**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

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**FORM 10-Q**

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**(Mark One)**

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

**Forthe quarterly period ended June 30, 2006**

**or**

**o**                                 TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACTOF 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 12 months(or for such shorter period that the registrant was required to file suchreports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes x    No o

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

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

As of August 1, 2006,Registrant had 61,994,492 shares of common stock outstanding.

 

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**TABLEOF CONTENTS**
| Item No.                              | ** **                                                                                                                         | ** ** | ** ** | ** ** | **Page No.** |
|--------------------------------------------|------------------------------------------------------------------------------------------------------------------------------------|------------|------------|------------|-------------------|
| **PART I—FINANCIAL INFORMATION** |
| Item 1                                | Financial Statements                                                                                                               |       | 1          |       |
|                                       | Condensed Consolidated  Balance Sheets at June 30, 2006 (Unaudited) and December 31, 2005  (Audited)                     |       | 1          |       |
|                                       | Condensed Consolidated  Statements of Operations for the three and six months ended June 30,  2006 and 2005 (Unaudited)       |       | 2          |       |
|                                       | Condensed Consolidated  Statement of Changes in Stockholders’ Equity for the six months ended  June 30, 2006 (Unaudited) |       | 3          |       |
|                                       | Condensed Consolidated  Statements of Cash Flows for the six months ended June 30, 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                                        |       | 16         |       |
| Item 3                                | Quantitative and Qualitative  Disclosures About Market Risk                                                                        |       | 16         |       |
| Item 4                                | Controls and Procedures                                                                                                            |       | 55         |       |
| **PART II—OTHER  INFORMATION**   |
| Item 1                                | Legal Proceedings                                                                                                                  |       | 56         |       |
| Item 1A                                    | Risk Factors                                                                                                                       |       | 56         |       |
| Item 2                                | Unregistered Sales of Equity  Securities and Use of Proceeds                                                                       |       | 57         |       |
| Item 3                                | Defaults Upon Senior  Securities                                                                                                   |       | 57         |       |
| Item 4                                | Submission of Matters to a  Vote of Security Holders                                                                               |       | 57         |       |
| Item 5                                | Other Information                                                                                                                  |       | 57         |       |
| Item 6                                | Exhibits                                                                                                                           |       | 57         |       |
|                                       | Signature Page                                                                                                                     |       | 62         |       |

 

 

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**Item 1.**                        FinancialStatements

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

| ** **                                                                                                                                                                                               | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                                               | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| ** **                                                                                                                                                                                               | ** ** | **(Unaudited)**   | ** ** | **(Audited)**         | ** ** |
| **ASSETS**                                                                                                                                                                                               |       |              |       |                  |       |   |   |
| Cash and cash  equivalents:                                                                                                                                                                              |       |              |       |                  |       |   |   |
| Unrestricted.                                                                                                                                                                                            |       | $                 | 50,017     |                  |       | $ | 36,078 |   |   |
| Restricted.                                                                                                                                                                                              |       | 67,384            |       |                  | 87,094     |   |   |
| Loans held for  sale, at lower of cost or market                                                                                                                                                         |       | 607,037           |       |                  | 951,177    |   |   |
| Loans held for  investment, net                                                                                                                                                                          |       | 3,398,074         |       |                  | 4,085,536  |   |   |
| Advances and  other receivables, net                                                                                                                                                                     |       | 38,377            |       |                  | 39,591     |   |   |
| Deferred income  taxes                                                                                                                                                                                   |       | 28,829            |       |                  | 28,489     |   |   |
| Equipment and  improvements, net                                                                                                                                                                         |       | 10,987            |       |                  | 10,810     |   |   |
| Prepaid expenses  and other assets                                                                                                                                                                       |       | 47,556            |       |                  | 30,713     |   |   |
| Derivative  financial instruments, at estimated fair value                                                                                                                                               |       | 42,927            |       |                  | 58,147     |   |   |
| Total assets                                                                                                                                                                                             |       | $                 | 4,291,188  |                  |       | $ | 5,327,635 |   |   |
| **LIABILITIES**                                                                                                                                                                                          |       |              |       |                  |       |   |   |
| Financings on loans held for investment                                                                                                                                                                  |       | $                 | 3,398,459  |                  |       | $ | 3,623,188 |   |   |
| Revolving  warehouse and repurchase facilities                                                                                                                                                           |       | 578,908           |       |                  | 1,341,683  |   |   |
| Borrowings                                                                                                                                                                                               |       | —            |       |                  | 16,487     |   |   |
| Accounts payable  and accrued expenses                                                                                                                                                                   |       | 50,017            |       |                  | 54,300     |   |   |
| Accrued dividends                                                                                                                                                                                        |       | —            |       |                  | 21,584     |   |   |
| Income taxes  payable                                                                                                                                                                                    |       | —            |       |                  | 889        |   |   |
| Total liabilities                                                                                                                                                                                        |       | 4,027,384         |       |                  | 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; 61,965,141 shares and  61,828,340 shares issued and outstanding at June 30, 2006 and December 31,  2005, respectively |       | 620               |       |                  | 618        |   |   |
| Additional  paid-in capital                                                                                                                                                                              |       | 656,660           |       |                  | 656,041    |   |   |
| Retained deficit                                                                                                                                                                                         |       | (393,476          | )          |                  | (387,155   | ) |   |
| Total stockholders’ equity                                                                                                                                                                          |       | 263,804           |       |                  | 269,504    |   |   |
| Total liabilities  and stockholders’ equity                                                                                                                                                         |       | $                 | 4,291,188  |                  |       | $ | 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** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                  | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                                  | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Interest income                                                             |       | $                                | 106,112    |                           | $          | 74,943 |   | $ | 218,157 |   | $ | 128,595 |   |
| Interest expense                                                            |       | 78,267                           |       | 46,446                         |       | 151,214 |   | 58,362 |   |
| Net interest income                                                         |       | 27,845                           |       | 28,497                         |       | 66,943 |   | 70,233 |   |
| Provision for  losses on loans held for investment                          |       | 2,336                            |       | 11,865                         |       | 14,937 |   | 18,365 |   |
| Net interest income after provision for loan losses                         |       | 25,509                           |       | 16,632                         |       | 52,006 |   | 51,868 |   |
| Noninterest  income:                                                        |       |                             |       |                           |       |   |   |   |   |
| Gain on sale of loans                                                       |       | 22,538                           |       | 4,666                          |       | 28,533 |   | 10,349 |   |
| Loan servicing                                                              |       | 2,537                            |       | 1,364                          |       | 4,960 |   | 2,404 |   |
| Total noninterest income                                                    |       | 25,075                           |       | 6,030                          |       | 33,493 |   | 12,753 |   |
| Net interest income after provision for loan losses  and noninterest income |       | 50,584                           |       | 22,662                         |       | 85,499 |   | 64,621 |   |
| Noninterest  expense:                                                       |       |                             |       |                           |       |   |   |   |   |
| Personnel                                                                   |       | 21,570                           |       | 20,980                         |       | 46,461 |   | 43,327 |   |
| Production                                                                  |       | 9,079                            |       | 8,577                          |       | 18,456 |   | 17,377 |   |
| General and administrative                                                  |       | 12,721                           |       | 15,015                         |       | 26,868 |   | 25,828 |   |
| Total noninterest expense                                                   |       | 43,370                           |       | 44,572                         |       | 91,785 |   | 86,532 |   |
| Income (loss) before income taxes                                           |       | 7,214                            |       | (21,910                        | )          | (6,286 | ) | (21,911 | ) |
| Income tax  provision                                                       |       | 40                               |       | 665                            |       | 57 |   | 1,430 |   |
| Net income (loss)                                                           |       | $                                | 7,174      |                           | $          | (22,575 | ) | $ | (6,343 | ) | $ | (23,341) |   |
| Net income (loss)  per common share:                                        |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                       |       | $                                | 0.11       |                           | $          | (0.37 | ) | $ | (0.10 | ) | $ | (0.38 | ) |
| Diluted                                                                     |       | $                                | 0.11       |                           | $          | (0.37 | ) | $ | (0.10 | ) | $ | (0.38 | ) |
| Dividends per common share declared during the  period                      |       | $                                | —     |                           | $          | 0.27 |   | $ | — |   | $ | 0.27 |   |
| Weighted average  number of common shares outstanding:                      |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                       |       | 62,560                           |       | 61,535                         |       | 62,547 |   | 61,478 |   |
| Diluted                                                                     |       | 62,560                           |       | 61,535                         |       | 62,547 |   | 61,478 |   |

 

See accompanying notes to condensed consolidated financial statements.

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

| ** **                                                         | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **   | ** ** | ** ** | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|----------------|------------|--------------|------------|------------|------------|
| ** **                                                         | ** ** | **Common** | ** ** | **Paid-in**    | ** ** | **Retained** | ** ** | ** ** | ** ** |
| ** **                                                         | ** ** | **Stock**  | ** ** | **Capital**    | ** ** | **Deficit**  | ** ** | **Total**  | ** ** |
| Balance at  December 31, 2005                                 |       |       | $          | 618            |       |         | $          | 656,041    |       | $ | (387,155 | ) | $ | 269,504 |   |
| Net loss                                                           |       |       | —     |           |       | —       |       | (6,343     | )          | (6,343 | ) |
| Conversion and cancellations of restricted stock  units and awards |       |       | 2          |           |       | (205         | )          | —     |       | (203 | ) |
| Stock-based compensation related to restricted stock  awards       |       |       | —     |           |       | 824          |       | —     |       | 824 |   |
| Dividend cancellation on restricted stock awards                   |       |       | —     |           |       | —       |       | 22         |       | 22 |   |
| Balance at June 30,  2006                                     |       |       | $          | 620            |       |         | $          | 656,660    |       | $ | (393,476 | ) | $ | 263,804 |   |

 

See accompanying notes to condensed consolidated financial statements.

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

| ** **                                                                       | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                       | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| **Cash Flows from Operating Activities:**                                        | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Net loss                                                                         |       | $                                             | (6,343     | ) | $ | (23,341 | ) |
| Adjustments to reconcile net loss to net cash  provided by operating activities: |       |                                          |       |   |   |
| Provision for losses on  loans held for investment                               |       | 14,937                                        |       | 18,365 |   |
| Depreciation and  amortization                                                   |       | 1,989                                         |       | 1,685 |   |
| Amortization of debt  discount                                                   |       | 4,822                                         |       | 508 |   |
| Stock-based compensation                                                         |       | 824                                           |       | — |   |
| Deferred income taxes                                                            |       | (340                                          | )          | — |   |
| Mark-to-market loss on  derivative financial instruments                         |       | 15,220                                        |       | 1,963 |   |
| Loans held for sale:                                                             |       |                                          |       |   |   |
| Originations and  purchases                                                      |       | (2,760,794                                    | )          | (2,958,630 | ) |
| Proceeds from sales                                                              |       | 3,104,934                                     |       | 3,063,102 |   |
| Net decrease in loans  held for sale                                             |       | 344,140                                       |       | 104,472 |   |
| Decrease (increase) in:                                                          |       |                                          |       |   |   |
| Advances and other  receivables, net                                             |       | 1,214                                         |       | (1,062 | ) |
| Residual interests                                                               |       | —                                        |       | 39,082 |   |
| Prepaid expenses and  other assets                                               |       | (16,843                                       | )          | (7,057 | ) |
| Derivative financial  instruments                                                |       | —                                        |       | (19,199 | ) |
| Increase (decrease) in:                                                          |       |                                          |       |   |   |
| Accounts payable and  accrued expenses                                           |       | (4,486                                        | )          | 5,886 |   |
| Income taxes payable                                                             |       | (889                                          | )          | (1,089 | ) |
| Net cash provided by  operating activities                                       |       | 354,245                                       |       | 120,213 |   |
| **Cash Flows from Investing Activities:**                                        | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Decrease (increase) in  loans held for investment                                |       | 672,525                                       |       | (2,167,192 | ) |
| Purchases of equipment  and improvements                                         |       | (2,166                                        | )          | (1,970 | ) |
| Net cash provided by  (used in) investment activities                            |       | 670,359                                       |       | (2,169,162 | ) |
| **Cash Flows from Financing Activities:**                                        | ** ** | ** **                                    | ** ** | ** ** | ** ** |
| Financings on loans held for investment:                                         |       |                                          |       |   |   |
| Proceeds from issuance                                                           |       | 618,256                                       |       | 2,004,376 |   |
| Repayments                                                                       |       | (847,807                                      | )          | — |   |
| Net (decrease) increase  in revolving warehouse and repurchase facilities        |       | (762,775                                      | )          | 158,585 |   |
| Reduction in borrowings                                                          |       | (16,487                                       | )          | (7,680 | ) |
| Payment of common stock  dividends                                               |       | (21,562                                       | )          | (20,932 | ) |
| Payment of expenses  related to equity issuance                                  |       | —                                        |       | (28 | ) |
| Net cash (used in)  provided by financing activities                             |       | (1,030,375                                    | )          | 2,134,321 |   |
| Net (decrease) increase  in cash and cash equivalents                            |       | (5,771                                        | )          | 85,372 |   |
| Cash and cash  equivalents, beginning of period                                  |       | 123,172                                       |       | 37,780 |   |
| Cash and cash  equivalents, end of period                                        |       | $                                             | 117,401    |   | $ | 123,152 |   |

 

See accompanying notes to condensed consolidated financial statements.

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

**Note 1.**   Recent Events

***Merger of Aames andAccredited.******  ***On May 24,2006, Aames Investment Corporation (“Aames Investment”), Accredited HomeLenders Holding Co. (“Accredited”), and AHL Acquisition, LLC, a wholly ownedsubsidiary of Accredited (“Merger Sub”), entered into an Agreement and Plan ofMerger (the “Merger Agreement”), pursuant to which Aames Investment will bemerged with and into Merger Sub, with Merger Sub as the surviving corporation(the “Merger”). In March 2006, Aames announced a corporate restructuringthat would eliminate its REIT status at the parent company level and itstaxable REIT subsidiary would become the parent company. After entering intothe Merger Agreement, Aames determined that it would not pursue therestructuring strategy.

In connection with the pending merger transaction,Aames Investment has scheduled a Special Meeting of its stockholders onThursday, September 14, 2006 at 9:00 a.m. Accredited filed with theSecurities and Exchange Commission, or SEC, a Registration Statement on Form S-4containing a Proxy Statement/Prospectus for the stockholders of Accredited andthe stockholders of Aames Investment. The Registration Statement was declaredeffective by the SEC on July 26, 2006. The final ProxyStatement/Prospectus was mailed to stockholders of Accredited and stockholdersof Aames Investment on or about August 9, 2006.

Pursuant to theMerger Agreement, upon consummation of the Merger each Aames Investmentstockholder will receive, in exchange for each share of Aames Investment commonstock held by such stockholder, *one* of thefollowing: 

·  cash in an amount equal to $51.94 (the closingprice of Accredited’s common stock on May 24, 2006, the date of the Merger Agreement)multiplied by the exchange ratio (which is explained below), *or*

·  a fraction of a share of Accredited commonstock equal to the exchange ratio. 

The exchange ratio was initially set at 0.1030. Thatmeans that on the day that the Merger Agreement was executed (and subject tothe limitations described below) each share of Aames Investment common stockwould have been converted into $5.35 in cash or a fraction of a share ofAccredited common stock that had a value of $5.35 (based on the closing priceof Accredited common stock on the day that the Merger Agreement was executed).However, the exchange ratio will be reduced by any dividends declared or paidby Aames Investment prior to the closing. The exchange ratio will be reduced bymultiplying it by 1 minus a fraction, the numerator of which is the amount ofany dividends Aames Investment declares or pays prior to closing, and thedenominator of which is approximately $340 million. 

Under the Merger Agreement, Aames Investment isrequired to pay prior to closing a dividend in an amount equal to AamesInvestment’s estimated 2006 REIT taxable income plus any other amounts thatAames Investment would need to distribute to qualify as a REIT for its finaltaxable year and to avoid to the extent reasonably possible the incurrence ofincome or excise tax.  Aames Investmentcurrently estimates that, if the closing were to occur on September 30, 2006,it would pay a dividend of approximately $30 million in the aggregate (or $0.48per share) pursuant to this provision, although Aames Investment cannot provideany assurance as to the amount of any such dividend.

Aames Investment and Accredited have made customaryrepresentations, warranties and covenants to each other in the Merger Agreement.Each of Aames Investment and Accredited has agreed, among other 

5

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

things, (i) tooperate its business in the ordinary course consistent with past practice andnot to take certain actions specified in the Merger Agreement, (ii) toconvene a special meeting of its stockholders to obtain requisite approvals ofits stockholders in connection with the Merger and the Merger Agreement and (iii) subjectto certain exceptions in the case of Aames Investment, to recommend approval ofsuch matters to its stockholders. Aames Investment has also agreed, subject tocertain exceptions, not to solicit, negotiate, provide non-public information infurtherance of, approve, recommend or otherwise declare advisable analternative acquisition proposal. Aames Investment will be required to paydividends prior to the closing of the transaction to the extent necessary tomaintain its status as a REIT.

Consummation of the Merger is subject to customaryconditions, including the approval of the Merger by the holders of AamesInvestment common stock, the approval of the issuance of shares of Accreditedcommon stock in connection with the Merger by the holders of Accredited commonstock, the absence of any law or order prohibiting the closing and theexpiration or earlier termination of any required waiting period under theHart-Scott-Rodino Antitrust Improvements Act of 1976 and the receipt of othergovernmental approvals. In addition, each party’s obligation to consummate theMerger is subject to (i) the material accuracy of the representations andwarranties of the other party and (ii) material compliance of the otherparty with its covenants. Accredited’s obligation to consummate the Merger isalso subject to the delivery of an opinion from counsel to Aames Investmentwith respect to Aames Investment’s status as a REIT.

The MergerAgreement contains customary termination rights for Aames Investment and Accredited,including, among others, the right of Aames Investment to terminate the MergerAgreement if it receives a superior proposal, subject to (i) Accredited’sright to match the superior proposal within three business days and (ii) paymentto Accredited by Aames Investment of a $10.0 million termination fee. Inaddition, Aames Investment must pay Accredited a $10 million termination fee ifthe Merger is terminated: 

·  By either party, if Aames Investment does notobtain the stockholder approval required to approve the Merger, a proposal orintention to make a proposal for an alternative transaction has been madepublicly prior to termination and Aames Investment enters into an agreement orconsummates an alternative transaction within 12 months of the termination forconsideration equal to or greater than $6.00 per share of Aames Investment commonstock. 

·  By Accredited, 

·  due to Aames Investment’s willful breach, aproposal or intention to make a proposal for an alternative transaction hasbeen made publicly prior to termination and Aames Investment enters into anagreement or consummates an alternative transaction within 12 months of thetermination for consideration equal to or greater than $5.00 per share of AamesInvestment common stock; or 

·  due to Aames Investment’s Board of Directorswithdrawing or adversely modifying its recommendation for approval of the Mergerand Aames Investment enters into an agreement or consummates an alternativetransaction within 12 months of the termination for consideration equal to orgreater than $6.00 per share of Aames Investment common stock.

***Sale  of Aames’ Wholesale Operations to Accredited.***   On June 26,2006, Aames Investment announced that its wholesale operations would be sold toAccredited for approximately $4.0 million plus the assumption of certainliabilities under an agreement dated June 23, 2006. The sale was completedin 

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

July 2006. The salewas intended to reduce employee attrition and maximize the potential synergiesfrom the combination of the Accredited and Aames Investment wholesaleoperations at the present time that would otherwise occur as part of the mergerof Accredited and Aames Investment contemplated to occur in the third quarterof 2006.

As part of the sale, Accredited hired approximately198 of Aames Investment’s wholesale sales and processing personnel, and assumedcertain liabilities of the wholesale business, including the lease of AamesInvestment’s Jacksonville, Florida, wholesale operations center.

