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 June 30, 2003


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


2381 Rosecrans Avenue, El Segundo, CA		90245
(Address of Principal Executive Offices)		(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 by check mark whether the registrant is an accelerated filer as defined in Rule 12b-2 of the Exchange Act. 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 7,713,310 shares of Common Stock, $0.01 par value, per share outstanding as of July 31, 2003.

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 Disclosure About Market Risks
	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
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1

HAWTHORNE FINANCIAL CORPORATION

FORM 10-Q INDEX
For the quarter ended June 30, 2003


				Page

		PART I — FINANCIAL INFORMATION
ITEM 1.	Financial Statements
	Consolidated Statements of Financial Condition at June 30, 2003 and December 31, 2002 (unaudited)				1
	Consolidated Statements of Income for the Three and Six Months Ended June 30, 2003 and 2002 (unaudited)				2
	Consolidated Statement of Stockholders’ Equity for the Six Months Ended June 30, 2003 (unaudited)				3
	Consolidated Statements of Cash Flows for the Six Months Ended June 30, 2003 and 2002 (unaudited)				4
	Notes to Unaudited Consolidated Financial Statements				6
ITEM 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations				10
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				36
ITEM 5.	Other Information				36
ITEM 6.	Exhibits and Reports on Form 8-K				36

CAUTIONARY STATEMENT REGARDING FORWARD LOOKING STATEMENTS

Certain statements in this filing constitute “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, amended, and Section 21E of the Securities Exchange Act of 1934, as amended, which involve risks and uncertainties. Our actual results may differ significantly from the results discussed in such forward-looking statements. Factors that might cause such a difference include but are not limited to economic conditions, competition in the geographic and business areas in which we conduct our operations, fluctuation in interest rates, credit quality and government regulation and other factors discussed in our reports filed with the Securities and Exchange Commission (“SEC”), including our Annual Report on Form 10-K for the year ended December 31, 2002.

HAWTHORNE FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(Unaudited)


					June 30,			December 31,
(Dollars in thousands)					2003			2002

Assets:
	Cash and cash equivalents				$	16,415		$	21,849
	Investment securities:
		Investment securities available-for-sale, at fair value				348,154			267,596
		Investment securities awaiting settlement				30,354			—

			Total investment securities			378,508			267,596
	Loans receivable (net of allowance for credit losses of $35,341 in 2003 and $35,309 in 2002)					2,103,105			2,114,255
	Accrued interest receivable					10,883			11,512
	Investment in capital stock of Federal Home Loan Bank, at cost					33,238			34,705
	Office property and equipment at cost, net					5,722			5,106
	Deferred tax asset, net					8,521			10,068
	Goodwill					22,970			22,970
	Intangible assets					1,183			1,388
	Other assets					32,743			5,521

				Total assets	$	2,613,288		$	2,494,970

Liabilities and Stockholders’ Equity:
	Liabilities:
		Deposits:
			Noninterest-bearing		$	44,970		$	39,818
			Interest-bearing:
				Transaction accounts		649,037			597,528
				Certificates of deposit		1,070,722			1,025,464

				Total deposits		1,764,729			1,662,810
		FHLB advances				576,736			600,190
		Capital securities				51,000			51,000
		Investment securities awaiting settlement				30,354			—
		Accounts payable and other liabilities				17,184			17,904

				Total liabilities		2,440,003			2,331,904

Stockholders’ Equity:
	Common stock — $0.01 par value; authorized 20,000,000 shares; issued, 9,015,102 shares (2003) and 8,576,048 shares (2002)					90			86
	Capital in excess of par value — common stock					82,027			81,087
	Retained earnings					118,774			105,134
	Accumulated other comprehensive income					1,374			1,504
	Less:
		Treasury stock, at cost — 1,331,792 shares (2003) and 1,188,383 shares (2002)				(28,980	)		(24,745	)

				Total stockholders’ equity		173,285			163,066

				Total liabilities and stockholders’ equity	$	2,613,288		$	2,494,970

See Accompanying Notes to Consolidated Financial Statements

HAWTHORNE FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF INCOME
(Unaudited)


				Three Months Ended					Six Months Ended
				June 30,					June 30,

(In thousands, except per share data)				2003			2002		2003			2002

Interest revenue:
	Loans			$	32,627		$	30,385	$	66,800		$	62,893
	Investments securities				2,603			69		5,555			69
	Investment in capital stock of FHLB, cash, fed funds and other				331			1,089		795			1,950

			Total interest revenue		35,561			31,543		73,150			64,912

Interest cost:
	Deposits				9,403			8,493		18,972			18,027
	FHLB advances				5,584			5,141		11,397			10,293
	Senior notes				—			805		—			1,611
	Capital securities				755			599		1,528			903

			Total interest cost		15,742			15,038		31,897			30,834

Net interest income					19,819			16,505		41,253			34,078
Provision for credit losses					100			170		400			670

			Net interest income after provision for credit losses		19,719			16,335		40,853			33,408
Noninterest revenue:
	Loan related and other fees				1,078			790		1,964			1,638
	Deposit fees				466			363		922			736
	Other				608			42		803			114

			Total noninterest revenue		2,152			1,195		3,689			2,488
Real estate operations, net					(4	)		—		(3	)		69
Noninterest expense:
	General and administrative expense:
		Employee			5,475			4,700		11,665			9,732
		Operating			2,278			1,516		4,679			3,019
		Occupancy			1,390			941		2,576			1,855
		Professional			339			599		786			706
		Technology			535			371		1,084			740
		SAIF premiums and OTS assessments			165			132		330			268
		Other/legal settlements			38			—		264			20

			Total general and administrative expense		10,220			8,259		21,384			16,340

Income before income taxes					11,647			9,271		23,155			19,625
Income tax provision					4,743			3,987		9,515			8,439

Net income				$	6,904		$	5,284	$	13,640		$	11,186

Basic earnings per share				$	0.90		$	0.91	$	1.79		$	2.00

Diluted earnings per share				$	0.83		$	0.69	$	1.64		$	1.46

Weighted average basic shares outstanding					7,690			5,821		7,633			5,597

Weighted average diluted shares outstanding					8,322			7,665		8,331			7,646

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’			Comprehensive
(In thousands)		Shares			Stock		Stock		Earnings		Income/(Loss)			Stock			Equity			Income/(Loss)

Balance at January 1, 2003			7,388		$	86	$	81,087	$	105,134	$	1,504		$	(24,745	)	$	163,066
Exercised stock options			49			—		516		—		—			—			516
Exercised warrants			390			4		16		—		—			—			20
Tax benefit for stock options exercised			—			—		408		—		—			—			408
Treasury stock			(144	)		—		—		—		—			(4,235	)		(4,235	)
Net income			—			—		—		13,640		—			—			13,640		$	13,640
Other comprehensive income (loss), net:
	Unrealized loss on investment securities available-for-sale, net of tax		—			—		—		—		(130	) (1)		—			(130	)		(130	)

Comprehensive income			—			—		—		—		—			—			—		$	13,510

Balance at June 30, 2003			7,683		$	90	$	82,027	$	118,774	$	1,374		$	(28,980	)	$	173,285



											June 30, 2003

(1)	Other comprehensive loss, before tax:
	Unrealized net holding loss on available-for-sale investment securities										$	(140	)
	Reclassification adjustment of net gain included in net income											(79	)

	Other comprehensive loss, before tax											(219	)
	Tax effect											89

	Other comprehensive loss, net of tax										$	(130	)

See Accompanying Notes to Consolidated Financial Statements

HAWTHORNE FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)


					Six Months Ended June 30,

(Dollars in thousands)					2003			2002

Cash Flows from Operating Activities:
	Net income				$	13,640		$	11,186
	Adjustments to reconcile net income to cash (used in)/provided by operating activities:
			Deferred income tax provision			1,637			1,686
			Provision for credit losses on loans			400			670
			Net gain from sales of investments			(79	)		—
			Net gain from sales of loans			(67	)		—
			Net gain from sales of real estate owned			—			(87	)
			Loan fee, premium and discount amortization			1,127			(19	)
			Depreciation and amortization			2,895			841
			Retirement of fixed assets			49			—
			FHLB dividends			(767	)		(703	)
			Decrease in accrued interest receivable			629			935
			Increase in other assets			(26,958	)		(2,064	)
			(Decrease)/increase in other liabilities			(720	)		307

				Net cash (used in)/provided by operating activities		(8,214	)		12,752

Cash Flows from Investing Activities:
	Certificates of deposit in banks, net					—			(20,000	)
	Loans:
		New loans funded				(455,512	)		(348,557	)
		Payoffs and principal payments				490,856			473,799
		Sales proceeds				6,138			9,839
		Purchases				(32,931	)		(22,100	)
		Other, net				1,139			3,493
	Activity in available-for-sale investment securities:
		Purchases				(259,760	)		(19,700	)
		Sales proceeds				116,678			—
		Principal payments				60,267			—
	Real estate owned:
		Sales proceeds				—			1,399
	FHLB stocks:
		Redemptions				2,234			—
	Office property and equipment:
		Additions				(1,549	)		(599	)

				Net cash (used in)/provided by investing activities		(72,440	)		77,574

See Accompanying Notes to Consolidated Financial Statements

HAWTHORNE FINANCIAL CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)


				Six Months Ended June 30,

(Dollars in thousands)				2003			2002

Cash Flows from Financing Activities:
	Deposit activity, net				101,919			(7,726	)
	Net decrease in FHLB advances				(23,000	)		(25,000	)
	Net proceeds from exercise of stock options and warrants				536			2,104
	Proceeds from Capital Securities				—			22,000
	Purchases of Treasury Stock				(4,235	)		(14,547	)

			Net cash provided by/(used in) financing activities		75,220			(23,169	)

Net (decrease)/increase in cash and cash equivalents					(5,434	)		67,157
Cash and cash equivalents, beginning of period					21,849			98,583

Cash and cash equivalents, end of period				$	16,415		$	165,740

Supplemental Cash Flow Information:
	Cash paid during the period for:
		Interest		$	32,223		$	13,686
		Income taxes			7,050			7,300
	Non-cash financing activities:
		Tax benefit for exercised stock options			408			261

See Accompanying Notes to Consolidated Financial Statements

HAWTHORNE FINANCIAL CORPORATION

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS

Note 1 — Summary of Significant Accounting Policies

The unaudited interim consolidated financial statements include the accounts of Hawthorne Financial Corporation (“Company”) 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 interim 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 six months ended June 30, 2003, are not necessarily indicative of the results that may be expected for any other interim period or the full year ending December 31, 2003.

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”). These unaudited interim 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, 2002.

Recent Accounting Pronouncements

In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities,” an interpretation of ARB No. 51. FIN 46 requires that variable interest entities be consolidated by a company if that company is subject to a majority of the risk of loss from the variable interest entity’s activities or is entitled to receive a majority of the entity’s residual returns or both. FIN 46 also requires disclosures about variable interest entities that companies are not required to consolidate but in which a company has a significant variable interest. The consolidation requirements of FIN 46 will apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements will apply to entities established prior to January 31, 2003 in the first fiscal year or interim period beginning after June 15, 2003. The Company does not believe the adoption of such interpretation will have a material impact on its results of operations, financial position or cash flows.

In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Instruments with Characteristics of Both Liabilities and Equity,” which establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. SFAS No. 150 requires that an issuer classify a financial instrument that is within its scope, which may have previously been reported as equity, as a liability (or an asset in some circumstances). This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003, except for mandatory redeemable financial instruments of nonpublic companies. The Company does not believe that the adoption of SFAS No. 150 will have a significant impact on its financial statements.

Note 2 — Reclassifications

Certain amounts in the 2002 consolidated financial statements have been reclassified to conform with classifications in 2003.

