Page No.
PART I - FINANCIAL INFORMATION
Item 1.	Financial Statements
	Consolidated Balance Sheets as of September 30, 2004 (unaudited) and December 31, 2003	1
	Consolidated Statements of Operations for the three and nine months ended
	September 30, 2004 and 2003 (unaudited)	2
	Consolidated Statement of Changes in Stockholders’ Equity for the nine months
	ended September 30, 2004 (unaudited)	3
	Consolidated Statements of Cash Flows for the nine months ended
	September 30, 2004 and 2003 (unaudited)	4
	Notes to Consolidated Financial Statements	5
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	16
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	45
Item 4.	Controls and Procedures	49
PART II - OTHER INFORMATION
Item 1.	Legal Proceedings	49
Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	51
Item 3.	Defaults Upon Senior Securities	51
Item 4.	Submission of Matters to a Vote of Security Holders	51
Item 5.	Other Information	51
Item 6.	Exhibits and Reports on Form 8-K	51
Signatures		52

 

			September 30, 2004			December 31, 2003
(Dollars in thousands, except for share data)			(Unaudited)			(Audited)
Assets:
Cash and cash equivalents		$	5,349		$	4,576
Mortgage loans held for sale, net			130,372			190,524
Mortgage loans held for investment, net of discounts and deferred origination fees			1,636,180			--
Less: Allowance for loan losses			(5,788	)		--
Mortgage loans held for investment, net			1,630,392			--
Trustee receivable			17,163			--
Accrued interest receivable			8,701			197
Excess cashflow certificates			16,709			19,853
Equipment, net			3,983			3,147
Accounts receivable			5,826			2,893
Prepaid and other assets			28,244			4,617
Deferred tax asset			39,833			31,184
Total assets		$	1,886,572		$	256,991
Liabilities and Stockholders’ Equity
Liabilities:
Bank payable		$	1,298		$	2,292
Warehouse financing			57,901			144,826
Financing on mortgage loans held for investment, net			1,712,675			--
Other borrowings			2,934			2,362
Accrued interest payable			2,629			62
Accounts payable and other liabilities			20,789			11,496
Total liabilities			1,798,226			161,038
Stockholders’ Equity:
Preferred stock, Series A, $100 preference value. Authorized 150,000 shares, 139,156 shares outstanding at December 31, 2003			--			13,916
Common stock, $.01 par value. Authorized 49,000,000 shares; 20,358,599 and 17,032,052 shares issued and 20,241,799 and 16,915,252 shares outstanding at  September 30, 2004 and December 31,2003, respectively			204			170
Additional paid-in capital			119,220			99,913
Accumulated deficit			(28,152	)		(16,728	)
Accumulated other comprehensive loss, net of taxes			(1,608	)		--
Treasury stock, at cost (116,800 shares)			(1,318	)		(1,318	)
Total stockholders’ equity			88,346			95,953
Total liabilities and stockholders’ equity		$	1,886,572		$	256,991

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		Three Months Ended September 30,						Nine Months Ended September 30,
(Dollars in thousands, except share and per share data)			2004			2003			2004			2003
Interest income		$	30,809		$	3,253		$	56,853		$	9,223
Interest expense			12,317			1,373			19,740			3,848
Net interest income			18,492			1,880			37,113			5,375
Provision for loan losses			3,113			--			5,813			--
Net interest income after provision for loan losses			15,379			1,880			31,300			5,375
Non-interest income:
Net gain on sale of mortgage loans			2,630			25,783			11,883			69,878
Other income			393			298			597			897
Total non-interest income			3,023			26,081			12,480			70,775
Non-interest expense:
Payroll and related costs			13,435			10,816			37,589			28,307
General and administrative			7,928			6,005			21,616			18,002
Loss on derivative instruments			7			--			146			--
Total non-interest expense			21,370			16,821			59,351			46,309
(Loss) income before income tax (benefit) expense			(2,968	)		11,140			(15,571	)		29,841
Provision for income tax (benefit) expense			(1,149	)		(30,455	)		(6,007	)		(30,152	)
Net (loss) income		$	(1,819	)	$	41,595		$	(9,564	)	$	59,993
Other Comprehensive (Loss) Income:
Net unrealized holding losses on derivatives arising during the period			(1,653	)		--			(1,608	)		--
Other comprehensive (loss) income		$	(3,472	)	$	41,595		$	(11,172	)	$	59,993
Per Share Data:
Basic - weighted average number of shares outstanding			19,347,154			16,283,420			17,744,372			16,132,909
Diluted - weighted average number of shares outstanding			19,347,154			18,543,094			17,744,372			18,453,931
Net (loss) income applicable to common shares		$	(1,819	)	$	41,595		$	(9,564	)	$	59,297
Basic earnings per share - net (loss) income		$	(0.09	)	$	2.55		$	(0.54	)	$	3.68
Diluted earnings per share - net (loss) income		$	(0.09	)	$	2.24		$	(0.54	)	$	3.21

 

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		Nine Months Ended September 30,
(Dollars in thousands)		2004			2003
Cash flows from operating activities:
Net (loss) income		$	(9,564	)	$	59,993
Adjustments to reconcile net income to net cash used in operating activities:
Provision for loan losses			5,813			--
Provision for recourse loans			--			88
Depreciation and amortization			1,416			1,245
Deferred tax benefit			(7,621	)		(30,143	)
Deferred origination costs			(1,731	)		(534	)
Gain on change in fair value of excess cashflow certificates			(307	)		(220	)
Amortization and fair value change of bond securitizations
deferred cost and premiums			(3,617	)		--
Cash flows received from excess cashflow certificates, net of
new excess cashflow certificates received in securitization			3,451			(5,001	)
Proceeds on sale of excess cashflow certificates			--			10,220
Proceeds from sale of mortgage servicing rights			12,342			--
Changes in operating assets and liabilities:
Increase in accounts receivable			(2,933	)		(406	)
Decrease (increase) in mortgage loans held for sale, net			61,668			(101,041	)
Increase in trustee receivable, net			(17,163	)
Increase in accrued interest receivable			(8,918	)		1
Increase in prepaid and other assets			(23,959	)		(1,083	)
Increase (decrease) in accrued interest payable			2,567			(245	)
Increase in accounts payable and other liabilities			8,846			1,647
Net cash provided by (used in) operating activities			20,290			(65,479	)
Cash flows from investing activities:
Increase in mortgage loans held for investment, net			(1,647,129	)		--
Purchase of equipment			(2,252	)		(1,471	)
Net cash used in investing activities			(1,649,381	)		(1,471	)
Cash flows from financing activities:
(Repayment of) proceeds from warehouse financing, net			(86,925	)		68,657
Proceeds of financing on mortgage loans held for investment, net			1,712,634			--
Proceeds from (repayment of) other borrowings, net			572			(637	)
Decrease in bank payable			(994	)		(77	)
Redemption of preferred stock			(13,916	)		--
Redemption of senior notes			--			(87	)
Cash dividends paid on preferred stock			--			(696	)
Cash dividends paid on common stock			(848	)		--
Proceeds from common stock issued in secondary offering, net			18,741			--
Proceeds from exercise of warrants			--			4
Proceeds from exercise of stock options			600			274
Net cash provided by financing activities			1,629,864			67,438
Net increase in cash and cash equivalents			773			488
Cash and cash equivalents at beginning of period			4,576			3,405
Cash and cash equivalents at end of period		$	5,349		$	3,893
Supplemental Information:
Cash paid during the period for:
Interest		$	17,173		$	4,094
Income taxes		$	1,719		$	853
Non cash transactions:
Dividends payable		$	1,012		$	--
Unrealized losses on derivatives		$	(1,608	)	$	--

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(1)  Basis of Presentation

(2)  Basis of Consolidation

(3)  Summary of Significant Accounting Policies

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In securitization transactions structured to be accounted for a sales (prior to 2004), the excess cash flow certificates may represent one or all of the following assets: (1) residual interest (“BIO”) certificates, (2) P certificates (prepayment penalty fees), (3) payments from our interest rate cap providers, and (4) net interest margin (“NIM&# 148;) owner trust certificates. Our excess cashflow certificates are classified as “trading securities” in accordance with SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” The amount initially recorded for the excess cashflow certificates at the date of a securitization structured as a sale reflected their allocated fair value. The amount recorded for the excess cashflow certificates is reduced for cash distributions received, and is adjusted for income accretion and subsequent changes in the fair value in accordance with SFAS No. 140. Any changes in fair value are recorded as a component of “other income” in our consolidated statement of operations. For the three and nine months ended September 30, 2004, we recorded $307,000 of income due to an increase in the fair value of excess cashflow certificates. For the three and nine months ended September 30, 2003, we recorded no fair value adjustments related to excess cashflow certificates.

Our securitizations of mortgage loans during the first nine months of 2004 were structured to be accounted for as a secured financing. Under this securitization structure, the securitization trust holds mortgage loans as assets (referred to as “securitized loans”) and issues debt represented by securitization pass-through certificates. Accordingly, the securitized loans are recorded as an asset on our balance sheet under “mortgage loans held for investment, net” and the corresponding debt is recorded as a liability under “financing on mortgage loans held for investment.” This structure recognizes the related revenue as interest on mortgage loans held for investment and the related expense as interest expense on the bond financi ng. In contrast, the structures we used prior to 2004 required us to record virtually all of the income as an upfront gain on sale of mortgage loans under SFAS No. 140. We plan to continue to structure our securitizations to be accounted for as secured financings, which eliminates gain-on-sale accounting treatment. Consequently, income that would have otherwise been recognized upfront as net gain on sale of mortgage loans under our prior securitization structure is now, beginning in 2004, recognized as net interest income (interest income received on the mortgage loans less the interest expense on the corresponding securitization debt) over the life of the loans. We believe structuring, and therefore accounting for, securitizations as secured financings should provide a relatively more consistent source of income from these transactions in future years.

