UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

AMNET MORTGAGE, INC.

(Exact name of registrant as specified in its charter)

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

ý  YES    o  NO

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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PART I.  FINANCIAL INFORMATION

Item 1.  Consolidated Financial Statements

AmNet Mortgage, Inc. and Subsidiaries

Consolidated Balance Sheets, unaudited

(in thousands, except share and per share data)

See accompanying notes to consolidated financial statements.

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AmNet Mortgage, Inc. and Subsidiaries

Consolidated Statements of Operations and Comprehensive Income (Loss), unaudited

(in thousands, except per share data)

See accompanying notes to consolidated financial statements.

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AmNet Mortgage, Inc. and Subsidiaries

Consolidated Statements of Cash Flows, unaudited

(in thousands)

See accompanying notes to consolidated financial statements.

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AMNET MORTGAGE, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1.  Summary of Significant Accounting Policies and Practices

Basis of Financial Statement Presentation

The consolidated financial statements include the accounts of AmNet Mortgage, Inc., a Maryland corporation, American Mortgage Network, Inc., a Delaware corporation and wholly-owned subsidiary of AmNet Mortgage, Inc., American Residential Eagle, Inc., a Delaware special purpose corporation and wholly-owned subsidiary of AmNet Mortgage, Inc. and American Residential Eagle 2, Inc., a Delaware limited purpose corporation and wholly-owned subsidiary of American Residential Eagle, Inc. Substantially all of the assets of American Residential Eagle, Inc. are pledged to support long-term debt in the form of collateralized mortgage bonds and are not available for the satisfaction of general claims of AmNet Mortgage, Inc. American Residential Holdings, Inc. is an affiliate of AmNet Mortgage, Inc. that is consolidated in accordance with FASB Interpretation No. 46R “Consolidation of Variable Interest Entities.” All entities are together referred to as the “Company” or “AmNet.” The Company’s exposure to loss on the assets pledged as collateral is limited to its net investment, as the collateralized mortgage bonds are non-recourse to the Company. All significant intercompany balances and transactions have been eliminated in the consolidation of AmNet. Certain reclassifications have been made to prior period amounts to conform to the current presentation.

In management’s opinion, all adjustments necessary for a fair statement are reflected in the interim period presented. These adjustments are of a normal recurring nature. The interim financial data as of March 31, 2005 and March 31, 2004 is unaudited; however, in the opinion of the Company, the interim data includes all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim periods.

Sales of mortgage loans are accounted for under Statement of Financial Accounting Standards (SFAS) No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” Mortgage loans are sold with the mortgage servicing rights released. Gains or losses on sales of mortgage loans are recognized based on the difference between the selling prices and the carrying value of the related mortgage loans sold. Deferred origination fees and expenses are recognized at the time of sale.

Please refer to the Company’s Form 10-K for the year ending December 31, 2004, for a detailed discussion of all significant accounting policies.

Stock Options and Restricted Stock

The Company elected to apply APB Opinion No. 25, “Accounting for Stock Issued to Employees,” in accounting for its stock-based compensation plans: the 2004 Equity Incentive Plan and 1997 Employee Stock Purchase Plan. Accordingly, no compensation cost has been recognized in the financial statements for stock options. Compensation in the form of restricted stock will be recognized through amortization of deferred compensation. SFAS No. 123 “Accounting for Stock Based Compensation” requires pro forma disclosures of expense computed as if the fair value-based method had been applied in the financial statements of companies that continue to account for such arrangements under Opinion No. 25.

In December 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 148, “Accounting For Stock Based Compensation Transition and Disclosure,” which amends SFAS No. 123. SFAS No. 148 requires more prominent and frequent disclosures about the effects of stock-based compensation. The Company continues to account for its stock based compensation according to the provisions of APB Opinion No. 25.

The FASB amended SFAS No. 123, “Accounting for Stock-Based Compensation,” which supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” in December, 2004. The amendment requires the Company to record compensation expense for all share-based compensation beginning January 1, 2006. When adopted, this standard will have a negative impact on earnings of approximately $40 thousand per month in future periods since stock options already issued will vest in future periods and be expensed.

During the three month period ending March 31, 2005 the Company authorized the issuance of 92,684 shares of restricted stock to executives within the Company which will vest over a three year period beginning in February of 2005. The value of these shares is being expensed over the vesting period.  The restricted shares were issued in April of 2005.  On March 31, 2005 the Company authorized 47,900 restricted stock units to eleven senior executives of the Company with 50% vesting on December 31, 2008 and 2009 respectively.

Had compensation cost for the Company’s stock options been recognized based upon the estimated fair value on the grant date under the fair value methodology, the Company’s net income (loss) would have been as follows (in thousands except income per share) (unaudited):

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The assumptions used to calculate the fair value of options granted are evaluated and revised as necessary to reflect market conditions and the Company’s experience. There have been no changes in these assumptions from December 31, 2004.

Note 2.  Concentrations

For the three months ending March 31, 2005, the Company sold the majority of its loans (by volume) to three correspondent investors, Countrywide Home Loans, Inc. (47.0%), Wells Fargo Funding, Inc. (18.5%) and Morgan Stanley Mortgage Capital Inc. (15.7%). The Company’s considerations in deciding where to sell loans are price and operational efficiency.  The Company also considers speed of execution and loan product guidelines.  The Company believes that all of the loans it sells currently could be sold to a number of other investors.

In addition, approximately 30% of the dollar value of loans generated was derived from loans originated in California.  While the Company generates loans on a nationwide basis, it is anticipated that the Company will continue to have a significant concentration of loans originated from California.

