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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

Commission File Number: 000-50938

Fieldstone Investment Corporation
(Exact name of registrant as specified in its charter)

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

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

        Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date. On May 12, 2005, the issuer had 48,835,876 shares of common stock outstanding.

Table of Contents

PART I

ITEM 1. FINANCIAL STATEMENTS.

FIELDSTONE INVESTMENT CORPORATION AND SUBSIDIARIES

Consolidated Statements of Condition

March 31, 2005 and December 31, 2004

(In thousands, except share and per share data)

See accompanying notes to consolidated financial statements.

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FIELDSTONE INVESTMENT CORPORATION AND SUBSIDIARIES

Consolidated Statements of Operations

Three Months Ended March 31, 2005 and 2004

(Unaudited; in thousands, except share and per share data)

See accompanying notes to consolidated financial statements.

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FIELDSTONE INVESTMENT CORPORATION AND SUBSIDIARIES

Consolidated Statements of Cash Flows

Three Months Ended March 31, 2005 and 2004

(Unaudited; in thousands)

See accompanying notes to consolidated financial statements.

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FIELDSTONE INVESTMENT CORPORATION AND SUBSIDIARIES

Notes to Consolidated Financial Statements

March 31, 2005 and 2004

(Unaudited)

(1)   Organization

(a) Organization

        Fieldstone Mortgage Company (FMC) was incorporated in the State of Maryland on April 27, 1995 under the name Fieldstone Management Company. Fieldstone Investment Corporation (FIC) was incorporated in the State of Maryland on August 20, 2003, as a wholly owned subsidiary of Fieldstone Holdings Corp. (FHC). FHC was incorporated in the State of Delaware in February 1998 as a C Corporation. In July 1998, FHC purchased 100% of the shares of FMC. Prior to 2003, FHC operated as a taxable C corporation. Effective January 1, 2003, FHC elected to be taxed as an S Corporation.

        In November 2003, FHC merged with and into FIC, with FIC as the surviving entity, in a transaction that was accounted for as a merger of entities under common control whereby the historical cost basis of the assets and liabilities was retained. Effective with the merger in November 2003, FIC elected to be taxed as a Real Estate Investment Trust (REIT), and FMC, its wholly owned subsidiary, elected to be taxed as a Taxable REIT Subsidiary (TRS).

        On February 3, 2004, FIC formed two wholly owned subsidiaries, Fieldstone Mortgage Ownership Corp. (FMOC) and Fieldstone Servicing Corp. (FSC), as Maryland corporations, which are treated as qualified REIT subsidiaries. FMOC holds securities and ownership interests in owner trusts and other financing vehicles, including securities issued by FIC or on FIC's behalf. FMOC holds the residual interest in FIC's securitized pools of mortgage loans, as well as any derivatives designated as economic interest rate hedges related to securitized debt. FSC holds the rights to direct the servicing of the mortgage loans held for investment.

        FMC originates, purchases, and sells, non-conforming and conforming residential mortgage loans and engages in other activities related to mortgage banking. FMC originates mortgage loans through wholesale and retail business channels through its network of over 4,700 independent mortgage brokers and its branch offices located in 26 states throughout the country.

        The accompanying unaudited consolidated financial statements include the accounts of Fieldstone Investment Corporation and its subsidiaries (together, the Company) and have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation
S-X. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. All significant intercompany balances and transactions have been eliminated in consolidation. Certain amounts in the prior period's unaudited consolidated financial statements have been reclassified to conform to the current period presentation.

        In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting of normal recurring accruals, necessary for a fair presentation. The results of operations and other data for the three months ended March 31, 2005 are not necessarily indicative of the results that may be expected for any other interim periods or the fiscal year ending December 31, 2005. The unaudited consolidated financial statements presented herein should be read in conjunction with the audited consolidated financial statements and related notes thereto in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2004.