Note 3 — Earnings Per Share Calculation

The following table sets forth the Company’s earnings per share calculations for the three and six months ended June 30, 2003 and 2002. 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						Six Months Ended
		June 30,						June 30,

(In thousands, except per share data)		2003			2002			2003			2002

Average shares outstanding:
	Basic		7,690			5,821			7,633			5,597
	Warrants		476			1,583			547			1,881
	Options (1)		593			656			625			678
	Less: Treasury stock (2)		(437	)		(395	)		(474	)		(510	)

	Diluted		8,322			7,665			8,331			7,646

Net income		$	6,904		$	5,284		$	13,640		$	11,186

Basic earnings per share		$	0.90		$	0.91		$	1.79		$	2.00

Diluted earnings per share		$	0.83		$	0.69		$	1.64		$	1.46

(1)		Excludes 85,067 and 85,583 options, for the three and six months ended June 30, 2003, respectively, for which the exercise price exceeded the average market price of the Company’s common stock. For the three and six months ended June 30, 2002, 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 associated with 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.

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.

Book Value Calculation:


		At June 30,

(In thousands, except per share data)		2003			2002

Period-end shares outstanding:
	Basic		7,683			5,703
	Warrants		476			1,373
	Options (1)		660			650
	Less: Treasury stock (2)		(490	)		(379	)

	Diluted		8,329			7,347

Basic book value per share		$	22.55		$	20.95

(1)		There were no options outstanding at June 30, 2003 and June 30, 2002, for which the exercise price exceeded the monthly average market price of the Company’s common stock at period-end.
(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 associated with 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.

Stock Option Plans

SFAS No. 123, “Accounting for Stock-Based Compensation,” permits entities to apply the provisions of Accounting Principles Board Opinion No. 25 (“APB 25”), and related interpretations. SFAS No. 123 requires pro forma disclosure of net income and, if presented, earnings per share, as if the fair value based method of accounting defined in this statement had been applied. As such, compensation expense would be recorded on the date of grant only if the current market price of the underlying stock exceeded the exercise price, rather than recognizing the fair value of all stock-based awards on the date of grant as compensation expense over the vesting period. The Company has elected to apply the provisions of APB 25 and provide the pro forma disclosure requirements of SFAS No. 123.

If compensation costs for the Stock Incentive Plan and Stock Option Plans had been determined based on the fair value at the grant date for awards for the six months ended June 30, 2003 and 2002, consistent with the provisions of SFAS No. 123, the Company’s net income and net earnings per share would have been reduced to the pro forma amounts as follows.


		Three Months Ended June 30,						Six Months Ended June 30,

(Dollars in thousands, except per share data)		2003			2002			2003			2002

Net earnings:
	As reported	$	6,904		$	5,284		$	13,640		$	11,186
	Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of tax		(303	)		(277	)		(603	)		(555	)

	Pro forma	$	6,601		$	5,007		$	13,037		$	10,631
Basic earnings per share:
	As reported	$	0.90		$	0.91		$	1.79		$	2.00
	Pro forma	$	0.86		$	0.86		$	1.71		$	1.90
Diluted earnings per share:
	As reported	$	0.83		$	0.69		$	1.64		$	1.46
	Pro forma	$	0.79		$	0.65		$	1.56		$	1.39
Weighted average fair value of options granted during the period, at date of grant		$	15.83		$	—	(1)	$	15.83		$	11.17	(1)

(1)

There were no grants issued during the three months ended June 30, 2002.

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions.


	Three Months Ended June 30,					Six Months Ended June 30,

	2003			2002 (1)		2003			2002 (1)

Dividend yield		n/a			—		n/a			n/a
Expected life	3 to 7 years				—	3 to 7 years			6 months to 5 years
Expected volatility		60.73	%		—		60.73	%		48.88	%
Risk-free interest rate		3.09	%		—		3.09	%		3.28	%

(1)

There were no grants issued during the three months ended June 30, 2002.

In 2000, the Company adopted a stock option program in an effort to further align the interests of our employees with our shareholders. The compensation committee of the board of directors generally reviews this program on a semi-annual basis and grants options to employees and directors on those occasions in January and July of each year. In January of 2003, no stock options were granted. However, at the board meeting held July 22, 2003, a total of 72,500 options were granted at the current market price, bringing the total options outstanding to 732,600. Of the options outstanding, 142,000 have been issued to outside directors, 326,000 have been granted to the executive officers, and the remaining 264,600 were distributed among approximately 100 officers of the Company.

Note 4 — Commitments and Contingencies

The Bank is a defendant in a construction defect case entitled Stone Water Terrace HOA v. Future Estates, Hawthorne Savings and Loan Association, et al, which was filed in the Superior Court of the State of California, County of Los Angeles. On June 16, 2003, the Court approved an application for approval of good faith settlement between the plaintiff on the one hand, and the Bank and a number of subcontractor defendants on the other hand (the “Settlement”). The Bank’s contribution to the Settlement was not material to the Company’s financial condition or results of operations and was appropriately accrued for in a prior period. Upon satisfaction of the conditions of the Settlement, the complaint against the Bank will be dismissed with prejudice, and the Bank will be released from all further liability in connection with the construction of the Stone Water Terrace development.

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. Financial instruments include letters of credit. These commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the consolidated statements of financial condition. The contractual amounts of the commitments reflect the extent of involvement the Company has in the financial instruments. The Company follows the same credit policies in making commitments as it does for on-balance sheet instruments. There were no outstanding letters of credit issued by the Bank at June 30, 2003 and 2002.

As of June 30, 2003, the Federal Home Loan Bank issued six letters of credit (“LC”) for a total of $215.5 million. The purpose of the LCs is to fulfill the collateral requirements for six deposits totaling $185.0 million placed by the State of California with the Bank. The LCs are issued in favor of the State Treasurer of the State of California and mature over the next six months. The maturities coincide with the maturities of the State’s deposits. There are no issuance fees associated with these LCs; however, the Bank pays a maintenance fee of 15 basis points per annum monthly.

At June 30, 2003, the Bank had commitments to fund the undisbursed portion of existing construction and land loans of $89.4 million and income property and residential loans of $8.1 million. The Bank’s commitments to fund the undisbursed portion of existing lines of credit totaled $9.6 million. The Bank follows the same credit policies in making commitments as it does for on-balance sheet instruments.

In addition, as of June 30, 2003, the Bank had commitments to fund $64.4 million in approved loans.

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.

Note 7 — Capital Securities

In 2001 and 2002, the Company organized four statutory business trusts and wholly owned subsidiaries of the Company (the “Capital Trusts”), which issued an aggregate of $51.0 million of fixed and floating rate Capital Securities. 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 the Capital Trusts (collectively, the “Common Securities” and together with the Capital Securities the “Trust Securities”). The Capital Trusts exist for the sole purpose of issuing the Trust Securities and investing the proceeds thereof in fixed rate and floating rate, junior subordinated deferrable interest debentures issued by the Company and engaging in certain other limited activities. Interest on the Capital Securities is payable semi-annually.

The table below sets forth information concerning the Company’s Capital Securities as of June 30, 2003.

(Dollars in thousands)


		Date of		Maturity								Current
Ownership	Subsidiary	Issuance		Date		Amount		Rate Cap			Rate	Rate			Call Date (1)

100%	HFC Capital Trust I		3/28/01		6/8/31	$	9,000		N/A		Fixed		10.18	%	10 Years
100%	HFC Capital Trust II		11/28/01		12/8/31		5,000		11.00	%	LIBOR + 3.75%		4.81	%	5 Years
100%	HFC Capital Trust III		4/10/02		4/10/32		22,000		11.00	%	LIBOR + 3.70%		4.99	%	5 Years
100%	HFC Capital Trust IV		11/1/02		11/1/32		15,000		12.00	%	LIBOR + 3.35%		4.60	%	5 Years

						$	51,000

(1)

Exercise of the call option on all of the capital securities is at par.

Note 8 — Business Combinations, Goodwill and Intangible Assets

On August 23, 2002, the Company acquired all of the assets and liabilities of First Fidelity. Prior to the acquisition, First Fidelity served Orange and San Diego counties through its four branch offices. First Fidelity was a real estate secured lender with 55% of its loans being secured by multi-family residential properties and 45% of its loans secured by commercial properties.

The acquisition of First Fidelity 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. Goodwill and other intangible assets represent the excess of purchase price over the fair value of net assets acquired by the Company. 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 and intangible assets of the acquired company.

Premiums and discounts on loans are amortized on a loan-by-loan basis, using the effective interest method over the estimated lives of the loans. Discounts on deposits and FHLB advances are amortized over the respective estimated lives using the effective interest method. Amortization of premiums and discounts are reflected in interest income or interest expense depending on the classification of the related asset or liability.

The following table summarizes the Company’s intangible assets as of June 30, 2003:


		Gross		Accumulated		Weighted Average
(In thousands)		Carrying Amount (1)		Amortization (2)		Amoritization Period

Amortized Intangible Assets:
Core deposit intangible - checking		$	876	$	151	5 years
Core deposit intangible - savings			648		190	5 years

	Total intangible assets	$	1,524	$	341

(1)		Reflects original amount at the time of acquisition.
(2)		Reflects accumulation since date of acquisition.


	Future
For the Years Ended December 31,	Amortization Expense

(In thousands)
2003 (remainder of the year)	$	207
2004		355
2005		216
2006		156
2007 and thereafter		249

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

OVERVIEW

The Company’s only operating segment is the Bank, which is headquartered in El Segundo, California. The Bank currently operates fifteen branches in the coastal counties of Southern California, from Westlake Village at the western edge of Los Angeles County to Mission Bay in San Diego County. The Company specializes in real estate secured loans within the markets it serves, including: 1) permanent loans collateralized by single family residential property, 2) permanent loans secured by multi-family residential and commercial real estate and 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. The Company funds its loans predominantly with retail deposits generated through its fifteen full service retail offices and FHLB advances.

CRITICAL ACCOUNTING POLICIES

Allowance for Credit Losses

Management evaluates the allowance for credit losses in accordance with GAAP, within the guidance established by Statements of Financial Accounting Standards (“SFAS”) No. 5, “Accounting for Contingencies,” and SFAS No. 114, as amended by SFAS No. 118, “Accounting by Creditors for Impairment of a Loan,” Staff Accounting Bulletin (“SAB”) 102, “Selected Loan Loss Allowance Methodology and Documentation Issues,” as well as standards established by regulatory Interagency Policy Statements on the Allowance for Loan and Lease Losses (“ALLL”). The allowance for credit losses represents management’s estimate of probable losses inherent in the Bank’s loan portfolio as of the balance sheet date. Management evaluates the adequacy of the allowance on at least a quarterly basis by reviewing its loan portfolio to estimate these inherent losses and to assess the overall probability of collection of the loans in the portfolio. Included in this quarterly review is the monitoring of delinquencies, default and historical loss experience, among other factors impacting portfolio risk. The Bank’s methodology for assessing the appropriate allowance level consists of several components, which include the allocated general valuation allowance (“GVA”), specific valuation allowances (“SVA”) for identified loans and the unallocated allowance.

Management establishes SVAs for credit losses on individual loans when it has determined that recovery of the Bank’s gross investment is not probable and when the amount of loss can be reasonably determined. SFAS No. 114 defines loan impairment as the existence of uncertainty concerning collection of all principal and interest per the contractual terms of a loan. Nonaccrual loans are typically impaired and analyzed individually for SVAs. For collateral dependent loans, impairment is typically measured by comparing the loan amount to the fair value of collateral (determined via appraisals and/or internal valuations), less costs to sell, with a SVA established for the shortfall amount. Other methods can be used to estimate impairment (market price or present value of expected future cash flows discounted at the loan’s original interest rate).

