class action on behalf of themselves
      and similarly situated Ohio borrowers, alleging that our subsidiary engaged
      in
      unlawful practices in originating and servicing the plaintiffs’ loans. The
      plaintiffs seek certification as a class and a judgment in favor of the
      plaintiffs for money damages, costs, attorneys’ fees, and other relief deemed
      appropriate by the court. During the second quarter of 2006, the court granted
      our motion to compel individual arbitration as to each of the two named
      plaintiffs and stayed the court proceedings with no class having been
      certified.





Brian
      Harris, et al., v. Capital Mortgage Company, et al .,
      is a
      matter filed in the Circuit Court of Cook County, County Department-Chancery
      Division, Illinois as Case No. 05CH 22369. Our subsidiary, Saxon Mortgage
      Services, was served with a summons and complaint on March 1, 2006. The
      plaintiffs included a class action claim, alleging, on behalf of themselves
      and
      those similarly situated, that our subsidiary Saxon Mortgage Services, Inc.
      and
      other named defendants engaged in unfair and deceptive acts and violated the
      Illinois Consumer Fraud Act in connection with originating and servicing the
      plaintiffs’ loans. The plaintiffs seek certification as a class and a judgment
      in favor of the plaintiffs for money damages, costs, attorneys’ fees, and other
      relief deemed appropriate by the court. There were no significant developments
      in this matter during the quarter ended June 30, 2006.





We
      are
      subject to other legal proceedings arising in the normal course of our business.
      In the opinion of management, the resolution of these other proceedings is
      not
      expected to have a material adverse effect on our financial position or our
      results of operations.





**Item
      1A. Risk Factors**





The
      significant risk factors and uncertainties known to us that, if they were to
      occur, could materially adversely affect our business, financial condition,
      operating results or cash flows are set forth under “Part I - Item 1A. “Risk
      Factors” in our 2005 Form 10-K and under “Part II - Item 1A. “Risk Factors” in
      our quarterly report on Form 10-Q for the period ended March 31, 2006.





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




None.




**Item
      3. Defaults Upon Senior Securities**




None.




85


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




On
      June
      13, 2006, we held our annual shareholders’ meeting. There were 50,054,212 shares
      of common stock outstanding and entitled to vote, and a total of 47,652,955
      (95%) were represented at the meeting in person or by proxy. The following
      summarizes vote results of proposals submitted to our shareholders at the annual
      meeting:




1.
            Proposal
                to elect six directors for one-year
                terms.





**NAME**
            **FOR**
            **WITHHELD**Richard
                A. Kraemer
            47,081,880
            571,075Louis
                C. Fornetti
            47,174,105
            478,850Anastasia
                D. Kelly
            47,002,864
            650,091Michael
                L. Sawyer
            47,083,843
            569,112Thomas
                J. Wageman
            46,925,613
            727,342David
                D. Wesselink
            46,927,440
            725,515







2.
            Ratification
                of the appointment by the Audit Committee of Deloitte & Touche LLP, as
                independent registered public accounting firm of the Company for
                the
                fiscal year ending December 31,
                2006.





**FOR**
            **AGAINST**
            **ABSTAIN**
            **BROKER
                NON-VOTES**47,211,653
            416,279
            25,023
            —





86


**Item
      5. Other Information**




(a)
            None.




(b)
            None.




**Item
      6. Exhibits**




2.1
            Agreement
                and Plan of Merger, dated as of August 8, 2006, among Saxon Capital,
                Inc.,
                Morgan Stanley Mortgage Capital Inc. and Angle Merger Subsidiary
                Corporation.




3.1
            Amended
                and Restated Certificate of Incorporation of Saxon Capital, Inc.




3.2
            Amended
                and Restated Bylaws of Saxon Capital, Inc.




4.1
            Form
                of Common Stock Certificate of Saxon Capital,
                Inc.




4.2
            Certain
                instruments defining the rights of the holders of long-term debt
                of the
                Company and certain of its subsidiaries, none of which authorize
                a total
                amount of indebtedness in excess of 10% of the total assets of the
                Company
                and its subsidiaries on a consolidated basis, have not been filed
                as
                Exhibits. The Company hereby agrees to furnish a copy of any of these
                agreements to the Securities and Exchange Commission upon
                request.




4.3
            Indenture,
                dated as of May 4, 2006, among Saxon Capital, Inc., as issuer, Saxon
                Capital Holdings, Inc., SCI Services, Inc., Saxon Mortgage, Inc.,
                Saxon
                Mortgage Services, Inc., Saxon Holding, Inc., and Saxon Funding
                Management, Inc., as guarantors, and Deutsche Bank Trust Company
                Americas,
                as trustee.




4.4
            Registration
                Rights Agreement, dated as of May 4, 2006, among Saxon Capital, Inc.,
                Saxon Capital Holdings, Inc., SCI Services, Inc., Saxon Mortgage,
                Inc.,
                Saxon Mortgage Services, Inc., Saxon Holding, Inc., and Saxon Funding
                Management, Inc., and J.P. Morgan Securities,
                Inc.




10.1
            Pooling
                and Servicing Agreement, dated as of May 1, 2006, among Deutsche
                Bank
                National Trust Company, as trustee, Saxon Asset Securities Company,
                as
                depositor, Saxon Mortgage, Inc., as master servicer and Saxon Mortgage
                Services, Inc., as servicer.