Through 2003, we derived the substantial majority of our revenue and cash flow from selling mortgage loans through securitizations, structured and accounted for as sales, which required gain-on-sale accounting treatment under SFAS No. 140. Additionally, we also sold loans on a whole loan basis. We selected the outlet depending on market conditions, relative profitability and cash flows.

We apply the net proceeds from securitizations and whole loan sales to pay down our warehouse lines of credit - in order to make available capacity under these facilities for future funding of mortgage loans - and utilize any additional funds for working capital.

The following table sets forth certain information regarding loans sold through our securitizations and on a whole loan basis during the three months and nine months ended September 30, 2004 and 2003:

		Three Months Ended September 30,						Nine Months Ended September 30,
(Dollars in thousands)		2004			2003			2004			2003
Loan securitizations - gain-on-sale(1)		$	--		$	448,246		$	113,927		$	1,044,111
Loan securitizations - portfolio based			639,999			--			1,709,990			--
Whole loan sales			49,236			12,242			90,660			33,578
Total securitizations and whole loan sales		$	689,235		$	460,488		$	1,914,577		$	1,077,689

(1)  For the nine months ended September 30, 2004, we delivered $113.9 million of mortgage loans under a pre-funding feature in our fourth quarter 2003 securitization and recorded gain-on-sale revenue related thereto during the first quarter of 2004. Because the fourth quarter 2003 securitization was structured as a sale, we recorded gain-on-sale revenue during the nine months ended September 30, 2004 when we delivered the loans under the pre-funding feature to the securitization trust in January 2004.

Securitizations

Securitizations, whether structured as a sale or secured financing, effectively provide us with a source of long-term financing.

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In a securitization, we pool together loans, typically each quarter, and sell these loans to a newly formed securitization trust. For securitizations structured as a sale, the securitization trust is formed as a qualified special purpose entity or QSPE (which is not consolidated for financial reporting purposes). For securitizations structured as a financing, the securitization trust is formed as a special purpose entity or SPE (which is consolidated for financial reporting purposes). These trusts are established for the limited purpose of buying our mortgage loans and are bankruptcy remote - meaning that purchasers of asset-backed securities may rely on the cash flows generated from the assets held by the securitization trust for payment and not upon the u s for payment; likewise, the assets held by the securitization trust are not available to our general creditors. We carry no contractual obligation related to these trusts or the loans sold to them, nor do we have any direct or contingent liability related to the trusts, except for the standard representations and warranties typically made as part of a sale of loans on a non-recourse basis. Furthermore, we provide no guarantees to investors with respect to the cash flow or performance of these trusts.

The securitization trust raises cash to purchase the mortgage loans from us by selling securities to the public. These securities, known as “asset-backed pass-through securities,” are secured, or backed, by the pool of mortgage loans purchased by the securitization trust from us. These asset-backed securities, or senior certificates, which are usually purchased by insurance companies, mutual funds and/or other institutional investors, represent senior interests in the cash flows (principal and interest payments) from the mortgage loans in the trust.

In our securitizations, the securitization trust issues senior certificates, which entitle their holders to receive the principal collected, including prepayments of principal, on the mortgage loans in the trust. In addition, holders receive a portion of the interest paid on the loans in the trust equal to the pass-through interest rate on the remaining principal balance of the pass-through certificates. Depending upon the structure, the securitization trust may also issue interest-only certificates, which entitle the holders to receive payments of interest at a predetermined rate over a fixed period of time. The securitization trust also issues other certificates i.e. a BIO certificate, and a P certificate (which entitles the holder to receive prepayment p enalties received from borrowers who payoff their loans early). For securitizations structured as sales, we recorded an upfront gain at the time of securitization and generally capitalized excess cashflow certificates on our balance sheet. For securitizations structured to be accounted for as secured financings, no up front gain is recorded; rather, the mortgage loans that underlie the excess cashflow certificates are recorded on our balance sheet as mortgage loans held for investment, together with the related financing on the mortgage loans held for investment.

Each month the holder of an excess cashflow certificate will receive payment only after all required payments have been made on all the other securities issued by the securitization trust, because the excess cashflow certificates are subordinate in right of payment to all other securities issued by the securitization trust. In addition, before the holder of the excess cashflow certificate receives payments, the excess cash flows are applied in a “waterfall” manner as follows:

	·	first, to cover any losses on the mortgage loans in the related mortgage pool;
	·	second, to reimburse the bond insurer, if any, of the related series of pass-through certificates for amounts paid by or otherwise owing to that insurer;
	·	third, to build or maintain the required level of the overcollateralization provision, as described below, for that securitization trust by applying the funds as an accelerated payment of principal to the holders of the pass-through certificates of the related series;
	·	fourth, to reimburse holders of the subordinate certificates of the related series of pass-through certificates for unpaid interest and for any losses previously allocated to those certificates; and
	·	fifth, to pay “the net rate cap carryover” which relates to the interest on the related pass-through certificates that exceeded the maximum net interest amount available from the mortgage loans underlying the securitization trust.

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Each of our securitizations contains an overcollateralization provision, or O/C, which is a credit enhancement that is designed to protect the securities sold to the securitization pass-through investors from credit losses, which arise principally from defaults on the underlying mortgage loans. In short, overcollateralization occurs when the amount of collateral (i.e., mortgage loans) owned by a securitization trust exceeds the aggregate amount of senior pass-through certificates. The O/C is created to absorb losses that the securitization trust may su ffer, as loans are liquidated at a loss. Beginning with our 2002 securitizations, and in each of our subsequent securitizations, we created the O/C by initially selling pass-through securities totaling approximately 97% to 98.5% of the total amount of mortgage loans sold to the trust. In doing so, we created the full amount of the O/C required by the trust at the time we completed the securitization, instead of over time. For example, if a securitization trust contains collateral of $100 million principal amount of mortgage loans, and our O/C requirement is 2%, we issue approximately $98 million in senior pass-through certificates. Prior to 2002, we generally built up the O/C typically over the first 18 to 24 months of a securitization (with the specific timing depending upon the structure, amount of excess spread, and performance of the securitization), by utilizing the cash flows from the excess cash flow to make additional payments of principal to the holders of the pass-through certificates until the req uired O/C level was reached. We typically issued pass-through certificates for a par purchase price, or a slight discount to par - with par representing the aggregate principal balance of the mortgage loans backing the asset-backed securities. For example, if a securitization trust contained collateral of $100 million of mortgage loans, we typically received close to $100 million in proceeds from the sales of those certificates, depending upon the structure we used for the securitization.

The O/C is generally expressed as a percentage of the initial mortgage loan or collateral principal balance sold to the securitization trust. The required O/C is initially determined by either the rating agencies and/or the bond insurer, if any, using various factors, including:

·	Characteristics of the mortgage loans sold to the trust, such as credit scores of the borrowers and loan-to-value ratios;
·	The amount of excess spread between the interest rate on the pool of mortgage loans sold to the securitization trust and the interest paid to the pass-through certificate holders, less the servicing fee, and other related expenses such as trustee fees and bond insurer fees, if any; and
·	The structure of the underlying securitization (e.g., issuing BBB- certificates creates greater credit enhancement in the securitization transaction, which generally results in a lower O/C).

Our securitizations have typically required an O/C of between 1.05% and 3.0% of the initial mortgage loans sold to the securitization trust. The required O/C can increase or decrease throughout the life of the transaction depending upon subordination levels, delinquency and/or loss tests and is subject to minimums and maximums, as defined by the rating agencies and/or the bond insurer insuring the securitization. In our securitizations prior to 2002, after the O/C requirement was reached, the excess cash flows are then distributed to us if we are the holder of the excess cashflow certificates in accordance with the “waterfall” described above. Over time, if the cash collected during the period exceeds the amount necessary to maintain the required O/C, all other required distributions have been made, and there is no shortfall in the related required O/C, the excess is remitted to us as holder of the excess cashflow certificate.

Each securitization trust also has the benefit of either a financial guaranty insurance policy from a monoline insurance company or a “senior-subordinated” securitization structure, or a combination of the two (referred to as a “hybrid”). In a securitization trust with a financial guaranty insurance policy, all bonds are senior certificates. The monoline insurance company guarantees the timely payment of principal and interest to the senior certificate holders in the event that the cashflows in the waterfall are not sufficient.  In “senior-subordinated” securitization structures, the senior certificate holders are protected from losses (and payment shortfalls) first by the excess cashflows and the O/C, then by subordinated certificates which absorb any losses prior to the senior certificate holders. In a hybrid structure, the senior certificates generally have both the subordinated certificates to absorb losses and a monocline insurance company that guarantees timely principal and interest payments.

We began utilizing a new securitization structure in 2002, in which we completed a concurrent net interest margin, or NIM, transaction. In a NIM transaction, the excess cashflow certificate is sold without recourse to a NIM trust, except for standard representations and warranties. The NIM trust issues NIM note(s) that one or more third party investors will purchase. The NIM trust uses the net proceeds to provide us with consideration for the excess cashflow certificate.

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The NIM note(s) entitles the holder to be paid a specified interest rate, and further provides for all cash flows generated by the excess cashflow certificate to be used to pay all principal and interest on the NIM note(s) until paid in full, which typically occurs approximately 20-25 months from the date the NIM note(s) were issued. The excess cashflow certificate entitles us to all cash flows generated by the excess cashflow certificate after the holder of the NIM note(s) has been paid in full.

As part of a NIM transaction, we are required by the rating agencies, and the NIM structure itself, to “fully fund” the O/C at closing - as opposed to having it build up over time as we had in past securitizations - which is why we sold senior pass-through certificates totaling approximately 1.05% to 3.00% less than the principal amount of mortgage loans we sold to the securitization trust. We use a portion of the net proceeds we receive from selling NIM note(s) to make up for the difference between (1) the principal amount of the mortgage loans sold, and (2) the proceeds from selling the senior pass-through certificates.

NIM transactions generally have enabled us to generate upfront cash flow from the cash proceeds that we receive when the securitization and related NIM transaction close, net of funding the upfront O/C, securitization and NIM costs, to offset a substantial portion of our cost to originate the loans included in the transaction.