The Bank maintains an allowance for credit losses, GVA, which is not tied to individual loans or properties. GVAs are maintained for each of the Bank’s principal loan portfolio components and supplemented by periodic additions through provisions for credit losses. In measuring the adequacy of the Bank’s GVA, management considers (1) the Bank’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, (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 may not be 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 currently intends to maintain an unallocated allowance, in the range of between 3% and 5% of the total GVA, for the inherent risk associated with imprecision in estimating the allowance, and an additional amount of up to approximately 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. However, if economic conditions were to deteriorate beyond the weaknesses currently identified by management, it is possible that the GVA would be deemed insufficient for the inherent losses in the loan portfolio and further provision might be required. This could negatively impact earnings for the relevant period. 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, 2002.

Management believes that the provision for credit losses of $100 thousand was appropriate during the second quarter of 2003, and that the allowance for credit losses of $35.3 million at June 30, 2003, 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 Bank generally ceases to accrue interest on a loan when: 1) principal or interest has been contractually delinquent 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.

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. 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 the sale of the REO property, 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.

Investment Securities

Investment 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, 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, as part of stockholders’ equity.

The Bank is permitted to invest in a variety of investment securities, including U.S. Government and agency backed securities, mortgage-backed securities and investment grade securities. The investment policy of the Bank seeks to provide and maintain liquidity, produce favorable returns on investments without incurring unnecessary interest rate or credit risk, while complementing the Bank’s lending activities. Management monitors the Bank’s investment activities to ensure that they are consistent with the Bank’s established guidelines and objectives. Purchase premiums and discounts are recognized in interest income using the interest method over the estimated lives of the securities. All investment securities of the Bank are classified as “available-for-sale.” Declines in the fair value of available-for-sale investment securities below cost that are deemed to be other than temporary are reflected in earnings as realized losses. Gains and losses on the sale of investment securities are recorded on the trade date and are determined using the specific identification method. See “Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations, Critical Accounting Policies – Investment Securities” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

Intangible Assets

As a result of the adoption of SFAS No. 142, “Goodwill and Other Intangible Assets,” which eliminates amortization of goodwill, the Company is required to evaluate goodwill annually, or more frequently if impairment indicators arise. See “Notes to Consolidated Financial Statements - Note 1 – Summary of Significant Accounting Policies” and “Notes to Consolidated Financial Statements - Note 7 – Business Combinations, Goodwill and Intangible Assets” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

Income Taxes

Management estimates the tax provision based on the amount it expects to owe various tax authorities. Taxes are discussed in more detail in “Notes to Consolidated Financial Statements - Note 1 – Summary of Accounting Policies” and “Notes to Consolidated Financial Statements - Note 10 – Income Taxes,” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

RESULTS OF OPERATIONS

Performance Summary

Net income in the first six months of 2003 included the financial impact of the Company’s acquisition of First Fidelity on August 23, 2002, which is discussed in “Notes to Consolidated Financial Statements - Note 7 – Business Combinations, Goodwill and Intangible Assets” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.


		Three Months Ended June 30,												Six Months Ended June 30,

								Change												Change
(Dollars in thousands)		2003			2002			$			%			2003			2002			$			%

Net interest income		$	19,819		$	16,505		$	3,314			20.1	%	$	41,253		$	34,078		$	7,175			21.1	%
Provision for credit losses			100			170			(70	)		(41.2	)		400			670			(270	)		(40.3	)
Noninterest revenue			2,152			1,195			957			80.1			3,689			2,488			1,201			48.3
Real estate operations, net			(4	)		—			(4	)		—			(3	)		69			(72	)		(104.3	)
Noninterest expense			10,220			8,259			1,961			23.7			21,384			16,340			5,044			30.9

	Income before income taxes		11,647			9,271			2,376			25.6			23,155			19,625			3,530			18.0
Income tax provision			4,743			3,987			756			19.0			9,515			8,439			1,076			12.8

	Net income	$	6,904		$	5,284		$	1,620			30.7	%	$	13,640		$	11,186		$	2,454			21.9	%

Diluted earnings per share		$	0.83		$	0.69		$	0.14			20.3	%	$	1.64		$	1.46		$	0.18			12.3	%
Net interest margin			3.18	%		3.56	%					(10.7	)%		3.31	%		3.68	%					(10.1	)%
Return on average assets (1)			1.08	%		1.14	%					(5.3	)%		1.07	%		1.20	%					(10.8	)%
Return on average equity (1)			16.34	%		17.03	%					(4.1	)%		16.40	%		18.27	%					(10.2	)%
Efficiency ratio (2)			46.34	%		46.66	%					(0.7	)%		46.99	%		44.63	%					5.3	%
G&A to average assets (3)			1.59	%		1.77	%					(10.2	)%		1.65	%		1.75	%					(5.7	)%

(1)		Annualized.
(2)		Represents total general and administrative expense (excluding other/legal settlements) divided by net interest income before provision for credit losses and noninterest revenues.
(3)		Represents annualized total general and administrative expense (excluding other/legal settlements) divided by average assets.

The Company’s positive results were achieved in an environment characterized by: unprecedented low and volatile interest rates, significant volumes of prepayments of loans, aggressive competition for loan originations and a high demand for fixed rate loan products. This environment poses challenges relative to growing assets that provide acceptable yields. The following describes the changes in the major components of income before income taxes for the six months ended June 30, 2003:

• Net interest income was positively impacted year-over-year by: 1) inclusion of the net assets from the acquisition of First Fidelity in August 2002, 2) continued strong origination volume of $485.2 million, 3) the majority of ARM loans ($1.4 billion) reaching their contractual floors, 4) income from the investment securities portfolio and 5) the lowering of interest rates on deposits and borrowings.

• Net interest income increased 20.1% during the second quarter of 2003, compared to the prior year and was lower than the prior quarter. Net interest margin for the second quarter of 2003 was 3.18% down from 3.44% in the prior quarter and 3.56% a year earlier. The reduction in the net interest margin compared to the prior quarter was largely due to a 26 basis point reduction in yields on loans outstanding due to new loans being originated at lower yields from the loans that are prepaying. This was partially offset by a reduction in the company’s cost of funds of 11 basis points.

• Year-to-date provision for credit losses decreased by $0.3 million, reflecting management’s evaluation of the allowance for credit losses and the risk inherent in the Company’s portfolio. At June 30, 2003, classified assets totaled $18.6 million, or 0.71% of total Bank assets, compared to $45.1 million, or 2.41% of total Bank assets, a year earlier. Year-to-date, classified assets have decreased $5.1 million, or approximately 21.6%. During the second quarter, nonaccrual loans increased by $1.3 million. However, the ratio of nonaccrual loans to total loans of 0.37% remains lower than the Bank’s peer group. At June 30, 2003, the ratio of total allowance for credit losses to loans receivable, net of specific valuation allowance, was 1.65%, compared with 1.64% at December 31, 2002 and 1.77% at June 30, 2002.

• For the six months ended June 30, 2003, noninterest revenues were $3.7 million, a 48.3% increase, compared to the $2.5 million earned during the same period in 2002. Loan and other related fees constituted 53.2% of noninterest revenues for the six months ended June 30, 2003, compared to 65.8% during the same period in 2002. During both periods, these fees were comprised primarily of prepayment fees resulting from the high level of refinancings. Fee income on deposits increased 25.3% for the first six months of 2003, compared with the same period in 2002, primarily due to growth in core transaction deposits and other fee generating initiatives.

• Year-to-date total general and administrative expense (“G&A”) increased by $5.0 million primarily due to additional costs as a result of the acquisition of First Fidelity. The ratio of G&A (excluding other/legal settlement) to average assets improved to 1.65% for the six months ended June 30, 2003, compared with 1.84% for the year ended December 31, 2002, which reflects the Company’s continued emphasis on efficiency.

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 June 30, 2003 and 2002.


				Three Months Ended June 30,

				2003							2002

								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)			$	2,126,756	$	32,627		6.14	%	$	1,654,830	$	30,385		7.35	%
	Investment securities (3)				331,474		2,603		3.14			8,722		69		3.17
	Investment in capital stock of Federal Home Loan Bank				33,792		321		3.81			25,001		382		6.13
	Cash, fed funds and other				2,169		10		1.85			169,220		707		1.68

			Total interest-earning assets		2,494,191		35,561		5.71			1,857,773		31,543		6.80

Noninterest-earning assets					69,247							3,846

			Total assets	$	2,563,438						$	1,861,619

Liabilities and Stockholders’ Equity:
	Interest-bearing liabilities:
		Deposits		$	1,718,063	$	9,403		2.20	%	$	1,151,892	$	8,493		2.96	%
		FHLB advances			549,508		5,584		4.02			468,615		5,141		4.34
		Senior notes			—		—		—			25,778		805		12.50
		Capital securities			51,000		755		5.92			33,824		599		7.08

			Total interest-bearing liabilities		2,318,571		15,742		2.71			1,680,109		15,038		3.57

	Noninterest-bearing checking				44,596							37,130
	Noninterest-bearing liabilities				31,236							20,258
	Stockholders’ equity				169,035							124,122

			Total liabilities and stockholders’ equity	$	2,563,438						$	1,861,619

Net interest income						$	19,819						$	16,505

Interest rate spread									3.00	%						3.23	%

Net interest margin									3.18	%						3.56	%

(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 $0.6 million for the three months ended June 30, 2003 and net deferred loan fees earned of $0.1 million for the three months ended June 30, 2002.
(3)		Excludes investment securities awaiting settlement.

The following table shows average balance sheet data, related revenues and costs and effective weighted average yields and costs, for the six months ended June 30, 2003 and 2002.


				Six Months Ended June 30,

				2003							2002

								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)			$	2,135,362	$	66,800		6.27	%	$	1,686,078	$	62,893		7.48	%
	Investment securities (3)				324,270		5,555		3.43			4,385		69		3.17
	Investment in capital stock of Federal Home Loan Bank				34,323		767		4.51			24,805		756		6.15
	Cash, fed funds and other				4,046		28		1.40			144,078		1,194		1.67

			Total interest-earning assets		2,498,001		73,150		5.87			1,859,346		64,912		7.00

Noninterest-earning assets					60,362							2,438

			Total assets	$	2,558,363						$	1,861,784

Liabilities and Stockholders’ Equity:
	Interest-bearing liabilities:
		Deposits		$	1,696,931	$	18,972		2.25	%	$	1,156,907	$	18,027		3.14	%
		FHLB advances			566,329		11,397		4.00			476,265		10,293		4.30
		Senior notes			—		—		—			25,778		1,611		12.50
		Capital securities			51,000		1,528		5.99			23,967		903		7.54

			Total interest-bearing liabilities		2,314,260		31,897		2.76			1,682,917		30,834		3.67

	Noninterest-bearing checking				42,959							36,546
	Noninterest-bearing liabilities				34,775							19,864
	Stockholders’ equity				166,369							122,457

			Total liabilities and stockholders’ equity	$	2,558,363						$	1,861,784

Net interest income						$	41,253						$	34,078

Interest rate spread									3.11	%						3.33	%

Net interest margin									3.31	%						3.68	%

(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 $1.1 million for the six months ended June 30, 2003 and net deferred loan fees earned of $49 thousand for the six months ended June 30, 2002.
(3)		Excludes investment securities awaiting settlement.

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 and the repricing or maturity of the Company’s liabilities which include deposits, FHLB advances and capital securities, (3) the speed at which loans and investment securities prepay and the impact of internal interest rate floors, (4) the magnitude of the Company’s assets which do not earn interest, including nonaccrual loans and REO and (5) the acquisition of First Fidelity on August 23, 2002.

