SECURITIES AND UNITED STATES EXCHANGE COMMISSION

FORM 10-Q

     Mark One

OR

     Commission File No.: 001-16577

FLAGSTAR BANCORP, INC.

(248) 312-2000
Registrant’s telephone number, including area code

     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 ninety days. Yes x No o.

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

     As of August 2, 2004, 61,218,120 shares of the registrant’s Common Stock, $0.01 par value, were issued and outstanding.

This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company including statements preceded by, followed by or that include the words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,” “objective,” “continue,” “remain,” “pattern” or similar expressions or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may” or similar expressions, which are intended to identify “forward looking statement” within the meaning of the Private Securities Litigation Reform Act of 1995.

There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) competitive pressures among depository institutions increase significantly; (2) changes in the interest rate environment reduce interest margins; (3) prepayment speeds, loan origination and sale volumes, charge-offs and loan loss provisions; (4) general economic conditions, either national or in the states in which the Company does business, are less favorable than expected; (5) political developments, wars or other hostilities may disrupt or increase volatility in securities markets or other economic conditions; (6) legislative or regulatory changes or actions adversely affect the businesses in which the Company is engaged; (7) changes and trends in the securities markets; (8) a delayed or incomplete resolution of regulatory issues; (9) the impact of reputational risk created by the developments discussed above on such matters as business generation and retention, funding and liquidity; and (10) the outcome of regulatory and legal investigations and proceedings.

The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

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Flagstar Bancorp, Inc.

The accompanying notes are an integral part of these statements.

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Flagstar Bancorp, Inc.

The accompanying notes are an integral part of these statements.

4

Flagstar Bancorp, Inc.

The accompanying notes are an integral part of these statements.

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Flagstar Bancorp, Inc.

The accompanying notes are an integral part of these statements.

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Flagstar Bancorp, Inc.

Note 1. Nature of Business

Flagstar Bancorp, Inc. (“Flagstar” or the “Company”) is the holding company for Flagstar Bank, fsb (the “Bank”), a federally chartered stock savings bank founded in 1987. With $12.0 billion in assets at June 30, 2004, Flagstar is the largest savings institution and 2nd largest banking institution headquartered in Michigan.

Flagstar is a consumer-oriented financial services organization. The Company’s principal business is obtaining funds in the form of deposits and borrowings and investing those funds in various types of loans. The acquisition or origination of single-family mortgage loans is the Company’s primary lending activity. The Company also originates consumer loans, commercial real estate loans, and non-real estate commercial loans for investment. The Company also services a significant volume of loans for others

The single-family mortgage loans originated that conform to the underwriting standards of Fannie Mae, Freddie Mac or Ginnie Mae are securitized and sold on a servicing retained basis. The out-of-market servicing rights are then sold in a separate transaction.

The Bank is a member of the Federal Home Loan Bank System (“FHLB”) and is subject to regulation, examination and supervision by the Office of Thrift Supervision (“OTS”) and the Federal Deposit Insurance Corporation (“FDIC”). The Bank’s deposits are insured by the FDIC through the Savings Association Insurance Fund (“SAIF”).

Note 2. Basis of Presentation

The accompanying consolidated unaudited financial statements of the Company, have been prepared in accordance with generally accepted accounting principles for interim information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission. Accordingly, they do not include all the information and footnotes required by United States generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. All interim amounts are subject to the year-end audit. The results of operations for the interim period, herein, are not necessarily indicative of the results that may be expected for the full year ended December 31, 2004.

Note 3. Reclassifications

Certain amounts within the accompanying consolidated financial statements and the related notes have been reclassified to conform to the 2004 presentation.

Note 4. Critical Accounting Policies

The Company has established various accounting policies that govern the application of generally accepted accounting principles in the preparation of the financial statements. Application of these accounting policies involves judgments, assumptions and estimates by management that have a material impact on the carrying value of certain assets and liabilities. These judgments, assumptions and estimates are based on the Company’s historical experience and other factors that managements believes to be reasonable under the circumstances.

The Company believes that the following topics involve critical areas of the Company’s operations and the accounting policies associated with these areas requires the most significant judgments, assumptions, and estimates.

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Note 4. Critical Accounting Policies (continued)

Allowance for Loan Losses

The allowance for loan losses represents management’s estimate of credit losses inherent in the Company’s investment loan portfolio at the reporting date. The estimate is a composite of a variety of factors including past experience, collateral value, and the general economy. The allowance includes a specific portion, a formula driven portion, and a general nonspecific portion. The collection and ultimate recovery of the book value of the collateral, in most cases, is beyond the Company’s control.

Mortgage Servicing Rights

Determining the fair value of mortgage servicing rights involves a calculation of the present value of a set of market driven and MSR specific cash flows. The Company is required to make assumptions about future market conditions, including interest rates, in order to complete the analysis. The model calculates a fair value based upon variables, but does not, and cannot, take into account the actual price the specific MSR could be sold at in a fair exchange. The Company has the portfolio valued by an outside valuation expert not less than annually, but interim valuations could fail to reflect any valuation changes created by a dynamic interest rate environment.

