HAWTHORNE FINANCIAL CORP - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q


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

For the quarter ended September 30, 2002

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

For the transition period from __________to __________ .
Commission File Number 0-1100

HAWTHORNE FINANCIAL CORPORATION

(Exact Name of Registrant as Specified in its Charter)


Delaware (State or Other Jurisdiction of Incorporation or Organization)		95-2085671 (I.R.S. Employer Identification Number)

2381 Rosecrans Avenue, El Segundo, CA (Address of Principal Executive Offices)		90245 (Zip Code)

Registrant’s telephone number, including area code (310) 725-5000

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

Indicate the number of shares outstanding of each of the issuer’s classes of Common Stock as of the latest practicable date: The Registrant had 7,475,246 shares of Common Stock, $0.01 par value, per share outstanding as of November 8, 2002.

TABLE OF CONTENTS


		CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
		CONSOLIDATED STATEMENTS OF INCOME
		CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
		CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	ITEM 3. Quantitative and Qualitative Disclosures about Market Risk
	ITEM 4. Controls and Procedures
PART II — OTHER INFORMATION
	ITEM 1. Legal Proceedings
	ITEM 2. Changes in Securities
	ITEM 3. Defaults upon Senior Securities
	ITEM 4. Submission of Matters to a Vote of Security Holders
	ITEM 5. Other Information
	ITEM 6. Exhibits and Reports on Form 8-K

HAWTHORNE FINANCIAL CORPORATION

FORM 10-Q INDEX
For the quarter ended September 30, 2002


		Page

PART I — FINANCIAL INFORMATION
ITEM 1.	Financial Statements
	Consolidated Statements of Financial Condition at September 30, 2002 and December 31, 2001 (unaudited)		1
	Consolidated Statements of Income for the Three and Nine Months Ended September 30, 2002 and 2001 (unaudited)		2
	Consolidated Statement of Stockholders’ Equity for the Nine Months Ended September 30, 2002 (unaudited)		3
	Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2002 and 2001 (unaudited)		4
	Notes to Unaudited Consolidated Financial Statements		6
ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations		11
ITEM 3.	Quantitative and Qualitative Disclosures About Market Risk		34
ITEM 4.	Controls and Procedures		35
PART II — OTHER INFORMATION
ITEM 1.	Legal Proceedings		35
ITEM 2.	Changes in Securities		35
ITEM 3.	Defaults upon Senior Securities		35
ITEM 4.	Submission of Matters to a Vote of Security Holders		35
ITEM 5.	Other Information		35
ITEM 6.	Exhibits and Reports on Form 8-K		35

CAUTIONARY STATEMENT REGARDING FORWARD LOOKING STATEMENTS

When used in this Form 10-Q or future filings by Hawthorne Financial Corporation (“Company”) with the Securities and Exchange Commission (“SEC”), in the Company’s press releases or other public or stockholder communications, or in oral statements made with the approval of an authorized executive officer, the words or phrases “will likely result”, “are expected to”, “will continue”, “is anticipated”, “estimate”, “project”, “believe” or similar expressions are intended to identify “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. The Company wishes to caution readers that all forward-looking statements are necessarily speculative and not to place undue reliance on any such forward-looking statements, which speak only as of the date made. Also, the Company wishes to advise readers that various risks and uncertainties could affect the Company’s financial performance and cause actual results for future periods to differ materially from those anticipated or projected. Specifically, the Company cautions readers that the following important factors could affect the Company’s business and cause actual results to differ materially from those expressed in any forward-looking statement made by, or on behalf of, the Company:

• Economic Conditions. The Company’s results are strongly influenced by general economic conditions in its market area. Accordingly, deterioration in these conditions could have a material adverse impact on the quality of the Company’s loan portfolio and the demand for its products and services. In particular, changes in economic conditions in the real estate industry or real estate values in our market may affect our performance.

•      Interest Rate Risk. The Company realizes income principally from the differential or spread between the interest earned on loans, investments, and other interest earning assets, and the interest paid on deposits and borrowings. The volumes and yields on loans, deposits, and borrowings are affected by market interest rates. As of September 30, 2002, 90.67% of the Company’s loan portfolio was tied to adjustable rate indices, such as MTA, Prime, LIBOR, COFI and CMT. Out of these adjustable rate loans, approximately 55.87%, or $1.08 billion, have reached their internal interest rate floors. Therefore, these loans have taken on fixed rate characteristics. The Company’s deposits of $1.4 billion are comprised of 60.85% time deposits with a stated maturity (generally one year or less) and a fixed rate of interest. As of September 30, 2002, 80.23% of the Company’s borrowings from the Federal Home Loan Bank (“FHLB”) are fixed rate, with remaining terms ranging from one to eight years (though such remaining terms are subject to early call provisions). The remaining 19.77% of the borrowings carry an adjustable interest rate, with 87.72% of the adjustable borrowings tied to the Prime Rate, maturing in 2003, and 12.28% tied to one-month LIBOR, maturing in 2003.

     Changes in the market interest rates directly and immediately affect the Company’s interest spread, and therefore profitability. Sharp and significant changes in market rates can cause the interest spread to shrink or expand significantly in the near term, principally because of the timing differences between the adjustable rate loans and the maturities (and therefore repricing) of the deposits and borrowings.

     Sharp decreases in interest rates have resulted in increased loan prepayments as borrowers refinance to fixed rate products. Due to the fact that the Bank is a variable rate lender and offers fixed rate products on a limited basis, a decreasing interest rate environment could negatively impact the Company’s ability to grow the balance sheet.

•      Credit Quality. We have invested in various assets that contain elements of credit risk. These assets include loans and investment securities, the majority of which are collateralized by mortgage loans. A significant source of risk arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. The Company has adopted underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for credit losses, that management believes are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying its credit portfolio. However, such policies and procedures may not prevent unexpected losses that could materially adversely affect the Company’s results.

•      Risk Associated With Merger. The Company acquired First Fidelity Bancorp, Inc. (“First Fidelity”) on August 23, 2002. The Company’s results may be affected if (1) the expected growth opportunities and cost savings from the merger are not fully realized or take longer to realize than expected; or (2) operating costs, customer losses and business disruption, including adverse effects on relationships with employees, are greater than expected.

•      Government Regulation And Monetary Policy. All forward-looking statements presume a continuation of the existing regulatory environment and United States’ government monetary policies. The banking industry is subject to extensive federal and state regulations, and significant new laws or changes in, or repeals of, existing laws may cause results to differ materially. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects credit conditions for the Company, primarily through open market operations in United States government securities, the discount rate for member bank borrowings and bank reserve requirements, and a material change in these conditions has had and is likely to continue to have a material impact on the Company’s results.

•      Competition. The Company competes with numerous other domestic and foreign financial institutions and non depository financial intermediaries. The Company’s results may differ if circumstances affecting the nature or level of competition change, such as the merger of competing financial institutions or the acquisition of California institutions by out-of-state companies.

•      Other Risks. From time to time, the Company details other risks with respect to its business and/or financial results in press releases and filings with the SEC. Stockholders are urged to review the risks described in such releases and filings.

The risks highlighted herein should not be assumed to be the only factors that could affect future performance of the Company. The Company does not undertake, and specifically disclaims any obligation, to publicly release the result of any revisions that may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

HAWTHORNE FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Unaudited)


					September 30,			December 31,
(Dollars in thousands)					2002			2001

Assets:
	Cash and cash equivalents				$	19,892		$	98,583
	Investment securities available for sale, at fair value					208,580			—
	Loans receivable (net of allowance for credit losses of $35,873 in 2002 and $30,602 in 2001)					2,101,080			1,709,283
	Real estate owned					—			1,312
	Accrued interest receivable					11,498			9,677
	Investment in capital stock of Federal Home Loan Bank, at cost					34,275			24,464
	Office property and equipment at cost, net					4,356			4,237
	Deferred tax asset					8,324			4,363
	Goodwill					22,970			—
	Other intangible assets					1,490			—
	Other assets					6,865			4,278

				Total assets	$	2,419,330		$	1,856,197

Liabilities and Stockholders’ Equity:
	Liabilities:
		Deposits:
			Noninterest-bearing		$	36,238		$	35,634
			Interest-bearing:
				Transaction accounts		591,876			338,829
				Certificates of deposit		976,104			825,182

				Total deposits		1,604,218			1,199,645
		FHLB advances				578,058			484,000
		Senior notes				23,078			25,778
		Capital securities				36,000			14,000
		Accounts payable and other liabilities				17,620			12,325

				Total liabilities		2,258,974			1,735,748

Stockholders’ Equity:
	Common stock — $0.01 par value; authorized 20,000,000 shares; issued and outstanding, 8,573,897 shares (2002) and 5,920,266 shares (2001)					85			59
	Capital in excess of par value— common stock					81,083			44,524
	Retained earnings					99,233			82,435
	Accumulated other comprehensive income					1,071			—
	Less:
		Treasury stock, at cost— 1,060,802 shares (2002) and 560,719 shares (2001)				(21,116	)		(6,569	)

				Total stockholders’ equity		160,356			120,449

				Total liabilities and stockholders’ equity	$	2,419,330		$	1,856,197

See Accompanying Notes to Consolidated Financial Statements

HAWTHORNE FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)


				Three Months Ended						Nine Months Ended
				September 30,						September 30,

(In thousands, except per share data)				2002			2001			2002			2001

Interest revenues:
	Loans			$	31,496		$	35,663		$	94,389		$	108,417
	Investments and other securities				1,149			—			1,218			—
	Fed funds and other				985			918			2,935			3,644

			Total interest revenues		33,630			36,581			98,542			112,061

Interest costs:
	Deposits				8,975			14,394			27,002			47,841
	FHLB advances				5,610			5,085			15,903			15,698
	Senior notes				801			956			2,412			3,118
	Capital securities				633			228			1,536			465

			Total interest costs		16,019			20,663			46,853			67,122

Net interest income					17,611			15,918			51,689			44,939
Provision for credit losses					100			400			770			2,900

	Net interest income after provision for credit losses				17,511			15,518			50,919			42,039

Noninterest revenues:
	Loan related fees				1,125			827			2,763			2,929
	Deposit fees				408			368			1,144			1,009
	Other fees				208			111			322			371

			Total noninterest revenues		1,741			1,306			4,229			4,309

Income from real estate operations, net					2			47			71			209
Noninterest expenses:
	General and administrative expenses:
		Employee			5,683			4,539			15,415			13,548
		Operating			2,063			1,898			5,082			5,048
		Occupancy			1,027			975			2,882			2,984
		Professional			658			481			1,364			2,376
		Technology			423			498			1,163			1,525
		SAIF premiums and OTS assessments			145			223			413			704
		Other/legal settlements			198			—			218			110

			Total general and administrative expenses		10,197			8,614			26,537			26,295

Income before income taxes and extraordinary item					9,057			8,257			28,682			20,262
Income tax provision					3,321			3,509			11,760			8,637

Income before extraordinary item					5,736			4,748			16,922			11,625
Extraordinary item, related to early extinguishment of debt (net of year-to-date taxes of $94 in 2002 and $194 in 2001)					(125	)		(11	)		(125	)		(266	)

Net income				$	5,611		$	4,737		$	16,797		$	11,359

Basic earnings per share before extraordinary item				$	0.83		$	0.89		$	2.80		$	2.21

Basic earnings per share after extraordinary item				$	0.81		$	0.89		$	2.78		$	2.16

Diluted earnings per share before extraordinary item				$	0.71		$	0.62		$	2.19		$	1.54

Diluted earnings per share after extraordinary item				$	0.69		$	0.62		$	2.18		$	1.50

Weighted average basic shares outstanding					6,910			5,350			6,034			5,269

Weighted average diluted shares outstanding					8,090			7,609			7,712			7,559

See Accompanying Notes to Consolidated Financial Statements

HAWTHORNE FINANCIAL CORPORATION

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(Unaudited)


							Capital in
							Excess of				Accumulated
		Number of					Par Value -				Other					Total
		Common			Common		Common		Retained		Comprehensive		Treasury			Stockholders'
(In thousands)		Shares			Stock		Stock		Earnings		Income/(Loss)		Stock			Equity

Balance at January 1, 2002			5,360		$	59	$	44,524	$	82,435	$	—	$	(6,569	)	$	120,449
Exercised stock options			105			1		1,122		—		—		—			1,123
Exercised warrants			1,282			13		2,715		—		—		—			2,728
Other comprehensive income, net
	Unrealized gain (loss) on securities available for sale, net of tax		—			—		—		—		1,071		—			1,071
Tax benefit for stock options exercised			—			—		729		—		—		—			729
Treasury stock			(500	)		—		—		—		—		(14,547	)		(14,547	)
Net income			—			—		—		16,798		—		—			16,798
Stock issued for acquisition of First Fidelity(1)			1,266			12		31,993		—		—		—			32,005

Balance at September 30, 2002			7,513		$	85	$	81,083	$	99,233	$	1,071	$	(21,116	)	$	160,356

(1)

Stock issued at $25.27.

