**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

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**(Mark One)**

**x**                              QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe quarterly period ended March 31, 2006**

**or**

**o**                                 TRANSITION REPORT PURSUANTTO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

**Forthe transition period from             to            **

**COMMISSIONFILE NUMBER 1-32340**

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**AAMES INVESTMENT CORPORATION**

(Exact name of registrantas specified in its charter)

| **MARYLAND**                                                    | **34-1981408**                        |
|-----------------------------------------------------------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization) | (I.R.S. Employer  Identification No.) |
| **350 SOUTH GRAND AVENUE,  LOS ANGELES, CA**                    | **90071-3459**                        |
| (Address of principal executive offices)                        | (Zip code)                            |

 

**(323) 210-5000**

(Registrant’s telephonenumber,including area code)

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Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes x  No o

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer or a non-accelerated filer. See definition of “acceleratedfiler and large accelerated filer” in Rule 12b-2 of the ExchangeAct.

Check one): Largeaccelerated filer o  Acceleratedfiler x  Non-accelerated filer o

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes o No x

Asof May 3, 2006, Registrant had 61,887,785 shares of common stockoutstanding.

 

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**TABLEOF CONTENTS**
| Item No.                              | ** ** | ** **                                                                                                                            | ** ** | ** ** | ** ** | **Page No.** |
|--------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|-------------------|
| **PART I—FINANCIAL INFORMATION** |       |                                                                                                                                  |       |       |
| Item 1                                |       | Financial Statements                                                                                                                  |       |       | 1          |              |
|                                       |       | Condensed Consolidated  Balance Sheets at March 31, 2006 (Unaudited) and December 31, 2005  (Audited)                       |       |       | 1          |              |
|                                       |       | Condensed Consolidated  Statements of Operations for the three months ended March 31, 2006 and  2005 (Unaudited)                 |       |       | 2          |              |
|                                       |       | Condensed Consolidated  Statement of Changes in Stockholders’ Equity for the three months ended  March 31, 2006 (Unaudited) |       |       | 3          |              |
|                                       |       | Condensed Consolidated  Statements of Cash Flows for the three months ended March 31, 2006 and  2005 (Unaudited)                 |       |       | 4          |              |
|                                       |       | Notes to Condensed  Consolidated Financial Statements (Unaudited)                                                                     |       |       | 5          |              |
| Item 2                                |       | Management’s Discussion and  Analysis of Financial Condition and Results of Operations                                           |       |       | 14         |              |
| Item 3                                |       | Quantitative and Qualitative  Disclosures About Market Risk                                                                           |       |       | 14         |              |
| Item 4                                |       | Controls and Procedures                                                                                                               |       |       | 48         |              |
| **PART II—OTHER  INFORMATION**   |       |                                                                                                                                  |       |       |
| Item 1                                |       | Legal Proceedings                                                                                                                     |       |       | 49         |              |
| Item 1A                                    |       | Risk Factors                                                                                                                          |       |       | 49         |              |
| Item 2                                |       | Unregistered Sales of Equity  Securities and Use of Proceeds                                                                          |       |       | 50         |              |
| Item 3                                |       | Defaults Upon Senior  Securities                                                                                                      |       |       | 50         |              |
| Item 4                                |       | Submission of Matters to a  Vote of Security Holders                                                                                  |       |       | 50         |              |
| Item 5                                |       | Other Information                                                                                                                     |       |       | 50         |              |
| Item 6                                |       | Exhibits                                                                                                                              |       |       | 50         |              |
|                                       |       | Signature Page                                                                                                                        |       |       | 55         |              |
|                                            |            |                                                                                                                                       |            |            |            |                   |  |  |  |

 

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**Item 1.   FinancialStatements**

**AAMES INVESTMENT CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED BALANCE SHEETS(In thousands, except share data)**

| ** **                                                                                                                                                                                                | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                                | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                                                | ** ** | **(Unaudited)**    | ** ** | **(Audited)**         | ** ** |
| **ASSETS**                                                                                                                                                                                                | ** ** | ** **         | ** ** |                  | ** ** | ** ** |   |
| Cash and cash  equivalents:                                                                                                                                                                               |       |               |       |                  |       |   |   |
| Unrestricted                                                                                                                                                                                              |       | $                  | 30,993     |                  |       | $ | 36,078 |   |   |
| Restricted                                                                                                                                                                                                |       | 87,016             |       |                  | 87,094     |   |   |
| Loans held for  sale, at lower of cost or market                                                                                                                                                          |       | 1,063,290          |       |                  | 951,177    |   |   |
| Loans held for  investment, net                                                                                                                                                                           |       | 3,656,520          |       |                  | 4,085,536  |   |   |
| Advances and  other receivables, net                                                                                                                                                                      |       | 37,957             |       |                  | 39,591     |   |   |
| Deferred income  taxes                                                                                                                                                                                    |       | 28,508             |       |                  | 28,489     |   |   |
| Equipment and  improvements, net                                                                                                                                                                          |       | 10,615             |       |                  | 10,810     |   |   |
| Prepaid expenses  and other assets                                                                                                                                                                        |       | 34,659             |       |                  | 30,713     |   |   |
| Derivative  financial instruments, at estimated fair value                                                                                                                                                |       | 52,961             |       |                  | 58,147     |   |   |
| Total assets                                                                                                                                                                                              |       | $                  | 5,002,519  |                  |       | $ | 5,327,635 |   |   |
| **LIABILITIES**                                                                                                                                                                                           | ** ** | ** **         | ** ** |                  | ** ** | ** ** |   |
| Financings on loans held for investment                                                                                                                                                                   |       | $                  | 3,240,614  |                  |       | $ | 3,623,188 |   |   |
| Revolving  warehouse and repurchase facilities                                                                                                                                                            |       | 1,454,933          |       |                  | 1,341,683  |   |   |
| Borrowings                                                                                                                                                                                                |       | 1,324              |       |                  | 16,487     |   |   |
| Accounts payable  and accrued expenses                                                                                                                                                                    |       | 49,473             |       |                  | 54,300     |   |   |
| Accrued dividends                                                                                                                                                                                         |       | —             |       |                  | 21,584     |   |   |
| Income taxes  payable                                                                                                                                                                                     |       | —             |       |                  | 889        |   |   |
| Total liabilities                                                                                                                                                                                         |       | 4,746,344          |       |                  | 5,058,131  |   |   |
| Commitments and  contingencies                                                                                                                                                                            |       |               |       |                  |       |   |   |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                                                             | ** ** | ** **         | ** ** |                  | ** ** | ** ** |   |
| Preferred stock, par value $0.01 per share; 160,000,000  shares authorized; none outstanding                                                                                                              |       | —             |       |                  | —     |   |   |
| Common stock, par  value $0.01 per share; 500,000,000 shares authorized; 61,882,670 shares and  61,828,340 shares issued and outstanding at March 31, 2006 and December 31,  2005, respectively |       | 619                |       |                  | 618        |   |   |
| Additional  paid-in capital                                                                                                                                                                               |       | 656,206            |       |                  | 656,041    |   |   |
| Retained deficit                                                                                                                                                                                          |       | (400,650           | )          |                  | (387,155   | ) |   |
| Total stockholders’ equity                                                                                                                                                                           |       | 256,175            |       |                  | 269,504    |   |   |
| Total liabilities and stockholders’ equity                                                                                                                                                           |       | $                  | 5,002,519  |                  |       | $ | 5,327,635 |   |   |

 

See accompanying notes to condensed consolidated financial statements.

1

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS(Unaudited)(In thousands, except per share data)**

| ** **                                                                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                  | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Interest income                                                             |       | $                                                | 112,045    |   | $ | 53,652 |   |
| Interest expense                                                            |       | 72,947                                           |       | 11,916 |   |
| Net interest income                                                         |       | 39,098                                           |       | 41,736 |   |
| Provision for  losses on loans held for investment                          |       | 12,601                                           |       | 6,500 |   |
| Net interest income after provision for loan losses                         |       | 26,497                                           |       | 35,236 |   |
| Noninterest  income:                                                        |       |                                             |       |   |   |
| Gain on sale of loans                                                       |       | 5,995                                            |       | 5,683 |   |
| Loan servicing                                                              |       | 2,423                                            |       | 1,040 |   |
| Total noninterest income                                                    |       | 8,418                                            |       | 6,723 |   |
| Net interest income after provision for loan losses  and noninterest income |       | 34,915                                           |       | 41,959 |   |
| Noninterest  expense:                                                       |       |                                             |       |   |   |
| Personnel                                                                   |       | 24,891                                           |       | 22,347 |   |
| Production                                                                  |       | 9,377                                            |       | 8,800 |   |
| General and administrative                                                  |       | 14,147                                           |       | 10,813 |   |
| Total noninterest expense                                                   |       | 48,415                                           |       | 41,960 |   |
| Loss before income taxes                                                    |       | (13,500                                          | )          | (1 | ) |
| Income tax  provision                                                       |       | 17                                               |       | 765 |   |
| Net loss                                                                    |       | $                                                | (13,517    | ) | $ | (766 | ) |
| Net loss to  common stockholders:                                           |       |                                             |       |   |   |
| Basic                                                                       |       | $                                                | (13,517    | ) | $ | (766 | ) |
| Diluted                                                                     |       | $                                                | (13,517    | ) | $ | (766 | ) |
| Net loss per  common share:                                                 |       |                                             |       |   |   |
| Basic                                                                       |       | $                                                | (0.22      | ) | $ | (0.01 | ) |
| Diluted                                                                     |       | $                                                | (0.22      | ) | $ | (0.01 | ) |
| Weighted average  number of common shares outstanding:                      |       |                                             |       |   |   |
| Basic                                                                       |       | 62,535                                           |       | 62,593 |   |
| Diluted                                                                     |       | 62,535                                           |       | 62,593 |   |

 

|   |   |   |   |   |
|--------|--------|--------|--------|--------|

 

See accompanying notes to condensed consolidated financial statements.

2

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY(Unaudited)(In thousands)**

| ** **                                                         | ** ** | **Common  Stock** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Deficit** | ** ** | **Total** | ** ** |
|--------------------------------------------------------------------|------------|-------------------|------------|----------------------------------|------------|-----------------------|------------|-----------|------------|
| Balance at  December 31, 2005                                 |       |              | $          | 618                              |       |                  | $          | 656,041   |       | $ | (387,155 | ) | $ | 269,504 |   |
| Net loss                                                           |       |              | —     |                             |       | —                |       | (13,517   | )          | (13,517 | ) |
| Conversion and cancellations of restricted stock  units and awards |       |              | 1          |                             |       | (183                  | )          | —    |       | (182 | ) |
| Stock-based compensation related to restricted stock  awards       |       |              | —     |                             |       | 348                   |       | —    |       | 348 |   |
| Dividend cancellation on restricted stock awards                   |       |              | —     |                             |       | —                |       | 22        |       | 22 |   |
| Balance at  March 31, 2006                                    |       |              | $          | 619                              |       |                  | $          | 656,206   |       | $ | (400,650 | ) | $ | 256,175 |   |

 

See accompanying notes to condensed consolidated financial statements.

3

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIESCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)(in thousands)**

| ** **                                                                                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| **Cash Flows from Operating  Activities:**                                                 |       |                                             |       |   |   |
| Net loss                                                                                   |       | $                                                | (13,517    | ) | $ | (766 | ) |
| Adjustments to  reconcile net loss to net cash (used in) provided by operating activities: |       |                                             |       |   |   |
| Provision for losses on loans held for investment                                          |       | 12,601                                           |       | 6,500 |   |
| Depreciation and amortization                                                              |       | 970                                              |       | 791 |   |
| Amortization of debt discount                                                              |       | 2,316                                            |       | 123 |   |
| Stock-based compensation                                                                   |       | 348                                              |       | — |   |
| Deferred income taxes                                                                      |       | (19                                              | )          | — |   |
| Mark-to-market loss (gain) on derivative financial  instruments                            |       | 5,187                                            |       | (9,532 | ) |
| Loans held for  sale:                                                                      |       |                                             |       |   |   |
| Originations and purchases                                                                 |       | (1,565,524                                       | )          | (1,361,616 | ) |
| Proceeds from sales                                                                        |       | 1,453,411                                        |       | 1,463,101 |   |
| Net (increase) decrease in loans held for sale                                             |       | (112,113                                         | )          | 101,485 |   |
| Decrease  (increase) in:                                                                   |       |                                             |       |   |   |
| Advances and other receivables, net                                                        |       | 1,634                                            |       | (1,839 | ) |
| Residual interests                                                                         |       | —                                           |       | 20,220 |   |
| Prepaid expenses and other assets                                                          |       | (3,946                                           | )          | 1,145 |   |
| Derivative financial instruments                                                           |       | —                                           |       | (10,491 | ) |
| Increase  (decrease) in:                                                                   |       |                                             |       |   |   |
| Accounts payable and accrued expenses                                                      |       | (5,010                                           | )          | (5,792 | ) |
| Income taxes payable                                                                       |       | (889                                             | )          | (500 | ) |
| Net cash (used in) provided by operating activities                                        |       | (112,438                                         | )          | 101,344 |   |
| **Cash  Flows from Investing Activities:**                                                 |       |                                             |       |   |   |
| Decrease (increase) in loans held for investment                                           |       | 416,415                                          |       | (1,143,861 | ) |
| Purchases of equipment and improvements                                                    |       | (775                                             | )          | (1,068 | ) |
| Net cash provided by (used in) investment activities                                       |       | 415,640                                          |       | (1,144,929 | ) |
| **Cash  Flows from Financing Activities:**                                                 |       |                                             |       |   |   |
| Proceeds from issuance of financings on loans held  for investment                         |       | 24,316                                           |       | 1,168,528 |   |
| Repayments of financings on loans held for  investment                                     |       | (409,206                                         | )          | (68,015 | ) |
| Net increase in revolving warehouse and repurchase  facilities                             |       | 113,250                                          |       | 45,170 |   |
| Reduction in borrowings                                                                    |       | (15,163                                          | )          | (7,680 | ) |
| Payment of common stock dividends                                                          |       | (21,562                                          | )          | (3,804 | ) |
| Payment of expenses related to equity issuance                                             |       | —                                           |       | (28 | ) |
| Net cash (used in) provided by financing activities                                        |       | (308,365                                         | )          | 1,134,171 |   |
| Net increase (decrease) in cash and cash equivalents                                       |       | (5,163                                           | )          | 90,586 |   |
| Cash and cash  equivalents, beginning of period                                            |       | 123,172                                          |       | 37,780 |   |
| Cash and cash  equivalents, end of period                                                  |       | $                                                | 118,009    |   | $ | 128,366 |   |

 

See accompanying notes to condensed consolidated financial statements.

4

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)**

**Note 1.   Generaland Basis of Presentation**

***Recent***Events.******   OnMarch 15, 2006, Aames Investment Corporation (“Aames Investment”), whichelected to qualify as a mortgage real estate investment trust, or REIT, forU.S. federal income tax purposes for the six months ended December 31,2004 and for the year ended December 31, 2005, announced that it intendsto reorganize so that it would no longer be required to pay out at least 90% ofits taxable earnings to public stockholders as dividends, but rather, wouldretain its capital for internal growth within the group. On March 24,2006, Aames Investment’s Board of Directors approved a corporate reorganizationsubject to stockholder approval at a special meeting to achieve that goal. Inthe reorganization, the following would occur:

1.                Aames FinancialCorporation (“Aames Financial”), Aames Investment’s current taxable REITsubsidiary or TRS, would form a wholly owned subsidiary to consummate themerger described below.

2.                If approved by thestockholders, the new subsidiary would merge with and into Aames Investment,which would result in: (i) Aames Financial becoming the new parent ofAames Investment, (ii) common stockholders of Aames Investment exchangingtheir shares for common shares of Aames Financial, and (iii) AamesInvestment becoming a subsidiary of Aames Financial.

3.                Since AamesInvestment, the REIT, would be a subsidiary of Aames Financial, it woulddistribute its taxable income, including income from the REIT portfolio, toAames Financial, rather than to public stockholders. This would enable AamesFinancial to retain the earnings on the REIT portfolio for internal capitalgrowth. In addition, by reorganizing Aames Investment as a subsidiary of AamesFinancial, Aames Investment’s taxable earnings, including the earnings from theREIT portfolio, would be sheltered from taxation through utilization of AamesFinancial’s historical net operating loss carryforwards (“NOLs”) until fullyutilized. The taxable income generated by Aames Financial is subject to regularcorporate income tax. However, as of December 31, 2005, Aames Financialhad approximately $304.1 million of NOLs for U.S. federal income tax purposesthat expire from 2017 through 2025. Aames Financial expects to be able to usethese NOLs to offset its future income, subject to annual limitations and, as aresult, Aames Financial will have substantially lower effective tax rates thanstatutory rates.

***General.***  *********Aames Investment is a mortgagereal estate investment trust, or REIT, which manages a portfolio of subprimeresidential mortgage loans. Its principal subsidiary, Aames Financial, is anational mortgage banking company, started in 1954, which focuses primarily onoriginating, selling and servicing residential mortgage loans through bothwholesale and retail channels under the name “Aames Home Loan.” AamesInvestment, together with its subsidiaries, is collectively referred to as the “Company.”***

Aames Investment is a Maryland corporation and wasincorporated on February 24, 2004. On November 5, 2004, AamesInvestment completed a $297.5 million initial public offering of35.0 million common shares and a $39.5 million concurrent privateplacement of 5.0 million shares of common stock. Subsequently, on November 24,2004, Aames Investment sold an additional 5.3 million shares of commonstock in an over-allotment transaction. All of the common shares sold werepriced at $8.50 per share, less certain discounts.

On November 9, 2004, Aames Investment completedits reorganization with Aames Financial Corporation, formerly Aames Investment’sparent company. The reorganization transaction was accounted 

5

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Continued)**

for as a recapitalizationrestructuring of entities under common control with no change in accountingbasis. The common shares of Aames Financial and the Series B, C and DConvertible Preferred Stock were exchanged in connection with thereorganization.

At March 31, 2006, Specialty Finance Partners (“SFP”),a partnership controlled by Capital Z Financial Services Fund, II, L.P., aBermuda partnership (together with SFP, “Capital Z”) and others affiliated withCapital Z together owned approximately 14.0 million shares, orapproximately 22.7% of the Company’s common shares outstanding. Representativesof Capital Z currently have two seats on the Company’s seven member Board ofDirectors.

Aames Investment elected to qualify as a REIT for U.S.federal income tax purposes. Aames Financial is the taxable REIT subsidiary (“TRS”)of Aames Investment.

Aames Investment’s strategy is to use its equitycapital and funds borrowed under revolving warehouse and repurchase facilitiesto finance mortgage loan production, and to use those financing sourcestogether with on-balance sheet securitizations to finance its REIT portfolio ofmortgage loans. Aames Investment will retain in its REIT portfolio a portion ofthese loans, largely hybrid/adjustable rate mortgage loans. Aames Investmentwill sell the remainder, including a majority of the fixed-rate mortgage loansoriginated, on a whole loan servicing-released basis to third parties.

The Company’s principal market is borrowers whosefinancing needs are not being met by traditional mortgage lenders for a varietyof reasons, including the need for specialized loan products or credithistories that may limit such borrowers’ access to credit. Mortgage loansoriginated are extended on the basis of equity in the borrower’s property andthe creditworthiness of the borrower.

***Basis***of Presentation.***  ***Thecondensed consolidated financial statements included herein have been preparedby the Company, without audit, pursuant to the rules and regulations ofthe United States Securities and Exchange Commission. Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with accounting principles in the United States have been omitted.

The condensed consolidatedfinancial statements include the accounts of the Company after eliminating allsignificant intercompany transactions and reflect all normal, recurringadjustments which are, in the opinion of management, necessary to present afair statement of the results of operations of the Company in conformity withaccounting principles generally accepted in the United States for the interimperiods reported. The results of operations for the Company for the threemonths ended March 31, 2006 are not necessarily indicative of the resultsexpected for the full calendar year.

***Reclassifications***

Certain amounts related toMarch 31, 2005 have been reclassified to conform to the March 31,2006 presentation.

**Note 2.   Cashand Cash Equivalents**

At March 31, 2006 andDecember 31, 2005, the Company had $66.3 million and $70.1 million ofovernight investments, respectively.

6

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Continued)**

**Note 3.   LoansHeld for Sale**

Thefollowing table summarizes the composition of the Company’s loans held for saleas of the dates indicated (in thousands):

| ** **                                             | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| Fixed rate  mortgages                                  |       | $                  | 270,583    |                  |       | $ | 397,112 |   |   |
| Adjustable rate  loans                                 |       | 811,362            |       |                  | 570,716    |   |   |
| Total unpaid principal balance                         |       | 1,081,945          |       |                  | 967,828    |   |   |
| Net deferred loan  origination (fees) costs            |       | (5,194             | )          |                  | (4,547     | ) |   |
| Valuation  allowance                                   |       | (13,461            | )          |                  | (12,104    | ) |   |
| Total loans held  for sale, at lower of cost or market |       | $                  | 1,063,290  |                  |       | $ | 951,177 |   |   |

 

The Company maintains a lower-of-cost-or-market (“LOCOM”)valuation allowance for certain loans held for sale that are severelydelinquent, have suffered declines in market value, had credit deterioration,have significant collateral deficiencies or have other attributes that reducetheir sale potential.