 

In the securitizations and related NIM transactions we completed prior to 2004, the underlying securitization was structured as a sale under SFAS No. 140. In these transactions, we recorded the net cash proceeds generated from the sale of the NIM notes as a component of our net gain on sale of mortgage loans. Under this structure, we also retained, and recorded as a component of our net gain on sale of mortgage loans, a relatively small excess cashflow certificate. We recorded the excess cashflow certificates at their estimated fair value, which normally ranged from 0.0% to 1.0% of the securitized collateral. Conversely, beginning with our first quarter 2004 securitization, the NIM transactions have been structured to be accounted for as a secured financing , no gain-on-sale was recorded; rather the amount of NIM notes is recorded as a component of the financing on mortgage loans held for investment, net (a liability) on our balance sheet. The change to secured financing accounting from gain-on-sale accounting has not changed the overall economics of the transaction. Only the timing of income recognition and how it is recorded on our financial statements has been affected by the change in accounting. The use of portfolio-based accounting structures will result in differences in our future expected results of operations as compared to historic results.

Securitizations Structured as a Sale - Off-Balance Sheet Arrangements. On securitizations structured as sales, we recorded gain-on-sale revenue upon the closing of each such securitization. For example, in each of the four securitizations that we issued in 2003, we derived, and recorded as gain-on-sale revenue, the following economic interests:

·	we received a cash purchase price from the sale of the NIM note(s) issued by a NIM trust to which we sold the excess cashflow certificates;
·	we received a cash purchase price from the sale of interest-only certificates, which entitles the holders to receive payments of interest at a pre-determined rate over a fixed period of time;
·	we received a cash purchase price from selling the right to service the loans that we securitized. This right entitles the contractual servicer to service the loans on behalf of the securitization trust and earn a contractual servicing fee, and ancillary servicing fees, including prepayment penalties, in some cases, relating to the servicing rights we previously sold;
·	we retained an excess cashflow certificate, which entitles us to receive cash flow generated from the excess cashflow certificate issued in connection with the securitization after the holder of the NIM note(s) has been paid in full. Although the cash flows generated by the excess cashflow certificates are received over time, under GAAP, we were required to report as income at the time of the securitization the present value of all projected cash flow we expected to receive in the future based upon an assumed discount rate. Our valuation of these excess cashflow certificates is primarily based on:

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·	our estimate of the amount of expected losses or defaults that will take place on the underlying mortgage loans over the life of the mortgage loans;
·	the expected amount of prepayments on the mortgage loans due to the underlying borrowers of the mortgage loans paying off their mortgage loans prior to their stated maturities;
·	the LIBOR forward curve, using current LIBOR as the floor rate; and
·	a discount rate.

 

At the time we completed the 2003 securitizations, we recognized as revenue each of the economic interests described above, which were recorded as net gain-on-sale of mortgage loans in our consolidated statement of operations. Our net investment in the pool of loans sold at the date of the securitization represented the amount originally paid to originate the loans, adjusted for the following:

·	Any direct loan origination costs incurred (an increase in the investment) and loan origination fees received (a decrease in the investment) in connection with the loans, which are treated as a component of the initial investment in loans;
·	The principal payments received, and the amortization of the net loan fees or costs, during the period we held the loans prior to their securitization; and
·	Any gains (a decrease in the investment) or losses (an increase in the investment) we incurred on any hedging instruments that we may have utilized to hedge against the effects of changes in interest rates during the period we hold the loans prior to their securitizations (See “-Summary of Critical Accounting Policies - Accounting for Hedging Activities”).

We allocated our basis in the mortgage loans and excess cashflow certificates between the portion of the mortgage loans and excess cashflow certificates sold through securitization and the portion retained based on the relative fair values of those portions on the date of sale. We may recognize gains or losses attributable to the changes in fair value of the excess cashflow certificates, which are recorded at estimated fair value and accounted for as “trading” securities. We are not aware of any active market for the sale of our excess cashflow certificates. Accordingly, our estimate of fair value is subjective. Although we believe that the assumptions we use are reasonable, there can be no assurance as to the accuracy of the assumptions or estima tes. The valuation of our excess cashflow certificates requires us to forecast interest rates, mortgage principal payments, prepayments and loan loss assumptions, each of which is highly uncertain and requires a high degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our excess cashflow certificates. Management uses internal, historical mortgage loan performance data and forward LIBOR curves to value future expected excess cash flows. We regularly analyze and review our assumptions to determine whether the expected return (interest income) on our excess cashflows certificates is within our expected range.

 

Securitizations Structured as a Financing. In the first nine months of 2004, we completed three securitizations, which were structured as secured financings. We intend to utilize this structure in the foreseeable future. The securitizations were structured for accounting purposes as secured financings under SFAS No. 140. The 2004 securitizations do not meet the QSPE criteria under SFAS No. 140 and related interpretations, because, after the loans are securitized, we have the uncon ditional right to repurchase from the trust up to one percent of the aggregate outstanding principal balance of the mortgage loans at any time subsequent to the securitization closing date. Additionally, the 2004 securitizations do not meet the QSPE criteria as we have the option to contribute a derivative instrument in to the trust. Prior securitization transactions met the QSPE criteria under SFAS No. 140 and were accounted for, recognized and recorded as a sale.

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Accordingly, the securitization trust holds mortgage loans as assets (referred to as “securitized loans”) and issues debt represented by securitization pass-through certificates. For financial reporting purposes, the securitized loans are recorded on our balance sheet as an asset under the line item “mortgage loans held for investment, net” and the corresponding debt is recorded as a liability under the line item “financing on mortgage loans held for investment, net.” On securitizations where we utilize a pre-funding feature, which enables us to deliver loans after the closing date of the securitization, we will record an asset - proceeds due from securitization trust - during the pre-funding period. The proceeds due from secur itization trust represents the balance of the cash proceeds remaining in the securitization trust that were received in connection with the trust issuing pass-through certificates and a NIM note in excess of the mortgage loans delivered to the securitization trust at closing. Upon delivering the subsequent eligible pool of mortgage loans, the trustee for the securitization trust will release the securitization trust proceeds, which will be used to repay any warehouse financing used to finance the subsequent pool of mortgage loans and to replenish our working capital. As this structure is a financing, no gain-on-sale revenue is recorded at the time the securitization is closed. Rather, we record interest income from the securitized loans and interest expense from the pass-through certificates issued in connection with the securitization over the life of the securitization. Deferred securitization debt issuance costs are amortized on a level yield basis over the estimated life of the bonds. We also defer on ou r balance sheet, as a component of mortgage loans held for investment, net the incremental direct fees and costs to originate the loans in accordance with SFAS No. 91, which are amortized on a level yield basis over the estimated life of the related loans using the interest method calculation. In addition, we allocate a portion of the accounting basis of the mortgage loans held for investment to the mortgage servicing rights, which results in a discount to the mortgage loans held for investment. The cost basis (fair value) of the MSR is determined based upon the price a third party servicer is willing to pay for the contract right to service that loan in the securitization. The allocation of the cost basis between the loan and the MSR, in accordance with SFAS No. 140, generally results in a discount being created on the loan retained in the securitization. That discount is accreted as an adjustment to yield on the mortgage loans over the estimated life of the related loans using the interest method calculati on.

Since we began structuring our securitizations in 2004 as secured financings, and recording our income over time instead of upfront, there is a significant difference in our results of operations in the three and nine months ended September 30, 2004 as compared to pre-2004 historical results. As such we do not expect historical results will provide a meaningful comparison to 2004 results. We believe that secured financing accounting treatment, however, more closely matches the recognition of income with the receipt of cash payments on the individual loans.

Despite carrying the securitized loans and the securitization financing on our financial statements, we are not legally required to make payments to the holders of the asset-backed pass-through securities issued as part of our securitizations. We are similarly not required to do so with respect to our prior securitizations. Rather, the holders of the pass-through certificates only recourse is related to the repayment from the underlying mortgages specifically collateralizing the debt. As with past securitizations, we have a potential liability to the securitization trust for any breach of the standard representations and warranties that we provide in connection with each securitization. Mortgage loans held for investment are not available to satisfy our gen eral creditors.

The following table sets forth information about our securitized mortgage loan portfolio at September 30, 2004:

(Dollars in Thousands)		Issue Date			Current Loan Principal Balance (1)			Current Pass-Through Certificate Balance (2)
Asset-backed Certificate Series:
2004-1			March 29, 2004		$	518,354		$	510,654
2004-2			June 25, 2004			509,447			493,847
2004-3			September 28, 2004			639,999			623,359
Total					$	1,667,800		$	1,627,860

(1)  The current loan principal balance shown includes amounts reflected on the consolidated balance sheet as mortgage loans held for investment and trustee receivables.

(2)  The current pass-through certificate (financing on mortgage loans held for investment) balance shown excludes discounts of $1.3 million at September 30, 2004.

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Whole Loan Sales. We also sell small pools of loans, on a servicing-released basis, at a premium above the unpaid principal balance, net of any deferred origination fees or costs, on the pool of mortgage loans. The premiums we receive from the loan sales are recorded as revenue under net gain on sale of mortgage loans at the time of sale. The average premium, net of reserves, we received for the loans sold in the nine months ended September 30, 2004 was 4.6%, compared to 4.8% for the comparable period one year ago.

We maintain a premium recapture reserve related to our contractual obligation to rebate a portion of any premium paid by a purchaser when a borrower prepays a sold loan within an agreed period of time. The premium recapture reserve is established at the time of the loan sale through a provision for losses, which is reflected as a reduction of the gain on sale of mortgage loans. The premium recapture reserve is recorded as a liability on the consolidated balance sheet. We estimate losses due to premium recaptures on early loan prepayments by reviewing loan product and interest rate, borrower prepayment fee, if any, and estimate the impact of future interest rate changes. The premium recapture reserve totaled $172,000 and $79,000 at September 30, 2004 and December 31, 2003, respectively. We recorded a pr ovision, net of reversals, for losses related to premium recapture of $89,000 and $173,000 for the three and nine months ended September 30, 2004, respectively. We recorded refunds related to premium recapture of $27,000 and $80,000 for the three and nine months ended September 30, 2004, respectively.