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(b) Use of Estimates

        The preparation of consolidated financial statements in conformity with GAAP, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Amounts on the consolidated statements of operations most affected by the use of estimates are the reserve for losses—loans sold (which is a component of gains on sales of mortgage loans, net), provision for loan losses—loans held for investment, derivative valuations (which are a component of other income(expense)—portfolio derivatives), stock-based compensation (which is a component of salaries and employee benefits) and deferred origination and issuance costs, which are components of net interest income after provision for loan losses.

(2) Mortgage Loans Held for Sale and Reserve for Losses—Loans Sold

        Mortgage loans that the Company acquires or originates with the intent to sell in the foreseeable future are initially recorded at cost including any premium paid or discount received, adjusted for the fair value change during the period in which the loan was an interest rate lock commitment. Loans held for sale are carried on the Company's books at the lower of cost or market value calculated on an aggregate basis by type of loan. Mortgage loans held for sale, net, as of March 31, 2005 and December 31, 2004 are as follows (in thousands):

        The Company maintains a reserve for its representation and warranty liabilities related to the sale of loans and for its contractual obligations to rebate a portion of any premium paid by an investor when a sold loan prepays within an agreed period. The reserve, which is recorded as a liability on the consolidated statements of condition, is established when loans are sold, and is calculated as the fair value of liabilities reasonably estimated to occur during the life of the related sold loans. The provision is recorded as a reduction of gain on sale of loans.

        The reserve for losses—loans sold is summarized as follows for the three months ended March 31, 2004 and 2005 (in thousands):

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        Historically, the Company has experienced substantially all of its losses on loans sold during the first three years following the sale. The reserve for losses—loans sold as of March 31, 2005 and 2004 primarily relate to loan sales, which approximated $13.4 billion during the period of April 1, 2002 through March 31, 2005 and $12.5 billion during the period April 1, 2001 through March 31, 2004, respectively.

(3) Mortgage Loans Held for Investment and Allowance for Loan Losses

        The Company originates fixed-rate and adjustable-rate mortgage loans that have a contractual maturity of up to 30 years. These mortgage loans are initially recorded at cost including any premium or discount. These mortgage loans are financed with warehouse debt until they are pledged as collateral for securitization financing. The Company is exposed to risk of loss from its mortgage loan portfolio and establishes an allowance for loan losses taking into account a variety of criteria, including the contractual delinquency status, market delinquency roll rates and market historical loss severities. The adequacy of this allowance for loan loss is reviewed on a quarterly basis and adjusted, as necessary, based on this review.

        The following is a detail of the mortgage loans held for investment, net as of March 31, 2005 and December 31, 2004 (in thousands):

        The allowance for loan losses—loans held for investment is summarized as follows for the three months ended March 31, 2004 and 2005 (in thousands):

        Mortgage loans held for investment, which were on non-accrual status for interest income recognition due to delinquencies greater than 90 days, were $61.7 million and $40.6 million as of March 31, 2005 and December 31, 2004, respectively.

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(4)   Warehouse Financing, Loans Held for Sale and Loans Held for Investment

        At March 31, 2005 and December 31, 2004, the Company had a total of $1.9 billion of warehouse lines of credit and repurchase facilities with six financial entities. Committed facilities comprised $1.85 billion of the total funds available, with uncommitted facilities totaling $50.0 million. The facilities are accounted for as short-term liabilities, secured by mortgage loans held for investment to be securitized, mortgage loans held for sale, the related investor commitments to purchase those loans held for sale, and all proceeds thereof.