Thefollowing table presents activity in the valuation allowance for the periodsindicated (in thousands):

| ** **                                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Balance,  beginning of period               |       | $                                                | 12,104     |   | $ | 4,234 |   |
| LOCOM provision                             |       | 11,312                                           |       | 2,424 |   |
| Transfer from advances receivable allowance |       | —                                           |       | 600 |   |
| Charge-offs                                 |       | (9,956                                           | )          | (1,313 | ) |
| Recoveries                                  |       | 1                                                |       | 20 |   |
| Net charge-offs                             |       | (9,955                                           | )          | (1,293 | ) |
| Balance, end of  period                     |       | $                                                | 13,461     |   | $ | 5,965 |   |

 

**Note 4.   LoansHeld for Investment, Net**

Thefollowing table summarizes loans held for investment, net, as of the datesindicated (in thousands): 

| ** **                            | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| Securitized                           |       | $                  | 3,241,334  |                  |       | $ | 3,659,657 |   |   |
| Not yet  securitized                  |       | 462,431            |       |                  | 461,451    |   |   |
| Total unpaid principal balance        |       | 3,703,765          |       |                  | 4,121,108  |   |   |
| Net deferred loan  origination costs  |       | 6,092              |       |                  | 7,787      |   |   |
| Allowance for  loan losses            |       | (53,337            | )          |                  | (43,359    | ) |   |
| Total loans held  for investment, net |       | $                  | 3,656,520  |                  |       | $ | 4,085,536 |   |   |

 

7

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) (Continued)**

Thefollowing table presents activity in the allowance for loan losses for theperiods indicated (in thousands): 

| ** **                                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                  | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Balance,  beginning of period               |       | $                                                | 43,359     |   | $ | 1,900 |   |
| Provision for loan losses                   |       | 12,601                                           |       | 6,500 |   |
| Transfer from advances receivable allowance |       | —                                           |       | — |   |
| Charge-offs                                 |       | (2,623                                           | )          | — |   |
| Recoveries                                  |       | —                                           |       | — |   |
| Net charge-offs                             |       | (2,623                                           | )          | — |   |
| Balance, end of  period                     |       | $                                                | 53,337     |   | $ | 8,400 |   |

 

The above allowanceactivity does not include losses on certain early prepayment representation andwarranty claims on loans transferred to loans held for sale and which areaccounted for in the Company’s representation and warranty allowance.

**Note 5.   AccountsPayable and Accrued Expenses**

The Company maintains a representation and warrantyallowance for exposure to losses that arise in connection with loans that it isrequired to repurchase from whole loan buyers. The allowance is included inaccounts payable and accrued expenses in the consolidated balance sheets. Theallowance is carried to address repurchase obligations arising fromrepresentations and warranty claims, and obligations for other contractualdisputes with investors with respect to mortgage loan sales. Allowance levelsare a function of expected losses based on expected and actual pending claimsand repurchase requests, historical experience, loan volume and loan sales distributionchannels and the assessment of probability related to such claims. Changes inthe level of provision to this allowance impacts the overall gain on salemargin from quarter to quarter.

Thefollowing table presents activity in the representation and warranty allowancefor the periods indicated (in thousands):

| ** **                                                                            | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                            | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Balance,  beginning of period                                                         |       | $                                                | 9,014      |   | $ | 13,137 |   |
| Provision (benefit) for representation, warranty and  other miscellaneous losses |       | 4,278                                            |       | (1,639 | ) |
| Release of claims                                                                     |       | (4,335                                           | )          | — |   |
| Charge-offs                                                                           |       | (2,833                                           | )          | (3,071 | ) |
| Recoveries                                                                            |       | —                                           |       | — |   |
| Net charge-offs                                                                       |       | (2,833                                           | )          | (3,071 | ) |
| Balance, end of  period                                                               |       | $                                                | 6,124      |   | $ | 8,427 |   |

 

During the three months ended March 31, 2006, theCompany released $4.3 million of aged claims due to management’s researchand determination that these were no longer valid.

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited)**

**Note 6.   Basicand Diluted Net Income (Loss) Per Common Share**

Thefollowing table sets forth information regarding basic and diluted net income(loss) per common share for the periods presented (in thousands, except pershare data): 

| ** **                                                                    | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| **Basic Net Income (Loss) Per  Common Share:**                                |       |                                             |       |   |   |
| Net loss                                                                      |       | $                                                | (13,517    | ) | $ | (766 | ) |
| Basic net loss to common stockholders                                         |       | $                                                | (13,517    | ) | $ | (766 | ) |
| Basic weighted average number of common shares  outstanding                   |       | 62,535                                           |       | 62,593 |   |
| Basic net loss per common share                                               |       | $                                                | (0.22      | ) | $ | (0.01 | ) |
| **Diluted  Net Income (Loss) Per Common Share:**                              |       |                                             |       |   |   |
| Diluted net loss to common stockholders                                       |       | $                                                | (13,517    | ) | $ | (766 | ) |
| Basic weighted average number of common shares  outstanding                   |       | 62,535                                           |       | 62,593 |   |
| Plus: Incremental shares from assumed conversions of  restricted stock awards |       | —                                           |       | — |   |
| Diluted weighted average number of common shares  outstanding                 |       | 62,535                                           |       | 62,593 |   |
| Diluted net loss  per common share                                            |       | $                                                | (0.22      | ) | $ | (0.01 | ) |

 

**Note 7.   Stock-BasedCompensation**

The Company adopted SFAS 123R effective January 1,2006 using the modified prospective method. Currently, the Company’sstock-based compensation consists of restricted stock awards, which are valuedbased on the fair value of the Company’s shares at the grant date using theclosing market price of the Company’s shares on that date. The fair value ofthe restricted stock awards is amortized to compensation expense, with anoffsetting credit to additional paid-in capital, over the period that serviceis rendered, which is the vesting period. Restricted stock awards generallyvest 25% per year commencing on the first anniversary date from the date ofgrant. The Company has considered historical forfeiture rates in its estimatedstock-based compensation expense related to awards that are ultimately expectedto vest. The recognition of compensation expense in the first quarter of 2006related to the vesting of restricted stock awards is consistent with theexpense recognition for the first quarter of 2005 and therefore the quarterlyresults are comparable to the prior year. As of March 31, 2006, there was$5.5 million of unrecognized compensation cost, adjusted for estimatedforfeitures, related to non-vested grants of restricted stock awards. Totalunrecognized compensation cost will be adjusted for future changes in estimatedforfeitures.

The Amended and Restated Aames Investment Corporation2004 Equity Incentive Plan (the “Plan”), which became effective in November 2004,is the Company’s only compensation plan under which its equity securities areauthorized for issuance, and it allows the Company to make awards to itsofficers and other employees, directors and all other persons who provide itservices. Those awards may be stock options, SARs, or “full value awards”(including shares of restricted stock and restricted stock units). Currently, amaximum of 5,550,000 shares of the Company’s common stock may be issued uponthe exercise of stock options or SARs, in connection with the vesting of sharesof restricted common stock or upon the distribution of shares underlyingrestricted stock units. To date, all awards made under the Plan 

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited)**

have been full valueawards (i.e. restricted stock awards and restricted stock units) and each shareof the Company’s common stock underlying a full value award reduces the numberof shares available for future issuance by 2.5 shares.

In connection with the Company’s reorganization as aREIT and its initial public offering in November 2004, the Company issued1,282,553 restricted stock units pursuant to the Plan and recorded compensationexpense of $10.9 million.

Thefollowing tables present activity in Restricted Stock Units (“RSU’s) andRestricted Stock Awards (“RSA’s”) for the period presented:

| ** **                    | ** ** | **Three Months Ended March 31, 2006** | ** ** |
|-------------------------------|------------|-----------------------------------------------------------|------------|
| ** **                    | ** ** | **RSU’s**                                            | ** ** | **RSA’s** | ** ** |
| ** **                    | ** ** | **Number**                                                | ** ** | **Grant** | ** ** | **Number** | ** ** | **Grant** | ** ** |
| ** **                    | ** ** | **of**                                                    | ** ** | **Price** | ** ** | **of** | ** ** | **Price** | ** ** |
| ** **                    | ** ** | **Shares**                                                | ** ** | **Range** | ** ** | **Shares** | ** ** | **Range** | ** ** |
| Balance,  beginning of period |       | 716,551                                                   |       | $ | 8.50 |   | 936,516 |   | $ | 6.05-9.82 |   |
| Granted                       |       | —                                                    |       | — |   | 36,000 |   | 5.90 |   |
| Expired                       |       | —                                                    |       | — |   | — |   | — |   |
| Cancelled(1)                  |       | (28,283                                                   | )          | 8.50 |   | (172,900 | ) | 7.94-9.82 |   |
| Converted                     |       | (45,974                                                   | )          | 8.50 |   | (8,356 | ) | 9.43-9.50 |   |
| Balance, end of period        |       | 642,294                                                   |       | $ | 8.50 |   | 791,260 |   | $ | 5.90-9.82 |   |

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(1)          Cancellationsof RSUs/RSAs include those arising from employee terminations as well as RSAsthat were returned to the Company to settle payroll tax obligations uponconversion of RSUs/RSAs to common stock.

**Note 8.   Commitmentsand Contingencies**

In July 2005, the Company was served with aputative class action complaint entitled *Webb v. Aames InvestmentCorporation, et. al.* brought in the United States District Court,Central District of California. In December 2005, the Company was servedwith a putative class action complaint entitled *Cooper v.Aames Investment Corporation, et. al.* brought in the United StatesDistrict Court, Eastern District of Wisconsin. These complaints allegeviolations of the Fair Credit Reporting Act (“FCRA”) in connection withprescreened offers of credit, which the Company made to plaintiffs. *Webb* also alleges that the Company’s direct mail piecesfailed to comply with the requirements of FCRA that the required notice beclear and conspicuous. The plaintiffs seek to recover on behalf of themselvesand others similarly situated compensatory and punitive damages and attorneys’fees. We filed a motion to dismiss the clear and conspicuous claims inconnection with *Webb*, which was granted in May2006. The court has requested further briefing to determine whether it willgrant leave for the plaintiffs to amend. The Company also filed a motion totransfer *Cooper* to the Central District ofCalifornia where *Webb* is pending, which wasgranted in March 2006, and the case was ultimately transferred on April 13,2006. There have been no rulings on the merits of the plaintiffs’ claims or theclaims of the putative class in either matter and no class has been certified.The Company intends to vigorously defend these matters, but if a class iscertified and prevails on the merits, the potential liability could have amaterial adverse affect on the Company’s business. The outcome of these casesand the amount of liability, if any, cannot be determined at this time.

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited)**

On April 27, 2004, Aames Financial received acivil investigative demand from the Federal Trade Commission, or the FTC, that,although not alleging any wrongdoing, sought documents and data relating toAames Financial’s business and lending practices. The demand was issuedpursuant to an April 8, 2004 resolution of the FTC authorizing non-publicinvestigations of various unnamed subprime lenders and loan brokers todetermine whether there have been violations of certain consumer protectionlaws. The Company has cooperated and intends to continue to cooperate fullywith the FTC in this investigation. Because the investigation is at an earlystage, the Company cannot predict the outcome of the investigation and itseffect, if any, on the Company’s business.

On September 7, 2004, Aames Financial received aCivil Investigative Demand and Notice to Proceed from the Office of theAttorney General of Iowa, that, although not alleging any wrongdoing, soughtdocuments and data relating to its business and lending practices in Iowa.Aames Financial has cooperated and intends to cooperate fully with the Officeof the Attorney General of Iowa in this investigation. Because theinvestigation is at an early stage, Aames Financial cannot predict the outcomeof the investigation and its effect, if any, on its business in Iowa, whichapproximated 0.009% and 0.02% of total mortgage loan production during thethree months ended March 31, 2006 and 2005, respectively.

In the ordinary course ofits business, the Company is subject to various claims made against it arisingfrom, among other things, the Company’s loan origination and collectionefforts, trade practices and alleged violations of the various federal andstate laws and regulations applicable to the Company’s business, such asconsumer protection laws and employment laws. The Company believes that theresolution of any of these pending incidental claims is not likely to have amaterial adverse effect on the Company’s consolidated financial position andresults of operations.

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited)**

**Note 9.   ParentCompany Information**

The followingtables present the condensed balance sheets and condensed statements ofoperations of Aames Investment Corporation (parent company only, prior tointercompany elimination entries) as of and for the dates indicated (inthousands): 

| ** **                                                   | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **Condensed Balance Sheets**                       | ** ** | ** **         | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Cash and cash  equivalents:                                  |       |               |       |                  |       |   |   |
| Unrestricted                                                 |       | $                  | 16,505     |                  |       | $ | 13,042 |   |   |
| Restricted                                                   |       | 87,016             |       |                  | 87,094     |   |   |
| Loans held for  investment, net:                             |       |               |       |                  |       |   |   |
| Securitized                                                  |       | 3,241,334          |       |                  | 3,659,657  |   |   |
| Not yet securitized                                          |       | 462,431            |       |                  | 461,451    |   |   |
| Net deferred loan origination costs                          |       | 6,092              |       |                  | 7,787      |   |   |
| Deferred loan acquisition premium                            |       | 35,418             |       |                  | 41,132     |   |   |
| Allowance for loan losses                                    |       | (53,337            | )          |                  | (43,359    | ) |   |
| Total loans held for investment, net                         |       | 3,691,938          |       |                  | 4,126,668  |   |   |
| Investment in  subsidiaries                                  |       | 51,970             |       |                  | 78,697     |   |   |
| Accrued interest  and other assets                           |       | 94,175             |       |                  | 57,480     |   |   |
| Derivative  finanancial instruments, at estimated fair value |       | 52,961             |       |                  | 58,147     |   |   |
| Total assets                                                 |       | $                  | 3,994,565  |                  |       | $ | 4,421,128 |   |   |
| Financings on loans held for investment                      |       | $                  | 3,240,614  |                  |       | $ | 3,623,188 |   |   |
| Revolving  warehouse and repurchase facilities               |       | 443,805            |       |                  | 433,241    |   |   |
| Borrowings                                                   |       | 1,324              |       |                  | 16,487     |   |   |
| Other liabilities                                            |       | 17,230             |       |                  | 37,577     |   |   |
| Total liabilities                                            |       | 3,702,973          |       |                  | 4,110,493  |   |   |
| Stockholders’  equity                                   |       | 291,592            |       |                  | 310,635    |   |   |
| Total liabilities and stockholders’ equity              |       | $                  | 3,994,565  |                  |       | $ | 4,421,128 |   |   |
|                                                              |            |                    |            |                       |            |  |  |  |  |  |  |

 

| ** **                                           | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------------------|------------|
| **Condensed Statement of Operations** | ** ** | ** **                                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net interest  income                                 |       | $                                                | 22,115     |   | $ | 32,463 |   |
| Provision for  losses on loans held for investment   |       | (12,601                                          | )          | (6,500 | ) |
| Net interest income after provision for loan losses  |       | 9,514                                            |       | 25,963 |   |
| Noninterest  expense                                 |       | (2,068                                           | )          | (2,035 | ) |
| Income before equity in net loss of subsidiary       |       | 7,446                                            |       | 23,928 |   |
| Equity in net  loss of subsidiary                    |       | (26,677                                          | )          | (22,372 | ) |
| Net income (loss)                                    |       | $                                                | (19,231    | ) | $ | 1,556 |   |
|                                                      |            |                                                  |            |  |  |  |  |  |  |

 

**Note 10.   RecentlyIssued Accounting Standards**

In December of 2004, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123R,*“Share-Based Payment”*(“SFAS 123R”), anamendment of 

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**AAMES INVESTMENT CORPORATION AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Continued) (Unaudited)**

SFAS 123. This Statementrequires companies to measure the cost of employee services received inexchange for an award of equity instruments based on the grant date fair valueof the award. SFAS 123R requires measurement of fair value of employee stockoptions using an option pricing model that takes into account the awardedoptions’ unique characteristics. SFAS 123R requires charging the recognizedcost to expense over the period the employee provides services to earn theaward, generally its vesting period. In April of 2005, the Securities andExchange Commission (“SEC”) revised the required adoption date of SFAS 123R. Asa result of this change, the Company was required to adopt SFAS 123R effective January 1,2006. The adoption of SFAS 123R did not have a material impact on our consolidatedfinancial statements.

In May 2005, the FASB issued Statement ofFinancial Accounting Standards No. 154, *“AccountingChanges and Error Corrections”* (“SFAS 154”), which replaces APB No. 20,*“Accounting Changes,”* and Statement ofFinancial Accounting Standards No. 3, *“Reporting Changes inInterim Financial Statements.”*SFAS 154 changes the accounting forand reporting of a change in accounting principle. SFAS 154 requiresretrospective application to prior periods’ financial statements of voluntarychanges in accounting principle and changes required by new accountingstandards when the standard does not include specific transition provisions,unless it is impracticable to do so. SFAS 154 is effective for accountingchanges and corrections of errors in fiscal years beginning after December 15,2005 and will only affect the Company’s consolidated financial statements uponadoption of a voluntary change in accounting principle by the Company.

In March 2006,the FASB issued Statement No. 156, Accounting for Servicing of FinancialAssets (“SFAS 156”), which amends FASB Statement No. 140, Accounting forTransfers and Servicing of Financial Assets and Extinguishments of Liabilities.SFAS 156 permits an entity to choose either of the following subsequentmeasurement methods for each class of separately recognized servicing assetsand servicing liabilities:

·       AmortizationMethod—Amortize servicing assets or servicing liabilities in proportion to andover the period of net servicing income or net servicing loss and assess theservicing assets or liabilities for impairment or increased obligation based onfair value at each reporting date. This method is consistent with currentsubsequent measurement guidance for servicing rights.

·       FairValue Measurement Method—Measure servicing assets or servicing liabilities atfair value at each reporting date and report changes in fair value in earningsin the period in which the change occurs. This method is a new alternative.

SFAS 156 is effective as of the beginning of an entity’sfirst fiscal year that begins after September 15, 2006. However, earlieradoption of the SFAS 156 is permitted as of the beginning of an entity’s fiscalyear, provided the entity has not yet issued financial statements for aninterim period of that fiscal year. The adoption of SFAS 156 is not expected tohave a material impact on the Company’s consolidated financial statements.

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

**Item 3.**                        Quantitativeand Qualitative Disclosures About Market Risk

The following discussionincludes Management’s Discussion and Analysis of Financial Condition andResults of Operations and Quantitative and Qualitative Disclosures about MarketRisk. This section should be read in conjunction with the CondensedConsolidated Financial Statements included in Item 1 of this Form 10-Q.

**FORWARD-LOOKINGINFORMATION**

This report may containforward-looking statements under federal securities laws. These statements arebased on management’s current expectations and beliefs and are subject to anumber of trends and uncertainties that could cause actual results to differmaterially from those described in the forward-looking statements. The risksand uncertainties that may cause the Company’s performance and results to varyinclude: (i) limited cash flow to fund operations and dependence onshort-term financing facilities; (ii) changes in overall economicconditions and interest rates; (iii) increased delinquency rates in theportfolio; (iv) intense competition in the mortgage lending industry; (v) adversechanges in the securitization and whole loan market for mortgage loans; (vi) declinesin real estate values; (vii) an inability to originate subprimehybrid/adjustable rate mortgage loans; (viii) obligations to repurchasemortgage loans and indemnify investors; (ix) concentration of operationsin California, Florida, New York and Texas; (x) the occurrence of naturaldisasters (including the adverse impact of hurricanes Katrina, Rita and Wilma);(xi) extensive government regulation; and (xii) an inability tocomply with the federal tax requirements applicable to REITs and effectivelyoperate within limitations imposed on REITs by federal tax rules. For a morecomplete discussion of these risks and uncertainties and information relatingto the Company, see the Form 10-K for the year ended December 31,2005 and other filings with the SEC made by the Company. Aames Investmentexpressly disclaims any obligation to update or revise any forward-lookingstatements in this report.

**RECENT EVENTS**

On March 31, 2006, the Company closed two of itsfive wholesale operations centers—those located in Deerfield, Florida andParsippany, New Jersey—and consolidated the functions previously performed inthose centers into its remaining centers located in Irvine, California,Jacksonville, Florida and Dallas, Texas. In connection with the wholesalerestructuring, the Company also eliminated over 120 positions in the wholesalechannel in April 2006. The Company estimates that the combined annualsavings from these actions will be approximately $10.0 million.

On March 15,2006, Aames Investment Corporation (“Aames Investment”), which elected toqualify as a mortgage real estate investment trust, or REIT, for U.S. federalincome tax purposes for the six months ended December 31, 2004 andfor the year ended December 31, 2005, announced that it intends toreorganize so that it would no longer be required to pay out at least 90% ofits taxable earnings to its public stockholders as dividends, but rather, wouldretain its capital for internal growth. On March 24, 2006, AamesInvestment’s Board of Directors approved a corporate reorganization subject tostockholder approval at a special meeting to achieve that goal. In thereorganization, the following would occur:

1.                Aames FinancialCorporation (“Aames Financial”), Aames Investment’s current taxable REIT subsidiaryor TRS, would form a wholly owned subsidiary to consummate the merger describedbelow.

2.                If approved by thestockholders, the new subsidiary would merge with and into Aames Investment,which would result in: (i) Aames Financial becoming the new parent ofAames 

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Investment, (ii) commonstockholders of Aames Investment exchanging their shares for common shares ofAames Financial, and (iii) Aames Investment becoming a subsidiary of AamesFinancial.

3.                SinceAames Investment, the REIT, would be a subsidiary of Aames Financial, it woulddistribute its taxable income, including income from the REIT portfolio, toAames Financial, rather than to public stockholders. This would enable AamesFinancial to retain the earnings on the REIT portfolio for internal capitalgrowth. In addition, by reorganizing Aames Investment as a subsidiary of AamesFinancial, Aames Investment’s taxable earnings, including the earnings from theREIT portfolio, would be sheltered from taxation through utilization of AamesFinancial’s historical net operating loss carryforwards (“NOLs”) until fullyutilized. The taxable income generated by Aames Financial is subject to regularcorporate income tax. However, as of December 31, 2005, Aames Financialhad approximately $304.1 million of NOLs for U.S. federal income tax purposesthat expire from 2017 through 2025. Aames Financial expects to be able to usethese NOLs to offset its future income, subject to annual limitations and, as aresult, Aames Financial will have substantially lower effective tax rates thanstatutory rates.