For the nine months ended September 30, 2004, we sold $90.7 million of mortgage loans on a servicing released basis.

 

Other Income. In addition to the income and cash flows we earn from securitizations (accounted for as sales and secured financings) and whole loan sales, we also earn income and generate cash flows from:

	·	the interest earned on mortgage loans while we hold the mortgage loans in inventory less the interest expense we pay to our warehouse lenders to fund our loans;
	·	any fair value adjustments related to the excess cashflow certificates;
	·	distributions from Delta Funding Residual Exchange Company LLC (the “LLC”), an unaffiliated limited liability company, which holds excess cashflow certificates. We have a non-voting membership interest in the LLC, which entitles us to receive 15% of the net cash flows from the LLC through June 2004 and, thereafter, 10% of the net cash flows from the LLC. We have not received our distributions since the second quarter of 2003 due to a dispute with the LLC’s President which has led us to commence a lawsuit to recover all of the amounts due to us. (See “-Part II, Item 1. - Legal Proceedings”); and
	·	miscellaneous interest income, including prepayment penalties received on some of the mortgage loans we sold in connection with our securitizations prior to 2002.

 

Summary of Critical Accounting Policies

Excess Cashflow Certificates. In securitization transactions structured to be accounted for a sales (prior to 2004), the excess cash flow certificates represent one or all of the following assets:

	·	BIO certificate - typically represents a subordinate right to receive excess cashflow, if any, generated by the related securitization pool. As a holder of the BIO certificate, we have the right to receive the difference, if any, between the interest payments due on the mortgage loans sold to the securitization trust and the interest payments due, at the pass-through rates, to the holders of the pass-through certificates of the same series, net of contractual servicing fees, trustee fees, insurer premiums, reimbursements and other costs and expenses of administering the securitization trust. As a holder of the BIO certificate, we will receive cash payments (which, when we sell NIM notes, is only received after the NIM notes are paid in full) only to the extent that the cash received by the securitization trust exceeds the amounts owed on all of the securities issued by that securitization trust, including amounts needed for the payment of any trust related expenses.
	·	P certificate - typically represents a right to receive prepayment penalties on the mortgage loans sold to the securitization trust. Generally, prepayment penalties are received from borrowers who pay off their loans within the first few years of the term of the notes (which, when we sell NIM notes, is only received after the NIM notes are paid in full).
	·	Interest rate cap - generally acquired by us to hedge variable rate securitization financing. We receive payments on interest rate caps from our third party interest rate cap providers.

 

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The excess cash flows we receive are highly dependent upon the interest rate environment, because “basis-risk” exists between the securitization trust’s assets and liabilities. For example, in each of the securitizations that we issued in 2003 and 2002, the excess cashflow certificates are impacted by the securitization pass-through rate sold to investors, which is indexed against the one-month LIBOR. As a result, the interest rate received by the pass-through certificate holders from the securitization trust each month may adjust upwards or downwards as the one-month LIBOR changes (liability) - while the majority of the underlying mortgage loans (assets) in the securitization trust are fixed-rate loans, or are at a fixed-rate for at least tw o to three years before becoming adjustable-rate loans. As a result, as rates rise and fall, the amount of our excess cash flows will fall and rise, respectively. This in turn will increase or decrease the fair value of our excess cashflow certificates. The excess cashflow certificates held at September 30, 2004 are those we acquired before we began to structure our securitizations to be accounted for as secured financings in 2004.

In each of our securitizations in which we sold NIM note(s), we purchased an interest rate cap, which helps mitigate the basis risk for the approximate time that the NIM notes are anticipated to be outstanding.

The accounting estimates we use to value excess cashflow certificates are deemed to be “critical accounting estimates” because they can materially affect our income. The valuation of our excess cashflow certificates requires us to forecast interest rates, mortgage principal payments, prepayments, index rates and loan loss assumptions, each of which is highly uncertain and requires a high degree of judgment. The rate used to discount the projected cash flows is also critical in the valuation of our excess cashflow certificates. Management uses internal, historical mortgage loan performance data and forward LIBOR curves to value future expected excess cash flows. We believe that the value of our excess cashflow certificates at the date of a securiti zation reflected their fair value. The amount recorded for the excess cashflow certificates is subsequently reduced for cash distributions we receive, increased for the expected return and adjusted for changes in fair value of these excess cashflow certificates.

At the closing date of each securitization transaction structured and accounted for as a sale, we determined the present value of the excess cashflow certificates using the same assumptions we made regarding the underlying mortgage loans. The excess cashflow certificate is then recorded on our consolidated financial statements at its estimated fair value. The value of each excess cashflow certificate represents the cash flow we expect to receive in the future based upon our best estimates. Our estimates primarily include the following:

·	future rate of prepayment of the mortgage loans - the expected amount of prepayments if the underlying borrowers pay off their mortgage loans prior to the expected maturity;
·	credit losses (default rates) on the mortgage loans - our estimated amount of losses or defaults that will take place on the underlying mortgage loans over their life because the excess cashflow certificates are subordinated to all other securities issued by the securitization trust. Consequently, any losses sustained on mortgage loans comprising a particular securitization trust are first absorbed by the excess cashflow certificates;
·	the LIBOR forward curve (using current LIBOR as the floor rate) - our estimate of future interest rates, which affects both the rate paid to the floating rate pass-through security investors (primarily the one-month LIBOR index) and the rates earned from the adjustable rate mortgage loans sold to the securitization trust (which typically provide for a fixed-rate of interest for the first 24 or 36 months and a six-month variable rate of interest thereafter using the six-month LIBOR index); and
·	a discount rate used to calculate present value.

 

We monitor the performance of the loans underlying each excess cashflow certificate, and any changes in our estimates resulting in a change in fair value of the excess cashflow certificates is reflected as a change in fair value of excess cashflow certificates recorded in the statement of operations as a component of “other income” in the period in which we make the change in our estimate. Although we believe that the assumptions we use are reasonable, there can be no assurance as to the accuracy of the assumptions or estimates.

In determining the fair value of each of the excess cashflow certificates, we make the following underlying assumptions regarding mortgage loan prepayments, mortgage loan default rates, the LIBOR forward curve and discount rates:

A.  Prepayments. We base our prepayment rate assumptions on our ongoing analysis of the performance of the mortgage pools we previously securitized, and the performance of similar pools of mortgage loans securitized by others in the industry. We apply different prepayment speed assumptions to different loan product types based on our experience with different loan product types exhibiting different prepayment patterns. Generally, our loans can be grouped into two loan products - f ixed-rate loans and adjustable-rate loans. With fixed-rate loans, an underlying borrower’s interest rate remains fixed throughout the life of the loan. Our adjustable-rate loans are a “hybrid” between fixed- and adjustable-rate loans, in that the interest rate generally remains fixed, typically for the first two or three years of the loan, and then adjusts, typically every six months thereafter. Within each product type, factors other than interest rates can affect our prepayment rate assumptions. These factors include:

·	whether or not a loan contains a prepayment penalty, which is the amount a borrower must pay to a lender if the borrower prepays the loan within a certain time period after the loan was originated. Historically, loans containing a prepayment penalty typically are not repaid as quickly as those without a penalty; and
·	as is customary in our industry with adjustable-rate mortgage loans, the introductory interest rate we charge to the borrower is lower, between one and two full percentage points, than the rate for which the borrower would have otherwise qualified. Generally, once the interest rate begins to adjust, the interest rate payable on that loan generally increases, at times at a fairly substantial rate. This interest rate increase can be exacerbated if there is an absolute increase in interest rates. As a result of these increases, and the potential for future increases, adjustable rate mortgage loans typically are more susceptible to early prepayments.
	There are several reasons why a loan may prepay prior to its maturity, including but not limited to:
·	a decrease in interest rates;
·	improvement in the borrower’s credit profile, which may allow the borrower to qualify for a loan with a lower interest rate;
·	competition in the mortgage market, which may result in lower interest rates being offered to the borrower;
·	the borrower’s sale of the home securing the mortgage;
·	the borrower’s need for additional funds; and
·	a default by the borrower, resulting in foreclosure by the lender.
	It is unusual for a borrower to prepay a mortgage loan during the first few months because:
·	it typically takes at least several months after the mortgage loans are originated for any of the above events to occur;
·	there are costs involved with refinancing a loan; and
·	the borrower does not want to incur prepayment penalties.

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We have found that the rate at which borrowers prepay their loans tends to fluctuate. In general, prepayment speeds are lowest in the first month after origination, as described above. Thereafter, prepayment speeds generally increase until a peak speed is reached. Generally, loans will continue to prepay at the peak speed for some period of time, and then prepayment speeds typically begin to decline. We use prepayment assumptions that reflect these tendencies. The following table shows our current assumptions regarding the percentage of loans that will be prepaid during the first month following the closing of a loan, and the peak speed.

Loan Type		Month One		Peak Speed
Fixed rate		4.00%		35.00% to 40.00%
Adjustable rate		4.00%		75.00%

If mortgage loans prepay faster than anticipated, we generally will earn less income in connection with the mortgage loans and receive less excess cash flow in the future because the mortgage loans have paid off. Conversely, if mortgage loans prepay at a slower rate than anticipated, we generally earn more income and more excess cash flow in the future, subject to other factors that can affect the cash flow from, and our valuation of, the excess cashflow certificates.