        Warehouse lines of credit and repurchase facilities consist of the following at March 31, 2005 and December 31, 2004 (dollars in millions):

        The interest rates are based on spreads to one month or overnight LIBOR, and are generally reset daily or weekly. The Company also pays facility fees based on the commitment amount and non-use fees. A summary of coupon interest expense and facility fees, included in total interest expense in the consolidated statements of operations, and the weighted average cost of funds of the warehouse lines of credit and repurchase facilities for the three months ended March 31, 2005 and 2004 is as follows
(in thousands):

        The warehouse lines and repurchase facilities generally have a term of 364 days or less. Management expects to renew these lines of credit prior to their respective maturity dates. The Countrywide Warehouse Lending facility has been extended to May 31, 2005. The JP Morgan Chase Bank facility has been renewed until April 2006 and the maximum committed amount available under the facility has been reduced to $150 million. The credit facilities are secured by substantially all of our unsecuritized mortgage loans and contain customary financial and operating covenants that require us to maintain specified levels of liquidity and net worth, restrict indebtedness and investments and require compliance with applicable laws. The Company was in compliance with all of these covenants at March 31, 2005 and December 31, 2004, respectively.

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(5) Securitization Financing

        During the three months ended March 31, 2005, the Company issued $0.7 billion of additional mortgage-backed bonds through securitization trusts to finance the Company's portfolio of loans held for investment. Interest rates on these bonds reset monthly and are indexed to one-month LIBOR. The bonds pay interest monthly based upon a spread over LIBOR. The estimated average life of the bonds is approximately 23 months, and is based on assumptions made by management. The actual period from inception to maturity may differ from expectations. The bonds are repaid from the cash flows received from the mortgage loans pledged to the trust.

        The following is a summary of the securitization series issued during the three months ended March 31, 2005 (dollars in millions):

        The average securitization financing outstanding was $4.2 billion and $2.3 billion for the three months ended March 31, 2005 and the fiscal year ended December 31, 2004, respectively. The unamortized bond issuance costs at March 31, 2005 and December 31, 2004 were $13.1 million and $12.5 million, respectively.

        A summary of interest expense, amortization of deferred issuance costs and original issue discount, and the weighted average cost of funds of the securitization financing for the three months ended March 31, 2005 and 2004 is as follows (in thousands):

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        The following is a summary of the outstanding securitization bond financing by series as of March 31, 2005 and December 31, 2004 (in thousands):

        The current carrying amount of the mortgage loans pledged to the securitization trusts was $4.5 billion and $4.2 billion as of March 31, 2005 and December 31, 2004, respectively.

(6) Segment Information

        The information presented below with respect to the Company's reportable segments is consistent with the content of the business segment data provided to the Company's management. This segment data uses a combination of business lines and channels to assess consolidated results. The Company has six reportable segments, which include four production segments, Non-Conforming Wholesale, Non-Conforming Retail, Conforming Wholesale, Conforming Retail, and two operating segments which include Investment Portfolio, and Corporate.

        The Company originates loans through two channels: a non-conforming channel and a conforming channel, each of which operates both wholesale and retail divisions. The Investment Portfolio segment primarily includes the net interest income earned by the loans held for investment. In addition, the Company has a Corporate segment that includes the timing and other differences between actual revenues and costs and amounts allocated to the production segments. The Corporate segment also includes the effects of the deferral and capitalization of net origination costs as required by FASB Statement No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases." Financial information by segment is evaluated regularly by management and used in decision-making relating to the allocation of resources and the assessment of company performance. The Company manages the business on a pre-tax basis and therefore all income tax expense or benefit is allocated to the Corporate segment. For the purposes of segment information provided in the tables below, certain fees, origination costs, and other expenses recorded as a component of gains on sale of mortgage loans, net, have been reflected in total revenues or total expenses consistent with intercompany allocations reported to the Company's management. Also, gain on sale revenue is recognized at the time of funding by the production segments as if all loans will be sold, and adjusted in the corporate segment to reflect the actual gain on sale recognizable for GAAP revenue reporting on the loans that are sold. In addition, net interest income is recognized on origination volume by the production segments and adjusted in the Corporate segment for the actual net interest income earned. The Corporate segment includes reconciling amounts necessary for the segment totals to agree to the consolidated financial statements.