Derivative Accounting

In its home lending operation, the Company enters into commitments to originate loans at certain prices and rates. The Company also sells forward mortgage-backed securities into the secondary market. The Company carries these commitments at fair value. The process of recording these commitments at fair value has the effect of recording a portion of the eventual gain or loss on the sale of these loans before a sale actually occurs. This estimation process may be prone to error and therefore could misstate the Company’s true financial position.

Secondary Market Reserve

The Company maintains a reserve against future losses that may be recognized upon the repurchase of mortgage loans previously sold to the secondary market. The reserve is recorded at a level based upon management’s analysis of the potential for repurchase of loans sold during the prior sixty-month period. There is no assurance that the Company will not, in any particular period, sustain losses that exceed the reserve, or that subsequent evaluation, in light of the factors then-prevailing, will not require increases to the reserve.

Note 5. Recent Accounting Developments

Staff Accounting Bulletin 105

The Securities and Exchange Commission staff recently released Staff Accounting Bulletin (SAB) 105, “Loan Commitments Accounted for as Derivative Instruments.” SAB 105 requires that a lender should not consider the expected future cash flows related to loan servicing or include any internally developed intangible assets, such as customer-related intangible assets, in determining the fair value of loan commitments accounted for as derivatives. Companies were required to adopt SAB 105 effective for commitments entered into after March 31, 2004. The requirements of SAB 105 apply to the Company’s mortgage loan interest rate lock commitments related to loans held for sale. At June 30, 2004, such commitments with a notional amount of approximately $2.6 billion were outstanding. The Company’s current accounting policy is to record a value for the MSR created upon the sale into the secondary market. The Company adopted SAB 105 at the beginning of its second quarter, and does not expect application of its guidance to have any material impact on its results of operations or financial position of the Company.

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Note 5. Recent Accounting Developments (continued)

Proposed Stock-Based Compensation Rule

On March 31, 2004, the FASB issued a proposed Statement, Share-Based Payment, an Amendment of FASB Statements No. 123 and APB No. 95, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise, or (b) liabilities that are based on the fair value of the enterprise’s equity instruments, or that may be settled by the issuance of such equity instruments. Under the FASB’s proposal, all forms of share-based payments to employees, including employee stock options, would be treated the same as other forms of compensation by recognizing the related cost in the income statement. The expense of the award would generally be measured at fair value at the grant date. Current accounting guidance requires that the expense relating to so-called fixed plan employee stock options only be disclosed in the footnotes to the financial statements. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees. The Company is currently evaluating this proposed statement and its potential effects on its results of operations.

FIN 46(R) - Variable interest entities

Management has determined that Flagstar Statutory Trust II, Flagstar Statutory Trust III, and Flagstar Statutory Trust IV (“the Trusts”) each qualify as variable interest entities under FIN 46, as revised. The Trusts issued mandatorily redeemable preferred stock to investors and loaned the proceeds to the Company. The Trusts are included in the Company’s consolidated balance sheet and statements of income as of and for the year ended December 31, 2003. Subsequent to the issuance of FIN 46 in January 2003, the FASB issued a revised interpretation, FIN 46(R) Consolidation of Variable Interest Entities, the provisions of which were to be applied to certain variable interest entities by March 31, 2004.

The Company adopted the provisions under the revised interpretation in the first quarter of 2004. Accordingly, the Company no longer consolidates the Trusts as of March 31, 2004. FIN 46(R) precludes consideration of the call option embedded in the preferred stock when determining if the Company has the right to a majority of the Trusts’ residual returns. The deconsolidation resulted in the investment in the common stock of the Trusts being included in “other assets” as of June 30, 2004 and the corresponding increase in outstanding debt of $2.3 million. In addition, the income received on the Company’s common stock investment is included in “other interest income.” The adoption of FIN 46(R) did not have a material impact on the Company’s financial position or results of operations.

Note 6. Stock-Based Compensation

The Company has two stock incentive plans, the 1997 Stock Option Plan and the 2000 Stock Incentive Plan (collectively, the “Plans”), which provide for the granting of non-qualified stock options, incentive stock options, restricted stock awards, performance stock awards, stock bonuses and other awards to our employees (including officers and directors). Awards are granted at the average market price of our stock on the grant date, vest over varying periods generally beginning at least one year from the date of grant, and expire in either five or ten years from the date of grant.

As permitted by SFAS 123, “Accounting for Stock-Based Compensation” (“SFAS 123”), the Company continues to measure and recognize compensation expense using the intrinsic value method specified in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”).

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Note 6. Stock-Based Compensation (continued)

As required under the provisions of SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” the following table discloses the pro forma net income and pro forma basic and diluted earnings per share had the fair value method been applied to all stock awards for the three and six months ended June 30, 2004 and 2003:

In addition, during the three and six months ended June 30, 2003, the Company recognized compensation expense of $357,000 ($232,000, net of taxes) and $714,000 ($464,000, net of taxes), respectively, related to restricted stock awards. These expenses were included in net earnings as reported. There was no compensation expense recognized during the three and six months ended June 30, 2004 related to restricted stock awards.
Note 7.		Significant Events

1.