**GENERAL**

Aames Investment was formed in February 2004 tobuild and manage a portfolio of high yielding subprime residential mortgageloans to offer its stockholders the opportunity for attractive dividend yieldsand earnings growth. In November 2004, we completed an initial publicoffering, and, concurrently with that offering, reorganization with AamesFinancial, formerly our parent company. As a result of the 2004 REITreorganization, Aames Financial became a wholly owned subsidiary of ours.

Aames Financial is a national mortgage bankingcompany, founded in 1954, which focuses primarily on originating, selling andservicing residential mortgage loans through both wholesale and retail channelsunder the name “Aames Home Loan.” Our strategy is to use our equity capital andfunds borrowed under revolving warehouse and repurchase facilities to financeour mortgage loan production, and to use those financing sources, together withon-balance sheet securitizations, to finance our REIT portfolio of mortgageloans. We retain in our REIT portfolio a portion of our mortgage loanoriginations, largely hybrid/adjustable rate mortgage loans or ARMs. Wesell the remainder, including a majority of the fixed-rate mortgage loans thatwe originate, on a whole loan, servicing-released basis to third parties.

As a REIT, we generallyare not subject to U.S. federal income tax on the REIT income that wedistribute to our stockholders. During the six months ended December 31,2004 and the year ended December 31, 2005, we distributed at least 90% ofthe earnings from our REIT portfolio of mortgage loans to our stockholders. Asdiscussed above, we have announced that we intend to reorganize so that wewould no longer be required to pay out at least 90% of our taxable earnings toour public stockholders. The taxable income generated by Aames Financial issubject to regular corporate income tax.

**BUSINESS STRATEGY**

Our goal is tomaximize stockholder value and increase earnings by:

·       ***Improving the profitability of our loan production***byincreasing interest rates charged on mortgage loans and eliminating productswith limited market liquidity;

·       ***Selling a portion of Aames Financial’s mortgageloan production on a whole loan, servicing-released basis***intothe secondary markets to maximize its earnings. We will sell the loans we donot retain for our REIT portfolio to third parties to capture gain on saleincome from these loans and grow our equity capital on a consolidated basis;and

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·       ***Servicing our loans***to enhance theperformance of our REIT portfolio, and growing our servicing operation with ourREIT portfolio which will lower our per loan servicing costs through economiesof scale.

·       ***Generating internal capital growth through theretention of earnings*****from mortgageloan originations, sales, and servicing, and if the proposed reorganization iscompleted, from our REIT portfolio.

·       ***Managing our portfolio of high yielding subprimeresidential mortgage loans*****and our equityleverage to maximize the return on our REIT portfolio of mortgage loans and ourreturns, while at the same time managing our financing costs and the increasedrisk of loss associated with our leverage. If the reorganization is completed,the REIT portfolio would be held by a REIT subsidiary of Aames Financial;

·       ***Continuing to improve our efficiency and loanquality*** and serving as a highly efficient originator. We intendto accomplish this by increasing the use of technology to streamline furtherour loan origination and underwriting processes. We intend to rigorously applyand continuously improve our underwriting criteria and processes in order tominimize defaults and losses and by collecting comprehensive performance dataon our REIT portfolio of mortgage loans to refine our underwriting guidelinesand risk-based pricing;

The strategies discussedabove contain forward-looking statements. Such statements are based on currentexpectations and are subject to risks, uncertainties and assumptions, includingthose discussed under “Item 7. Management’s Discussion and Analysis ofFinancial Condition and Results of Operations—Risk Factors” included in ourAnnual Report on Form 10-K for the year ended December 31, 2005and other filings with the SEC. Should one or more of these risks oruncertainties materialize, or should underlying assumptions prove incorrect,actual results may vary materially from those anticipated, estimated orprojected. Thus, no assurance can be given that we will be able to accomplishthe above strategies.

**Mortgage LoanPortfolio Management**

We invest in subprime one-to-four family, residentialmortgage loans, operating as a long-term portfolio investor. We purchase loansoriginated by Aames Financial that we anticipate holding on our balance sheetin our REIT portfolio, largely hybrid/adjustable rate mortgage loans. Aames Financialservices the loans in our REIT portfolio.

To provide us withlong-term financing for our REIT portfolio of mortgage loans, we securitizesubstantially all of those loans through on-balance sheet transactionsstructured as financings rather than sales, for both tax and financialaccounting purposes. Accordingly, these loans will remain on our consolidatedbalance sheet as an asset and reported as “Loans held for investment, net,”while the underlying bonds issued through the securitization will be reportedas a liability as “Financings on loans held for investment.” Thus, we recordinterest income generated by the mortgage loans and recognize interest expenseon the related bonds issued in the securitization over the life of thesecuritization, rather than generate a gain or loss upon completion of thesecuritization.

**Managing InterestRate Risk**

The hybrid/adjustable rate mortgage loans in our REITportfolio may have a fixed rate for two, three or five years prior to theirfirst adjustment, while the related on-balance sheet securitization debt mayhave rates that adjust monthly. As a result, our net interest income and cashflow could be negatively impacted by changes in short-term interest rates. Tocounteract this possibility, we may hedge the aggregate risk of interest ratefluctuations with respect to our borrowing index. We generally intend to hedgeonly the risk 

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related to changes in thebenchmark interest rate used in the variable rate index, usually a LondonInterbank Offered Rate, known as LIBOR, or a U.S. Treasury rate.

To reduce these risks, we may enter into interest ratecap agreements whereby, in exchange for a fee, we would be reimbursed forinterest paid in excess of a certain capped rate. With respect to interest ratecap agreements, any net payments under, or fluctuations in the fair value of,these cap agreements would be recorded in current income.

Derivative financialinstruments contain credit risk to the extent that the institutionalcounterparties may be unable to meet the terms of the agreements. We expect tominimize this risk by using multiple counterparties and limiting them to majorfinancial institutions with good credit ratings. In addition, we regularlymonitor the potential risk of loss with any one party resulting from this typeof credit risk. Accordingly, we do not expect any material losses as a resultof default by other parties.

**REIT Compliance**

If Aames Investment completes the reorganization, itwould no longer be required to pay out at least 90% of its taxable earnings to publicstockholders as dividends, but rather, would retain its capital for internalgrowth within the group. As a result, all future dividends distributions wouldbe at the discretion of our Board of Directors.

We elected to qualify as a REIT for U.S. federalincome tax purposes for the six months ended December 31, 2004 and for theyear ended December 31, 2005. Aames Financial has continued its operationsas our primary mortgage origination and servicing subsidiary. To meet some ofthe REIT qualification requirements, we conduct our loan sales, as well asother servicing and origination functions, through Aames Financial, our taxableREIT subsidiary. All loans are sourced, underwritten and processed by AamesFinancial. We purchase from Aames Financial the loans that we anticipateholding on our balance sheet in our REIT portfolio, largely hybrid/adjustablerate mortgage loans, and Aames Financial sells the remainder of the loans itoriginates, including a majority of its fixed-rate mortgage loans, to thirdparties. We are required to purchase loans from Aames Financial at fair marketvalue and Aames Financial recognizes gain or loss on the sale.

Any taxable income generated by Aames Financial willbe subject to regular corporate income tax and Aames Financial will continue torecord a provision for income taxes. However, we anticipate that AamesFinancial will have substantially lower effective tax rates due to historicalnet operating loss carryforwards for U.S. federal income tax purposes. Subjectto annual limitations, these losses are available to offset future income.Aames Financial may retain any income it generates, net of any tax liability itincurs on that income, without affecting the REIT distribution requirements. IfAames Financial chooses to pay a dividend to us, the dividend could be includedin the REIT distribution. Any distributions that Aames Financial makes in thefuture will be at the discretion of its Board of Directors and will depend on,among other things, its actual results of operations and liquidity levels.

U.S. federal income taxlaw requires that a REIT distribute annually to its stockholders at least 90%of its taxable income, excluding the retained earnings of any taxable REITsubsidiary it owns. During the six months ended December 31, 2004 and theyear ended December 31, 2005, we distributed at least 90% of our taxableincome to our stockholders, and were not subject to U.S. federal income tax,and will not record an income tax provision with respect to the income we distributed.

**Mortgage LoanOriginations**

We purchase subprime, one-to-four family residentialmortgage loans that Aames Financial originates. These loan originations aresignificant to our financial results because they are the primary 

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source of the loans thatwe hold in our on-balance sheet REIT portfolio of loans held for investment,and of the loans that we sell to the secondary markets.

Our principal market isborrowers whose financing needs are not being met by traditional mortgagelenders for a variety of reasons, including the need for specialized loanproducts or credit histories that may limit such borrowers’ access to credit.These types of borrowers generally pay higher mortgage loan origination feesand interest rates than those charged by conventional lending sources. Webelieve that these borrowers continue to present an opportunity for us to earna return commensurate with the risk assumed. Our residential mortgage loans,which include fixed and hybrid/adjustable rate loans, are generally used byborrowers to consolidate indebtedness, obtain cash to finance other consumerneeds, purchase homes or lower their monthly payment. We believe that loanorigination volume is affected by general levels of interest rates. A majorityof our loan originations are cash-out refinancings and purchase money loans,and, as a result, our loan origination volume is generally less cyclical thanconventional mortgage lending, which has a higher percentage of rate/termrefinance loans. However, given recent rises in interest rates, we believe thatsubprime borrowers with hybrid ARMs or interest only loans may seek torefinance when the initial fixed period expires to avoid the increased paymentafter the interest fixed or interest only period.

**Mortgage Loan Salesto Third Parties and Off-Balance Sheet Securitizations**

Aames Financialsells whole loans not retained for the REIT portfolio to third parties on aservicing-released basis in order to capture gain on sale income from theseloans and to grow our equity capital base on a consolidated basis. AamesFinancial does not currently sell loans in off-balance sheet securitizations;however, Aames Financial may in the future sell a portion of its loans in off-balancesheet securitizations depending on market conditions at that time. AamesFinancial generally sells these loans within 45 days of funding and servicesthese loans during the period between origination and transfer of servicing tothe buyer, which is generally within 90 days after the sale of the loan. AamesFinancial generates income primarily from:

·       gainon sale income, which includes the premiums received on the sale of the loans,

·       netinterest income earned on its loans held prior to sale,

·       pointsand fees charged to borrowers, less any yield spread premiums paid to wholesalebrokers, during the loan origination process, and

·       loanservicing income earned on its loans held prior to sale, loans retained in ourREIT portfolio, and loans owned by others.

Aames Financial uses themajority of the net proceeds of its loan sales to pay down its warehouse andrepurchase facilities to increase capacity under these facilities for futurefundings of mortgage loans. Proceeds that we receive from financings on loansheld for investment are also used to pay down our warehouse and repurchasefacilities.

**Mortgage LoanServicing**

Aames Financial servicesresidential mortgage loans, those held in its portfolio prior to sale, thoseheld in our REIT portfolio, and, to a much lesser extent, for others. Loanservicing remains an integral part of our business operation. We believe thatmaintaining contact with our borrowers improves our ability to manage creditrisk and retain our borrowers. Subprime borrowers are more likely to default ontheir obligations than conventional borrowers. By servicing our loans, westrive to identify problems with borrowers early and take quick action toaddress these problems. By keeping in close touch with borrowers, we canprovide them with information about our products and encourage borrowersexpressing an interest 

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inrefinancing to refinance with us. Mortgage loan servicing provides fee incomefor Aames Financial in the form of normal customer service and processing fees.

**CRITICAL ACCOUNTINGPOLICIES**

Several of the critical accounting policies that areimportant to the portrayal of our financial condition and results of operationsrequire management to make difficult and complex judgments that rely onestimates about the effect of matters that are inherently uncertain duegenerally to the impact of changing market conditions and/or borrower behavior.We believe our most critical accounting policies relate to (1) owning aportfolio of loans held for investment, which is separate and distinct from aportfolio of loans held for sale, (2) our allowance for losses on mortgageloans held for investment, (3) gain on sale of loans held for sale and oursecondary market related allowances and (4) income taxes.

***Owning a Portfolioof Hybrid/Adjustable Rate Mortgage Loans.******  ***We have a portfolio of loansheld for investment in addition to Aames Financial’s portfolio of loans heldfor sale. We differentiate our interest income and expense into two components:“Interest income—loans held for sale” and “Interest income—loans held forinvestment.” Interest expense is also differentiated between “Interest expense—loansheld for sale” and “Interest expense—loans held for investment.” We also recorda provision for loan losses on loans held for investment, which increases ourallowance for loan losses, based on an estimate of probable and inherent lossesin our portfolio of loans held for investment.

Our REIT portfolio of loans is shown on our balancesheet as “Loans held for investment.” Prior to our 2004 REIT reorganization,all loans were shown as “Loans held for sale, at lower of cost or market.”Because Aames Financial intends to sell a portion of its loans to third partiesin the secondary markets, we continue to show these loans as “Loans held forsale, at lower of cost or market.” Bonds that we issue in our on-balance sheetsecuritizations to finance our REIT portfolio of loans held for investment areshown as “Financings on loans held for investment.” Warehouse financing of ourloans held for sale and loans held for investment but not yet securitized areshown as “Revolving warehouse and repurchase facilities.”

The majority of our portfolio of loans held forinvestment was created through on-balance sheet securitizations and must complywith the provisions of FASB Statement of Financial Accounting Standards No. 140“*Accounting for Transfers and Servicing of FinancialAssets and Extinguishments of Liabilities*” (“SFAS 140”). SFAS 140sets forth the criteria applicable to determining whether a transfer of financialassets is to be treated as a sale or a secured financing under generallyaccepted accounting principles, or GAAP. We intend for our on-balance sheetsecuritizations to be treated as secured financings and, accordingly, one ofour critical accounting policies is compliance with the SFAS 140 requirementsnecessary to obtain secured financing treatment for our securitizations.

***Allowance forLosses on Mortgage Loans Held for Investment.****  *For mortgage loans held for investment, we maintainan allowance for loan losses based on our estimate of losses inherent andprobable as of the balance sheet date. We view our mortgage loans held forinvestment as a homogeneous pool of loans that exhibit similar characteristics,including default probabilities and loss severities. We evaluate the adequacyof this allowance monthly, giving consideration to factors such as the currentperformance of the loans, delinquency status of the loans, historicalperformance of similar loans, credit characteristics of the portfolio, thevalue of the underlying collateral and the general economic environment.

In order to estimate an appropriate allowance forlosses on loans held for investment, we estimate losses using “static pooling,”which stratifies the loans held for investment into separately identifiedvintage pools. Using historic experience and taking into consideration thefactors above, we estimate an allowance for loan losses which we believe is adequatefor probable and inherent losses in the portfolio of mortgage loans held forinvestment. Provisions for losses are charged to our consolidated statement ofoperations. Charge-offs of mortgage loans held for investment are charged tothe allowance. While we use available 

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information to estimatelosses on loans held for investment, future additions to the allowance may benecessary based on changes in estimates resulting from economic and otherconditions.

***Gain on Sale ofLoans Held for Sale and Secondary Market Related Allowances.******  ***Our current loan dispositionstrategy for loans not retained in our REIT portfolio relies on whole loansales. We sell our loans in whole loan sale transactions on a cash basis. Inwhole loan sale transactions, the buyer acquires all future rights (includingmortgage servicing rights) to the loans, without recourse, except for standardrepresentations and warranties. Gains and losses on whole loan sales arerecognized when we surrender control over the loans (generally on thesettlement date) based upon the difference between the proceeds received andthe net carrying amount of the loans, less the provision for representation,warranty and other miscellaneous losses recorded on the settlement date tocover repurchases, if any, of loans that have a first or early payment defaultto the purchaser or otherwise breach representations and warranties.

As part of the normal course of business involvingloans sold to the secondary market, we are occasionally required to repurchaseloans or make payments to settle breaches of the standard representations andwarranties made as part of our loan sales. The secondary market allowancesinclude (1) a representation and warranty allowance for probable losses onrepurchases arising from representation and warranty claims, and probableobligations related to disputes with investors and (2) a lower of cost ormarket valuation allowance for certain loans held for sale that we believe havea market value of less than par.

The level of the representation and warranty allowanceis a function of expected losses based on actual pending claims and repurchaserequests, historical experience, loan sales and the assessment of probableinvestor claims. An increase to this allowance is recorded as a reduction ofthe gain on sale of loans in our consolidated statements of operations and thecorresponding allowance is recorded in accounts payable and accrued expenses inour consolidated balance sheets. At the time we repurchase a loan, theestimated loss on the loan is charged against this allowance and recorded as areduction of the basis of the loan.

The lower of cost or market valuation allowance ismaintained for loans held for sale that are severely delinquent, have suffereddeclines in market value, had credit deterioration, have significant collateraldeficiencies or other attributes that reduce their sale potential. An increaseto this valuation allowance is recorded as a reduction of gain on sale of loansin our consolidated statement of operations and the valuation allowance isrecorded as an offset to loans held for sale in our consolidated balance sheets.At the time we sell a loan having the aforementioned attributes, the estimatedloss on the loan is charged against this allowance.

***Accounting forOff-Balance Sheet Securitizations.******  ***During the three months endedMarch 31, 2006 and the year ended December 31, 2005, we did notdispose of any of our mortgage loans in off-balance sheet securitizationtransactions. Previously, our retained residual interests related tooff-balance sheet securitizations which closed during the year ended June 30,2000. We called the seven remaining securitization trusts in which we retainedresidual interests during the year ended December 31, 2005. No adjustmentsto the carrying values of the retained residual interests were deemed necessaryas a result of calling these securitization trusts. In addition, during theyear ended December 31, 2005, the actual performance of our retainedresidual interests as compared to the key assumptions and estimates used toevaluate their carrying value (i.e., credit losses, rate of prepayment anddiscount rate) did not result in write-downs. Performing mortgage loancollateral received in the calls of the securitization trusts was placed intothe portfolio of loans held for investment for inclusion in the $1.2 billionsecuritization that closed on September 12, 2005 and the $180.1 millionsecuritization that was completed on August 12, 2005.

***Accounting forIncome Taxes.***   We elected to qualify as aREIT for U.S. federal income tax purposes for the six months ended December 31,2004 and for the year ended December 31, 2005. This means that 

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generally we were notsubject to U.S. federal income taxes on the REIT income that we distributed toour stockholders.

Aames Financial’s taxable income is subject to regularcorporate income tax. Taxes are provided on substantially all income andexpense items included in the earnings of Aames Financial, regardless of theperiod in which such items are recognized for tax purposes. We use an asset andliability approach that requires the recognition of deferred tax assets andliabilities for the expected future tax consequences of events that have beenrecognized in our financing statements or tax returns. In estimating future taxconsequences, we generally consider all expected future events other than theenactment of changes in the tax law or rates.

Deferred income tax assets and liabilities arerecognized by Aames Financial to reflect the future tax consequences of netoperating loss carry forwards and differences between the tax basis andfinancial reporting basis of assets and liabilities. We have established avaluation allowance to reflect management’s determination that it is not morelikely than not that certain deferred tax assets will be realized.

In determining therealization of deferred tax assets, we consider future taxable income from thefollowing sources: (a) the reversal of taxable temporary differences, (b) futureoperations exclusive of reversing temporary differences, and (c) taxplanning strategies that, if necessary, would be implemented to acceleratetaxable income into periods in which net operating losses might otherwiseexpire. The realization of deferred tax assets is evaluated by managementquarterly and changes in realizability are reflected in the income taxprovision.

**RESULTS OFOPERATIONS**

Thefollowing table sets forth information regarding our results of operations forthe periods indicated (in thousands): 

| ** **                                                                  | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------|------------|
| ** **                                                                  | ** ** | **2006**                                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** |
| Interest income                                                             |       | $                                                | 112,045    |         | $          | 53,652 | ** ** |   | $ | 58,393 |   |   |
| Interest expense                                                            |       | 72,947                                           |       | 11,916       |       |   | 61,031 |   |   |
| Net interest income                                                         |       | 39,098                                           |       | 41,736       |       |   | (2,638 | ) |   |
| Provision for  loan losses                                                  |       | 12,601                                           |       | 6,500        |       |   | 6,101 |   |   |
| Net interest income after provision for loan losses                         |       | 26,497                                           |       | 35,236       |       |   | (8,739 | ) |   |
| Noninterest income:                                                         |       |                                             |       |         |       |   |   |   |   |
| Gain on sale of loans                                                       |       | 5,995                                            |       | 5,683        |       |   | 312 |   |   |
| Loan servicing                                                              |       | 2,423                                            |       | 1,040        | ** ** |   | 1,383 |   |   |
| Total noninterest income                                                    |       | 8,418                                            |       | 6,723        |       |   | 1,695 |   |   |
| Net interest income after provision for loan losses  and noninterest income |       | 34,915                                           |       | 41,959       |       |   | (7,044 | ) |   |
| Noninterest expense:                                                        |       |                                             |       |         |       |   |   |   |   |
| Personnel                                                                   |       | 24,891                                           |       | 22,347       |       |   | 2,544 |   |   |
| Production                                                                  |       | 9,377                                            |       | 8,800        |       |   | 577 |   |   |
| General and administrative                                                  |       | 14,147                                           |       | 10,813       |       |   | 3,334 |   |   |
| Total noninterest expense                                                   |       | 48,415                                           |       | 41,960       |       |   | 6,455 |   |   |
| Loss before income taxes                                                    |       | (13,500                                          | )          | (1           | )          |   | (13,499 | ) |   |
| Income tax  provision (benefit)                                             |       | 17                                               |       | 765          |       |   | (748 | ) |   |
| Net loss                                                                    |       | $                                                | (13,517    | )            | $          | (766 | ) |   | $ | (12,751 | ) |   |

 

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**Interest Income andInterest Expense**

***Interest income.****  *Interest income includes interest earned on loansheld for investment and loans held for sale. To a lesser extent, interestincome also includes interest on short-term overnight investments, prepaymentfees earned on loans held for investment, interest income on in-the-moneyinterest rate cap agreements, and amortization of net deferred loan originationcosts on mortgage loans held for investments.