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        The assets of the Company that are specifically identified to a segment include mortgage loans held for sale and investment, net, trustee receivable, derivative assets, net and furniture and equipment, net. All other assets are attributed to the Corporate segment. Total assets by segment at March 31, 2005 and December 31, 2004 are summarized as follows (in thousands):

        Operating results by business segment for the three months ending March 31, 2005 are as follows (in thousands):

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        Operating results by business segment for the three months ending March 31, 2004 are as follows (in thousands):

(7) Earnings Per Share

        Information relating to the calculations of earnings per share (EPS) of common stock for the three months ended March 31, 2005 and 2004 is summarized as follows (in thousands, except per share data):

        Effects of potentially dilutive securities are presented only in periods in which they are dilutive. For the three months ended March 31, 2005, 46,000 stock options, each at a strike price of $19.25, were excluded from the calculation of diluted earnings per share. These stock options would have an antidilutive effect on earnings per share. For the three months ended March 31, 2004, all outstanding stock options and restricted stock were excluded from the calculation of diluted earnings per share.

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(8) Commitments and Contingencies

(a) Loan Commitments

        At March 31, 2005 and December 31, 2004, the Company had origination commitments outstanding to fund approximately $542 million and $422 million in mortgage loans, respectively. Fixed rate and hybrid ARM mortgages which are fixed for the initial two to three year term of the loan comprised 95.5% and 96.9%, respectively, of the outstanding origination commitments. The Company had forward delivery commitments to sell approximately $0.9 billion and $0.4 billion of loans at March 31, 2005 and December 31, 2004, respectively, of which $78.2 million and $63.1 million, respectively, were mandatory sales of mortgage backed securities and investor whole loan trades. At March 31, 2005 and December 31, 2004, the Company had a commitment to sell $110 million and $40 million, respectively, of treasury note forward contracts, used to economically hedge the interest rate risk of its non-conforming loans.

(b) Legal Matters

        In 2004, former shareholders of the Company whose shares were redeemed for approximately $188.1 million following the closing of the private placement offering in November 2003, filed an action alleging that they are entitled to an additional post-closing redemption price payment of approximately $19.0 million. Presently, the ultimate outcome of this claim and the amount of liability, if any, that may result is not determinable, and no amounts have been accrued in the Company's financial statements with respect to this claim. Regardless of the outcome, in the opinion of management, the final resolution of this dispute will not have a material effect on the Company's business, financial condition or results of operations. If the Company is unsuccessful in defending this matter, the Company could be required to make a cash payment of approximately $19.0 million to the former shareholders. Any such payment would be accounted for as an increase in the redemption price of the shares, and accordingly, will be recorded as a reduction of paid in capital in the period in which the dispute is resolved, and will have no impact on the Company's statements of operations. In addition, the Company could be required to pay interest or third-party costs associated with the litigation, which, if payable as part of a settlement, will be recorded to current period earnings.

(9) Subsequent Event

        On April 21, 2005, the Company agreed to sell approximately $550 million of loans that were classified as held for investment on March 31, 2005. These loans did not meet the Company's new target return requirement for loans that would be retained for the investment portfolio and, accordingly, were transferred and classified as held for sale in April 2005. These loans were included as part of a $1.0 billion pool that also included loans held for sale at March 31, 2005 and additional loans originated in April 2005. The Company has agreed to sell this pool at a price of 103.50% of par. The sale is scheduled to settle in the second half of May 2005.

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

        The following discussion and analysis of our results of operations, financial condition and liquidity and capital resources should be read in conjunction with our unaudited consolidated financial statements and related notes contained in this Quarterly Report on Form 10-Q, as well as the audited financial statements and related notes for the fiscal year ended December 31, 2004 and "Management's Discussion and Analysis of Financial Condition and Results of Operations," contained in the our Annual Report on Form 10-K, as amended, filed with the Securities and Exchange Commission (SEC) on March 24, 2005.