Note 3.  Income Per Share

The following table illustrates the computation of basic and diluted income per share (in thousands, except share and per share data) (unaudited):

For the three months ended March 31, 2005 and 2004 there were 1,189,221 and 1,411,917 options, respectively, that were antidilutive and, therefore, not included in the calculations above.

Note 4.  Mortgage Loans Held for Sale, net, pledged

AmNet has pledged loans held for sale totaling approximately $424.4 million to secure credit lines (warehouse facilities) from four financial institutions. (See Note 7. “Short-Term Debt.”). Mortgage loans held for sale at March 31, 2005 consist of loans which have been committed for sale of approximately $313.0 million and loans available for sale of approximately $111.4 million, all of which are carried at the lower of cost or market value.

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Note 5.  Bond Collateral, Mortgage Loans, net

AmNet has pledged collateral in order to secure the long-term debt issued in the form of CMOs. Bond Collateral Mortgage Loans consist primarily of subprime credit, 30-year mortgage loans secured by first liens on one-to-four family residential properties. As of March 31, 2005 and 2004, 0% and 17.17%, respectively, of the bond collateral mortgage loans were fixed rate loans. The balance of the bond collateral mortgage loans are adjustable-rate mortgages. All Bond Collateral Mortgage Loans are pledged to secure repayment of the related long-term debt obligation. All principal and interest (less servicing and related fees) on the bond collateral is remitted to a trustee and is available for payment of the long-term debt obligation. The obligations under the long-term debt are payable solely from the bond collateral and are otherwise non-recourse to AmNet.

In March of 2004, approximately $113.9 million in Bond Collateral Mortgage Loans and approximately $2.3 million in REO bond collateral were reclassified as held for sale.  By September 30, 2004 all of these mortgage loans including real estate owned, had been sold.  One remaining portfolio (CMO/FASIT 1998-1) was not sold.  Bond collateral for this structure is shown as Bond collateral, mortgage loans, net and Bond collateral, real estate owned, net.

Note 6.  Derivative Financial Instruments

AmNet makes commitments to fund mortgages at set interest rates, which are referred to as rate locked loan commitments. Additionally, most of the Company’s loans are not yet committed for sale at the time of funding. Collectively, rate locked loan commitments and funded loans not yet committed for sale (closed loans) are the Company’s pipeline.  The value of the pipeline will vary depending on changes in market interest rates between the time that a rate locked loan commitment is made and the time that the loan funds and is committed for sale to an investor.

AmNet estimates the number of rate locked loan commitments in the pipeline that will not close in order to calculate its interest rate exposure on a daily basis. AmNet then purchases hedging instruments in order to try to protect profit margins on the pipeline. The hedging instruments typically used are forward sales of mortgage-backed securities (“TBA”) and options on forward sales of mortgage-backed securities. Historically, changes in the price of these instruments closely relate to changes in the value (price) of loans in the pipeline. The Company has elected not to apply hedge accounting on the loan pipeline.

At March 31, 2005 and December 31, 2004 AmNet had the following commitments to originate loans and loans not yet committed for sale to investors, and offsetting hedge coverage; (dollars in thousands) (unaudited).  (Note that interest rate exposure does not directly correspond to the notional amounts of hedge coverage without applying an option adjusted spread factor to the pipeline and hedges):

The fair value of forward sales of mortgage-backed securities and options on forward sales of mortgage-backed securities are based on quoted market prices for these instruments. The rate locked loan commitments are also considered a derivative instrument and are assigned fair values based on the change in the quoted market value of the underlying loans due to market movements, less an estimated factor for loans that will not close (fallout ratio). The fallout ratio is affected by the Company’s recent fallout history, interest rate changes and loan characteristics.

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The following is a summary of the carrying value of AmNet’s derivative instruments as of March 31, 2005 and December 31, 2004 (dollars in thousands) (unaudited):

The following is a summary of the components within Total derivative financial instruments and market adjustments income (expense) (dollars in thousands) (unaudited):

Note 7.  Short-Term Debt

As of March 31, 2005, mortgage loans held for sale totaling $424.4 million were pledged as collateral for warehouse facility borrowings of $409.8 million with four financial institutions. At March 31, 2005, the Company’s maximum borrowing capacity combined from these four financial institutions was $1.4 billion.  The table below shows the age of pledged mortgage loans as of March 31, 2005 (in thousands) (unaudited):

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Of the $409.8 million of warehouse line usage at March 31, 2005, $145.9 million was funded through uncommitted warehouse facilities.

The warehouse facilities mature on various dates in 2005 and 2006, and generally bear interest at one-month LIBOR plus spread. The weighted average borrowing rates were 4.14% and 3.65% at March 31, 2005 and December 31, 2004 respectively. The weighted-average borrowing rate was 3.97% for the three months ending March 31, 2005 and 3.65% for the three months ending December 31, 2004. The weighted-average facility fee was .23% for the three months ending March 31, 2005 and 0.23% for the three months ending December 31, 2004 on the aggregate committed amount of the warehouse facilities. The warehouse facilities are repaid as principal payments on mortgage loans are received, or as the mortgage loans are sold. We are generally allowed to borrow from 96% to 99% of the lesser of par or market value of the loans, and must comply with various lender covenants restricting, among other things, the absolute level of leverage, requiring minimum levels of cash reserves, profitability and stockholders’ equity. We are also, in a certain instance, required to maintain a restricted cash account with one of our warehouse lenders. During the quarter ending March 31, 2005 we were required to add $750 thousand to our cash account due to general business conditions.  As of March 31, 2005 the Company was in compliance with all warehouse line facility covenants. We believe we are in good standing with all of our warehouse lenders.