Pursuant to FASB Statement of Financial AccountingStandards No. 91, “*Accounting forNonrefundable Fees and Costs Associated with Originating or Acquiring Loans andInitial Direct Costs of Leases”*(“SFAS 91”), net loanorigination fees and costs related to mortgage loans originated and held forinvestment are deferred and amortized to interest income.

Thefollowing table summarizes the components of interest income for the periodsindicated (in thousands): 

| ** **                                            | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------------------|------------|--------------|------------|
| ** **                                            | ** ** | **2006**                                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** |
| Interest earned  on:                                  |       |                                             |       |         |       |   |   |   |   |
| Loans held for investment                             |       | $                                                | 71,178     |         | $          | 41,604 |   |   | $ | 29,574 |   |   |
| Loans held for sale                                   |       | 19,926                                           |       | 7,866        |       |   | 12,060 |   |   |
| Overnight investments                                 |       | 1,040                                            |       | 220          |       |   | 820 |   |   |
| Income from  derivative financial instruments         |       | 13,634                                           |       | 2,630        |       |   | 11,004 |   |   |
| Prepayment  penalty fees on loans held for investment |       | 7,515                                            |       | 1,884        |       |   | 5,631 |   |   |
| Amortization of  net deferred loan origination costs  |       | (1,318                                           | )          | (672         | )          |   | (646 | ) |   |
| Other                                                 |       | 70                                               |       | 120          |       |   | (50 | ) |   |
| Total interest  income                                |       | $                                                | 112,045    |         | $          | 53,652 |   |   | $ | 58,393 |   |   |

 

Interest income grew by $58.4 million, to $112.0million, during the three months ended March 31, 2006 compared to thethree months ended March 31, 2005. This was primarily due to increases of$29.6 million, $12.1 million, $11.0 million and $5.6 million in interestearned on our REIT portfolio of loans held for investment, interest earned onloans held for sale, income from derivative financial instruments, andprepayment penalty fees, respectively. The growth in interest on loans held forinvestment and loans held for sale was primarily due to higher balances inthese portfolios during the three months ended March 31, 2006 compared tothe same period a year ago. The income from derivative financial instrumentsrelated to remittances to us from counterparties on in-the-money interest ratecap agreements used to hedge interest rate exposure on our REIT portfolio andrelated financings. The growth in prepayment penalty fees earned on early loanpay-offs was due to a higher average balance in our REIT portfolio during thethree months ended March 31, 2006 compared to the three months ended March 31,2005, and the seasoning of the portfolio since its inception in December 2004.

***Interest expense.****  *Interest expense includes interest incurred on thebalances outstanding of financings on loans held for investment, revolvingwarehouse and repurchase facilities, and borrowings. Interest expense alsoincludes fair value adjustments to derivative instruments used to hedgeinterest rate risk on our financings of mortgage loans held for investment,amortization of debt issuance costs and debt discount on financings on mortgageloans held for investment and the amortization of commitment fees on revolvingwarehouse and repurchase facilities.

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Thefollowing table summarizes the components of interest expense for the periodsindicated (in thousands): 

| ** **                                                                                                                                   | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------|------------|
| ** **                                                                                                                                   | ** ** | **2006**                                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** |
| Interest incurred on:                                                                                                                        |       |                                             |       |         |       |   |   |   |   |
| Financings on loans held for investment                                                                                                      |       | $                                                | 43,968     |         | $          | 12,170 |   |   | $ | 31,798 |   |   |
| Revolving warehouse and repurchase facilities                                                                                                |       | 19,055                                           |       | 7,778        |       |   | 11,277 |   |   |
| Borrowings                                                                                                                                   |       | 70                                               |       | 44           |       |   | 26 |   |   |
| Amortization of  commitment fees, debt issuance costs, and debt discount                                                                     |       | 4,547                                            |       | 1,319        |       |   | 3,228 |   |   |
| Mark to market  (gain) loss on interest rate cap agreements designed to hedge interest rate  risk on financings of loans held for investment |       | 5,187                                            |       | (9,532       | )          |   | 14,719 |   |   |
| Bank charges and  other                                                                                                                      |       | 120                                              |       | 137          |       |   | (17 | ) |   |
| Total interest  expense                                                                                                                      |       | $                                                | 72,947     |         | $          | 11,916 |   |   | $ | 61,031 |   |   |

 

Interest expense grew by $61.0 million, to $72.9million, during the three months ended March 31, 2006 compared to thethree months ended March 31, 2005. This was primarily due to increases of$31.8 million, $14.7 million, $11.3 million, and $3.2 million in interest incurredon financings on loans held for investment, the negative mark to fair value oninterest rate cap agreements in place to hedge interest rate exposure on ourfinancings of loans held for investment, interest incurred on revolvingwarehouse and repurchase facilities, and amortization of commitment fees, debtissuance costs and debt discount, respectively. The growth in interest onfinancings of loans held for investment was primarily due to a higher borrowingbalance during the three months ended March 31, 2006 compared to the sameperiod a year ago. The increase in interest on revolving warehouse andrepurchase facilities was due to higher average borrowings and interest ratesassociated with our revolving warehouse and repurchase facilities used to fundloans held for sale and loans held for investment not yet securitized duringthe three months ended March 31, 2006 compared to the three-month period ayear ago. The growth in amortization of commitment fees, debt issuance costsand debt discount was primarily due to increased debt issuance costs and debtdiscount related to higher financings on loans held for investment during thethree months ended March 31, 2006 compared to the same period a year ago.

Interest expense is expected to increase in futureperiods due to our continued reliance on warehouse and repurchase facilities tofund mortgage loan production and expected continued upward pressure on theone-month LIBOR, the index used in our borrowing arrangements, in comingquarters.

***Provision for LoanLosses.******  ***Theamounts provided for loan losses are determined based upon quarterlyevaluations of the portfolio of loans held for investment. In our evaluation,we apply various judgments, assumptions and estimates concerning the impactcertain factors might have on the amounts provided. Such factors include actualand past loan loss experience, loan portfolio composition and risk,delinquencies, underlying collateral value and current economic conditions thatmay affect a borrower’s ability to pay.

During the three monthsended March 31, 2006, the provision for loan losses was $12.6 millioncompared to $6.5 million during the three months ended March 31, 2005 dueto the increase in the portfolio of loans held for investment and to theseasoning of the portfolio since its inception in December 2004. Theunpaid principal balance of the portfolio of loans held for investment was $3.2billion at March 31, 2006, an increase of $0.9 billion from March 31,2005.

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**Noninterest Income**

***Gain on Sale ofLoans.***   Gain on sale of loans includes gainfrom whole loan sale transactions, realized loan origination fees and costs,provisions for representation, warranty and other miscellaneous losses, andmiscellaneous costs related to loan sale activities. Gain on sale of loans isimpacted by the timing and mix of loan originations and sales as, pursuant toSFAS 91, net loan origination fees and costs related to mortgage loansoriginated and held for sale are deferred and recognized as a charge or creditto gain on sale of loans at the time the mortgage loans are sold.

Thefollowing table summarizes the components of gain on sale of loans for theperiods indicated (in thousands):

| ** **                                                                                       | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|--------------|------------|
| ** **                                                                                       | ** ** | **2006**                                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** |
| Gain on whole  loan sales                                                                        |       | $                                                | 9,861      |         | $          | 4,583 |   |   | $ | 5,278 |   |   |
| Loan origination  fees (costs), net                                                              |       | 7,525                                            |       | 2,097        |       |   | 5,428 |   |   |
| Provision for  LOCOM adjustments, representation, warranty, and other miscellaneous  losses |       | (11,255                                          | )          | (785         | )          |   | (10,470 | ) |   |
| Other                                                                                            |       | (136                                             | )          | (212         | )          |   | 76 |   |   |
| Total gain on  sale on sale of loans                                                             |       | $                                                | 5,995      |         | $          | 5,683 |   |   | $ | 312 |   |   |

 

Gain on sale of loans grew by $0.3 million, to $6.0million, during the three months ended March 31, 2006 from the comparablethree-month period a year ago. This was primarily due increases of $5.4 millionand $5.3 million in loan origination fees realized on loans sold and gain onsale from whole loan sale transactions, respectively, substantially offset by a$10.5 million increase in the provision for LOCOM adjustments, representation,warranty and other miscellaneous losses.

The growth in loan origination fees was principallydue to a higher percentage of retail loans originated and sold during the threemonths ended March 31, 2006 compared to the same period a year ago. Thegrowth in gain on whole loan sales was primarily due to an increase in wholeloan sales of $1.2 billion, to $1.5 billion, during the three months endedMarch 31, 2006 compared to the same period a year ago. During the quarterended March 31, 2006, we sold a larger percentage of our loan productioninto the secondary markets compared to the comparable quarter in 2005, when wewere retaining a significant portion of our loan production to build our REITportfolio of loans held for investment. However, the larger volume of loanssold was partially offset by lower gain on sale rates realized on whole loansales during the three months ended March 31, 2006 compared to such ratesduring the comparable 2005 period. The growth in the provision for LOCOMadjustments, representation, warranty, and other miscellaneous losses for thethree months ended March 31, 2006 compared to the same period a year agowas primarily due to a higher LOCOM provision on loans held for sale that aredelinquent, have collateral deficiencies or have other attributes that affecttheir sale potential.

***Loan Servicing.***   Loanservicing revenue consists of late charges and other fees we earn in connectionwith our loan servicing activities. Loan servicing revenue also includesprepayment fees on loans held for sale. Loan servicing revenue grew by $1.4million, to $2.4 million, during the three months ended March 31, 2006from the three months ended March 31, 2005. This was primarily due toincreases of $0.8 million and $0.7 million in late and prepayment fees,respectively, partially offset by a decrease of $0.2 million in servicingfees for the three months ended March 31, 2006.

**Total NoninterestExpense**

***Personnel.*****  **Personnel expense includes salaries, payroll taxesand medical and other employee benefits. Personnel expense also includescommissions that are generally related to our loan origination 

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volume, as retail andbroker account executives earn incentives on funded loans. Pursuant to SFAS 91,direct personnel costs incurred on mortgage loans originated are deferred andamortized to interest income over the estimated economic life of the loans. Whenthe loans are sold, the deferred costs are recognized as a charge to gain onsale.

Thefollowing table summarizes the components of personnel expense for the periodsindicated (in thousands): 

| ** **                       | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase** | ** ** |
|----------------------------------|------------|--------------------------------------------------|------------|--------------|------------|
| ** **                       | ** ** | **2006**                                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** |
| Compensation                     |       | $                                                | 43,057     |         | $          | 35,682 |   |   | $ | 7,375 |   |   |
| Deferred loan  origination costs |       | (21,148                                          | )          | (16,620      | )          |   | (4,528 | ) |   |
| Medical and other  benefits      |       | 2,730                                            |       | 2,711        |       |   | 19 |   |   |
| Other                            |       | 252                                              |       | 574          |       |   | (322 | ) |   |
| Total personnel  expense         |       | $                                                | 24,891     |         | $          | 22,347 |   |   | $ | 2,544 |   |   |

 

Personnel expense grew by $2.5 million, to $24.9million, during the three months ended March 31, 2006 from the comparablethree-month period a year ago. This was principally due to an increase of $7.4 millionin compensation expense, partially offset by a $4.5 million increase indeferred loan origination costs and a $0.3 million decrease in other personnelexpense. The $7.4 million growth in compensation expense resulted primarilyfrom a $4.5 million increase in commissions, bonuses and incentives, togetherwith a $0.9 million increase in management bonus incentives, a $1.3 millionincrease in salary expense due to increased headcount, and a $0.1 millioncharge for termination benefits related to the closure of two of our wholesaleoperating centers on March 31, 2006. In addition, compensation costsrelated to the issuance of restricted stock awards, payroll taxes and temporaryhelp costs grew by $0.3 million, $0.2 million, and $0.2 million,respectively, during the three months ended March 31, 2006 when comparedto the same three month period a year ago. The $4.5 million growth incommissions, bonuses and incentives was primarily due to the $203.9 million, or15.0%, increase in total loan production during the three months ended March 31,2006 when compared to the same three-month period a year ago. The $4.5 millionincrease in deferred personnel costs on mortgage loans originated was primarilydue to the change in the composition of loan production during the three monthsended March 31, 2006. Production during the March 2006 quarter had ahigher percentage of retail production, which has a higher incrementalpersonnel cost, when compared to the mix of loans originated during the threemonths ended March 31, 2005, which was comprised of more wholesaleproduction. The $0.3 million decline in other personnel expense during thethree months ended March 31, 2006 from the comparable period a year agowas attributable to lower employee recruitment costs.

***Production.*****  **Production expense grew by $0.6 million, to $9.4million, during the three months ended March 31, 2006 from the threemonths ended March 31, 2005. This was primarily due to increases of $0.6 millionand $0.3 million in advertising and travel and entertainment costs,respectively, partially offset by a $0.3 million decrease in sales incentives.

Production expense, when expressed as a percentage oftotal loan origination volume, declined to 0.6% for the three months ended March 31,2006 from 0.7% for the three months ended March 31, 2005, primarily due toa smaller increase in loan production expense than production volume during thethree months ended March 31, 2006 compared to the three months ended March 31,2005.

***General andAdministrative.***   General and administrativeexpense grew by $3.3 million, to $14.1 million, during the three monthsended March 31, 2006 from the three months ended March 31, 2005. Thiswas primarily due to a $2.6 million increase in occupancy expense, a $0.4million increase in communication expense and a $0.2 million increase inprofessional fees. Contributing to the growth in 

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occupancy expense was a$0.7 million charge for the termination of the leases at two of our wholesaleoperating centers and a $1.5 million charge for the termination of the lease atour former headquarters location due to a change in its lease status. Althoughthese actions increased our occupancy expense during the quarter, they will reduceour occupancy expense going forward.

During the three monthsended March 31, 2006 and 2005, our rent payments totaled $5.0 million and$2.8 million, respectively, and we received total sublease payments of $0.3million and $0.4 million, respectively.

**Income TaxProvision (Benefit)**

During the three monthsended March 31, 2006 and 2005, we recorded an income tax provision of$0.02 million and $0.8 million, respectively. Our $0.02 million income taxprovision for the three months ended March 31, 2006 differed from anexpected federal income tax benefit of $4.7 million calculated at the federalmarginal tax rate of 35.0% primarily due to the $8.2 million provisionresulting from the increase in the tax valuation allowance, partially offset bythe $2.6 million benefit related to the non-taxability of the REITearnings and the $0.9 million state tax benefit. Our $0.8 million income taxprovision for the three months ended March 31, 2005 differed from anexpected federal income tax benefit of $0 million calculated at the federalmarginal tax rate of 35.0% primarily due to the $9.9 million provisionresulting from the increase in the tax valuation allowance, partially offset bythe $8.4 million benefit related to the non-taxability of the REIT earnings andthe $0.7 million state tax benefit.

**MORTGAGE LOANPORTFOLIO MANAGEMENT**

We did not complete any on-balance sheet oroff-balance sheet securitizations during the three months ended March 31,2006. On May 2, 2006, we securitized $608.9 million of mortgage loansthrough an on-balance sheet securitization. During the year ended December 31,2005, we securitized $3.7 billion of mortgage loans through the completion offour on-balance sheet transactions, and during the year ended December 31,2004, we securitized $1.2 billion of mortgage loans through the completion ofone on-balance sheet transaction. These securitizations were structured ason-balance sheet securitizations for accounting purposes under SFAS 140. Priorto our reorganization, Aames Financial’s previous securitizations werestructured as off-balance sheet securitizations for accounting purposes underSFAS 140. We expect net interest income from our REIT portfolio of mortgageloans to generate a substantial portion of our earnings.

Thefollowing table sets forth information regarding our on-balance sheetsecuritizations for the periods indicated (in thousands):

| ** **                        | ** ** | **Three Months Ended  March 31,** | ** ** | **Increase (Decrease)** | ** ** |
|-----------------------------------|------------|--------------------------------------------------|------------|------------------------------|------------|
| ** **                        | ** ** | **2006**                                         | ** ** | **2005**                     | ** ** | **Amount** | ** ** | **%** | ** ** |
| On-balance sheet  securitizations |       |                                             | $          | —                       |       |   | $ | 1,198,482 |   | $ | (1,198,482 | ) | (100.0 | )% |
|                                   |            |                                                  |            |                              |            |  |  |  |  |  |  |  |  |  |

 

We have not established a limit on the amount of leveragewe may incur, but we generally intend to maintain a REIT portfolio that isapproximately 12 to 15 times the amount of our consolidated stockholders’equity. We will continue to purchase a portion of Aames Financial’soriginations to maintain our target leverage ratio. Aames Financial will thensell the remainder of its loan originations, including a portion of itshybrid/adjustable rate mortgage loans, to third parties in the secondarymarket.

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A significant risk to our operations that relates toour REIT portfolio management is the risk that our net interest income willdecline because interest rates on our assets will not adjust at the same timeor amount as the rates on our liabilities adjust. This is because the intereston the underlying hybrid/adjustable rate mortgage loans is based on fixed ratespayable on the underlying loans for the first two or three years fromorigination, while the holders of the applicable bonds issued in securitizationsare generally paid based on an adjustable one-month LIBOR-based yield.Moreover, even after the initial fixed period, our loans generally adjust everysix months and are subject to periodic rate caps, whereas the bonds adjustmonthly based primarily on one-month LIBOR and are not capped. Therefore, anincrease in one-month LIBOR generally reduces the net interest income wereceive from our securitized loan portfolio.

We attempt to mitigate a portion of this net interestmargin variability during the first two years after loan origination bypurchasing derivative financial instruments referred to as interest rate capagreements. We do not use formalized hedge accounting for our derivativefinancial instruments as set forth in generally accepted accounting principlesin the United States. Instead, we are required to record the change in thevalue of the derivatives as a component of earnings even though they may reduceour interest risk. In times when short-term rates drop significantly, the valueof our interest rate cap agreements will decrease; in times when short-termrates increase, the value of the interest rate cap agreements will increase.The interest rate cap agreements are designed to exchange the cost of ourvariable rate liabilities to fixed rates for the first two years of theirestimated duration, thereby better matching our interest-earninghybrid/adjustable rate mortgage loans during the initial fixed rate period.

In addition, the netinterest income we receive from securitizations will be reduced if there are asignificant amount of loan defaults or loan prepayments, especially on loanswith interest rates that are high relative to the rest of the securitizedmortgage loan pool.

**INVESTMENT ANDOPERATIONAL POLICIES**

Our investment strategy is subject to change if andwhen our Board of Directors determines that a change is in our stockholders’best interest. Neither stockholder approval nor notification is required priorto changing our investment strategy.

If we change ourinvestment strategy, the new strategy may entail more risk than our currentinvestment strategy. Alternative strategies that our Board of Directors maychoose to put in place include:

·       purposefullyexposing the value of our holdings to changes in interest rates or changes inthe difference between short- and long-term rates; or

·       holding mortgage-backedsecurities with a credit rating lower than AAA or mortgage-backed securitiescollateralized by mortgage loans originated by and purchased from thirdparties.

**Mortgage Loans**

In general, our strategyis to maintain a portfolio of mortgage loans primarily originated by AamesFinancial. Our mortgage loans are generally underwritten in accordance with thecategories and criteria described in our underwriting guidelines. For furtherinformation, please see “Business-Underwriting Standards” in our December 31,2005 Annual Report on Form 10-K.

**Mortgage-backedSecurities**

Our current REIT portfolioconsists of mortgage loans originated by Aames Financial that collateralizemortgage-backed bonds, as well as mortgage loans originated by Aames Financialthat will collateralize future mortgage-backed securitizations. From time totime, under certain market conditions, we may acquire and hold mortgage-backedsecurities issued by third parties. Any such mortgage-backed 

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securitieswould be expected to be backed primarily by first mortgages on one- tofour-family dwellings and are expected to be rated by S&P or Moody’s. Wehave not previously acquired or held any third-party mortgage-backed securitiesin our investment portfolio.

**Leverage Policy**

We employ a leveragestrategy by securitizing existing mortgages in transactions that we believewill be treated as borrowings for accounting and tax purposes. We generallyintend to maintain a REIT portfolio that is approximately 12 to 15 times theamount of our consolidated stockholders’ equity.

**Hedging Policy**

To mitigate the adverse effects from interest rateincreases on our mortgage loans held for sale or investment, we use severaltools and risk management strategies to monitor and address interest rate risk.We believe that these tools allow us to monitor and evaluate our exposure tointerest rates and to manage the risk profile of our mortgage loan portfolio inresponse to changes in market conditions. As part of our interest rate riskmanagement process, we have used derivative financial instruments, such asinterest rate cap agreements, interest rate swap agreements, Treasury futuresand options on interest rates. We may also use other hedging instrumentsincluding mortgage derivative securities, when necessary. Hedging strategiesalso involve transaction and other costs. Because we use derivative financialinstruments more than we did prior to the 2004 REIT reorganization, theaggregate costs to us of entering into contracts for these instruments issignificantly higher than in the past.

The derivative financialinstruments that we currently use are interest rate cap agreements. Thesederivative financial instruments have an active secondary market and areintended to provide supplemental income and cash flow to offset potentialreduced interest income and cash flow in certain interest rate environments. Itis not our policy to use derivatives to speculate on interest rates. We reportour derivative financial instruments on our consolidated balance sheet at theirfair value with any changes in fair value reported as either a gain or loss tothe consolidated statement of operations.

**Financing Policy**

We may raise funds through additional equity offerings,debt financings, retention of cash flow subject to Internal Revenue Codeprovisions regarding distribution requirements and taxability of undistributedREIT taxable income or a combination of these methods. If the proposedreorganization is completed, we would no longer be required to distribute atleast 90% of our earnings to public stockholders, but could retain that capitalfor internal growth. If our Board of Directors decides to raise additionalequity capital, it has the authority to issue additional common or preferredstock, in any manner and on terms it deems appropriate, up to the amountauthorized in our articles of incorporation without stockholder approval.