On April 30, 2004 the Company redeemed all of its 9.50% preferred securities from its subsidiary Flagstar Trust (“Trust”).

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

Selected Financial Ratios ( in thousands, except per share data )

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Results of Operations

Net Earnings

Net earnings during the three and six month periods ended June 30, 2004, constituted a return on average equity of 23.79% and 22.98% and a return on average assets of 1.37% and 1.34%, respectively. These results were substantially down from the record net earnings of 2003, but constitute results near the top of the financial services industry. Returns in 2003, were an extraordinary 69.55% and 54.67% as of percentage of average equity and 3.48% and 2.71% of average assets, respectively.

Net earnings in 2004 have been negatively impacted by the decrease in loan originations and therefore the decrease in loans sold in the secondary market. During the three and six months ended June 30, 2004, loan originations were down 48.6% and 43.3%, respectively. During this period of lower originations, management reduced the amount of salaried and commissioned personnel in its mortgage banking operation to reflect this decreased productivity. While the home lending group was downsizing its operations, the banking group added five new banking centers and increased its deposits within the banking centers $0.3 billion, or 8.3%, during the first six months of 2004. The banking group also increased its account relationships by 14,000 customers.

Earnings for the three and six months ended June 30, 2004 reflect this shift in production. The banking group, which was responsible for approximately 25.1% of earnings during 2003, accounted for approximately 58.8% and 54.2% of earnings during the three and six months ended June 30, 2004. Earnings in the banking group increased approximately 32.5% in the second quarter of 2004 when compared to the first quarter of 2004 and 8.2% when compared to the last six months of 2003. The majority of these increases are attributable to the increases in the amount of attributable assets in each successive period.

     Three months

Net earnings for the three months ended June 30, 2004 were $41.2 million ($0.65 per share-diluted), a $44.4 million decrease from the $85.6 million ($1.34 per share-diluted) reported in 2003. The decrease resulted from a $84.0 million, or 54.2%, decrease in non interest income which was partially offset by a $10.2 million increase in net interest income, a $2.2 million decrease in operating expenses, a $24.0 million decrease in the provision for federal income taxes, and a $3.2 million decrease in the provision for losses.

     Six months

Net earnings for the six months ended June 30, 2004 were $78.1 million ($1.22 per share-diluted), a $48.8 million, or 38.5% decrease from the $126.9 million ($2.00 per share-diluted) reported in 2003. The decrease resulted from an $83.5 million decrease in non interest income and a $2.6 million increase in operating expenses, which was partially offset by a $9.8 million increase in net interest income, a $25.8 million decrease in the provision for federal income taxes, and a $1.8 million decrease in the provision for losses.

Segment reporting

     Banking operations

The Company provides a full range of banking services to consumers and small businesses in southern Michigan and Indiana. At June 30, 2004, the Bank operated a network of 103 banking centers not including its Internet branch. The Company has continued to focus on expanding its branch network in order to increase its access to retail deposits. During the six months ended June 30, 2004, the Company opened five new banking centers.

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Segment reporting (continued)

     Banking operations (continued)

In each successive period, the banking operation has expanded its deposit portfolio and the number of banking centers. Each new banking center has been opened on a de novo basis. The result has been that each year revenues and expenses related to this operation have increased. During 2004, annualized revenues increased 14.9%, while annualized pre-tax earnings increased 33.4%. Additionally, identifiable assets associated with the banking operation increased 13.6% during the first six months of 2004. Further expansion of the deposit branch network is planned. During of all 2003, the Company opened 12 banking centers. The Company has plans to open an additional 17 banking centers during the remainder of 2004.

The Company does not expect that it will have an immediate increase in retail deposits by opening these new locations. Nonetheless, the Company believes that the growth in deposits will occur over time, with FHLB advances and other sources providing sufficient funding in the interim.

At June 30, 2004, the Company operated 103 branches that serviced over 210,000 accounts totaling $3.9 billion in deposits. The average branch had deposits of $36.6 million in deposits. Of the 103 banking centers, eighteen are located in Indiana and eighty-five are located in Michigan. Thirty-six of the banking centers are operated under our in-store program, forty-four are free standing buildings, and twenty-three of our banking centers are found in strip malls and office centers.

Of the in-store banking centers, thirty-three are located in Wal-Mart superstores. Fifteen of the in-store branches were located in Indiana and 21 were located in Michigan communities. The first of the Wal-Mart banking centers was placed into operation in June 2000. The Company expects to open one more Wal-Mart facility in 2004. In June 2004, the Company entered into an agreement to open four banking centers in Meijer superstores within the Grand Rapids market. The in-store banking centers have an average deposit portfolio of only $18.1 million compared with the Company average of $36.6 million.