The Company’s net interest income (after provision for credit losses) was $19.7 million for the second quarter of 2003, which was lower than the prior quarter of $21.1 million. This decrease was primarily due to the Company’s yield on earning assets reducing faster than the Company’s cost of funds. This is a result of the significant prepayments of higher yielding loans and due to the fact that 67.6% of the Company’s funding sources have rates that are contractually fixed.

The Bank is a variable rate lender and although the static gap report shows that the balance sheet is asset sensitive, the current repricing behavior more closely approximates a liability sensitive balance sheet, as the majority of its adjustable-rate loans have reached their contractual floors. As of June 30, 2003, 93.27% of the loans in the Bank’s loan portfolio were adjustable rate, of which approximately 66.2%, or $1.4 billion, have reached their internal interest rate floors and thus have taken on fixed rate characteristics. The variable rate loans are priced at a margin over various market

sensitive indices, including MTA (36.9% of the portfolio), LIBOR (34.8% of the portfolio), CMT (10.3% of the portfolio), Prime (9.8% of the portfolio), and COFI (7.8% of the portfolio).

The Company initiated treasury activities in June 2002, to manage and redirect liquidity into an investment securities portfolio with durations of less than four years. As of June 30, 2003, the Company had an investment portfolio of $345.7 million in book value and earned $2.6 million with a yield of 3.14% during the second quarter and $5.6 million with a yield of 3.43% for the first six months. The Company treats these investments as available-for-sale investment securities and has reflected the unrealized gains or losses, net of deferred taxes, associated with the changes in the market prices in accumulated other comprehensive income as part of its stockholders’ equity.

At June 30, 2003, 60.7% of the Bank’s interest-bearing deposits were comprised of certificates of deposit accounts (“CDs”), with an original weighted average term of 14.3 months, compared with 63.2% with an original weighted average term of 14.5 months at December 31, 2002. The remaining weighted average term to maturity for the Bank’s CDs approximated 7.3 months at June 30, 2003, compared with 7.7 months at December 31, 2002 and 5.7 months at June 30, 2002. Generally, the Bank’s offering rates for CDs move directionally with the general level of short-term interest rates, though the margin may vary due to competitive pressures.

As of June 30, 2003, 100% of the Bank’s borrowings from the FHLB were fixed rate, with remaining terms ranging from 1 day to 8 years, compared with 81.0% with remaining terms ranging from 1 day to 8 years at December 31, 2002 and 1 year to 8 years at June 30, 2002 (though such remaining terms are subject to early call provisions). The remaining 19% of the borrowings at December 31, 2002 carried adjustable interest rates and matured in the first quarter of 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 June 30, 2003 and 2002
		Increase (Decrease) Due to Change In

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

Interest-earning assets:
	Loans receivable (2)	$	8,665		$	(4,998	)	$	(1,425	)	$	2,242
	Investment securities (3)		2,553			—			(19	)		2,534
	Investment in capital stock of Federal Home Loan Bank		135			(145	)		(51	)		(61	)
	Cash, fed funds and other		(698	)		73			(72	)		(697	)

			10,655			(5,070	)		(1,567	)		4,018

Interest-bearing liabilities:
	Deposits		4,175			(2,189	)		(1,076	)		910
	FHLB advances		887			(379	)		(65	)		443
	Senior notes		(805	)		—			—			(805	)
	Capital securities		304			(98	)		(50	)		156

			4,561			(2,666	)		(1,191	)		704

Change in net interest income		$	6,094		$	(2,404	)	$	(376	)	$	3,314

(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.
(3)		Excludes investment securities awaiting settlement.

Total Interest Revenue—Three Months Analysis

The increase in interest revenue of $4.0 million, or 12.7%, during the three months ended June 30, 2003, compared with the same period in 2002 was primarily attributable to an increase of $2.5 million earned on investment securities and $2.2 million earned on loans receivable.

Contributing to the increase in interest revenue was a $471.9 million increase in average loans outstanding principally due to the acquisition, which was partially offset by a 121 basis point decrease in the yield on average loans receivable. The decline in the Company’s weighted average yield was a result of downward repricing of the Company’s adjustable rate loans and the weighted average interest rate on loan payoffs exceeding the weighted average interest rate on loan originations. During the three months ended June 30, 2003, both net interest income and net interest margin continued to be adversely impacted as borrowers refinanced loans, which resulted in $201.9 million in prepayments with a weighted average interest rate of 6.89%, while new loan production of $248.7 million reflected an average yield of 5.38% during the same period. As a result, the yield on loans receivable was 6.14% during the three months ended June 30, 2003, compared to 6.40% during the prior quarter and 7.35% during the second quarter 2002.

The increase in average investment securities of $322.8 million was primarily due to deployment of excess liquidity and a shift in earning assets from lower yielding cash and fed funds to higher yielding investment securities. The percentage of average investment securities to average total interest-earning assets increased to 13.3% during the three months ended June 30, 2003 from 0.5% during the same period in 2002.

Total Interest Cost—Three Months Analysis

The $0.7 million increase in interest costs during the second quarter of 2003, compared to the same period of 2002, was primarily attributable to a $638.5 million increase in the average balance of interest-bearing liabilities, partially offset by an 86 basis point decrease in the average cost of interest-bearing liabilities.

Average interest-bearing deposits increased $566.2 million principally due to the acquisition, which were partially mitigated by a 76 basis point decrease in the weighted average cost. The reduction in the cost of deposits was the result of the combination of the continued downward pressure on interest rates, maturing certificates of deposit with higher than current market rates, and the shift in the deposit mix. The average balance of certificates of deposit increased $408.5 million, to $1.1 billion with an average cost of funds of 2.32% during the three months ended June 30, 2003, compared with $684.2 million and a 3.16% average cost of funds during the same period in 2002. The average balance of money market accounts reflected an increase of $110.6 million, to $471.2 million with an average cost of funds of 2.19% during the three months ended June 30, 2003, compared with $360.6 million and a 2.91% average cost of funds during the same period in 2002. The Company’s lowering of interest rates on its deposit products resulted primarily from the cumulative 550 basis point reduction in the federal funds target rate by the Federal Reserve from 2001 through 2003.

The average balance of FHLB advances reflected an increase of $80.9 million, partially mitigated by a 32 basis point decrease in the average cost of these borrowings. The $17.2 million increase in the average balance of capital securities outstanding was offset by a 116 basis point decrease in the weighted average cost; over 82% of these capital securities have adjustable rates priced at a margin over LIBOR (see Note 7—“Capital Securities” included herein). The growth in average capital securities was due to the Company’s issuance of $15.0 million (current rate of 4.60%) in capital securities in November of 2002, which was offset by the early payoff of the Company’s balance of its 12.5% Senior Notes ($25.8 million), the majority of which were redeemed on December 31, 2002 at the call premium of 106.25%.


		Six Months Ended June 30, 2003 and 2002
		Increase (Decrease) Due to Change In

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

Interest-earning assets:
	Loans receivable (2)	$	16,759		$	(10,148	)	$	(2,704	)	$	3,907
	Investment securities (3)		5,034			6			446			5,486
	Investment in capital stock of Federal Home Loan Bank		290			(202	)		(77	)		11
	Cash, fed funds and other		(1,161	)		(196	)		191			(1,166	)

			20,922			(10,540	)		(2,144	)		8,238

Interest-bearing liabilities:
	Deposits		8,415			(5,093	)		(2,377	)		945
	FHLB advances		1,946			(708	)		(134	)		1,104
	Senior notes		(1,611	)		—			—			(1,611	)
	Capital securities		1,019			(185	)		(209	)		625

			9,769			(5,986	)		(2,720	)		1,063

Change in net interest income		$	11,153		$	(4,554	)	$	576		$	7,175

(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.
(3)		Excludes investment securities awaiting settlement.

Total Interest Revenue—Six Months Analysis

The increase in interest revenue of $8.2 million, or 12.7%, during the six months ended June 30, 2003, compared with the same period in 2002 was primarily attributable to an increase of $5.5 million earned on investment securities and $3.9 million earned on loans receivable.

Contributing to the increase was a $449.3 million increase in average loans outstanding principally due to the acquisition, which was partially offset by the Company’s 121 basis point decrease in the yield on average loans receivable. During 2003, both net interest income and net interest margin continued to be adversely impacted as borrowers refinanced loans, which resulted in $381.8 million in prepayments with a weighted average interest rate of 7.08%, while new loan production of $485.2 million reflected an average yield of 5.44%, during the same period. As a result, the yield on loans receivable was 6.27% during the six months ended June 30, 2003, compared to 7.48% during the same period in 2002.

The increase in average investment securities of $319.9 million was primarily due to deployment of excess liquidity and a shift in earning assets from lower yielding cash and fed funds to higher yielding investment securities. The percentage of average investment securities to average total interest-earning assets increased to 13.0% during the six months ended June 30, 2003 from 0.2% during the same period in 2002.

Total Interest Cost—Six Months Analysis

The $1.1 million increase in interest costs during the first six months of 2003, compared to the same period of 2002, was primarily attributable to a $631.3 million increase in the average balance of interest-bearing liabilities, partially offset by a 91 basis point decrease in the average cost of interest-bearing liabilities.

Average interest-bearing deposits increased $540.0 million principally due to the acquisition, which were partially mitigated by an 89 basis point decrease in the weighted average cost. The reduction in the cost of deposits was the result of the combination of the continued downward pressure on interest rates, maturing certificates of deposit with higher than current market rates, and the shift in the deposit mix. The average balance of certificates of deposit increased $357.7 million, to $1.1 billion with an average cost of funds of 2.37% during the six months ended June 30, 2003, compared with $730.7 million and a 3.42% average cost of funds during the same period in 2002. The average balance of money market accounts reflected an increase of $136.1 million, to $457.8 million with an average cost of funds of 2.24% during the six

months ended June 30, 2003, compared with $321.7 million and a 2.91% average cost of funds during the same period in 2002.

As a percentage of total average interest-bearing deposits, transaction accounts have decreased slightly to 35.9% for the six months ended June 30, 2003, compared with 36.8% of total average interest-bearing deposits during the same period in 2002. During the last half of 2003, approximately $447.7 million of CDs are scheduled to mature, which represents approximately 25.3% of total deposits. The weighted average cost of these CDs is 2.33%, which is approximately 1.00% higher than the current 6 month CD rate. Other initiatives that the Company has undertaken to reduce the overall cost of funds include repricing a number of its deposit products.

Since the acquisition of the Orange County and San Diego branches in August 2002, the Company has more than doubled the balances in checking accounts, and increased the number of accounts in these branches by approximately 67%. Deposits in these branches have decreased by $28 million, primarily as a result of higher costing certificates of deposit maturing. At the end of 2002, the cost of funds in these branches was 98 basis points higher than the cost of funds at other branches. As of June 30, 2003, that differential narrowed to 68 basis points. The Bank’s goal is to continue to work to improve the mix of deposits at these branches, building core customers and lowering the overall cost of funds.

The average balance of FHLB advances reflected an increase of $90.1 million, partially mitigated by a 30 basis point decrease in the average cost of these borrowings. The $27.0 million increase in the average balance of capital securities outstanding was offset by a 155 basis point decrease in the weighted average cost; over 82% of these capital securities have adjustable rates priced at a margin over LIBOR (see Note 7—“Capital Securities” included herein). The growth in average capital securities was due to the Company’s issuance of $22.0 million (current rate of 4.99%) and $15.0 million (current rate of 4.60%) in capital securities in April and November of 2002, respectively, which was offset by the early payoff of the Company’s balance of its 12.5% Senior Notes ($25.8 million), the majority of which were redeemed on December 31, 2002 at the call premium of 106.25%.

Provision for Credit Losses

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.