On November 4, 2005, our Form S-3 selfregistration statement, filed for the purpose of selling our common stock,preferred stock, debt securities or other securities in one or more offeringsup to an aggregate dollar amount of $500.0 million, was declared effective bythe Securities and Exchange Commission. Depending on our liquidity needs andmarket conditions, we may issue one or more of these securities in differentamounts and at different times. We intend to use the proceeds from any sale ofthese securities for general corporate purposes, which includes continuing tobuild a portfolio of self-originated mortgage loans, for general workingcapital purposes and to reduce short-term indebtedness. As part of the Form S-3filing, we also registered 5.0 million shares of common stock issuable inconnection with our Dividend Reinvestment and Direct Stock Purchase Plan.

Currently, our borrowings consist primarily of fundsborrowed under revolving warehouse and repurchase facilities and on-balancesheet securitization financings on loans held for investment. In addition, wehave a revolving credit facility collateralized by subordinated mortgage-backedbonds which 

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we have retained in ouron-balance sheet securitizations. We also have a revolving line of credit witha Southern California commercial bank that is secured by all of our corporateassets, excluding loans pledged under our revolving warehouse and repurchasefacilities. Future borrowings may be in the form of bank borrowings, secured orunsecured, and publicly or privately placed debt instruments, purchase moneyobligations to the sellers of assets, long-term, tax-exempt bonds or otherpublicly or privately placed debt instruments, financing from banks,institutional investors or other lenders, and securitizations, includingcollateralized debt obligations, any of which may be unsecured or secured bymortgages or other interests in the assets. This indebtedness may entailrecourse to all or any part of our assets or may be limited to the particularassets to which the indebtedness relates.

We enter intocollateralized borrowings only with institutions that we believe arefinancially sound and that are rated investment grade by at least onenationally recognized statistical rating organization.

**MORTGAGE LOANORIGINATIONS**

As of March 31, 2006 Aames Financial originatedloans in 44 states through its retail and wholesale channels. Its wholesalechannel operated three regional wholesale operations centers throughout theUnited States and originated loans through a nationwide network ofapproximately 1,600 independent mortgage brokers who submit mortgage loans toit. Its retail channel had a network of 76 retail branch offices directlyserving borrowers throughout the United States. From time to time, depending onmarket conditions and attractiveness of terms, we may supplement our loanproduction by purchasing mortgage loans from secondary market sellers.

Thefollowing table shows our total loan production by retail and wholesalechannels for the periods indicated (in thousands):

| ** ** | ** ** | **Three Months Ended** | ** ** |
|------------|------------|----------------------------------|------------|
| ** ** | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** | **December 31, 2005** | ** ** |
| ** ** | ** ** | **Loans  Funded**                | ** ** | **% of   Total** | ** ** | **Loans  Funded** | ** ** | **% of   Total** | ** ** | **Loans  Funded** | ** ** | **% of   Total** | ** ** |
| Retail     |       | $                                | 746,131    |   | 47.7 | % | $ | 516,558 |   | 37.9 | % | $ | 811,096 |   | 43.1 | % |
| Wholesale  |       | 819,393                          |       | 52.3 | % | 845,058 |   | 62.1 | % | 1,071,507 |   | 56.9 | % |
| Total      |       | $                                | 1,565,524  |   | 100.0 | % | $ | 1,361,616 |   | 100.0 | % | $ | 1,882,603 |   | 100.0 | % |

 

A significant risk to ourmortgage loan originations operations is liquidity risk—the risk that we willnot have the financing facilities and cash available to fund and hold loansprior to their sale or securitization. We maintain committed borrowingfacilities with large banking and investment institutions to reduce this risk.

**Our Retail Channel**

We generate loan applications for our retail loanoffice network principally through a direct response marketing program, whichrelies primarily on the use of direct mailings to homeowners, telemarketing andInternet generated leads and through referrals from our customers, real estateagents and others. We generate customer leads for the retail network based uponmodels that we have derived and commercially developed customer lists. Ourdirect mail invites prospective borrowers to call us to apply for a loan. Wealso generate leads through several commercially available Internet sites aswell as through our own retail Internet web site “Aames.com”. We believe thatour marketing efforts establish name recognition and serve to distinguish usfrom our competitors. We continually monitor the source of our applications todetermine the most effective methods and manner of marketing. Whether generatedthrough direct mail or the Internet, leads are generally followed up withtelephone calls to potential customers. Our loan officers at the local retailloan office pre-qualify a potential customer and if the customer is interested,

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takes an application overthe telephone or schedules an appointment with the customer at the retail loanoffice most conveniently located to the customer or in the customer’s home,depending on the customer’s needs.

The retail loan officer assists the applicant incompleting the loan application, arranges for an appraisal, orders a creditreport from an independent, nationally recognized credit reporting agency andperforms various other tasks in connection with the completion of the loanpackage. The loan package is underwritten for loan approval on a centralizedbasis. If we approve the loan package, the loan is funded. Our loan officersare trained to structure loans that meet the applicant’s needs while satisfyingour lending guidelines.

We continually monitor ourretail operations in the markets in which we operate and evaluate existing andpotential retail offices on the basis of selected demographic statistics,marketing analyses and other criteria that we have developed in order tofurther enhance our mortgage loan production capabilities. As part of thisevaluation process, we have closed retail branches in markets where it was notfinancially feasible to continue to service the market area in this manner.However, we continue to service many of these areas through our wholesalechannel and the Internet.

**Our WholesaleChannel**

During the three months ended March 31, 2006, weoriginated loans through our network of approximately 1,600 independentwholesale mortgage brokers throughout the United States, none of whichaccounted for more than 5.0% of total wholesale loan production.

The broker’s role is to identify the applicant, assistin completing the loan application, gather necessary information and documents,submit the application requesting the interest rate and terms of the loan, andserve as our liaison with the borrower through the lending process. We reviewand underwrite the applications submitted by the broker in accordance with ourunderwriting guidelines and then approve or deny the application. If the loanis approved, we approve or counter the requested interest rate and other termsof the loan and, upon acceptance by the borrower and satisfaction of allconditions imposed by us, we fund the loan. Because brokers conduct their ownmarketing and employ their own personnel to complete loan applications andmaintain contact with borrowers, originating loans through our wholesalenetwork allows us to increase our loan volume without incurring the highermarketing and employee costs associated with retail loan production.

Because mortgage brokers generally submit loan filesto several prospective lenders simultaneously, competitive pricing, consistentunderwriting, quick response times and personal service are critical tosuccessfully producing loans through independent mortgage brokers. To meetthese requirements, we strive to respond to the loan application within 24hours. In addition, the loans are processed and underwritten in regionaloffices, and loan consultants, loan processors, and underwriters are availableto answer questions, assist in the loan application process, and facilitateultimate funding of the loan.

On March 31, 2006, weclosed two regional wholesale operations centers and consolidated theiroperations into three remaining centers.

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**Total LoanProduction**

Thefollowing table presents certain information about our loan production at orfor the periods indicated:

| ** **                                          | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|
| ** **                                          | ** ** | **March 31,**               | ** ** | **December 31,** | ** ** |
| ** **                                          | ** ** | **2006**                         | ** ** | **2005** | ** ** | **2005** | ** ** |
| **Retail  Production:**                             |       |                             |       |   |   |   |   |   |   |
| Total dollar amount (in thousands)                  |       | $                                | 746,131    |   | $ | 516,558 |   |   | $ | 811,096 |   |   |
| Number of loans                                     |       | 4,814                            |       | 3,718 |   |   | 5,269 |   |   |
| Average loan amount                                 |       | $                                | 154,992    |   | $ | 138,934 |   |   | $ | 153,937 |   |   |
| Average initial LTV                                 |       | 74.44                            | %          | 75.88 | % |   | 75.05 | % |   |
| Weighted average interest rate(1)                   |       | 8.13                             | %          | 7.53 | % |   | 7.56 | % |   |
| Retail branch offices at period end                 |       | 76                               |       | 94 |   |   | 76 |   |   |
| **Wholesale Production:**                           |       |                             |       |   |   |   |   |   |   |
| Total dollar amount (in thousands)                  |       | $                                | 819,393    |   | $ | 845,058 |   |   | $ | 1,071,507 |   |   |
| Number of loans                                     |       | 5,702                            |       | 6,028 |   |   | 7,356 |   |   |
| Average loan amount                                 |       | $                                | 143,703    |   | $ | 140,189 |   |   | $ | 145,664 |   |   |
| Average initial LTV                                 |       | 82.06                            | %          | 81.25 | % |   | 81.90 | % |   |
| Weighted average interest rate(1)                   |       | 8.63                             | %          | 7.60 | % |   | 8.00 | % |   |
| Regional wholesale operations centers at period end |       | 3                                |       | 5 |   |   | 5 |   |   |
| **Total Production:**                               |       |                             |       |   |   |   |   |   |   |
| Total dollar amount (in thousands)                  |       | $                                | 1,565,524  |   | $ | 1,361,616 |   |   | $ | 1,882,603 |   |   |
| Number of loans                                     |       | 10,516                           |       | 9,746 |   |   | 12,625 |   |   |
| Average loan amount                                 |       | $                                | 148,871    |   | $ | 139,710 |   |   | $ | 149,117 |   |   |
| Average initial LTV                                 |       | 78.43                            | %          | 79.21 | % |   | 78.95 | % |   |
| Weighted average  interest rate(1)                  |       | 8.39                             | %          | 7.57 | % |   | 7.81 | % |   |

----

(1)          Calculatedwith respect to the interest rate at the time we originated or purchased themortgage loan.

| ** **                                       | ** ** | **Three Months Ended**     | ** ** |
|--------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **March 31, 2006**         | ** ** | **March 31, 2006** | ** ** |
| ** **                                       | ** ** | **vs March 31, 2005** | ** ** | **vs December 31, 2005** | ** ** |
| ** **                                       | ** ** | **Amount**                           | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| **Increase (Decrease) in Total  Production:**    | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| (in thousands)                              | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Retail                                           |       | $                                    | 229,573    |   | 44.4 | % | $ | (64,965 | ) | (8.0 | )% |
| Wholesale                                        |       | (25,665                              | )          | (3.0 | )% | (252,114 | ) | (23.5 | )% |
| Total                                            |       | $                                    | 203,908    |   | 15.0 | % | $ | (317,079 | ) | (16.8 | )% |
| **Increase  (Decrease) in Number of Loans:**     |       |                                 |       |   |   |   |   |   |   |
| Retail                                           |       | 1,096                                |       | 29.5 | % | (455 | ) | (8.6 | )% |
| Wholesale                                        |       | (326                                 | )          | (5.4 | )% | (1,654 | ) | (22.5 | )% |
| Total                                            |       | 770                                  |       | 7.9 | % | (2,109 | ) | (16.7 | )% |
| **Increase  (Decrease) in Average Loan Amount:** |       |                                 |       |   |   |   |   |   |   |
| Retail                                           |       | $                                    | 16,058     |   | 11.6 | % | $ | 1,055 |   | 0.7 | % |
| Wholesale                                        |       | 3,514                                |       | 2.5 | % | (1,961 | ) | (1.3 | )% |
| Total                                            |       | 9,161                                |       | 6.6 | % | (246 | ) | (0.2 | )% |

 

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Total loan production during the three months ended March 31,2006 declined by $317.1 million, or 16.8%, to $1.6 billion over the $1.9billion for the three months ended December 31, 2005, and grew by $203.9million, or 15.0%, from $1.4 billion for the three months ended March 31,2005. The $317.1 million decline during the three months ended March 31,2006 compared to the three months ended December 31, 2005 was primarilydue to a decrease of 2,109, or 16.7%, in the number of loans originated. The$203.9 million growth during the three months ended March 31, 2006compared to the same period a year ago was due to an increase of 770, or 7.9%,in the number of loans originated, as well as to an increase of $9,161, or6.6%, in the average loan amount originated. The overall decline in loanproduction for the three months ended March 31, 2006 from the priorthree-month period ended December 31, 2005 was primarily due tocompetitive pressures in the marketplace due to increases in short-terminterest rates, and the elimination of certain 80% LTV first lien andsimultaneous 20% LTV second lien (100% combined LTV) purchase money loans forborrowers with lower credit scores and stated income which negatively impactedour loan production, especially in wholesale, for the three months ended March 31,2006. Since March 31, 2006, we have eliminated additional high LTVproducts and we expect these recent product eliminations will negatively impactour loan production volume in the current quarter.

Total retail production during the three months ended March 31,2006 declined by $65.0 million, or 8.0%, to $746.1 million from the $811.1million for the three months ended December 31, 2005, and grew by $229.6million, or 44.4%, from $516.6 million for the three months ended March 31,2005. The $65.0 million decline during the three months ended March 31,2006 compared to the three months ended December 31, 2005 was primarilydue to a decrease of 455, or 8.6%, in the number of loans originated. The$229.6 million increase during the three months ended March 31, 2006compared to the same period a year ago was principally due to an increase of1,096, or 29.5%, in the number of loans originated, coupled with an increase of$16,058, or 11.6%, in the average loan amount originated.

Total wholesale production during the three monthsended March 31, 2006 declined by $252.1 million, or 23.5%, to $819.4million from the $1.1 billion for the three months ended December 31,2005, and declined by $25.7 million, or 3.0%, from $845.1 million for the threemonths ended March 31, 2005. The $252.1 million decline during the threemonths ended March 31, 2006 compared to the three months ended December 31,2005 was primarily due to a decrease of 1,654, or 22.5%, in the number of loansoriginated coupled with a $1,961, or 1.3%, decline in average loan amountoriginated. The $25.7 million decline during the three months ended March 31,2006 compared to the same period a year ago was principally due to a decreaseof 326, or 5.4%, in the number of loans originated, partially offset by anincrease of $3,514, or 2.5%, in the average loan amount originated.

During the three months ended March 31, 2006 and2005, we did not purchase loans as part of our loan production efforts.

Thefollowing tables summarize certain information about our loan production bypurpose and property type for the periods indicated (dollars in thousands):

| ** **          | ** ** | **Three Months Ended** | ** ** |
|---------------------|------------|----------------------------------|------------|
| ** **          | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** | **December 31, 2005** | ** ** |
| ** **          | ** ** | **Loans**                        | ** ** | **% of** | ** ** | **Loans** | ** ** | **% of** | ** ** | **Loans** | ** ** | **% of** | ** ** |
| ** **          | ** ** | **Funded**                       | ** ** | **Total** | ** ** | **Funded** | ** ** | **Total** | ** ** | **Funded** | ** ** | **Total** | ** ** |
| **Purpose:**        | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash-out refinance  |       | $                                | 950,589    |   | 60.7 | % | $ | 799,342 |   | 58.7 | % | $ | 1,106,317 |   | 58.8 | % |
| Purchase money      |       | 559,527                          |       | 35.8 | % | 519,656 |   | 38.2 | % | 710,890 |   | 37.7 | % |
| Rate/term refinance |       | 55,408                           |       | 3.5 | % | 42,618 |   | 3.1 | % | 65,396 |   | 3.5 | % |
| Total               |       | $                                | 1,565,524  |   | 100.0 | % | $ | 1,361,616 |   | 100.0 | % | $ | 1,882,603 |   | 100.0 | % |

 

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| ** **              | ** ** | **Three Months Ended** | ** ** |
|-------------------------|------------|----------------------------------|------------|
| ** **              | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** | **December 31, 2005** | ** ** |
| ** **              | ** ** | **Loans**                        | ** ** | **% of** | ** ** | **Loans** | ** ** | **% of** | ** ** | **Loans** | ** ** | **% of** | ** ** |
| ** **              | ** ** | **Funded**                       | ** ** | **Total** | ** ** | **Funded** | ** ** | **Total** | ** ** | **Funded** | ** ** | **Total** | ** ** |
| **Property type:**      | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Single-family residence |       | $                                | 1,359,045  |   | 86.8 | % | $ | 1,194,927 |   | 87.8 | % | $ | 1,638,563 |   | 87.0 | % |
| Multi-family residence  |       | 106,542                          |       | 6.8 | % | 94,399 |   | 6.9 | % | 136,021 |   | 7.2 | % |
| Condominium             |       | 99,937                           |       | 6.4 | % | 72,290 |   | 5.3 | % | 108,019 |   | 5.8 | % |
| Total                   |       | $                                | 1,565,524  |   | 100.0 | % | $ | 1,361,616 |   | 100.0 | % | $ | 1,882,603 |   | 100.0 | % |

 

Thefollowing tables show our loan production by geographic region (i.e., state ofmortgage property) for the periods indicated (dollars in thousands): 

| ** **                                                              | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                              | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** | **December 31, 2005** | ** ** |
| ** **                                                              | ** ** | **Loans**                        | ** ** | **% of** | ** ** | **Loans** | ** ** | **% of** | ** ** | **Loans** | ** ** | **% of** | ** ** |
| ** **                                                              | ** ** | **Funded**                       | ** ** | **Total** | ** ** | **Funded** | ** ** | **Total** | ** ** | **Funded** | ** ** | **Total** | ** ** |
| California                                                              |       | $                                | 322,733    |   | 20.6 | % | $ | 372,922 |   | 27.4 | % | $ | 389,707 |   | 20.7 | % |
| Florida                                                                 |       | 424,039                          |       | 27.1 | % | 296,851 |   | 21.8 | % | 459,669 |   | 24.4 | % |
| New York                                                                |       | 121,819                          |       | 7.8 | % | 93,558 |   | 6.9 | % | 157,288 |   | 8.3 | % |
| Texas                                                                   |       | 130,170                          |       | 8.3 | % | 111,392 |   | 8.2 | % | 141,395 |   | 7.5 | % |
| Other Western  States (AZ, CO, HI, ID, MT, NV, NM, OR, UT, WA, WY)      |       | 133,245                          |       | 8.5 | % | 139,291 |   | 10.2 | % | 164,982 |   | 8.8 | % |
| Midwestern States  (IL, IN, IA, KS, MI, MN, MO, NE, ND, OH, SD, WI)     |       | 84,691                           |       | 5.4 | % | 95,226 |   | 7.0 | % | 116,635 |   | 6.2 | % |
| Other  Northeastern States (CT, DE, ME, MD, MA, NH, NJ, PA, RI)         |       | 199,534                          |       | 12.8 | % | 145,853 |   | 10.7 | % | 275,863 |   | 14.7 | % |
| Other  Southeastern States (AR, GA, KY, LA, MS, NC, SC, OK, TN, VA, WV) |       | 149,293                          |       | 9.5 | % | 106,523 |   | 7.8 | % | 177,064 |   | 9.4 | % |
| Total                                                                   |       | $                                | 1,565,524  |   | 100.0 | % | $ | 1,361,616 |   | 100.0 | % | $ | 1,882,603 |   | 100.0 | % |

 

Thefollowing tables summarize certain information by loan product about our loanproduction for the periods indicated (dollars in thousands): 

| ** **    | ** ** | **Three Months Ended** | ** ** |
|---------------|------------|----------------------------------|------------|
| ** **    | ** ** | **March 31, 2006**     | ** ** | **March 31, 2005** | ** ** | **December 31, 2005** | ** ** |
| ** **    | ** ** | **Loans**                        | ** ** | **% of** | ** ** | **Loans** | ** ** | **% of** | ** ** | **Loans** | ** ** | **% of** | ** ** |
| ** **    | ** ** | **Funded**                       | ** ** | **Total** | ** ** | **Funded** | ** ** | **Total** | ** ** | **Funded** | ** ** | **Total** | ** ** |
| Hybrid:       |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Traditional   |       | $                                | 688,062    |   | 44.0 | % | $ | 947,520 |   | 69.6 | % | $ | 931,507 |   | 49.5 | % |
| Interest Only |       | 30,131                           |       | 1.9 | % | 148,807 |   | 10.9 | % | 167,197 |   | 8.9 | % |
| 40/30         |       | 540,549                          |       | 34.5 | % | — |   | 0.0 | % | 366,295 |   | 19.4 | % |
|          |       | 1,258,742                        |       | 80.4 | % | 1,096,327 |   | 80.5 | % | 1,464,999 |   | 77.8 | % |
| Fixed Rate:   |       |                             |       |   |   |   |   |   |   |   |   |   |   |
| Traditional   |       | 279,316                          |       | 17.8 | % | 265,289 |   | 19.5 | % | 380,559 |   | 20.2 | % |
| 40/30         |       | 27,466                           |       | 1.8 | % | — |   | 0.0 | % | 37,045 |   | 2.0 | % |
|          |       | 306,782                          |       | 19.6 | % | 265,289 |   | 19.5 | % | 417,604 |   | 22.2 | % |
| Total         |       | $                                | 1,565,524  |   | 100.0 | % | $ | 1,361,616 |   | 100.0 | % | $ | 1,882,603 |   | 100.0 | % |

 

33

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**LOAN PRODUCTION BYBORROWER RISK CLASSIFICATION**

Thefollowing tables set forth our loan production under Super Aim guidelines forthe periods indicated (dollars in thousands): 

| ** **         | ** ** | **Three Months Ended March 31, 2006** | ** ** |                 |
|--------------------|------------|----------------------------------------------------------------|------------|----------------------|
| ** **         | ** ** | ** **                                                     | ** ** | ** **           | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |   |
| ** **         | ** ** | ** **                                                     | ** ** | ** **           | ** ** | **Average** | ** ** | **Average** | ** ** | **Average** | ** ** |   |
| ** **         | ** ** | **Loans  Funded**                                              | ** ** | **% of  Total** | ** ** | **Credit  Score** | ** ** | **Interest  Rate(1)** | ** ** | **Loan-to-Value  Ratio** | ** ** |
| **Credit  Grade:** | ** ** | ** **                                                     | ** ** |                 | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| A+                 |       | $                                                              | 1,215,636  |                 |   | 77 | % |   |   | 625 | ** ** |   |   | 8.2 | % |   |   | 80 | % |   |
| A             |       | 164,395                                                        |       |                 | 11 | % |   |   | 588 | ** ** |   |   | 8.4 | % |   |   | 77 | % |   |
| A-                 |       | 68,653                                                         |       |                 | 4 | % |   |   | 565 | ** ** |   |   | 8.8 | % |   |   | 74 | % |   |
| B             |       | 74,750                                                         |       |                 | 5 | % |   |   | 556 | ** ** |   |   | 9.7 | % |   |   | 74 | % |   |
| C             |       | 32,495                                                         |       |                 | 2 | % |   |   | 541 | ** ** |   |   | 10.1 | % |   |   | 69 | % |   |
| C-                 |       | 9,595                                                          |       |                 | 1 | % |   |   | 542 | ** ** |   |   | 11.0 | % |   |   | 63 | % |   |
| Total              |       | $                                                              | 1,565,524  |                 |   | 100 | % |   |   | 613 | ** ** |   |   | 8.4 | % |   |   | 78 | % |   |

 

| ** **         | ** ** | **Three Months Ended March 31, 2005** | ** ** |
|--------------------|------------|--------------------------------------------|------------|
| ** **         | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **         | ** ** | ** **                                 | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** **         | ** ** | **Loans**                                  | ** ** | **% of** | ** ** | **Credit** | ** ** | **Interest** | ** ** | **Loan-to-Value** | ** ** |
| ** **         | ** ** | **Funded**                                 | ** ** | **Total** | ** ** | **Score** | ** ** | **Rate(1)** | ** ** | **Ratio** | ** ** |
| **Credit  Grade:** | ** ** | ** **                                 | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| A+                 |       | $                                          | 1,045,216  |   |   | 77 | % |   |   | 627 | ** ** |   |   | 7.4 | % |   |   | 80 | % |   |
| A                  |       | 135,323                                    |       |   | 10 | % |   |   | 584 | ** ** |   |   | 7.6 | % |   |   | 77 | % |   |
| A-                 |       | 57,664                                     |       |   | 4 | % |   |   | 557 | ** ** |   |   | 8.0 | % |   |   | 75 | % |   |
| B             |       | 76,578                                     |       |   | 5 | % |   |   | 559 | ** ** |   |   | 8.4 | % |   |   | 76 | % |   |
| C             |       | 37,533                                     |       |   | 3 | % |   |   | 552 | ** ** |   |   | 9.0 | % |   |   | 70 | % |   |
| C-                 |       | 9,302                                      |       |   | 1 | % |   |   | 550 | ** ** |   |   | 10.4 | % |   |   | 64 | % |   |
| Total              |       | $                                          | 1,361,616  |   |   | 100 | % |   |   | 613 | ** ** |   |   | 7.6 | % |   |   | 79 | % |   |

----

(1)   Calculatedwith respect to the interest rate at the time the mortgage loan was originatedor purchased.