Note 8.  Long-Term Debt Related to Securitizations, net

The components of the long-term debt at March 31, 2005 and December 31, 2004, along with selected other information are summarized below (dollars in thousands) (unaudited):

The table below shows the Company’s expected future payments for future obligations under long-term debt agreements (000’s):

Note 9.  Recourse Liabilities Associated With Loan Sales

We sell loans to private investors and other financial institutions. Each loan sale is subject to certain terms and conditions, which generally require us to repurchase loans or indemnify and hold the investor harmless against any loss arising from early payoff default activity and errors and omissions in the origination, processing and/or underwriting of the loans. We are subject to this risk for loans that we originate as well as loans we acquire from brokers and correspondents. At March 31, 2005 and December 31, 2004, we had approximately $5.6 million and $4.6 million, respectively, recorded as an estimate for losses that may occur as a result of the guarantees described above based on trends in repurchase and indemnification requests, actual loss experience, known and inherent risks in the loans, and current economic

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conditions. The length of the indemnification period, which varies by investor and the nature of the potential defect, may extend to the life of the loan.

Under most of our loan sale agreements, we are also obligated to refund premiums to investors if loans pay off within a certain number of days after the settlement of our loan sale. These refunds are referred to as early prepayment premiums or (“EPPs”). The EPP exposure period generally ranges from 60-120 days after the settlement date. At March 31, 2005 and December 31, 2004, we had approximately $772 and $894 thousand, respectively, recorded as an estimated reserve for premium refunds that may occur as a result of loans sales which were still subject to EPP liability.

Reserve activity for the periods presented is as follows (dollars in thousands):

The balances for the Reserve For Repurchase Obligations and Premium Prepayment Reserve are included in the Consolidated Balance Sheets in the Recourse liabilities associated with loan sales line item. The payments and provisions represent the yearly change of the balance sheet accounts. The related expense for the three months ending March 31, 2005 and March 31, 2004 is included in the Consolidated Statements  of Operations and Comprehensie Income (Loss) in the revenue section, gain on sales of loans line item.

Note 10.  Stock Plans

As of March 31, 2005, shares of common stock were reserved for issuance under the Company’s stock option plans as follows (unaudited):

* The 1997 Stock Plan continues until all options outstanding under it are terminated or exercised. No new options will be granted.

** Includes 92,684 shares of restricted stock authorized February 2005 and issued April 2005.

Stock option activity during the three months ending March 31, 2005 was as follows (unaudited):

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At March 31, 2005, the range of exercise prices for outstanding options was $1.75 to $15.00 and the weighted-average remaining contractual life of outstanding options was 6.11 years. The weighted average exercise price of exercisable outstanding options was $8.79.  The table below shows options and prices for all outstanding options at March 31, 2005 (unaudited):

For the first quarter ending March 31, 2005 the per share weighted-average fair value of stock options granted was $2.13. This value was calculated using the Black-Scholes option-pricing model, using the following weighted-average assumptions (unaudited):

On February 7, 2005 the Company’s Compensation Committee authorized payments under the Long-Term Incentive Cash Plan. However, the Committee determined that it is in the best interests of the Company to pay half of each award value in cash and half in restricted stock of the Company. Consequently, 92,684 restricted shares of the Company’s stock were authorized to be issued to the executives of the Company with a three year vesting period.  Issuance of the restricted stock was made in April 2005.  The cost to the Company will be approximately $278 thousand per year for three years beginning in 2005. On March 31, 2005 the Committee authorized 47,900 restricted stock units to eleven senior executives of the Company with 50% vesting on December 31, 2008 and 2009 respectively. The result of both awards was $1.3 million of deferred compensation, which was reduced during the quarter ending March 31, 2005 to $1.2 million by monthly amortization and included in the equity section of the Consolidated Balance Sheets.

Note 11.  Income Taxes

During 1997, the Company elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended. As a result of this election, the Company was not, with certain exceptions, taxed at the corporate level on the net income distributed to the Company’s stockholders. On July 19, 2002, the stockholders of the Company approved two proposals that allowed for the conversion of the Company from a REIT to a fully taxable entity. On February 7, 2003, the Company filed a notice with the Internal Revenue Service of its decision to relinquish its REIT status, effective January 1, 2003.

As a result of the conversion to a fully taxable status, an income tax benefit and related deferred tax asset of $5.7 million was recorded in 2003. As of March 31, 2005, our deferred tax asset amounts to $10.2 million which reflects a change in the tax provision from December 31, 2004. The tax provision was calculated based on an assumed income tax rate of 44% for 2005.

At March 31, 2005, in determining the possible future realization of deferred tax assets, management considers future taxable income from the following sources: (a) reversal of taxable temporary differences, (b) future operations exclusive of reversing temporary differences, and (c) tax planning strategies that, if necessary, would be implemented to accelerate taxable income into years in which net operating losses might otherwise expire.

As the Company’s net income and its projections of net income vary over time, the expected realizability of its deferred tax assets may change. If the Company determines that its ability to realize all of its deferred taxes is unlikely, the Company will set up certain valuation allowances against those assets, which would negatively affect its net income. However, currently, we expect to fully utilize our deferred tax assets.