The purchase of AamesInvestment wholesale operation does not otherwise affect the Merger Agreement,or any of the terms under which Accredited will acquire Aames Investment,including the consideration to be paid to the Aames Investment stockholders fortheir common stock.

**Note 2.**   General and Basis of Presentation

***General.******  ******Aames Investment is a mortgagereal estate investment trust, or REIT, which manages a portfolio of subprimeresidential mortgage loans. Since announcing the proposed merger withAccredited, we no longer retain mortgage loans for our REIT portfolio and sellall of our loan production in the secondary markets. Its principal subsidiary,Aames Financial, is a national mortgage banking company, started in 1954, whichfocuses primarily on originating, selling and servicing residential mortgageloans through its retail channel under the name “Aames Home Loan.” From 1996through July 2006, Aames Financial also originated loans through itswholesale channel. Aames Investment, together with its subsidiaries, iscollectively 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 for as a recapitalizationrestructuring of entities under common control with no change in accountingbasis.

At June 30, 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 22.5% 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 sell its loan production tothird parties in the secondary markets. Aames Investment built a REIT portfolioof mortgage loans from its initial public 

7

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

offering by retaining aportion of these loans, largely hybrid/adjustable rate mortgage loans. AamesInvestment built its REIT portfolio using its equity capital, borrowings underrevolving warehouse and repurchase facilities, and on-balance sheetsecuritizations of mortgage loans. Since announcing the proposed merger withAccredited, Aames Investment no longer retains mortgage loans for its REITportfolio and sells all of its loan production in the secondary markets.

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 ofPresentation.******  ***The condensed consolidated financial statementsincluded herein have been prepared by the Company, without audit, pursuant tothe rules and regulations of the United States Securities and ExchangeCommission. Certain information and footnote disclosures normally included infinancial statements prepared in accordance with accounting principles in theUnited 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 three andsix months ended June 30, 2006 are not necessarily indicative of theresults expected for the full calendar year.

***Reclassifications***

Certain amounts related toJune 30, 2005 have been reclassified to conform to the June 30, 2006presentation.

**Note 3.**   Cash and Cash Equivalents

At June 30, 2006 and December 31,2005, the Company had $73.7 million and $70.1 million of overnight investments,respectively.

**Note 4.**   Loans Held for Sale

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

| ** **                                             | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                             | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Fixed rate  mortgages                                  |       | $                 | 189,718    |                  |       | $ | 397,112 |   |   |
| Adjustable rate  loans                                 |       | 437,904           |       |                  | 570,716    |   |   |
| Total unpaid principal balance                         |       | 627,622           |       |                  | 967,828    |   |   |
| Net deferred loan  origination fees                    |       | (7,209            | )          |                  | (4,547     | ) |   |
| Valuation  allowance                                   |       | (13,376           | )          |                  | (12,104    | ) |   |
| Total loans held  for sale, at lower of cost or market |       | $                 | 607,037    |                  |       | $ | 951,177 |   |   |

 

8

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

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, have experienced creditdeterioration, have significant collateral deficiencies or have otherattributes that reduce their sale potential.

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

| ** **                                  | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                  | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                  | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Balance,  beginning of period               |       | $                                | 13,461     |                           | $          | 5,965 |   | $ | 12,104 |   | $ | 4,234 |   |
| LOCOM provision                             |       | 8,708                            |       | 1,296                          |       | 20,020 |   | 3,720 |   |
| Transfer from advances receivable allowance |       | —                           |       | —                         |       | — |   | 600 |   |
| Charge-offs                                 |       | (8,795                           | )          | (3,796                         | )          | (18,751 | ) | (5,109 | ) |
| Recoveries                                  |       | 2                                |       | 28                             |       | 3 |   | 48 |   |
| Net charge-offs                             |       | (8,793                           | )          | (3,768                         | )          | (18,748 | ) | (5,061 | ) |
| Balance, end of  period                     |       | $                                | 13,376     |                           | $          | 3,493 |   | $ | 13,376 |   | $ | 3,493 |   |

 

**Note 5.**   Loans Held for Investment, Net

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

| ** **                            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Securitized                           |       | $                 | 3,422,366  |                  |       | $ | 3,659,657 |   |   |
| Not yet  securitized                  |       | 23,517            |       |                  | 461,451    |   |   |
| Total unpaid principal balance        |       | 3,445,883         |       |                  | 4,121,108  |   |   |
| Net deferred loan  origination costs  |       | 4,401             |       |                  | 7,787      |   |   |
| Allowance for  loan losses            |       | (52,210           | )          |                  | (43,359    | ) |   |
| Total loans held  for investment, net |       | $                 | 3,398,074  |                  |       | $ | 4,085,536 |   |   |

 

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

| ** **                    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                    | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                    | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Balance,  beginning of period |       | $                                | 53,337     |                           | $          | 8,400 |   | $ | 43,359 |   | $ | 1,900 |   |
| Provision for loan losses     |       | 2,336                            |       | 11,865                         |       | 14,937 |   | 18,365 |   |
| Charge-offs                   |       | (3,463                           | )          | —                         |       | (6,086 | ) | — |   |
| Recoveries                    |       | —                           |       | —                         |       | — |   | — |   |
| Net charge-offs               |       | (3,463                           | )          | —                         |       | (6,086 | ) | — |   |
| Balance, end of  period       |       | $                                | 52,210     |                           | $          | 20,265 |   | $ | 52,210 |   | $ | 20,265 |   |

 

9

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

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 6.**   Accounts Payable 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 condensed consolidated balancesheets. The allowance 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 salesdistribution channels and the assessment of probability related to such claims.Changes in the level of provision to this allowance impacts the overall gain onsale margin from quarter to quarter.

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

| ** **                                                              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                              | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                              | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Balance,  beginning of period                                           |       | $                                | 6,124      |                           | $          | 8,427 |   | $ | 9,014 |   | $ | 13,137 |   |
| Provision for representation, warranty, and other miscellaneous  losses |       | 6,387                            |       | 2,720                          |       | 10,664 |   | 1,081 |   |
| Release of claims                                                       |       | —                           |       | —                         |       | (4,335 | ) | — |   |
| Charge-offs                                                             |       | (1,668                           | )          | (1,679                         | )          | (4,500 | ) | (4,750 | ) |
| Recoveries                                                              |       | —                           |       | —                         |       | — |   | — |   |
| Net charge-offs                                                         |       | (1,668                           | )          | (1,679                         | )          | (4,500 | ) | (4,750 | ) |
| Balance, end of  period                                                 |       | $                                | 10,843     |                           | $          | 9,468 |   | $ | 10,843 |   | $ | 9,468 |   |

 

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

10

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

**Note 7.**   Basic and Diluted Net Income (Loss) PerCommon 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** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                    | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                    | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Basic net income (loss) per common share:**                 |       |                             |       |                           |       |   |   |   |   |
| Basic net income (loss)                                       |       | $                                | 7,174      |                           | $          | (22,575 | ) | $ | (6,343 | ) | $ | (23,341 | ) |
| Basic weighted average  number of common shares outstanding   |       | 62,560                           |       | 61,535                         |       | 62,547 |   | 61,478 |   |
| Basic net income (loss)  per common share                     |       | $                                | 0.11       |                           | $          | (0.37 | ) | $ | (0.10 | ) | $ | (0.38 | ) |
| **Diluted net income (loss) per common share:**               |       |                             |       |                           |       |   |   |   |   |
| Diluted net income  (loss)                                    |       | $                                | 7,174      |                           | $          | (22,575 | ) | $ | (6,343 | ) | $ | (23,341 | ) |
| Diluted weighted average  number of common shares outstanding |       | 62,560                           |       | 61,535                         |       | 62,547 |   | 61,478 |   |
| Diluted net income (loss) per common share                    |       | $                                | 0.11       |                           | $          | (0.37 | ) | $ | (0.10 | ) | $ | (0.38 | ) |

 

**Note 8.**   Stock-BasedCompensation

The Company adopted SFAS123R effective January 1, 2006 using the modified prospective method.Currently, the Company’s stock-based compensation consists of restricted stockawards, which are valued based on the fair value of the Company’s shares at thegrant date using the closing market price of the Company’s shares on that date.The fair value of the restricted stock awards is amortized to compensationexpense, with an offsetting credit to additional paid-in capital, over theperiod that service is rendered, which is the vesting period. Restricted stockawards generally vest 25% per year commencing on the first anniversary datefrom the date of grant. The Company has considered historical forfeiture ratesin its estimated stock-based compensation expense related to awards that areultimately expected to vest. The recognition of compensation expense for thethree and six months ended June 30, 2006 related to the vesting ofrestricted stock awards is consistent with the expense recognition for the sameperiods in 2005 and therefore the quarterly results are comparable to the prioryear. As of June 30, 2006, there was $5.0 million of unrecognizedcompensation cost, adjusted for estimated forfeitures, related to non-vestedgrants of restricted stock awards. Total unrecognized compensation cost will beadjusted for future changes in estimated forfeitures.

The Amended and RestatedAames Investment Corporation 2004 Equity Incentive Plan (the “Plan”), whichbecame effective in November 2004, is the Company’s only compensation planunder which its equity securities are authorized for issuance, and it allowsthe Company to make awards to its officers and other employees, directors andall other persons who provide it services. Those awards may be stock options,SARs, or “full value awards” (including shares of restricted stock andrestricted stock units). Currently, a maximum of 5,550,000 shares of theCompany’s common stock may be issued upon the exercise of stock options orSARs, in connection with the vesting of shares of restricted common stock orupon the distribution of shares underlying restricted stock units. To date, allawards made under the Plan have been full value awards (i.e. restricted stockawards and restricted stock units) and each share of the Company’s common stockunderlying a full value award reduces the number of shares available for futureissuance by 2.5 shares.

11

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

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.

The following tables presentactivity in Restricted Stock Units (“RSU’s”) and Restricted Stock Awards (“RSA’s”)for the period presented:

| ** **                    | ** ** | **Six Months Ended  June 30, 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 |   | $ | 5.90-9.82 |   |
| Granted                       |       | —                                                  |       | — |   | 36,000 |   | 5.90 |   |
| Expired                       |       | —                                                  |       | — |   | — |   | — |   |
| Cancelled(1)                  |       | (28,997                                                 | )          | 8.50 |   | (180,860 | ) | 5.90-9.82 |   |
| Converted                     |       | (72,426                                                 | )          | 8.50 |   | (64,375 | ) | 7.92-9.50 |   |
| Balance, end of period        |       | 615,128                                                 |       | $ | 8.50 |   | 727,281 |   | $ | 5.90-9.82 |   |

----

       (1) Cancellations of RSUs/RSAs include thosearising from employee terminations as well as RSAs that were returned to theCompany to settle payroll tax obligations upon conversion of RSUs/RSAs to commonstock.

**Note 9.**   Commitments and 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 (the “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 be clearand conspicuous. The plaintiffs seek to recover on behalf of themselves andothers similarly situated compensatory and punitive damages and attorneys’fees. The Company filed a motion to dismiss the clear and conspicuous claims inconnection with *Webb,*which was ultimately deniedby the Court on May 30, 2006, leaving this claim as to all direct mailsent prior to December 2004. The Court has requested further briefing todetermine whether it will grant leave for the plaintiffs to amend. The Companyalso 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. The Company intends to vigorously defend thesematters, but if a class is certified and prevails on the merits, the potentialliability could have a material adverse affect on its business. The outcome ofthese cases and the amount of liability, if any, cannot be determined at thistime.

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 

12

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

to Aames Financial’sbusiness and lending practices. The demand was issued pursuant to an April 8,2004 resolution of the FTC authorizing non-public investigations of variousunnamed subprime lenders and loan brokers to determine whether there have beenviolations of certain consumer protection laws. The Company has cooperated andintends to continue to cooperate fully with the FTC in this investigation.Because the investigation is at an early stage, the Company cannot predict theoutcome of the investigation and its effect, 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 0.01% and 0.01% of total mortgage loan production during the six monthsended June 30, 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.

**Note 10.**   ParentCompany Information

The following tablespresent the condensed balance sheets and condensed statements of operations ofAames Investment Corporation (parent company only, prior to intercompanyelimination entries) as of and for the dates indicated (in thousands):

13

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

 

| ** **                                                   | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **Condensed  Balance Sheets**                                | ** ** | ** **        | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Cash and cash equivalents:                                   |       |              |       |                  |       |   |   |
| Unrestricted                                                 |       | $                 | 26,690     |                  |       | $ | 13,042 |   |   |
| Restricted                                                   |       | 67,384            |       |                  | 87,094     |   |   |
| Loans held for investment, net:                              |       |              |       |                  |       |   |   |
| Securitized                                                  |       | 3,422,366         |       |                  | 3,659,657  |   |   |
| Not yet securitized                                          |       | 23,517            |       |                  | 461,451    |   |   |
| Net deferred loan  origination costs                         |       | 4,401             |       |                  | 7,787      |   |   |
| Deferred loan acquisition  premium                           |       | 28,736            |       |                  | 41,132     |   |   |
| Allowance for loan  losses                                   |       | (52,210           | )          |                  | (43,359    | ) |   |
| Total loans held for  investment, net                        |       | 3,426,810         |       |                  | 4,126,668  |   |   |
| Investment in  subsidiaries                                  |       | 44,738            |       |                  | 78,697     |   |   |
| Accrued interest and  other assets                           |       | 105,140           |       |                  | 57,480     |   |   |
| Derivative finanancial  instruments, at estimated fair value |       | 42,927            |       |                  | 58,147     |   |   |
| Total assets                                                 |       | $                 | 3,713,689  |                  |       | $ | 4,421,128 |   |   |
| Financings on loans held  for investment                     |       | $                 | 3,398,459  |                  |       | $ | 3,623,188 |   |   |
| Revolving warehouse and  repurchase facilities               |       | 6,012             |       |                  | 433,241    |   |   |
| Borrowings                                                   |       | —            |       |                  | 16,487     |   |   |
| Other liabilities                                            |       | 16,678            |       |                  | 37,577     |   |   |
| Total liabilities                                            |       | 3,421,149         |       |                  | 4,110,493  |   |   |
| Stockholders’ equity                                    |       | 292,540           |       |                  | 310,635    |   |   |
| Total liabilities and stockholders’ equity              |       | $                 | 3,713,689  |                  |       | $ | 4,421,128 |   |   |
|                                                              |            |                   |            |                       |            |  |  |  |  |  |  |

 

| ** **                                          | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **June 30,**              | ** ** |
| **Condensed  Statement of Operations**              | ** ** | ** **                     | ** ** | **2006** | ** ** | **2005** | ** ** |
| Net interest  income                                |       | $                              | 34,077     |   | $ | 47,956 |   |
| Provision for  losses on loans held for investment  |       | (14,937                        | )          | (18,365 | ) |
| Net interest income after provision for loan losses |       | 19,140                         |       | 29,591 |   |
| Noninterest  expense                                |       | (3,880                         | )          | (4,199 | ) |
| Income before equity in net loss of subsidiary      |       | 15,260                         |       | 25,392 |   |
| Equity in net  loss of subsidiary                   |       | (33,999                        | )          | (32,935 | ) |
| Net loss                                            |       | $                              | (18,739    | ) | $ | (7,543 | ) |
|                                                     |            |                                |            |  |  |  |  |  |  |

 

**Note 11.**   Recently Issued Accounting Standards

In December of 2004,the Financial Accounting Standards Board (“FASB”) issued Statement of FinancialAccounting Standards No. 123R, *“Share-Based Payment”*(“SFAS123R”), an amendment of SFAS 123. This Statement requires companies to measurethe cost of employee services received in exchange for an award of equityinstruments based on the grant date fair value of the award. SFAS 123R requiresmeasurement of fair value of employee stock options using an option pricingmodel that takes into account the awarded options’ unique characteristics. SFAS123R requires charging the recognized cost to expense over the period theemployee provides services to earn the award, generally its vesting period. In April of2005, the Securities and Exchange Commission (“SEC”) revised the required adoptiondate of SFAS 123R. As a result of this change, the Company was required toadopt SFAS 123R effective 

14

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

January 1,2006. The adoption of SFAS 123R did not have a material impact on ourconsolidated financial statements.

In May 2005, the FASBissued Statement of Financial Accounting Standards No. 154, *“Accounting Changes and Error Corrections”* (“SFAS 154”),which replaces APB No. 20, *“Accounting Changes,”*and Statement of Financial Accounting Standards No. 3, *“Reporting Changes in Interim Financial Statements.”*SFAS154 changes the accounting for and reporting of a change in accountingprinciple. SFAS 154 requires retrospective application to prior periods’financial statements of voluntary changes in accounting principle and changesrequired by new accounting standards when the standard does not includespecific transition provisions, unless it is impracticable to do so. SFAS 154is effective for accounting changes and corrections of errors in fiscal yearsbeginning after December 15, 2005 and will only affect the Company’sconsolidated financial statements upon adoption of a voluntary change inaccounting principle by the Company.

In February 2006, theFASB issued Statement No. 155, *“Accounting for CertainHybrid Financial Instruments—an amendment of FASB Statements No. 133 and140”* (“SFAS 155”). SFAS 155 requires companies to evaluate theirinterests in securitized financial assets and determine whether the interestsare freestanding derivatives or hybrid financial instruments that may besubject to bifurcation. SFAS 155 provides companies with relief from having toseparately determine the fair value of an embedded derivative that wouldotherwise be required to be bifurcated from its host contract in accordancewith Statement No. 133, *“Accounting for DerivativeInstruments and Hedging Activities.”* SFAS 155 also clarifies thatconcentrations of credit risk in the form of subordination are not embeddedderivatives and amends Statement No. 140, *“Accountingfor Transfers and Servicing of Financial Assets and Extinguishments ofLiabilities”* (“SFAS 140”) to eliminate the prohibition on aqualifying special-purpose entity from holding a derivative financialinstrument that pertains to a beneficial interest other than another derivativefinancial instrument. SFAS 155 is effective for all financial instrumentsacquired or issued after January 1, 2007. The Company does not believe theadoption of SFAS 155 will have a significant impact on the Company’s financialposition or results of operations.

In March 2006,the FASB issued Statement No. 156, *“Accounting for Servicingof Financial Assets”* (“SFAS 156”), which amends SFAS 140. SFAS156 permits an entity to choose either of the following subsequent measurementmethods for each class of separately recognized servicing assets and servicingliabilities:

·       AmortizationMethod—Amortize servicing assets or servicing liabilities in proportion to and overthe 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.

15

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**InJune 2006, the FASB issued Interpretation No. 48, “*Accounting for Uncertainty in Income Taxes*” (“FIN 48”). FIN48 clarifies the accounting for uncertainty in income taxes recognized in anenterprise’s financial statements in accordance with Statement No. 109, “*Accounting for Income Taxes*” and prescribes a recognitionthreshold and measurement attribute for the financial statement recognition andmeasurement of a tax position taken or expected to be taken in a tax return.FIN 48 also provides guidance on derecognition, classification, interest andpenalties, accounting in interim periods, disclosure, and transition. FIN 48 iseffective for fiscal years beginning after December 15, 2006. The Companywill be evaluating the impact of FIN 48 on its consolidated financialstatements.**

**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, including without limitation the expected benefitsof the Merger and the sale of the wholesale operations to Accredited, underfederal securities laws. These statements are based on management’s currentexpectations and beliefs and are subject to a number of trends anduncertainties that could cause actual results to differ materially from thosedescribed in the forward-looking statements. The risks and uncertainties thatmay cause the Company’s performance and results to vary include: (i) limitedcash flow to fund operations and dependence on short-term financing facilities;(ii) changes in overall economic conditions and interest rates; (iii) increaseddelinquency rates in the portfolio; (iv) intense competition in themortgage lending industry; (v) adverse changes in the securitization andwhole loan market for mortgage loans; (vi) declines in real estate values;(vii) an inability to originate subprime hybrid/adjustable rate mortgage loans;(viii) obligations to repurchase mortgage loans and indemnify investors; (ix) concentrationof operations in California, Florida, New York and Texas; (x) theoccurrence of natural disasters; (xi) extensive government regulation; (xii) aninability to comply with the federal tax requirements applicable to REITs andeffectively operate within limitations imposed on REITs by federal tax rules;and (xiii) other risk factors as outlined in the Registration Statement onForm S-4 containing a Proxy Statement/Prospectus as filed byAccredited with the SEC on July 14, 2006 (the “Accredited S-4”).For a more complete discussion of these risks and uncertainties and informationrelating to the Company, see the Form 10-K for the year ended December 31,2005, the Accredited S-4, and other filings with the SEC made by theCompany. Aames Investment expressly disclaims any obligation to update orrevise any forward-looking statements in this report.