B.  Default Rate. The default rate is the percentage of estimated total loss of principal, interest and related advances that will take place over the life of the mortgage loans within a loan pool to the total original principal balance of the mortgage loans in the pool. A default rate is determined for each securitization reflecting the overall credit scores, average loan sizes and layered risks on the fixed- and adjustable-rate loans comprising each securitization trust. We appl y a default or loss rate to the excess cashflow certificate because it is the “first-loss” piece and is subordinated in right of payment to all other securities issued by the securitization trust. If defaults are higher than we anticipate, we will receive less income and less excess cash flow than expected in the future. Conversely, if defaults are lower than we expected, we will receive more income and more excess cash flow than expected in the future, subject to the other factors that can affect the cash flow from, and our valuation of, the excess cashflow certificates. The current default rates applied on the excess cashflow certificates range from 4.5% to 8.0%, with the majority ranging from 4.5% to 5.0%.

C.  LIBOR Forward Curve. The LIBOR forward curve is used to project future interest rates, which affects both the rate to the floating rate pass-through security investors (primarily one-month LIBOR) and the adjustable rate mortgage loans sold to the securitization trust (a fixed-rate of interest for either the first 24 or 36 months and a variable rate of interest thereafter using six-month LIBOR). Most of our loans are fixed-rate mortgages, and a significant amount of the securit ies sold by the securitization trust are floating-rate securities (the interest rate adjusts based upon an index, such as one-month LIBOR). As such, our excess cashflow certificates are subject to significant basis risk and a change in LIBOR will impact our excess spread. If LIBOR is lower than anticipated, we will receive more income and more excess cash flow than expected in the future, subject to the other factors that can affect the cash flow from, and our valuation of, the excess cashflow certificates. Conversely, if LIBOR is higher than expected, we will receive less income and less excess cash flow than expected in the future. In each of our securitizations in which we sold NIM note(s), we purchased an interest rate cap, which helps mitigate the basis risk for the approximate time that the NIM notes are outstanding. We have adjusted the valuation of each excess cashflow certificate to use a forward interest rate curve that represents both today’s rates and the expectation for rates in the future. We use a forward LIBOR curve that we believe reflects the estimate of future LIBOR rates.

D.  Discount Rate. We use a discount rate that we believe reflects the risks associated with our excess cashflow certificates. Due to the unavailability of quoted market prices on comparable excess cashflow certificates, we compare our valuation assumptions and performance experience to our competitors in the non-conforming mortgage industry. Our discount rate takes into account the asset quality and the performance of our securitized mortgage loans compared to that of the industr y and other characteristics of our securitized loans. We quantify the risks associated with our excess cashflow certificates by comparing the asset quality and payment and loss performance experience of the underlying securitized mortgage pools to comparable industry performance. The discount rate we use to determine the present value of the cash flow from excess cashflow certificates reflects increased uncertainty surrounding current and future market conditions, including, without limitation, uncertainty concerning inflation, recession, home prices, interest rates and conditions in the equity markets.

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We utilized a discount rate of 15% at September 30, 2004 and 2003 on all excess cashflow certificates.

Our valuation of retained excess cashflow certificates is highly dependent upon the reasonableness of our assumptions and the predictiveness of the relationships that drive the results of our valuation model. The assumptions we utilize, described above, are complex, as we must make judgment calls about the effects of matters that are inherently uncertain. As the number of variables and assumptions affecting the possible future resolution of the uncertainties increase, those judgments become even more complex.

In volatile markets, like those we have experienced over the past several years, there is increased risk that our actual results may vary significantly from our assumed results. The longer the time period over which the uncertainties exist, the greater the potential for volatility in our valuation assumptions and thus impacting the fair value of our excess cashflow certificates.

For example, assumptions regarding prepayment speeds, defaults and LIBOR rates are used in estimating fair value of our excess cashflow certificates. If loans prepay faster than estimated, or loan loss levels are higher than anticipated, or LIBOR is higher than anticipated, a reduction in the fair value of these certificates will be recorded in earnings. We believe that our assumptions are reasonable based upon the estimates using our historical loan performance and the performance of similar mortgage pools from other lenders - in addition to accessing other public information about market factors such as interest rates, inflation, recession, unemployment and real estate market values, among other things. However, these are just estimates and it is virtuall y impossible to predict the actual level of prepayments and losses, which are also driven by consumer behavior.

Accounting for Hedging Activities. We regularly issue securitization pass-through certificates, backed by fixed- and variable-rate mortgage loans. As a result of this activity, we are exposed to interest rate risk beginning when our mortgage loans close and are recorded as assets, until permanent financing is arranged, such as when the pass-through certificates are issued. Our strategy is to use interest rate swap contracts in an effort to lock in a pre-determined base interest rate on designated portions of our prospective future securitization financing. At times, we also use corridors that are designed to limit our financing costs within t he securitization to maintain minimum margins, with the possibility of allowing us to increase margins in lower than anticipated interest rate environments. Both the interest rate swaps and corridors are derivative instruments that trade in liquid markets, and neither is used for speculative purposes.

In accordance with SFAS No. 133, we record all derivatives on our balance sheet at fair value. For derivative financial instruments not designated as hedging instruments, gains or losses resulting from a change in fair value, are recognized in current period earnings. When derivatives are used as hedges, however, hedge accounting is permitted only if we document the hedging relationship and its effectiveness at the time we designate the derivative as a hedge instrument. If we meet certain requirements under SFAS No. 133, we may account for the hedge instrument as a hedge.

Cash flow hedge accounting is appropriate for hedges of uncertain cash flows associated with future periods - whether as a consequence of interest to be received or paid on existing variable rate assets or liabilities or in connection with intended purchases or sales.

Under cash flow hedge accounting treatment, derivative results are divided into two portions, “effective” and “ineffective.” The effective portion of the derivative's gain or loss is initially reported as a component of Other Comprehensive Income or Loss (“OCI”) and subsequently reclassified into earnings when the forecasted transaction affects earnings. The ineffective portion of the gain or loss is reported in earnings immediately.

To qualify for cash flow accounting treatment:

·	hedges must be documented, with the objective and strategy stated, along with an explicit description of the methodology used to assess and measure hedge effectiveness;
·	dates (or periods) for the expected forecasted events and the nature of the exposure involved (including quantitative measures of the size of the exposure) must be explicitly documented;
·	hedges must be expected to be “highly effective,” both at the inception of the hedge and on an ongoing basis. Effectiveness measures must relate the gains or losses of the derivative to changes in the cash flow associated with the hedged item;
·	forecasted transactions must be probable; and
·	forecasted transactions must be made with different counterparties other than the reporting entity.

 

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If and when hedge accounting is discontinued, typically when it is determined that the hedge no longer qualifies for hedge accounting, the derivative will continue to be recorded on the balance sheet at its fair value, with gains or losses being recorded in earnings.

Accounting for Income Taxes. Significant management judgment is required in developing our provision for income taxes, including the determination of deferred tax assets and liabilities and any valuation allowances that might be required against the deferred tax asset. At September 30, 2004, we did not maintain a valuation allowance against our deferred tax assets due to management’s belief that our operating income will more likely than not be sufficient to realize the benefit of these assets over time. The evaluation of the need for a valuation allowance takes into consideration our recent earnings history, current tax position and est imate of taxable income in the near term.

Significant judgment is required in considering the relative impact of negative and positive evidence related to the ability to realize deferred tax assets. If our actual results differ from these estimates, we may be required to record a valuation allowance on our deferred tax assets, which could negatively impact our consolidated financial condition and results of operations. We recognize all of our deferred tax assets if we believe, on a more likely than not basis, that all of the benefits of the carryforward losses and other deferred tax assets will be realized. Management believes that, based on the currently available evidence, it is more likely than not that we will realize that benefit from our deferred tax assets.

Allowance for Loan Losses on Mortgage Loans Held for Investment. In connection with our 2004 securitizations, which we structured to be accounted for as secured financings with the underlying mortgage loans held for investment, we established an allowance for loan losses based on an estimate of losses to be incurred in the foreseeable future. We will charge off uncollectible loans at the time they are deemed not probable of collection.

In order to estimate an appropriate allowance for losses on loans held for investment, we estimate losses using detailed analysis of historical loan performance data. This data is analyzed for loss performance and prepayment performance by product type, origination year and securitization issuance. The results of that analysis are then applied to the current long-term mortgage portfolio held for investment and an estimate is created. In accordance with SFAS No. 5, we believe that pooling of mortgages with similar characteristics is an appropriate methodology in which to evaluate the amount of the allowance for loan losses. A provision for loan losses is charged to our consolidated statement of operations. Losses incurred, if any, will be written-off against the allowance.

While we will continually evaluate the adequacy of this allowance, we recognize that there are qualitative factors that must be taken into consideration when evaluating and measuring potential expected losses on mortgage loans. These items include, but are not limited to, current performance of the loans, economic indicators that may affect the borrower’s ability to pay, changes in the market value of the collateral, political factors and the general economic environment. As these estimates are influenced by factors outside of our control and as uncertainty is inherent in these estimates, it is reasonably possible that they could change. In particular, if conditions were such that we were required to increase the provision for loan losses, any increase in the provision for loan losses may negatively impact our results of operations.

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Results of Operations

Three Months Ended September 30, 2004 Compared to the Three Months Ended September 30, 2003

General

Our net loss for the three months ended September 30, 2004 was $1.8 million, or $(0.09) per share basic and diluted, compared to net income of $41.6 million, or $2.55 per share basic and $2.24 per share diluted, for the three months ended September 30, 2003. The loss resulted from our third quarter 2004 securitization that was structured to be accounted for as a secured financing, instead of a sale; consequently, we did not record any gain-on-sale revenue in connection with this securitization and will instead record interest income from the securitized loans and interest expense from the pass-through certificates issued in connection with the securitization over the life of the securitization. Conversely, our third quarter 2003 securitization was structured as a sale under SFAS No. 140, requiring us t o record an upfront gain-on-sale equal to the present value of the estimated cash flows we expected to receive over the life of the securitization. Additionally, the third quarter of 2003 net income was significantly impacted by a tax benefit of $30.5 million, or $1.87 per share basic and $1.64 per share diluted, recorded during the quarter.