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Note 12.  Commitments and Contingencies

Lease Commitments

The Company rents certain premises and equipment under non-cancelable operating leases expiring at various dates through the year 2010. Rental expense under such leases is included in office and occupancy expense, and other operating expenses. Lease costs totaled $985 thousand in the three months ending March 31, 2005 and $913 thousand in the three months ending March 31, 2004. Future minimum lease payments under these leases as of March 31, 2005, are as follows (dollars in thousands) (unaudited):

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ITEM 2.  MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The statements contained in this Form 10-Q that are not purely historical are forward looking statements, including statements regarding our expectations, hopes, beliefs, intentions, or strategies regarding the future. Such statements use words such as “expect,” “will,” “may,” “anticipate,” “goal,” “intend,” “seek,” “believe, “target”, “ “plan,” “strategy” and derivatives of such words. Forward looking statements in this report include those statements regarding:

•                  Our future results of operations and the factors that could impact our results;

•                  The factors that may impact our future liquidity;

•                  Our strategies;

•                  Changes in the mortgage market and competitive factors;

•                  The estimates we use in preparing our financial statements and the impact of accounting standards;

•                  The risks that may impact our business.

These forward looking statements are based on information available to us on the date hereof, and we assume no obligation to update any such forward looking statements. It is important to note that our actual results and timing of certain events could differ materially from those in such forward looking statements.  Some of the most significant risks that we face that could harm our future operating results or prevent us from meeting our goals and objectives are the following:

•                  We are maximizing the utilization of our existing infrastructure while managing our staffing levels and growing our sales presence in existing and new markets. Due to market contraction, our strategy requires us to capture an increasing percentage of the market in a highly competitive environment, which will put pressure on our gross margins. If we are not able to do this, we would likely experience losses (due to our increased level of expenses or lower gross margins).

•                  We have expanded our branch system and fixed expenses over the past year in a contracting market.  Additionally, our market share increases are dependent on retaining and expanding our sales force and broker customer base, which is more challenging in a highly competitive market environment. In particular we must remain competitive relative to our pricing of loans, which could cause us to lower our gross margins.

•                  We sell a substantial portion of our loans to two of our competitors.  If these competitors stop purchasing our loans on favorable terms, we could be required to find alternate purchasers and/or accept unfavorable terms.  In either case, this could reduce our revenues and earnings.

•                  In 2004 we made the strategic decision to create a correspondent lending operating platform and in 2005 we began purchasing closed loans from small mortgage bankers and other financial institutions.  Some of the risks associated with this channel are different from our wholesale lending business, and our Company has no experience competing in this highly competitive segment of the mortgage market.  We have committed overhead to this new channel, and expect to make additional investments in 2005 to try to build this new source of revenue.  However it is difficult to evaluate our competitive posture and growth prospects for this channel, and we may not be able to compete effectively against larger, well established correspondent lenders.

•                  In 2004 we began offering subprime loans to wholesale brokers, and we intend to increase our proportion of subrpime loans significantly in 2005 as we hire dedicated account executives to call on mortgage brokers who specialize in subprime loans.  While we have a centralized underwriting and funding center to process these loans and have hired experienced personnel, subprime loans are more complex and any errors we make in underwriting or funding these loans could cause loans to be un-saleable or to be sold at a significant loss.  Additionally subprime lending is extremely competitive making it difficult to evaluate the potential growth prospects and profit margins for this product line.

•                  We are dependent on our warehouse lending facilities to operate our business.  We must maintain, renew or replace our warehouse lines of credit in order to continue to fund loans.  We believe we are in good standing with our warehouse lenders, however, any future reductions or restrictions in our warehouse capacity would reduce the volume of loans that we could fund and would therefore reduce our revenues and earnings.

•                  A large portion of the loans we fund are concentrated in California and therefore our results are subject to adverse economic conditions in California.

•                  Our hedging strategies may not be successful in mitigating risks associated with interest rate changes.  In particular, for new loan products with shorter terms and loan products with adjustable rates, hedging strategies may not be effective at certain times.

Other factors that may impact our results, include but are not limited to, general economic conditions, the world political climate, unexpected expense increases, overall interest rates, volatility in interest rates, the shape of the yield curve,  changes in accounting rules or their application, changes in the margins for gains on sale of originated loans, changes in the demand of mortgage brokers for our loan products and services or of loan purchasers for originated loans, undetected fraud on the part of

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borrowers, brokers, appraisers or our employees, changes in the mortgage industry regulatory environment, increases in prepayment rates and default rates, changes in the requirements of correspondent loan programs or our ability to meet such requirements and changes in our anticipated cash requirements. These and other risk factors that could cause actual results to differ materially are set forth in more detail in this item under the heading “Business Risk Factors.”

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Introduction

Our Company was founded in 1997 as an externally managed Real Estate Investment Trust. Until 2001, substantially all of our operations consisted of the acquisition of residential mortgages for investment purposes. In mid-2001, our Board of Directors and management determined that it was in the best interest of the stockholders to fundamentally shift our strategic direction to mortgage banking. We started the transition in 2001 by forming a subsidiary, American Mortgage Network, Inc., to engage in the wholesale lending segment of the mortgage banking industry. Effective January 1, 2002 we began reporting our financial results in two segments: the Mortgage Banking Business and the Mortgage Asset Portfolio Business. In January of 2003 we elected to relinquish our REIT status with the Internal Revenue Service, which had previously been approved by our stockholders. In order to more closely align our name with our mortgage banking focus, we changed our name from American Residential Investment Trust, Inc. to AmNet Mortgage, Inc., as of May 5, 2004. On September 29, 2004 our Company’s stock began trading on the NASDAQ National Market System under the trading symbol AMNT. Previously we were listed on the American Stock Exchange under the trading symbol INV and prior to that we were listed on the NYSE.