Each of the in-store banking centers offer the same products and services to our customers as are available at our free-standing banking centers without any significant difference in operating costs. The in-store facilities use a cashless electronic kiosk-operating environment that is supported by at least two customer service representatives. By relying upon in-store banking centers to expand our retail branch network, the Company avoids the significant building costs of free-standing banking centers while obtaining market exposure in a high customer traffic area. The customers using our in-store banking centers are substantially the same as the customers using our freestanding banking centers.

Forty-one of the Company’s banking centers were opened within the past three years. Those branches have an average deposit base of $14.2 million. Banking centers opened in 2004, 2003, 2002 and 2001 have average deposits of $13.6 million, $16.9 million, $21.0 million, and $24.9 million, respectively.

Of the 103 branches, 12 branches had deposits of less than $10.0 million at June 30, 2004 compared to June 30, 2003 when 26 branches had less than $10.0 million in deposits.

The 18 banking centers in Indiana were all opened in the past four years and 15 of those banking centers are in-store branches. The Indiana branches have an average deposit portfolio of $18.2 million. Banking centers in the Indianapolis metropolitan area have an average balance of $22.7 million.

The 85 banking centers in Michigan have an average deposit portfolio of $40.5 million and 21 of these banking centers are in-store facilities. Banking centers in the Detroit metropolitan area have an average balance of $40.3 million. All of the Detroit area banking centers were opened in the past five years.

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Segment reporting (continued)

     Banking operations (continued)

The Company’s Internet branch is available for customer use at www.flagstar.com. At June 30, 2004, this operation serviced $147.6 million of deposits from a national deposit base. All of our banking customers have access and options to maintain their account on-line but these deposit customers are strictly Internet based. At June 30, 2004, 95.7% of these deposits were certificates of deposit.

Despite the Company’s growing banking operation and the large number of banking centers that are not mature, the banking operation was responsible for approximately 46.8% of revenues and approximately 58.8% of net earnings during the three months ended June 30, 2004. During 2003, the banking operation produced approximately 33.1% of revenues and 25.1% of net earnings.

The following tables present certain financial information concerning the results of operations of Flagstar’s banking group.

     Home lending operation

Flagstar’s home lending activities involve the origination of mortgage loans or the purchase of mortgage loans from the originating lender. The originated mortgage loans are primarily sold in the secondary market. To a lesser extent, the Company invests in a small portion of the loans originated as leverage limits allow. The Company later sells the related servicing rights in a separate transaction.

Company personnel originate loans and conduct business from 137 loan origination centers in 26 states. Company personnel also originate loans from the Bank’s 103 banking centers. Flagstar also purchases mortgage loans on a wholesale basis through a network of correspondents consisting of other banks, thrifts, mortgage companies, and mortgage brokers. This network includes mortgage lending operations in all 50 states. The majority of the mortgage loans conform to the underwriting standards of either Freddie Mac, Fannie Mae or Ginnie Mae.

The home lending operation also services a large portfolio of primarily conforming loans for others. This portfolio, which totaled $26.7 billion at June 30, 2004, provides additional earnings in a rising rate environment. In its capacity as a mortgage loan servicer, the Company maintains escrow balances for its customers. At June 30, 2004, the Company held $795.8 million of escrow balances.

The home lending operation is a much more volatile source of earnings when compared to the banking operation. Home lending, for the most part, is reliant on the prevailing interest rate environment, which is outside the Company’s control. The earnings volatility inherent in the home lending operation is visually apparent in the allocated revenues and pre-tax earnings of the operation shown below. The results show that during 2004 and 2003, revenues decreased 33.0% and increased 70.8%, respectively, while pre-tax earnings decreased 54.5% and increased 232.6%, respectively. The primary cause for these large swings is the mortgage loan production completed during the periods. The future revenue, earnings, and profitability of this operation are fully dependent on production volume and the interest rate environment.

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Segment reporting (continued)

     Home lending operations (continued)

The following tables present certain financial information concerning the results of operations of Flagstar’s home lending group.

Net Interest Income

     Three months

The Company recorded $59.3 million in net interest income for the three months ended June 30, 2004. This level of interest income was an increase from the $49.0 million recorded for the comparable 2003 period. These results include a $15.9 million increase in interest income, which was offset by a $5.7 million increase in interest expense. During the period, the Company increased its earning asset base by $2.2 billion. The Company also raised $1.9 billion in average interest-bearing liabilities to fund these new assets. The liabilities used for these acquisitions and the liabilities that were used to replace maturing liabilities were acquired at a discounted rate compared to the liabilities used in the 2003 period.

Earning assets as a whole repriced down 55 basis points while the liabilities repriced down only 45 basis points on a like period comparison. This net decrease is reflected in the decrease in the Company’s net interest spread of 10 basis points to 1.92% for the three months ended June 30, 2004 from 2.02% for the comparable 2003 period. It is also reflected in the decrease in the net interest margin of 8 basis points to 2.13% for the quarter ended June 30, 2004 from 2.21% for the same period in 2003.