We recorded net interest income of $18.5 million during the third quarter of 2004, an increase of $16.6 million, from the $1.9 million recorded in the same period in 2003. The increase in interest income primarily reflects the net effect of recognizing interest income on $1.6 billion of mortgage loans held for investment compared to no such loans held for investment in the prior period, and similarly the increase in interest expense primarily reflects the net effect of recognizing interest expense on $1.7 billion on financing on mortgage loans held for investment compared to no such financing on mortgage loans held for investment in the prior period. During the same comparable periods, total non-interest income decreased $23.1 million and total non-interest expense increased by $4.6 million. The increa se in interest income and interest expense, and the decrease in non-interest income, primarily reflects the impact of the change from gain on sale accounting to secured financing accounting in 2004, while the increase in non-interest expense primarily reflects the increases in origination volume and personnel.

We originated $682.0 million of mortgage loans for the three months ended September 30, 2004, representing a $157.2 million or 29.9% increase from $524.8 million of mortgage loans originated for the comparable period in 2003. We securitized and/or sold $689.2 million of loans during the three months ended September 30, 2004, compared to $460.5 million of loans during the same period in 2003.

Net Interest Income

We recorded net interest income of $18.5 million during the third quarter of 2004, an increase of $16.6 million, from the $1.9 million recorded in the same period in 2003. The increase in net interest income primarily reflects the impact of the change from gain on sale accounting to secured financing accounting in 2004. Net interest income is comprised of the following:

Interest Income. Interest income increased $27.5 million to $30.8 million for the three months ended September 30, 2004, from $3.3 million for the comparable period in 2003. The increase is primary due to (1) the recording of interest on our $1.6 billion of loans held for investment of $23.8 million; (2) an increase in the composition of fixed-rate versus adjustable-rate pass-through certificates on a quarter over quarter basis; relating to securitization bonds and (3) a higher average loan balance on the loans we originated and held for sale during the three months ended September 30, 2004 compared to the same period in 2003.

The following table is a summary of interest income:

		Three Months Ended
		September 30,
(Dollars in thousands)		2004			2003
Interest income on mortgage loans held for sale, net		$	5,617		$	2,339
Interest income on mortgage loans held for investment, net			23,837			--
Interest income on excess cashflow certificates			126			528
Securitization bond interest income			1,229			329
Miscellaneous interest income			--			57
Total interest income		$	30,809		$	3,253

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Interest Expense. Interest expense increased by $10.9 million to $12.3 million for the three months ended September 30, 2004, from $1.4 million for the comparable period in 2003. The increase was primarily due to the interest expense related to the financing of mortgage loans held for investment, NIM notes and interest-only notes and, to a lesser extent, the increase in loans originated and financed during the period using our warehouse facilities, compared to the same period in 2003. Another factor contributing to the increase in interest expense was the higher warehouse financing costs due to a higher average one-month LIBOR rate, which is the benchmark index used to determine our cost of borrowed funds. The rate increased on average to 1.60% for the third quarter of 2004, compared to an average of 1.11% for the third quarter of 2003. Partially offsetting these increases was the elimination of the quarterly interest expense on the senior notes paid in the third quarter 2003, as we redeemed the senior notes during the fourth quarter of 2003.

The following table presents the components of interest expense:

		Three Months Ended
		September 30,
(Dollars in thousands)		2004			2003
Interest expense on warehouse financing		$	2,343		$	1,058
Interest expense on mortgage loans held for investment financing			8,941			--
Interest expense on NIM financing			922			--
Interest expense on interest-only financing			40			--
Interest expense on other borrowings			71			59
Interest expense on senior notes (1)			--			256
Total interest expense		$	12,317		$	1,373

(1) On October 30, 2003, we redeemed, at par, all of our outstanding 9.5% senior notes due August 2004.

Provision for Loan Losses

A provision for loan losses on mortgage loans held for investment is recorded to maintain the related allowance for loan loss at an appropriate level for currently existing probable losses of principal.

We recorded a provision for loan losses of $3.1 million for the quarter ended September 30, 2004 related to mortgage loans held for investment. We did not record a provision for mortgage loans held for investment in the quarter ended September 30, 2003, as we did not hold loans for investment during this period.

Non-Interest Income

Total non-interest income decreased $23.1 million to $3.0 million for the three months ended September 30, 2004, from $26.1 million for the comparable period in 2003. The decrease in non-interest income primarily resulted from changing our securitization structure in 2004, and consequently, our accounting for securitizations of our mortgage loans to secured financing accounting, where interest income is recognized over the life of the loans, from gain-on-sale accounting, where revenue is recorded upfront at time of sale in accordance with SFAS No. 140. In the third quarter of 2004, we recorded a net gain on the sale of mortgage loans of $2.6 million as compared to $25.8 million during the same quarter in 2003.

Net Gain on Sale of Mortgage Loans. Net gain on sale of mortgage loans for the quarter ended September 30, 2004 is comprised of the premium received from selling whole loans on a servicing-released basis, together with any deferred origination costs or fees associated with mortgage loans sold. Through the end of 2003, our securitizations were structured to be accounted for as sales under SFAS No. 140. Accordingly, we recorded gain-on-sale revenue upon the closing of each such securitization. For the quarter ended September 30, 2003, net gain on sale of mortgage loans was comprised of the following:

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	(1)	the sum of:
		a)	the cash purchase price we received in connection with selling one or more of the following securities in connection with our securitization(s) structured to be accounted for as sales for a particular period: (i) a NIM note, net of overcolleralization amount and interest rate cap and/or (ii) an interest-only certificate;
		b)	the fair value of the excess cashflow certificates we retained in a securitization structured as a sale for such period;
		c)	the premium received from selling mortgage servicing rights in connection with each securitization structured as a sale; and
		d)	the difference between the selling price and the carrying value of the related mortgage loans sold.
	(2)	less the:
		a)	costs associated with the securitization structured as a sale;
		b)	any hedge loss (gain) associated with such securitization accounted for as a sale; and
		(c)	any loss associated with loans sold at a discount, together with any deferred origination costs or fees associated with mortgage loans sold.

 

The following table is a summary of our net gain on sale of mortgage loans for the three months ended September 30, 2004 and 2003:

		Three Months Ended
		September 30,
(Dollars in thousands)		2004			2003
Net Gain on Sale of Mortgage Loans:
Loans sold		$	49,236		$	460,488
NIM proceeds, net		$	--		$	16,875
Interest-only certificate proceeds			--			4,824
Excess cashflow certificate (owner trust certificate)(1)			--			982
Mortgage servicing rights			--			2,710
Gain on whole loan sales			2,125			673
Net loan origination fees			505			1,777
Less: securitization transaction costs			--			(2,058	)
Net gain on sale recorded		$	2,630		$	25,783
Net gain on sale recorded as a percent of loans sold			5.34	%		5.60	%

(1) We did not record any excess cashflow certificates in the third quarter of 2004 or 2003. (See “-Summary of Critical Accounting Policies - Excess Cashflow Certificates”). The excess cashflow certificate recorded during the third quarter of 2003 related to loans delivered in July 2003 relating to the second quarter of 2003 securitization.

Net gain on sale of mortgage loans decreased $23.2 million to $2.6 million for the three months ended September 30, 2004, from $25.8 million for the comparable period in 2003. This decrease was directly related to our completing a securitization in the third quarter of 2004 that was structured as a secured financing. This structure recognizes the related revenue as interest income over the life of the loans instead of recording virtually all of the income upfront as a gain on sale as our 2003 and prior structures required under SFAS No. 140. In the third quarter of 2004, we sold $49.2 million of mortgage loans on a servicing-released basis, compared to $448.2 million of mortgage loans securitized and $12.2 million of mortgage loans sold on a servicing-relea sed basis in the same period in 2003.

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The weighted average net gain on sale ratio for the three months ended September 30, 2004 and for the comparable period in 2003 was 5.3% and 5.6%, respectively. The weighted-average net gain on sale ratio is calculated by dividing the net gain on sale by the total amount of loans securitized and sold.

Other Income. Other income increased $95,000 to $393,000 for the quarter ended September 30, 2004, from $298,000 for the quarter ended September 30, 2003. Other income for the quarter ended September 30, 2004, primarily relates to a fair value adjustment on our excess cashflow certificates of $307,000. Other income for the quarter ended September 30, 2003, primarily relates to a $220,000 gain on the sale of three excess cashflow certificates. No such sale of excess cashflow certificates occurred in 2004.

Non-interest Expense

Total non-interest expense increased by $4.6 million, or 27.0%, to $21.4 million for the three months ended September 30, 2004, from $16.8 million for the comparable period in 2003. The increase is primarily due to an increase in payroll and related costs associated with a 29.9% increase in our mortgage loan production and a 19.4% increase in personnel, coupled with an increase in other production related expenses.

Payroll and Related Costs. Payroll and related costs include salaries, benefits and payroll taxes for all non-production related employees and non-deferrable production related employees cost.

Payroll and related costs increased by $2.6 million, or 24.2%, to $13.4 million for the three months ended September 30, 2004, from $10.8 million for the comparable period in 2003. The increase was primarily the result of higher compensation and related payroll cost associated with an increase in our staff. As of September 30, 2004, we employed 1,052 full- and part-time employees, an increase of 19.4% over the 881 full- and part-time employees as of September 30, 2003. Additionally, payroll and related costs were higher due to the higher loan commissions paid as a result of an increase in loan production during the third quarter of 2004 compared to the same period in 2003.

General and Administrative Expenses. General and administrative expenses consist primarily of office rent, insurance, telephone, depreciation, legal reserves and fees, license fees, accounting fees, travel and entertainment expenses, advertising and promotional expenses.

General and administrative expenses increased $1.9 million, or 32.0%, to $7.9 million for the quarter ended September 30, 2004, from $6.0 million for the quarter ended September 30, 2003. The increase was primarily due to an increase in expenses associated with higher loan production, the consequent 19.4% increase in personnel and ongoing expansion of our wholesale and retail divisions. Also contributing to the increase in general and administrative expenses was an increase in accounting and professional fees related to Sarbanes-Oxley documentation initiatives undertaken in 2004.