**RECENT EVENTS**

***Merger of Aames andAccredited.******  ***On May 24,2006, Aames Investment Corporation (“Aames Investment”), Accredited HomeLenders Holding Co. (“Accredited), and AHL Acquisition, LLC, a wholly ownedsubsidiary of Accredited (“Merger Sub”), entered into an Agreement and Plan ofMerger (the “Merger Agreement”), pursuant to which Aames Investment will bemerged with and into Merger Sub, with Merger Sub as the surviving corporation(the “Merger”). In March 2006, Aames announced a corporate restructuringthat would eliminate its REIT status at the parent company level and itstaxable REIT subsidiary would become the parent company. After entering intothe Merger Agreement, Aames Investment determined that it would not pursue therestructuring strategy.

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In connection with the pending mergertransaction, Aames Investment has scheduled a Special Meeting of itsstockholders on Thursday, September 14, 2006 at 9:00 a.m. Accreditedfiled with the Securities and Exchange Commission, or SEC, a RegistrationStatement on Form S-4 containing a Proxy Statement/Prospectus forthe stockholders of Accredited and the stockholders of Aames Investment. TheRegistration Statement was declared effective by the SEC on July 26, 2006.The final Proxy Statement/Prospectus was mailed to stockholders of Accreditedand stockholders of Aames Investment on or about August 9, 2006.

Pursuant to theMerger Agreement, upon consummation of the Merger each Aames Investmentstockholder will receive, in exchange for each share of Aames Investment commonstock held by such stockholder, *one* of thefollowing: 

·       cashin an amount equal to $51.94 (the closing price of Accredited’s common stock onMay 24, 2006, the date of the Merger Agreement) multiplied by the exchangeratio (which we explain below), *or*

·       afraction of a share of Accredited common stock equal to the exchange ratio. 

The exchange ratio was initially set at 0.1030. Thatmeans that on the day that we executed the Merger Agreement (and subject to thelimitations described below) each share of Aames Investmentcommon stock would have been converted into $5.35 in cash or a fractionof a share of Accredited common stock that had a value of $5.35 (based on theclosing price of Accredited common stock on the day we executed the Merger Agreement).However, the exchange ratio will be reduced by any dividends declared or paidby Aames Investment prior to the closing.We will reduce the exchange ratio by multiplying it by 1 minus a fraction, thenumerator of which is the amount of any dividends Aames Investment declares or pays prior to closing, and the denominatorof which is approximately $340 million. 

Under the Merger Agreement, Aames Investment is required to pay prior to closinga dividend in an amount equal to Aames Investment’sestimated 2006 REIT taxable income plus any other amounts that Aames Investment would need to distribute to qualifyas a REIT for its final taxable year and to avoid to the extent reasonablypossible the incurrence of income or excise tax.  Aames Investment currently estimates that, ifthe closing were to occur on September 30, 2006, it would pay a dividend ofapproximately $30 million in the aggregate (or $0.48 per share) pursuant tothis provision, although Aames Investment cannot provide any assurance as tothe amount of any such dividend.

Aames Investment and Accredited have made customaryrepresentations, warranties and covenants to each other in the Merger Agreement.Each of Aames Investment and Accredited has agreed, among other things, (i) tooperate its business in the ordinary course consistent with past practice andnot to take certain actions specified in the Merger Agreement, (ii) toconvene a special meeting of its stockholders to obtain requisite approvals ofits stockholders in connection with the Merger and the Merger Agreement and (iii) subjectto certain exceptions in the case of Aames Investment, to recommend approval ofsuch matters to its stockholders. Aames Investment has also agreed, subject tocertain exceptions, not to solicit, negotiate, provide non-public informationin furtherance of, approve, recommend or otherwise declare advisable analternative acquisition proposal. Aames Investment will be required to paydividends prior to the closing of the transaction to the extent necessary tomaintain its status as a REIT.

Consummation of the Merger is subject to customaryconditions, including the approval of the merger by the holders of Aames Investmentcommon stock, the approval of the issuance of shares of Accredited common stockin connection with the Merger by the holders of Accredited common stock, theabsence of any law or order prohibiting the closing and the expiration orearlier termination of any required waiting period under the Hart-Scott-RodinoAntitrust Improvements Act of 1976 and the receipt of other governmentalapprovals. In addition, each party’s obligation to consummate the Merger issubject to (i) the material accuracy of the representations and warrantiesof the other party and (ii) material compliance of 

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the other party with itscovenants. Accredited’s obligation to consummate the Merger is also subject tothe delivery of an opinion from counsel to Aames Investment with respect toAames Investment’s status as a REIT.

The MergerAgreement contains customary termination rights for Aames Investment andAccredited, including, among others, the right of Aames Investment to terminatethe Merger Agreement if it receives a superior proposal, subject to (i) Accredited’sright to match the superior proposal within three business days and (ii) paymentto Accredited by Aames Investment of a $10.0 million termination fee. Inaddition, Aames Investment must payAccredited a $10 million termination fee if the Merger is terminated: 

·       Byeither party, if Aames Investment doesnot obtain the stockholder approval required to approve the Merger, a proposalor intention to make a proposal for an alternative transaction has been made publiclyprior to termination and Aames Investment entersinto an agreement or consummates an alternative transaction within 12 months ofthe termination for consideration equal to or greater than $6.00 per share ofAames Investment common stock. 

·       ByAccredited, 

·       dueto Aames Investment’s willful breach, aproposal or intention to make a proposal for an alternative transaction hasbeen made publicly prior to termination and Aames Investmententers into an agreement or consummates an alternative transactionwithin 12 months of the termination for consideration equal to or greater than$5.00 per share of Aames Investment commonstock; or 

·       dueto Aames Investment’s Board of Directorswithdrawing or adversely modifying its recommendation for approval of the Mergerand Aames Investment enters into an agreement or consummates an alternativetransaction within 12 months of the termination for consideration equal to orgreater than $6.00 per share of Aames Investment common stock.

***Sale of Aames’Wholesale Operations to Accredited.***   OnJune 26, 2006, Aames Investment announced that its wholesale operationswould be sold to Accredited for approximately $4.0 million plus the assumptionof certain liabilities under an agreement dated June 23, 2006. The salewas completed in July 2006. The sale was intended to reduce employeeattrition and maximize the potential synergies from the combination of theAccredited and Aames Investment wholesale operations at the present time thatwould otherwise occur as part of the merger of Accredited and Aames Investmentcontemplated to occur in the third quarter of 2006.

As part of the sale, Accredited hired approximately198 of Aames Investment’s wholesale sales and processing personnel, and assumedcertain liabilities of the wholesale business, including the lease of AamesInvestment’s Jacksonville, Florida, wholesale operations center.

The purchase of AamesInvestment’s wholesale operation does not otherwise affect the MergerAgreement, or any of the terms under which Accredited will acquire AamesInvestment, including the consideration to be paid to the Aames Investment stockholders for their common stock.

**GENERAL**

Aames Investment was formed in February 2004 tobuild and manage a portfolio of high yielding subprime residential mortgage loansto offer its stockholders the opportunity for attractive dividend yields andearnings growth. In November 2004, we completed an initial publicoffering, and, concurrently with that offering, the 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 its retail channel under the name 

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“Aames Home Loan.” From1996 through July 2006, Aames Financial also originated loans through itswholesale channel. Our strategy is to use our equity capital and funds borrowedunder revolving warehouse and repurchase facilities to finance our mortgageloan production, and to sell our loan production to third parties in thesecondary markets. We built a REIT portfolio of mortgage loans from our initialpublic offering in November, 2004, through May, 2006, by retaining a portion ofour mortgage loan originations, largely hybrid/adjustable rate mortgage loansor ARMs. We built our REIT portfolio using our equity capital, borrowingsunder revolving warehouse and repurchase facilities, and on-balance sheetsecuritizations of mortgage loans. Since announcing the proposed Merger withAccredited, we no longer retain mortgage loans for our REIT portfolio and sellall of our loan production in the secondary markets.

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. Thetaxable income generated by Aames Financial is subject to regular corporateincome tax.

**Mortgage LoanPortfolio Management**

In building our REIT portfolio, we invest in subprimeone-to-four family, residential mortgage loans, operating as a long-termportfolio investor. We purchase loans originated by Aames Financial that weanticipate holding on our balance sheet in our REIT portfolio, largelyhybrid/adjustable rate mortgage loans. Aames Financial services the loans inour 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 related to changes in the benchmark interest rate used in thevariable rate index, usually a London Interbank 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. We may also enter interestrate swap agreements, whereby we pay a fixed rate and receive a floating ratebased on a notional amount. With respect to interest rate cap agreements andinterest rate swap agreements, any net payments under, or fluctuations in thefair 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.

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**REIT Compliance**

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

Under the MergerAgreement, we are required to pay prior to closing of the Merger a dividend inthe amount equal to our estimated 2006 REIT taxable income, plus any otheramounts that we would need to distribute in order to qualify as a REIT for ourfinal taxable year and to avoid to the extent reasonably possible theincurrence of income or excise tax.

**Mortgage LoanOriginations**

Aames Financial originates one-to-four familyresidential mortgage loans, which are the primary source of the loans that wehold in our on-balance sheet REIT portfolio of loans held for investment, andof 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 as a result, our loanorigination volume is generally less cyclical than conventional mortgagelending, which has a higher percentage of rate/term refinance loans. However,given recent rises in interest rates, we believe that subprime borrowers withhybrid ARMs or interest only loans may seek to refinance when the initial fixedperiod expires to avoid the increased payment after the interest fixed orinterest only period.

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

Aames Financialsells whole loans to third parties on a servicing-released basis in order tocapture gain on sale income from these loans and to grow our equity capitalbase on a consolidated basis. Aames Financial generally sells these loanswithin 45 days of funding and services these loans during the period betweenorigination and transfer of servicing to the buyer, which is generally within90 days after the sale of the loan. Aames Financial generates income primarilyfrom:

·       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 in refinancing to refinance with us. Mortgage loanservicing provides fee income for Aames Financial in the form of normalcustomer 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.******  ***Wehave a REIT portfolio of loans held for investment in addition to AamesFinancial’s portfolio of loans held for sale. We differentiate our interestincome and expense into two components: “Interest income—loans held for sale”and “Interest income—loans held for investment.” Interest expense is alsodifferentiated between “Interest expense—loans held for sale” and “Interestexpense—loans held for investment.” We also record a provision for loan losseson loans held for investment, which increases our allowance for loan losses,based on an estimate of probable and inherent losses in our portfolio of loansheld 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.” 

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Because Aames Financialintends to sell its loans to third parties in the secondary markets, wecontinue to show these loans as “Loans held for sale, at lower of cost ormarket.” Bonds that we issue in our on-balance sheet securitizations tofinance our REIT portfolio of loans held for investment are shown as “Financingson loans held for investment.” Warehouse financing of our loans held for saleand loans held for investment but not yet securitized are shown as “Revolvingwarehouse 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 offinancial assets is to be treated as a sale or a secured financing undergenerally accepted accounting principles, or GAAP. We intend for our on-balancesheet securitizations to be treated as secured financings and, accordingly, oneof our critical accounting policies is compliance with the SFAS 140requirements necessary to obtain secured financing treatment for oursecuritizations.

***Allowance forLosses on Mortgage Loans Held for Investment.****  *For mortgageloans held for investment, we maintain an allowance for loan losses based onour estimate of losses inherent and probable as of the balance sheet date. Weview our mortgage loans held for investment as a homogeneous pool of loans thatexhibit similar characteristics, including default probabilities and lossseverities. We evaluate the adequacy of this allowance monthly, givingconsideration to factors such as the current performance of the loans,delinquency status of the loans, historical performance of similar loans,credit characteristics of the portfolio, the value of the underlying collateraland 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 isadequate for probable and inherent losses in the portfolio of mortgage loansheld for investment. Provisions for losses are charged to our consolidatedstatement of operations. Charge-offs of mortgage loans held for investment arecharged to the allowance. While we use available information to estimate losseson 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.******  ***Ourcurrent loan disposition strategy for loans relies on whole loan sales. We sellour loans in whole loan sale transactions on a cash basis. In whole loan saletransactions, the buyer acquires all future rights (including mortgageservicing 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 

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loans in our condensedconsolidated statements of operations and the corresponding allowance isrecorded in accounts payable and accrued expenses in our condensed consolidatedbalance sheets. At the time we repurchase a loan, the estimated loss on theloan is charged against this allowance and recorded as a reduction of the basisof 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 condensed consolidated statement of operations and the valuationallowance is recorded as an offset to loans held for sale in our condensedconsolidated balance sheets. At the time we sell a loan having theaforementioned attributes, the estimated loss on the loan is charged againstthis allowance.

***Accounting forIncome Taxes.***   We elected to qualify as a REIT for U.S.federal income tax purposes for the six months ended December 31, 2004 andfor the year ended December 31, 2005. This means that generally we werenot subject to U.S. federal income taxes on the REIT income that we distributedto our 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.

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**RESULTS OFOPERATIONS**

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

| ** **                                                                  | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase** | ** ** |
|-----------------------------------------------------------------------------|------------|-------------------------------------------------|------------|--------------|------------|-----------------------------------------------|------------|--------------|------------|
| ** **                                                                  | ** ** | **2006**                                        | ** ** | **2005**     | ** ** | **(Decrease)**                                | ** ** | **2006**     | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| Interest income                                                             |       | $                                               | 106,112    |         | $          | 74,943                                        |       |         | $          | 31,169 |   |   | $ | 218,157 |   | $ | 128,595 |   |   | $ | 89,562 |   |   |
| Interest expense                                                            |       | 78,267                                          |       | 46,446       |       |                                          | 31,821     |         |       | 151,214 |   | 58,362 |   |   | 92,852 |   |   |
| Net interest income                                                         |       | 27,845                                          |       | 28,497       |       |                                          | (652       | )            |       | 66,943 |   | 70,233 |   |   | (3,290 | ) |   |
| Provision for  loan losses                                                  |       | 2,336                                           |       | 11,865       |       |                                          | (9,529     | )            |       | 14,937 |   | 18,365 |   |   | (3,428 | ) |   |
| Net interest income after provision for loan  losses                   |       | 25,509                                          |       | 16,632       |       |                                          | 8,877      |         |       | 52,006 |   | 51,868 |   |   | 138 |   |   |
| Noninterest income:                                                         |       |                                            |       |         |       |                                          |       |         |       |   |   |   |   |   |   |   |   |
| Gain on sale of loans                                                       |       | 22,538                                          |       | 4,666        |       |                                          | 17,872     |         |       | 28,533 |   | 10,349 |   |   | 18,184 |   |   |
| Loan servicing                                                              |       | 2,537                                           |       | 1,364        |       |                                          | 1,173      |         |       | 4,960 |   | 2,404 |   |   | 2,556 |   |   |
| Total noninterest income                                                    |       | 25,075                                          |       | 6,030        |       |                                          | 19,045     |         |       | 33,493 |   | 12,753 |   |   | 20,740 |   |   |
| Net interest  income after provision for loan losses and noninterest income |       | 50,584                                          |       | 22,662       |       |                                          | 27,922     |         |       | 85,499 |   | 64,621 |   |   | 20,878 |   |   |
| Noninterest expense:                                                        |       |                                            |       |         |       |                                          |       |         |       |   |   |   |   |   |   |   |   |
| Personnel                                                                   |       | 21,570                                          |       | 20,980       |       |                                          | 590        |         |       | 46,461 |   | 43,327 |   |   | 3,134 |   |   |
| Production                                                                  |       | 9,079                                           |       | 8,577        |       |                                          | 502        |         |       | 18,456 |   | 17,377 |   |   | 1,079 |   |   |
| General and administrative                                                  |       | 12,721                                          |       | 15,015       |       |                                          | (2,294     | )            |       | 26,868 |   | 25,828 |   |   | 1,040 |   |   |
| Total noninterest expense                                                   |       | 43,370                                          |       | 44,572       |       |                                          | (1,202     | )            |       | 91,785 |   | 86,532 |   |   | 5,253 |   |   |
| Income (loss)  before income taxes                                          |       | 7,214                                           |       | (21,910      | )          |                                          | 29,124     |         |       | (6,286 | ) | (21,911 | ) |   | 15,625 |   |   |
| Income tax  provision                                                       |       | 40                                              |       | 665          |       |                                          | (625       | )            |       | 57 |   | 1,430 |   |   | (1,373 | ) |   |
| Net income (loss)                                                           |       | $                                               | 7,174      |         | $          | (22,575                                       | )          |         | $          | 29,749 |   |   | $ | (6,343 | ) | $ | (23,341 | ) |   | $ | 16,998 |   |   |

 

**Interest Income andInterest Expense**

***Interest income.****  *Interest incomeincludes interest earned on loans held for investment and loans held for sale.To a lesser extent, interest income also includes interest on short-termovernight investments, prepayment fees earned on loans held for investment,interest income on in-the-money interest rate cap and forward interest rateswap agreements, and amortization of net deferred loan origination costs onmortgage 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.

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

| ** **                                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase** | ** ** |
|------------------------------------------------------------|------------|-------------------------------------------------|------------|--------------|------------|-----------------------------------------------|------------|--------------|------------|
| ** **                                                 | ** ** | **2006**                                        | ** ** | **2005**     | ** ** | **(Decrease)**                                | ** ** | **2006**     | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| Interest earned on:                                        |       |                                            |       |         |       |                                          |       |         |       |   |   |   |   |   |   |   |   |
| Loans held for investment                                  |       | $                                               | 63,701     |         | $          | 59,261                                        |       |         | $          | 4,440 |   |   | $ | 134,878 |   | $ | 100,865 |   |   | $ | 34,013 |   |   |
| Loans held for sale                                        |       | 19,585                                          |       | 6,754        |       |                                          | 12,831     |         |       | 39,510 |   | 14,620 |   |   | 24,890 |   |   |
| Overnight investments                                      |       | 1,301                                           |       | 520          |       |                                          | 781        |         |       | 2,341 |   | 740 |   |   | 1,601 |   |   |
| Income from  derivative financial instruments              |       | 15,883                                          |       | 4,629        |       |                                          | 11,254     |         |       | 29,518 |   | 7,258 |   |   | 22,260 |   |   |
| Prepayment  penalty fees on loans held for investment |       | 6,767                                           |       | 4,856        |       |                                          | 1,911      |         |       | 14,282 |   | 6,740 |   |   | 7,542 |   |   |
| Amortization of net  deferred loan origination costs       |       | (1,180                                          | )          | (1,143       | )          |                                          | (37        | )            |       | (2,498 | ) | (1,815 | ) |   | (683 | ) |   |
| Other                                                      |       | 55                                              |       | 66           |       |                                          | (11        | )            |       | 126 |   | 187 |   |   | (61 | ) |   |
| Total interest income                                      |       | $                                               | 106,112    |         | $          | 74,943                                        |       |         | $          | 31,169 |   |   | $ | 218,157 |   | $ | 128,595 |   |   | $ | 89,562 |   |   |

 

Interest income grew by $31.2 million, to $106.1million, during the three months ended June 30, 2006 compared to the threemonths ended June 30, 2005. This was primarily due to increases of $12.8million, $11.3 million, $4.4 million, $1.9 million and $0.8 million in interestearned on loans held for sale, income from derivative financial instruments,interest earned on our REIT portfolio of loans held for investment, prepaymentpenalty fees, and interest on overnight investments, respectively. The growthin interest on loans held for investment and loans held for sale was primarilydue to higher balances in these portfolios during the three months ended June 30,2006 compared to the same period a year ago. The income from derivativefinancial instruments primarily related to remittances to us fromcounterparties on in-the-money interest rate cap agreements used to hedgeinterest rate exposure on our REIT portfolio and related financings. The growthin prepayment penalty fees earned on early loan pay-offs was due to a higheraverage balance in our REIT portfolio during the three months ended June 30,2006 compared to the three months ended June 30, 2005, and the seasoningof the portfolio since its inception in December 2004.