See Accompanying Notes to Consolidated Financial Statements

HAWTHORNE FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)


					Nine Months Ended
					September 30,

(Dollars in thousands)					2002			2001

Cash Flows from Operating Activities:
	Net income				$	16,797		$	11,359
	Adjustments to reconcile net income to cash provided by operating activities:
			Deferred income tax benefit			(457	)		(2,000	)
			Provision for credit losses on loans			770			2,900
			Net gain from sale of real estate owned			(87	)		(106	)
			Loan fee and discount amortization (accretion)			463			(2,130	)
			Depreciation and amortization			1,692			2,140
			FHLB dividends			(1,216	)		(898	)
			Decrease in accrued interest receivable			662			635
			Decrease in other assets			50,055			175
			(Decrease)/ increase in other liabilities			(1,092	)		2,748

				Net cash provided by operating activities		67,587			14,823

Cash Flows from Investing Activities:
	Loans:
		New loans funded				(500,074	)		(502,531	)
		Payoffs and principal payments				670,368			416,200
		Sales proceeds				9,839			25,765
		Purchases				(34,424	)		(55,458	)
		Other, net				(11,189	)		3,181
	Activity in available for sale investment securities:
		Purchases				(145,479	)		—
		Payments				3,430			—
	FHLB stock:
		Purchases				—			(1,564	)
	Real estate owned:
		Sales proceeds				1,399			2,968
		Capitalized costs				—			(5	)
	Office property and equipment:
		Sales proceeds				—			1
		Additions				(925	)		(894	)
		Acquisition of First Fidelity, net of cash				(24,836	)		—

				Net cash used in investing activities		(31,891	)		(112,337	)

See Accompanying Notes to Consolidated Financial Statements

HAWTHORNE FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)


				Nine Months Ended
				September 30,

(Dollars in thousands)				2002			2001

Cash Flows from Financing Activities:
	Deposit activity, net				(45,320	)		33,214
	Net (decrease)/increase in FHLB advances				(77,671	)		75,000
	Net proceeds from exercise of stock options and warrants				3,851			460
	Reduction in Senior Notes				(2,700	)		(9,180	)
	Proceeds from Capital Securities				22,000			9,000
	Purchases of Treasury Stock				(14,547	)		(1,290	)

			Net cash (used in)/provided by financing activities		(114,387	)		107,204

Net (decrease)/increase in cash and cash equivalents					(78,691	)		9,690
Cash and cash equivalents, beginning of period					98,583			99,919

Cash and cash equivalents, end of period				$	19,892		$	109,609

Supplemental Cash Flow Information:
	Cash paid during the period for:
		Interest		$	43,955		$	64,977
		Income taxes, net			15,195			8,100
	Non-cash investing and financing activities:
		Tax benefit for exercised stock options			729			1,972
		Retirement of assets			314			—
	The Company purchased all of the assets of First Fidelity on August 23, 2002. In conjunction with the acquisition, assets acquired and liabilities assumed were as follows:
		Total purchase price		$	71,905
		Assets acquired			(677,045	)
		Liabilities assumed			628,181
		Net asset valuation			(71	)

		Goodwill		$	22,970
	Stock issued in connection with the acquisition			$	32,005

See Accompanying Notes to Consolidated Financial Statements

HAWTHORNE FINANCIAL CORPORATION

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — Summary of Significant Accounting Policies

The consolidated financial statements include the accounts of Hawthorne Financial Corporation and its wholly owned subsidiaries, Hawthorne Savings, F.S.B. and its wholly owned subsidiary, HS Financial Services Corporation, (“Bank”), HFC Capital Trust I, HFC Capital Trust II, HFC Capital Trust III and HFC Capital Trust IV, which are collectively referred to herein as the “Company.” All significant intercompany transactions and balances have been eliminated in consolidation.

The unaudited consolidated financial statements contain all adjustments (consisting solely of normal recurring adjustments) which are, in the opinion of management, necessary to present fairly the Company’s results for the interim periods presented. These consolidated financial statements for the three and nine months ended September 30, 2002, are not necessarily indicative of the results that may be expected for any other interim period or the full year ending December 31, 2002.

Certain information and note disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). The unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.

Recent Accounting Pronouncements

In July 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 141, “Business Combinations,” which requires the purchase method of accounting for business combinations initiated after September 30, 2001 and eliminates the pooling-of-interests method. See “Note 8 — Business Combinations, Goodwill and Acquired Intangible Assets” for the impact on the financial position, results of operations and cash flows of the Company.

In July 2001, the FASB issued SFAS No. 142, “Goodwill and Other Intangible Assets.” SFAS No. 142 establishes new standards for goodwill acquired in a business combination and eliminates amortization of goodwill and instead sets forth methods to periodically evaluate goodwill for impairment. The provisions of SFAS No. 142 are to be applied starting with fiscal years beginning after December 15, 2001. See “Note 8 — Business Combinations, Goodwill and Acquired Intangible Assets” for the impact on the financial position, results of operations and cash flows of the Company.

In August 2001, the FASB issued SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” which is effective for fiscal years beginning after December 15, 2001. This pronouncement supercedes SFAS No. 121, “Accounting for the Impairment of Long-Lived Assets to be Disposed of,” and the accounting and reporting provisions of Accounting Principles Board Opinion No. 30 for the disposal of a segment of a business. The adoption of SFAS No. 144 did not have a significant impact on the financial position, result of operations, or cash flows of the Company.

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections,” that, among various topics, eliminated the requirement that all forms of gains or losses on debt extinguishments be reported as extraordinary items. The provision of SFAS No. 145 related to the extinguishment of debt will be effective for fiscal years beginning after May 15, 2002. Adoption of this statement is not expected to have a significant impact on the financial position, results of operations, or cash flows of the Company, but it will have an impact on the presentation of the results of operations.

In June 2002, the FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” which addresses financial accounting and reporting for costs associated with exit or disposal activities and supersedes Emerging Issues Task Force (“EITF”) Issue 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” SFAS No. 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. Under EITF Issue 94-3, a liability for an exit cost, as defined in EITF Issue 94-3, was recognized at the date of an entity’s commitment to an exit plan. SFAS No.146 also establishes that the liability should initially be measured and recorded at fair value. The Company will adopt the provisions of SFAS No. 146 for exit or disposal activities that are initiated after December 31, 2002. Adoption of this statement is not expected to have a significant impact on the financial position, results of operations, or cash flows of the Company.

In October 2002, the FASB issued SFAS No. 147, “Acquisitions of Certain Financial Institutions,” which provides guidance on the accounting for the acquisition of a financial institution. This statement requires that the excess of the fair value of liabilities assumed over the fair value of tangible and identifiable intangible assets acquired in a business combination represents goodwill that should be accounted for under SFAS No. 142, “Goodwill and Other Intangible Assets.” Thus, the specialized accounting guidance in paragraph 5 of SFAS No. 72, “Accounting for Certain Acquisitions of Banking or Thrift Institutions,” will not apply after September 30, 2002. If certain criteria in SFAS No. 147 are met, the amount of the unidentifiable intangible asset will be reclassified to goodwill upon adoption of this statement. Financial institutions meeting conditions outlined in SFAS No. 147 will be required to restate previously issued financial statements. Additionally, the scope of SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”, is amended to include long-term customer-relationship intangible assets such as depositor- and borrower-relationship intangible assets and credit cardholder intangible assets. The Company has adopted the new standard, effective October 1, 2002, and the adoption of this standard did not have a material impact on the financial position, results of operation, or cash flows of the Company.

Note 2 — Reclassifications

Certain amounts in the 2001 consolidated financial statements have been reclassified to conform with classifications in 2002.

Note 3 — Book Value and Earnings Per Share

The following table sets forth the Company’s earnings per share calculations for the three and nine months ended September 30, 2002 and 2001. In the following table, (1) “Warrants” refer to the Warrants issued by the Company in December 1995, which are currently exercisable and which expire December 11, 2005, and (2) “Options” refer to stock options previously granted to employees and directors of the Company and which were outstanding at each measurement date.


		Three Months Ended						Nine Months Ended
		September 30,						September 30,

(In thousands, except per share data)		2002			2001			2002			2001

Average shares outstanding:
	Basic		6,910			5,350			6,034			5,269
	Warrants		1,056			2,286			1,606			2,374
	Options(1)		635			602			664			588
	Less: Treasury stock(2)		(511	)		(629	)		(592	)		(672	)

	Diluted		8,090			7,609			7,712			7,559

Net income before extraordinary item		$	5,736		$	4,748		$	16,922		$	11,625

Net income after extraordinary item		$	5,611		$	4,737		$	16,797		$	11,359

Basic earnings per share before extraordinary item		$	0.83		$	0.89		$	2.80		$	2.21
Extraordinary item (net of taxes)		$	(0.02	)	$	—		$	(0.02	)	$	(0.05	)

Basic earnings per share after extraordinary item		$	0.81		$	0.89		$	2.78		$	2.16

Diluted earnings per share before extraordinary item		$	0.71		$	0.62		$	2.19		$	1.54
Extraordinary item (net of taxes)		$	(0.02	)	$	—		$	(0.01	)	$	(0.04	)

Diluted earnings per share after extraordinary item		$	0.69		$	0.62		$	2.18		$	1.50

(1)		Excludes 88,000 options for the three and nine months ended September 30, 2002, for which the exercise price exceeded the average market price of the Company’s common stock. For the three and nine months ended September 30, 2001, there were no options for which the exercise price exceeded the average market price of the Company’s common stock during the period.




(2)		Under the treasury stock method, it is assumed that the Company will use proceeds from the proforma exercise of the Warrants and Options to acquire actual shares currently outstanding, including the amount of tax benefits assumed from the exercise of nonqualified options, thus increasing treasury stock. In this calculation, treasury stock was assumed to be repurchased at the average closing stock price for the respective period.


		At September 30,

(In thousands, except per share data)		2002			2001

Period-end shares outstanding(1):
	Basic		7,513			5,360
	Warrants		897			2,279
	Options(2)		653			581
	Less: Treasury stock(3)		(520	)		(621	)

	Diluted		8,543			7,599

Basic book value per share(1)		$	21.34		$	21.77

Diluted book value per share(1)		$	18.77		$	15.35

Tangible diluted book value per share(1)		$	15.98		$	15.35

(1)		Book values were calculated using period-end shares outstanding.




(2)		At September 30, 2002, there were 88,000 options outstanding for which the exercise price exceeded the monthly average market price of the Company’s stock at period-end. There were no options outstanding at September 30, 2001, for which the exercise price exceeded the monthly average market price of the Company’s common stock at period-end.




(3)		Under the treasury stock method, it is assumed that the Company will use proceeds from the proforma exercise of the Warrants and Options to acquire actual shares currently outstanding, thus increasing treasury stock. In this calculation, treasury stock was assumed to be repurchased at the average closing stock price for the respective period.

Subsequent to September 30, 2002, there were 125,000 shares repurchased at an average price of $28.48. As discussed under “Note 6 — Stockholders’ Equity,” contained herein, the Company issued an additional 1,266,540 shares of its common stock for the acquisition of First Fidelity Bancorp, Inc., which closed on August 23, 2002.

Note 4 — Commitments and Contingencies

There have been no material changes to the litigation matters disclosed in “Note 13 — Commitments and Contingencies” on the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.

The Company is involved in a variety of litigation matters in the ordinary course of its business, and anticipates that it will become involved in new litigation matters from time to time in the future. Based on the current assessment of these other matters, management does not presently believe that any one of these existing other matters is likely to have a material adverse impact on the Company’s financial condition, result of operations or cash flows. However, the Company will incur legal and related costs concerning the litigation and may from time to time determine to settle some or all of the cases, regardless of management’s assessment of the Company’s legal position. The amount of legal defense costs and settlements in any period will depend on many factors, including the status of cases (and the number of cases that are in trial or about to be brought to trial) and the opposing parties’ aggressiveness in pursuing their cases and their perception of their legal position. Further, the inherent uncertainty of jury or judicial verdicts makes it impossible to determine with certainty the Company’s maximum cost in any pending litigation. Accordingly, the Company’s litigation costs and expenses may vary materially from period to period, and no assurance can be given that these costs will not be material in any particular period.

Note 5 — Off-Balance Sheet Activity

The Company is a party to credit-related financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. At September 30, 2002, the Company had commitments to fund the undisbursed portion of existing construction and land loans of $90.1 million and income property and estate loans of $9.6 million. The Company’s commitments to fund the undisbursed portion of existing lines of credit totaled $11.1 million. The Company follows the same credit policies in making commitments as it does for on-balance sheet instruments.

On July 8, 2002, the FHLB issued a $33.0 million Letter of Credit (“LC”) to the Company to replace the $33.0 million LC issued on January 10, 2002, which matured on July 12, 2002. On September 10, 2002 the FHLB issued a new $45.0 million LC to the Company. The purpose of the LCs is to fulfill the collateral requirements for deposits placed by the State of California with the Company. The LCs are issued in favor of the State Treasurer of the State of California and mature on January 16, 2003 and September 10, 2003. There were no issuance fees associated with these letters of credit; however, a maintenance fee of 15 basis points per annum is paid monthly by the Company.

Note 6 — Stockholders’ Equity

On August 23, 2002 the Company issued 1,266,540 shares of Hawthorne Financial Corporation stock and $37.8 million in cash for the 1,815,115 shares of First Fidelity Bancorp, Inc. stock and 88,000 options outstanding.

In October 2002, the Company announced that its Board of Directors approved exercising the option to redeem the $23.1 million 12.50% Senior Notes currently outstanding at the call price of 106.25% on December 31, 2002. Formal notice of redemption will be given in accordance with the provisions of the Senior Notes. The Company will use the proceeds of a $15.0 million private issuance of Trust Preferred Securities, as described in Note 7, and excess cash currently at the holding company to repurchase the Senior Notes, which will result in approximately $2.1 million reduction in our interest expense in 2003. The repurchase of the outstanding Senior Notes will result in a one-time nonrecurring extraordinary charge to net income in the fourth quarter of $1.1 million after tax.

Note 7 —Capital Securities

The Company owns all the outstanding stock of the Bank. On March 28, 2001, November 28, 2001, April 10, 2002 and November 1, 2002, HFC Capital Trust I (“Trust I”), HFC Capital Trust II (“Trust II”), HFC Capital Trust III (“Trust III”) and HFC Capital Trust IV (“Trust IV”), respectively, statutory business trusts and wholly owned subsidiaries of the Company, issued $9.0 million of 10.18% fixed rate capital securities (the “Capital Securities I”), $5.0 million of floating rate capital securities (the “Capital Securities II”), $22.0 million of floating rate capital securities (the “Capital Securities III”) and $15.0 million of floating rate capital securities (the “Capital Securities IV”), respectively. The Capital Securities, which were issued in separate private placement transactions, represent undivided preferred beneficial interests in the assets of the respective Trusts. The Company is the owner of all the beneficial interests represented by the common securities of Trust I, Trust II, Trust III and Trust IV (the “Common Securities I,” “Common Securities II”, “Common Securities III” and “Common Securities IV”) (together with the “Capital Securities I,” “Capital Securities II,” “Capital Securities III” and “Capital Securities IV”) and, collectively the “Trust Securities”). Trust I, Trust II, Trust III and Trust IV exist for the sole purpose of issuing the Trust Securities and investing the proceeds thereof in 10.18% fixed rate and floating rates, respectively, junior subordinated deferrable interest debentures (the “Junior Subordinated Debentures I,” “Junior Subordinated Debentures II,” “Junior Subordinated Debentures III” and “Junior Subordinated Debentures IV”) issued by the Company and engaging in certain other limited activities. Interest on the Capital Securities is payable semi-annually.