12.1
            Statement
                regarding computation of ratios of earnings to fixed
                charges.




31.1
            Certification
                of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) under
                the
                Securities Exchange Act of 1934.




31.2
            Certification
                of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) under
                the
                Securities Exchange Act of 1934.




32.1
            Certification
                of Chief Executive Officer and Chief Financial Officer pursuant to
                Rule
                13a-14(b)/15d-14(b) under the Securities Exchange Act of 1934 and
                18
                U.S.C. Section 1350 as adopted pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002.






87





**SIGNATURES**




Pursuant
      to the requirements of the Securities Exchange Act of 1934, the registrant
      has
      duly caused this report to be signed on its behalf by the undersigned, thereunto
      duly authorized.





SAXON
                CAPITAL, INC.Dated:
                August 9, 2006
            By:/s/
                Michael L.
                SawyerName:
                Michael L. SawyerTitle:
                Chief Executive Officer (authorizedofficer
                of registrant)Dated:
                August 9, 2006
            By:/s/
                Robert B.
                EastepName:
                Robert B. EastepTitle:
                Chief Financial Officer (principalfinancial
                officer)











88





**EXHIBIT
      INDEX**





Exhibit
      No.  Description







2.1
            Agreement
                  and Plan of Merger, dated as of August 8, 2006, among Saxon Capital,
                  Inc.,
                  Morgan Stanley Mortgage Capital Inc. and Angle Merger Subsidiary
                  Corporation. (Incorporated herein by reference to our Exhibit 2.1
                  to
                  Current Report on Form 8-K filed with the Securities and Exchange
                  Commission on August 9,
                  2006.)




3.1
            Amended
                and Restated Certificate of Incorporation of Saxon Capital, Inc.
                (Incorporated herein by reference to our Annual Report on Form 10-K
                for
                the year ended December 31, 2005, filed with the Securities and Exchange
                Commission on March 31, 2006. Our Commission file number is
                001-32447.)




3.2
            Amended
                and Restated Bylaws of Saxon Capital, Inc. (Incorporated herein by
                reference to our Current Report on Form 8-K filed with the Securities
                and
                Exchange Commission on March 4, 2005.)




4.1
            Form
                of Common Stock Certificate of Saxon Capital, Inc. (Incorporated
                herein by
                reference to Amendment No. 3 to our Registration Statement on Form
                S-4
                (No. 333-112834) filed with the Securities and Exchange Commission
                on June
                18, 2004.)




4.2
            Certain
                instruments defining the rights of the holders of long-term debt
                of the
                Company and certain of its subsidiaries, none of which authorize
                a total
                amount of indebtedness in excess of 10% of the total assets of the
                Company
                and its subsidiaries on a consolidated basis, have not been filed
                as
                Exhibits. The Company hereby agrees to furnish a copy of any of these
                agreements to the Securities and Exchange Commission upon
                request.




4.3
            Indenture,
                dated as of May 4, 2006, among Saxon Capital, Inc., as issuer, Saxon
                Capital Holdings, Inc., SCI Services, Inc., Saxon Mortgage, Inc.,
                Saxon
                Mortgage Services, Inc., Saxon Holding, Inc., and Saxon Funding
                Management, Inc., as guarantors, and Deutsche Bank Trust Company
                Americas,
                as trustee. (Incorporated herein by reference to our Current Report
                on
                Form 8-K filed with the Securities and Exchange Commission on May
                5,
                2006.)




4.4
            Registration
                Rights Agreement, dated as of May 4, 2006, among Saxon Capital, Inc.,
                Saxon Capital Holdings, Inc., SCI Services, Inc., Saxon Mortgage,
                Inc.,
                Saxon Mortgage Services, Inc., Saxon Holding, Inc., and Saxon Funding
                Management, Inc., and J.P. Morgan Securities, Inc. (Incorporated
                herein by
                reference to our Current Report on Form 8-K filed with the Securities
                and
                Exchange Commission on May 5,
                2006.)




10.1
            Pooling
                and Servicing Agreement, dated as of May 1, 2006, among Deutsche
                Bank
                National Trust Company, as trustee, Saxon Asset Securities Company,
                as
                depositor, Saxon Mortgage, Inc., as master servicer and Saxon Mortgage
                Services, Inc., as servicer (incorporated herein by reference to
                our
                Current Report on Form 8-K filed with the Securities and Exchange
                Commission on June 21, 2006).




12.1
            Statement
                regarding computation of ratios of earnings to fixed charges.




31.1
            Certification
                of Chief Executive Officer pursuant to Rule 13a-14(a)/15d-14(a) under
                the
                Securities Exchange Act of 1934.




31.2
            Certification
                of Chief Financial Officer pursuant to Rule 13a-14(a)/15d-14(a) under
                the
                Securities Exchange Act of 1934.




32.1
            Certification
                of Chief Executive Officer and Chief Financial Officer pursuant to
                Rule
                13a-14(b)/15d-14(b) under the Securities Exchange Act of 1934 and
                18
                U.S.C. Section 1350 as adopted pursuant to Section 906 of the
                Sarbanes-Oxley Act of 2002.







89