34

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Thefollowing tables present certain information about our loan production bycredit score range for the periods indicated (dollars in thousands): 

| ** **              | ** ** | **Three Months Ended March 31, 2006** | ** ** |
|-------------------------|------------|---------------------------------------|------------|
| ** **              | ** ** | ** **                            | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **              | ** ** | ** **                            | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** **              | ** ** | **Loans**                             | ** ** | **% of** | ** ** | **Interest** | ** ** | **Loan-to-Value** | ** ** |
| ** **              | ** ** | **Funded**                            | ** ** | **Total** | ** ** | **Rate(1)** | ** ** | **Ratio** | ** ** |
| **Credit Score Range:** | ** ** | ** **                            | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Above 700               |       | $                                     | 93,046     |   |   | 6 | % |   |   | 7.8 | % |   |   | 79 | % |   |
| 661-700                 |       | 190,645                               |       |   | 12 | % |   |   | 7.8 | % |   |   | 79 | % |   |
| 621-660                 |       | 432,800                               |       |   | 28 | % |   |   | 8.1 | % |   |   | 80 | % |   |
| 581-620                 |       | 426,046                               |       |   | 27 | % |   |   | 8.3 | % |   |   | 79 | % |   |
| 541-580                 |       | 236,818                               |       |   | 15 | % |   |   | 8.9 | % |   |   | 77 | % |   |
| 540 and below           |       | 185,449                               |       |   | 12 | % |   |   | 9.4 | % |   |   | 73 | % |   |
| Not available           |       | 720                                   |       |   | NM |   |   |   | 9.0 | % |   |   | 83 | % |   |
| Total                   |       | $                                     | 1,565,524  |   |   | 100 | % |   |   | 8.4 | % |   |   | 78 | % |   |

 

| ** **              | ** ** | **Three Months Ended March 31, 2005** | ** ** |
|-------------------------|------------|--------------------------------------------|------------|
| ** **              | ** ** | ** **                                 | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **              | ** ** | ** **                                 | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** **              | ** ** | **Loans**                                  | ** ** | **% of** | ** ** | **Interest** | ** ** | **Loan-to-Value** | ** ** |
| ** **              | ** ** | **Funded**                                 | ** ** | **Total** | ** ** | **Rate(1)** | ** ** | **Ratio** | ** ** |
| **Credit Score Range:** | ** ** | ** **                                 | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Above 700               |       | $                                          | 88,485     |   |   | 7 | % |   |   | 7.0 | % |   |   | 79 | % |   |
| 661-700                 |       | 176,452                                    |       |   | 13 | % |   |   | 7.0 | % |   |   | 79 | % |   |
| 621-660                 |       | 371,222                                    |       |   | 27 | % |   |   | 7.3 | % |   |   | 81 | % |   |
| 581-620                 |       | 329,911                                    |       |   | 24 | % |   |   | 7.4 | % |   |   | 80 | % |   |
| 541-580                 |       | 230,475                                    |       |   | 17 | % |   |   | 8.1 | % |   |   | 79 | % |   |
| 540 and below           |       | 163,907                                    |       |   | 12 | % |   |   | 8.6 | % |   |   | 74 | % |   |
| Not available           |       | 1,164                                      |       |   | NM |   |   |   | 8.2 | % |   |   | 84 | % |   |
| Total                   |       | $                                          | 1,361,616  |   |   | 100 | % |   |   | 7.6 | % |   |   | 79 | % |   |

----

(1)          Calculated with respectto the interest rate at the time the loan was originated or purchased.

NM = NotMeaningful

**Quality Control**

Our quality controlprogram is intended to monitor and improve the overall quality of loanproduction generated by our retail channel and wholesale channel and identifyand communicate to management existing or potential underwriting and loanpackaging problems or areas of concern. The quality control file reviewexamines compliance with our underwriting guidelines and federal and stateregulations. This is accomplished by focusing on*:*

·       theaccuracy of all credit and legal information; 

·       acollateral analysis;  

·       employmentand/or income verification; and 

·       legal document review toensure that the necessary documents are in place. 

35

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**MORTGAGE LOAN SALESTO THIRD PARTIES**

Aames Financial uses the majority of the net proceedsfrom its whole loan sales to third parties to pay down its revolving warehouseand repurchase facilities in order to increase capacity under these facilitiesfor future funding of mortgage loans. Proceeds we receive from on-balance sheetsecuritization financings on loans held for investment are also used to paydown our revolving warehouse and repurchase facilities. 

Thefollowing table sets forth information regarding our whole loan sales to thirdparties for the periods indicated (in thousands): 

| ** **       | ** ** | **Three Months Ended** | ** ** | ** **              | ** ** |
|------------------|------------|------------------------|------------|-------------------------|------------|
| ** **       | ** ** | **March 31,**     | ** ** | **Increase (Decrease)** | ** ** |
| ** **       | ** ** | **2006**               | ** ** | **2005**                | ** ** | **Amount** | ** ** | **%** | ** ** |
| Whole loan sales |       | $                      | 1,494,848  |                    | $          | 320,638 |   | $ | 1,174,210 |   | 366.2 | % |
|                  |            |                        |            |                         |            |  |  |  |  |  |  |  |

 

Our whole loan sales to third parties during the threemonths ended March 31, 2006 increased by $1.2 billion, or 366.2%, to $1.5billion from $320.6 million during the comparable three-month period a yearago. We achieved our targeted REIT portfolio leverage ratio during the thirdquarter of 2005 and since then have sold a larger percentage of our productioninto the secondary markets compared to the first two quarters of 2005, when weretained the majority of our loan production to build our REIT portfolio ofloans held for investment. 

Changes in the secondarymortgage markets, the current interest rate environment, and the currenteconomic climate could affect our current strategy of selling loans to thirdparties in whole loan sales. Going forward, our loan disposition strategiescould include off-balance sheet securitizations as well as whole loan sales forcash. 

**MORTGAGE LOANSERVICING**

We currently have in place a subprime mortgage loanservicing team with over 100 servicing employees and a scalable servicingplatform. We have a servicing portfolio, including loans held for investmentand loans held for sale, of approximately $5.6 billion at March 31, 2006.Aames Financial’s servicing platform has received a SQ3 rating from Moody’s andan RPS3-Rating from Fitch. As previously reported, in April 2006, S&Pinformed Aames Financial Corporation, that as a result of Aames Financial’sfinancial performance during the three most recent quarters, Aames Financial nolonger meets the S&P minimum financial performance standards to continue tobe a Select Servicer, and, as a result, S&P was removing Aames Financialfrom S&P’s Select Servicer List. To date, the removal has not affected theCompany’s ability to service its loan portfolio.

In addition to our REIT portfolio of loans held forinvestment, our servicing portfolio consists of loans serviced on an interimbasis, including loans held for sale and loans sold to others and subservicedon an interim basis, and to a lesser extent, mortgage loans sold to others andsubserviced on a long-term basis. Servicing includes collecting and remittingloan payments, accounting for principal and interest, contacting delinquentborrowers, managing borrower defaults and liquidating foreclosed properties. Inorder to maximize profitability and cash flow, we do not retain servicing onloans we sell to third parties in whole loan sales for cash. 

36

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Thefollowing table sets forth information regarding our servicing portfolio as ofthe dates indicated (dollars in thousands):

| ** **                                        | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| Mortgage loans serviced:                          |       |               |       |                  |       |   |   |
| Loans held for investment                         |       | $                  | 3,670,346  |                  |       | $ | 4,077,448 |   |   |
| Loans serviced on an interim basis                |       | 1,812,531          |       |                  | 1,926,876  |   |   |
| Loans subserviced for others on a long-term basis |       | 85,717             |       |                  | 92,213     |   |   |
| Total serviced in-house                           |       | 5,568,594          |       |                  | 6,096,537  |   |   |
| Loans held for investment subserviced by others   |       | 49,844             |       |                  | 50,202     |   |   |
| Total servicing portfolio                         |       | $                  | 5,618,438  |                  |       | $ | 6,146,739 |   |   |
| Percentage  serviced in-house                     |       | 99.1               | %          |                  | 99.2       | % |   |

 

Our total loan servicing portfolio at March 31,2006 declined by $528.3 million, to $5.6 billion, from $6.1 billion at December 31,2005, due primarily to decreases of $407.1 million and $114.3 million inservicing of loans held for investment and loans serviced on an interim basis,respectively. The decline in loans held for investment represents portfoliorun-off, while the decline in loans serviced on an interim basis reflects thedecrease in loans sold but not yet transferred to new servicers by whole loanbuyers. 

We receive servicing fees on our REIT portfolio of loansheld for investment. We receive a servicing fee for loans subserviced forothers on a long-term basis. In addition, as servicer we generally receive allprepayment fees, late fees and assumption charges paid by borrowers on loansthat we service directly, as well as other miscellaneous fees for performingvarious loan servicing functions. 

Our agreements with thesecuritization trusts typically require us, in our role as servicer, to advanceprincipal and interest on delinquent loans to the holders of the senior bondinterests in the related securitization trusts. The agreements also require usto make certain servicing advances (e.g., for property taxes or hazardinsurance) unless we determine that those advances would not be recoverable. 

**Collections, Delinquenciesand Foreclosures**

We send borrowers a monthly billing statementapproximately 10 days prior to the monthly payment due date. Although borrowersgenerally make loan payments within 10 to 15 days after the due date (the “graceperiod”), if a borrower fails to pay the monthly payment within this graceperiod, we begin collection efforts by notifying the borrower of thedelinquency. In the case of borrowers with certain credit characteristics orwith a poor payment history with us, collection efforts may begin immediatelyafter the due date. We continue to make contact with the borrower to determinethe cause of the delinquency and to obtain a commitment to cure the delinquencyat the earliest possible time. 

As a general matter, if efforts to obtain payment havenot been successful, a pre-foreclosure notice will be sent to the borrowerimmediately after the due date of the next subsequently scheduled installment(five days after the initial due date for loans with certain creditcharacteristics), providing 30 days’ notice of impending foreclosure action.During the 30-day notice period, collection efforts continue and we evaluatevarious legal options and remedies to protect the value of the loan, includingarranging for extended repayment terms, accepting a deed-in-lieu offoreclosure, entering into a short sale (a sale for less than the outstandingprincipal amount) or commencing foreclosure proceedings. If no substantialprogress has been made in collecting delinquent payments from the borrower, foreclosureproceedings will begin. Generally, we will begin foreclosure proceedings when aloan is 80 to 100 days delinquent, depending upon credit considerations,borrower bankruptcy status and state regulations. 

37

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We monitor our servicing and collection practices toinsure they comply with applicable laws and regulations and meet industrystandards. 

Subprime mortgage loans generally have higherdelinquency rates than those prevailing in the mortgage industry. As a subprimemortgage lender, we have historically experienced delinquency rates that arehigher than those prevailing in the mortgage industry due to the origination oflower credit grade mortgage loans. Delinquent loans are loans for which morethan one payment is due. 

Setforth below are our delinquency rates compared to delinquency rates forsubprime mortgage loans (seasonally adjusted) and all mortgage loans(seasonally adjusted) according to the National Delinquency Survey of theMortgage Bankers Association of America as of the dates indicated:

| ** **               | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|--------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **               | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| Aames Investment         |       |               | 6.2        | %                     |       |   | 5.4 | % |   |
| Subprime Mortgage  Loans |       |               | NY         | A                     |       |   | 11.6 | % |   |
| All Mortgage  Loans      |       |               | NY         | A                     |       |   | 4.7 | % |   |

----

NYA = Not yet announced

Thefollowing table sets forth delinquency information relating to our servicingportfolio as of the dates indicated (dollars in thousands): 

| ** **                                                                    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                                                    | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| Percentage of dollar  amount of delinquent loans serviced (period end)(1)(2): |       |               |       |                  |       |   |   |   |   |
| One month                                                                     |       |               | 1.9        | %                     |       |   | 1.9 | % |   |
| Two months                                                                    |       |               | 0.9        | %                     |       |   | 0.9 | % |   |
| Three or more months                                                          |       |               |       |                  |       |   |   |   |   |
| Not foreclosed(3)                                                             |       |               | 3.1        | %                     |       |   | 2.5 | % |   |
| Foreclosed(4)                                                                 |       |               | 0.3        | %                     |       |   | 0.1 | % |   |
| Total                                                                         |       |               | 6.2        | %                     |       |   | 5.4 | % |   |
| Percentage of  total dollar amount of delinquent loans in:                    |       |               |       |                  |       |   |   |   |   |
| Loans held for investment                                                     |       |               | 7.4        | %                     |       |   | 7.0 | % |   |
| Loans serviced on an interim basis                                            |       |               | 3.6        | %                     |       |   | 2.0 | % |   |
| Loans subserviced  for others on a long-term basis                            |       |               | 7.6        | %                     |       |   | 8.9 | % |   |

----

(1)          Delinquent loans areloans for which more than one payment is due.

(2)          The delinquency andforeclosure percentages are calculated on the basis of the total dollar amountof mortgage loans serviced by us including loans serviced on an interim basis.

(3)          Represents loans whichare in foreclosure but as to which foreclosure proceedings have not concluded.

(4)          Represents propertiesacquired following a foreclosure sale and still serviced by us at period end.

38

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Thefollowing table summarizes the unpaid principal balance of delinquent loans asof the dates indicated in the total servicing portfolio (in thousands): 

| ** **                                         | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| Loans held for  investment                         |       | $                  | 276,044    |                  |       | $ | 287,348 |   |   |
| Loans serviced on  an interim basis                |       | 65,871             |       |                  | 38,437     |   |   |
| Loans subserviced  for others on a long-term basis |       | 6,514              |       |                  | 8,225      |   |   |
| Total                                              |       | $                  | 348,429    |                  |       | $ | 334,010 |   |   |

 

Delinquent loans, by principal balance of the totalservicing portfolio, grew to $348.4 million at March 31, 2006 from $334.0million at December 31, 2005. The delinquency rate at March 31, 2006was 6.2% compared to 5.4% at December 31, 2005. This increase in thedelinquency rate was primarily due to the growth in delinquencies in loansserviced on an interim basis, as well as to an increase in the delinquency rateon our on-balance sheet REIT portfolio of mortgage loans. We expect thedelinquency rate to increase in future periods due to the seasoning of our REITportfolio.

Thefollowing table sets forth foreclosure and loss information relating to ourservicing portfolio for the periods indicated (dollars in thousands):

| ** **                                                                                               | ** ** | **Three Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                               | ** ** | **March 31,**               | ** ** |
| ** **                                                                                               | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| Percentage of  dollar amount of loans foreclosed during the  period to loans serviced (period end)(1)(2) |       | 0.2                              | %          | 0.1 | % |
| Number of loans  foreclosed during the period                                                            |       | 104                              |       | 42 |   |
| Principal amount  of loans foreclosed during the period                                                  |       | $                                | 13,144     |   | $ | 2,351 |   |
| Number of loans  liquidated during the period                                                            |       | 43                               |       | 69 |   |
| Net losses on liquidations during the period  from(3):                                                   |       |                             |       |   |   |
| Loans held for investment serviced:                                                                      |       |                             |       |   |   |
| In-house                                                                                                 |       | $                                | 891        |   | $ | — |   |
| By others                                                                                                |       | —                           |       | — |   |
| Loans serviced on an interim basis                                                                       |       | 522                              |       | 963 |   |
| Loans subserviced for others on a long-term basis                                                        |       | —                           |       | — |   |
| Loans in off-balance sheet securitization trusts  serviced  in-house                                     |       | —                           |       | 1,141 |   |
| Total                                                                                                    |       | $                                | 1,413      |   | $ | 2,104 |   |
| Percentage of annualized losses to servicing portfolio(1)(2)                                        |       | 0.1                              | %          | 0.3 | % |
| Servicing portfolio at  period end                                                                       |       | $                                | 5,618,000  |   | $ | 3,710,000 |   |

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(1)          The delinquency andforeclosure percentages are calculated on the basis of the total dollar amount ofmortgage loans serviced by us.

(2)          The percentages werecalculated to reflect the dollar volume of loans foreclosed or annualizedlosses, as the case may be, to the average dollar amount of mortgage loansserviced by us and any subservicer during the related periods indicated.

(3)          Represents losses, netof gains, on properties sold through foreclosure or other default management activitiesduring the periods indicated.

During the three monthsended March 31, 2006, net losses on loan liquidations declined to $1.4million from $2.1 million during the comparable three-month period during 2005.Of the $1.4 million of 

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netlosses on loan liquidations during the three months ended March 31, 2006,$0.9 million and $0.5 million related to mortgage loans held for investment andmortgage loans held for sale, respectively. We expect net losses on loanliquidations to increase in future periods once our on-balance sheet REITportfolio of mortgage loans becomes more seasoned and fewer new loans are addedto the REIT portfolio.

**FINANCIAL CONDITION**

Thefollowing table presents changes in balance sheet account balances as of thedates indicated (in thousands):

| ** **                                                       | ** ** | **March 31,** | ** ** | **December 31,** | ** ** | **Increase**   | ** ** |
|------------------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|----------------|------------|
| ** **                                                       | ** ** | **2006**           | ** ** | **2005**              | ** ** | **(Decrease)** | ** ** |
| Loans held for  sale, at lower of cost or market                 |       | $                  | 1,063,290  |                  |       | $              | 951,177    |   |   | $ | 112,113 |   |
| Loans held for  investment, net                                  |       | 3,656,520          |       |                  | 4,085,536  |           |       | (429,016 | ) |
| Advances and  other receivables, net                             |       | 37,957             |       |                  | 39,591     |           |       | (1,634 | ) |
| Equipment and  improvements, net                                 |       | 10,615             |       |                  | 10,810     |           |       | (195 | ) |
| Prepaid expenses  and other assets                               |       | 34,659             |       |                  | 30,713     |           |       | 3,946 |   |
| Derivative  financial instruments, at estimated fair value  |       | 52,961             |       |                  | 58,147     |           |       | (5,186 | ) |
| Financings on  loans held for investment                         |       | 3,240,314          |       |                  | 3,623,188  |           |       | (382,874 | ) |
| Revolving  warehouse and repurchase facilities                   |       | 1,454,933          |       |                  | 1,341,683  |           |       | 113,250 |   |
| Borrowings                                                       |       | 1,324              |       |                  | 16,487     |           |       | (15,163 | ) |
|                                                                  |            |                    |            |                       |            |                |            |  |  |  |  |  |

 

***Loans Held forSale.******  ***Loansheld for sale grew by $112.1 million to $1.1 billion, during the three monthsended March 31, 2006, primarily due to total loan originations exceedingtotal loan sales and transfers of mortgage loans held for sale to mortgageloans held for investment. 

***Loans Held forInvestment, Net.*****  **Loansheld for investment, net, declined by $429.0 million, to $3.7 billion, duringthe three months ended March 31, 2006, and was primarily due to portfoliorun-off. At March 31, 2006, the portfolio of loans held for investment wascomprised of $3.2 billion and $462.4 million of loans securitized and loans notyet securitized, respectively. In comparison, at December 31, 2005, theportfolio of loans held for investment was comprised of $3.7 billion and $461.5million of loans securitized and loans not yet securitized, respectively. 