Provision for credit losses were $0.1 million and $0.4 million for the three and six months ended June 30, 2003, respectively, compared with and $0.2 million and $0.7 million for the same periods in 2002. The decrease in the provision for credit losses was due to the overall improvement in asset quality. At June 30, 2003, classified assets totaled $18.6 million, or 0.71% of total Bank assets, compared to $45.1 million, or 2.41% of total Bank assets, a year earlier. Year-to-date, classified assets have decreased $5.1 million, or approximately 21.6%. During the second quarter, nonaccrual loans increased by $1.3 million primarily as a result of the addition of two single family residential loans, offset by the payoff of one development multi-family loan. However, the ratio of nonaccrual loans to total loans of 0.37% remains lower than the Bank’s peer group. At June 30, 2003, the ratio of total allowance for credit losses to loans receivable, net of specific valuation allowance, was 1.65%, compared with 1.64% at December 31, 2002 and 1.77% at June 30, 2002. Additionally, total classified assets to Bank core capital and GVA for credit losses was 8.05% at June 30, 2003, compared with 10.81% at December 31, 2002 and 23.04% at June 30, 2002.

Noninterest Revenues

Noninterest revenues were $2.2 million and $3.7 million for the three and six months ended June 30, 2003, respectively, an increase of 80.1% and 48.3%, compared with $1.2 million and $2.5 million during the same periods in 2002, attributable, in part, to the acquisition. Loan related and other fees were $1.1 million and $2.0 million for the three and six months ended June 30, 2003, respectively, compared with $0.8 million and $1.6 million, during the same periods of 2002 and 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 Bank’s loan) and (3) in connection with certain loans which contain exit or release fees payable to the Bank upon the maturity or repayment of the Bank’s loan. Loan related and other fees constituted 50.1% and 53.2% of noninterest revenues for the three and six months ended June 30, 2003, respectively, compared to 66.1% and 65.8% during the same period in 2002. During both periods, these fees were comprised primarily of prepayment fees resulting from the high level of refinancings.

Noninterest revenues also include deposit fee income for service fees, nonsufficient fund fees and other miscellaneous check and service charges. Fee income on deposits increased 28.4% and 25.3%, during the three and six months ended June 30, 2003, respectively, compared with the same periods in 2002, as a result of the growth in core transaction deposits and other fee generating initiatives. The Company continues to expand its product array, which includes a new courtesy overdraft program. As a result of the cross selling efforts by the Company’s employees, the ratio of products per household increased to 2.64 at June 30, 2003, compared with 2.46 for the prior quarter.

More than one-half of the other fee income of $0.8 million for the six months ended June 30, 2003, is primarily comprised of commission income from the sale of investment products and the increased value of bank owned life insurance (“BOLI”), which was purchased on March 31, 2003.

Real Estate Owned

The following table sets forth the costs and revenues attributable to the Bank’s real estate owned (“REO”) properties for the periods indicated.


		Three Months Ended June 30,								Six Months Ended June 30,

(Dollars in thousands)		2003			2002		Change			2003			2002			Change

(Expense)/income associated with real estate operations:
	Repairs, maintenance, renovation and other	$	(4	)	$	—	$	(4	)	$	(3	)	$	(19	)	$	16
Net recoveries from sales of REO			—			—		—			—			87			(87	)
Property operations, net			—			—		—			—			1			(1	)

(Expense)/income from real estate operations, net		$	(4	)	$	—	$	(4	)	$	(3	)	$	69		$	(72	)

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. The Bank owned no REO properties during the six months ended June 30, 2003, compared with the sale of one property generating net cash proceeds of $1.4 million and a net recovery of $87 thousand during the same period in 2002.

Noninterest Expense

General and Administrative Expense

The table below details the Company’s general and administrative expense for the periods indicated.


		Three Months Ended June 30,							Six Months Ended June 30,

(Dollars in thousands)		2003		2002		Change			2003		2002		Change

Employee		$	5,475	$	4,700	$	775		$	11,665	$	9,732	$	1,933
Operating			2,278		1,516		762			4,679		3,019		1,660
Occupancy			1,390		941		449			2,576		1,855		721
Professional			339		599		(260	)		786		706		80
Technology			535		371		164			1,084		740		344
SAIF premiums and OTS assessments			165		132		33			330		268		62
Other/legal settlements			38		—		38			264		20		244

	Total	$	10,220	$	8,259	$	1,961		$	21,384	$	16,340	$	5,044

G&A increased to $10.2 million and $21.4 million, respectively, for the three and six months ended June 30, 2003, compared with $8.3 million and $16.3 million incurred during the same periods in 2002. The increase in G&A for the six months ended June 30, 2003 was primarily attributable to the acquisition of First Fidelity. Employee related expense increased primarily due to increased headcount resulting from the inclusion of First Fidelity employees; the average number of full time equivalent employees increased by 97 for the six months ended June 30, 2003, compared to the same period in 2002. Operating expense increased primarily due to advertising, insurance, additional supplies, higher contributions and amortization of the core deposit intangible, primarily resulting from the acquisition. Occupancy increased primarily due to rent for the acquired First Fidelity locations. Annualized G&A (excluding other/legal settlements) to average assets decreased to 1.65% for the six months ended June 30, 2003, compared with 1.84% for the year ended December 31, 2002. The Company has been successful in significantly reducing G&A as a percentage of average assets in each of the last five years. The Company’s efficiency ratio was 46.99% for the six months ended June 30, 2003, which was better than the 47.62% achieved during the first quarter of 2003 and the 48.07% achieved during the year ended 2002.

FINANCIAL CONDITION, CAPITAL RESOURCES & LIQUIDITY AND ASSET QUALITY

ASSETS

Investment Securities

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


				June 30, 2003

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

Investment securities
	Investment securities available-for-sale:
		Mortgage-backed securities (MBS)		$	297,369	$	2,420	$	325	$	299,464
		Collateralized mortgage obligations (CMO)			48,366		324		—		48,690

			Total investment securities available-for-sale		345,735		2,744		325		348,154
	Investment securities awaiting settlement				30,354		—		—		30,354

			Total investment securities	$	376,089	$	2,744	$	325	$	378,508

The contractual maturities of MBS and CMO investment securities available-for-sale, excluding periodic principal payments and reductions due to estimated prepayments, at June 30, 2003 were as follows:


				Available-for-Sale:

								Weighted
				Net Balance		Fair		Average
(Dollars in thousands)				At Cost		Value		Yield (1)

Investment securities
	Investment securities available-for-sale:
		After 5 years through 10 years		$	93,483	$	94,217		3.81	%
		Over 10 years			252,252		253,937		3.64	%

			Total investment securities available-for-sale		345,735		348,154		3.68	%
	Investment securities awaiting settlement				30,354		30,354		n/a

			Total investment securities	$	376,089	$	378,508		3.68	% (2)

(1)		Weighted average yield at June 30, 2003 is based on a projected yield using prepayment assumptions in calculating the amortized cost of the securities.
(2)		Excludes investment securities awaiting settlement.

At June 30, 2003, the weighted average effective duration and weighted average life of the Bank’s investment securities portfolio were approximately 2.23 and 3.65 years, respectively. The portfolio had a weighted average coupon of 4.54%. The weighted average book price of the portfolio was 102.41% (net premium of $8.1 million). At June 30, 2003, the Bank did not hold securities of any issuer where the aggregate book value of such securities exceed 10% of stockholders’ equity.

Proceeds from the sales of available-for-sale investment securities during the year were $116.7 million. The Bank recognized a net gain of $79 thousand on the sale of various investment securities ($397 thousand in realized gains and $318 thousand in realized losses) for the six months ended June 30, 2003.

Thirty-three securities with net balances at cost and fair value of $193.7 million and $196.0 million, respectively, at June 30, 2003 were pledged to secure a FHLB advance of $149.0 million. At December 31, 2002, two securities with net balance at cost and fair value of $4.9 million were pledged to secure a FHLB advance of $5.0 million.

Risks Associated with Investment Securities. The securities in the Bank’s investment portfolio (primarily Mortgage Backed Securities) are classified as “available-for-sale.” Changes in the fair value of the investment portfolio result from numerous and often uncontrollable events such as changes in interest rates, prepayment speeds, market perception of risk in the economy and other factors. To the extent that the Bank continues to have both the ability and intent to hold these securities for yield enhancement, changes in the fair value will be included as a component of stockholders’ equity. If a decline in fair value, if any, is deemed to be “other than temporary,” it will be treated as an “impairment” and reflected in earnings. Fluctuations in interest rates may cause actual prepayments to vary from the estimated prepayments over the life of the security. This may result in adjustments to the amortization of premiums or accretion of discounts related to these instruments, consequently changing the net yield on such securities. Reinvestment risk is also associated with the cash flows from such securities.

Loans Receivable

General

The Bank’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 Bank’s loan portfolio as of the dates indicated.


			June 30, 2003						December 31, 2002

(Dollars in thousands)			Balance			Percent			Balance			Percent

Single family residential			$	839,184			37.56	%	$	854,220			38.32	%
Income property:
	Multi-family (1)			733,812			32.85	%		690,137			30.96	%
	Commercial (1)			387,692			17.36	%		391,538			17.57	%
	Development (2)
		Multi-family		73,318			3.28	%		85,655			3.85	%
		Commercial		35,855			1.61	%		49,314			2.21	%
Single family construction:
	Single family residential (3)			126,726			5.67	%		114,637			5.14	%
Land (4)				26,683			1.19	%		32,612			1.46	%
Other				10,726			0.48	%		10,978			0.49	%

Gross loans receivable (5)				2,233,996			100.00	%		2,229,091			100.00	%

Less:
	Undisbursed funds			(107,114	)					(90,596	)
	Deferred costs, net			11,564						11,069
	Allowance for credit losses			(35,341	)					(35,309	)

Net loans receivable			$	2,103,105					$	2,114,255

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


			June 30, 2003				December 31, 2002

			No. of		Average		No. of		Average
(Dollars in thousands)			Loans		Loan Size		Loans		Loan Size

Single family residential				1,384	$	606		1,484	$	576
Income property:
	Multi-family			1,265		580		1,309		527
	Commercial			383		1,012		394		994
	Development:
		Multi-family		23		3,188		26		3,294
		Commercial		8		4,482		12		4,110
Single family construction:
	Single family residential			81		1,565		74		1,549
Land				25		1,067		28		1,165
Other				5		1,456		3		1,967

Total loans, excluding overdrafts				3,174	$	702		3,330	$	668

Overdraft & overdraft protection outstanding				359	$	2		383	$	2

The table below sets forth the Bank’s loan portfolio diversification by loan size.


					June 30, 2003					December 31, 2002

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

Loans in excess of $10.0 million:
	Income property:
		Commercial				2	$	22,337			1	$	11,789
		Development:
				Commercial		1		10,800			2		21,836

						3		33,137			3		33,625

			Percentage of total gross loans					1.48	%				1.51	%
Loans between $5.0 and $10.0 million:
	Single family residential					1		6,437			3		22,984
	Income property:
		Multi-family				6		38,487			3		18,865
		Commercial				6		39,456			5		32,462
		Development:
				Multi-family		4		24,850			6		38,678
				Commercial		2		12,560			4		23,445
	Single family construction:
		Single family residential				1		5,415			2		11,240

						20		127,205			23		147,674

			Percentage of total gross loans					5.70	%				6.62	%
Loans less than $5.0 million								2,073,654					2,047,792

			Percentage of total gross loans					92.82	%				91.87	%
				Gross loans receivable			$	2,233,996				$	2,229,091

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


				June 30, 2003					December 31, 2002

(Dollars in thousands)				Balance		Percent			Balance		Percent

Single family residential				$	836,421		39.33	%	$	851,268		39.81	%
Income property:
	Multi-family				731,983		34.42	%		689,100		32.22	%
	Commercial				381,423		17.93	%		387,354		18.11	%
	Development:
		Multi-family			47,381		2.23	%		57,037		2.67	%
		Commercial			25,972		1.22	%		41,168		1.93	%
Single family construction:
	Single family residential				73,217		3.44	%		75,218		3.52	%
Land					26,659		1.25	%		32,612		1.52	%
Other					3,826		0.18	%		4,738		0.22	%

			Total loan principal (1)	$	2,126,882		100.00	%	$	2,138,495		100.00	%

(1)

Excludes net deferred fees and costs.