Interest income grew by $89.6 million, to $218.2million, during the six months ended June 30, 2006 compared to the sixmonths ended June 30, 2005. This was primarily due to increases of$34.0 million, $24.9 million, $22.3 million, $7.5 million, and $1.6million in interest earned on our REIT portfolio of loans held for investment,interest earned on loans held for sale, income from derivative financialinstruments, prepayment penalty fees, and interest on overnight investments,respectively. The growth in interest on loans held for investment and loansheld for sale was primarily due to higher balances in these portfolios duringthe six months ended June 30, 2006 compared to the same period a year ago.The income from derivative financial instruments primarily related toremittances to us from counterparties on in-the-money interest rate capagreements 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 thesix months ended June 30, 2006 compared to the six months ended June 30,2005, and the seasoning of the portfolio since its inception in December 2004.

***Interest expense.****  *Interestexpense includes interest incurred on the balances outstanding of financings onloans held for investment, revolving warehouse and repurchase facilities, andborrowings. Interest expense also includes fair value adjustments to derivativeinstruments used to hedge interest rate risk on our financings of mortgageloans held for investment, amortization of debt issuance costs and debtdiscount on financings on mortgage loans held for investment and theamortization of commitment fees on revolving warehouse and repurchasefacilities.

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

| ** **                                                                                                                                       | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|--------------|------------|-----------------------------------------------|------------|--------------|------------|
| ** **                                                                                                                                       | ** ** | **2006**                                        | ** ** | **2005**     | ** ** | **(Decrease)**                                | ** ** | **2006**     | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| Interest incurred on:                                                                                                                            |       |                                            |       |         |       |                                          |       |         |       |   |   |   |   |   |   |   |   |
| Financings on loans held for investment                                                                                                          |       | $                                               | 48,238     |         | $          | 22,466                                        |       |         | $          | 25,772 |   |   | $ | 92,206 |   | $ | 34,637 |   |   | $ | 57,569 |   |   |
| Revolving warehouse and repurchase facilities                                                                                                    |       | 15,550                                          |       | 9,860        |       |                                          | 5,690      |         |       | 34,605 |   | 17,638 |   |   | 16,967 |   |   |
| Borrowings                                                                                                                                       |       | 38                                              |       | —       |       |                                          | 38         |         |       | 108 |   | 44 |   |   | 64 |   |   |
| Amortization of commitment  fees, debt issuance costs, and debt discount                                                                         |       | 4,823                                           |       | 2,471        |       |                                          | 2,352      |         |       | 9,370 |   | 3,790 |   |   | 5,580 |   |   |
| Mark to market  (gain) loss on derivative financial instruments designed to hedge interest  rate risk on financings of loans held for investment |       | 9,499                                           |       | 11,495       |       |                                          | (1,996     | )            |       | 14,685 |   | 1,963 |   |   | 12,722 |   |   |
| Bank charges and  other                                                                                                                          |       | 119                                             |       | 154          |       |                                          | (35        | )            |       | 240 |   | 290 |   |   | (50 | ) |   |
| Total interest expense                                                                                                                           |       | $                                               | 78,267     |         | $          | 46,446                                        |       |         | $          | 31,821 |   |   | $ | 151,214 |   | $ | 58,362 |   |   | $ | 92,852 |   |   |

 

Interest expense grew by $31.8 million, to $78.3million, during the three months ended June 30, 2006 compared to the threemonths ended June 30, 2005. This was primarily due to increases of$25.8 million, $5.7 million, and $2.4 million in interest incurred onfinancings on loans held for investment, interest incurred on revolvingwarehouse and repurchase facilities, and amortization of commitment fees, debtissuance costs and debt discount, respectively. This was partially offset by adecrease of $2.0 million in the negative mark to fair value on derivativefinancial instruments in place to hedge interest rate exposure on ourfinancings of loans held for investment. The growth in interest on financingsof loans held for investment was due to a higher borrowing balance and higherinterest rates during the three months ended June 30, 2006 compared to thesame period 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 June 30, 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 June 30, 2006 compared to the same period a year ago.

Interest expense grew by $92.9 million, to $151.2million, during the six months ended June 30, 2006 compared to the sixmonths ended June 30, 2005. This was primarily due to increases of$57.6 million, $17.0 million, $12.7 million, and $5.6 million in interestincurred on financings on loans held for investment, interest incurred onrevolving warehouse and repurchase facilities, the increase in the negativemark to fair value on derivative financial instruments in place to hedgeinterest rate exposure on our financings of loans held for investment, andamortization of commitment fees, debt issuance costs and debt discount,respectively. The growth in interest on financings of loans held for investmentwas due to a higher borrowing balance and higher interest rates during the sixmonths ended June 30, 2006 compared to the same period a year ago. Theincrease in interest on revolving warehouse and repurchase facilities was dueto higher average borrowings and interest rates associated with our revolvingwarehouse and repurchase facilities used to fund loans held for sale and loansheld for investment not yet securitized during the six months ended June 30,2006 compared to the six-month period a year ago. The growth in amortization ofcommitment fees, debt issuance costs and debt discount was primarily due toincreased 

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debt issuance costs anddebt discount related to higher financings on loans held for investment duringthe six months ended June 30, 2006 compared to the same period a year ago.

***Provision for LoanLosses.******  ***The amounts provided for loan losses aredetermined based upon quarterly evaluations of the portfolio of loans held forinvestment. In our evaluation, we apply various judgments, assumptions andestimates concerning the impact certain factors might have on the amountsprovided. Such factors include actual and past loan loss experience, loanportfolio composition and risk, delinquencies, underlying collateral value andcurrent economic conditions that may affect a borrower’s ability to pay.

During the three and sixmonths ended June 30, 2006, the provision for loan losses was $2.3 millionand $14.9 million, respectively, compared to $11.9 million and $18.4 millionduring the three and six months ended June 30, 2005, respectively. Thedecrease in the provision for loan losses during the three and six months endedJune 30, 2006 from the comparable periods a year ago resulted frommanagement’s evaluation of delinquency levels and charge-off trends in theportfolio of loans held for investment coupled with management’s assessment ofcredit loss risk in the loans held for investment portfolio which has declinedsince December 31, 2005. During the three months ended June 30, 2006,we saw a decline in the rate at which loans were migrating into delinquencystatus compared to what we had previously assumed and we have begun to seeearly period delinquencies trend closer to expected levels than in priorperiods. In addition, during the three months ended June 30, 2006, netcharge-offs were below expected levels. Finally, the unpaid principal balanceof the portfolio loans held for investment at June 30, 2006 was $3.4 billion,a $700.0 million decline from the $4.1 billion reported at December 31,2005.

**Noninterest Income**

***Gain on Sale ofLoans.***   Gainon sale of loans includes gain from whole loan sale transactions, realized loanorigination fees and costs, provisions for representation, warranty and othermiscellaneous losses, and miscellaneous costs related to loan sale activities.Gain on sale of loans is impacted by the timing and mix of loan originationsand sales as, pursuant to SFAS 91, net loan origination fees and costs relatedto mortgage loans originated and held for sale are deferred and recognized as acharge or credit to gain on sale of loans at the time the mortgage loans aresold.

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

| ** **                                 | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase** | ** ** |
|--------------------------------------------|------------|-------------------------------------------------|------------|--------------|------------|-----------------------------------------------|------------|--------------|------------|
| ** **                                 | ** ** | **2006**                                        | ** ** | **2005**     | ** ** | **(Decrease)**                                | ** ** | **2006**     | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| Gain on whole  loan sales                  |       | $                                               | 24,637     |         | $          | 7,060                                         |       |         | $          | 17,577 |   |   | $ | 34,498 |   | $ | 11,643 |   |   | $ | 22,855 |   |   |
| Loan origination  fees (costs), net        |       | 13,094                                          |       | 2,617        |       |                                          | 10,477     |         |       | 20,619 |   | 4,714 |   |   | 15,905 |   |   |
| Provision for  secondary market allowances |       | (15,095                                         | )          | (4,016       | )          |                                          | (11,079    | )            |       | (26,349 | ) | (4,801 | ) |   | (21,548 | ) |   |
| Other                                      |       | (98                                             | )          | (995         | )          |                                          | 897        |         |       | (235 | ) | (1,207 | ) |   | 972 |   |   |
| Total gain on  sale of loans               |       | $                                               | 22,538     |         | $          | 4,666                                         |       |         | $          | 17,872 |   |   | $ | 28,533 |   | $ | 10,349 |   |   | $ | 18,184 |   |   |

 

Gain on sale of loans grew by $17.9 million, to $22.5million, during the three months ended June 30, 2006 from the comparablethree-month period a year ago. This was primarily due increases of $17.6 millionand $10.5 million in gain on sale from whole loan sale transactions and loanorigination fees realized on loans sold, respectively, partially offset by a$11.1 million increase in the provision for secondary market allowances.

The growth in gain on whole loan sales was primarilydue to a $400.0 million increase in whole loan sales from $1.1 billion, to$1.5 billion, during the three months ended June 30, 2006 compared to thesame 

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period a year ago. Duringthe quarter ended June 30, 2006, we sold a larger percentage of our loanproduction into the secondary markets compared to the comparable quarter in2005, when we were retaining a significant portion of our loan production tobuild our REIT portfolio of loans held for investment. The growth in loanorigination fees was principally due to a higher percentage of retail loansoriginated and sold during the three months ended June 30, 2006 comparedto the same period a year ago. The increase in the provision for secondarymarket allowances during the three months ended June 30, 2006 over theprovision during the comparable period a year ago is due primarily to carryinghigher balances of mortgage loans held for sale secured by second trust deedswhich had lower valuations at June 30, 2006 when compared to a year ago.  In addition, at June 30, 2006, we carriedhigher levels of mortgage loans that were delinquent, had collateraldeficiencies or had other attributes that affected their sale potential. To alesser extent, the increase in the provision for secondary allowances wasattributable to increased potential representation and warranty loss exposureas a consequence of having reverted to a pattern of selling a majority of ourloan production in whole loan sales for cash during the three months ended June 30,2006 as compared to the three months ended June 30, 2005 when the majorityof our loan production was used to build our REIT portfolio of loans held forinvestment.

Gain on sale of loans grew by $18.2 million, to $28.5million, during the six months ended June 30, 2006 from the comparablesix-month period a year ago. This was primarily due increases of $22.9 millionand $15.9 million in gain on sale from whole loan sale transactions and loanorigination fees realized on loans sold, respectively, partially offset by a$21.5 million increase in the provision for secondary market allowances.

The growth in gain on whole loan sales was primarilydue to an increase in whole loan sales of $700.0 million, from$2.3 billion, to $3.0 billion, during the six months ended June 30,2006 compared to the same period a year ago. During the six months ended June 30,2006, we sold a larger percentage of our loan production into the secondarymarkets compared to the comparable quarter in 2005, when we were retaining asignificant portion of our loan production to build our REIT portfolio of loansheld for investment. The growth in loan origination fees was principally due toa higher percentage of retail loans originated and sold during the six monthsended June 30, 2006 compared to the same period a year ago. The increasein the provision for secondary market allowances during the six months ended June 30,2006 over the provision during the comparable period a year ago is dueprimarily to carrying higher balances of mortgage loans held for sale securedby second trust deeds which had lower valuations at June 30, 2006 whencompared to a year ago.  In addition,during the six months ended June 30, 2006 we carried higher levels ofmortgage loans that were delinquent, had collateral deficiencies or had otherattributes that affected their sale potential. To a lesser extent, the increasein the provision for secondary allowances was attributable to increasedpotential representation and warranty loss exposure as a consequence of havingreverted to a pattern of selling a majority of our loan production in wholeloan sales for cash during the six months ended June 30, 2006 as comparedto the comparable period a year ago when the majority of our loan productionwas used to build our REIT portfolio of loans held for investment.

***Loan Servicing.***   Loan servicingrevenue consists of late charges and other fees we earn in connection with ourloan servicing activities. Loan servicing revenue also includes prepayment feeson loans held for sale. Loan servicing revenue grew by $1.2 million, to $2.5million, during the three months ended June 30, 2006 from the three monthsended June 30, 2005. This was primarily due to increases of$0.5 million and $0.8 million in late and prepayment fees, respectively,partially offset by an increase of $0.1 million in compensating interestfor the three months ended June 30, 2006. Loan servicing revenue grew by$2.6 million, to $5.0 million, during the six months ended June 30,2006 from the six months ended June 30, 2005. This was primarily due toincreases of $1.3 million and $1.5 million in late and prepayment fees,respectively, partially offset by a decrease of $0.3 million in servicingfees and an increase of $0.1 million in compensating interest for the sixmonths ended June 30, 2006.

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**Total NoninterestExpense**

***Personnel.*****  **Personnelexpense includes salaries, payroll taxes and medical and other employeebenefits. Personnel expense also includes commissions that are generallyrelated to our loan origination volume, as retail and broker account executivesearn incentives on funded loans. Pursuant to SFAS 91, direct personnel costsincurred on mortgage loans originated are deferred and amortized to interestincome over the estimated economic life of the loans. When the loans are sold,the deferred costs are recognized as a charge to gain on sale.

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

| ** **                       | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase** | ** ** |
|----------------------------------|------------|-------------------------------------------------|------------|--------------|------------|-----------------------------------------------|------------|--------------|------------|
| ** **                       | ** ** | **2006**                                        | ** ** | **2005**     | ** ** | **(Decrease)**                                | ** ** | **2006**     | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| Compensation                     |       | $                                               | 37,318     |         | $          | 38,162                                        |       |         | $          | (844 | ) |   | $ | 80,375 |   | $ | 73,844 |   |   | $ | 6,531 |   |   |
| Deferred loan  origination costs |       | (18,600                                         | )          | (19,434      | )          |                                          | 834        |         |       | (39,749 | ) | (36,054 | ) |   | (3,695 | ) |   |
| Medical and other  benefits      |       | 2,496                                           |       | 2,016        |       |                                          | 480        |         |       | 5,226 |   | 4,727 |   |   | 499 |   |   |
| Other                            |       | 356                                             |       | 236          |       |                                          | 120        |         |       | 609 |   | 810 |   |   | (201 | ) |   |
| Total personnel expense          |       | $                                               | 21,570     |         | $          | 20,980                                        |       |         | $          | 590 |   |   | $ | 46,461 |   | $ | 43,327 |   |   | $ | 3,134 |   |   |

 

Personnel expense grew by $0.6 million to $21.6million, during the three months ended June 30, 2006 from the comparablethree-month period a year ago. This was principally due to a decrease of $0.8million in deferred loan origination costs, a $0.5 million increase in medicaland other benefits, and a $0.1 million increase in other personnel expense,partially offset by a $0.8 million decrease in compensation expense. The $0.8million decrease in deferred personnel costs on mortgage loans originated wasprimarily due to the $540.9 million, or 55.6%, decline in wholesale production,which has a lower incremental personnel cost than retail production, partiallyoffset by the $139.2 million, or 22.3%, growth in retail production, during thethree months ended June 30, 2006 compared to the same period last year. The$0.5 million increase in medical and other benefits during the three months endedJune 30, 2006 over the comparable period a year ago is primarily due to a$0.3 million increase in group insurance costs and a $0.2 million increase inthe 401(k) company match. During the three months ended June 30,2005, the forfeiture reserve was used to match employee contributions to the401(k) plan. The $0.1 million increase in other personnel expense duringthe three months ended June 30, 2006 over the comparable period a year agowas primarily due to an increase in employee recruitment. The $0.8 milliondecrease in compensation expense resulted primarily from a $1.6 milliondecrease in commissions, bonuses and incentives, partially offset by a $0.5million increase in compensation costs related to the issuance of restrictedstock awards and a $0.2 million increase in overtime. The $1.6 million decreasein commissions, bonuses and incentives was primarily due to the $401.7 million,or 25.2%, decrease in total loan production during the three months ended June 30,2006 when compared to the same three-month period a year ago, partially offsetby a $0.2 million increase related to the activity in our loan closingsubsidiary, AaRCS.

Personnel expense grew by $3.1 million, to $46.5million, during the six months ended June 30, 2006 from the comparable six-monthperiod a year ago. This was principally due to an increase of $6.5 millionin compensation expense and a $0.5 million increase in medical and otherbenefits, partially offset by a $3.7 million increase in deferred loanorigination costs and a $0.2 million decrease in other personnel expense. The$6.5 million growth in compensation expense resulted primarily from a $2.9million increase in commissions, bonuses and incentives, together with a $0.9million increase in management bonus incentives, a $1.4 million increase insalary expense and a $0.1 million charge for termination benefits related tothe closure of two of our wholesale operating centers on March 31, 2006.In addition, compensation costs related to the issuance of restricted stockawards, payroll taxes and temporary help costs grew by $0.8 million, $0.2million, and $0.3 million, respectively, during the six months ended 

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June 30, 2006when compared to the same six month period a year ago. The $2.9 million growth in commissions, bonuses and incentives wasprimarily due to the $368.7 million, or 32.3%, increase in retail loanproduction during the six months ended June 30, 2006 when compared to thesame six-month period a year ago, as well as to a $0.5 million increase relatedto the activity in our loan closing subsidiary, AaRCS. This was partiallyoffset by the $566.6 million, or 31.2%, decrease in wholesale loan productionduring the six months ended June 30, 2006 when compared to the six-monthperiod a year ago. The $3.7 million increase in deferred personnel costson mortgage loans originated was primarily due to the change in the compositionof loan production during the six months ended June 30, 2006. Productionduring the six months ended June 30, 2006 had a higher percentage ofretail production, which has a higher incremental personnel cost, when comparedto the mix of loans originated during the six months ended June 30, 2005,which was comprised of more wholesale production. The $0.2 million decline inother personnel expense during the six months ended June 30, 2006 from thecomparable period a year ago was attributable to lower employee recruitmentcosts.

***Production.*****  **Productionexpense grew by $0.5 million, to $9.1 million, during the three months ended June 30,2006 from the three months ended June 30, 2005. This was primarily due toan increase of $0.6 million in advertising costs.

Production expense, when expressed as a percentage oftotal loan origination volume, grew to 0.8% for the three months ended June 30,2006 over 0.5% for the three months ended June 30, 2005, primarily due toa decrease in production volume while production expense increased during thethree months ended June 30, 2006 compared to the three months ended June 30,2005.

Production expense grew by $1.1 million, to $18.5million, during the six months ended June 30, 2006 from the six monthsended June 30, 2005. This was primarily due to an increase of$1.2 million in advertising costs.

Production expense, when expressed as a percentage oftotal loan origination volume, grew to 0.7% for the six months ended June 30,2006 over 0.6% for the six months ended June 30, 2005, primarily due to adecrease in production volume while production expense increased during thesix months ended June 30, 2006 compared to the six months ended June 30,2005.

***General******and******Administrative.***   General andadministrative expense declined by $2.3 million, to $12.7 million, duringthe three months ended June 30, 2006 from the three months endedJune 30, 2005. This was primarily due to a $3.1 million decrease in legalexpense, partially offset by a $0.2 million increase in professional fees.