The Junior Subordinated Debentures I held by Trust I will mature on June 8, 2031, at which time the Company is obligated to redeem the Capital Securities I. The Capital Securities I are callable, in whole or in part, at par value after ten years. The proceeds were used to repurchase, in a market transaction, $7.2 million of the Company’s Senior Notes at an average price of 101.4% of par value. See “Note 17 — Extraordinary Item” on the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.

The floating rate on the Capital Securities II, with a current rate of 5.78%, reprices semi-annually based on the index of nine month LIBOR plus a spread of 3.75%, with a cap of 11.00% through December 8, 2006. The Junior Subordinated Debentures II held by Trust II will mature on December 8, 2031, at which time the Company is obligated to redeem the Capital Securities II. The Capital Securities II are callable, in whole or in part, at par value after five years. The proceeds were used to repurchase, in a market transaction, $4.0 million of its Senior Notes at an average price of 105.0% of par value. See “Note 17 — Extraordinary Item” on the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.

The floating rate on the Capital Securities III, with a current rate of 5.32%, reprices semi-annually based on the index of six month LIBOR plus a spread of 3.70%, with a cap of 11.00% through April 10, 2007, after which time the rate will be fully indexed. The Junior Subordinated Debentures III held by Trust III will mature on April 10, 2032, at which time the Company is obligated to redeem the Capital Securities III. The Capital Securities III are callable, in whole or in part, at par value after five years.

On November 1, 2002, Hawthorne Financial Corporation participated in a pooled offering of floating rate trust preferred securities, raising $15.0 million (“Capital Securities IV”). The Company will use the proceeds of the $15.0 million private issuance of Trust Preferred Securities and excess cash currently at the holding company to repurchase the 12.50% Senior Notes on December 31, 2002. Formal notice of the redemption will be given in accordance with the provisions of the Senior Notes. The floating rate on the Capital Securities IV, with an initial start rate of 4.97%, reprices semi-annually based on the index of six month LIBOR plus a spread of 3.35%, with a cap of 12.00% through November 2007, after which time the rate will be fully indexed. The Junior Subordinated Debentures IV held by Trust IV will mature on November 1, 2032, at which time the

Company is obligated to redeem the Capital Securities IV. The Capital Securities IV are callable, in whole or in part, at par value after five years.

Note 8. Business Combinations, Goodwill and Acquired Intangible Assets

On August 23, 2002, the Company acquired all of the assets and liabilities of First Fidelity. This acquisition was accounted for under the purchase method of accounting, and accordingly, all assets and liabilities were adjusted to and recorded at their estimated fair values as of the acquisition date.

In accordance with SFAS No. 141, the Company recorded goodwill for a purchase business combination to the extent that the purchase price of the acquisition exceeded the net identifiable assets of the acquired company.

The following tables summarize the fair values of assets and liabilities and the related premiums, discounts and goodwill associated with the acquisition:


			Book Values of			Fair Values of		Premiums/
			Assets Acquired and			Assets Acquired and		Discounts at
(In thousands)			Liabilities Assumed			Liabilities Assumed		Date of Acquisition

Loans receivable, net			$	527,598		$	530,122	$	2,524
	Discounts/deferred fees on acquired loans			(927	)		—		927
Intangible assets subject to amortization				—			—		1,524
Investments				64,808			64,844		36
Fixed assets				543			242		(301	)
FHLB stock				8,595			8,595		—
Other assets				76,428			77,031		603
Deferred tax on valuations				—			—		(1,978	)

		Total Assets		677,045			680,834		3,335

Deposits				449,893			453,790		3,897
FHLB advances				171,902			173,633		1,731
Other liabilities				6,386			6,386		—
Deferred tax on valuations				—			—		(2,364	)

		Total Liabilities		628,181			633,809		3,264

Net asset value			$	48,864				$	71


		Purchase Price
		and Goodwill

Purchase Price and Goodwill Analysis:
	Total consideration		69,847
	Direct costs		2,058

Total purchase price			71,905
Net assets acquired			(48,864	)
Net asset valuation			(71	)

	Goodwill	$	22,970

Premiums and discounts on loans are amortized on a loan-by-loan basis using an effective interest method over the estimated lives of the loans. Discounts on deposits and FHLB advances are amortized over the respective estimated lives using an effective interest method.

The following table summarizes the Company’s intangible assets as of September 30, 2002:


		Gross		Accumulated Amortization
		Carrying Amount		for the Three Months
(In thousands)		at September 30, 2002		Ended September 30, 2002

Amortized Intangible Assets:
Core deposit intangible — checking		$	861	$	15
Core deposit intangible — savings			629		19

	Total intangible assets	$	1,490	$	34

As of September 30, 2002, the Company’s only intangible assets that are currently being amortized are core deposit intangibles, with $34 thousand in amortization expense incurred for the three months ended September 30, 2002.

The following table summarizes estimated future amortization expense on core deposit intangibles:


	Future
For the Years Ended December 31,	Amortization Expense

(In thousands)
2002	$	137
2003		412
2004		355
2005		216
2006		156

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

OVERVIEW

The Company operates thirteen branches in the coastal counties of Southern California. The Company specializes in real estate secured loans in the niche markets that it serves, including: 1) permanent loans collateralized by single family residential property, 2) permanent loans secured by multi-family residential and commercial real estate, 3) loans for the construction of multi-family residential, commercial and individual single family residential properties and the acquisition and development of land for the construction of such projects. In the ordinary course of business, the Company purchases loans consistent with its current underwriting standards. The Company initiated a treasury function to manage and redirect excess liquidity into an investment securities portfolio. The Company funds its loans and investments predominantly with retail deposits generated through its thirteen full service retail offices and FHLB advances.

The following discussion includes fifty-four days of Hawthorne Financial Corporation’s results pre-acquisition and thirty-eight days of results including First Fidelity post-acquisition.

CRITICAL ACCOUNTING POLICIES

Allowance for Credit Losses

Management evaluates the allowance for credit losses in accordance with GAAP, within the guidance established by SFAS No. 5, “Accounting for Contingencies,” and SFAS No. 114, as amended by SFAS No. 118, “Accounting by Creditors for Impairment of a Loan,” as well as standards established by regulatory Interagency Policy Statements on the Allowance for Loan and Lease Losses (“ALLL”). In making this determination, management considers (1) the status of the asset, (2) the value of the asset or underlying collateral and (3) management’s intent with respect to the asset. In quantifying the loss, if any, associated with individual loans, management utilizes external sources of information as deemed appropriate (i.e., appraisals, price opinions from real estate professionals, comparable sales data and internal estimates). In establishing specific valuation allowances (“SVA”) for impaired loans, in accordance with SFAS No. 114, management estimates the revenues expected to be generated from disposal of the Company’s collateral or owned property, less construction and renovation costs (if any), holding costs and transaction costs. Other methods may be used to estimate impairment (market price or present value of expected future cash flows discounted at the loan’s original interest rate). See “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Policies — Allowance for Credit Losses” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.

The Company maintains an allowance for credit losses, which is not tied to individual loans or properties (General Valuation Allowances, or “GVA”). GVAs are maintained for each of the Company’s principal loan portfolio components and supplemented by periodic additions through provisions for credit losses. In measuring the adequacy of the Company’s

GVA, management considers (1) the Company’s historical loss experience for each loan portfolio component and in total, (2) the historical migration of loans within each portfolio component and in total (i.e., from performing to nonperforming, from nonperforming to REO), (3) observable trends in the performance of each loan portfolio component, and (4) additional analyses to validate the reasonableness of the Bank’s GVA balance, such as the FFIEC Interagency “Examiner Benchmark” and review of peer information. The GVA includes an unallocated amount, based upon management’s evaluation of various conditions, such as general economic and business conditions affecting our key lending areas, the effects of which are not directly measured in the determination of the GVA formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio components. Management intends to maintain an unallocated allowance, in the range of between 3% and 5% of the GVA, to account for the economic uncertainty in Southern California until economic or other conditions warrant a reassessment of the level of the unallocated GVA. See “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Policies — Allowance for Credit Losses” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.

Management believes that the provision for credit losses was at an adequate level during the third quarter of 2002, and that the allowance for credit losses of $35.9 million at September 30, 2002, is adequate to absorb the losses that, in the opinion and judgment of management, are known and inherent in the Bank’s loan portfolio.

Nonaccrual Loans

The Company generally ceases to accrue interest on a loan when: 1) principal or interest has been in default for a period of 90 days or more unless the loan is both well secured and in the process of collection; or, 2) full collection of principal and/or interest is not reasonably assured. In addition, classified construction loans for which interest is being paid from interest reserve loan funds rather than the borrower’s own funds may also be placed on nonaccrual status. A nonaccrual loan may be restored to accrual status when delinquent principal and interest payments are brought current, the loan is paying in accordance with its payment terms for a period, typically between three to six months, and future monthly principal and interest payments are expected to be collected. Classified construction loans may remain on nonaccrual status until the respective loan is upgraded.

Real Estate Owned

Properties acquired through foreclosure, or deed in lieu of foreclosure (“real estate owned,” “REO”), are transferred to REO and carried at the lower of cost or estimated fair value less the estimated costs to sell the property (“fair value”). The fair value of the property is based upon a current appraisal. The difference between the fair value of the real estate collateral and the loan balance at the time of transfer is recorded as a loan charge-off if fair value is lower. Subsequent to foreclosure, management periodically performs valuations and the REO property is carried at the lower of carrying value or fair value, less estimated costs to sell. The determination of a property’s estimated fair value incorporates (1) revenues projected to be realized from disposal of the property, (2) construction and renovation costs, (3) marketing and transaction costs and (4) holding costs (e.g., property taxes, insurance and homeowners’ association dues). Any subsequent declines in the fair value of the REO property after the date of transfer are recorded through a write-down of the asset. In accordance with SFAS No. 66, “Accounting for Sales of Real Estate,” if the Bank originates a loan to facilitate, revenue recognition upon disposition of the property is dependent upon the sale having met certain criteria relating to the buyer’s initial investment in the property sold. Gains and losses from sales of real estate owned properties are reflected in “Income from real estate operations, net” in the consolidated statements of income.

Goodwill

As a result of the adoption of SFAS No. 142, which eliminates amortization of goodwill, the Company is required to evaluate goodwill annually or more frequently if impairment indicators arise. See “Note 8 — Business Combinations, Goodwill and Acquired Intangible Assets” to the Consolidated Financial Statements, included herein.

RESULTS OF OPERATIONS

Net income for the three and nine months ended September 30, 2002, was $5.6 million, or $0.69 per diluted share, and $16.8 million, or $2.18 per diluted share, respectively, compared with $4.7 million, or $0.62 per diluted share, and $11.4 million, or $1.50 per diluted share after extraordinary item, respectively, for the three and nine months ended September 30, 2001.

Net income for the three and nine months ended September 30, 2002, resulted in an annualized return on average assets (“ROA”) of 1.06% and 1.15%, respectively, and an annualized return on average equity (“ROE”) of 16.81% and 17.75%, respectively, compared with an annualized ROA of 1.04% and 0.85%, respectively, and an annualized ROE of 16.72% and 13.87%, respectively, for the three and nine months ended September 30, 2001. Income before income taxes and extraordinary item increased 9.69% and 41.56%, respectively, for the three and nine months ended September 30, 2002, to $9.1 million from $8.3 million and to $28.7 million from $20.3 million, during the same periods in 2001. Included in the third quarter 2002 earnings was a $0.6 million nonrecurring tax benefit resulting from a change in state tax law related to the treatment of bad debts, which impacted all California financial institutions with assets in excess of $500.0 million.

The Company’s net interest income before provision for credit losses increased 10.64% to $17.6 million and 15.02% to $51.7 million, during the three and nine months ended September 30, 2002, respectively, compared with $15.9 million and $44.9 million during the same periods in 2001. The Company’s net interest margin for the three and nine months ended September 30, 2002, was 3.38% and 3.57%, respectively, compared with 3.49% and 3.37% during the same periods in 2001. The Company’s yield on average earning assets was 6.47% and 6.81%, respectively, for the three and nine months ended September 30, 2002, compared with 8.03% and 8.40% during the same periods in 2001. During the nine months ended September 30, 2002, interest of $1.0 million was collected on loans that were brought current, producing a positive but nonrecurring impact on the Company’s net interest margin of 7 basis points.

The Company initiated treasury activities in June 2002, with the intent of increasing net interest income and thereby reducing the impact of the compression of the net interest margin. The treasury function will manage and redirect excess liquidity into an investment securities portfolio with durations of less than four years. As of September 30, 2002, the Company had an investment portfolio of $208.6 million and earned a yield on its excess liquidity of 5.08% during the third quarter rather than the 1.63% it otherwise could have earned in fed funds sold. The Company treats these investments as available-for-sale securities and has reflected the unrealized gain, net of deferred taxes, associated with the changes in the market price in accumulated other comprehensive income as part of its stockholders’ equity. Year-to-date interest income earned on the Bank’s investment portfolio totaled $1.1 million and $1.2 million, for the three and nine month periods ended September 30, 2002, respectively.

Provisions for credit losses totaled $0.1 million and $0.8 million, respectively, for the three and nine months ended September 30, 2002, respectively, compared with $0.4 million and $2.9 million, during the same periods in 2001. The decrease in the provision for credit losses was due to the overall improvement in asset quality. At September 30, 2002, the ratio of total allowance for credit losses to loans receivable, net of specific allowance and deferred fees and costs, was 1.68%, compared with 1.76% at December 31, 2001 and 1.72% at September 30, 2001.