On a sequential quarter basis, the Company reported a 2 basis point decrease in the interest rate spread and 13 basis point increase in the interest margin. The Company reported a $8.3 million, or 16.3% increase in net interest income during the current period versus the first quarter of 2004.

     Six months

The Company recorded $110.3 million in net interest income for the six months ended June 30, 2004. This level of interest income is an increase from the $100.5 million recorded for the comparable 2003 period. These results include a $24.1 million increase in interest income, which was offset by a $14.3 million increase in interest expense. In this period, the Company increased the average earning asset base by over $2.3 billion. The Company also raised $2.1 billion in average interest-bearing liabilities to fund these new assets. The liabilities used for these acquisitions and the liabilities that were used to replace maturing liabilities were acquired at a discounted rate compared to the liabilities used in the 2003 period.

During the six months ended June 30, 2004, the Company reported a decrease of 33 basis points in the interest rate spread and a decrease of 34 basis points in the interest margin. Earning assets as a whole repriced down 81 basis points, while the liabilities repriced down only 48 basis points on a like period comparison.

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AVERAGE YIELDS EARNED AND RATES PAID

The following tables present interest income from average earning assets, expressed in dollars and yields, and interest expense on average interest-bearing liabilities, expressed in dollars and rates. Interest income from earning assets includes the amortization of net premiums and the amortization of net deferred loan origination costs. Non-accruing loans were included in the average loan amounts outstanding.

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AVERAGE YIELDS EARNED AND RATES PAID

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RATE/VOLUME ANALYSIS

The following tables present the dollar amount of changes in interest income and interest expense for the components of earning assets and interest-bearing liabilities that are presented above. The tables distinguish between the changes related to average outstanding balances (changes in volume while holding the initial rate constant) and the changes related to average interest rates (changes in average rates while holding the ending volume constant).

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Provision for Losses

     Three months

During the three months ended June 30, 2004, the Company’s provision for losses was $3.6 million. This is a 47.1% decrease from the $6.8 million recorded in the comparable 2003 period and a 61.3% decrease from the $9.3 million recorded in the prior quarter.

Net charge-offs during the three months ended June 30, 2004 were an annualized 0.12% of average investment loans outstanding. Comparatively, net charge-offs were an annualized 0.73% during the three months ended June 30, 2003.

At each period end, management believes that the allowance was at a level that would offset the inherent risks associated with the Company’s loan portfolio. The loan portfolio increased 27.9% from December 31, 2003 to June 30, 2004. The Company’s increase in its general reserves between these two dates constituted an increase of $5.7 million, or 15.8%. Non-performing loans increased $1.3 million, or 2.2%, since December 31, 2003.

The allowance, which now totals $41.7 million, is 0.48% of loans held for investment and 70.0% of non-performing loans.

     Six months

During the six months ended June 30, 2004, the Company’s provision for losses was $12.9 million. This is a 12.2% decrease from the $14.7 million recorded in the comparable 2003 period. Net charge-offs were an annualized 0.17% in the 2004 period versus 0.84% in the 2003 period.

Non-Interest Income

     Loan Administration

     Three months

Net loan administration fee income increased to $5.6 million during the three months ended June 30, 2004, from a negative $13.1 million in the 2003 period. This $18.7 million increase between the comparable periods was the result of the $13.5 million decrease in the amortization of the mortgage servicing rights (“MSR”) and the $5.2 million increase in the amount of gross servicing fees received. This amortization decrease resulted from the anticipated decrease in the amount of prepayment activity on the underlying mortgage loans serviced for others. The increase in the gross fee revenue was the result of a larger portfolio of serviced loans during the 2004 period.

     Six months

Net loan administration fee income for the six months ended June 30, 2004 increased to $13.8 million from a negative $38.7 million recorded in the 2003 period. This $52.5 million increase similarly was the result of the decrease in the amortization of mortgage servicing rights offset by increased servicing revenue. MSR amortization equaled $45.1 million during the 2004 period versus $85.6 million during the comparable 2003 period. Gross fee income, before the amortization of serving rights, was $58.9 million for the six months ended June 30, 2004 and $46.9 million for the comparable 2003 period. This increase in gross fee income was the result of the larger portfolio of serviced loans during the 2004 period.

At June 30, 2004, the unpaid principal balance of loans serviced for others was $26.7 billion versus $29.9 billion serviced at March 31, 2004 and $30.4 billion serviced at December 31, 2003. The weighted average servicing fee on loans serviced for others at June 30, 2004 was 0.348% (i.e., 34.8 basis points). The weighted average age of the loans serviced for others at June 30, 2004 was 12 months.

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     Non-Interest Income (continued)

     Net Gain on Loan Sales

As previously stated, one of the Company’s operating strategies involves the origination of mortgage loans on a national basis, the sale of those loans on a servicing retained basis, and then the strategic sale of the created servicing rights.

Typically, as the supply of available loans in the marketplace increases, the Company is able to acquire these loans at a lower price. Inversely, as interest rates rise or are stable but at higher levels, the amount of available loans are less and the competing companies must originate at decreased margins to applicable secondary market resale prices in order to maintain production levels.