Loss on Derivative Instruments. The loss on derivative instruments represents the realized loss on the interest rate swaps used to effectively lock in a pre-determined interest rate on designated portions of our prospective future securitization financing and any fair value changes to our corridors we use to protect the variable-rate financing.

During the quarter ended September 30, 2004, we recorded a loss on derivative instruments totaling $7,000. The loss related to the ineffective portion of our hedge related to our future securitization financing. There were no gains or losses related to derivative instruments for the quarter ended September 30, 2003.

Income Taxes

Deferred tax assets and liabilities are recognized based upon the income reported in the financial statements regardless of when such taxes are paid. These deferred taxes are measured by applying current enacted tax rates.

We recorded an income tax benefit of $1.1 million for the three months ended September 30, 2004 due to the pretax loss recorded for the period (utilizing an effective tax rate of approximately 39%). We recorded a tax benefit of $30.5 million for the three months ended September 30, 2003, which includes a benefit resulting from the reversal of the deferred tax valuation allowance. The valuation allowance was reversed based upon management’s assessment of the positive trend in our profitability and cash flows as of September 30, 2003.

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Nine Months Ended September 30, 2004 Compared to the Nine Months Ended September 30, 2003

General

Our net loss for the nine months ended September 30, 2004 was $9.6 million, or $(0.54) per share basic and diluted, compared to net income of $60.0 million, or $3.68 per share basic and $3.21 per share diluted, for the nine months ended September 30, 2003. The loss resulted from our 2004 securitizations that were structured to be accounted for as secured financings, instead of sales; consequently, we did not record any gain-on-sale revenue in connection with these securitizations and will instead record interest income from the securitized loans and interest expense from the pass-through certificates issued in connection with the securitizations over the life of the securitizations. Conversely, our 2003 securitizations were structured as sales under SFAS No . 140, requiring us to record an upfront gain-on-sale equal to the present value of the estimated cash flows we expected to receive over the life of the securitizations. Additionally, the net income for the nine months ended September 30, 2003 was significantly impacted by a tax benefit of $30.2 million, or $1.87 per share basic and $1.63 per share diluted, recorded during the period.

We recorded net interest income of $37.1 million during the nine months ended September 30, 2004, an increase of $31.7 million, from the $5.4 million recorded in the same period in 2003. The increase in interest income primarily reflects the net effect of recognizing interest income on $1.6 billion of mortgage loans held for investment compared to no such loans held for investment in the prior period, and similarly the increase in interest expense primarily reflects the net effect of recognizing interest expense on $1.7 billion on financing on mortgage loans held for investment compared to no such financing on mortgage loans held for investment in the prior period. We also recorded a provision for loan losses of $5.8 million during the nine months ended September 30, 2004, compared to no such provision in the comparable 2003 period. During the nine months ended September 30, 2004 as compared to the same period in 2003, total non-interest income decreased $58.3 million and total non-interest expense increased by $13.0 million. The increases in interest income, interest expense and provision for loan losses as well as the decrease in non-interest income, primarily reflect the impact of the change from gain on sale accounting to secured financing accounting in 2004, while the increase in non-interest expense primarily reflects the 55.3% increase in origination volume and 19.4% increase in personnel for the nine months ended September 30, 2004 as compared to the same period in 2003.

We originated $1.9 billion of mortgage loans during the nine months ended September 30, 2004, from $1.2 billion of mortgage loans originated for the comparable period in 2003. We securitized and sold $1.9 billion of loans during the nine months ended September 30, 2004, compared to $1.1 billion of loans during the same period in 2003.

Net Interest Income

We recorded net interest income of $37.1 million during the nine months ended September 30, 2004, an increase of $31.7 million, from the $5.4 million recorded in the same period in 2003. The increase in net interest income primarily reflects the impact of the change from gain on sale accounting to secured financing accounting in 2004. Net interest income is comprised of the following:

Interest Income. Interest income increased $47.7 million to $56.9 million for the nine months ended September 30, 2004, from $9.2 million for the comparable period in 2003. The increase is primarily due to (1) the recording of interest on our $1.6 billion of loans held for investment of $39.5 million; (2) a higher average loan balance on the loans we originated and held for sale during the nine months ended September 30, 2004 compared to the same period in 2003; and (3) the increase in securitization bond interest due to the composition of fixed-rate pass-through certificates issued during the nine months ended September 30, 2004, co mpared to adjustable rate pass-through certificates issued in the same period of 2003.

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The following table is a summary of interest income:

		Nine Months Ended
		September 30,
(Dollars in thousands)		2004			2003
Interest income on mortgage loans held for sale, net		$	12,802		$	6,750
Interest income on mortgage loans held for investment, net			39,491			--
Interest income on excess cashflow certificates			1,526			1,765
Securitization bond interest income			2,920			606
Miscellaneous interest income			114			102
Total interest income		$	56,853		$	9,223

Interest Expense. Interest expense increased by $15.9 million to $19.7 million for the nine months ended September 30, 2004 from $3.8 million for the comparable period in 2003. The increase was primarily due to the interest expense related to the financing of mortgage loans held for investment, NIMs and interest-only notes and, to a lesser extent, the increase in loans originated and financed during the period on our warehouse facilities, compared to the same period in 2003. Additionally, contributing to the increase in interest expense was the slightly higher warehouse financing costs due to a higher average one-month LIBOR rate, wh ich is the benchmark index used to determine our cost of borrowed funds. The rate increased on average to 1.29% for the first nine months of 2004, compared to an average of 1.24% for the same period in 2003. Partially offsetting these increases was the elimination of the interest expense paid on the senior notes in the third quarter 2003, as we redeemed the senior notes during the fourth quarter of 2003.

The following table presents the components of interest expense:

		Nine Months Ended
		September 30,
(Dollars in thousands)		2004			2003
Interest expense on warehouse financing		$	5,279		$	2,886
Interest expense on mortgage loans held for investment financing			12,329			--
Interest expense on NIM financing			1,466			--
Interest expense on interest-only financing			451			--
Interest expense on other borrowings			215			191
Interest expense on senior notes (1)			--			771
Total interest expense		$	19,740		$	3,848

(1)

On October 30, 2003, we redeemed, at par, all of our outstanding 9.5% senior notes due August 2004.

Provision for Loan Losses

We recorded a provision for loan losses of $5.8 million for the nine months ended September 30, 2004 related to mortgage loans held for investment. The amount of the provision for loan losses is primarily driven by our securitization activities ($1.6 billion of mortgage loans held for investment at September 30, 2004) conducted during the nine months ended September 30, 2004. We did not have a provision for loan loss during the comparable period in 2003, as we did not hold loans for investment at that time.

Non-interest Income

Total non-interest income decreased $58.3 million, or 82.4%, to $12.5 million for the nine months ended September 30, 2004, from $70.8 million for the comparable period in 2003. The decrease in revenue was primarily the result of our changing the securitization structure we used in 2004, and consequently, our accounting for securitizations of our mortgage loans to secured financing accounting, where interest income is recognized over the life of the loans, from gain-on-sale accounting, where revenue is recognized upfront at time of sale in accordance with SFAS No. 140.

Net Gain on Sale of Mortgage Loans. Net gain on sale of mortgage loans for the nine months ended September 30, 2004 is comprised of the difference between the selling price and the carrying value of the related mortgage loans sold on a servicing released basis. Through the end of 2003, our securitizations were structured to be accounted for as sales under SFAS No. 140. Accordingly, we recorded gain-on-sale revenue upon the closing of each such securitization. See three months ended September 30, 2004 discussion above for more information regarding components of net gain on sale of mortgage loans.

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The following table is a summary of our net gain on sale of mortgage loans for the nine months ended September 30, 2004 and 2003:

		Nine Months Ended
(Dollars in thousands)		September 30,
		2004			2003
Net Gain on Sale of Mortgage Loans:
Loans sold (1)		$	204,587		$	1,077,689
NIM proceeds, net		$	4,712		$	49,426
Interest-only certificate proceeds			1,292			7,703
Excess cashflow certificate (owner trust certificate)			--			6,941
Mortgage servicing rights			661			6,258
Gain on whole loan sales			4,162			1,689
Net loan origination fees			1,540			3,356
Less: securitization transaction costs			(484	)		(5,495	)
Net gain on sale recorded		$	11,883		$	69,878
Net gain on sale recorded as a percent of loans sold			5.81	%		6.48	%

(1) For the nine months ended September 30, 2004, we delivered $113.9 million of mortgage loans under a pre-funding feature in our fourth quarter 2003 securitization and recorded gain-on-sale revenue related thereto during the first quarter of 2004. Because the fourth quarter 2003 securitization was structured as a sale, we recorded gain-on-sale revenue during the nine months ended September 30, 2004 when we delivered the loans under the pre-funding feature to the securitization trust in January 2004. (See “- Securitizations”).

Net gain on sale of mortgage loans decreased $58.0 million, or 83.0%, to $11.9 million for the nine months ended September 30, 2004, from $69.9 million for the comparable period in 2003. This decrease was directly related to our structuring the securitizations we issued in the first nine months of 2004 as secured financings. This structure recognizes the related revenue as interest income over the life of the loans instead of recording virtually all of the income upfront as a gain on sale as our 2003 and prior structures required under SFAS No. 140. In the nine months ended September 30, 2004, we delivered $113.9 million of mortgage loans through a pre-funding feature in connection with our fourth quarter 2003 securitization (which was structured as a sale) and sold $90.7 million of mortgage loans on a servicing-released basis, compared to $1.0 billion of mortgage loans securitized (all of which in securitizations structured to be accounted for as sales) and $33.6 million of mortgage loans sold on a servicing-released basis during the same period in 2003.