Nonaccrual loans totaled $8.7 million at September 30, 2002 (or 0.36% of total assets) compared with nonaccrual loans of $20.7 million (or 1.11% of total assets) at December 31, 2001 and $25.0 million (or 1.33% of total assets) at September 30, 2001. Total classified loans were $33.1 million at September 30, 2002, compared with $58.0 million at December 31, 2001. The Company held no other real estate owned properties at September 30, 2002, compared with $1.3 million at December 31, 2001.

Noninterest revenues were $1.7 million and $4.2 million for the three and nine months ended September 30, 2002, compared with noninterest revenues of $1.3 million and $4.3 million earned during the same periods in 2001. In July 2002, the Bank’s subsidiary, HS Financial Services Corporation, commenced operations, the primary business of which is the sale of non-deposit investment and insurance products.

Total general and administrative expenses (“G&A”) were $10.2 million and $26.5 million, for the three and nine months ended September 30, 2002, respectively, compared with $8.6 million and $26.3 million of G&A incurred during the same periods in 2001. For the nine months ended 2002, G&A reflected less than a 1% increase compared with G&A for the same period in 2001. G&A to average assets decreased from 1.93% to 1.79%, during the same periods, respectively. The Company’s efficiency ratios (defined as total general and administrative expenses, excluding legal settlements/other, divided by net interest income before provision and noninterest revenues, excluding REO, net) were 51.67% and 47.07% for the three and nine months ended September 30, 2002, respectively, compared with 50.01% and 53.17% during the same periods in 2001.

Net Interest Income

The following table shows average balance sheet data, related revenues and costs and effective weighted average yields and costs, for the three months ended September 30, 2002 and 2001:


				Three Months Ended September 30,

				2002							2001

								Weighted							Weighted
				Average		Revenues/		Average			Average		Revenues/		Average
(Dollars in thousands)				Balance		Costs		Yield/Cost			Balance		Costs		Yield/Cost

Assets:
Interest-earning assets:
	Loans receivable(1)(2)			$	1,814,902	$	31,496		6.92	%	$	1,725,012	$	35,663		8.23	%
	Cash, Fed funds and other				138,455		578		1.66			68,245		630		3.66
	Investment securities				89,777		1,149		5.08			—		—		—
	Investment in capital stock of Federal Home Loan Bank				28,943		407		5.58			21,577		288		5.30

			Total interest-earning assets		2,072,077		33,630		6.47			1,814,834		36,581		8.03

Noninterest-earning assets(3)					41,699							7,618

			Total assets	$	2,113,776						$	1,822,452

Liabilities and Stockholders’ Equity:
	Interest-bearing liabilities:
		Deposits		$	1,320,797	$	8,975		2.70	%	$	1,212,953	$	14,394		4.71	%
		FHLB advances			512,926		5,610		4.28			403,293		5,085		4.93
		Senior notes			25,590		801		12.52			30,608		956		12.50
		Capital securities			36,000		633		7.03			9,000		228		10.18

			Total interest-bearing liabilities		1,895,313		16,019		3.34			1,655,854		20,663		4.94

	Noninterest-bearing checking				37,661							32,926
	Noninterest-bearing liabilities(3)				47,248							20,379
	Stockholders’ equity				133,554							113,293

			Total liabilities and stockholders’ equity	$	2,113,776						$	1,822,452

Net interest income						$	17,611						$	15,918

Interest rate spread									3.13	%						3.09	%

Net interest margin									3.38	%						3.49	%

(1)		Includes the interest on nonaccrual loans only to the extent that it was paid and recognized as interest income.




(2)		Includes net deferred loan costs incurred of $0.32 million and net deferred loan fees earned of $0.57 million for the three months ended September 30, 2002 and September 30, 2001, respectively.




(3)		Includes investment securities awaiting settlement of $22.0 million during the three months ended September 30, 2002.

The following table shows average balance sheet data, related revenues and costs and effective weighted average yields and costs, for the nine months ended September 30, 2002 and 2001:


				Nine Months Ended September 30,

				2002							2001

								Weighted							Weighted
				Average		Revenues/		Average			Average		Revenues/		Average
(Dollars in thousands)				Balance		Costs		Yield/Cost			Balance		Costs		Yield/Cost

Assets:
Interest-earning assets:
	Loans receivable(1)(2)			$	1,729,492	$	94,389		7.28	%	$	1,680,910	$	108,417		8.61	%
	Cash, Fed funds and other				142,183		1,772		1.67			78,895		2,747		4.66
	Investment securities				33,162		1,218		4.91			—		—		—
	Investment in capital stock of Federal Home Loan Bank				26,200		1,163		5.93			21,215		897		5.65

			Total interest-earning assets		1,931,037		98,542		6.81			1,781,020		112,061		8.40

Noninterest-earning assets(3)					15,446							3,697

			Total assets	$	1,946,483						$	1,784,717

Liabilities and Stockholders’ Equity:
	Interest-bearing liabilities:
		Deposits		$	1,212,137	$	27,002		2.98	%	$	1,192,961	$	47,841		5.36	%
		FHLB advances			488,620		15,903		4.29			390,502		15,698		5.30
		Senior notes			25,715		2,412		12.51			33,226		3,118		12.51
		Capital securities			28,022		1,536		7.31			6,165		465		10.06

			Total interest-bearing liabilities		1,754,494		46,853		3.55			1,622,854		67,122		5.51

	Noninterest-bearing checking				36,923							32,640
	Noninterest-bearing liabilities(3)				28,869							20,014
	Stockholders’ equity				126,197							109,209

			Total liabilities and stockholders’ equity	$	1,946,483						$	1,784,717

Net interest income						$	51,689						$	44,939

Interest rate spread									3.26	%						2.89	%

Net interest margin									3.57	%						3.37	%

(1)		Includes the interest on nonaccrual loans only to the extent that it was paid and recognized as interest income.




(2)		Includes net deferred loan costs incurred of $0.27 million and net deferred loans fees earned of $2.0 million for the nine months ended September 30, 2002 and September 30, 2001, respectively.




(3)		Includes investment securities awaiting settlement of $7.4 million during the nine months ended September 30, 2002.

The operations of the Company are substantially dependent on its net interest income, which is the difference between the interest income earned from its interest-earning assets and the interest expense incurred on its interest-bearing liabilities. The Company’s net interest margin is its net interest income divided by its average interest-earning assets. Net interest income and net interest margin are affected by several factors, including (1) the level of, and the relationship between, the dollar amount of interest-earning assets and interest-bearing liabilities, (2) the relationship between the repricing or maturity of the Company’s adjustable rate and fixed rate loans, prepayments, as well as the impact of internal interest rate floors, and short term investment securities and its deposits and borrowings, and (3) the magnitude of the Company’s noninterest-earning assets, including nonaccrual loans and REO.

The Company’s net interest income before provision for credit losses increased 10.64% to $17.6 million and 15.02% to $51.7 million, during the three and nine months ended September 30, 2002, respectively, compared with $15.9 million and $44.9 million during the same periods in 2001. The Company’s yield on average earning assets was 6.47% and 6.81% for the three and nine months ended September 30, 2002, respectively, compared with 8.03% and 8.40% during the same periods in 2001. The average cost of interest-bearing liabilities for the Company decreased to 3.34% and 3.55% for the three and nine months ended September 30, 2002, respectively, compared with 4.94% and 5.51% during the same periods in 2001. Expressed as a percentage of interest-earning assets, the Company’s resulting net interest margin for the three and nine months ended September 30, 2002 was 3.38% and 3.57%, respectively, compared with 3.49% and 3.37% for the three and nine months ended September 30, 2001. The Company’s net interest income was impacted by the 475

basis point drop in interest rates during 2001 and continues to be adversely impacted by lower yields on new loan production, continued runoff of existing loans and repricing of the respective indices. The compression in the net interest margin quarter-over-quarter was partially mitigated by the interest rate floors in the loan portfolio and $1.2 million earned on investment securities. In a rising interest rate environment, these adjustable rate loans, which have taken on fixed rate loan characteristics, will result in potential net interest margin compression. These loans will not reprice until rates have increased enough to bring the fully indexed rate above the internal floor rate, while interest-bearing deposits will reprice more quickly.

As of September 30, 2002, 90.67% of the Company’s net loan portfolio was adjustable rate, with 83.45% of such loans subject to repricing on an annual or more frequent basis. However, the decline is partially mitigated by the contractual floors, with 55.87% of all adjustable rate loans taking on fixed rate loan characteristics. The substantial majority of such loans are priced at a margin over various market sensitive indices, including MTA, Prime, LIBOR, COFI and CMT. Based upon the continued decline in the effective yield of the lagging indices, the Company expects that the yield on its loan portfolio will decline over the coming months to fully incorporate the decrease in current market interest rates.

At September 30, 2002, 60.85% of the Company’s interest-bearing deposits were comprised of certificate accounts, the majority of which have original terms ranging from six to twelve months. The remaining, weighted average term to maturity for the Company’s certificate accounts approximated eight months at September 30, 2002. Generally, the Company’s offering rates for certificate accounts move directionally with the general level of short term interest rates.

As of September 30, 2002, 80.23% of the Company’s borrowings from the FHLB are fixed rate, with remaining terms ranging from one to eight years (though such remaining terms are subject to early call provisions). The remaining 19.77% of the borrowings carry an adjustable interest rate, with 87.72% of the adjustable borrowings tied to the Prime Rate, maturing in 2003, and 12.28% tied to one month LIBOR, maturing in 2003.

The following table sets forth the dollar amount of changes in interest revenues and interest costs attributable to changes in the balances of interest-earning assets and interest-bearing liabilities, and changes in interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (1) changes in volume (i.e., changes in volume multiplied by old rate), (2) changes in rate (i.e., changes in rate multiplied by old volume) and (3) changes attributable to both rate and volume.


		Three Months Ended September 30, 2002 and 2001
		Increase (Decrease) Due to Change In

								Volume and			Net
(Dollars in thousands)		Volume			Rate			Rate(1)			Change

Interest-earning assets:
	Loans receivable(2)	$	1,858		$	(5,727	)	$	(298	)	$	(4,167	)
	Cash, Fed funds and other		648			(345	)		(355	)		(52	)
	Investment securities		—			—			1,149			1,149
	Investment in capital stock of Federal Home Loan Bank		99			15			5			119

			2,605			(6,057	)		501			(2,951	)

Interest-bearing liabilities:
	Deposits		1,280			(6,152	)		(547	)		(5,419	)
	FHLB advances		1,382			(674	)		(183	)		525
	Senior notes		(157	)		2			—			(155	)
	Capital securities		684			(70	)		(209	)		405

			3,189			(6,894	)		(939	)		(4,644	)

Change in net interest income		$	(584	)	$	837		$	1,440		$	1,693

(1)		Calculated by multiplying change in rate by change in volume.




(2)		Includes the interest on nonaccrual loans only to the extent that it was paid and recognized as interest income.

Interest revenues decreased by $3.0 million, or 8.07%, during the three months ended September 30, 2002, compared with the same period in 2001. This decrease was primarily attributable to the 131 basis point decrease in the yield on average loans receivable, which averaged 6.92% during the third quarter of 2002, compared with 8.23% during the same period in 2001, partially mitigated by the Company’s increase in average loans outstanding, net of deferred fees/costs, of $89.9 million for the three months ended September 30, 2002. The Company continued to experience prepayments of $176.6 million with a weighted average interest rate of 7.49%, as borrowers refinanced loans, while new loan production of $193.6 million reflected an average yield of 6.56%, for the three months ended September 30, 2002. The net decrease in revenues was partially offset by an increase of $1.1 million earned on investment securities. The Company initiated treasury activities in June 2002, with the intent of increasing net interest income and thereby reducing the impact of the compression of the net interest margin.

The Company’s interest costs decreased by $4.6 million, or 22.47%, during the three months ended September 30, 2002, compared with the same period in 2001. This decrease was primarily attributable to the 160 basis point decrease in the average cost of interest-bearing liabilities, which averaged 3.34% during the third quarter of 2002, compared with 4.94% during the same period in 2001. In addition, the Company’s average interest-bearing deposits were $1.32 billion with an average cost of funds of 2.70% during the third quarter of 2002, compared with $1.21 billion and a 4.71% average cost of funds during the same period in 2001. The average balance of certificates of deposits decreased $129.7 million, to $781.7 million with an average cost of funds of 2.87% during the three months ended September 30, 2002, compared with $911.4 million and a 5.19% average cost of funds during the same period in 2001. The average balance of money market accounts reflected an increase of $202.2 million, to $416.0 million with an average cost of funds of 2.62% during the three months ended September 30, 2002, compared with $213.7 million and a 3.52% average cost of funds during the same period in 2001. As a percentage of total average deposits, transaction accounts have increased to 40.81% for the three months ended September 30, 2002, compared with 24.86% of total average deposits during the same period in 2001. In addition, the average balance of FHLB advances reflected an increase of $109.6 million, to $512.9 million with an average cost of funds of 4.28% during the three months ended September 30, 2002, compared with $403.3 million and a 4.93% average cost of funds during the same period in 2001. The change in deposit mix and the decrease in average cost of funds on deposits and FHLB advances had a positive impact on the Company’s total interest costs during the three months ended September 30, 2002.

These changes in interest revenues and interest costs produced an increase of $1.7 million, or 10.64%, in the Company’s net interest income for the three months ended September 30, 2002, compared with the same period in 2001.

Expressed as a percentage of interest-earning assets, the Company’s net interest margin increased to 3.38% during the three months ended September 30, 2002, compared with the net interest margin of 3.49% produced during the same period in 2001. The Company’s net interest income was impacted by the 475 basis point drop in interest rates during 2001, and continues to be adversely impacted by lower yields on new loan productions, continued runoff of existing loans, repricing of the respective indices and flattening of the yield curve. The majority of the loans are priced off of the MTA index. The negative impact on the net interest margin in the third quarter of 2002 was partially mitigated by the interest rate floors in the loan portfolio. In a rising interest rate environment these adjustable rate loans, that have taken on fixed rate loan characteristics, will result in potential net interest margin compression. These loans will not reprice until rates have increased enough to bring the fully indexed rate above the internal floor rate, while interest-bearing deposits will reprice more quickly.