Management has historically maintained a profitable spread between the price at which it acquires loans versus the price level at which the loans can be sold in the secondary market. There can be no assurances that the Company will be able to maintain this profitability level in the future.

     Three months

For the three months ended June 30, 2004, net gain on loan sales decreased $146.8 million, to $7.5 million, from $154.3 million in the 2003 period. The 2004 period reflects the sale of $8.1 billion in loans versus $17.3 billion sold in the 2003 period. A lower interest rate environment in the 2003 period resulted in a larger mortgage loan origination volume ($17.5 billion in the 2003 period vs. $9.0 billion in the 2004 period) and a larger or wider gain on sale spread (96 basis points in the 2003 period versus 17 basis points in the 2004 period) recorded when the loans were sold.

     Six months

For the six months ended June 30, 2004, net gain on loan sales were $39.6 million versus $243.5 million in the comparable 2003 period. The 2004 period includes the sale of $15.7 billion in loans versus $30.5 billion sold in the 2003 period. For the six month period ended June 30, 2003, the lower interest rate environment also resulted in a larger or wider gain on sale spread recorded (88 basis points in the 2003 period versus 30 basis points in the 2004 period) when the loans were sold.

     Derivative Accounting

In its home lending operation, the Company enters into commitments to originate loans at certain prices and rates. The Company also sells forward mortgage-backed securities into the secondary market. In accordance with FASB 133, the Company carries these commitments at market value. The process of recording these fair value adjustments has the effect of adjusting current period sales up or down. Although the Company utilizes published fair value estimates in its valuation process, the estimation process may be prone to error and therefore could misstate the Company’s true position. At June 30, 2004, the Company had commitments to originate $2.6 billion of single-family mortgage loans. The Company also had commitments to sell $2.7 billion of mortgage-backed securities. These net positions had a net market value of $13.5 million. During the six months ended June 30, 2004, the Company’s position increased $6.5 million from the $7.0 million recorded at December 31, 2003.

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Non-Interest Income (continued)

     Net Gain on Loan Sales (continued)

     Secondary Marketing Reserve

When the Company sells loans to the secondary market, the Company must provide assurances to the market that the data relied upon in the sales process is accurate, the loans have been originated under proper guidelines, and there was no fraudulent data delivered. From time to time, the Company must repurchase loans it had previously sold to the market because of these representations even though the loans were sold on a non-recourse basis.

The Company maintains a reserve against future losses created by the repurchase of mortgage loans previously sold to the secondary market. The secondary market reserve is recorded at a level based upon management’s analysis of the potential for repurchase of loans sold during the prior sixty-month period. There is no assurance that the Company will not, in any particular period, sustain loan losses that exceed this reserve, or that subsequent evaluation, in light of the factors then-prevailing, will not require increases to the reserve.

During the six months ended June 30, 2004, the Company repurchased $43.9 million in non-performing mortgage loans from secondary market investors. At June 30, 2004, the Company had sold $153.4 billion in loans to the secondary market over the previous 60 months.

Based on its analysis of loan repurchase data, management believes that repurchases are expected to be 0.113% of all loan sales. It is expected that the Company will have the exposure for these repurchases for a period of 60 months from the time of sale. Periods of lower rates and higher refinance volume have shown less exposure to repurchase requirements than periods of higher rates and lower refinance volume. The Company’s experience has been a net loss of 17.0% on all foreclosed loans and repurchases. Any increase in the secondary market reserve is charged as an offset to net loan sale gains.

The Company recorded net charge-offs of $4.9 million and $11.3 million related to secondary market repurchases in the three and six months ended June 30, 2004, respectively. At June 30, 2004, the Company had a reserve of $12.9 million for future losses related to secondary market repurchases.

     Net Gain on the Sale of Mortgage Servicing Rights

As previously stated, one of the Company’s operating strategies involves the strategic sale of organically created servicing rights.

Typically, the Company enters into a flow sale agreement to sell a portion of its newly originated MSR. The Company will then sell the remaining portion of its MSR on a strategic basis in a bulk sale transaction as conditions warrant. The Company continually monitors the marketplace for sale opportunities versus the value the Company can create by retaining a larger portfolio of MSR. The Company is limited in the amount of MSR it can hold for regulatory purposes and is also limited on an operational basis to the amount of loans the Company can service.

Management has historically maintained a profitable spread between the price at which it acquires MSR and the price level at which the MSR can be sold in the secondary market. Management also has not been required to record a valuation adjustment to the MSR for impairment because of its policy of selling substantially all of the MSR it originates. Impairment in a MSR portfolio is typically created by a sudden and unexpected change in the interest rate environment. Since the interest rate environment is beyond the control of management, there can be no assurances made that the Company will be able to avoid an impairment charge in the future.