During the three months ended June 30, 2006 and2005, our rent payments totaled $2.8 million and $3.4 million, respectively, andwe received total sublease payments of $0.3 million and $0.4 million,respectively.

General and administrative expense grew by $1.0million, to $26.9 million, during the six months ended June 30, 2006from the six months ended June 30, 2005. This was primarily due to a $2.5million increase in occupancy expense, a $0.2 million increase in communicationexpense and a $0.4 million increase in professional fees, partially offset by a$3.2 million decrease in legal expense. Contributing to the growth in occupancyexpense was a $0.7 million charge for the termination of the leases at two ofour wholesale operating centers and a $1.5 million charge for the terminationof the lease at our former headquarters location due to a change in its leasestatus.

During the six monthsended June 30, 2006 and 2005, our rent payments totaled $7.8 million and$6.2 million, respectively, and we received total sublease payments of$0.6 million and $0.8 million, respectively.

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**Income TaxProvision (Benefit)**

During the three months ended June 30, 2006 and2005, we recorded an income tax provision of $0.04 million and $0.7million, respectively. Our $0.04 million income tax provision for the threemonths ended June 30, 2006 differed from an expected federal income taxprovision of $2.5 million calculated at the federal marginal tax rate of 35.0%primarily due to the $2.7 million benefit related to the non-taxabilityof the REIT earnings and the $0.1 million state tax benefit, partially offsetby the $0.3 million provision resulting from the increase in the tax valuationallowance. Our $0.7 million income tax provision for the three months ended June 30,2005 differed from an expected federal income tax benefit of $7.7 millioncalculated at the federal marginal tax rate of 35.0% primarily due to the $9.5million provision resulting from the increase in the tax valuation allowance,partially offset by the $0.5 million benefit related to the non-taxability ofthe REIT earnings and the $0.7 million state tax benefit.

During the six monthsended June 30, 2006 and 2005, we recorded an income tax provision of $0.06 millionand $1.4 million, respectively. Our $0.06 million income tax provision for thesix months ended June 30, 2006 differed from an expected federal incometax benefit of $2.2 million calculated at the federal marginal tax rate of35.0% primarily due to the $8.5 million provision resulting from the increasein the tax valuation allowance, partially offset by the $5.3 million benefitrelated to the non-taxability of the REIT earnings and the $1.0 millionstate tax benefit. Our $1.4 million income tax provision for the six monthsended June 30, 2005 differed from an expected federal income tax benefitof $7.7 million calculated at the federal marginal tax rate of 35.0% primarilydue to the $19.4 million provision resulting from the increase in the taxvaluation allowance, partially offset by the $8.9 million benefit related tothe non-taxability of the REIT earnings and the $1.4 million state tax benefit.

**MORTGAGE LOANPORTFOLIO MANAGEMENT**

On May 2, 2006, we securitized $611.5 million ofmortgage loans through an on-balance sheet securitization. During the yearended December 31, 2005, we securitized $3.7 billion of mortgage loans throughthe completion of four on-balance sheet transactions, and during the year endedDecember 31, 2004, we securitized $1.2 billion of mortgage loans throughthe completion of one on-balance sheet transaction. These securitizations werestructured as on-balance sheet securitizations for accounting purposes underSFAS 140. Prior to our reorganization, Aames Financial’s previoussecuritizations were structured as off-balance sheet securitizations foraccounting purposes under SFAS 140. We expect net interest income from our REITportfolio of mortgage loans 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  June 30,** | ** ** | **Increase** | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase** | ** ** |
|-----------------------------------|------------|-------------------------------------------------|------------|--------------|------------|-----------------------------------------------|------------|--------------|------------|
| ** **                        | ** ** | **2006**                                        | ** ** | **2005**     | ** ** | **(Decrease)**                                | ** ** | **2006**     | ** ** | **2005** | ** ** | **(Decrease)** | ** ** |
| On-balance sheet  securitizations |       | $                                               | 611,536    |         | $          | 1,158,029                                     |       | $            | (546,493   | ) | $ | 611,536 |   | $ | 2,356,511 |   | $ | (1,744,975 | ) |
|                                   |            |                                                 |            |              |            |                                               |            |              |            |  |  |  |  |  |  |  |  |  |  |

 

We have not established a limit on the amount ofleverage we may incur, but we expect our leverage to decline as our REITportfolio continues to run off until the merger with Accredited is completed. Ourcurrent leverage is approximately 12.9 times the amount of our consolidatedstockholders’ equity.

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 

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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 primarilyby purchasing derivative financial instruments referred to as interest rate capagreements and to a much lesser extent, by entering interest rate swapagreements. 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 and interest rate swap agreements willdecrease; in times when short-term rates increase, the value of theseagreements will increase. The interest rate cap agreements are designed toexchange the cost of our variable rate liabilities to fixed rates for the firsttwo years of their estimated duration, thereby better matching ourinterest-earning hybrid/adjustable rate mortgage loans during the initial fixedrate 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 securities wouldbe expected to be backed primarily by first mortgages on one- to four-familydwellings and are expected to be rated by S&P or Moody’s. We have notpreviously acquired or held any third-party mortgage-backed securities in ourinvestment portfolio.

32

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**Leverage Policy**

We employ a leveragestrategy by securitizing existing mortgages in transactions that we believe willbe treated as borrowings for accounting and tax purposes. We have notestablished a limit on the amount of leverage we may incur, but we expect ourleverage to decline as our REIT portfolio continues to run off until the Mergerwith Accredited is completed. Our current leverage is approximately 12 timesthe amount 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 primarily interest rate cap agreementsand, to a much lesser extent, interest rate swap agreements. These derivativefinancial instruments have an active secondary market and are intended toprovide supplemental income and cash flow to offset potential reduced interestincome and cash flow in certain interest rate environments. It is not our policyto use derivatives to speculate on interest rates. We report our derivativefinancial instruments on our consolidated balance sheet at their fair valuewith any changes in fair value reported as either a gain or loss to theconsolidated statement of operations.

**Financing Policy**

We may raise funds through additional equityofferings, debt financings, retention of cash flow subject to Internal RevenueCode provisions regarding distribution requirements and taxability ofundistributed REIT taxable income or a combination of these methods. In March2006, we announced a corporate restructuring that would eliminate AamesInvestment’s REIT status at the parent company level and also eliminate therequirement to distribute at least 90% of our earnings to public stockholders.We could therefore retain that capital for internal growth. However, afterentering into the Merger Agreement, we determined that we would not pursue therestructuring strategy. 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. 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. As aresult of our pending Merger with Accredited, we currently do not intend toissue any securities under that S-3 Registration Statement.

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 

33

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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, institutionalinvestors or other lenders, and securitizations, including collateralized debtobligations, any of which may be unsecured or secured by mortgages or otherinterests in the assets. This indebtedness may entail recourse to all or anypart of our assets or may be limited to the particular assets to which theindebtedness 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 June 30, 2006 Aames Financial originatedloans in 44 states through its retail and wholesale channels. On June 26,2006, we announced the sale of our wholesale operations to Accredited, whichwas completed in July 2006. See “Recent Events—Sale of Aames’ WholesaleOperations to Accredited.” Its retail channel had a network of 76 retail branchoffices directly serving borrowers throughout the United States. From time totime, depending on market conditions and attractiveness of terms, we maysupplement our loan production by purchasing mortgage loans from secondarymarket sellers.

The following table shows our total loan production byretail and wholesale channels for the periods indicated (in thousands):

| ** **        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **        | ** ** | **June 30,**                | ** ** | **March 31,**             | ** ** | **June 30,** | ** ** |
| ** **        | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Loans Funded:** |       |                             |       |                           |       |   |   |   |   |   |   |
| Retail            |       | $                                | 763,979    |                           | $          | 624,816 |   | $ | 746,131 |   | $ | 1,510,110 |   | $ | 1,141,374 |   |
| Wholesale         |       | 431,291                          |       | 972,198                        |       | 819,393 |   | 1,250,684 |   | 1,817,256 |   |
| Total             |       | $                                | 1,195,270  |                           | $          | 1,597,014 |   | $ | 1,565,524 |   | $ | 2,760,794 |   | $ | 2,958,630 |   |
| **% of  Total:**  |       |                             |       |                           |       |   |   |   |   |   |   |
| Retail            |       | 63.9                             | %          | 39.1                           | %          | 47.7 | % | 54.7 | % | 38.6 | % |
| Wholesale         |       | 36.1                             | %          | 60.9                           | %          | 52.3 | % | 45.3 | % | 61.4 | % |
| Total             |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % | 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 to 

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determine the mosteffective methods and manner of marketing. Whether generated through directmail or the Internet, leads are generally followed up with telephone calls topotential customers. Our loan officers at the local retail loan officepre-qualify a potential customer and if the customer is interested, takes anapplication over the telephone or schedules an appointment with the customer atthe retail loan office most conveniently located to the customer or in thecustomer’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.

**Total LoanProduction**

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

| ** **                                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                          | ** ** | **June 30,**                | ** ** | **March 31,**             | ** ** | **June 30,** | ** ** |
| ** **                                          | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Retail  Production:**                             |       |                             |       |                           |       |   |   |   |   |   |   |
| Total dollar amount (in thousands)                  |       | $                                | 763,979    |                           | $          | 624,816 |   | $ | 746,131 |   | $ | 1,510,110 |   | $ | 1,141,374 |   |
| Number of loans                                     |       | 5,026                            |       | 4,315                          |       | 4,814 |   | 9,840 |   | 8,033 |   |
| Average loan amount                                 |       | $                                | 152,005    |                           | $          | 144,801 |   | $ | 154,992 |   | $ | 153,466 |   | $ | 142,086 |   |
| Average initial LTV                                 |       | 74.78                            | %          | 76.33                          | %          | 74.44 | % | 74.61 | % | 76.12 | % |
| Weighted average interest rate(2)                   |       | 8.69                             | %          | 7.37                           | %          | 8.13 | % | 8.41 | % | 7.44 | % |
| Retail branch offices at period end                 |       | 76                               |       | 84                             |       | 76 |   | 76 |   | 84 |   |
| **Wholesale Production(1):**                        |       |                             |       |                           |       |   |   |   |   |   |   |
| Total dollar amount (in thousands)                  |       | $                                | 431,291    |                           | $          | 972,198 |   | $ | 819,393 |   | $ | 1,250,684 |   | $ | 1,817,256 |   |
| Number of loans                                     |       | 3,141                            |       | 6,830                          |       | 5,702 |   | 8,843 |   | 12,858 |   |
| Average loan amount                                 |       | $                                | 137,310    |                           | $          | 142,342 |   | $ | 143,703 |   | $ | 141,432 |   | $ | 141,333 |   |
| Average initial LTV                                 |       | 80.98                            | %          | 80.38                          | %          | 82.06 | % | 81.69 | % | 80.79 | % |
| Weighted average interest rate(2)                   |       | 8.77                             | %          | 7.66                           | %          | 8.63 | % | 8.68 | % | 7.63 | % |
| Regional wholesale operations centers at period end |       | 1                                |       | 4                              |       | 3 |   | 1 |   | 4 |   |
| **Total Production:**                               |       |                             |       |                           |       |   |   |   |   |   |   |
| Total dollar amount (in thousands)                  |       | $                                | 1,195,270  |                           | $          | 1,597,014 |   | $ | 1,565,524 |   | $ | 2,760,794 |   | $ | 2,958,630 |   |
| Number of loans                                     |       | 8,167                            |       | 11,145                         |       | 10,516 |   | 18,683 |   | 20,891 |   |
| Average loan amount                                 |       | $                                | 146,354    |                           | $          | 143,294 |   | $ | 148,871 |   | $ | 147,770 |   | $ | 141,622 |   |
| Average initial LTV                                 |       | 77.02                            | %          | 78.79                          | %          | 78.43 | % | 77.82 | % | 78.98 | % |
| Weighted average  interest rate(2)                  |       | 8.72                             | %          | 7.55                           | %          | 8.39 | % | 8.53 | % | 7.56 | % |

----

        (1) From1996 through July 2006, we originated loans through a wholesale channel whichwas sold to Accredited in July 2006.

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

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Thefollowing table presents changes in total production, number of loans, andaverage loan amount for the periods indicated:

| ** **                                            | ** ** | **Three Months Ended**    | ** ** | **Six Months Ended**       | ** ** |
|-------------------------------------------------------|------------|-------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **June 30, 206**          | ** ** | **June 30, 206**           | ** ** | **June 30,** | ** ** |
| ** **                                            | ** ** | **vs June 30, 2005** | ** ** | **vs March 31, 2006** | ** ** | **2006 vs. 2005** | ** ** |
| ** **                                            | ** ** | **Amount**                          | ** ** | **%**                                | ** ** | **Amount** | ** ** | **%** | ** ** | **Amount** | ** ** | **%** | ** ** |
| ** **                                            | ** ** | **(in thousands)**             | ** ** |
| **Increase (Decrease) in Total  Production:**         | ** ** | ** **                          | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Retail                                                |       | $                                   | 139,163    |                                 | 22.3       | % | $ | 17,848 |   | 2.4 | % | $ | 368,736 |   | 32.3 | % |
| Wholesale                                             |       | (540,907                            | )          | (55.6                                | )%         | (388,102 | ) | (47.4 | )% | (566,572 | ) | (31.2 | )% |
| Total                                                 |       | $                                   | (401,744   | )                                    | (25.2      | )% | $ | (370,254 | ) | (23.7 | )% | $ | (197,836 | ) | (6.7 | )% |
| **Increase  (Decrease) in Number of Loans:**          | ** ** | ** **                          | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Retail                                                |       | 711                                 |       | 16.5                                 | %          | 212 |   | 4.4 | % | 1,807 |   | 22.5 | % |
| Wholesale                                             |       | (3,689                              | )          | (54.0                                | )%         | (2,561 | ) | (44.9 | )% | (4,015 | ) | (31.2 | )% |
| Total                                                 |       | (2,978                              | )          | (26.7                                | )%         | (2,349 | ) | (22.3 | )% | (2,208 | ) | (10.6 | )% |
| **Increase (Decrease) in Average  Loan Amount:** | ** ** | ** **                          | ** ** | ** **                           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Retail                                                |       | $                                   | 7,204      |                                 | 5.0        | % | $ | (2,987 | ) | (1.9 | )% | $ | 11,381 |   | 8.0 | % |
| Wholesale                                             |       | (5,032                              | )          | (3.5                                 | )%         | (6,393 | ) | (4.4 | )% | 99 |   | 0.1 | % |
| Total                                                 |       | 3,059                               |       | 2.1                                  | %          | (2,517 | ) | (1.7 | )% | 6,148 |   | 4.3 | % |

 

Total loan production during the three months endedJune 30, 2006 declined by $370.3 million, or 23.7%, to $1.2 billion from the$1.6 billion for the three months ended March 31, 2006, and declined by$401.7 million, or 25.2%, from $1.6 billion for the three months ended June 30,2005. The $370.3 million decline during the three months ended June 30, 2006compared to the three months ended March 31, 2006 was primarily due to adecrease of 2,349, or 22.3%, in the number of loans originated, as well as to adecrease of $2,517, or 1.7%, in the average loan amount originated. The$401.7 million decline during the three months ended June 30, 2006compared to the same period a year ago was due to a decrease of 2,978, or 26.7%,in the number of loans originated, partially offset by an increase of $3,059,or 2.1%, in the average loan amount originated. The overall decline in loanproduction for the three months ended June 30, 2006 from the prior three-monthperiod ended March 31, 2006 was primarily due to competitive pressures inthe marketplace due to increases in short-term interest rates, and theelimination of certain 80% LTV first lien and simultaneous 20% LTV second lien(100% combined LTV) purchase money loans for borrowers with lower credit scoresand stated income which negatively impacted our loan production, especially inwholesale, for the three months ended June 30, 2006. 

Total loan production during the six months ended June30, 2006 declined by $197.8 million, or 6.7%, to $2.8 billion from the $3.0billion for the six months ended June 30, 2005. This decline was due to adecrease of 2,208, or 10.6%, in the number of loans originated, partiallyoffset by an increase of $6,148, or 4.3%, in the average loan amount originated.

Total retail production during the three months endedJune 30, 2006 grew by $17.8 million, or 2.4%, to $764.0 million over the $746.1million for the three months ended March 31, 2006, and grew by $139.2million, or 22.3%, over $624.8 million for the three months ended June 30,2005. The $17.8 million growth during the three months ended June 30, 2006compared to the three months ended March 31, 2006 was due to an increaseof 212, or 4.4%, in the number of loans originated, partially offset by adecrease of $2,987, or 1.9%, in the average loan amount originated. The $139.2million growth during the three months ended June 30, 2006 compared to the sameperiod a year ago was principally due to an increase of 

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711, or 16.5%, in thenumber of loans originated, coupled with an increase of $7,204, or 5.0%, in theaverage loan amount originated.

Total retail production during the six months endedJune 30, 2006 grew by $368.7 million, or 32.3%, to $1.5 billion over the $1.1billion for the six months ended June 30, 2005. This growth was principally due to an increase of 1,807, or 22.5%, inthe number of loans originated, coupled with an increase of $11,381, or 8.0%,in the average loan amount originated.

Total wholesale production during the three months endedJune 30, 2006 declined by $388.1 million, or 47.4%, to $431.3 million from the$819.3 million for the three months ended March 31, 2006, and declined by$540.9 million, or 55.6%, from $972.2 million for the three months endedJune 30, 2005. The $388.1 million decline during the three months endedJune 30, 2006 compared to the three months ended March 31, 2006 wasprimarily due to a decrease of 2,561, or 44.9%, in the number of loansoriginated, coupled with a $6,393, or 4.4%, decline in average loan amountoriginated. The $540.9 million decline during the three months endedJune 30, 2006 compared to the same period a year ago was principally dueto a decrease of 3,689, or 54.0%, in the number of loans originated, coupledwith a decrease of $5,032, or 3.5%, in the average loan amount originated.

Total wholesale production during the six months endedJune 30, 2006 declined by $566.6 million, or 31.2%, to $1.3 billion from the$1.8 billion for the six months ended June 30, 2005. This decline was due to adecrease of 4,015, or 31.2%, in the number of loans originated.