Loans held for investment at March 31, 2006 andDecember 31, 2005 were net of a $53.3 million and $43.4 million allowancefor loan losses, respectively. During the three months ended March 31,2006, we recorded a provision for loan losses of $12.6 million and netcharge-offs of $2.6 million. We expect net charge-offs on loan liquidations toincrease in future periods as the loans in the held for investment portfoliobecome more seasoned.

***Advances and OtherReceivables.******  ***Advancesand other receivables are comprised of interest and servicing advances,servicing and miscellaneous fees, accrued interest receivable and othermiscellaneous receivables. The level of servicing advances, in any givenperiod, depends upon portfolio delinquencies, the level of real estate ownedand loans in the process of foreclosure, and the timing and remittance of cashcollections on mortgage loans in the portfolio. We fund advances on a recurringbasis not otherwise covered by our financing arrangements that we have in placefrom time to time and recover those advances on a periodic basis. 

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Advances and other receivables declined by $1.6million, to $38.0 million, during the three months ended March 31, 2006. AtMarch 31, 2006 and December 31, 2005, advances and other receivableswere net of an advance receivable allowance of $1.4 million and $1.9 million,respectively. The decline in advances and other receivables was due primarilyto a decrease of $3.3 million in accrued interest and other receivables,partially offset by increases of $1.1 million and $0.6 million in interest andservicing advances and vendor receivables, respectively.

The $3.3 million decrease in accrued interest andother receivables was primarily due to a $4.0 million decline in accruedinterest receivable related to the decrease in the balance of loans held forinvestment, partially offset by a $0.3 million increase in accrued interestreceivable related to the increase in loans held for sale and a $0.3 millionincrease in amounts due from counterparties. The $1.1 million growth ininterest and servicing advances was primarily due to the seasoning of our REITportfolio and the related increase in delinquencies.

***Equipment andImprovements, Net.******  ***Equipmentand improvements, net, declined by $0.2 million, to $10.6 million, during thethree months ended March 31, 2006, reflecting depreciation andamortization outpacing the capitalization of new equipment and improvementacquisitions. 

***Prepaid Expensesand Other Assets.******  ***Prepaidexpenses and other assets grew by $3.9 million, to $34.7 million, during thethree months ended March 31, 2006. This was primarily due to an increaseof $8.4 million in real estate owned, partially offset by decreases of $1.8million, $1.7 million, and $1.4 million in licensing, permit and performancebond deposits, defunded loans, and unamortized debt issuance costs,respectively.

***DerivativeFinancial Instruments.******  ***AtMarch 31, 2006, we had notional amounts of $6.4 billion of interest ratecap agreements compared to $6.9 billion at December 31, 2005 to hedge raterisk exposure to our portfolio of mortgage loans held for investment andrelated financings. We carry our derivative financial instruments at estimatedfair value, which at March 31, 2006 was $53.0 million compared to $58.1million at December 31, 2005. Included in interest expense during thethree months ended March 31, 2006 was a $5.2 million loss related to thenegative mark to fair value of our interest rate cap agreements at March 31,2006. Included in interest expense for the three months ended March 31,2005 was a $9.5 million gain related to the positive mark to fair value of ourinterest rate cap agreements at March 31, 2005.

***Financings on LoansHeld for Investment.*****  **Amountsoutstanding under our financings on loans held for investment declined by$382.9 million, to $3.2 billion, during the three months ended March 31,2006, primarily due to principal repayments, partially offset by the issuanceof $24.3 million of financings, net of discount, related to our retained bonds.

***Revolving Warehouseand Repurchase Facilities.******  ***Amountsoutstanding under revolving warehouse and repurchase facilities grew by $113.3million, to $1.5 billion, during the three months ended March 31, 2006,primarily as a result of increased reliance on the facilities to fund loansheld for sale and loans held for investment prior to their securitization. At March 31,2006, we had $462.4 million of mortgage loans classified as loans held forinvestment, not yet securitized, that were being held pending an on-balancesheet securitization planned for closing in the middle of the quarter ended June 30,2006. Proceeds from whole loan sales and securitizations are used first toreduce balances outstanding under our revolving warehouse and repurchasefacilities, and then used to satisfy corporate operating requirements. 

***Borrowings.*****  **At March 31, 2006, we had $1.3 million ofborrowings outstanding under our short-term collateral financing facilitycompared to $16.5 million at December 31, 2005. At December 31, 2005,we pledged $35.6 million of our retained bonds resulting from oursecuritization of loans as collateral for this facility. During January 2006,we elected to issue certain of these retained bonds and the proceeds from theissuance were used to pay down $15.2 million of borrowings under the facility.

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**LIQUIDITY ANDCAPITAL RESOURCES**

Our operations require access to short-term and long-termsources of cash.

Our primary sourcesof liquidity are expected to be:

·       fundingsfrom revolving warehouse and repurchase facilities; 

·       fundingsfrom financings on loans held for investment; 

·       theproceeds from the sale of mortgage loans;

·       theproceeds from monetization of retained mortgage-backed bonds from ouron-balance sheet securitizations;

·       proceedsfrom a revolving line of credit facility; and

·       theproceeds from the issuance of additional debt and equity securities.

Our primaryoperating cash requirements include: 

·       thefunding of mortgage loan originations and purchases prior to theirsecuritization and sale; 

·       interestand principal payments on financings on loans held for investment; 

·       interestand principal payments and liquidity requirements under our revolving warehouseand repurchase facilities, and other borrowings; 

·       advancesin connection with our servicing portfolio; 

·       overcollateralizationrequirements in connection with on-balance sheet securitizations; 

·       fees,expenses and hedging costs, if any, incurred in connection with thesecuritization and sale of loans; and 

·       ongoingadministrative, operating, and tax expenses.

***Fundings fromRevolving Warehouse and Repurchase Facilities.****  *We borrow substantial sums of cash on a regular basisto originate mortgage loans and to hold loans in our REIT portfolio prior tosecuritization. Therefore, we rely on revolving warehouse and repurchasefacilities to finance the origination and holding of mortgage loans prior tosecuritization or sale. At March 31, 2006, we had total revolvingwarehouse and repurchase facilities in the amount of $2.8 billion, of which$2.7 billion and $0.1 billion were committed and uncommitted, respectively. At March 31,2006, amounts outstanding under our facilities totaled $1.5 billion, leaving uswith $1.2 billion of available committed borrowing capacity under thefacilities. The $2.8 billion of total revolving warehouse and repurchasefacilities available at March 31, 2006 are scheduled to mature as follows:$300.0 million on May 31, 2006; $500.0 million on August 4, 2006;$300.0 million on September 29, 2006; $500.0 million on December 1,2006; $500.0 million January 17, 2007; and $700.0 million on April 3,2007. While no assurance can be made, we expect to renew our warehousefacilities on the same or similar terms at or prior to their maturity. 

At December 31, 2005, we had total revolvingwarehouse and repurchase facilities in the amount of $2.8 billion, of which$2.7 billion and $0.1 billion were committed and uncommitted, respectively. At December 31,2005, amounts outstanding under our facilities totaled $1.3 billion, leaving uswith $1.4 billion of available committed borrowing capacity under thefacilities at that time.

Certain of the revolving warehouse and repurchasefacility lenders advance less than 100% of the principal balance of themortgage loans originated, requiring the use of our working capital to fund theremaining portion. The revolving warehouse and repurchase facility agreementscontain provisions requiring us to meet certain periodic financial covenants,including, among other things, minimum 

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liquidity, stockholders’equity, leverage, and net income levels. The facility agreements also containcustomary representations and warranties. 

Although our actual debt to equity ratio may vary fromtime to time depending on market conditions and other factors that ourmanagement and Board of Directors deem relevant, in general, our creditfacilities limit our total debt-to-equity ratio to a level of 20.0 to 1.0.However, each of our credit facility lenders disregards nonrecourse financing,including the bonds underlying our on-balance sheet securitizations, incomputing our adjusted leverage ratio which is limited to 7.0 to 1.0. We werein compliance with the ratios at March 31, 2006. 

***Fundings fromFinancings on Loans Held for Investment.******  ***Our ability to generatefundings from on-balance sheet securitization financings on loans held forinvestment is necessary to generate cash proceeds to pay down our revolvingwarehouse and repurchase facilities, which fund loans held for investment priorto their on-balance sheet securitization. During the three months ended March 31,2006, we did not complete any on-balance sheet securitizations. During the yearended December 31, 2005, we completed four on-balance sheet transactionsresulting in the securitization of $3.7 billion of mortgage loans.

***Proceeds from theSale of Mortgage Loans.******  ***Ourability to sell loans we originate in the secondary market through whole loansales is necessary to generate cash proceeds to pay down our revolvingwarehouse and repurchase facilities and fund mortgage loan production. Ourability to sell loans in the secondary market on acceptable terms is essentialfor the continuation of our loan origination operations. 

During the three months ended March 31, 2006, wesold $1.5 billion of mortgage loans in whole loan sales for cash to thesecondary market, an increase of $1.2 billion over the $320.6 million of wholeloan sales during the three months ended March 31, 2005. We achieved ourtargeted REIT portfolio leverage ratio during the third quarter of 2005 andsince then have been selling a larger percentage of our production into thesecondary markets compared to the first two quarters of 2005, when we retaineda majority of our loan production to build a REIT portfolio of loans held forinvestment. 

***Proceeds fromMonetization of Retained Mortgage-Backed Bonds from Our On-Balance SheetSecuritizations.******  ***AtMarch 31, 2006, we were party to a revolving short-term collateralizedfinancing facility pursuant to which $4.1 million at par value of retainedbonds was pledged as collateral. Amounts outstanding under the facility at March 31,2006 of $1.3 million were subject to interest at one-month or one-week LIBOR,plus 65 to 150 basis points, depending on the term of the requested advance.

***Proceeds fromRevolving Line of Credit Facility.******  ***During March 2006, weentered into a revolving line of credit agreement with a commercial bank. Underthe terms of the agreement, we can borrow up to $25.0 million at an interestrate of one-month LIBOR plus 175 basis points. The facility is secured by allof our corporate assets, excluding loans pledged under our revolving warehouseand repurchase facilities and retained bonds pledged under our short-termcollateral financing facility. The agreement expires in March 2007. At March 31,2006, there was no amount outstanding under this facility.

***Proceeds from theIssuance of Debt and Equity Securities.******  ***On November 4, 2005, ourForm S-3 shelf registration statement, filed for the purpose of sellingour common stock, preferred stock, debt securities or other securities in oneor more offerings up to an aggregate dollar amount of $500.0 million, wasdeclared effective by the Securities and Exchange Commission. Depending on ourliquidity needs and market conditions, we may issue one or more of thesesecurities in different amounts and at different times. We intend to use theproceeds from any sale of these securities for general corporate purposes,which includes continuing to build a portfolio of self-originated mortgageloans, for general working capital purposes and to reduce short-termindebtedness.

***Cash Flow.*****  **The following summarizes our material cash flowactivities during the three months ended March 31, 2006 and 2005. 

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The principal operating activities which effect ournet cash provided by or used in such activities in any period are (i) theincrease or decrease in loan production, and the mix of that production betweenwholesale and retail, which causes an increase or decrease in the use of cash,respectively; (ii) the increase or decrease in the level of loan sales andon-balance sheet securitizations, which causes an increase or decrease in cashprovided, respectively; and (iii) net income. 

During the three months ended March 31, 2006, ournet cash used in operating activities grew by $213.7 million, to $112.4million, from the $101.3 million of net cash provided by operating activitiesduring the three months ended March 31, 2005. This was primarily due to a$213.6 million growth in cash used to fund originations of loans held for sale,net of proceeds from loan sales, as well as to a $12.7 million increase in netloss, partially offset by a $12.6 million change in other operating items.

During the three months ended March 31, 2006, ournet cash provided by investing activities grew by $1.6 billion, to $415.6million, from $1.1 billion of cash used during the comparable three-monthperiod during 2005. This was primarily attributable to a reduction in transfersfrom loans held for sale to our REIT portfolio of loans held for investment aswell as principal payments received on our REIT portfolio. As we monitor ourREIT portfolio, we may again use cash in that investing activity. However, asour REIT portfolio of loans held for investment is stabilized at a level wedeem appropriate, cash used in this investing activity will decline from 2005levels. 

During the three months ended March 31, 2006, ournet cash used in financing activities grew by $1.4 billion, to $308.4 million,over the $1.1 billion of cash provided for the three months ended March 31,2005. This was primarily attributable to a $1.1 billion decline in proceedsfrom issuance of financings on loans held for investment, a $341.1 millionincrease in repayments of financings on loans held for investment, and a $17.8million increase in cash used for common stock dividend payments during thethree months ended March 31, 2006 over the same period a year ago. Thesefactors were partially offset by $68.1 million net increase in revolvingwarehouse and repurchase facilities. The primary activities affecting our cashflows from financing activities are increases and decreases in the level offinancings of loans held for investment and in the level of borrowings underour revolving warehouse and repurchase facilities. In addition, financingactivities also include capital related cash flows.

As a financial institution, our lending and borrowingfunctions are integral parts of our business. When evaluating sources and usesof cash, we consider cash used to increase our assets and borrowings used tofinance those assets separately from our operating cash flows. Our mostsignificant use of cash is for the acquisition of loans held for sale, which isfunded primarily through borrowings under our revolving warehouse andrepurchase facilities. In accordance with U.S. GAAP, originations of loans heldfor sale, net of sales of such loans, are required to be included in ourconsolidated statements of cash flows as a component of cash flows fromoperating activities. However, borrowings used to fund such loans, andrepayment of such borrowings, are required to be included in the consolidatedstatements of cash flows as a component of cash flows from financingactivities. 

The amount of net originations of loans held for saleincluded as a component of cash flows used in operating activities was $112.1million during the three months ended March 31, 2006 compared to $101.5million as a component of cash provided by operating activities for the threemonths ended March 31, 2005. Excluding the origination and sale activityof loans held for sale, our operating activities used $0.3 million and provided$202.8 million of cash during the three months ended March 31, 2006 and2005, respectively. 

At March 31, 2006, we had net operating liquidityof approximately $56.5 million, which consisted of approximately $31.0 millionof unrestricted cash and cash equivalents, $25.0 million of drawing capacityunder a revolving line of credit facility, and approximately $0.5 million ofcash that could be immediately raised through the pledging of unencumbered andeligible loans held for sale as collateral pursuant to 

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committed revolvingwarehouse and repurchase facilities. We currently believe that our netoperating liquidity level is sufficient to satisfy our operating requirements. 

If our access to warehouselines, working capital, or the securitization or whole loan markets isrestricted, we may have to seek additional equity. There can be no assurancethat sufficient sources of liquidity will be available to us at any given timeor that favorable terms will be available. If we are unable to maintainsufficient liquidity, we would be restricted in the amount of loans that wewill be able to produce and sell, which would negatively impact profitabilityand jeopardize our ability to continue to operate as a going concern. 

**CONTRACTUALOBLIGATIONS**

Thefollowing table summarizes our material contractual obligations as of March 31,2006 (in millions):

| ** **                                     | ** ** | ** ** | ** ** | **Payments Due by Period** | ** ** |
|------------------------------------------------|------------|------------|------------|----------------------------|------------|
| ** **                                     | ** ** | ** ** | ** ** | **Less Than**         | ** ** | **1-3** | ** ** | **3-5** | ** ** | **More Than** | ** ** |
| ** **                                     | ** ** | **Total**  | ** ** | **1 year**            | ** ** | **Years** | ** ** | **Years** | ** ** | **5 years** | ** ** |
| Financing on  loans held for investment        |       | $          | 3,260.7    |                       |       | $ | 1,435.1 |   |   | $ | 1,287.6 |   | $ | 337.1 |   |   | $ | 200.9 |   |   |
| Revolving  warehouse and repurchase agreements |       | 1,454.9    |       |                       | 1,454.9    |   |   | — |   | — |   |   | — |   |   |
| Borrowings                                     |       | 1.3        |       |                       | 1.3        |   |   | — |   | — |   |   | — |   |   |
| Operating leases,  net                         |       | 48.7       |       |                       | 12.6       |   |   | 21.3 |   | 10.6 |   |   | 4.2 |   |   |
| Purchase and  other obligations                |       | 0.1        |       |                       | 0.1        |   |   | — |   | — |   |   | — |   |   |
| Total                                          |       | $          | 4,765.7    |                       |       | $ | 2,904.0 |   |   | $ | 1,308.9 |   | $ | 347.7 |   |   | $ | 205.1 |   |   |

 

Our revolving warehouseand repurchase agreements contain terms which require us to meet periodicfinancial covenants and other contractual obligations as on-going conditions toborrow under the warehouse and repurchase agreements. If we are unable tocomply with the financial covenants or the other contractual obligations goingforward, or if we are unable to obtain subsequent amendments or waivers, ifrequired, the lenders can declare default events. If we do not cure the defaultevents, the lenders are entitled to liquidate the residential mortgage loanswhich collateralize borrowings under the revolving warehouse and repurchasefacilities to recover funds advanced.

**RISK MANAGEMENT**

At March 31, 2006 and 2005, we had notionalamounts of $6.4 billion and $4.2 billion, respectively, of interest rate capagreements in place to hedge interest rate risk exposure to our portfolio ofmortgage loans held for investment and related financings. Interest expenseduring the three months ended March 31, 2006 included a loss of $5.2million related to the negative mark to fair value of these interest rate capagreements at March 31, 2006. During the three months ended March 31,2005, interest expense included a gain of $9.5 million related to the positivemark to fair value of these interest rate cap agreements at March 31,2005. Interest income during the three months ended March 31, 2006 and2005 included $13.6 million and $2.6 million, respectively, of income relatedto remittances to us from counterparties on in-the-money interest rate capagreements.

We continually monitor theinterest rate environment and our hedging strategies. However, there can be noassurance that our earnings would not be adversely affected during any periodof unexpected changes in interest rates or prepayment rates, including chargesto earnings on future derivative contracts into which we may enter.

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**INTEREST RATESENSITIVITY**

***Sale of Loans—Interest Rate Risk.******  ***We are exposed to risinginterest rates for loans originated or purchased which are held pending sale inthe whole loan market. From time to time, we mitigate exposure to risinginterest rates through the use of interest rate cap agreements, forward interestrate swap agreements, or other hedging activities. These hedging activitieshelp mitigate the risk of absolute movements in interest rates.

**INTEREST RATESENSITIVE ASSETS AND LIABILITIES**

***Fair Value ofFinancial Instruments.*****  **Ourfinancial instruments, which are recorded at contractual amounts thatapproximate market or fair value, primarily consist of loans held for sale,advances and other receivables, and revolving warehouse and repurchasefacilities. As these amounts are short-term in nature and/or generally bearmarket rates of interest, the carrying amounts of these instruments arereasonable estimates of their fair values. Our financial instruments alsoinclude our loans held for investment, which are recorded at contractualamounts. The fair value of our loans held for investment are based on currentmarket prices for similar loans using current investor yield requirements. Thecarrying amount of our warehouse borrowings approximates fair value when valuedusing available quoted market prices.

***Interest Rate Risk.******  ***We are exposed to on-balancesheet interest rate risk related to our loans held for investment and loansheld for sale.

***WarehouseFacilities Exposure.******  ***Weutilize revolving warehouse and repurchase financing facilities to facilitatethe holding of mortgage loans prior to sale and securitization. Revolvingwarehouse and repurchase facilities are typically for a term of one year orless and are designated to fund mortgages originated within specifiedunderwriting guidelines. The majority of the assets remain in the facilitiesfor a period of up to 90 days at which point they are securitized or sold toinstitutional investors. As these amounts are short-term in nature and/orgenerally bear market rates of interest, the contractual amounts of theseinstruments are reasonable estimates of their fair values.