In March of 2004, we began providing loan programs tailored to sub-prime borrowers with credit that does not meet conventional guidelines or who require non-conventional loan terms with respect to loan-to-value, debt ratio, cash-out or documentation. We offer sub-prime loans through several different loan programs. However, our Company policy is not to provide high cost loans which are defined as mortgage loans that feature either an interest rate or points and fees charged in connection with loans that exceed certain thresholds prescribed by federal or state law or local ordinances. Sub-prime lending provides loan solutions for borrowers with credit problems who would not qualify for other lending products we offer. The unit cost to originate these loans is higher due to more labor intensive underwriting and funding processes, higher sales commission rates and a higher percentage of loan applications that are not approved or funded. As a result of higher credit risk and cost, we must charge higher interest rates for assuming this risk. To help mitigate the additional risks, underwriting for these loans is performed at our centralized sub-prime operations center located in our San Diego headquarters office as opposed to the regional underwriting and funding we utilize for all other wholesale loan products we offer. Our long-term strategy is to grow this segment of our business to up to 20% of our loan funding volume. Our subprime volume was one percent of total loan volume funded in the first quarter of 2005 and is expected to reach four percent of total loan volume by the end of 2005. We have hired seasoned staff to augment our expertise in this area of lending. We also have negotiated with investors to buy the loans we generate and amended our agreements with existing warehouse lenders to finance these loans.

In the second half of 2004 we made a strategic decision to create a correspondent lending channel. Incremental revenues from this channel will help us to more fully leverage our wholesale lending infrastructure, particularly our headquarter administrative costs. Correspondents are larger brokers, mortgage bankers or other financial institutions who originate and fund loans and sell closed loans on a servicing-released basis. We have hired an experienced sales team and established an operations center in Columbia Maryland to process these loan purchases. We began originating loans through this channel in the first quarter of 2005.

We originate mortgage loans predominately to prime quality borrowers (except our subprime division) secured by first trust deeds through a network of independent mortgage brokers. A concentration of our business is in California (30% of loans originated in the three months ending March 31, 2005); however, we do business on a nationwide basis. We sell the loans that we originate to institutional purchasers on a servicing-released basis.

We use a dedicated sales force to offer our loan products to approved wholesale mortgage brokers, who refer their clients’ loans to us for underwriting and funding. Loans meeting our underwriting criteria are generally approved and funded at our regional underwriting loan centers. Our headquarters office performs various functions through multiple departments including establishment of policy, risk management, secondary marketing, loan delivery to investors, finance, accounting, administration, marketing, human resources, and information technology.

At March 31, 2005, we are operational in thirty office locations which represents a net reduction of two offices from December 31, 2004. We had a total of 784 employees at March 31, 2005 which is an increase of 25 employees from December 31, 2004.

We borrow funds under our warehouse credit facilities to fund and accumulate loans prior to sale to correspondent investors on a servicing-released basis. Currently we have four warehouse facilities that enable us to borrow up to an aggregate of $1.4 billion. We have also been preapproved by one lender for an additional $200 million in borrowing capacity as we need it. We are generally allowed to borrow from 96% to 99% of the lesser of par or market value of the loans, and must comply with various lender covenants requiring, among other things, minimum levels of cash reserves, certain levels of profitability and restricting our leverage ratios.

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We generate revenue in our mortgage banking business in three principal ways:

•                                          Gain on loan sales. Loan rates, fees and discount points are set based on our targeted gain on sale. This is referred to as our pricing margin. We currently sell the loans that we originate to institutional purchasers on a servicing-released basis for cash. We record the difference between the sale price of loans that we have sold and our cost to originate the loans sold as gain on loan sales. We recognize revenue at the time that we complete the loan sale, which is generally when we receive loan sale proceeds from the purchaser.  Gain on loan sales also includes fees we charge for loan origination such as underwriting fees, loan document preparation fees and wiring fees, net of premiums we pay to brokers.

•                                          Hedging and market adjustments. Hedging instruments are used to help mitigate exposure to interest rate fluctuations and protect our pricing margins. The gains or losses from this activity will be highly negatively correlated to revenue derived from loan sales. Typically higher than expected gains from the sale of loans will be offset by hedging losses and market adjustments, while lower than expected gains from the sale of loans will be offset by hedging gains. The value of our rate lock loan commitments are measured at the end of each accounting period. The change from the prior period is recorded as a market adjustment. Hedging gains or losses and market adjustments are included in the consolidated statements of operation and comprehensive income as derivative financial instruments and market adjustments.

•                                          Interest income. We earn interest on a loan from the time we fund it until the time we sell it. The interest that we earn is partially offset by the interest we pay under our warehouse credit facilities used to finance our mortgage originations.

Relative to our Mortgage Asset Portfolio, we made a strategic decision to sell the vast majority of our mortgage portfolio assets in the first quarter of 2004 and we completed the sales in the third quarter of 2004. The remaining mortgage assets of approximately $13.7 million are pledged to secure long term debt totaling approximately $12.2 million.  These assets are referred to as our CMO/FASIT 1998-1 Securitization and are referred to on the balance sheet as bond collateral.  Our Company over-collateralized the bonds at the time of issuance by pledging assets in excess of new liabilities.   These bond collateral assets are carried at the lower of cost or net realizable value.   At March 31, 2005, our bond collateral assets were carried on our balance sheet at approximately $1.5 million more than our remaining long term debt.