		Nine Months Ended September 30, 2002 and 2001
		Increase (Decrease) Due to Change In

								Volume and			Net
(Dollars in thousands)		Volume			Rate			Rate(1)			Change

Interest-earning assets:
	Loans receivable(2)	$	3,133		$	(16,679	)	$	(482	)	$	(14,028	)
	Cash, Fed funds and other		2,204			(1,764	)		(1,415	)		(975	)
	Investment securities		—			—			1,218			1,218
	Investment in capital stock of Federal Home Loan Bank		211			44			11			266

			5,548			(18,399	)		(668	)		(13,519	)

Interest-bearing liabilities:
	Deposits		769			(21,266	)		(342	)		(20,839	)
	FHLB advances		3,944			(2,988	)		(751	)		205
	Senior notes		(705	)		(1	)		—			(706	)
	Capital securities		1,649			(127	)		(451	)		1,071

			5,657			(24,382	)		(1,544	)		(20,269	)

Change in net interest income		$	(109	)	$	5,983		$	876		$	6,750

(1)		Calculated by multiplying change in rate by change in volume.




(2)		Includes the interest on nonaccrual loans only to the extent that it was paid and recognized as interest income.

The Company’s interest revenues decreased by $13.5 million, or 12.06%, during the nine months ended September 30, 2002, compared with the same period in 2001. This decrease was primarily attributable to the 133 basis point decrease in the yield on average loans receivable, which averaged 7.28% during 2002, compared with 8.61% in 2001, partially offset by a 2.89% increase in the average balance of loans outstanding, which grew to $1.73 billion for the first nine months of 2002, compared with $1.68 billion for the same period in 2001. For the nine months ended September 30, 2002, interest of $1.0 million was collected on loans that were brought current, producing a positive but nonrecurring impact on the Company’s net interest margin of 7 basis points. Although loan production was strong, the Bank experienced accelerated prepayments of higher yielding assets during the first nine months of 2002, which totaled $504.3 million, with a weighted average rate of 7.67%, while new loan production of $527.9 million reflected an average yield of 6.36%. The net decrease in revenues was partially mitigated by an increase of $1.2 million earned on investment securities. The Company’s initiated treasury activities in June 2002 with the intent of increasing net interest income and thereby reducing the impact of the net interest margin compression. The Company earned a yield on its excess liquidity of 4.91% during 2002 rather than the 1.66% it could have earned in fed funds.

The Company’s interest costs decreased by $20.3 million, or 30.20%, during the nine months ended September 30, 2002, compared with the same period in 2001. This decrease was primarily attributable to the 196 basis point decrease in the average cost of interest-bearing liabilities, which averaged 3.55% during the first nine months of 2002, compared with 5.51% during the same period in 2001. In addition, the Company’s average interest-bearing deposits were $1.21 billion with an average cost of funds of 2.98% during the nine months ended September 30, 2002, compared with $1.19 billion

and a 5.36% average cost of funds during the same period in 2001. The average balance of certificates of deposits decreased $151.2 million, to $747.9 million with an average cost of funds of 3.23% during the nine months ended September 30, 2002, compared with $899.1 million and a 5.86% average cost of funds during the same period in 2001. The average balance of money market accounts reflected an increase of $140.1 million, to $353.5 million with an average cost of funds of 2.79% during the nine months ended September 30, 2002, compared with $213.4 million and a 4.29% average cost of funds during the same period in 2001. As a percentage of total average deposits, transaction accounts have increased to 38.30% for the nine months ended September 30, 2002, compared with 24.63% of total average deposits during the same period in 2001. In addition, the average balance of FHLB advances reflected an increase of $98.1 million, to $488.6 million with an average cost of funds of 4.29% during the nine months ended September 30, 2002, compared with $390.5 million and a 5.30% average cost of funds during the same period in 2001. The change in deposit mix and the decrease in average cost of funds on deposits and FHLB advances had a positive impact on the Company’s total interest costs during the nine months ended September 30, 2002.

These changes in interest revenues and interest costs produced an increase of $6.8 million, or 15.02%, in the Company’s net interest income for the nine months ended September 30, 2002, compared with the same period in 2001. Expressed as a percentage of interest-earning assets, the Company’s net interest margin increased to 3.57% during the nine months ended September 30, 2002, compared with the net interest margin of 3.37% produced during the same period in 2001. The Company’s net interest income was impacted by the 475 basis point drop in interest rates during 2001, and continues to be adversely impacted by lower yields on new loan productions, continued runoff of existing loans, repricing of the respective indices and flattening of the yield curve. The negative impact on the net interest margin in the first nine months of 2002 was partially mitigated by the interest rate floors in the loan portfolio. In a rising interest rate environment these adjustable rate loans, that have taken on fixed rate loan characteristics, will result in potential net interest margin compression. These loans will not reprice until rates have increased enough to bring the fully indexed rate above the internal floor rate, while interest-bearing deposits will reprice more quickly.

Provisions for Credit losses

Provisions for credit losses were $0.1 million and $0.8 million for the three and nine months ended September 30, 2002, respectively, compared with $0.4 million and $2.9 million for the three and nine months ended and September 30, 2001, respectively. The decrease in the provision for credit losses was due to the overall improvement in asset quality, as reflected by a decrease of $20.9 million in total classified assets, to $33.1 million at September 30, 2002, from $54.1 million at September 30, 2001. The Company’s total nonaccrual loans to total assets was 0.36% at September 30, 2002 compared with 1.11% at December 31, 2001, and 1.33% at September 30, 2001. Additionally, total classified assets to Bank core capital and general allowance for credit losses was 15.49% at September 30, 2002, compared with 32.59% at December 31, 2001 and 30.88% at September 30, 2001.

The Company’s annualized ratio of charge-offs to average loans increased from 0.18% during the first nine months of 2001 to 0.21% during the first nine months of 2002, due to a $2.2 million and $0.2 million charge-off of SVA associated with the disposition of an $11.5 million income property construction loan and a $4.4 million estate loan, respectively.

Although the Company maintains its allowance for credit losses at a level which it considers to be adequate to provide for probable losses, based on presently known conditions, there can be no assurance that such losses will not exceed the estimated amounts, thereby adversely affecting future results of operations. The calculation of the adequacy of the allowance for credit losses, and therefore the requisite amount of provision for credit losses, is based on several factors, including underlying loan collateral values, delinquency trends and historical loan loss experience, all of which can change without notice based on market and economic conditions and other factors. See “Critical Accounting Policies” for a more complete discussion of the Company’s allowance for credit losses.

Noninterest Revenues

Noninterest revenues were $1.7 million and $4.2 million for the three and nine months ended September 30, 2002, respectively, compared with noninterest revenues of $1.3 million and $4.3 million earned during the same periods in 2001.

Loan related fees primarily consist of fees collected from borrowers (1) for the early repayment of their loans, (2) for the extension of the maturity of loans (predominantly short term construction loans, with respect to which extension options are often included in the original term of the Company’s loan) and (3) in connection with certain loans which contain exit or release fees payable to the Company upon the maturity or repayment of the Company’s loan. Noninterest revenues also include deposit fee income for service fees, nonsufficient fund fees and other miscellaneous check and service charges, which increased to $0.4 million and $1.1 million for the three and nine months ended September 30, 2002, respectively, an increase of 10.87% and 13.38%, respectively, from $0.4 million and $1.0 million earned during the same

periods in 2001. Fee income on deposits increased compared with the same period in 2001, resulting from the growth in core transaction deposits, which by design earn more transaction related fee income than certificates of deposit. The ratio of products per household was 2.41 at September 30, 2002, for the combined Bank, compared with 2.37 at December 31, 2001.

In July 2002, the Bank’s subsidiary, HS Financial Services Corporation, commenced operations, which include the sale of nondeposit investment and insurance products. The alternative investment program further expands the array of products offered in the Company’s branches and will contribute to the Company’s strategic goal of expanding the cross-sell ratio.

Real Estate Operations

The following table sets forth the costs and revenues attributable to the Company’s real estate owned (“REO”) properties for the periods indicated. The compensatory and legal costs directly associated with the Company’s property management and disposal operations are included in general and administrative expenses.


		Three Months Ended September 30,							Nine Months Ended September 30,

(Dollars in thousands)		2002		2001		Change			2002			2001			Change

Expenses associated with real estate operations:
	Repairs, maintenance and renovation	$	—			$	—		$	(19	)	$	(18	)	$	(1	)
	Insurance and property taxes		—				—			—			(9	)		9

			—		—		—			(19	)		(27	)		8
Net recoveries from sales of REO			—		27		(27	)		87			106			(19	)
Property operations, net			2		20		(18	)		3			130			(127	)

Income from real estate operations, net		$	2	$	47	$	(45	)	$	71		$	209		$	(138	)

Net income from sales of REO properties represents the difference between the proceeds received from property disposal and the carrying value of such properties upon disposal. Property operations principally include the net operating income (collected rental revenues less operating expenses and certain renovation costs) from foreclosed income producing properties or receipt, following foreclosure, of similar funds held by receivers during the period the original loan was in default. During the nine months ended September 30, 2002, the Company sold its last property generating net cash proceeds of $1.4 million and a net recovery of $0.09 million, compared with sales of five properties generating net cash proceeds of $3.0 million and a net recovery of $0.1 million during the same period in 2001. As of September 30, 2002, the Company held no other real estate owned properties.

Noninterest Expenses

General and Administrative Expenses

The table below details the Company’s general and administrative expenses for the periods indicated:


		Three Months Ended September 30,							Nine Months Ended September 30,

(Dollars in thousands)		2002		2001		Change			2002		2001		Change

Employee		$	5,683	$	4,539	$	1,144		$	15,415	$	13,548	$	1,867
Operating			2,063		1,898		165			5,082		5,048		34
Occupancy			1,027		975		52			2,882		2,984		(102	)
Professional			658		481		177			1,364		2,376		(1,012	)
Technology			423		498		(75	)		1,163		1,525		(362	)
SAIF premiums and OTS assessments			145		223		(78	)		413		704		(291	)
Other/legal settlements			198		—		198			218		110		108

	Total	$	10,197	$	8,614	$	1,583		$	26,537	$	26,295	$	242

Total general and administrative expenses (“G&A”) were $10.2 million and $26.5 million, for the three and nine months ended September 30, 2002, respectively, compared with $8.6 million and $26.3 million of G&A incurred during the same periods in 2001. For the nine months ended 2002, G&A reflected less than a 1% increase, compared with G&A for the same period in 2001. G&A to average assets decreased from 1.93% to 1.79%, during the same periods, respectively. The increase in G&A for the nine months ended September 30, 2002 was primarily due to an increase of $1.9 million in employee costs, primarily due to increased headcount, partially offset by a decrease of $1.0 million in professional fees, as a result of first quarter 2002 insurance company reimbursements totaling $0.7 million for legal fees related to litigation and fewer outstanding legal issues. The First Fidelity merger, which is being accounted for as a

purchase transaction, resulted in one-time nonrecurring merger-related expenses on an after tax basis of approximately $0.1 million in 2002. The Company’s efficiency ratios (defined as total general and administrative expenses, excluding legal settlements/other, divided by net interest income before provision and noninterest revenues, excluding REO, net) were 51.67% and 47.07% for the three and nine months ended September 30, 2002, respectively, compared with 50.01% and 53.17% during the same periods in 2001.

Income Taxes

The Company recorded an income tax provision of $3.3 million and $11.8 million for the three and nine months ended September 30, 2002, respectively, compared with $3.5 million and $8.6 million during the same periods in 2001. The Company’s effective tax rate was 36.67% and 41.00%, respectively, for the three and nine months ended September 30, 2002, compared with 42.50% and 42.63% during the same periods in 2001. Included in the third quarter 2002 earnings was a $0.6 million nonrecurring tax benefit resulting from a change in state tax law related to the treatment of bad debts, which impacted all California financial institutions with assets in excess of $500.0 million.

FINANCIAL CONDITION, CAPITAL RESOURCES & LIQUIDITY AND ASSET QUALITY

The following discussion includes the financial impact of the Company’s acquisition of First Fidelity, which closed on August 23, 2002.

Assets

Investment Securities

Debt securities that management has the positive intent and ability to hold to maturity are classified as “held to maturity” and recorded at amortized cost. Securities not classified as held to maturity or trading, including equity securities with readily determinable fair values, are classified as “available for sale” and recorded at fair value, with unrealized gains and losses excluded from earnings and reported in other comprehensive income.

Purchase premiums and discounts are recognized in interest income using the interest method over the terms of the securities. Declines in the fair value of held-to-maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. Gains and losses on the sale of securities are recorded on the trade date and are determined using the specific identification method.

The table below sets forth the net balance at cost and fair value of available for sale investment securities, with gross unrealized gains.


				September 30, 2002

						Gross		Gross
				Net Balance		Unrealized		Unrealized		Fair
(In thousands)				At Cost		Gains		Losses		Value

Investment securities available-for-sale
	Debt securities:
		U.S. Government and federal agency		$	84,193	$	959	$	6	$	85,146
		Corporate			—		—		—		—
		Mortgage-backed			102,809		958		72		103,695
		Other			19,700		39		—		19,739

			Total	$	206,702	$	1,956	$	78	$	208,580

The table below sets forth the net balance at cost and fair value of available for sale debt securities by contractual maturity at September 30, 2002.


			Available for Sale

			Net Balance		Fair
(In thousands)			At Cost		Value

Debt securities available-for-sale
Debt securities:
	Within 1 year		$	—	$	—
	After 1 year through 5 years			—		—
	After 5 years through 10 years			50,534		50,701
	Over 10 years			156,168		157,879

		Total	$	206,702	$	208,580

The expected average life on these securities is 2.8 years and the average duration is expected to be 2.0 years based on prepayments. For the three and nine months ended September 30, 2002, there were no proceeds from sales of securities available for sale.