The significant drop in the 10-year treasury rate has increased prepayment speeds to an annualized rate of 38% in the second quarter of 2003.

The tables below set forth the approximate composition of the Bank’s gross new loan originations, net of internal refinances of $6.9 million and $19.1 million, respectively, for the periods indicated, by dollars and as a percentage of total loans originated.


				Three Months Ended					Three Months Ended
				June 30, 2003					June 30, 2002

(Dollars in thousands)				Amount		%			Amount		%

Single family residential				$	100,057		40.23	%	$	80,344		50.61	%
Income property:
	Multi-family (1)				89,254		35.88	%		44,890		28.28	%
	Commercial (2)				22,650		9.11	%		8,130		5.12	%
	Development:
		Multi-family (3)			3,420		1.38	%		8,735		5.51	%
		Commercial (4)			2,500		1.00	%		—		—
Single family construction:
	Single family residential (5)				24,067		9.68	%		12,516		7.89	%
Land (6)					6,764		2.72	%		4,116		2.59	%

			Total	$	248,712		100.00	%	$	158,731		100.00	%


				Six Months Ended					Six Months Ended
				June 30, 2003					June 30, 2002

(Dollars in thousands)				Amount		%			Amount		%

Single family residential				$	192,662		39.71	%	$	180,414		53.96	%
Income property:
	Multi-family (1)				150,877		31.09	%		75,436		22.56	%
	Commercial (2)				42,258		8.71	%		17,400		5.21	%
	Development:
		Multi-family (3)			19,677		4.06	%		16,149		4.83	%
		Commercial (4)			9,865		2.03	%		3,807		1.14	%
Single family construction:
	Single family residential (5)				57,687		11.89	%		32,663		9.77	%
Land (6)					12,180		2.51	%		8,467		2.53	%

			Total	$	485,206		100.00	%	$	334,336		100.00	%

(1)		Includes unfunded commitments of $1.6 million and $0.5 million as of June 30, 2003 and June 30, 2002, respectively.
(2)		Includes unfunded commitments of $1.5 million as of June 30, 2002.
(3)		Includes unfunded commitments of $16.8 million and $8.4 million as of June 30, 2003 and June 30, 2002, respectively.
(4)		Includes unfunded commitments of $7.9 million as of June 30, 2003.
(5)		Includes unfunded commitments of $41.2 million and $7.7 million as of June 30, 2003 and June 30, 2002, respectively.
(6)		Includes unfunded commitments of $0.2 million as of June 30, 2003.

Asset Quality

Classified Assets

The table below sets forth information concerning the Bank’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 Bank’s classification policies and Office of Thrift Supervision (“OTS”) regulations and guidelines (“performing/classified” loans).


			June 30,			December 31,			June 30,
(Dollars in thousands)			2003			2002			2002

Risk elements:
	Nonaccrual loans (1)		$	9,649		$	7,675		$	6,081
	Real estate owned, net			—			—			—

				9,649			7,675			6,081
	Performing loans classified substandard or lower (2)			8,904			16,002			38,984

		Total classified assets	$	18,553		$	23,677		$	45,065

		Total classified loans	$	18,553		$	23,677		$	45,065

Loans restructured and paying in accordance with modified terms (3)			$	2,351		$	2,468		$	2,317

Gross loans before allowance for credit losses			$	2,138,446		$	2,149,564		$	1,620,857

Loans receivable, net of specific valuation allowance			$	2,138,070		$	2,149,376		$	1,619,807

Delinquent loans:
	30 - 89 days		$	6,469		$	5,357		$	9,920
	90+ days			6,989			7,175			1,931

		Total delinquent loans	$	13,458		$	12,532		$	11,851

Allowance for credit losses:
	General valuation allowance (“GVA”)		$	34,965		$	35,121		$	27,607
	Specific valuation allowance (“SVA”)			376			188			1,050

		Total allowance for credit losses	$	35,341		$	35,309		$	28,657

Net loan charge-offs:
	Net charge-offs for the quarter ended		$	265		$	664		$	189
	Percent to loans receivable, net of SVA (annualized)			0.05	%		0.12	%		0.05	%
	Percent to beginning of period allowance for credit losses (annualized)			2.99	%		7.40	%		2.64	%
Selected asset quality ratios at period end:
	Total nonaccrual loans to total assets			0.37	%		0.31	%		0.32	%
	Total allowance for credit losses to loans receivable, net of SVA			1.65	%		1.64	%		1.77	%
	Total GVA to loans receivable, net of SVA			1.64	%		1.63	%		1.70	%
	Total allowance for credit losses to nonaccrual loans			366.27	%		460.05	%		471.25	%
	Total classified assets to Bank core capital and GVA			8.05	%		10.81	%		23.04	%

(1)		Nonaccrual loans include five loans totaling $3.5 million, three loans totaling $0.6 million and one loan totaling $0.1 million, in bankruptcy at June 30, 2003, December 31, 2002 and June 30, 2002, respectively. Nonaccrual loans include one troubled debt restructured loan (“TDRs”) at June 30, 2003 for $0.5 million, and none at December 31, 2002 and June 30, 2002.
(2)		Excludes nonaccrual loans.
(3)		Represents TDRs not classified and not on nonaccrual.

The table below sets forth information concerning the Bank’s gross classified loans, by category, as of June 30, 2003.


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

Single family residential			10	$	6,196		10	$	7,452		20	$	13,648
Income property:
	Multi-family		2		661		2		942		4		1,603
	Commercial		3		2,788		1		510		4		3,298
Other			1		4		—		—		1		4

Gross classified loans			16	$	9,649		13	$	8,904		29	$	18,553

Allowance for Credit Losses

The table below summarizes the activity of the Bank’s allowance for credit losses for the periods indicated.


				Three Months Ended						Six Months Ended
				June 30,						June 30,

(Dollars in thousands)				2003			2002			2003			2002

Average loans outstanding				$	2,126,756		$	1,654,830		$	2,135,362		$	1,686,078

Total allowance for credit losses at beginning of period				$	35,506		$	28,676		$	35,309		$	30,602
Provision for credit losses					100			170			400			670
Charge-offs:
	Single family residential				(6	)		(196	)		(6	)		(476	)
	Income Property:
		Commercial			—			—			(100	)		—
		Development:
			Commercial		—			—			—			(2,171	)
			Multi-family		(129	)		—			(129	)		—
	Land				(136	)		—			(136	)		—
	Other				(12	)		—			(24	)		—
Recoveries:
	Commercial				—			—			5			—
	Other				18			7			22			32

Net charge-offs					(265	)		(189	)		(368	)		(2,615	)

Total allowance for credit losses at end of period				$	35,341		$	28,657		$	35,341		$	28,657

Annualized ratio of charge-offs to average loans outstanding during the period					0.05	%		0.05	%		0.03	%		0.31	%

Management decreased the provision for credit losses during 2003, based on the overall improvement in asset quality, as reflected by a $26.5 million decrease in classified assets, to $18.6 million at June 30, 2003, from $45.1 million at June 30, 2002. The Bank’s ratio of classified assets to Bank core capital and GVA improved to 8.05% at June 30, 2003, compared with 10.81% at December 31, 2002, and 23.04% at June 30, 2002. The Bank’s total nonaccrual loans to total assets was 0.37% at June 30, 2003, compared with 0.31% at December 31, 2002, and 0.32% at June 30, 2002. At June 30, 2003, the ratio of total allowance (GVA and SVA) for credit losses to loans receivable, net of SVA, was 1.65%, compared with 1.64% at December 31, 2002 and 1.77% at June 30, 2002.

The table below summarizes the Bank’s allowance for credit losses by category for the periods indicated.


			June 30, 2003								December 31, 2002

								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			$	10,605		30.01	%		1.26	%	$	10,822		30.65	%		1.26	%
Income property:
	Multi-family			9,147		25.88	%		1.24	%		8,517		24.12	%		1.23	%
	Commercial			8,335		23.58	%		2.18	%		7,272		20.60	%		1.87	%
	Development:
		Multi-family		1,242		3.51	%		2.63	%		2,087		5.91	%		3.68	%
		Commercial		636		1.80	%		2.45	%		861		2.44	%		2.08	%
Single family construction:
	Single family residential			1,611		4.56	%		2.21	%		1,317		3.73	%		1.76	%
Land				568		1.61	%		2.14	%		1,211		3.43	%		3.72	%
Other				198		0.56	%		5.21	%		199		0.56	%		4.23	%
Unallocated				2,999		8.49	%		n/a			3,023		8.56	%		n/a

	Total		$	35,341		100.00	%		1.65	%	$	35,309		100.00	%		1.64	%

(1)

Percent of allowance for credit losses to loans receivable, net of SVA.

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 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 currently intends to maintain an unallocated allowance, in the range of between 3% and 5% of the total GVA, for the inherent risk associated with imprecision in estimating the allowance, and an additional amount of up to approximately 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. However, if economic conditions were to deteriorate beyond the weaknesses currently considered by management, it is possible that the GVA would be deemed insufficient for the inherent losses in the loan portfolio and further provision might be required. This could negatively impact earnings for the relevant period.

Management believes that the allowance for credit losses of $35.3 million at June 30, 2003, 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 June 30, 2003 and at December 31, 2002.

On July 21, 2003, the Bank acquired one real estate property through foreclosure, with a carrying value of $2.3 million. This REO was classified as a nonaccrual loan at June 30, 2003.

Other Assets

On March 31, 2003, the Bank invested $25.0 million in bank owned life insurance (“BOLI”) policies. Investments in BOLI are included in other assets with increases in the cash surrender value of these policies recorded as other noninterest revenues.

LIABILITIES

Sources of Funds

General

The Bank’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 investment securities, and sales of loans, investment 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.


				June 30, 2003										December 31, 2002

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

Transaction accounts:
	Noninterest-bearing checking			$	44,970		2.55	%		0.69	%		—	$	39,818		2.39	%		—			—
	Check/NOW				80,857		4.58	%		1.18	%		—		77,648		4.67	%		1.69	%		—
	Passbook				72,553		4.11	%		2.30	%		—		64,662		3.89	%		1.60	%		—
	Money Market				495,627		28.09	%		1.13	%		—		455,218		27.38	%		2.33	%		—

		Total transaction accounts			694,007		39.33	%							637,346		38.33	%

Certificates of deposit:
	7 day maturities				37,320		2.11	%		1.10	%		—		30,793		1.85	%		1.40	%		—
	Less than 6 months				16,924		0.96	%		1.32	%		2		116,857		7.03	%		1.45	%		2
	6 months to 1 year				467,039		26.47	%		1.78	%		4		240,570		14.47	%		2.11	%		3
	1 to 2 years				342,776		19.42	%		2.47	%		7		426,270		25.63	%		2.95	%		7
	More than 2 years				206,663		11.71	%		3.84	%		18		210,974		12.69	%		4.29	%		19

		Total certificates of deposit			1,070,722		60.67	%							1,025,464		61.67	%

			Total	$	1,764,729		100.00	%		1.92	%		7	$	1,662,810		100.00	%		2.51	%		8

(1)

Deposits in excess of $100,000 were 29.9% of total deposits at June 30, 2003 and December 31, 2002, respectively.