Safe Harbor for Forward-Looking Statements

        The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. Any written or oral statement, made by or on our behalf, using words such as "believes," "expects," "intends," "estimates," "projects," "predicts," "assumes," "anticipates," "plans," "seeks," and comparable terms, is a forward-looking statement. Forward-looking statements are not statements of historical fact, but rather are based on our views and assumptions regarding future events and performance, taking into account all information currently available to us. Because we have a limited operating history, many statements relating to us and our business, including statements relating to our competitive strengths and business strategies, may be forward-looking statements.

        All forward-looking statements (none of which is intended as a guarantee of performance) are subject to certain risks and uncertainties, known and unknown, that could cause our actual results to differ materially from the expected results expressed by the forward-looking statements. We believe that the factors that may affect future performance and the accuracy of forward-looking statements contained in this Form 10-Q include, but are not limited to, the following:

•

our limited operating history with building and managing an investment portfolio, which limits your ability to evaluate a key component of our business strategy and our growth prospects and increases your investment risk;



•

our ability to estimate future loan performance on our loans held for investment;



•

the availability, terms and deployment of capital;



•

the success of our portfolio-based model of securitizations, which is subject to the effects of interest rate fluctuations, margin calls and credit enhancement levels;



•

our ability to execute successfully a hedging strategy to mitigate our risks associated with changes in interest rates;



•

our ability to qualify or remain qualified as a REIT in any taxable year;



•

general volatility of the capital markets;



•

the degree and nature of our competition;



•

changes in government regulations that affect our ability to originate and securitize mortgage loans; and



•

certain other factors set forth in our filings, from time to time, with the SEC, including our Annual Report on Form 10-K for the fiscal year ended December 31, 2004.

These factors are illustrative, but by no means exhaustive. All forward-looking statements should be read in conjunction with the other cautionary statements that are included in this Quarterly Report on Form 10-Q. You are cautioned not to place undue reliance on the forward-looking statements contained in this Quarterly Report on Form 10-Q, which speak only as of the date it is filed with the

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SEC. We undertake no obligation to update publicly any forward-looking statement, whether as a result of new information, future events or otherwise.

Executive Overview

        We are a mortgage REIT that invests in non-conforming loans originated by our wholly owned subsidiary, Fieldstone Mortgage Company (Fieldstone Mortgage), which are financed with mortgage-backed securities. Fieldstone Mortgage originates loans through both wholesale and retail origination channels. Through Fieldstone Mortgage, we originate, service and sell both non-conforming and conforming single family residential mortgage loans.

        Currently, our primary sources of income are the net interest income on our loans, both held for investment and held for sale, and the gains on sales of mortgage loans held for sale sold servicing-released. Our current strategy is to retain a certain portion of our non-conforming loans in our REIT investment portfolio, to finance our portfolio of loans with mortgage-backed securities collateralized by those loans, and to continue to sell our conforming loans and the remainder of our non-conforming loans. The non-conforming loans that we retain meet certain cash flow, credit and return requirements.

        Our portfolio of loans held for investment increased to $5.1 billion at March 31, 2005, a 7.4% increase from December 31, 2004. At March 31, 2005, our financing debt on the loans held in our portfolio was 8.5 times our equity. Based on the current size of our portfolio and management's estimates and assumptions regarding expected future origination levels and market factors, we have increased our target debt to equity ratio on our portfolio from 11 times our equity to 13 times our equity. We intend to continue to grow our portfolio by retaining the majority of our non-conforming fundings; however, the percentage of loans we retain for the portfolio in any given period is likely to vary based upon the size of the portfolio we hold, prepayments in the prior periods and the availability of loans which meet our cash flow, credit and return criteria.

        During the first quarter of 2005, our net income was $42.1 million. Our earnings in the first quarter of 2005 benefited from increased net interest income on our growing portfolio of loans held for investment, an increase in the non-cash mark to market gain on our interest rate swap and cap agreements and lower total expenses due to decreased origination activity. These benefits were offset partially by lower sales volumes and decreased sale margins due, in part, to a rising interest rate environment and higher sales of second lien mortgages, which generally provide lower sale premiums.