On a cash basis, we continue to receive principal and interest payments on the bond collateral assets and these proceeds are used by the bond trustee to service and pay down the long term debt. Any excess cash flow is remitted to us on a monthly basis. The long term debt is non-recourse to our Company, meaning that only the principal and interest received from the bond collateral assets, combined with any proceeds from the sale of REO loans, can be used to service the bond liabilities.  As such, while we do generally receive some net cash flow from the bond collateral assets each month, we will never be required to have any cash outlay associated with these assets and the related long term liability.

The expenses of our business include variable costs such as commissions, loan expenses and contract labor, as well as fixed overhead expenses such as personnel, rent, supplies and utilities.

Due to the immateriality of our mortgage asset portfolio business, we are discontinuing our segment reporting.  As such, management’s discussion and analysis of financial condition and our results of operations will be presented on a consolidated basis beginning with the three months ended March 31, 2005.

Our 1^st Quarter 2005 Highlights (Executive Overview)

Our consolidated operating results for the first quarter of 2005 were dominated by the following:

•                  We funded approximately $2.7 billion in loan volume for the period while fundings for the same period in 2004 were $1.9 billion.  This represents an increase of approximately 44.9% while the overall mortgage market declined from approximately $619 billion for the quarter ending March 31, 2004 to approximately $588 billion for the quarter ending March 31, 2005, according to the Mortgage Bankers Association (“MBA”). Key reasons for this increase are: a sales force increase (90 account executives at March 31, 2004 compared to 168 at March 31, 2005), a maturing of our branch network resulting in better market penetration and a broader range of loan products offered by the Company. The graph below shows monthly loan production comparisons between the first quarters of 2005 and 2004.

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•                                          Revenues, net of derivative financial instruments and market adjustments, totaled $31.7 million. This revenue was sufficient to cover variable and fixed expenses totaling $30.8 million resulting in a pretax profit of $0.9 million.

•                                          Unrestricted cash and cash equivalents decreased by $13.3 million during the first quarter of 2005 from $50.6 million at December 31, 2004, to $37.3 million at March 31, 2005. The key factors in the decrease were cash invested in warehouse haircuts (1% to 4% of loans held for sale) and advances made to mortgage brokers until loans are sold and loans which are held for sale and funded entirely with Company cash (approximately $4.3 million at March 31, 2005).

•                                          Our mortgage asset portfolio received approximately $1.1 million in principal and REO sale proceeds. The Company reduced related long term debt by approximately $1.3 million.

Critical Accounting Policies

The following analysis of financial condition and results of operations are based upon our consolidated financial statements and the notes thereto, which have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The preparation of these consolidated financial statements requires us to make a number of estimates and assumptions that affect the reported amounts and disclosures in the consolidated financial statements. On an ongoing basis, we evaluate our estimates and assumptions based upon historical experience and various other factors and circumstances. We believe that our estimates and assumptions are reasonable in the circumstances; however, actual results may differ significantly from these estimates and assumptions, which could have a material impact on the carrying value of assets and liabilities at the balance sheet dates and our results of operations for the reporting periods.

We believe that estimates and assumptions are important factors in the portrayal of our financial condition and results of operations. Our critical accounting policies that require management’s most subjective judgments include the following:

•                  Derivative hedging activities / determination of fair values

•                  Fair value of mortgage loans held for sale

•                  Income taxes and benefits

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•                  Recourse liabilities associated with loan sales

Please refer to the Company’s Form 10-K for the year ending December 31, 2004, for a detailed discussion of these policies.

Management’s Financial Analysis

We present non-GAAP financial measures in this report. We believe that these measures are helpful in understanding our business and operating results. You should not consider our non-GAAP financial measures as a replacement for any GAAP financial measures. The non-GAAP financial measures that we present are as follows:

Gross Margins - Gains from the sale of loans are a function of the volume of loans sold in the period, and the value of the loans at the time these loans are committed for sale to an investor.  We also generate gains and losses on the derivative financial instruments that we acquire to hedge our targeted gain on sale of the loans.  We consider our gross margin to be the sum of our (i) gain on sale of loans and (ii) total derivative financial instruments and market adjustments.  This sum expressed as a percentage of our loan sales volume is our gross margin percentage (or basis point gross margin).

When we develop the pricing of our loans, we incorporate a target gross margin percentage that we expect to obtain.  We then provide rate lock commitments to borrowers based on that pricing and the related target gross margin percentage.  However, if market interest rates increase between the time we make a rate lock commitment and commit a loan for sale, then the market value of the loan would be reduced and we would not achieve our target margin percentage.  If interest rates decrease, then the opposite would be true. Accordingly, we acquire derivative financial instruments to hedge, or protect our target margins from interest rate increases.  We hedge our loans from the time of a rate lock commitment to the time the loan is committed for sale to an investor.

If our hedging is effective, as the value of our pipeline decreases and we record a lower gain on sale, our hedge instruments increase in value to offset the reduced gain.  Alternatively, as the value of our pipeline increases, we record a larger gain on sale but the larger gain is offset by a loss on our hedges.  Accordingly, if we successfully hedge our pipeline, the gross margin percentage that we ultimately earn will be close to our target gross margin percentage and we will not be significantly impacted by interest rate changes.  In order to evaluate the effectiveness of our hedging program, management believes that it is important to evaluate our gross margins and then compare our actual gross margin percentage against our target gross margin percentage.