FHLB Advances

A primary alternate funding source for the Bank is a line of credit through the FHLB, subject to sufficient qualifying collateral. The FHLB system functions as a source of credit to savings institutions that are members of the FHLB. Advances are secured by the Bank’s mortgage loans, the capital stock of the FHLB owned by the Bank and certain investment securities owned by the Bank. Subject to the FHLB’s advance policies and requirements, these advances can be requested for any business purpose in which the Bank is authorized to engage. In granting advances, the FHLB considers a member’s creditworthiness and other relevant factors. At June 30, 2003, the Bank had an approved line of credit with the FHLB for a maximum advance of up to 45% of the Bank’s total assets. Therefore, as of June 30, 2003, the net funds available to the Company pursuant to the FHLB borrowing arrangement totaled $408.5 million ($1.2 billion, less the advances outstanding of $576.0 million and the outstanding letters of credit used as collateral for state deposits of $215.5 million).

The table below summarizes the balance and rate of FHLB advances, excluding discounts on advances associated with the purchase of First Fidelity, for the dates indicated.


			June 30, 2003					December 31, 2002

(Dollars in thousands)			Principal		Rate (1)			Principal		Rate (1)

Original Term:
	Overnight		$	64,000		1.39	%	$	40,000		1.30	%
	2 Weeks			80,000		1.06	%		—		0.00	%
	24 Months			15,000		4.33	%		23,000		4.51	%
	36 Months			172,000		3.20	%		236,000		2.89	%
	60 Months			80,000		6.18	%		135,000		5.92	%
	84 Months			25,000		4.18	%		25,000		4.18	%
	120 Months			140,000		5.19	%		140,000		5.18	%

		Total	$	576,000		3.67	%	$	599,000		4.12	%

(1)

Weighted average interest rate at period end.

The weighted average remaining term of the Bank’s FHLB advances was 2 years 6 months as of June 30, 2003. At June 30, 2003, 59.9% of the Bank’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 1 to 5 years from origination.

On August 4, 2003, the Bank prepaid $36.0 million of advances with an average life of 9.0 months and replaced them with new advances with an average life of 36 months. The new advances had a lower weighted average cost of 129 basis points as of August 4, 2003.

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 June 30, 2003, amounted to $173.3 million and which equaled 6.6% of the Company’s total assets.

As of June 30, 2003, 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 June 30, 2003, 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 June 30, 2003
	Total capital to risk weighted assets	$	218,004		12.17	%	$	143,364		8.00	%	$	179,205		10.00	%
	Core capital to adjusted tangible assets		195,449		7.56	%		103,346		4.00	%		129,182		5.00	%
	Tangible capital to adjusted tangible assets		195,449		7.56	%		38,755		1.50	%		n/a		n/a
	Tier 1 capital to risk weighted assets		195,449		10.91	%		n/a		n/a		$	107,523		6.00	%
As of December 31, 2002
	Total capital to risk weighted assets	$	206,175		11.68	%	$	141,263		8.00	%	$	176,579		10.00	%
	Core capital to adjusted tangible assets		183,942		7.46	%		98,663		4.00	%		123,329		5.00	%
	Tangible capital to adjusted tangible assets		183,942		7.46	%		36,999		1.50	%		n/a		n/a
	Tier 1 capital to risk weighted assets		183,942		10.42	%		n/a		n/a			105,974		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 maintained cash and cash equivalents of $0.6 million at June 30, 2003. Hawthorne Financial Corporation is a holding company with no significant business operations outside of the Bank. 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 holding company’s capital securities and the acquisition of treasury stock for the foreseeable future.

The Bank’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 the sale of loans and investment securities, commercial bank lines of credit, and direct access, under certain conditions, to borrowings from the Federal Reserve System. The cash needs of the Bank 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. The Bank maintains an adequate level of liquid assets to ensure safe and sound daily operations.

A primary alternate funding source for the Bank is a credit line with the FHLB with a maximum advance of up to 45% of the total Bank assets subject to sufficient qualifying collateral. At June 30, 2003, the Bank had 29 FHLB advances outstanding totaling $576.0 million which had a weighted averaged interest rate of 3.67% and a weighted average remaining term of 2 years and 6 months. See “FHLB Advances” on page 28.

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.

During the six months ended June 30, 2003, the Company repurchased 143,409 shares at an average price of $29.53. As of June 30, 2003, cumulative repurchases were 1,326,392 shares at an average price of $21.81. Currently, $1.6 million remains available for additional share repurchases under existing board approved authorizations.

Issuance of each trust preferred debt obligation (capital securities) is through statutory business trusts and wholly owned subsidiaries of the Company. See “Note 7 – Capital Securities,” contained herein.

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.

The following table shows the Company’s contractual obligations as of June 30, 2003:


		Less than		1-3		3-5		More than
Contractual Obligations		1 year		Years		Years		5 years		Total

(Dollars in thousands)

Long - Term Debt Obligations:
	FHLB Advances	$	180,000	$	231,000	$	20,000	$	145,000	$	576,000
	Capital Securities		—		—		—		51,000		51,000
Operating Lease Obligations			2,352		3,331		1,100		1,717		8,500
Purchase Obligations			591		918		557		279		2,345

Lending Commitments – At June 30, 2003, the Bank had commitments to fund the undisbursed portion of existing construction and land loans of $89.4 million and income property and residential loans of $8.1 million. The Bank’s commitments to fund the undisbursed portion of existing lines of credit totaled $9.6 million. The Company follows the same credit policies in making commitments as it does for on-balance sheet instruments.

In addition, as of June 30, 2003, the Bank had commitments to fund $64.4 million in approved loans.

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 than usual and customary representations and warranties regarding ownership by the Bank.

Other Contractual Obligations – The Company does not have material financial guarantees or other contractual commitments that are reasonably likely to adversely affect liquidity. As of June 30, 2003, the Federal Home Loan Bank issued six letters of credit (“LC”) for a total of $215.5 million. The purpose of the LCs is to fulfill the collateral requirements for six deposits totaling $185.0 million placed by the State of California with the Bank. The LCs are issued in favor of the State Treasurer of the State of California and mature over the next six months. The maturities coincide with the maturities of the State’s deposits. There are no issuance fees associated with these LCs; however, the Bank pays a monthly maintenance fee of 15 basis points per annum.

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 17 – Related Parties” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002. 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 six months ended June 30, 2003. 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

Interest rate risk (“IRR”) and credit risk constitute the two primary sources of financial exposure for insured financial institutions. Please refer to “Item 1 — Business, Loan Portfolio,” in the Bank’s Annual Report on Form 10-K for the year ended December 31, 2002 for a thorough discussion of the Bank’s lending activities. The Bank realizes income principally from the differential or spread between the interest earned on loans, investments, and other interest-earning assets and the interest expensed on deposits and borrowings. IRR represents the impact that changes in the levels of market interest rates may have upon the Bank’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 indices (basis risk), and changes in the shape of the yield curve. Changes in the market level of interest rates directly and immediately affect the Bank’s interest spread, and therefore profitability. Sharp and significant changes to market rates can cause the interest spread to shrink or expand significantly in the near term, principally because of the timing differences between the repricing of the adjustable rate loans and the repricing of the deposits and borrowings, and the changes in the volume of loan prepayments.

As of June 30, 2003, 93.3% of the Bank’s loan portfolio was tied to adjustable rate indices, such as MTA, LIBOR, CMT, Prime and COFI. As of June 30, 2003, $1.4 billion, or 66.2%, of the Bank’s adjustable rate loan portfolio had reached their internal interest rate floors. These loans have taken on fixed rate repricing characteristics until sufficient upward interest rate movements bring the fully indexed rate above the internal interest rate floors. Currently, $278.1 million of the loans at floors are single-family construction and hybrid products that will not reprice for at least one year.

As of June 30, 2003, 54% of the Bank’s investment securities portfolio was fixed rate and the remainder were hybrid, substantially all of which are fixed for 5 years. However, because fluctuations in interest rates may cause actual prepayments to vary from the original estimated prepayments over the life of the security, the net yield is subject to change. This is the result of adjustments to the amortization of premiums or accretion of discounts related to these instruments. Reinvestment risk is also associated with the cash flows from such securities. The unrealized gain/loss on such securities may also be adversely impacted by changes in interest rates.

At June 30, 2003, 60.7% of the Bank’s interest-bearing deposits were comprised of CDs, with an original weighted average term of 14.3 months. The remaining weighted average term to maturity for the Bank’s CDs approximated 7.3 months at June 30, 2003. In the last half of 2003, approximately $447.7 million of CDs are scheduled to mature. The weighted average cost of these CDs is approximately 1.00% higher than the current 6 month CD rate. Generally, the Bank’s offering rates for CDs move directionally with the general level of short-term interest rates, though the margin may vary due to competitive pressures.

As of June 30, 2003, 100% of the Bank’s borrowings from the FHLB were fixed rate, with remaining terms ranging from 1 day to 8 years. However, 59.9% of the Bank’s FHLB advances contain options, which allow the FHLB to call the advances prior to maturity, subject to an initial non-callable period of 1 to 3 years from origination.

The Bank’s Asset/Liability Committee (“ALCO”) is responsible for managing the Bank’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 Bank’s NII and NPV through the matching of its rate-sensitive assets and liabilities by maintaining the maturity and repricing of these assets and liabilities at appropriate levels given the interest rate environment. The speed and velocity of the repricing of assets and liabilities, as well as the presence or absence of periodic and lifetime internal interest rate caps and floors all effect the Bank’s NII and NPV in varying interest rate environments. When the amount of rate-sensitive liabilities exceeds rate-sensitive assets within specified time periods (liability sensitive), 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 (asset sensitive), net interest income will generally be positively impacted by increasing rates and negatively impacted by decreasing rates.

The Bank utilizes internal interest rate floors and caps on individual loans to mitigate the risk of interest margin compression. A risk to the Bank associated with the internal interest rate floors in a declining interest rate environment is that, while the margin is being protected, the borrower may choose to refinance the loan, resulting in the Bank having to

replace the higher-yielding asset at a lower rate. Prepayment speeds remained at high levels in the second quarter of 2003. If this trend continues, it could negatively impact growth in interest earning assets, which in turn could negatively impact net income and NPV calculations. The assumptions being used for the June 30th IRR analysis include a continuation of the current high level of prepayments in the third quarter of 2003, and a decrease in the prepayments during the fourth quarter of 2003 and 2004.

The Bank utilizes two methods for measuring interest rate risk, firstly static gap analysis and secondly interest rate simulations. Gap analysis focuses on measuring absolute dollar amounts subject to repricing within certain periods of time, specifically the one year horizon. Interest rate simulations are produced using a software model that is based on actual cash flows and repricing characteristics for all of the Bank’s financial instruments and incorporates market-based assumptions regarding the impact of changing interest rates on current levels 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 NPV. 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 Risk.”

Static gap is the difference between the amount of assets and liabilities (adjusted for any off-balance sheet positions), which are expected to mature or reprice within a specific period. Although the cumulative static gap position indicates an asset-sensitive position, the Bank’s net interest income will be impacted by the significant amount of adjustable rate loans that have reached floor interest rates in excess of current market rates. In a rising rate environment, the Bank’s liabilities within a cumulative static gap period will reprice upward to market rates while the loan portfolio may not reprice up because of the floors, causing a reduction in net interest income until such time as the rates exceed the floors. Conversely, in a declining rate environment, the Bank’s liabilities will continue to reprice downward, while its loan portfolio remains at its floor rates, thereby creating an increase in net interest income reduced by the impact resulting from accelerated prepayments. Furthermore, a portion of the Bank’s interest sensitive assets and liabilities are tied to indices that may lag changes in market interest rates by three months or more.