Loans Receivable

General

The Company’s loan portfolio consists primarily of loans secured by real estate located in the coastal counties of Southern California. The table below sets forth the composition of the Company’s loan portfolio as of the dates indicated:


		September 30, 2002						December 31, 2001

(Dollars in thousands)		Balance			Percent			Balance			Percent

Single family residential		$	873,434			39.05	%	$	918,877			49.12	%
Income property:
	Multi-family(1)		620,969			27.76	%		255,183			13.64	%
	Commercial(1)		410,474			18.35	%		248,092			13.26	%
	Development(2)		163,957			7.33	%		227,190			12.14	%
Single family construction:
	Single family residential(3)		125,719			5.62	%		159,224			8.51	%
Land(4)			31,242			1.40	%		50,984			2.72	%
Other			11,072			0.49	%		11,482			0.61	%

Gross loans receivable(5)			2,236,867			100.00	%		1,871,032			100.00	%

Less:
	Undisbursed funds		(110,785	)					(137,484	)
	Deferred costs, net		10,871						6,337
	Allowance for credit losses		(35,873	)					(30,602	)

Net loans receivable		$	2,101,080					$	1,709,283

(1)		Predominantly term loans secured by improved properties, with respect to which the properties’ cash flows are sufficient to service the Company’s loan.




(2)		Predominantly loans to finance the construction of income producing properties. Also includes loans to finance the renovation of existing properties.




(3)		Predominantly loans for the construction of individual and custom homes.




(4)		The Company expects that a majority of these loans will be converted into construction loans, and the land secured loans repaid with the proceeds of these construction loans, within 12 months.




(5)		Gross loans receivable includes the principal balance of loans outstanding, plus outstanding but unfunded loan commitments, predominantly in connection with construction loans.

Loan growth was impacted by the higher level of loan prepayments as borrowers refinanced loans. See further discussion in the rate volume analysis, contained herein.

The table below sets forth the Company’s loan portfolio diversification by loan size:


					September 30, 2002					December 31, 2001

					No. of		Gross			No. of		Gross
(Dollars in thousands)					Loans		Commitment			Loans		Commitment

Loans in excess of $10.0 million:
	Income property:
		Commercial				1	$	11,818			2	$	22,699
		Development				2		21,866			5		56,477

						3		33,684			7		79,176

			Percentage of total gross loans					1.51	%				4.23	%
Loans between $5.0 and $10.0 million:
	Single family residential					3		23,000			4		25,036
	Income property:
		Multi-family				—		—			1		7,651
		Commercial				6		37,581			10		74,078
		Development				13		80,558			12		76,545
	Single family construction:
		Single family residential				2		11,240			2		12,915
	Land					—		—			2		11,200

						24		152,379			31		207,425

			Percentage of total gross loans					6.81	%				11.09	%
Loans less than $5.0 million								2,050,804					1,584,431

				Gross loans receivable			$	2,236,867				$	1,871,032

The table below sets forth the Company’s net loan portfolio composition, as of the dates indicated:


				September 30, 2002					December 31, 2001

(Dollars in thousands)				Balance		Percent			Balance		Percent

Single family residential				$	868,778		40.86	%	$	913,255		52.68	%
Income property:
	Multi-family				620,101		29.17	%		254,530		14.68	%
	Commercial				403,620		18.98	%		235,156		13.57	%
	Development:
		Multi-family			75,634		3.56	%		102,682		5.92	%
		Commercial			42,455		2.00	%		68,431		3.95	%
Single family construction:
	Single family residential				82,101		3.86	%		104,158		6.01	%
Land					30,669		1.44	%		48,719		2.81	%
Other					2,724		0.13	%		6,617		0.38	%

			Total loan principal(1)	$	2,126,082		100.00	%	$	1,733,548		100.00	%

(1)

Excludes net deferred fees and costs.

The tables below sets forth the approximate composition of the Company’s gross new loan originations, net of internal refinances of $16.3 million and $43.1 million, respectively, for the periods indicated, by dollars and as a percentage of total loans originated:


				Three Months Ended					Nine Months Ended
				September 30, 2002					September 30, 2002

(Dollars in thousands)				Amount		%			Amount		%

Single family residential(1)				$	75,844		39.18	%	$	256,258		48.54	%
Income property:
	Multi-family(2)				45,252		23.38	%		120,688		22.86	%
	Commercial(3)				15,927		8.23	%		33,327		6.31	%
	Development:
		Multi-family(4)			15,186		7.85	%		31,335		5.94	%
		Commercial(5)			7,788		4.02	%		11,595		2.20	%
Single family construction:
	Single family residential(6)				28,606		14.78	%		61,269		11.61	%
Land					4,958		2.56	%		13,425		2.54	%

			Total	$	193,561		100.00	%	$	527,897		100.00	%

(1)		Includes unfunded commitments of $0.1 million as of September 30, 2002.




(2)		Includes unfunded commitments of $0.7 million as of September 30, 2002.




(3)		Includes unfunded commitments of $1.5 million as of September 30, 2002.




(4)		Includes unfunded commitments of $23.3 million as of September 30, 2002.




(5)		Includes unfunded commitments of $5.8 million as of September 30, 2002.




(6)		Includes unfunded commitments of $24.3 million as of September 30, 2002.


				Three Months Ended					Nine Months Ended
				September 30, 2001					September 30, 2001

(Dollars in thousands)				Amount		%			Amount		%

Single family residential(1)				$	99,303		54.93	%	$	249,959		47.34	%
Income property:
	Multi-family(2)				29,938		16.56	%		59,358		11.24	%
	Commercial(3)				—		—			49,019		9.28	%
	Development:
		Multi-family(4)			14,723		8.14	%		30,286		5.74	%
		Commercial			5,195		2.87	%		46,732		8.86	%
Single family construction:
	Single family residential(5)				27,258		15.08	%		69,481		13.16	%
Land(6)					4,369		2.42	%		23,108		4.38	%
Other					4		—			14		—

			Total	$	180,790		100.00	%	$	527,957		100.00	%

(1)		Includes unfunded commitments of $0.6 million as of September 30, 2001.




(2)		Includes unfunded commitments of $0.3 million as of September 30, 2001.




(3)		Includes unfunded commitments of $0.4 million as of September 30, 2001.




(4)		Includes unfunded commitments of $38.9 million as of September 30, 2001.




(5)		Includes unfunded commitments of $35.0 million as of September 30, 2001.




(6)		Includes unfunded commitments of $2.6 million as of September 30, 2001.

Asset Quality

Classified Assets

The table below sets forth information concerning the Company’s risk elements as of the dates indicated. Classified assets include REO, nonaccrual loans and performing loans which have been adversely classified pursuant to the Company’s classification policies and Office of Thrift Supervision (“OTS”) regulations and guidelines (“performing/classified” loans).


					September 30,			December 31,			September 30,
(Dollars in thousands)					2002			2001			2001

Risk elements:
		Nonaccrual loans(1)			$	8,683		$	20,666		$	25,033
		Real estate owned, net				—			1,312			—

						8,683			21,978			25,033
	Performing loans classified substandard or lower(2)					24,461			37,341			29,035

				Total classified assets	$	33,144		$	59,319		$	54,068

				Total classified loans	$	33,144		$	58,007		$	54,068

Loans restructured and paying in accordance with modified terms(3)					$	2,109		$	4,506		$	12,617

Gross loans before allowance for credit losses					$	2,136,953		$	1,739,885		$	1,749,654

Loans receivable, net of specific allowance and deferred (fees) and costs					$	2,136,165		$	1,736,310		$	1,746,079

Delinquent loans:
		30 - 89 days			$	7,527		$	2,742		$	4,956
		90+ days				7,204			4,982			5,917

			Total delinquent loans		$	14,731		$	7,724		$	10,873

Allowance for credit losses:
		General			$	35,085		$	27,027		$	26,540
		Specific				788			3,575			3,575

			Total allowance for credit losses		$	35,873		$	30,602		$	30,115

Net loan charge-offs:
		Net charge-offs for the quarter ended			$	73		$	13		$	137
		Percent to loans receivable, net of specific allowance and deferred (fees) and costs (annualized)				0.01	%		0.00	%		0.03	%
		Percent to beginning of period allowance for credit losses (annualized)				1.02	%		0.17	%		1.84	%
Selected asset quality ratios at period end:
	Total nonaccrual loans to total assets					0.36	%		1.11	%		1.33	%
	Total allowance for credit losses to loans receivable, net of specific allowance and deferred (fees) and costs					1.68	%		1.76	%		1.72	%
	Total general allowance for credit losses to loans receivable, net of specific allowance and deferred (fees) and costs					1.64	%		1.56	%		1.52	%

(1)		Nonaccrual loans include two loans totaling $0.5 million, six loans totaling $4.7 million and four loans totaling $4.6 million, in bankruptcy at September 30, 2002, December 31, 2001 and September 30, 2001, respectively. Nonaccrual loans include no troubled debt restructured loans (“TDRs”) at September 30, 2002, December 31, 2001 and September 30, 2001.




(2)		Excludes nonaccrual loans.




(3)		Represents TDRs not classified and not on nonaccrual.

The table below sets forth information concerning the Company’s gross classified loans, by category, as of September 30, 2002:


		No. of		Nonaccrual		No. of		Other		No. of
(Dollars in thousands)		Loans		Loans		Loans		Classified Loans		Loans		Total

Single family residential			6	$	2,133		12	$	8,090		18	$	10,223
Income property:
	Multi-family		1		418		3		1,108		4		1,526
	Commercial		4		6,128		2		2,479		6		8,607
	Development		—		—		1		8,498		1		8,498
Single family construction:
	Single family residential		—		—		1		95		1		95
Land			—		—		3		4,191		3		4,191
Other			1		4		—		—		1		4

Gross classified loans			12	$	8,683		22	$	24,461		34	$	33,144

Allowance for Credit Losses

The table below summarizes the activity of the Company’s allowance for credit losses for the periods indicated:


				Three Months Ended						Nine Months Ended
				September 30,						September 30,

(Dollars in thousands)				2002			2001			2002			2001

Average loans outstanding				$	1,814,902		$	1,725,012		$	1,729,492		$	1,680,910

Total allowance for credit losses at beginning of period				$	28,657		$	29,852		$	30,602		$	29,450
Provision for credit losses					100			400			770			2,900
Acquisition of FFIL reserve					7,189			—			7,189			—
Charge-offs:
	Single family residential				—			(111	)		(476	)		(2,251	)
	Income Property:
			Multi-family		—			(26	)		—			(26	)
			Development		(75	)		—			(2,246	)		—
	Single family construction:
			Single family residential		—			—			—			(43	)
Recoveries:
		Other			2			—			34			85

Net charge-offs					(73	)		(137	)		(2,688	)		(2,235	)

Total allowance for credit losses at end of period				$	35,873		$	30,115		$	35,873		$	30,115

Annualized ratio of charge-offs to average loans outstanding during the period					0.02	%		0.03	%		0.21	%		0.18	%

Management decreased the provision for credit losses during 2002, based on overall improvement in asset quality, as reflected by a $20.9 million decrease in classified assets, to $33.1 million at September 30, 2002, from $54.1 million at September 30, 2001. The Company’s total nonaccrual loans to total assets was 0.36% at September 30, 2002, compared with 1.11% at December 31, 2001, and 1.33% at September 30, 2001. At September 30, 2002, the ratio of total allowance (GVA and SVA) for credit losses to loans receivable, net of specific allowance and deferred fees and costs, was 1.68%, compared with 1.76% at December 31, 2001 and 1.72 % at September 30, 2001.

The table below summarizes the Company’s allowance for credit losses by category for the periods indicated:


		September 30, 2002								December 31, 2001

							Percent of								Percent of
							Reserves to								Reserves to
							Total Loans(1)								Total Loans(1)
(Dollars in thousands)		Balance		Percent			by Category			Balance		Percent			by Category

Single family residential		$	10,121		28.21	%		1.16	%	$	9,878		32.28	%		1.08	%
Income property:
	Multi-family		6,252		17.43	%		1.01	%		2,009		6.57	%		0.79	%
	Commercial		9,228		25.72	%		2.29	%		4,531		14.80	%		1.83	%
	Development		5,570		15.53	%		4.72	%		8,420		27.52	%		3.71	%
Single family construction:
	Single family residential		1,612		4.49	%		1.96	%		2,679		8.75	%		1.68	%
Land			1,574		4.39	%		5.13	%		1,818		5.94	%		3.57	%
Other			182		0.51	%		6.68	%		144		0.47	%		1.25	%
Unallocated			1,334		3.72	%		n/a			1,123		3.67	%		n/a

		$	35,873		100.00	%		1.69	%	$	30,602		100.00	%		1.64	%

(1)

Percent of allowance for credit losses to gross loan portfolio.

The GVA includes an unallocated amount. The unallocated allowance is based upon management’s evaluation of various conditions, such as general economic and business conditions affecting our key lending areas, the effects of which are not directly measured in the determination of the GVA formula and specific allowances. The evaluation of the inherent loss with respect to these conditions is subject to a higher degree of uncertainty because they are not identified with specific problem credits or portfolio components. Management intends to maintain an unallocated allowance, in the range of between 3% and 5% of the total GVA, to account for the economic uncertainty in Southern California until economic or other conditions warrant a reassessment of the level of the unallocated GVA.

Management believes that the allowance for credit losses of $35.9 million at September 30, 2002, is adequate to absorb the losses that, in the opinion and judgment of management, are known and inherent in the Bank’s loan portfolio.

Real Estate Owned

Real estate acquired in satisfaction of loans is transferred to REO at the lower of the carrying value or the estimated fair value, less any estimated disposal costs (“fair value”). The difference between the fair value of the real estate collateral and the loan balance at the time of transfer is recorded as a charge-off, if the fair value is lower. The fair value of collateral includes capitalized costs. Any subsequent declines in the fair value of the REO property after the date of transfer are recorded through a write-down of the asset. The Company held no real estate owned properties at September 30, 2002, compared with $1.3 million at December 31, 2001.

The table below summarizes the composition of the Company’s portfolio of real estate owned properties as of the dates indicated:


	September 30,		December 31,
(Dollars in thousands)	2002		2001

Single family residential	$	—	$	1,312

LIABILITIES

Sources of Funds

General

The Company’s principal sources of funds in recent years have been deposits obtained on a retail basis through its branch offices and advances from the FHLB. In addition, funds have been obtained from maturities and repayments of loans and securities, and sales of loans, securities and other assets, including real estate owned.