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Non-Interest Income (continued)

Net Gain on the Sale of Mortgage Servicing Rights (continued)

     Three months

The Company sold MSR with underlying loans totaling $8.6 billion during the 2004 period versus $7.8 billion during the 2003 period. The Company sold $4.8 billion in bulk servicing packages in the 2004 period versus a $1.0 billion package in the 2003 period. During 2004, the Company sold the servicing rights to $3.6 billion of newly originated loans on a flow basis and $0.2 billion of loans in servicing released transactions. During 2003, the Company sold $6.2 billion of newly originated servicing rights on a flow basis and $0.6 billion of loans in servicing released transactions.

For the three months ended June 30, 2004, the net gain on the sale of mortgage servicing rights increased from $0.3 million during the 2003 period to $37.2 million. The gain on sale in the 2004 period was higher than the gain recorded in the 2003 period because of the wide spread between the basis in the MSR sold and the sales price received for the MSR. The MSR was originated in a period when the market value was less than half the value it became in the period of sale.

     Six months

For the six months ended June 30, 2004, the net gain on the sale of mortgage servicing rights increased $57.4 million to $59.0 million, from $1.6 million for the same period in 2003. The gain on sale of mortgage servicing rights increased due to the sale of $8.8 billion of seasoned servicing rights in 2004 versus the sale of $5.0 billion during 2003. During 2004, the Company sold a total of $15.0 billion in servicing versus the $15.7 billion of mortgage servicing rights originated. In 2003, the Company sold $18.2 billion and originated $30.5 billion in mortgage servicing rights.

     Other

     Three months

During the three months ended June 30, 2004, the Company recorded $20.7 million in other income. In the comparable 2003 period, the Company recorded $13.4 million. The collection and recording of these fees are dependent on the amount of deposit accounts, the number of certain types of loans closed, the amount of earnings recorded in certain subsidiaries, and the collection of any miscellaneous fees. The major difference between the two periods is found in the deposit and loan fees collected.

During the three months ended June 30, 2004 the Company collected $3.0 million in deposit fees versus $0.5 million collected in the comparable 2003 period. This increase is attributable to the automated check processing and overdraft protection program instituted in the fourth quarter of 2003.

Net loan fees collected during the three months ended June 30, 2004 totaled $6.0 million compared to $4.8 million collected during the comparable 2003 period. This increase is the result of an increase in the production and subsequent sale of brokered loans.

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Non-Interest Income (continued)

     Other (continued)

     Six months

During the six months ended June 30, 2004, the Company recorded $36.6 million in other income. In the comparable 2003 period, the Company recorded $26.2 million. The collection and recording of these fees are dependent on the amount of deposit accounts, the number of certain types of loans closed, the amount of earnings recorded in certain subsidiaries, and the collection of any miscellaneous fees. The major difference between the two periods is found in the deposit fees collected.

During the six months ended June 30, 2004 the Company collected $6.2 million in deposit fees versus $0.8 million collected in the comparable 2003 period. This increase is attributable to the automated check processing and overdraft protection program instituted in the fourth quarter of 2003.

Net loan fees collected during the six months ended June 30, 2004 totaled $10.1 million compared to $9.4 million collected during the comparable 2003 period. This increase is the result of an increase in the production and subsequent sale of brokered loans.

During the six months ended June 30, 2004, the Company recorded $4.9 million in dividends received on FHLB stock, compared to the $4.1 million received during the six months ended June 30, 2003. The increase was a result of the increased balance of FHLB stock owned. At June 30, 2004 the Company owned $229.8 million and at June 30, 2003 the Company owned $152.8 million.

Non-Interest Expense

The following table sets forth the components of the Company’s non-interest expense, along with the allocation of expenses related to loan originations that are deferred pursuant to SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.” As required by SFAS No. 91, mortgage loan fees and certain direct origination costs (principally compensation and benefits) are capitalized as an adjustment to the basis of the loans originated during a period. Certain other expenses associated with loan production, however, are not required or allowed to be capitalized. These expense amounts are reflected on the Company’s statement of earnings. Management believes that the analysis of non-interest expense on a “gross” basis (i.e., prior to the deferral of capitalized loan origination costs) more clearly reflects the changes in non-interest expense when comparing periods.

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Non-Interest Expense (continued)

Three months

The following are the major changes affecting the quarterly income statement:

§		The retail banking operation conducted business from 8 more facilities at June 30, 2004 than at June 30, 2003.
§		The Company conducted business from 29 more retail loan origination offices at June 30, 2004 than at June 30, 2003.
§		The home lending operation originated $9.0 billion in residential mortgage loans during the 2004 quarter versus $17.5 billion in the comparable 2003 quarter.
§		The Company employed 2,482 salaried employees at June 30, 2004 versus 3,106 salaried employees at June 30, 2003.
§		The Company employed 135 full-time national account executives at June 30, 2004 versus 121 at June 30, 2003.
§		The Company employed 862 full-time retail loan originators at June 30, 2004 versus 883 at June 30, 2003.
§		The Company changed its policy on evaluating personnel salaries on the respective employees anniversary date and changed it to a calendar basis. The annual increases for salaried employees were received on January 1, 2004.