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Thefollowing tables illustrate the timing of the maturities of our interest ratesensitive assets and liabilities as of the dates indicated (in thousands): 

| ** **                                                                                        | ** ** | **Maturity Range** | ** ** | ** **        | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------|------------|
| ** **                                                                                        | ** ** | **Zero to**        | ** ** | **6 Months** | ** ** | **1-2** | ** ** | **3-4** | ** ** | **5-6** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **March 31, 2006**                                                                      | ** ** | ** **              | ** ** | **6 Months** | ** ** | **to 1 Year** | ** ** | **Years** | ** ** | **Years** | ** ** | **Years** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Interest rate sensitive assets:                                                              |       |                    |       |              |       |   |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                                                                         |       | $                       | 118,009    |              | $          | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 118,009 |   |
| Loans held for sale, net                                                                          |       | 1,063,290               |       | —            |       | — |   | — |   | — |   | — |   | 1,063,290 |   |
| Loans held for investment, net                                                                    |       | 836,131                 |       | 772,932           |       | 1,042,866 |   | 723,456 |   | 127,752 |   | 153,383 |   | 3,656,520 |   |
| Interest rate cap agreements                                                                      |       | 52,961                  |       | —            |       | — |   | — |   | — |   | — |   | 52,961 |   |
| Total interest rate sensitive assets                                                         |       | $                       | 2,070,391  |              | $          | 772,932 |   | $ | 1,042,866 |   | $ | 723,456 |   | $ | 127,752 |   | $ | 153,383 |   | $ | 4,890,780 |   |
| Interest rate sensitive liabilities:                                                         |       |                    |       |              |       |   |   |   |   |   |   |   |   |   |   |
| Short-term collateralized financing facility                                                      |       | $                       | 1,324      |              | $          | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 1,324 |   |
| Revolving warehouse and repurchase facilities                                                |       | 1,454,933               |       | —            |       | — |   | — |   | — |   | — |   | 1,454,933 |   |
| Financings on loans held for investment                                                      |       | 747,679                 |       | 687,400           |       | 883,344 |   | 621,233 |   | 120,137 |   | 200,868 |   | 3,260,661 |   |
| Total interest rate sensitive liabilities                                                    |       | $                       | 2,203,936  |              | $          | 687,400 |   | $ | 883,344 |   | $ | 621,233 |   | $ | 120,137 |   | $ | 200,868 |   | $ | 4,716,918 |   |
| Excess of  interest rate sensitive assets over interest rate sensitive liabilities |       | $                       | (133,545   | )                 | $          | 85,532 |   | $ | 159,522 |   | $ | 102,223 |   | $ | 7,615 |   | $ | (47,485 | ) | $ | 173,862 |   |
| Cumulative net interest rate  sensitivity gap                                                |       | $                       | (133,545   | )                 | $          | (48,013 | ) | $ | 111,509 |   | $ | 213,732 |   | $ | 221,347 |   | $ | 173,862 |   | $ | 173,862 |   |
|                                                                                                   |            |                         |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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| ** **                                                                                        | ** ** | **Maturity Range** | ** ** | ** **        | ** ** |
|---------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-------------------|------------|
| ** **                                                                                        | ** ** | **Zero to**        | ** ** | **6 Months** | ** ** | **1-2** | ** ** | **3-4** | ** ** | **5-6** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **December 31, 2005**                                                                   | ** ** | ** **              | ** ** | **6 Months** | ** ** | **to 1 Year** | ** ** | **Years** | ** ** | **Years** | ** ** | **Years** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Interest rate sensitive assets:                                                              |       |                    |       |              |       |   |   |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents                                                                        |       | $                       | 123,172    |              | $          | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 123,172 |   |
| Loans held for sale, net                                                                     |       | 951,177                 |       | —            |       | — |   | — |   | — |   | — |   | 951,177 |   |
| Loans held for  investment, net                                                                   |       | 856,993                 |       | 816,289           |       | 1,221,175 |   | 855,266 |   | 143,890 |   | 191,923 |   | 4,085,536 |   |
| Interest rate cap  agreements                                                                     |       | 58,147                  |       | —            |       | — |   | — |   | — |   | — |   | 58,147 |   |
| Total interest rate sensitive  assets                                                        |       | $                       | 1,989,489  |              | $          | 816,289 |   | $ | 1,221,175 |   | $ | 855,266 |   | $ | 143,890 |   | $ | 191,923 |   | $ | 5,218,032 |   |
| Interest rate sensitive liabilities:                                                         |       |                    |       |              |       |   |   |   |   |   |   |   |   |   |   |
| Short-term collateralized  financing facility                                                     |       | $                       | 16,487     |              | $          | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 16,487 |   |
| Revolving warehouse and  repurchase facilities                                                    |       | 1,341,683               |       | —            |       | — |   | — |   | — |   | — |   | 1,341,683 |   |
| Financings on loans held  for investment                                                     |       | 768,926                 |       | 729,479           |       | 1,057,794 |   | 720,561 |   | 135,214 |   | 226,428 |   | 3,638,402 |   |
| Total interest rate sensitive  liabilities                                                   |       | $                       | 2,127,096  |              | $          | 729,479 |   | $ | 1,057,794 |   | $ | 720,561 |   | $ | 135,214 |   | $ | 226,428 |   | $ | 4,996,572 |   |
| Excess of interest rate sensitive  assets over interest rate sensitive liabilities |       | $                       | (137,607   | )                 | $          | 86,810 |   | $ | 163,381 |   | $ | 134,705 |   | $ | 8,676 |   | $ | (34,505 | ) | $ | 221,460 |   |
| Cumulative net interest rate sensitivity gap                                                 |       | $                       | (137,607   | )                 | $          | (50,797 | ) | $ | 112,584 |   | $ | 247,289 |   | $ | 255,965 |   | $ | 221,460 |   | $ | 221,460 |   |
|                                                                                                   |            |                         |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**Item 4.**                        Controlsand Procedures.

As of the end of the period covered by this report on Form 10-Q,Aames Investment carried out an evaluation, under the supervision and with theparticipation of its Disclosure Committee and management,including the Chief Executive Officer and Chief Financial Officer, of theeffectiveness of Aames Investment’s disclosure controls and procedures pursuantto Exchange Act Rule 13a-15. Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that Aames Investment’sdisclosure controls and procedures are effective as of the end of the periodcovered by this report. Subsequent to the date of that evaluation, there havebeen no changes in Aames Investment’s internal controls over financialreporting (as defined in Rule 13a-15f) that have materially affectedor are reasonably likely to materially affect our internal control overfinancial reporting.

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**PART II—OTHERINFORMATION**

**Item 1.**                        LegalProceedings

In July 2005, we were served with a class actioncomplaint entitled*Webb v. Aames Investment Corporation, et.al*. brought in the United States District Court, Central District ofCalifornia. In December 2005, we were served with a class action complaintentitled *Cooper v. Aames Investment Corporation, et. al*.brought in the United States District Court, Eastern District of Wisconsin. Thesecomplaints allege violations of the Fair Credit Reporting Act in connectionwith prescreened offers of credit, which we made to plaintiffs. *Webb* also alleges that the Company’s direct mail piecesfailed to comply with the requirements of FCRA that the required notice beclear and conspicuous. The plaintiffs seek to recover on behalf of themselvesand others similarly situated compensatory and punitive damages and attorneys’fees. We filed a motion to dismiss the clear and conspicuous claims inconnection with *Webb* and while we believe that amotion with leave to amend will be granted, an order has not yet been entered.We also filed a motion to transfer *Cooper* to theCentral District of California where *Webb* ispending, which was granted in March 2006, and the case was ultimatelytransferred on April 13, 2006. There have been no rulings on the merits ofthe plaintiffs’ claims or the claims of the putative class in either matter andno class has been certified. We intend to vigorously defend these matters butif a class is certified and prevails on the merits, the potential liabilitycould have a material adverse affect on our business. The outcome of thesecases and the amount of liability, if any, cannot be determined at this time.

In April 2004, we received a civil investigativedemand from the Federal Trade Commission, or the FTC, that, although notalleging any wrongdoing, sought documents and data relating to our business andlending practices. The demand was issued pursuant to an April 8, 2004resolution of the FTC authorizing non-public investigations of various unnamedsubprime lenders and loan brokers to determine whether there have beenviolations of certain consumer protection laws. We cooperated and intend tocontinue to cooperate fully with the FTC in this investigation. Because theinvestigation is at an early stage, we cannot predict the outcome of theinvestigation and its effect, if any, on our business.

In September 2004, we received a CivilInvestigative Demand and Notice to Proceed from the Office of the AttorneyGeneral of Iowa, that, although not alleging any wrongdoing, sought documentsand data relating to our business and lending practices in Iowa. We havecooperated and intend to continue to cooperate fully with the Office of theAttorney General of Iowa in this investigation. Because the investigation is atan early stage, we cannot predict the outcome of the investigation and itseffect, if any on our business in Iowa, which approximated 0.009% and 0.02% oftotal mortgage loan production during the three months ended March 31,2006 and 2005, respectively.

In the ordinary course of ourbusiness, we are subject to various claims made against us arising from, amongother things, our loan origination and collection efforts, trade practices andalleged violations of the various federal and state laws and regulationsapplicable to our business, such as consumer protection laws and employmentlaws. We believe that the resolution of any of these pending incidental claimsis not likely to have a material adverse effect on our consolidated financialposition and results of operations.

**Item 1A.**                RiskFactors

The Risk Factors included in our Annual Report on Form 10-Kfor the fiscal year ended December 31, 2005 have not materially changedother than as set forth below. The information set forth below should be readin conjunction with the risk factors and information disclosed in that Form 10-K.

**We are the subjectof current putative class action litigation and investigations by governmentalagencies, which could adversely affect our business and attract class actionlitigation against us.**

As disclosed in our AnnualReport on Form 10-K for the fiscal year ended December 31, 2005and under “Item 1. Legal Proceedings,” in July 2005 we were served with aclass action complaint entitled 

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*Webb v.Aames Investment Corporation, et. al.* brought in the UnitedStates District Court, Central District of California, and in December 2005we were served with a class action complaint entitled *Cooper v.Aames Investment Corporation, et. al.* brought in the United StatesDistrict Court, Eastern District of Wisconsin. These complaints allegeviolations of the Fair Credit Reporting Act in connection with prescreenedoffers of credit, which we made to plaintiffs. The plaintiffs seek to recoveron behalf of themselves and others similarly situated compensatory and punitivedamages and attorneys’ fees. At the time we filed that Form 10-K,our motion to transfer *Cooper* to theCentral District of California where *Webb* is pendinghad not yet been granted. It was subsequently granted in March 2006, andthe case was ultimately transferred on April 13, 2006.

**Item 2.**                        UnregisteredSales of Equity Securities and Use of Proceeds—None

**Item 3.**                        Defaultsupon Senior Securities—None

**Item 4.**                        Submissionof Matters to a Vote of Security Holders—None

**Item 5.**                        OtherInformation—None

**Item 6.**                        Exhibits

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**EXHIBIT INDEX** 

| Exhibit No. | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                        | ** ** | **Description** |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|
| 2.1              |       | Form of Agreement  and Plan of Merger (incorporated by reference to Exhibit 2.1 to  Amendment No. 3 to the registration statement on Form S-11  (333-113890) filed with the SEC on September 7, 2004 (“Amendment  No. 3 to S-11”)).                                                                                                                                       |
| 3.1              |       | Articles of  Amendment and Restatement (incorporated by reference to Exhibit 3.1 to  the Aames Investment Corporation Annual Report on Form 10-K for  the fiscal year ended December 31, 2004 (the “2004 10-K”)).                                                                                                                                                                        |
| 3.2              |       | Amended and  Restated Bylaws (incorporated by reference to Exhibit 3.2 to the Aames  Investment Corporation Annual Report on Form 10-K for the fiscal  year ended December 31, 2005 (the “2005 10-K”)).                                                                                                                                                                                  |
| 4.1              |       | Common Stock  Certificate (incorporated by reference to Exhibit 4.1 to Amendment  No. 3 to S-11).                                                                                                                                                                                                                                                                                             |
| 10.1             |       | Amended and  Restated Aames Investment Equity Incentive Plan (incorporated by reference to  Exhibit 10.1 to the 2004 10-K).                                                                                                                                                                                                                                                                                  |
| 10.2             |       | Registration  Rights and Governance Agreement dated November 1, 2004 among Specialty  Finance Partners, Capital Z Management LLC and Aames Investment (incorporated  by reference to Exhibit 10.2 to the 2004 10-K).                                                                                                                                                                                    |
| 10.3             |       | Employment  Agreement dated November 3, 2004 among Aames Investment Corporation,  Aames Financial Corporation and A. Jay Meyerson (incorporated by reference to  Exhibit 10.3 to the 2004 10-K).*                                                                                                                                                                                                       |
| 10.4             |       | Form of  Aames Investment Corporation Indemnification Agreement with directors and  executive officers (incorporated by reference to Exhibit 10.4 to the  2004 10-K).*                                                                                                                                                                                                                                  |
| 10.5(b)          |       | Amendment  No. 1 dated March 18, 2005 to Master Repurchase Agreement dated  August 5, 2004 among Bear Stearns Mortgage Capital Corporation, Aames  Capital Corporation, Aames Investment Corporation, and Aames Funding  Corporation (incorporated by reference to Exhibit 10.5(b) to the  2004 10-K).                                                                                   |
| 10.5(c)          |       | Extension Letter  to the Master Repurchase Agreement dated as of July 29, 2005 by and  among Bear Stearns Mortgage Capital Corporation, Aames Capital Corporation,  Aames Investment Corporation and Aames Funding Corporation (incorporated by  reference to Exhibit 10.5(d) to the June 2005 10-Q).                                                                                         |
| 10.5(d)          |       | Amendment  No. 3 to the Master Repurchase Agreement dated as of October 31,  2005 by and among Bear Stearns Mortgage Capital Corporation, Aames Capital  Corporation, Aames Investment Corporation and Aames Funding Corporation  (incorporated by reference to Exhibit 10.5(e) to the  September 30, 2005 10-Q (the “September 2005 10-Q”)).                             |
| 10.5(e)          |       | Amendment No. 4 to  the Master Repurchase Agreement dated as of March 1, 2006 by and among  Bear Stearns Mortgage Capital Corporation, Aames Capital Corporation, Aames  Investment Corporation and Aames Funding Corporation (incorporated by  reference to Exhibit 10.5(e) to the 2005 10-K).                                                                                               |
| 10.6             |       | Stock Purchase Agreement  dated November 1, 2004 by and among Aames Investment Corporation,  Friedman, Billings, Ramsey Group, Inc., Aames Financial Corporation,  Aames TRS, Inc. and Aames Newco, Inc. (incorporated by reference to  Exhibit 10.6 to Amendment No. 10 to the registration statement on  Form S-11 333-113890 filed with the SEC on October 29,  2004). |

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| 10.7     |   | Registration Rights  Agreement dated November 1, 2004 by and between Aames Investment  Corporation, Inc. and Friedman, Billings, Ramsey Group, Inc.  (incorporated by reference to Exhibit 10.7 to the 2004 10-K).                                                                                                                         |
|----------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.8(a)  |   | Master Repurchase  Agreement among Aames Capital Corporation, Aames Funding Corporation, Aames  Investment Corporation and Morgan Stanley Bank dated December 2, 2005  (incorporated by reference to Exhibit 10.8(a) to the 2005 10-K).                                                                                                         |
| 10.8(b)  |   | Amendment  No. 1 dated as of January 5, 2006 to the Master Repurchase  Agreement among Aames Capital Corporation, Aames Funding Corporation and  Morgan Stanley Bank dated December 2, 2005 (incorporated by reference to  Exhibit 10.8(b) to the 2005 10-K).                                                                         |
| 10.8(c)  |   | Amendment  No. 2 dated as of March 3, 2006 to the Master Repurchase Agreement  among Aames Capital Corporation, Aames Funding Corporation and Morgan Stanley  Bank dated December 2, 2005 (incorporated by reference to  Exhibit 10.8(c) to the 2005 10-K).                                                                           |
| 10.9(a)  |   | Amended and  Restated Master Loan and Security Agreement dated as of April 28, 2005  among Aames Capital Corporation, Aames Investment Corporation and Citigroup  Global Markets Realty Corp. (incorporated by reference to Exhibit 10.9  to the June 2005 10-Q).                                                                               |
| 10.9(b)  |   | Amendment Number  One dated as of September 30, 2005 to the Amended and Restated Master  Loan and Security Agreement dated as of April 28, 2005 among Aames  Capital Corporation, Aames Investment Corporation and Citigroup Global  Markets Realty Corp. (incorporated by reference to  Exhibit 10.9(b) to the September 2005 10-Q). |
| 10.9(c)  |   | Amendment Number  Two dated as of November 3, 2005 to the Amended and Restated Master Loan  and Security Agreement dated as of April 28, 2005 among Aames Capital Corporation,  Aames Investment Corporation and Citigroup Global Markets Realty Corp.  (incorporated by reference to Exhibit 10.9(c) to the  September 2005 10-Q).   |
| 10.9(d)  |   | Amendment Number  Three dated as of March 1, 2006 to the Amended and Restated Master Loan  and Security Agreement dated as of April 28, 2005 among Aames Capital  Corporation, Aames Investment Corporation and Citigroup Global Markets Realty  (incorporated by reference to Exhibit 10.9(d) to the 2005 10-K).                          |
| 10.10(a) |   | Master Repurchase  Agreement dated as of April 10, 2006 among Aames Investment Corporation,  Aames Capital Corporation, Aames Funding Corporation and Greenwich Capital  Financial Products, Inc.                                                                                                                                                    |
| 10.11(a) |   | Master Repurchase  Agreement Governing Purchases and Sales of Mortgage Loans dated as of  January 18, 2005 among Lehman Brothers Bank, FSB, Aames Capital  Corporation and Aames Investment Corporation (incorporated by reference to  Exhibit 10.11 to the 2004 10-K).                                                                         |
| 10.11(b) |   | Second Amendment dated  October 28, 2005 to Master Repurchase Agreement Governing Purchases and  Sales of Mortgage Loans among Lehman Brothers Bank, FSB, Aames Capital  Corporation and Aames Investment Corporation (incorporated by reference to  Exhibit 10.11(c) to the September 2005 10-Q).                                              |
| 10.11(c) |   | Third Amendment dated as  of January 17, 2006 to the Master Repurchase Agreement Governing  Purchases and Sales of Mortgage Loans among Lehman Brothers Bank, FSB, Aames  Capital Corporation and Aames Investment Corporation (incorporated by  reference to Exhibit 10.11(d) to the September 2005 10-Q).                                |

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| 10.11(d) |   | Fourth Amendment dated  as of March 3, 2006 to the Master Repurchase Agreement Governing  Purchases and Sales of Mortgage Loans among Lehman Brothers Bank, FSB, Aames  Capital Corporation and Aames Investment Corporation (incorporated by  reference to Exhibit 10.11(d) to the 2005 10-K).                                                                                            |
|----------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.12(a) |   | Revolving Credit  and Security Agreement dated as of July 1, 2003 among Aames Capital  Corporation, Aames Funding Corporation and Countrywide Warehouse Lending  (incorporated by reference to Exhibit 10.35(a) to the Aames  Financial Corporation Form 10-K for the year ended June 30,  2003).                                                                                |
| 10.12(b) |   | Amendment  No. 3 to Revolving Credit and Security Agreement dated as of  November 4, 2004 among Aames Capital Corporation, Aames Funding  Corporation and Countrywide Warehouse Lending (incorporated by reference to  Exhibit 10.12(b) to the 2004 10-K).                                                                                                                            |
| 10.12(c) |   | Commitment Letter  for the Revolving Credit and Security Agreement dated March 25, 2005  among Aames Capital Corporation, Aames Funding Corporation, Aames Investment  Corporation, Aames Financial Corporation and Countrywide Warehouse Lending  (incorporated by reference to Exhibit 10.12(c) to the  June 2005 10-Q).                                                            |
| 10.12(d) |   | Amendment  No. 4 to Revolving Credit and Security Agreement dated as of  March 25, 2005 among Aames Capital Corporation, Aames Funding  Corporation and Countrywide Warehouse Lending (incorporated by reference to  Exhibit 10.12(e) to the Aames Investment Corporation Quarterly  Report on Form 10-Q for the quarter ended March 31, 2005).                        |
| 10.12(e) |   | Amendment  No. 2 to the Countrywide Commitment Letter dated as of November 4,  2005 (incorporated by reference to Exhibit 10.12(f) to the  September 2005 10-Q).                                                                                                                                                                                                                 |
| 10.12(f) |   | Amendment  No. 3 to the Countrywide Commitment Letter dated March 9, 2006.                                                                                                                                                                                                                                                                                                                      |
| 10.13    |   | Office Lease  dated as of September 15, 1998, between Colonnade Wilshire Corp. and  Aames Financial Corporation for the premises located at 3731 Wilshire  Boulevard, Los Angeles, California (incorporated by reference to  Exhibit 10.12 to the Aames Financial Corporation Form 10-K  for the year ended June 30, 1999).                                                           |
| 10.14(a) |   | Office Building  Lease dated as of August 7, 1996 between Aames Financial Corporation and  California Plaza IIA, LLC for the premises located at 350 S. Grand Avenue,  Los Angeles, California (incorporated by reference to  Exhibit 10.17(a) to the Aames Financial Corporation Form 10-K  for the year ended June 30, 1997 (the “Aames Financial 1997 10-K”)). |
| 10.14(b) |   | First Amendment  to Office Building Lease dated as of August 15, 1997 between Aames  Financial Corporation and California Plaza IIA, LLC (incorporated by  reference to Exhibit 10.17(b) to the Aames Financial 1997 10-K).                                                                                                                                                                |
| 10.14(c) |   | Second Amendment  to Office Building Lease dated as of July 29, 2005 by and between EOP-TWO  California Plaza, LLC and Aames Financial Corporation (incorporated by  reference to Exhibit 10.14(c) to the June 2005 10-Q).                                                                                                                                                            |
| 10.15    |   | Office Building Lease  dated as of September 13, 2002 between Aames Financial Corporation and  Jamboree LLC for the premises located at 3347 and 3351 Michelson Drive,  Irvine, California (incorporated by reference to Exhibit 10.18 to the  Aames Financial Corporation Form 10-K for the fiscal year ended  June 30, 2002).                                                       |
| 10.16    |   | Director Compensation  Plan Summary (incorporated by reference to Exhibit 99.1 to the Aames  Investment Corporation Current Report on Form 8-K/A dated  March 23, 2005 filed with the SEC on March 31, 2005).*                                                                                                                                                                        |

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| 10.17 |   | 2005 Executive  Management Incentive Compensation Plan Summary (incorporated by reference to  the Exhibit 10.17 to the 2004 10-K).*                                                                                             |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.18 |   | Aames Financial  Corporation Executive Severance Plan, amended and released dated as of  August 4, 2005 (incorporated by reference to Exhibit 10.18 to the  September 2005 10-Q).*                                    |
| 10.19 |   | Amendment  No. 1 dated July 1, 2005 to the Employment Agreement among Aames  Investment Corporation, Aames Financial Corporation and A. Jay Meyerson  (incorporated by reference to Exhibit 10.19 to the 2005 10-K).* |
| 31.1  |   | Certification of  A. Jay Meyerson pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                               |
| 31.2  |   | Certification of  Jon D. Van Deuren pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                             |
| 32.1  |   | Certification pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                       |

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*                    Indicates amanagement contract or compensatory arrangement.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.
|                          | AAMES INVESTMENT CORPORATION                                                                        |
|--------------------------|-----------------------------------------------------------------------------------------------------|
| Dated: May 10, 2006 | /s/ JON  D. VAN  DEUREN                                                                        |
|                     | Jon D. Van Deuren                                                                                   |
|                     | *Executive Vice President—Finance and  Chief Financial Officer  (Principal Financial Officer)* |

 

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