Deposits

The table below summarizes the Company’s deposit portfolio by original term, weighted average interest rates (“WAIR”) and weighted average remaining maturities in months (“WARM”) as of the dates indicated:


					September 30, 2002										December 31, 2001

(Dollars in thousands)					Balance(1)		Percent			WAIR			WARM		Balance(1)		Percent			WAIR			WARM

Transaction accounts:
	Noninterest-bearing checking				$	36,238		2.26	%		—			—	$	35,634		2.97	%		—			—
	Checking/NOW					69,693		4.34	%		1.78	%		—		57,687		4.81	%		1.98	%		—
	Passbook					64,332		4.01	%		1.74	%		—		40,751		3.39	%		1.91	%		—
	Money Market					457,851		28.54	%		2.45	%		—		240,391		20.04	%		2.85	%		—

			Total transaction accounts			628,114		39.15	%							374,463		31.21	%

Certificates of deposit:
		7 day maturities				33,126		2.07	%		1.58	%		—		55,396		4.62	%		2.33	%		—
		Less than 6 months				58,452		3.64	%		1.84	%		1		21,291		1.77	%		2.42	%		2
		6 months to 1 year				303,080		18.89	%		2.45	%		4		268,100		22.35	%		3.75	%		3
		1 year to 2 years				371,967		23.19	%		3.20	%		6		459,408		38.30	%		4.66	%		6
		Greater than 2 years				209,479		13.06	%		4.44	%		21		20,987		1.75	%		4.82	%		16

			Total certificates of deposit			976,104		60.85	%							825,182		68.79	%

				Total	$	1,604,218		100.00	%		2.75	%		8	$	1,199,645		100.00	%		3.59	%		5

(1)

Deposits in excess of $100,000 were 37.63% of total deposits at September 30, 2002, compared with 28.00% of total deposits at December 31, 2001.

FHLB Advances

A primary alternate funding source for the Company is a credit line with the FHLB with a maximum advance of up to 40% of the Company’s total assets based on qualifying collateral. The FHLB system functions as a source of credit to savings institutions who are members of the FHLB. Advances are secured by the Company’s mortgage loans and the capital stock of the FHLB owned by the Company. Subject to the FHLB’s advance policies and requirements, these advances can be requested for any business purpose in which the Company is authorized to engage. In granting advances, the FHLB considers a member’s creditworthiness and other relevant factors. The table below summarizes the balance and rate of FHLB advances for the dates indicated:


	September 30, 2002						December 31, 2001

(Dollars in thousands)	Principal			Rate			Principal		Rate

Original term:
12 Months	$	5,000			2.66	%	$	—		—
24 Months		35,500			5.07	%		40,000		2.89	%
36 Months		236,000			3.10	%		185,000		2.88	%
60 Months		135,000			5.92	%		135,000		5.92	%
84 Months		25,000			4.18	%		25,000		4.18	%
120 Months		140,000			5.18	%		99,000		5.19	%

	$	576,500	(1)		4.43	%(2)	$	484,000		4.27	%(2)

(1)		Excludes discount on FHLB advances due to acquisition of First Fidelity.
(2)		Weighted average interest rate at period end.

The weighted average remaining term of the Company’s FHLB advances was 2 years 11 months as of September 30, 2002. At September 30, 2002, 60.71% of the Company’s FHLB advances outstanding contain options, which allow the FHLB to call the advances prior to maturity, subject to an initial non-callable period of one to three years from origination.

STOCKHOLDERS’ EQUITY AND REGULATORY CAPITAL

The Company owns all the outstanding stock of the Bank. The Company’s capital consists of common stockholders’ equity, which at September 30, 2002, amounted to $160.4 million and which equaled 6.63% of the Company’s total assets.

As shown below, the Bank’s regulatory capital exceeded minimum regulatory capital requirements applicable to it as of September 30, 2002:


		Tangible Capital						Core Capital						Risk-based Capital

(Dollars in thousands)		Balance			%			Balance			%			Balance			%

Core capital		$	203,824					$	203,824					$	203,824
Adjustments:
	Goodwill		(22,970	)					(22,970	)					(22,970	)
	Deposit intangible, net of tax		(864	)					(864	)					(864	)
	General reserves		—						—						21,861
	Other(1)		(1,071	)					(1,071	)					(1,071	)

Regulatory capital			178,919			7.49	%		178,919			7.49	%		200,780			11.57	%
Capital requirements to be well capitalized			n/a			n/a			119,469			5.00			173,565			10.00

Excess capital(2)		$	178,919			7.49	%	$	59,450			2.49	%	$	27,215			1.57	%

Adjusted assets(3)		$	2,389,385					$	2,389,385					$	1,735,648

(1)		Includes accumulated (gain) on certain available for sale securities, net of taxes.




(2)		Excess capital is defined as the percentage over well capitalized under Prompt Correction Action (“PCA”) rules.




(3)		The term “adjusted assets” refers to (i) the term “adjusted total assets” as defined in 12 C.F.R. Section 567.1 (a) for purposes of tangible and core capital requirements, and (ii) the term “risk-weighted assets” as defined in 12 C.F.R. Section 567.5 (d) for purposes of the risk-based capital requirements.

As of September 30, 2002, the Bank is categorized as “well capitalized” under the regulatory framework for PCA Rules based on the most recent notification from the OTS. There are no conditions or events subsequent to September 30, 2002, that management believes have changed the Bank’s category. The following table compares the Bank’s actual capital ratios to those required by regulatory agencies to meet the minimum capital requirements required by the OTS and to be categorized as “well capitalized” under the PCA Rules for the periods indicated:


												To Be Well
												Capitalized Under
							For Capital					Prompt Corrective
		Actual					Adequacy Purposes					Action Provisions

(Dollars in thousands)		Amount		Ratios			Amount		Ratios			Amount		Ratios

As of September 30, 2002
	Total capital to risk weighted assets	$	200,780		11.57	%	$	138,852		8.00	%	$	173,565		10.00	%
	Core capital to adjusted tangible assets		178,919		7.49	%		95,575		4.00	%		119,469		5.00	%
	Tangible capital to adjusted tangible assets		178,919		7.49	%		35,841		1.50	%		n/a		n/a
	Tier 1 capital to risk weighted assets		178,919		10.31	%		n/a		n/a			104,139		6.00	%
As of December 31, 2001
	Total capital to risk weighted assets	$	169,278		12.70	%	$	106,619		8.00	%	$	133,274		10.00	%
	Core capital to adjusted tangible assets		154,981		8.36	%		74,153		4.00	%		92,692		5.00	%
	Tangible capital to adjusted tangible assets		154,981		8.36	%		27,807		1.50	%		n/a		n/a
	Tier 1 capital to risk weighted assets		154,981		11.63	%		n/a		n/a			79,965		6.00	%

If the OTS determines that an institution is in an unsafe or unsound condition, or if the institution is deemed to be engaging in unsafe and unsound practices, the OTS may, if the institution is well capitalized, reclassify it as adequately capitalized; if the institution is adequately capitalized but not well capitalized, require it to comply with restrictions applicable to undercapitalized institutions; and, if the institution is undercapitalized, require it to comply with certain restrictions applicable to significantly undercapitalized institutions.

CAPITAL RESOURCES AND LIQUIDITY

Hawthorne Financial Corporation, parent company only, maintained cash and cash equivalents of $11.9 million at September 30, 2002. Hawthorne Financial Corporation is a holding company with no significant business operations outside of the Bank. From time to time, the Company is dependent upon the Bank for dividends in order to make semi-annual interest payments. The ability of the Bank to provide dividends to Hawthorne Financial Corporation is governed by applicable regulations of the OTS. Based upon these applicable regulations, the Bank’s supervisory rating and the Bank’s current and projected earnings rate, management fully expects the Bank to maintain the ability to provide dividends to Hawthorne Financial Corporation for the payment of interest on the Company’s long-term debt for the foreseeable future.

The Company’s primary funding sources are deposits, principal payments on loans, FHLB advances and cash flows from operations. Other possible sources of liquidity available to the Company include whole loan sales, commercial bank lines of credit, and direct access, under certain conditions, to borrowings from the Federal Reserve System. The cash needs of the Company are principally for the payment of interest on, and withdrawals of, deposit accounts, the funding of loans, investments and operating costs and expenses. OTS regulations no longer require a savings association to maintain a specified average daily balance of liquid assets (including cash, certain time deposits and savings accounts, bankers’ acceptances, certain government obligations, and certain other investments). The Bank maintains an adequate level of liquid assets to ensure safe and sound daily operations.

On August 23, 2002, the Company issued 1,266,540 shares of Hawthorne Financial Corporation stock and $37.8 million in cash for the 1,815,115 shares of First Fidelity Bancorp, Inc. stock and 88,000 options outstanding.

On January 22, 2002, the Securities and Exchange Commission issued an interpretive release on disclosures related to liquidity and capital resources, including off-balance sheet arrangements. The Company does not have material off-balance sheet arrangements or related party transactions that are not disclosed herein. The Company is not aware of factors that are reasonably likely to adversely affect liquidity trends, other than the risk factors presented herein and in other Company filings. However, the following additional information is provided to assist financial statement users.

Lending Commitments — At September 30, 2002, the Company had commitments to fund the undisbursed portion of existing construction and land loans of $90.1 million and income property and estate loans of $9.6 million. The Company’s commitments to fund the undisbursed portion of existing lines of credit totaled $11.1 million.

Operating Leases — These leases generally are entered into only for non-strategic investments (e.g., office buildings, warehouses) where the economic profile is favorable. The liquidity impact of outstanding leases is not material to the Company.

Participation Loans — The Bank enters into agreements with other financial institutions to participate a percentage of ownership interest in selected loan originations of the Bank, in the ordinary course of business. The participation agreements reflect an absolute and outright sale from the Bank to the participant for a percentage ownership interest in the loan originated by the Bank. These agreements are made by the Bank to the participant without recourse, representation, or warranty of any kind, either expressed or implied.

Other Contractual Obligations — The Company does not have material financial guarantees or other contractual commitments that are reasonably likely to adversely affect liquidity. On July 8, 2002, the FHLB issued a $33.0 million LC to the Company to replace the $33.0 million LC issued January 10, 2002, which matured on July 12, 2002. On September 10, 2002, the FHLB issued a $45.0 million LC to the Company. The purpose of the LCs is to fulfill the collateral requirements for two $30.0 million deposits placed by the State of California with the Company. The LCs are issued in

favor of the State Treasurer of the State of California and mature on January 16, 2003 and September 10, 2003, respectively.

The Company purchased $96.3 million and $125.8 million in investment securities for the three and nine months ended September 30, 2002, respectively. During the quarter, the Company settled the $29.5 million of investment securities awaiting settlement at June 30, 2002. The investment securities were purchased at 103.3 of par value and 103.1 of par value, respectively, with an average life of 4.05 years and 3.98 years, respectively, and an average yield of 4.3% and 4.4%, respectively. All securities detailed above have been subjected to the FFIEC stress test and all exhibited price volatility within regulatory guidelines.

Related Party Transactions — The Company has related party transactions in the ordinary course of business. In the ordinary course of business, the Company extended credit in the form of overdraft protection lines, as disclosed in “Note 16 — Related Parties” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2001. All such transactions were made in accordance with the lending restriction of Section 22(h) of the Federal Reserve Act, as applied by the OTS. There were no significant related party transactions for the nine months ended September 30, 2002. The Company does not have any other related party transactions that materially affect the results of operations, cash flow or financial condition.

INTEREST RATE RISK MANAGEMENT

The following static gap table sets forth information concerning repricing opportunities for the Company’s interest-earning assets and interest-bearing liabilities as of September 30, 2002. The amount of assets and liabilities shown within a particular period were determined in accordance with their contractual maturities, except that adjustable rate products are included in the period in which they are scheduled to adjust and not in the period in which they mature. Such assets and liabilities are classified by the earlier of their contractual maturity or repricing period.

As of September 30, 2002, 90.7% of the Company’s loan portfolio was tied to adjustable rate indices, such as MTA, Prime, LIBOR, COFI and CMT and are reflected in the three months or less repricing category. Out of these adjustable rate loans, approximately 55.9%, or $1.08 billion, have reached their internal interest rate floors. Therefore, these loans have taken on fixed rate characteristics. Of the loans that have reached their internal interest rate floor, approximately 49.8% would currently be between zero and 199 basis points lower if they were at their fully indexed rate, approximately 33.4% would currently be between 200 and 300 basis points lower, and the remaining 16.8% would currently be more than 300 basis points lower if they were at their fully indexed rate. An additional $318.9 million, or 16.6%, reflect a starting interest rate that does not adjust for 36-60 months. Following the initial term, these loans will reprice based on adjustable rate indices.


			September 30, 2002

						Over Three			Over Six			Over One
			Three			Through			Through			Year			Over
			Months			Six			Twelve			Through			Five
(Dollars in thousands)			Or Less			Months			Months			Five Years			Years			Total

Interest-earning assets:
	Cash, Fed funds and other(1)		$	9,751		$	—		$	—		$	—		$	—		$	9,751
	Investments and FHLB stock			54,947			—			—			180,955			—			235,902
	Loans receivable(2)			1,162,555			725,513			52,646			36,527			148,841			2,126,082

		Total interest-earning assets	$	1,227,253		$	725,513		$	52,646		$	217,482		$	148,841		$	2,371,735

Interest-bearing liabilities:
	Deposits:
		Non-certificates of deposit	$	591,876		$	—		$	—		$	—		$	—		$	591,876
		Certificates of deposit		295,291			308,490			187,408			181,367			—			972,556
	FHLB advances			415,500			10,000			38,000			113,000			—			576,500
	Senior notes			—			—			—			23,078			—			23,078
	Capital securities			—			27,000			—			—			9,000			36,000

		Total interest-bearing liabilities	$	1,302,667		$	345,490		$	225,408		$	317,445		$	9,000		$	2,200,010

	Interest rate sensitivity gap		$	(75,414	)	$	380,023		$	(172,762	)	$	(99,963	)	$	139,841		$	171,725
	Cumulative interest rate sensitivity gap			(75,414	)		304,609			131,847			31,884			171,725			171,725
	As a percentage of total interest-earning assets			-3.18	%		12.84	%		5.56	%		1.34	%		7.24	%		7.24	%

(1)		Excludes noninterest-earning cash balances.