The following table sets forth information concerning repricing timeframes for the Bank’s interest-earning assets and interest-bearing liabilities as of June 30, 2003. The amount of assets and liabilities shown within a particular period were determined in accordance with their contractual maturities, except that adjustable rate products, including those loans that have reached their internal interest rate floors are reflected in the earlier period of when they are first scheduled to adjust or mature.


			June 30, 2003

						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)		$	2,063		$	—		$	—		$	—		$	—		$	2,063
	Investments and FHLB stock (2)			33,238			—			—			144,251			193,345			370,834
	Loans receivable (3)			1,330,905			285,749			50,933			349,694			109,601			2,126,882

		Total interest-earning assets	$	1,366,206		$	285,749		$	50,933		$	493,945		$	302,946		$	2,499,779

Interest-bearing liabilities:
	Deposits:
		Non-certificates of deposit	$	649,037		$	—		$	—		$	—		$	—		$	649,037
		Certificates of deposit (4)		298,261			363,167			277,436			130,130			—			1,068,994
	FHLB advances (5) (6)			159,000			—			21,000			251,000			145,000			576,000
	Capital securities			—			42,000			—			—			9,000			51,000

		Total interest-bearing liabilities	$	1,106,298		$	405,167		$	298,436		$	381,130		$	154,000		$	2,345,031

	Interest rate sensitivity gap		$	259,908		$	(119,418	)	$	(247,503	)	$	112,815		$	148,946		$	154,748
	Cumulative interest rate sensitivity gap			259,908			140,490			(107,013	)		5,802			154,748			154,748
	As a percentage of total interest-earning assets			10.40	%		5.62	%		-4.28	%		0.23	%		6.19	%		6.19	%

(1)		Excludes noninterest-earning cash balances.
(2)		Excludes investments’ mark-to-market adjustment, (discounts)/premiums and investment securities awaiting settlement.
(3)		Balances include $9.6 million of nonaccrual loans, and exclude deferred (fees) and costs and allowance for credit losses.
(4)		Excludes discounts on certificates of deposit acquired in connection with the acquisition of First Fidelity.
(5)		Excludes discounts on FHLB advances acquired in connection with the acquisition of First Fidelity.
(6)		The maturity date was used for the repricing model since the borrowing rate exceeded the current market rate by 50 basis points or more.

ITEM 3. Quantitative and Qualitative Disclosure About Market Risk

A sudden and substantial increase or decrease in interest rates may adversely impact the Bank’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 Bank’s primary objective in managing interest rate risk is to minimize the adverse impact of changes in interest rates on the Bank’s net interest income and capital, while structuring the Bank’s asset-liability mix to obtain the maximum yield-cost spread on that structure. The Bank has adopted formal policies and practices to monitor its interest rate risk exposure. As a part of this effort, the Bank uses the NPV methodology to gauge IRR exposure.

Using an internally generated model, the Bank monitors interest rate sensitivity by estimating the change in NPV over a range of interest rate shocks. 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 change 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 interest 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 June 30, 2003, based on the Bank’s internally generated model, it was estimated that the Bank’s NPV ratio was 9.60% in the event of a 200 basis point increase in rates, a decrease of 126 basis points from basecase of 10.86%. If rates were to decrease by 100 basis points, the Bank’s NPV ratio was estimated at 11.33%, an increase of 47 basis points from basecase.

Presented below, as of June 30, 2003, is an analysis of the Bank’s IRR as measured in the NPV for instantaneous and sustained parallel shifts of 100, 200, 300 and -100 basis point increments in market interest rates.


		Net Portfolio Value

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

	+300 bp	$	236,488		(53,058	)		9.24	%	(162)bp
	+200 bp		248,642		(40,903	)		9.60	%	(126)bp
	+100 bp		268,264		(21,281	)		10.22	%	(64)bp
	0 bp		289,545					10.86	%
	-100 bp		305,772		16,227			11.33	%	47bp

Management believes that the NPV methodology overcomes several shortcomings of the typical static 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. Fourth, prepayment behavior can be changed in response to changes in market interest rates. In addition, NPV takes into account the caps and floors on loans. In the table shown above, this is reflected in the losses of value in the up 100 bp, 200 bp and 300 bp scenarios and the gain in value in the down 100 bp scenario. The adjustable rate loans that have reached their floors gain value as rates drop and lose value as rates rise until each loan’s internal rate floor is exceeded.

On a quarterly basis, the results of the internally generated model are reconciled to the results of the OTS model. In the first quarter of 2003, the OTS changed their methodology for establishing discount rates for multi-family and commercial loans by assuming that these loans are carried at market rates, with little premium over face value. This reduced their NPV for the Bank. However, the OTS’ model does not take into account floors on loans. The Bank’s model accounts for the existing floors by increasing the fair market value in the basecase, resulting in an increase to the NPV. This results in analyses that are directionally inconsistent. However, based on both the Bank’s model and the regulatory model, in accordance with the OTS Thrift Bulletin 13a, Management of Interest Rate Risk, the Bank falls within the OTS’ minimal risk category.

ITEM 4. Controls and Procedures

1. Current Controls and Procedures

As of June 30, 2003, 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 June 30, 2003 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 June 30, 2003.

PART II — OTHER INFORMATION

ITEM 1. Legal Proceedings

The Bank is a defendant in a construction defect case entitled Stone Water Terrace HOA v. Future Estates, Hawthorne Savings and Loan Association, et al, which was filed in the Superior Court of the State of California, County of Los Angeles. On June 16, 2003, the Court approved an application for approval of good faith settlement between the plaintiff on the one hand, and the Bank and a number of subcontractor defendants on the other hand (the “Settlement”). The Bank’s contribution to the Settlement was not material to the Company’s financial condition or results of operations and was appropriately accrued in a prior period. Upon satisfaction of the conditions of the Settlement, the complaint against the Bank will be dismissed with prejudice, and the Bank will be released from all further liability in connection with the construction of the Stone Water Terrace development.

The Company is involved in a variety of other 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.

Risks Associated with Litigation. We are, and have been involved, from time to time, in various claims, complaints, proceedings and litigation relating to activities arising from the normal course of our operations, including those discussed herein. Further, our business is primarily conducted in California, which is one of the most highly litigious states in the country. If new facts are developed that would change our current assessment of the litigation matters that we are currently involved in, or if we become subject to significant new litigation, we may incur legal and related costs that could affect our results.

ITEM 2. Changes in Securities

None

ITEM 3. Defaults upon Senior Securities

None

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

The Annual Meeting of Stockholders of the Company was held on May 20, 2003. At the Annual Meeting the following seven nominees were elected until the 2004 Annual Meeting of Stockholders and their successors have been duly elected and qualified as directors.


	Number of Shares
Director	For		Withheld

Gary Brummett		5,820,511		951,719
Timothy R. Chrisman		6,619,629		152,601
Carlton J. Jenkins		6,292,153		480,077
Simone Lagomarsino		6,758,408		8,799
Anthony W. Liberati		6,613,697		158,533
Harry F. Radcliffe		6,616,075		156,155
Howard E. Ritt		6,638,500		133,730

ITEM 5. Other Information

Corporate Governance

The following are some of the key corporate governance practices at the Company, which are oriented to ensure that there are no conflicts of interest and that the Company is operated in the best interest of shareholders:

• Six of the Company’s seven directors are independent outside directors, as defined by National Association of Securities Dealers, Inc.’s (“Nasdaq”) proposed rules regarding independence.

• None of the Company’s executive officers and directors has loans from the Company, other than overdraft lines of credit associated with checking accounts.

• There are no loans by the Company to outside companies controlled by or affiliated with executive officers or directors.

The Company’s Board of Directors has audit, compensation and nominating committees comprised solely of independent outside directors. On May 20, 2003, the non-employee directors of the Board formally reviewed each member of the Board and determined that all of the Board members, except Simone Lagomarsino, President and CEO, qualify as independent directors. Accordingly, Ms. Lagomarsino, as an employee director, is not a member of the audit, compensation or nominating committees.

On May 20, 2003, the non-employee directors of the Board, excluding Gary Brummett, a member of the Audit Committee, reviewed the qualifications and experience of Mr. Gary Brummett, and determined that he qualifies as a “financial expert” under the Company’s current Audit Committee guideline requirements and Section 10A of the Securities Exchange Act of 1934, as amended by the Sarbanes-Oxley Act of 2002.

ITEM 6. Exhibits and Reports on Form 8-K

1. Exhibits


		Exhibit 31.1 – Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

		Exhibit 31.2 – Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

		Exhibit 32.1 – Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

2. Reports on Form 8-K


		The following report on Form 8-K was filed for the three months ended June 30, 2003.

		April 29, 2003 – First Quarter 2003 Earnings Press Release and Conference Call Transcript

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 August 13, 2003		/s/ SIMONE LAGOMARSINO

		Simone Lagomarsino
		President and Chief Executive Officer

Dated August 13, 2003		/s/ DAVID ROSENTHAL

		David Rosenthal
		Executive Vice President and Chief Financial Officer

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	•		Net interest income was positively impacted year-over-year by: 1) inclusion of the net assets from the acquisition of First Fidelity in August 2002, 2) continued strong origination volume of $485.2 million, 3) the majority of ARM loans ($1.4 billion) reaching their contractual floors, 4) income from the investment securities portfolio and 5) the lowering of interest rates on deposits and borrowings.

	•		Net interest income increased 20.1% during the second quarter of 2003, compared to the prior year and was lower than the prior quarter. Net interest margin for the second quarter of 2003 was 3.18% down from 3.44% in the prior quarter and 3.56% a year earlier. The reduction in the net interest margin compared to the prior quarter was largely due to a 26 basis point reduction in yields on loans outstanding due to new loans being originated at lower yields from the loans that are prepaying. This was partially offset by a reduction in the company’s cost of funds of 11 basis points.

	•		Year-to-date provision for credit losses decreased by $0.3 million, reflecting management’s evaluation of the allowance for credit losses and the risk inherent in the Company’s portfolio. At June 30, 2003, classified assets totaled $18.6 million, or 0.71% of total Bank assets, compared to $45.1 million, or 2.41% of total Bank assets, a year earlier. Year-to-date, classified assets have decreased $5.1 million, or approximately 21.6%. During the second quarter, nonaccrual loans increased by $1.3 million. However, the ratio of nonaccrual loans to total loans of 0.37% remains lower than the Bank’s peer group. At June 30, 2003, the ratio of total allowance for credit losses to loans receivable, net of specific valuation allowance, was 1.65%, compared with 1.64% at December 31, 2002 and 1.77% at June 30, 2002.

	•		For the six months ended June 30, 2003, noninterest revenues were $3.7 million, a 48.3% increase, compared to the $2.5 million earned during the same period in 2002. Loan and other related fees constituted 53.2% of noninterest revenues for the six months ended June 30, 2003, compared to 65.8% during the same period in 2002. During both periods, these fees were comprised primarily of prepayment fees resulting from the high level of refinancings. Fee income on deposits increased 25.3% for the first six months of 2003, compared with the same period in 2002, primarily due to growth in core transaction deposits and other fee generating initiatives.

	•		Year-to-date total general and administrative expense (“G&A”) increased by $5.0 million primarily due to additional costs as a result of the acquisition of First Fidelity. The ratio of G&A (excluding other/legal settlement) to average assets improved to 1.65% for the six months ended June 30, 2003, compared with 1.84% for the year ended December 31, 2002, which reflects the Company’s continued emphasis on efficiency.

	•		Six of the Company’s seven directors are independent outside directors, as defined by National Association of Securities Dealers, Inc.’s (“Nasdaq”) proposed rules regarding independence.

	•		None of the Company’s executive officers and directors has loans from the Company, other than overdraft lines of credit associated with checking accounts.

	•		There are no loans by the Company to outside companies controlled by or affiliated with executive officers or directors.