Net Interest Income - We earn interest income and incur interest expense in our operations. We earn interest on a loan from the date the loan is funded until its sale to an investor. Accordingly, interest income is a function of the volume of loans funded, the interest rate on the loans and the length of time the loans are held prior to sale. To the extent we fund loans with borrowings under our warehouse facilities, we record interest expense based on the same factors. We also generate revenue from the interest we receive on the bond collateral mortgage loans we hold for investment and we incur interest expense on the borrowings used to finance our loan fundings and bond collateral.

Because the interest income and interest expense of our business are closely related and dependant on many of the same factors, in particular the volume of loans we originate, management believes that it is helpful in understanding our operations to analyze the impact of interest income on mortgage loans held for sale and related short term debt expense together. For this reason, the discussion below provides information regarding the net interest income (interest income less interest expense). Management believes that this is consistent with how financial analysts typically consider interest in analyzing mortgage banking operations.

Fixed and Variable Operating Expenses — For the same reasons described in “Net Interest Income” above, the explanation of expenses includes a discussion of our operating expenses, excluding interest expense. Because certain other expenses we incur in the mortgage banking business, such as commissions and contract labor, also vary with the volume of our loan originations, management believes that it is important in understanding our business to consider the variable and fixed expenses separately. Accordingly, we have included an estimated breakdown between variable and fixed amounts for each category of our operating expenses. Management believes that this will enable a better understanding of our results and the likely impact of future changes in our origination volumes.

Interest Rate Risk Management And The Relationship Between Our Hedging Instruments And The Market Adjustments And Gain On Sale That We May Record For A Period

Our mortgage banking business is subject to the risk of changing interest rates between the time we commit to extend credit at a set interest rate (rate lock) and the time we commit the mortgage loans for sale. Our pipeline consists of loans for which we have provided a rate lock but which we have not yet closed (rate locked loan commitments) and closed loans that have not yet been committed for sale (closed loans). Generally, as market interest rates rise, our pipeline, which then has lower interest rates than the prevailing market, is not as attractive to investors and therefore we lose value in the pipeline. Conversely, as market interest rates fall, our pipeline is more attractive to investors and we gain value in the pipeline. However, some of this gain in value may be offset by an increase in the fallout of our rate locked loans as borrowers chose not to fund their loan with us and seek alternative loans with the new, lower interest rates.

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To mitigate the risk of rising interest rates and protect our pricing margins, we purchase hedge instruments.  The gains or losses from this activity will generally correlate to losses or gains derived from market adjustments on our rate locked loan commitments and losses or gains that we record on sales of our closed loans. Typically, higher than expected market adjustments and gains from the sale of loans will be offset by hedging losses, while lower than expected market adjustments and gains from the sale of loans will be offset by hedging gains.  However, we will at times have timing differences between the time we recognize hedge losses and the time we are able to recognize corresponding increases in the value of our closed loans as we do not apply hedge accounting as defined by SFAS 133.  These timing differences may impact some of our quarterly operating results and are therefore explained in detail in this section.

Utilizing past loan fallout history, we estimate the percentage of our loan rate lock loan commitments that will close, but these projections are difficult, especially during periods of volatile interest rates. We hedge (or protect) our loan sale margin in the pipeline using forward sales of mortgage-backed securities (“TBA’s”), options on mortgage-backed securities (“MBS”) and similar agreements.

We generally adjust our hedge coverage on a daily basis based upon changes in the size and composition of the pipeline and resultant changes to our estimated pipeline exposure, seeking to protect our loan sale margin targets. Since August of 2002, we have used an outside company, Mortgage Capital Management, Inc. (“MCM”), to help us manage our interest rate risks. MCM is a quantitative software and advisory service firm that currently serves a number of clients in the mortgage banking industry. MCM performs pipeline exposure analysis and provides hedging recommendations on a daily basis. Our loan pipeline at March 31, 2005 was approximately $1.1 billion, at December 31, 2004 was approximately 0.8 billion and at March 31, 2004 was approximately $1.6 billion. We believe our hedges have correlated to both increases and decreases in the value of our loan rate locked loans and uncommitted closed loans. In the future, as our loan products change and our subprime and correspondent channels increase production, our hedging strategies, fallout assumptions and hedging instruments may change to better mitigate the risk of interest rate changes.

The aggregate gains or losses that we ultimately recognize on our rate locked loans, closed loans and hedge instruments, is our gross margin. We record gains or losses on the three components of our gross margin as follows:

•                  Rate locked loan commitments.  Any change in the value of our rate locked loan commitments, from the expected value of the loan at the time the rate lock commitment was made to the end of the period is measured at the end of each accounting period, and is recorded as a market adjustment. Both increases and decreases in value are recorded at the end of a period. These changes are recorded as a “market adjustment on interest rate lock commitments” in our Statement of Operations.

•                  Closed loans.  We do not recognize any increase in value in our closed loan inventory until a true sale has taken place. However, if the cost basis of the loan is more than could be obtained by sale in the marketplace, a market adjustment is recorded (referred to as the lower of cost or market, or “LOCOM”). Accordingly, increases in value are not recorded at the end of a period, but decreases are. Any declines in value are recorded in our Statement of Operations as an adjustment to our “gain on sale of loans” revenue at the time they are recognized.

•                  Hedge instruments.  Our hedging instruments (forward sales of mortgage backed securities and options on forward sales of mortgage backed securities) are marked to market at the end of each period and both increases and decreases in value are recorded. These changes in value are recorded as “derivative financial instruments” in our Statement of Operations.