(2)		Balances include $6.1 million of nonaccrual loans, and are gross of deferred fees and costs and allowance for credit losses.

Interest rate risk (“IRR”) and credit risk constitute the two greatest sources of financial exposure for insured financial institutions. IRR represents the impact that changes in absolute and relative levels of market interest rates may have upon the Company’s net interest income (“NII”) and theoretical liquidation value, also referred to as net portfolio value (“NPV”). NPV is defined as the present value of expected net cash flows from existing assets minus the present value of expected net cash flows from existing liabilities. Changes in the NII (the net interest spread between interest-earning assets and interest-bearing liabilities) are influenced to a significant degree by the repricing characteristics of assets and liabilities (timing risk), the relationship between various rates (basis risk), and changes in the shape of the yield curve.

The Company utilizes two methods for measuring interest rate risk, gap analysis and interest rate simulations. Gap analysis focuses on measuring absolute dollar amounts subject to repricing within certain periods of time, particularly the one year maturity horizon. Interest rate simulations are produced using a software model that is based on actual cash flows and repricing characteristics for all of the Company’s financial instruments and incorporates market-based assumptions regarding the impact of changing interest rates on current volumes of applicable financial instruments. These assumptions are inherently uncertain, and, consequently, the model cannot precisely measure net interest income or precisely predict the impact of changes in interest rates on net interest income. Actual results will differ from simulated results due to timing, magnitude and frequency of interest rate changes, as well as changes in market conditions and management strategies. See “Item 3, Quantitative and Qualitative Disclosure about Market Risks.”

Interest rate simulations provide the Company with an estimate of both the dollar amount and percentage change in NII under various rate scenarios. Ordinarily, all assets and liabilities are subjected to tests of 300 basis points in increases and decreases in interest rates in 100 basis point increments. Due to the unusually low rate environment experienced during the year, the rate shock down was performed only for a decrease of 100 basis points. The Bank’s analysis is consistent with the OTS approach. Under each interest rate scenario, the Company projects its net interest income and the NPV of its current balance sheet. From these results, the Company can then develop alternatives in dealing with the tolerance thresholds.

The Company’s Asset/Liability Committee (“ALCO”) is responsible for managing the Company’s assets and liabilities in a manner that balances profitability, IRR and various other risks including liquidity. ALCO operates under policies and within risk limits prescribed by, reviewed and approved by the Board of Directors.

ALCO seeks to stabilize the Company’s NII and NPV by matching its rate-sensitive assets and liabilities through maintaining the maturity and repricing of these assets and liabilities at appropriate levels given the interest rate environment. When the amount of rate-sensitive liabilities exceeds rate-sensitive assets within specified time periods, the NII generally will be negatively impacted by increasing rates and positively impacted by decreasing rates. Conversely, when the amount of rate-sensitive assets exceeds the amount of rate-sensitive liabilities within specified time periods, net interest income will generally be positively impacted by increasing rates and negatively impacted by decreasing rates. The speed and velocity of the repricing of assets and liabilities will also contribute to the effects on the Company’s NII and NPV, as will the presence or absence of periodic and lifetime interest rate caps and floors.

As of September 30, 2002, with a downward shift of 100 basis points in the yield curve, the Bank’s net interest income is projected to increase 5%. With upward shifts of 100, 200 and 300 basis points in the yield curve, the Bank’s net interest income is projected to decrease 4%, 6% and 8%, respectively.

ITEM 3. Quantitative and Qualitative Disclosures about Market Risk

The Company realizes income principally from the differential or spread between the interest earned on loans, investments, other interest-earning assets and the interest paid on deposits and borrowings. The Company, like other financial institutions, is subject to interest rate risk (“IRR”) to the degree that its interest-earning assets reprice differently than its interest-bearing liabilities. The Company’s primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on the Company’s net interest income and capital, while structuring the Company’s asset-liability mix to obtain the maximum yield-cost spread on that structure.

An increase or decrease in interest rates may adversely impact the Company’s income to the extent that the interest rates borne by the assets and liabilities do not change at the same speed, to the same extent, or on the same basis. The Company has adopted formal policies and practices to monitor its interest rate risk exposure. As a part of this effort, the Company uses the net portfolio value (“NPV”) methodology to gauge interest rate risk exposure.

Using an internally generated model, the Company monitors interest rate sensitivity by estimating the change in NPV over a range of interest rate scenarios. NPV is the discounted present value of the difference between incoming cashflows on interest-earning assets and other assets, and the outgoing cashflows on interest-bearing liabilities and other liabilities. The NPV ratio is defined as the NPV for a given rate scenario divided by the market value of the assets in the same scenario. The Sensitivity Measure is the decline in the NPV ratio, in basis points, caused by a 200 basis point increase or decrease in interest rates, whichever produces the largest decline. By agreement with the OTS, the downward rate shock was performed for 100 basis points down only, due to the overall compression of market rates. The higher an institution’s Sensitivity Measure, the greater is considered its exposure to IRR. The OTS also produces a similar analysis using its own model, based upon data submitted on the Bank’s quarterly Thrift Financial Report (“TFR”).

At September 30, 2002, based on the Company’s internally generated model, the Company’s estimated NPV ratio was 10.95% in the event of a 200 basis point increase in rates, an increase of 1.11% from basecase of 10.83%. If rates were to decrease by 100 basis points, the Company’s NPV ratio was estimated at 10.67%, a decrease of 1.48% from basecase.

Presented below, as of September 30, 2002, is an analysis of the Company’s IRR as measured in the NPV for instantaneous and sustained parallel shifts of 100, 200, and 300 basis point increments in market interest rates.


		Net Portfolio Value

				$ Change						Change
	Change			from						from
(Dollars in thousands)	in Rates	$Amount		Basecase			Ratio			Basecase

	+300 bp	$	273,391		1,234			11.09	%	+26bp
	+200 bp		271,150		(1,007	)		10.95	%	+12bp
	+100 bp		271,672		(485	)		10.89	%	+06bp
	0 bp		272,157					10.83	%
	-100 bp		270,130		(2,027	)		10.67	%	-16bp
	-200 bp		n/a		n/a			n/a			n/a
	-300 bp		n/a		n/a			n/a			n/a

Management believes that the NPV methodology overcomes three shortcomings of the typical maturity gap methodology. First, it does not use arbitrary repricing intervals and accounts for all expected cash flows, weighing each by its appropriate discount factor. Second, because the NPV method projects cash flows of each financial instrument under different rate environments, it can incorporate the effect of embedded options on an association’s IRR exposure. Third, it allows interest rates on different instruments to change by varying amounts in response to a change in market interest rates, resulting in more accurate estimates of cash flows.

On a quarterly basis, the results of the internally generated model are reconciled to the results of the OTS model. Historically the OTS has valued the NPV higher, but the changes in NPV as a result of the rate increases and decreases are normally directionally consistent between the two models. The difference between the two models resides in the prepayment assumptions, the ability of the Company to analyze each individual rate index in a changing environment and the ability of the Company’s model to include caps and floors on loans in the rate shock analyses. Through the inclusion of more specific information regarding the Company’s loan portfolio, the internal model reflects greater sensitivity in both an increasing and a declining rate environment.

ITEM 4. Controls and Procedures

        1.    Current Controls and Procedures



     As of September 30, 2002, an evaluation was performed under the supervision and with the participation of the Company’s management, including the Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on that evaluation, the Company’s management, including the CEO and CFO, concluded that the Company’s disclosure controls and procedures were effective as of September 30, 2002 for gathering, analyzing and disclosing the information that the Company is required to disclose in the reports it files under the Securities Exchange Act (“SEC”) within the time period specified in the SEC’s rules and forms.

        2.    Changes in Internal Control Procedures



     There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to September 30, 2002.

PART II — OTHER INFORMATION

ITEM 1. Legal Proceedings

ITEM 2. Changes in Securities

None

ITEM 3. Defaults upon Senior Securities

None

ITEM 4. Submission of Matters to a Vote of Security Holders

None

ITEM 5. Other Information

None

ITEM 6. Exhibits and Reports on Form 8-K

1. Exhibits

None

        2.    Reports on Form 8-K

           The following reports on Form 8-K were filed for the three months ended September 30, 2002.

           August 23, 2002 — Hawthorne Financial Announces Completion of Merger with First Fidelity Bancorp, Inc.

           October 8, 2002 — Update on Impact of First Fidelity Merger; Announces Expansion of Securities Repurchase Program

           November 5, 2002 — Hawthorne Financial Corporation Participation in a Pooled Offering of Floating Rate Trust Preferred Securities, Raising $15.0 Million

           November 5, 2002 — Pro Forma Update Regarding S-4 Combined Financial Statements

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


		HAWTHORNE FINANCIAL CORPORATION


Dated November 14, 2002		/s/ SIMONE LAGOMARSINO Simone Lagomarsino President and Chief Executive Officer


Dated November 14, 2002		/s/ DAVID ROSENTHAL David Rosenthal Executive Vice President and Chief Financial Officer

Certification

I, Simone F. Lagomarsino, certify that:

1.    I have reviewed this quarterly report on Form 10-Q of Hawthorne Financial Corporation;

2.    Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.    Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.    The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

        a)    designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

        b)    evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

        c)    presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of registrant’s board of directors (or persons performing the equivalent function):

a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weakness in internal controls; and

b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and

6. The registrant’s other certifying officer and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective action with regard to significant deficiencies and material weaknesses.


		By:		/s/ SIMONE LAGOMARSINO Simone Lagomarsino President and Chief Executive Officer

Date: November 14, 2002

Certification

I, David Rosenthal, certify that:


		By:		/s/ DAVID ROSENTHAL David Rosenthal Executive Vice President and Chief Financial Officer

Date: November 14, 2002

•		Interest Rate Risk. The Company realizes income principally from the differential or spread between the interest earned on loans, investments, and other interest earning assets, and the interest paid on deposits and borrowings. The volumes and yields on loans, deposits, and borrowings are affected by market interest rates. As of September 30, 2002, 90.67% of the Company’s loan portfolio was tied to adjustable rate indices, such as MTA, Prime, LIBOR, COFI and CMT. Out of these adjustable rate loans, approximately 55.87%, or $1.08 billion, have reached their internal interest rate floors. Therefore, these loans have taken on fixed rate characteristics. The Company’s deposits of $1.4 billion are comprised of 60.85% time deposits with a stated maturity (generally one year or less) and a fixed rate of interest. As of September 30, 2002, 80.23% of the Company’s borrowings from the Federal Home Loan Bank (“FHLB”) are fixed rate, with remaining terms ranging from one to eight years (though such remaining terms are subject to early call provisions). The remaining 19.77% of the borrowings carry an adjustable interest rate, with 87.72% of the adjustable borrowings tied to the Prime Rate, maturing in 2003, and 12.28% tied to one-month LIBOR, maturing in 2003.

		Changes in the market interest rates directly and immediately affect the Company’s interest spread, and therefore profitability. Sharp and significant changes in market rates can cause the interest spread to shrink or expand significantly in the near term, principally because of the timing differences between the adjustable rate loans and the maturities (and therefore repricing) of the deposits and borrowings.

		Sharp decreases in interest rates have resulted in increased loan prepayments as borrowers refinance to fixed rate products. Due to the fact that the Bank is a variable rate lender and offers fixed rate products on a limited basis, a decreasing interest rate environment could negatively impact the Company’s ability to grow the balance sheet.

•		Credit Quality. We have invested in various assets that contain elements of credit risk. These assets include loans and investment securities, the majority of which are collateralized by mortgage loans. A significant source of risk arises from the possibility that losses will be sustained because borrowers, guarantors and related parties may fail to perform in accordance with the terms of their loans. The Company has adopted underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for credit losses, that management believes are appropriate to minimize this risk by assessing the likelihood of nonperformance, tracking loan performance and diversifying its credit portfolio. However, such policies and procedures may not prevent unexpected losses that could materially adversely affect the Company’s results.

•		Risk Associated With Merger. The Company acquired First Fidelity Bancorp, Inc. (“First Fidelity”) on August 23, 2002. The Company’s results may be affected if (1) the expected growth opportunities and cost savings from the merger are not fully realized or take longer to realize than expected; or (2) operating costs, customer losses and business disruption, including adverse effects on relationships with employees, are greater than expected.

•		Government Regulation And Monetary Policy. All forward-looking statements presume a continuation of the existing regulatory environment and United States’ government monetary policies. The banking industry is subject to extensive federal and state regulations, and significant new laws or changes in, or repeals of, existing laws may cause results to differ materially. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects credit conditions for the Company, primarily through open market operations in United States government securities, the discount rate for member bank borrowings and bank reserve requirements, and a material change in these conditions has had and is likely to continue to have a material impact on the Company’s results.

•		Competition. The Company competes with numerous other domestic and foreign financial institutions and non depository financial intermediaries. The Company’s results may differ if circumstances affecting the nature or level of competition change, such as the merger of competing financial institutions or the acquisition of California institutions by out-of-state companies.

•		Other Risks. From time to time, the Company details other risks with respect to its business and/or financial results in press releases and filings with the SEC. Stockholders are urged to review the risks described in such releases and filings.


	There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to September 30, 2002.

	2.		Reports on Form 8-K

			The following reports on Form 8-K were filed for the three months ended September 30, 2002.

			August 23, 2002 — Hawthorne Financial Announces Completion of Merger with First Fidelity Bancorp, Inc.

			October 8, 2002 — Update on Impact of First Fidelity Merger; Announces Expansion of Securities Repurchase Program

			November 5, 2002 — Hawthorne Financial Corporation Participation in a Pooled Offering of Floating Rate Trust Preferred Securities, Raising $15.0 Million

			November 5, 2002 — Pro Forma Update Regarding S-4 Combined Financial Statements

1.		I have reviewed this quarterly report on Form 10-Q of Hawthorne Financial Corporation;

2.		Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

3.		Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;

4.		The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:

	a)		designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;

	b)		evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and

	c)		presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;

	a)		all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weakness in internal controls; and

	b)		any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and