The weighted average net gain on sale ratio for the nine months ended September 30, 2004 (representing the mortgage loans we delivered under the pre-funding feature of our fourth quarter 2003 securitization and whole loans sales), and for the comparable period in 2003, was 5.8% and 6.5%, respectively. The weighted-average net gain on sale ratio is calculated by dividing the net gain on sale by the total amount of loans securitized and sold.

Other Income. Other income decreased $300,000, to $597,000 for the nine months ended September 30, 2004, from $897,000 for the nine months ended September 30, 2003. The decrease was primarily the result of not receiving any income from the LLC in the nine months ended September 30, 2004. During the nine months ended September 30, 2003, we received $218,000 of income related to the LLC. We have a non-voting membership interest in the LLC, which entitles us to receive 10% - 15% of the net cash flows from the LLC. We have not received our distributions since the second quarter of 2003, due to a dispute with the LLC’s President, whi ch has led us to commence a lawsuit to recover all of the amounts due to us. See “- Part II, Item 1. - Legal Proceedings.”

 

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Non-interest Expense

Total non-interest expense increased by $13.1 million, or 28.2%, to $59.4 million for the nine months ended September 30, 2004, from $46.3 million for the comparable period in 2003. The increase is primarily due to an increase in payroll and related costs associated with a 55.3% increase in our mortgage loan production, together with an increase in our personnel expenses and an increase in general and administrative expenses related primarily to other production related expenses. The increase was also slightly related to a $146,000 net loss we recorded on derivative instruments that was incurred in connection with our 2004 securitizations.

Payroll and Related Costs. Payroll and related costs increased by $9.3 million, or 32.8%, to $37.6 million for the nine months ended September 30, 2004, from $28.3 million for the comparable period in 2003. The increase was primarily the result of higher compensation and related payroll costs (including medical and 401(k) expenses) associated with an increase in our staff. As of September 30, 2004, we employed 1,052 full- and part-time employees, an increase of 19.4% over the 881 full- and part-time employees as of September 30, 2003. Additionally, payroll and related costs were higher due to higher loan commissions paid, resulting f rom higher loan production during the first nine months of 2004 compared to the same period in 2003.

General and Administrative Expenses. General and administrative expenses increased $3.6 million, or 20.1%, to $21.6 million for the nine months ended September 30, 2004, from $18.0 million for the nine months ended September 30, 2003. The increase was primarily due to an increase in expenses associated with a 55.3% year-over-year increase in loan production, the consequent 19.4% increase in personnel and the ongoing expansion of our wholesale and retail divisions. Also contributing to the increase in general and administrative expenses was approximately $450,000 in accounting and professional fees related to Sarbanes-Oxley documentat ion initiatives undertaken in 2004, among other things.

Loss on Derivative Instruments. During the nine months ended September 30, 2004, we recorded a net loss on derivative instruments totaling $146,000. The net loss was comprised of (1) a $4.3 million loss relating to the interest rate swaps used to hedge approximately $540.2 million of securitization variable-rate debt that were not accounted for as hedge instruments; and (2) a $4.2 million gain related to the fair value changes on our corridors that were not accounted for as hedging instruments prior to May 2004. There were no gains or losses related to derivative instruments for the nine months ended September 30, 2003.

Income Taxes

We recorded an income tax benefit of $6.0 million for the nine months ended September 30, 2004 due to the pretax loss recorded based on an effective tax rate of approximately 39%. We recorded a tax benefit of approximately $30.2 million for the nine months ended September 30, 2003, which includes a benefit resulting from the reversal of the deferred tax valuation allowance. The valuation allowance was reversed based upon management’s assessment of the positive trend in our profitability and cash flows as of September 30, 2003.

Financial Condition

September 30, 2004 Compared to December 31, 2003

Mortgage Loans Held for Sale, Net. Mortgage loans held for sale, net decreased $60.1 million, or 31.6%, to $130.4 million at September 30, 2004, from $190.5 million at December 31, 2003. This represents mortgage loans held for sale awaiting either a whole loan sale or securitization. The decrease was primarily due to the net difference between loan originations and loans securitized or sold during the nine months ended September 30, 2004.

The following table sets forth a summary of mortgage loans held for sale, net:

(Dollars in thousands)		September 30, 2004			December 31, 2003
Mortgage loans held for sale		$	130,814		$	191,025
Net deferred origination fees			(442	)		(501	)
Mortgage loans held for sale, net		$	130,372		$	190,524

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Mortgage Loans Held for Investment, Net. Mortgage loans held for investment, net were $1.6 billion at September 30, 2004. Our securitizations of mortgage loans during the first nine months of 2004 were structured to be accounted for as secured financings. Under this securitization structure, the securitization trust holds mortgage loans as assets. This account represents our basis in the mortgage loans that were delivered to the securitization trusts, net of discounts, deferred fees and allowance for loan losses. Prior to 2004, we did not structure our securitizations as financings and, we did not have mortgage loans held for investm ent.

The following table sets forth a summary of mortgage loans held for investment, net:

(Dollars in thousands)		September 30, 2004
Mortgage loans held for investment		$	1,650,637
Discounts (MSR related)			(11,139	)
Net deferred origination fees			(3,318	)
Allowance for loan losses			(5,788	)
Mortgage loans held for investment, net		$	1,630,392

We maintain an allowance for loan losses based on our estimate of losses to be incurred in the foreseeable future on our mortgage loans held for investment. At September 30, 2004, we established a provision for loan losses totaling $5.8 million. Prior to 2004, we did not have mortgage loans held for investment and, therefore, did not have an allowance against mortgage loans held for investment at that time.

Trustee Receivable. Trustee receivable principally represents any un-remitted principal payments collected by the securitization trust’s third party loan servicer subsequent to the monthly remittance cut-off date. The unscheduled principal payments and prepaid loan payments received after the remittance cut-off date as of September 30, 2004 totaled $17.2 million, relating to the three securitizations accounted for as secured financings in 2004. The trustee will remit these amounts on the following month’s scheduled remittance date, at which time they principally will be used to pay down financing on mortgage loans held for investment, net. There was no outstanding trustee receivable balance at December 31, 2003.

Accrued Interest Receivable. Accrued interest receivable increased $8.5 million to $8.7 million at September 30, 2004, from $197,000 at December 31, 2003. The increase is primarily due to the $8.6 million of accrued interest we recorded at September 30, 2004 relating to mortgage loans held for investment as of the same date. Partially offsetting the increase was an $116,000 decrease in the accrued interest receivable related to mortgage loans held for sale during the same time period.

Excess Cashflow Certificates. The following table presents the activity related to our excess cashflow certificates for the nine months ended September 30, 2004 and twelve months ended December 31, 2003:

(Dollars in thousands)		September 30, 2004			December 31, 2003
Balance, beginning of year		$	19,853		$	24,565
Originated excess cashflow certificates			--			6,941
Excess cashflow certificates sold			--			(10,000	)
Accretion			1,525			2,418
Cash receipts			(4,976	)		(4,071	)
Net change in fair value			307			--
Balance, end of period		$	16,709		$	19,853

Since we began structuring our securitizations in 2004 to be accounted for as secured financings, we no longer record excess cashflow certificates on newly issued securitizations on the consolidated balance sheet. During the year ended December 31, 2003, we sold $10.0 million of excess cashflow certificates for $10.2 million. No such sales have occurred during the nine months ended September 30, 2004.

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Prepaid and Other Assets. Prepaid and other assets increased $23.6 million to $28.2 million at September 30, 2004, from $4.6 million at December 31, 2003. The increase is primarily due to (1) $13.0 million of fair value of hedging instruments (corridors) used to hedge the one-month LIBOR securitization cost of funds that will be recognized as a yield adjustment to interest expense over the life of the corridors, (2) $7.8 million of interest rate swaps capitalized in association with hedge accounting that will be recognized as a yield adjustment to interest expense over the life the previously hedged variable rate debt, and (3) $6.5 m illion of prepaid securitization transaction costs, net that will be recognized as a yield adjustment to interest expense over the estimated life of the secured financing. The latter increase was partially offset by the recognition in January 2004 of $2.7 million of securitization transaction costs that had been capitalized at December 31, 2003 relating to the fourth quarter 2003 securitization. These securitization transaction costs were recognized in income when we delivered the loans subsequently in January 2004 to the securitization trust created in the fourth quarter 2003 and structured as a sale as part of the pre-funding mechanism.

Deferred Tax Asset. Deferred tax asset increased $8.6 million, or 27.7%, to $39.8 million at September 30, 2004, from $31.2 million at December 31, 2003. The increase is primarily due the tax benefit recorded on the pre-tax loss for the nine months ended September 30, 2004.

Warehouse Financing. Our warehouse financing decreased $86.9 million, or 60.0%, to $57.9 million at September 30, 2004, from $144.8 million at December 31, 2003. The decrease was primarily due to a lower amount of mortgage loans held for sale to be financed under our warehouse credit facilities at September 30, 2004 compared to December 31, 2003, and to a lesser extent due to our self-funding more of our mortgage loans held for sale.

Financing on Mortgage Loans Held for Investment, Net. Financing on mortgage loans held for investment, net was $1.7 billion at September 30, 2004. This represents the corresponding securitization debt used to finance loans held for investment, and notes issued in connection with the issuance of interest-only certificates and NIM securities. The balance of this account will generally increase in proportion to the increase in mortgage loans held for investment. Prior to 2004, we did not structure our securitizations as financings and we did not have mortgage loans held for investment or related borrowings.

The following is a summary of financing on mortgage loans held for investment, net:

(Dollars in thousands)		September 30, 2004
Securitization pass-through certificates, net		$	1,626,569
NIM notes			79,680
Interest-only notes			6,426
Total financing on mortgage loans held for investment, net		$	1,712,675

Accrued Interest Payable. Accrued interest payable increased $2.6 million to $2.6 million at September 30, 2004 from $62,000 at December 31, 2003. This increase was directly related to the accrued interest on the securitization debt. Prior to 2004, we did not structure our securitizations as secured financings and had no related accrued interest payable, and only limited accrued interest payable associated with our warehouse debt.