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

| ** **          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **          | ** ** | **June 30,**                | ** ** | **March 31,**             | ** ** | **June 30,** | ** ** |
| **Purpose**         | ** ** | ** **                       | ** ** | **2006**                       | ** ** | **2005** | ** ** | **2006** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Loans Funded:**   | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash-out refinance  |       | $                                | 790,093    |                           | $          | 900,379 |   | $ | 950,589 |   | $ | 1,740,682 |   | $ | 1,699,747 |   |
| Purchase money      |       | 344,458                          |       | 645,301                        |       | 559,527 |   | 903,985 |   | 1,164,929 |   |
| Rate/term refinance |       | 60,719                           |       | 51,334                         |       | 55,408 |   | 116,127 |   | 93,954 |   |
| Total               |       | $                                | 1,195,270  |                           | $          | 1,597,014 |   | $ | 1,565,524 |   | $ | 2,760,794 |   | $ | 2,958,630 |   |
| **% of  Total:**    | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash-out refinance  |       | 66.1                             | %          | 56.4                           | %          | 60.7 | % | 63.1 | % | 57.4 | % |
| Purchase money      |       | 28.8                             | %          | 40.4                           | %          | 35.8 | % | 32.7 | % | 39.4 | % |
| Rate/term refinance |       | 5.1                              | %          | 3.2                            | %          | 3.5 | % | 4.2 | % | 3.2 | % |
| Total               |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % | 100.0 | % |
|                     |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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Amajority of our purchase money loan originations was originated through ourwholesale channel. As a result of the sale of our wholesale business toAccredited, we expect the dollar volume and percentage of our purchase moneymortgage loans to decrease in the coming quarters to under 10%.

| ** **              | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **              | ** ** | **June 30,**                | ** ** | **March 31,**             | ** ** | **June 30,** | ** ** |
| **Property Type**  | ** ** | ** **                       | ** ** | **2006**                       | ** ** | **2005** | ** ** | **2006** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Loans Funded:**       | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Single-family residence |       | $                                | 1,064,357  |                           | $          | 1,399,906 |   | $ | 1,359,045 |   | $ | 2,423,402 |   | $ | 2,594,833 |   |
| Multi-family residence  |       | 64,715                           |       | 114,499                        |       | 106,542 |   | 171,257 |   | 208,898 |   |
| Condominiums            |       | 66,198                           |       | 82,609                         |       | 99,937 |   | 166,135 |   | 154,899 |   |
| Total                   |       | $                                | 1,195,270  |                           | $          | 1,597,014 |   | $ | 1,565,524 |   | $ | 2,760,794 |   | $ | 2,958,630 |   |
| **% of  Total:**        | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Single-family residence |       | 89.1                             | %          | 87.6                           | %          | 86.8 | % | 87.8 | % | 87.7 | % |
| Multi-family residence  |       | 5.4                              | %          | 7.2                            | %          | 6.8 | % | 6.2 | % | 7.1 | % |
| Condominiums            |       | 5.5                              | %          | 5.2                            | %          | 6.4 | % | 6.0 | % | 5.2 | % |
| Total                   |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % | 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** | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                    | ** ** | **June 30,**                | ** ** | **March 31,**             | ** ** | **June 30,** | ** ** |
| ** **                                                                    | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Loans Funded:**                                                             | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| California                                                                    |       | $                                | 215,895    |                           | $          | 439,308 |   | $ | 322,733 |   | $ | 538,628 |   | $ | 812,230 |   |
| Florida                                                                       |       | 313,855                          |       | 372,851                        |       | 424,039 |   | 737,894 |   | 669,702 |   |
| New York                                                                      |       | 109,071                          |       | 94,357                         |       | 121,819 |   | 230,890 |   | 187,915 |   |
| Texas                                                                         |       | 120,378                          |       | 136,411                        |       | 130,170 |   | 250,548 |   | 247,803 |   |
| Other Western  States (AZ, CO, HI, ID, MT, NV, NM, OR, UT, WA, WY)  |       | 113,108                          |       | 128,581                        |       | 133,245 |   | 246,353 |   | 267,872 |   |
| Midwestern States  (IL, IN, IA, KS, MI, MN, MO, NE, ND, OH, SD, WI) |       | 65,684                           |       | 101,325                        |       | 84,691 |   | 150,375 |   | 196,551 |   |
| Other  Northeastern States (CT, DE, ME, MD, MA, NH, NJ, PA, RI)          |       | 164,407                          |       | 177,435                        |       | 199,534 |   | 363,941 |   | 323,288 |   |
| Other  Southeastern States (AR, GA, KY, LA, MS, NC, OK, TN, VA, WV)      |       | 92,872                           |       | 146,746                        |       | 149,293 |   | 242,165 |   | 253,269 |   |
| Total                                                                         |       | $                                | 1,195,270  |                           | $          | 1,597,014 |   | $ | 1,565,524 |   | 2,760,794 |   | $ | 2,958,630 |   |
|                                                                               |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |  |  |  |

 

38

----

 

| ** **                                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                               | ** ** | **June 30,**                | ** ** | **March 31,**             | ** ** | **June 30,** | ** ** |
| ** **                                                               | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **  2006  ** | ** ** | **  2005  ** | ** ** |
| **% of Total:**                                                          | ** ** | ** **                       | ** ** | ** **                     | ** ** |   | ** ** | ** ** |   |   | ** ** |   |   |   | ** ** |   |   |
| California                                                               |       | 18.1                             | %          | 27.5                           | %          |   | 20.6 | % |   |   | 19.5 | % |   |   | 27.5 | % |   |
| Florida                                                                  |       | 26.2                             | %          | 23.4                           | %          |   | 27.1 | % |   |   | 26.7 | % |   |   | 22.6 | % |   |
| New York                                                                 |       | 9.1                              | %          | 5.9                            | %          |   | 7.8 | % |   |   | 8.4 | % |   |   | 6.4 | % |   |
| Texas                                                                    |       | 10.1                             | %          | 8.5                            | %          |   | 8.3 | % |   |   | 9.1 | % |   |   | 8.4 | % |   |
| Other Western  States (AZ, CO, HI, ID, MT, NV, NM, OR, UT, WA, WY)       |       | 9.5                              | %          | 8.1                            | %          |   | 8.5 | % |   |   | 8.9 | % |   |   | 9.1 | % |   |
| Midwestern States  (IL, IN, IA, KS, MI, MN, MO, NE, ND, OH, SD, WI)      |       | 5.5                              | %          | 6.3                            | %          |   | 5.4 | % |   |   | 5.4 | % |   |   | 6.6 | % |   |
| Other  Northeastern States (CT, DE, ME, MD, MA, NH, NJ, PA, RI)     |       | 13.7                             | %          | 11.1                           | %          |   | 12.8 | % |   |   | 13.2 | % |   |   | 10.9 | % |   |
| Other  Southeastern States (AR, GA, KY, LA, MS, NC, OK, TN, VA, WV) |       | 7.8                              | %          | 9.2                            | %          |   | 9.5 | % |   |   | 8.8 | % |   |   | 8.5 | % |   |
| Total                                                                    |       | 100.0                            | %          | 100.0                          | %          |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |

 

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

| ** **        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **        | ** ** | **June 30,**                | ** ** | **March 31,**             | ** ** | **June 30,** | ** ** |
| ** **        | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **Loans Funded:** | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Hybrid:           |       |                             |       |                           |       |   |   |   |   |   |   |
| Traditional       |       | $                                | 459,747    |                           | $          | 976,427 |   | $ | 688,062 |   | 1,147,809 |   | $ | 1,923,946 |   |
| Interest Only     |       | 11,947                           |       | 190,110                        |       | 30,131 |   | 42,078 |   | 338,918 |   |
| 40/30             |       | 489,974                          |       | 38,190                         |       | 540,549 |   | 1,030,523 |   | 38,190 |   |
|              |       | 961,668                          |       | 1,204,727                      |       | 1,258,742 |   | 2,220,410 |   | 2,301,054 |   |
| Fixed rate:       |       |                             |       |                           |       |   |   |   |   |   |   |
| Traditional       |       | 216,924                          |       | 392,287                        |       | 279,316 |   | 496,240 |   | 657,576 |   |
| 40/30             |       | 16,678                           |       | —                         |       | 27,466 |   | 44,144 |   | — |   |
|              |       | 233,602                          |       | 392,287                        |       | 306,782 |   | 540,384 |   | 657,576 |   |
| Total             |       | $                                | 1,195,270  |                           | $          | 1,597,014 |   | $ | 1,565,524 |   | 2,760,794 |   | $ | 2,958,630 |   |

 

| ** **      | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **      | ** ** | **June 30,**                | ** ** | **March 31,**             | ** ** | **June 30,** | ** ** |
| ** **      | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2006** | ** ** | **2005** | ** ** |
| **% of Total:** | ** ** | ** **                       | ** ** | ** **                     | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Hybrid:         |       |                             |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Traditional     |       | 38.5                             | %          | 61.1                           | %          |   | 44.0 | % |   |   | 41.6 | % |   |   | 65.0 | % |   |
| Interest Only   |       | 1.0                              | %          | 11.9                           | %          |   | 1.9 | % |   |   | 1.5 | % |   |   | 11.5 | % |   |
| 40/30           |       | 41.0                             | %          | 2.4                            | %          |   | 34.5 | % |   |   | 37.3 | % |   |   | 1.3 | % |   |
|            |       | 80.5                             | %          | 75.4                           | %          |   | 80.4 | % |   |   | 80.4 | % |   |   | 77.8 | % |   |
| Fixed rate:     |       |                             |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Traditional     |       | 18.1                             | %          | 24.6                           | %          |   | 17.8 | % |   |   | 18.0 | % |   |   | 22.2 | % |   |
| 40/30           |       | 1.4                              | %          | 0.0                            | %          |   | 1.8 | % |   |   | 1.6 | % |   |   | 0.0 | % |   |
|            |       | 19.5                             | %          | 24.6                           | %          |   | 19.6 | % |   |   | 19.6 | % |   |   | 22.2 | % |   |
| Total           |       | 100.0                            | %          | 100.0                          | %          |   | 100.0 | % |   |   | 100.0 | % |   |   | 100.0 | % |   |

 

39

----

**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 June 30, 2006** | ** ** |
|-------------------|------------|---------------------------------------------------------------|------------|
| ** **        | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **        | ** ** | ** **                                                    | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** **        | ** ** | **Loans**                                                     | ** ** | **% of** | ** ** | **Credit** | ** ** | **Interest** | ** ** | ** Loan-to-Value ** | ** ** |
| ** **        | ** ** | **Funded**                                                    | ** ** | **Total** | ** ** | **Score** | ** ** | **Rate(1)** | ** ** | **Ratio** | ** ** |
| **Credit Grade:** | ** ** | ** **                                                    | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| A+                |       | $                                                             | 877,927    |   |   | 73 | % |   |   | 625 | ** ** |   |   | 8.5 | % |   |   | 78 | % |   |
| A                 |       | 158,041                                                       |       |   | 13 | % |   |   | 587 | ** ** |   |   | 8.7 | % |   |   | 75 | % |   |
| A-                |       | 63,346                                                        |       |   | 5 | % |   |   | 567 | ** ** |   |   | 9.5 | % |   |   | 74 | % |   |
| B                 |       | 58,623                                                        |       |   | 5 | % |   |   | 552 | ** ** |   |   | 10.2 | % |   |   | 73 | % |   |
| C                 |       | 30,529                                                        |       |   | 3 | % |   |   | 545 | ** ** |   |   | 10.5 | % |   |   | 70 | % |   |
| C-                |       | 6,804                                                         |       |   | 1 | % |   |   | 543 | ** ** |   |   | 11.5 | % |   |   | 64 | % |   |
| Total             |       | $                                                             | 1,195,270  |   |   | 100 | % |   |   | 611 | ** ** |   |   | 8.7 | % |   |   | 77 | % |   |

 

| ** **        | ** ** | **Three Months Ended June 30, 2005** | ** ** |
|-------------------|------------|---------------------------------------------------------------|------------|
| ** **        | ** ** | ** **                                                    | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **        | ** ** | ** **                                                    | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** **        | ** ** | **Loans**                                                     | ** ** | **% of** | ** ** | **Credit** | ** ** | **Interest** | ** ** | **Loan-to-Value** | ** ** |
| ** **        | ** ** | **Funded**                                                    | ** ** | **Total** | ** ** | **Score** | ** ** | **Rate(1)** | ** ** | **Ratio** | ** ** |
| **Credit Grade:** | ** ** | ** **                                                    | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| A+                |       | $                                                             | 1,209,249  |   |   | 76 | % |   |   | 629 | ** ** |   |   | 7.5 | % |   |   | 81 | % |   |
| A                 |       | 205,063                                                       |       |   | 13 | % |   |   | 625 | ** ** |   |   | 7.1 | % |   |   | 72 | % |   |
| A-                |       | 57,317                                                        |       |   | 4 | % |   |   | 566 | ** ** |   |   | 8.1 | % |   |   | 76 | % |   |
| B                 |       | 82,829                                                        |       |   | 5 | % |   |   | 560 | ** ** |   |   | 8.5 | % |   |   | 76 | % |   |
| C                 |       | 35,445                                                        |       |   | 2 | % |   |   | 553 | ** ** |   |   | 9.1 | % |   |   | 70 | % |   |
| C-                |       | 7,111                                                         |       |   | 0 | % |   |   | 536 | ** ** |   |   | 10.6 | % |   |   | 66 | % |   |
| Total             |       | $                                                             | 1,597,014  |   |   | 100 | % |   |   | 620 | ** ** |   |   | 7.6 | % |   |   | 79 | % |   |

 

| ** **        | ** ** | **Six Months Ended June 30, 2006** | ** ** |
|-------------------|------------|-------------------------------------------------------------|------------|
| ** **        | ** ** | ** **                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **        | ** ** | ** **                                                  | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** **        | ** ** | **Loans**                                                   | ** ** | **% of** | ** ** | **Credit** | ** ** | **Interest** | ** ** | **Loan-to-Value** | ** ** |
| ** **        | ** ** | **Funded**                                                  | ** ** | **Total** | ** ** | **Score** | ** ** | **Rate(1)** | ** ** | **Ratio** | ** ** |
| **Credit Grade:** | ** ** | ** **                                                  | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| A+                |       | $                                                           | 2,093,564  |   |   | 76 | % |   |   | 625 | ** ** |   |   | 8.3 | % |   |   | 79 | % |   |
| A                 |       | 322,436                                                     |       |   | 12 | % |   |   | 588 | ** ** |   |   | 8.6 | % |   |   | 76 | % |   |
| A-                |       | 131,999                                                     |       |   | 5 | % |   |   | 566 | ** ** |   |   | 9.2 | % |   |   | 74 | % |   |
| B                 |       | 133,372                                                     |       |   | 5 | % |   |   | 554 | ** ** |   |   | 9.9 | % |   |   | 74 | % |   |
| C                 |       | 63,024                                                      |       |   | 2 | % |   |   | 543 | ** ** |   |   | 10.3 | % |   |   | 69 | % |   |
| C-                |       | 16,399                                                      |       |   | 1 | % |   |   | 542 | ** ** |   |   | 11.2 | % |   |   | 64 | % |   |
| Total             |       | $                                                           | 2,760,794  |   |   | 100 | % |   |   | 612 | ** ** |   |   | 8.5 | % |   |   | 78 | % |   |

 

40

----

 

| ** **         | ** ** | **Six Months Ended June 30, 2005** | ** ** |
|--------------------|------------|-------------------------------------------------------------|------------|
| ** **         | ** ** | ** **                                                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **         | ** ** | ** **                                                  | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** **         | ** ** | **Loans**                                                   | ** ** | **% of** | ** ** | **Credit** | ** ** | **Interest** | ** ** | **Loan-to-Value** | ** ** |
| ** **         | ** ** | **Funded**                                                  | ** ** | **Total** | ** ** | **Score** | ** ** | **Rate(1)** | ** ** | **Ratio** | ** ** |
| **Credit  Grade:** | ** ** | ** **                                                  | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| A+                 |       | $                                                           | 2,254,464  |   |   | 76 | % |   |   | 628 | ** ** |   |   | 7.4 | % |   |   | 81 | % |   |
| A                  |       | 340,386                                                     |       |   | 12 | % |   |   | 609 | ** ** |   |   | 7.3 | % |   |   | 74 | % |   |
| A-                 |       | 114,982                                                     |       |   | 4 | % |   |   | 561 | ** ** |   |   | 8.0 | % |   |   | 76 | % |   |
| B                  |       | 159,407                                                     |       |   | 5 | % |   |   | 559 | ** ** |   |   | 8.5 | % |   |   | 76 | % |   |
| C                  |       | 72,978                                                      |       |   | 2 | % |   |   | 552 | ** ** |   |   | 9.0 | % |   |   | 70 | % |   |
| C-                 |       | 16,413                                                      |       |   | 1 | % |   |   | 544 | ** ** |   |   | 10.5 | % |   |   | 65 | % |   |
| Total              |       | $                                                           | 2,958,630  |   |   | 100 | % |   |   | 617 | ** ** |   |   | 7.6 | % |   |   | 79 | % |   |

----

  (1) Calculated with respect to the interest rate atthe time the mortgage loan was originated or purchased.

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

| ** **              | ** ** | **Three Months Ended June 30, 2006** | ** ** |
|-------------------------|------------|---------------------------------------------------------------|------------|
| ** **              | ** ** | ** **                                                    | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **              | ** ** | ** **                                                    | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** **              | ** ** | **Loans**                                                     | ** ** | **% of** | ** ** | **Interest** | ** ** | **Loan-to-Value** | ** ** |
| ** **              | ** ** | **Funded**                                                    | ** ** | **Total** | ** ** | **Rate(1)** | ** ** | **Ratio** | ** ** |
| **Credit Score Range:** | ** ** | ** **                                                    | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Above 700               |       | $                                                             | 65,767     |   |   | 6 | % |   |   | 8.1 | % |   |   | 78 | % |   |
| 661-700                 |       | 144,752                                                       |       |   | 12 | % |   |   | 8.1 | % |   |   | 78 | % |   |
| 621-660                 |       | 326,466                                                       |       |   | 27 | % |   |   | 8.4 | % |   |   | 78 | % |   |
| 581-620                 |       | 321,204                                                       |       |   | 27 | % |   |   | 8.6 | % |   |   | 78 | % |   |
| 541-580                 |       | 180,850                                                       |       |   | 15 | % |   |   | 9.2 | % |   |   | 74 | % |   |
| 540 and below           |       | 155,869                                                       |       |   | 13 | % |   |   | 10.0 | % |   |   | 73 | % |   |
| Not available           |       | 362                                                           |       |   | NM |   |   |   | 8.8 | % |   |   | 75 | % |   |
| Total                   |       | $                                                             | 1,195,270  |   |   | 100 | % |   |   | 8.7 | % |   |   | 77 | % |   |

 

| ** **               | ** ** | **Three Months Ended June 30, 2005** | ** ** |
|--------------------------|------------|---------------------------------------------------------------|------------|
| ** **               | ** ** | ** **                                                    | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **               | ** ** | ** **                                                    | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** **               | ** ** | **Loans**                                                     | ** ** | **% of** | ** ** | **Interest** | ** ** | **Loan-to-Value** | ** ** |
| ** **               | ** ** | **Funded**                                                    | ** ** | **Total** | ** ** | **Rate(1)** | ** ** | **Ratio** | ** ** |
| **Credit  Score Range:** | ** ** | ** **                                                    | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Above 700                |       | $                                                             | 140,071    |   |   | 8 | % |   |   | 6.6 | % |   |   | 73 | % |   |
| 661-700                  |       | 218,264                                                       |       |   | 14 | % |   |   | 7.0 | % |   |   | 79 | % |   |
| 621-660                  |       | 426,012                                                       |       |   | 27 | % |   |   | 7.3 | % |   |   | 81 | % |   |
| 581-620                  |       | 428,174                                                       |       |   | 27 | % |   |   | 7.6 | % |   |   | 80 | % |   |
| 541-580                  |       | 226,715                                                       |       |   | 14 | % |   |   | 8.1 | % |   |   | 79 | % |   |
| 540 and below            |       | 154,924                                                       |       |   | 10 | % |   |   | 8.8 | % |   |   | 74 | % |   |
| Not available            |       | 2,854                                                         |       |   | NM |   |   |   | 8.0 | % |   |   | 72 | % |   |
| Total                    |       | $                                                             | 1,597,014  |   |   | 100 | % |   |   | 7.6 | % |   |   | 79 | % |   |

 

41

----

 

| ** **              | ** ** | **Six Months Ended June 30, 2006** | ** ** |
|-------------------------|------------|-------------------------------------------------------------|------------|
| ** **              | ** ** | ** **                                                  | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **              | ** ** | ** **                                                  | ** ** | **Average** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **              | ** ** | **Loans**                                                   | ** ** | **% of** | ** ** | **Interest** | ** ** | **Loan-to-Value** | ** ** |
| ** **              | ** ** | **Funded**                                                  | ** ** | **Total** | ** ** | **Rate(1)** | ** ** | **Ratio** | ** ** |
| **Credit Score Range:** | ** ** | ** **                                                  | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Above 700               |       | $                                                           | 158,813    |   |   | 6 | % |   |   | 7.9 | % |   |   | 79 | % |   |
| 661-700                 |       | 335,397                                                     |       |   | 12 | % |   |   | 8.0 | % |   |   | 79 | % |   |
| 621-660                 |       | 759,266                                                     |       |   | 28 | % |   |   | 8.3 | % |   |   | 79 | % |   |
| 581-620                 |       | 747,250                                                     |       |   | 27 | % |   |   | 8.4 | % |   |   | 79 | % |   |
| 541-580                 |       | 417,667                                                     |       |   | 15 | % |   |   | 9.0 | % |   |   | 76 | % |   |
| 540 and below           |       | 341,318                                                     |       |   | 12 | % |   |   | 9.6 | % |   |   | 73 | % |   |
| Not available           |       | 1,083                                                       |       |   | NM |   |   |   | 8.9 | % |   |   | 80 | % |   |
| Total                   |       | $                                                           | 2,760,794  |   |   | 100 | % |   |   | 8.5 | % |   |   | 78 | % |   |

 

| ** **              | ** ** | **Six Months Ended June 30, 2005** | ** ** |
|-------------------------|------------|-------------------------------------------------------------|------------|
| ** **              | ** ** | ** **                                                  | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Weighted** | ** ** |
| ** **              | ** ** | ** **                                                  | ** ** | ** ** | ** ** | **Average** | ** ** | **Average** | ** ** |
| ** **              | ** ** | **Loans**                                                   | ** ** | **% of** | ** ** | **Interest** | ** ** | **Loan-to-Value** | ** ** |
| ** **              | ** ** | **Funded**                                                  | ** ** | **Total** | ** ** | **Rate(1)** | ** ** | **Ratio** | ** ** |
| **Credit Score Range:** | ** ** | ** **                                                  | ** ** |   | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   |
| Above 700               |       | $                                                           | 228,556    |   |   | 8 | % |   |   | 6.8 | % |   |   | 75 | % |   |
| 661-700                 |       | 394,716                                                     |       |   | 13 | % |   |   | 7.0 | % |   |   | 79 | % |   |
| 621-660                 |       | 797,235                                                     |       |   | 27 | % |   |   | 7.3 | % |   |   | 81 | % |   |
| 581-620                 |       | 758,084                                                     |       |   | 26 | % |   |   | 7.5 | % |   |   | 80 | % |   |
| 541-580                 |       | 457,191                                                     |       |   | 15 | % |   |   | 8.1 | % |   |   | 79 | % |   |
| 540 and below           |       | 318,830                                                     |       |   | 11 | % |   |   | 8.7 | % |   |   | 74 | % |   |
| Not available           |       | 4,018                                                       |       |   | NM |   |   |   | 8.1 | % |   |   | 76 | % |   |
| Total                   |       | $                                                           | 2,958,630  |   |   | 100 | % |   |   | 7.6 | % |   |   | 79 | % |   |

----

  (1)   Calculatedwith respect to the interest rate at the time the loan was originated orpurchased.