Non-interest expense, excluding the capitalization of direct loan origination costs, decreased $28.2 million to $104.7 million during the three months ended June 30, 2004, from $132.9 million for the comparable 2003 period. This large decrease in costs is for the most part explained above, but further explanation follows.

The decreased compensation and benefits expense of $9.1 million is the direct result of the decreased personnel count utilized in the home lending operation offset by the salary increases given to the remaining employees and the staff that was required to support the additional banking centers.

The largest change occurred in commissions paid to the commissioned sales staff. On a year over year basis, there was a $12.4 million decrease. This is the direct result of the decreased mortgage loan originations during the period. During the 2004 period commissions were 31.5 basis points of loan originations versus 23.3 basis points during the 2003 period.

The decrease in general and administrative expense is reflective of the decreased mortgage loan originations offset by the increased number of banking centers in operation during the period.

During the three months ended June 30, 2004, the Company capitalized direct loan origination costs of $41.4 million, a decrease of $26.0 million from $67.4 million for the comparable 2003 period. The 2004 deferral equates to a capitalization of $796 per loan versus $636 per loan in the 2003 period.

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Non-Interest Expense (continued)

Six months

During the six months ended June 30, 2004, non-interest expense, excluding the capitalization of direct loan origination costs, decreased by $45.9 million, or 18.4%, to $204.2 million, from $250.1 million for the comparable 2003 period. The decreased costs are primarily attributable to the same items as mentioned above in the “three month” section, but further explanation follows.

The decreased compensation and benefits expense of $15.4 million, or 16.4%, is the direct result of the decreased personnel count utilized in the home lending operation, offset by the salary increases given to the remaining employees and the new staff that was required to support the additional banking centers.

The decreased commission expense of $25.7 million, or 33.0%, is the direct result of the 43.3% decrease in mortgage loan originations during the period. During the 2004 and 2003 periods, commissions were 28.2 and 23.9 basis points of loan originations, respectively.

The $1.9 million increase in occupancy and equipment costs is directly attributable to the 18.2% increase in operating facilities and the equipment required to accommodate the increased staff.

The decrease in general and administrative expense is reflective of the decreased mortgage loan originations, offset by the increased number of banking centers in operation during the period.

During the six months ended June 30, 2004, the Company capitalized direct loan origination costs of $78.4 million, a decrease of $48.6 million, or 38.3%, from $127.0 million for the comparable 2003 period. The 2004 deferral equates to a capitalization of $743 per loan versus $644 per loan in the 2003 period.

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Financial Condition

Assets

The Company’s assets totaled $12.0 billion at June 30, 2004, an increase of $1.4 billion, or 13.2%, as compared to $10.6 billion at December 31, 2003. This increase was primarily due to an increase in earning assets at June 30, 2004.

     Cash and cash equivalents

Cash and cash equivalents increased from $148.4 million at December 31, 2003 to $162.6 million at June 30, 2004.

     Mortgage-backed securities held to maturity

Mortgage-backed securities decreased from $30.7 million at December 31, 2003 to $26.1 million at June 30, 2004. The net decrease was attributed to payoffs received, which was offset slightly by a small purchase of $1.1 million in June of 2004. The purchase was for CRA investment purposes. This portfolio also includes loans originated by the Company and securitized for credit enhancement reasons.

     Investment securities held to maturity

The Company’s investment portfolio increased 9.2%, from $14.1 million at December 31, 2003 to $15.4 million at June 30, 2004. The investment portfolio is limited to a small portfolio of contractually required collateral, regulatory required collateral, and reinvestments made by non-bank subsidiaries.

     Loans available for sale

Mortgage loans available for sale decreased $0.6 billion, or 21.4%, to $2.2 billion at June 30, 2004, from $2.8 billion at December 31, 2003. This decrease is primarily attributable to the decrease in loan production originated during June versus December. At June 30, 2004, the majority of these loans were originated within the two weeks prior to the end of the quarter. The majority of these loans will be sold or exchanged for mortgage-backed securities and sold in the secondary market within the next 45 days.

     Investment loan portfolio

The investment loan portfolio at June 30, 2004 increased $1.9 billion from December 31, 2003. The increase included a $1.9 billion increase in single-family mortgage loans and a $109.5 million decrease in warehouse loans.

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     Allowance for losses

The allowance for losses totaled $41.7 million at June 30, 2004 and $36.0 million at December 31, 2003, respectively. The allowance for losses as a percentage of non-performing loans was 70.0% and 61.7% at June 30, 2004 and December 31, 2003, respectively. The Company’s non-performing loans totaled $59.6 million and $58.3 million at June 30, 2004 and December 31, 2003, respectively. The allowance for losses as a percentage of investment loans was 0.48% and 0.53% at June 30, 2004 and December 31, 2003, respectively. The allowance for losses is considered adequate based upon management’s assessment of relevant factors, including the types and amounts of non-performing loans, historical, and current loss experience on such types of loans, and the current economic environment. The following table provides the amount of delinquent loans at the date listed. At June 30, 2004, 88.1% of all delinquent loans were loans where the Company had a first lien position on residential real estate.