With respect to these three related components of our revenue, the only change in value that is not recorded at the end of each period is an increase in value of our closed loans.  A drop in market interest rates will generate an increase in the value of these loans, but this increase is not recognized in our operating income until the loan sales have settled.  Accordingly, we may have increased value attributable to our closed loans at the end of a period which may not be recognized until the next period.  Nevertheless, the related decrease in value of any hedge instruments we purchased to hedge these closed loans will be recorded at the end of the period.  As a result, we may recognize hedge loss in one quarter and not recognize the corresponding increase in the value of loans until the next quarter.

We have provided a more detailed description of the methods and estimates we use to calculate the value of our derivative instruments and gain on sale in our Annual Report on form 10-K under the heading “Derivative and Hedging Activities / Determination of Fair Values”.

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Results of Operations

Three Month Results

We recorded net income of $507 thousand for the three-month period ending March 31, 2005 as compared to a net loss of $5.7 million in 2004 for the same period. These results were due in large part to (i) a 47.3% increase in loan sales volume from the same period in 2004, (ii) an increase in our gross margin from 52.3 basis points to 85.4 basis points (loans funded basis) and (iii) for the three month period ending March 31, 2004 we recorded a $4.4 million loss on the sale of portfolio assets.  Note that in the chart below we compare our revenue categories to basis points of loans sold.  This provides a direct correlation of revenue to our main source of revenue (loans sold).

($ amounts in 000’s) (unaudited)

The overall mortgage loan market is expected to contract from $2.7 trillion in 2004 to $2.5 trillion in 2005 according to the MBA. Our strategy is to capture an increasing percentage of the market through sales force expansion. In the first quarter of 2005, we increased loan production 8.7%, from $2.5 billion for the quarter ending December 31, 2004, to $2.7 billion for the quarter ending March 31, 2005. If we are not able to do this, we would likely experience losses due to our current level of operating expenses.

Gain on sales of loans after derivative financial instruments and market adjustments, increased for the quarter ended March 31, 2005 over the quarter ended March 31, 2004 due to a higher level of loans sold and better gross margins. Note that increasing interest rates for the quarter ended March 31, 2005 increased the gain on derivative financial instruments and market adjustments and reduced the gain on sale margins. For the quarter ended March 31, 2004 decreasing interest rates during the quarter also decreased the value of derivative financial instruments but increased our gain on sale margins.

Our gain on the sale of loans was made up of a combination of various account categories which are summarized in the chart above, and quantified in basis points of loan sales volume. Premiums represent the price at which we sell the loans to investors in excess of the principal balance of loans sold. Broker fees represent various charges to brokers for services rendered by us which are deferred and recognized as part of the gain on the sales of the loans. Premiums and broker fees are offset by capitalized (deferred) loan origination costs. The largest deferred cost associated with loan production is mortgage broker premiums, or yield spread premiums. Other offsets to gain on sale include (i) loan premiums repaid to investors (“premium recapture”) and loan loss provisions and (ii) deferred origination costs, which are recognized at the time of loan sale. Premium recapture expenses represent repayment of a portion of certain loan sale premiums to investors on previously sold loans which subsequently payoff within six months of loan sale. We sell a substantial portion of our loans to two of our competitors.  If these competitors stop purchasing our loans on favorable terms, we could be required to find alternate purchasers and/or accept  less favorable terms.  In either case, this could reduce our revenues and earnings.

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Premium recapture and loan loss provisions decreased by $315 thousand in the first quarter of 2005 compared to the same period in 2004. The decrease was mainly due to a reduction in premium recapture expense in the first quarter of 2005 which was the result of rising interest rates and the anticipated reduction in early payoffs. Going forward we generally expect premium recapture expense to decline due to anticipated rising interest rates and less refinance activity. However, this decrease may be partially offset by the anticipated increase in our loan volume. Conversely while we believe that our underwriting process is sound and effective, loan loss provisions may increase in the future due to a higher mix of Alt-A and sub-prime loans which have more complex underwriting criteria and are more likely to be rejected by investors if we sell them loans which do not meet their underwriting guidelines. The increase in deferred origination costs was a result of increased loan volume.

The use of hedges (recorded as derivative financial instruments) is key to protecting our profit margins between the time of the interest rate lock and when the loan is committed for sale to an investor. Generally when mortgage interest rates rise, the value of loans we have in our pipeline declines, and when interest rates decline the opposite is true.  We utilize hedge instruments to help protect the value of loans in our pipeline from increases in interest rates.  Consequently, basis point loan premiums, and gain on sales of loans, are best analyzed in conjunction with the basis point gain or loss from our derivative financial instruments and market adjustments on our pipeline. We continued to use forward sales of mortgage-backed securities (TBA) and options on forward sales of mortgage-backed securities as our primary hedging instruments. Due to increases in mortgage interest rates during the first quarter of 2005 we recorded gains on derivative financial instruments of $3.1 million. For the first quarter of 2004 we recorded net losses of $6.6 million due to decreasing mortgage interest rates during the quarter.

Our gross margins were $21.3 million for the three months ended March 31, 2005 or 85 basis points on $2.5 billion in loan sales volume, representing an increase of $12.4 million from $8.9 million on $1.7 billion in loan sales volume for the comparable period in 2004. Loan sales volume increased $0.8 billion. Overall competitive pressure remains intense although not at levels seen in 2004. There can be no assurances that margins will remain at current levels and accordingly our gross margins would be affected if competitive pressures increase or decrease.