NM = Not Meaningful

**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. 

**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 facilities 

42

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for future funding ofmortgage loans. Proceeds we receive from on-balance sheet securitizationfinancings on loans held for investment are also used to pay down our revolvingwarehouse and repurchase facilities. 

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

| ** **       | ** ** | **Three Months Ended** | ** ** | ** **                   | ** ** | ** ** | ** ** |
|------------------|------------|----------------------------------|------------|------------------------------|------------|------------|------------|
| ** **       | ** ** | **June 30,**                | ** ** | **Increase (Decrease)** | ** ** |
| ** **       | ** ** | **2006**                         | ** ** | **2005**                     | ** ** | **Amount** | ** ** | **%** | ** ** |
| Whole loan sales |       | $                                | 1,488,719  |                         | $          | 410,714    |       | $ | 1,078,005 |   | 262.5 | % |
|                  |            |                                  |            |                              |            |            |            |  |  |  |  |  |

 

| ** **       | ** ** | **Six Months Ended** | ** ** | ** **                   | ** ** | ** ** | ** ** |
|------------------|------------|--------------------------------|------------|------------------------------|------------|------------|------------|
| ** **       | ** ** | **June 30,**              | ** ** | **Increase (Decrease)** | ** ** |
| ** **       | ** ** | **2006**                       | ** ** | **2005**                     | ** ** | **Amount** | ** ** | **%** | ** ** |
| Whole loan sales |       | $                              | 2,983,567  |                         | $          | 731,352    |       | $ | 2,252,215 |   | 308.0 | % |
|                  |            |                                |            |                              |            |            |            |  |  |  |  |  |

 

Our whole loan sales tothird parties during the three months ended June 30, 2006 increased by$1.1 billion, or 262.5%, to $1.5 billion over $410.7 million during thecomparable three-month period a year ago. Our whole loan sales to third partiesduring the six months ended June 30, 2006 increased by $2.3 billion, or308.0%, to $3.0 billion over $731.4 million during the comparable six-monthperiod a year ago. We achieved our targeted REIT portfolio leverage ratioduring the third quarter of 2005 and since then have sold a larger percentageof our production into the secondary markets compared to the first two quartersof 2005, when we retained the majority of our loan production to build our REITportfolio of loans held for investment. In addition, since announcing theproposed Merger with Accredited, we no longer retain mortgage loans for ourREIT portfolio and sell all of our loan production in the secondary markets.

**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 $5.0 billion at June 30, 2006.Aames Financial’s servicing platform has received a SQ3 rating from Moody’s andan RPS3-Rating from Fitch.

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.

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

| ** **                                        | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|---------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Mortgage loans serviced:                          |       |                    |       |                        |       |   |   |
| Loans held for investment                         |       | $                       | 3,425,581  |                        |       | $ | 4,077,448 |   |   |
| Loans serviced on an interim basis                |       | 1,433,887               |       |                        | 1,926,876  |   |   |
| Loans subserviced for others on a long-term basis |       | 79,094                  |       |                        | 92,213     |   |   |
| Total serviced in-house                           |       | 4,938,562               |       |                        | 6,096,537  |   |   |
| Loans held for investment subserviced by others   |       | 48,151                  |       |                        | 50,202     |   |   |
| Total servicing portfolio                         |       | $                       | 4,986,713  |                        |       | $ | 6,146,739 |   |   |
| Percentage  serviced in-house                     |       | 99.0                    | %          |                        | 99.2       | % |   |

 

Our total loan servicing portfolio at June 30,2006 declined by $1.2 billion, to $5.0 billion, from $6.1 billion at December 31,2005, due primarily to decreases of $651.9 million and $493.0 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 ofloans held 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 us tomake certain servicing advances (e.g., for property taxes or hazard insurance)unless we determine that those advances would not be recoverable.

**Collections,Delinquencies and 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 weevaluate various legal options and remedies to protect the value of the loan,including arranging 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,foreclosure proceedings will begin. Generally, we will begin foreclosureproceedings when a loan is 80 to 100 days delinquent, depending upon creditconsiderations, borrower bankruptcy status and state regulations.

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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:

| ** **               | ** ** | **June 30,  2006** | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|--------------------------|------------|-------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Aames Investment         |       |                    | 8.2        | %                        |       |                        | 6.2        | % |   |   | 5.4 | % |   |
| Subprime Mortgage  Loans |       |                    | NYA        |                     |       |                        | 11.5       | % |   |   | 11.6 | % |   |
| All Mortgage  Loans      |       |                    | NYA        |                     |       |                        | 4.4        | % |   |   | 4.7 | % |   |

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NYA = Not yet announced

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

| ** **                                                                    | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|-------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Percentage of  dollar amount of delinquent loans serviced (period end)(1)(2): |       |                    |       |                        |       |   |   |   |   |
| One month                                                                     |       |                    | 2.8        | %                           |       |   | 1.9 | % |   |
| Two months                                                                    |       |                    | 0.8        | %                           |       |   | 0.9 | % |   |
| Three or more months                                                          |       |                    |       |                        |       |   |   |   |   |
| Not foreclosed(3)                                                        |       |                    | 4.0        | %                           |       |   | 2.5 | % |   |
| Foreclosed(4)                                                            |       |                    | 0.6        | %                           |       |   | 0.1 | % |   |
| Total                                                                         |       |                    | 8.2        | %                           |       |   | 5.4 | % |   |
| Percentage of total dollar amount of delinquent  loans in:                    |       |                    |       |                        |       |   |   |   |   |
| Loans held for investment                                                     |       |                    | 9.9        | %                           |       |   | 7.0 | % |   |
| Loans serviced on an interim basis                                            |       |                    | 4.5        | %                           |       |   | 2.0 | % |   |
| Loans subserviced  for others on a long-term basis                            |       |                    | 8.7        | %                           |       |   | 8.9 | % |   |

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

       (2) The delinquency and foreclosure percentages are calculated on thebasis of the total dollar amount of mortgage loans serviced by us includingloans serviced on an interim basis.

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

       (4) Represents properties acquired following a foreclosure sale andstill serviced by us at period end.

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The following table summarizes the unpaid principalbalance of delinquent loans as of the dates indicated in the total servicingportfolio (in thousands): 

| ** **                                         | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| Loans held for  investment                         |       | $                       | 340,052    |                        |       | $ | 287,348 |   |   |
| Loans serviced on  an interim basis                |       | 65,265                  |       |                        | 38,437     |   |   |
| Loans subserviced  for others on a long-term basis |       | 6,891                   |       |                        | 8,225      |   |   |
| Total                                              |       | $                       | 412,208    |                        |       | $ | 334,010 |   |   |

 

Delinquent loans, by principal balance of the totalservicing portfolio, grew to $412.2 million at June 30, 2006 from $334.0million at December 31, 2005. The delinquency rate at June 30, 2006was 8.2% compared to 5.4% at December 31, 2005. This increase in thedelinquency rate was primarily due to an increase in the delinquency rate onour on-balance sheet REIT portfolio of mortgage, as well as to the growth indelinquencies in loans serviced on an interim basis. We expect the delinquencyrate to increase in future periods due to the seasoning of our REIT portfolio.

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

| ** **                                                                                                     | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                                                     | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| Percentage of  dollar amount of loans foreclosed during the period to loans serviced (period  end)(1)(2)  |       | 0.6                                           | %          | 0.1 | % |
| Number of loans  foreclosed during the period                                                                  |       | 214                                           |       | 83 |   |
| Principal amount  of loans foreclosed during the period                                                        |       | $                                             | 30,064     |   | $ | 6,284 |   |
| Number of loans  liquidated during the period                                                                  |       | 156                                           |       | 151 |   |
| Net losses on  liquidations during the period from(3):                                                         |       |                                          |       |   |   |
| Loans held for investment                                                                                      |       | $                                             | 3,028      |   | $ | 42 |   |
| Loans serviced on an interim basis                                                                             |       | 2,737                                         |       | 2,646 |   |
| Loans subserviced for others on a long-term basis                                                              |       | —                                        |       | 19 |   |
| Loans in off-balance sheet securitization trusts  serviced in-house                                            |       | —                                        |       | 2,850 |   |
| Total                                                                                                          |       | $                                             | 5,765      |   | $ | 5,557 |   |
| Percentage of annualized losses to servicing  portfolio(1)(2)                                             |       | 0.2                                           | %          | 0.2 | % |
| Servicing portfolio at  period end                                                                             |       | $                                             | 4,987,000  |   | $ | 4,482,000 |   |

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

       (2) The percentages were calculated to reflect the dollar volume ofloans foreclosed or annualized losses, as the case may be, to the averagedollar amount of mortgage loans serviced by us and any subservicer during therelated periods indicated.

       (3) Represents losses, net of gains, on properties sold throughforeclosure or other default management activitiesduring the periods indicated.

During the six monthsended June 30, 2006, net losses on loan liquidations increased $0.1million to $5.7 million, from $5.6 million during the comparable six-monthperiod during 2005. Of the $5.7 million of net losses on loan liquidationsduring the six months ended June 30, 2006, $3.0 million and $2.7 millionrelated to mortgage loans held for investment and mortgage loans held for sale,respectively. We expect 

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netlosses on loan liquidations to increase in future periods once our on-balancesheet REIT portfolio of mortgage loans becomes more seasoned and fewer newloans are added to the REIT portfolio.

**FINANCIAL CONDITION**

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

| ** **                                                 | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** | **Increase  (Decrease)** | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|--------------------------|------------|
| Loans held for  sale, at lower of cost or market           |       | $                       | 607,037    |                        |       | $                        | 951,177    |   |   | $ | (344,140 | ) |
| Loans held for  investment, net                            |       | 3,398,074               |       |                        | 4,085,536  |                     |       | (687,462 | ) |
| Advances and  other receivables, net                       |       | 38,377                  |       |                        | 39,591     |                     |       | (1,214 | ) |
| Equipment and  improvements, net                           |       | 10,987                  |       |                        | 10,810     |                     |       | 177 |   |
| Prepaid expenses  and other assets                         |       | 47,556                  |       |                        | 30,713     |                     |       | 16,843 |   |
| Derivative  financial instruments, at estimated fair value |       | 42,927                  |       |                        | 58,147     |                     |       | (15,220 | ) |
| Financings on  loans held for investment                   |       | 3,398,459               |       |                        | 3,623,188  |                     |       | (224,729 | ) |
| Revolving  warehouse and repurchase facilities             |       | 578,908                 |       |                        | 1,341,683  |                     |       | (762,775 | ) |
| Borrowings                                                 |       | —                  |       |                        | 16,487     |                     |       | (16,487 | ) |
|                                                            |            |                         |            |                             |            |                          |            |  |  |  |  |  |

*** ***

***Loans Held forSale.******  ***Loans held for sale decreased by $344.1 millionto $607.0 million, during the six months ended June 30, 2006, primarilydue to total loan sales and transfers of mortgage loans held for sale tomortgage loans held for investment exceeding total loan originations.

***Loans Held forInvestment, Net.*****  **Loans held for investment,net, declined by $687.5 million, to $3.4 billion, during the six months ended June 30,2006, and was primarily due to portfolio run-off. At June 30, 2006, theportfolio of loans held for investment was comprised of $3.4 billion and $23.5million of loans securitized and loans not yet securitized, respectively. Incomparison, at December 31, 2005, the portfolio of loans held forinvestment was comprised of $3.7 billion and $461.5 million of loanssecuritized and loans not yet securitized, respectively.

Loans held for investment at June 30, 2006 and December 31,2005 were net of a $52.2 million and $43.4 million allowance for loan losses,respectively. During the six months ended June 30, 2006, we recorded aprovision for loan losses of $14.9 million and net charge-offs of $6.1 million.We expect net charge-offs on loan liquidations to increase in future periods asthe loans in the held for investment portfolio become more seasoned.

***Advances and OtherReceivables.******  ***Advances and other receivables are comprised ofinterest and servicing advances, servicing and miscellaneous fees, accruedinterest receivable and other miscellaneous receivables. The level of servicingadvances, in any given period, depends upon portfolio delinquencies, the levelof real estate owned and loans in the process of foreclosure, and the timingand remittance of cash collections on mortgage loans in the portfolio. We fundadvances on a recurring basis not otherwise covered by our financing arrangementsthat we have in place from time to time and recover those advances on aperiodic basis.A

Advances and other receivables declined by $1.2million, to $38.4 million, during the six months ended June 30, 2006. At June 30,2006 and December 31, 2005, advances and other receivables were net of anadvance receivable allowance of $1.2 million and $1.9 million, respectively.The decline in advances and other receivables was due primarily to a decreaseof $5.5 million in accrued interest and other receivables, partially offset byincreases of $2.8 million and $1.8 million in interest and servicing advancesand vendor receivables, respectively.

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The $5.5 million decrease in accrued interest andother receivables was primarily due to a $5.2 million decline in accruedinterest receivable related to the decrease in the balance of loans held forinvestment, coupled with a $0.8 million decrease in accrued interest receivablerelated to the decline in loans held for sale, partially offset by a $0.4million increase in amounts due from counterparties. The $2.8 million growth ininterest and servicing advances was primarily due to the seasoning of our REITportfolio and the related increase in delinquencies.

***Equipment andImprovements, Net.******  ***Equipment andimprovements, net, declined by $0.2 million, to $11.0 million, during the sixmonths ended June 30, 2006, reflecting the capitalization of new equipmentand improvement acquisitions outpacing depreciation and amortization.

***Prepaid Expenses andOther Assets.******  ***Prepaid expenses and other assets grew by $16.8million, to $47.6 million, during the six months ended June 30, 2006. Thiswas primarily due to increases of $18.8 million and $2.0 million in real estateowned and prepaids, security deposits and other deferred charges, respectively,partially offset by decreases of $2.0 million, $1.5 million, and $0.5 millionin licensing, permit and performance bond deposits, defunded loans, andunamortized debt issuance costs, respectively.

***Derivative FinancialInstruments.******  ***Weuse derivative financial instruments to hedge interest rate risk exposure toour portfolio of mortgage loans held for investment and related financings. At June 30,2006, we had derivative financial instruments with notional amounts of $6.5billion, of which $5.9 billion and $0.6 billion of such derivative financialinstruments were interest rate cap agreements and interest rate swapagreements, respectively. In comparison, we had $6.9 billion of notionalamounts comprised wholly of interest rate cap agreements at December 31,2005. The Company entered into an interest rate swap agreement with anamortizing notional amount in connection with the on-balance sheetsecuritization completed in May 2006. Under the terms of the agreement,the Company pays interest at a fixed rate of 5.36% and receives interest at afloating rate based on LIBOR.

We carry our derivative financial instruments atestimated fair value, which at June 30, 2006 was $42.9 million compared to$58.1 million at December 31, 2005. Included in interest expense duringthe six months ended June 30, 2006 was a $15.2 million charge related tothe negative mark to fair value of our interest rate cap agreements andinterest rate swap agreements at June 30, 2006. Included in interestexpense for the six months ended June 30, 2005 was a $2.0 million chargerelated to the negative mark to fair value of our interest rate cap agreementsat June 30, 2005.

***Financings on LoansHeld for Investment.*****  **Amounts outstanding underour financings on loans held for investment declined by $224.7 million, to $3.4billion, during the six months ended June 30, 2006, primarily due to$847.8 million of principal repayments, partially offset by the issuance of$618.3 million of financings, excluding the amortization of debt discount.

***Revolving Warehouseand Repurchase Facilities.******  ***Amounts outstandingunder revolving warehouse and repurchase facilities decreased by $762.8million, to $578.9 billion, during the six months ended June 30, 2006,primarily as a result of decreased reliance on the facilities to fund loansheld for sale and loans held for investment prior to their securitization.Proceeds from whole loan sales and securitizations are used first to reducebalances outstanding under our revolving warehouse and repurchase facilities,and then used to satisfy corporate operating requirements.

***Borrowings.*****  **At June 30,2006, we had no borrowings outstanding under our short-term collateralfinancing facility compared 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 used the proceeds fromthe issuance 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 andlong-term sources of cash.

Our primary sourcesof liquidity are expected to be:

·       fundingsfrom revolving warehouse and repurchase facilities;

·       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 their 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 the sale of loans;and

·       ongoingadministrative, operating, and tax expenses.

***Liquidity.******  ***At June 30, 2006, we hadnet operating liquidity of approximately $83.4 million, which consisted ofapproximately $50.0 million of unrestricted cash and cash equivalents, $25.0million of drawing capacity under a revolving line of credit facility, $1.3 millionof drawing capacity under a short-term collateralized financing facility, andapproximately $7.1 million of cash that could be immediately raised through thepledging of unencumbered and eligible loans held for sale as collateralpursuant to committed revolving warehouse and repurchase facilities. Wecurrently believe that our net operating liquidity level is sufficient tosatisfy our operating requirements.

If our access to warehouse lines, working capital, orwhole loan markets is restricted, we may have to seek additional equity. Therecan be no assurance that sufficient sources of liquidity will be available tous at any given time or that favorable terms will be available. If we areunable to maintain sufficient liquidity, we would be restricted in the amountof loans that we will be able to produce and sell, which would negativelyimpact profitability and jeopardize our ability to continue to operate as agoing concern.

***Fundings fromRevolving Warehouse and Repurchase Facilities.****  *We borrowsubstantial sums of cash on a regular basis to originate mortgage loans and tohold loans in our REIT portfolio. Therefore, we rely on revolving warehouse andrepurchase facilities to finance the origination and holding of mortgage loansprior to sale. At June 30, 2006, we had total revolving warehouse andrepurchase facilities in the amount of $2.6 billion, of which $2.5 billion and$0.1 billion were committed and uncommitted, respectively. At June 30,2006, amounts outstanding under our facilities totaled $578.9 million, leavingus with $2.0 billion of available committed borrowing capacity under thefacilities. Because of our decreased needs for revolving warehouse andrepurchase facilities due to the sale of our wholesale operations in July, 2006,we did not renew the $100.0 million facility that expired on July 31, 2006,reducing our total revolving warehouse and repurchase facilities to $2.5billion, of which $2.4 billion and $0.1 billion were committed 

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and uncommitted,respectively. Moreover, the committed $500.0 million facility that expiredon August 4, 2006 was renewed on an uncommitted basis untilOctober 31, 2006. The remaining $2.5 billion of total revolving warehouseand repurchase facilities are scheduled to mature as follows: $300.0 million onSeptember 29, 2006; $500.0 million on October 31, 2006; $500.0million on December 1, 2006; $500.0 million January 17, 2007; and$700.0 million on April 3, 2007. Pending the Merger with Accredited, we donot expect to renew the $300.0 million facility which expires on September 29,2006.

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. AtDecember 31, 2005, amounts outstanding under our facilities totaled $1.3billion, leaving us with $1.4 billion of available committed borrowing capacityunder the facilities 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 liquidity, stockholders’ equity,leverage, and net income levels. The facility agreements also contain customaryrepresentations 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 June 30, 2006.

***Fundings fromFinancings on Loans Held for Investment.******  ***Ourability to generate fundings from on-balance sheet securitization financings onloans held for investment is necessary to generate cash proceeds to pay downour revolving warehouse and repurchase facilities, which fund loans held forinvestment prior to their on-balance sheet securitization. During the sixmonths ended June 30, 2006, we completed an on-balance sheet transactionresulting in the securitization of $608.9 million of mortgage loans. During theyear ended December 31, 2005, we completed four on-balance sheettransactions resulting in the securitization of $3.7 billion of mortgage loans.

***Proceeds from theSale of Mortgage Loans.******  ***Our ability to sellloans we originate in the secondary market through whole loan sales isnecessary to generate cash proceeds to pay down our revolving warehouse andrepurchase facilities and fund mortgage loan production. Our ability to sellloans in the secondary market on acceptable terms is essential for thecontinuation of our loan origination operations.

During the six months ended June 30, 2006, wesold $1.5 billion of mortgage loans in whole loan sales for cash to thesecondary market, an increase of $1.1 billion over the $410.7 million of wholeloan sales during the six months ended June 30, 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. In addition, since announcing the proposed merger with Accredited,we no longer retain mortgage loans for our REIT portfolio and sell all of ourloan production in the secondary markets.

***Proceeds fromMonetization of Retained Mortgage-Backed Bonds from Our On-Balance SheetSecuritizations.******  ***At June 30, 2006,we were party to a revolving short-term collateralized financing facilitypursuant to which $4.1 million at par value of retained bonds was pledged ascollateral. There were no amounts outstanding under the facility atJune 30, 2006.

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***Proceeds fromRevolving Line of Credit Facility.******  ***DuringMarch 2006, we entered into a revolving line of credit agreement with acommercial bank. Under the terms of the agreement, we can borrow up to $25.0million at an interest rate of one-month LIBOR plus 175 basis points. Thefacility is secured by all of our corporate assets, excluding loans pledgedunder our revolving warehouse and repurchase facilities and retained bondspledged under our short-term collateral financing facility. The agreementexpires in March 2007. At June 30, 2006, we had not borrowed underthis facility.

***Proceeds from theIssuance of Debt and Equity Securities.******  ***On November 4,2005, our Form S-3 shelf registration statement, filed for thepurpose of selling our common stock, preferred stock, debt securities or othersecurities in one or more offerings up to an aggregate dollar amount of $500.0million, was declared effective by the Securities and Exchange Commission.Depending on our liquidity needs and market conditions, we may issue one ormore of these securities in different amounts and at different times. We intendto use the proceeds from any sale of these securities for general corporatepurposes, which includes continuing to build a portfolio of self-originatedmortgage loans, for general working capital purposes and to reduce short-termindebtedness.

***Cash Flow.*****  **The followingsummarizes our material cash flow activities during the six months ended June 30,2006 and 2005.

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 six months ended June 30, 2006, ournet cash provided by operating activities grew by $234.0 million, to $354.2million, from the $120.2 million of net cash provided by operating activitiesduring the six months ended June 30, 2005. This was primarily due to a$239.6 million decrease in cash used to fund originations of loans held forsale, net of proceeds from loan sales, as well as to a $17.0 million decreasein net loss, partially offset by a $22.6 million change in other operatingitems.

During the six months ended June 30, 2006, ournet cash provided by investing activities grew by $2.8 billion, to $670.4million, from $2.2 billion of cash used during the comparable six-month periodduring 2005. This was primarily attributable to a reduction in transfers fromloans held for sale to our REIT portfolio of loans held for investment as wellas principal payments received on our REIT portfolio.

During the six months ended June 30, 2006, ournet cash used in financing activities grew by $3.2 billion, to $1.0 billion,over the $2.1 billion of cash provided during the six months ended June 30,2005. This was primarily attributable to a $1.4 billion decline in proceedsfrom issuance of financings on loans held for investment, a $0.8 millionincrease in repayments of financings on loans held for investment, and a $0.9million increase in reductions to revolving warehouse and repurchase facilitiesduring the six months ended June 30, 2006 over the same period a year ago.The primary activities affecting our cash flows from financing activities areincreases and decreases in the level of financings of loans held for investmentand in the level of borrowings under our revolving warehouse and repurchasefacilities. In addition, financing activities also include capital related cashflows.

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, and 

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repayment of suchborrowings, are required to be included in the consolidated statements of cashflows as a component of cash flows from financing activities.

The amount of netoriginations of loans held for sale included as a component of cash flowsprovided by operating activities was $344.1 million during the six months endedJune 30, 2006 compared to $104.5 million as a component of cash providedby operating activities for the six months ended June 30, 2005. Excludingthe origination and sale activity of loans held for sale, our operatingactivities provided $10.1 million and $15.7 million of cash during the sixmonths ended June 30, 2006 and 2005, respectively.

**CONTRACTUALOBLIGATIONS**

Thefollowing table summarizes our material contractual obligations as of theperiod indicated (in millions):

| ** **                                     | ** ** | **Payments Due By Period** | ** ** | ** **      | ** ** |
|------------------------------------------------|------------|-------------------------------------------|------------|-----------------|------------|
| ** **                                     | ** ** | **Less Than**                        | ** ** | **1-3**         | ** ** | **3-5** | ** ** | **More Than** | ** ** | ** ** | ** ** |
| **June 30, 2006**                    | ** ** | ** **                                | ** ** | **1 year** | ** ** | **Years** | ** ** | **Years** | ** ** | **5 years** | ** ** | **Total** | ** ** |
| Financing on  loans held for investment        |       |                                      | $          | 1,554.1         |       |   | $ | 1,299.1 |   | $ | 352.3 |   |   | $ | 213.1 |   |   | $ | 3,418.6 |   |
| Revolving  warehouse and repurchase agreements |       |                                      | 578.9      |            |       | — |   | — |   |   | — |   |   | 578.9 |   |
| Operating leases,  net                         |       |                                      | 13.2       |            |       | 21.3 |   | 11.9 |   |   | 3.4 |   |   | 49.8 |   |
| Purchase and  other obligations                |       |                                      | 0.2        |            |       | — |   | — |   |   | — |   |   | 0.2 |   |
| Total                                          |       |                                      | $          | 2,146.4         |       |   | $ | 1,320.4 |   | $ | 364.2 |   |   | $ | 216.5 |   |   | $ | 4,047.5 |   |
|                                                |            |                                           |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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**

Thefollowing table provides information related to our derivative financialinstruments used to hedge interest rate risk exposure to our portfolio ofmortgage loans held for investment and related financings at the datesspecified (in thousands):

| ** **                   | ** ** | **June 30,** | ** ** |
|------------------------------|------------|-------------------|------------|
| ** **                   | ** ** | **2006**          | ** ** | **2005** | ** ** |
| Notional amounts:            |       |              |       |   |   |
| Interest rate cap agreements |       | $                 | 5,873,500  |   | $ | 6,011,727 |   |
| Interes rate swap  agreement |       | 591,786           |       | — |   |
|                              |            |                   |            |  |  |  |  |

 

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| ** **                            | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------|------------|--------------------------------|------------|
| ** **                            | ** ** | **June 30,**              | ** ** |
| ** **                            | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| Interest income:                      |       |                           |       |   |   |
| Remittances from  counterparties for: |       |                           |       |   |   |
| Interest rate cap agreements          |       | $                              | 29,488     |   | $ | 7,258 |   |
| Interes rate swap agreement           |       | 30                             |       | — |   |
| Total                                 |       | $                              | 29,518     |   | $ | 7,258 |   |
| Interest expense:                     |       |                           |       |   |   |
| Mark to market  (gain) loss on:       |       |                           |       |   |   |
| Interest rate cap agreements          |       | $                              | 17,122     |   | $ | 1,963 |   |
| Interes rate swap agreement           |       | (2,437                         | )          | — |   |
| Total                                 |       | $                              | 14,685     |   | $ | 1,963 |   |

 

The Company entered into an interest rate swapagreement in May 2006. Under the terms of the swap agreement, the Companypays interest at a fixed rate of 5.36% and receives interest at a floating ratebased on LIBOR. The Company was a net receiver of interest during the sixmonths ended June 30, 2006, and expects to continue to be a net receiverof interest as interest rates continue to rise.

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.

**INTEREST RATESENSITIVITY**

***Sale of Loans—Interest Rate Risk.******  ***Weare exposed to rising interest rates for loans originated or purchased whichare held pending sale in the whole loan market. From time to time, we mitigateexposure to rising interest rates through the use of interest rate capagreements, forward interest rate swap agreements, or other hedging activities.These hedging activities help mitigate the risk of absolute movements ininterest rates.

**INTEREST RATESENSITIVE ASSETS AND LIABILITIES**

***Fair Value ofFinancial Instruments.*****  **Our financial instruments,which are recorded at contractual amounts that approximate market or fairvalue, primarily consist of loans held for sale, advances and otherreceivables, and revolving warehouse and repurchase facilities. As theseamounts are short-term in nature and/or generally bear market rates ofinterest, the carrying amounts of these instruments are reasonable estimates oftheir fair values. Our financial instruments also include our loans held forinvestment, which are recorded at contractual amounts. The fair value of ourloans held for investment are based on current market prices for similar loansusing current investor yield requirements. The carrying amount of our warehouseborrowings approximates fair value when valued using available quoted marketprices.

***Interest Rate Risk.******  ***Weare exposed to on-balance sheet interest rate risk related to our loans heldfor investment and loans held for sale.

***WarehouseFacilities Exposure.******  ***We utilize revolvingwarehouse and repurchase financing facilities to facilitate the holding ofmortgage loans prior to sale and securitization. Revolving warehouse andrepurchase facilities are typically for a term of one year or less and aredesignated to fund mortgages originated within specified underwritingguidelines. The majority of the assets remain in the facilities for a period ofup to 90 days at which point they are securitized or sold to institutionalinvestors. As these amounts are short-term in nature and/or generally bearmarket rates of interest, the contractual amounts of these instruments arereasonable 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** | ** ** | ** ** | ** ** | ** ** | ** ** |
| **June 30, 2006**                                                        | ** ** | ** **              | ** ** | **6 Months** | ** ** | **to 1 Year** | ** ** | **Years** | ** ** | **Years** | ** ** | **Years** | ** ** | **Thereafter** | ** ** | **Total** | ** ** |
| Interest rate  sensitive assets:                                                   |       |                    |       |              |       |   |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                                                          |       | $                       | 117,401    |              | $          | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 117,401 |   |
| Loans held for sale, net                                                           |       | 607,037                 |       | —            |       | — |   | — |   | — |   | — |   | 607,037 |   |
| Loans held for investment, net                                                     |       | 837,858                 |       | 727,918           |       | 915,949 |   | 653,460 |   | 125,094 |   | 137,795 |   | 3,398,074 |   |
| Derivative financial instruments                                                   |       | 42,927                  |       | —            |       | — |   | — |   | — |   | — |   | 42,927 |   |
| Total interest rate sensitive assets                                               |       | $                       | 1,605,223  |              | $          | 727,918 |   | $ | 915,949 |   | $ | 653,460 |   | $ | 125,094 |   | $ | 137,795 |   | $ | 4,165,439 |   |
| Interest rate  sensitive liabilities:                                              |       |                    |       |              |       |   |   |   |   |   |   |   |   |   |   |
| Revolving warehouse and repurchase facilities                                      |       | $                       | 578,908    |              | $          | — |   | $ | — |   | $ | — |   | $ | — |   | $ | — |   | $ | 578,908 |   |
| Financings on loans held for investment                                       |       | 833,670                 |       | 720,370           |       | 887,306 |   | 636,973 |   | 127,212 |   | 213,082 |   | 3,418,613 |   |
| Total interest rate sensitive liabilities                                          |       | $                       | 1,412,578  |              | $          | 720,370 |   | $ | 887,306 |   | $ | 636,973 |   | $ | 127,212 |   | $ | 213,082 |   | $ | 3,997,521 |   |
| Excess of  interest rate sensitive assets over interest rate sensitive liabilities |       | $                       | 192,645    |              | $          | 7,548 |   | $ | 28,643 |   | $ | 16,487 |   | $ | (2,118 | ) | $ | (75,287 | ) | $ | 167,918 |   |
| Cumulative net interest  rate sensitivity gap                                      |       | $                       | 192,645    |              | $          | 200,193 |   | $ | 228,836 |   | $ | 245,323 |   | $ | 243,205 |   | $ | 167,918 |   | $ | 167,918 |   |
|                                                                                    |            |                         |            |                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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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 |   |
| Derivative financial instruments                                                   |       | 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 ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of AamesInvestment’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15.Based upon that evaluation, the Chief Executive Officer and Chief FinancialOfficer concluded that Aames Investment’s disclosure controls and proceduresare effective as of the end of the period covered by this report. Subsequent tothe date of that evaluation, there have been no changes in Aames Investment’sinternal controls over financial reporting (as defined in Rule 13a-15f)that have materially affected or are reasonably likely to materially affect ourinternal control over financial reporting.

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**PART II—OTHERINFORMATION**

**Item 1.**                        LegalProceedings

In July 2005, we were served with a putativeclass action complaint entitled*Webb v. Aames InvestmentCorporation, et. al*. brought in the United States District Court,Central District of California. In December 2005, we were served with aputative class action complaint entitled *Cooper v. Aames InvestmentCorporation, et. al*. brought in the United States District Court,Eastern District of Wisconsin. These complaints allege violations of the FairCredit Reporting Act (the “FCRA”) in connection with prescreened offers ofcredit, which we made to plaintiffs. *Webb* alsoalleges that our direct mail pieces failed to comply with the requirements ofFCRA that the required notice be clear and conspicuous. The plaintiffs seek torecover on behalf of themselves and others similarly situated compensatory andpunitive damages and attorneys’ fees. We filed a motion to dismiss the clearand conspicuous claims in connection with *Webb,*which wasultimately denied by the Court on May 30, 2006, leaving this claim as toall direct mail sent prior to December 2004. The Court has requestedfurther briefing to determine whether it will grant leave for the plaintiffs toamend. 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.

On April 27, 2004, we received a civilinvestigative demand from the Federal Trade Commission, or the FTC, that,although not alleging any wrongdoing, sought documents and data relating to ourbusiness and lending practices. The demand was issued pursuant to an April 8,2004 resolution of the FTC authorizing non-public investigations of variousunnamed subprime 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.

On September 7, 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 0.01% and 0.01% oftotal mortgage loan production during the six months ended June 30, 2006and 2005, respectively.

In the ordinary course ofour business, we are subject to various claims made against us arising from,among other things, our loan origination and collection efforts, tradepractices and alleged violations of the various federal and state laws andregulations applicable to our business, such as consumer protection laws andemployment laws. We believe that the resolution of any of these pendingincidental claims is not likely to have a material adverse effect on ourconsolidated financial position 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 subject ofcurrent putative class action litigation and investigations by governmentalagencies, which could adversely affect our business and attract class actionlitigation against us.**

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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 aputative class action complaint entitled *Webb v. AamesInvestment Corporation, et. al.* brought in the United StatesDistrict Court, Central District of California, and in December 2005 wewere 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 (the “FCRA”) in connection withprescreened offers of credit, which we made to plaintiffs. *Webb*also alleges that our direct mail pieces failed to comply with the requirementsof the FCRA that the required notice be clear and conspicuous. The plaintiffsseek to recover on behalf of themselves and others similarly situatedcompensatory and punitive damages and attorneys’ fees. At the time we filedthat Form 10-K, we believed that our motion to dismiss the clear andconspicuous claims would be granted with leave to amend. Such motion was,however, ultimately denied by the Court on May 30, 2006, leaving theseclaims as to all direct mail sent prior to December 2004.

**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 Quarterly Report on Form 10-Q  for the quarter ended June 30, 2005 (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).                                                                                                      |
| 10.5(f)          |       | Amendment No. 5 to  the Master Repurchase Agreement dated as of May 10, 2006 among Bear  Stearns Mortgage Capital Corporation, Aames Investment Corporation and Aames  Funding Corporation.                                                                                                                                                                                                                    |

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| 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). |
|----------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 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).                                                                                                                             |
| 10.8(d)  |   | Amendment No. 3  dated May 9, 2006 to the Master Repurchase Agreement among Aames Capital  Corporation, Aames Funding Corporation and Morgan Stanley Bank dated  December 2, 2005.                                                                                                                                                                                                                |
| 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. (incorporated by reference to  Exhibit 10.10(a) to the March 31, 2006 Quarterly Report on  Form 10-Q).                                                                                |
| 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).                                                                                                                           |

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| 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).                                                                           |
| 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).                                                                                            |
| 10.11(e) |   | Fifth Amendment to  Master Repurchase Agreement Governing Purchases and Sales of Mortgage Loans  dated May 10, 2006, among Lehman Brothers Bank, FSB, Aames Capital  Corporation and Aames Investment Corporation.                                                                                                                                                                                   |
| 10.12    |   | 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).                                                           |
| 10.13(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”)). |
| 10.13(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).                                                                                                                                                                |
| 10.13(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).                                                                                                                                                            |
| 10.14    |   | 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).                                                       |
| 10.15    |   | 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).*                                                                                                                                                                        |
| 10.16    |   | 2005 Executive  Management Incentive Compensation Plan Summary (incorporated by reference to  the Exhibit 10.17 to the 2004 10-K).*                                                                                                                                                                                                                                                                  |
| 10.17    |   | 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).*                                                                                                                                                                                                         |
| 10.18    |   | 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).*                                                                                                                                                                      |

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| 10.19 |   | Agreement and Plan of Merger among Aames Investment  Corporation, Accredited Home Lenders Holding Co. and AHL Acquisition, LLC  dated as of May 24, 2006 (incorporated by reference to the current  Report on Form 8-K filed with the SEC on June 28, 2006 (the  “June 28, 2006 8-K”)). |
|-------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.20 |   | Asset Purchase Agreement  dated as of June 23, 2006 among Aames Investment Coropration, Aames  Funding Corporation, Accredited Home Lenders Holding Co. and Accredited Home  Lenders, Inc. (incorporated by reference to the June 28, 2006 8-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 a management contract or compensatoryarrangement.

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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: August 9,  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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