        We use interest rate swaps and caps to economically hedge the financing costs on our two and three year hybrid mortgage loans held for investment. Because these derivatives are not designated as cash flow hedges under Statement of Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities," changes in the fair market value of the swaps and caps are recorded to current period earnings and reported in our consolidated statement of operations in "Other income (expense)—portfolio derivatives." We cannot predict the magnitude by which these changes in the fair market value of our swaps and cap could cause our total revenue and net income to increase or decrease significantly during periods of interest rate volatility.

Key Components of Financial Results of Operations

Revenues

        The principle factors that affect our revenues are interest rate volatility, origination volumes, prepayment rates of our mortgage loans held for investment, credit losses on our investment portfolio and sale margins on our loans held for sale. Rising interest rates may result in an increase in the mortgage rates we charge on our loan originations, but also will increase our costs of borrowing to finance the loans. Rising interest rates may lead to decreases in loan prepayments of our hybrid adjustable rate mortgages during the initial loan period in which our borrowers pay a fixed interest

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rate, generally during the first two years of the loan, but increase prepayments at or near the reset date of the loan, when the coupon resets to a margin over six-month LIBOR. In addition, rising interest rates will generally increase the fair value on the swaps and caps economically hedging our portfolio financing costs.

Expenses

        The principle factors which lead to changes in our expenses are funding volumes, the number of origination offices we operate, our staffing required to support our origination business, the balance of our investment portfolio incurring third-party servicing fee expenses and the corporate overhead required to support a publicly traded company. As loan volumes increase, we generally would expect salaries, benefits and variable operating expenses, net of deferred direct origination costs, which include commissions, to increase. We also expect expenses to increase in 2005 due to costs related to enhanced portfolio analytic tools, higher audit and legal fees, and increased amortization expense as our new loan origination software becomes fully operational.

Critical Accounting Policies

        We consider the policies discussed below to be critical to an understanding of our financial statements because their application places the most significant demands on the judgment of our management, with financial reporting results relying on estimates and assumptions about the effects of matters that are inherently uncertain. Specific risks for these critical accounting policies are described in the following paragraphs. While we believe that the estimates and assumptions management utilizes in preparing our financial statements are reasonable, such estimates and assumptions routinely require periodic adjustment. Actual results could differ from our estimates, and these differences could be significant.

Securitizations

        We must comply with the provisions of Statement of Financial Accounting Standards No. 140 "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" (Statement No. 140) and Financial Interpretation Number 46R, "Consolidation of Variable Interest Entities," (FIN 46R) relating to each securitization. Depending on the structure of the securitization, it will either be treated as a sale or secured financing for financial statement purposes. We account for our securitizations of mortgage loans as secured financing transactions, and accordingly, we hold the securitized mortgage loans for investment. The loans are sold to a trust which is a wholly-owned special purpose entity; however, the securitizations do not meet the qualifying special purpose entity criteria of Statement No. 140.

Allowance for Loan Losses—Loans Held for Investment

        Because we maintain our loans held for investment on the statements of condition for the life of the loans, we maintain an allowance for loan losses, which is based on our estimates of the losses inherent in the portfolio. This is a critical accounting policy because of the subjective nature of the estimates required and potential for imprecision. Two critical assumptions used in estimating the loss reserve are an assumed rate at which the loans go into foreclosure subsequent to initial default and an assumed loss severity rate, which represents the expected rate of realized loss upon disposition of the properties that have been foreclosed. Because we have limited historical loss data on our past originations, all of which were sold servicing-released, we currently utilize industry loss assumptions for loans similar in credit, loan size and product type. These assumptions result in an estimate that approximately 24% of loans that are delinquent 30+ days ultimately will default and experience an average principal balance loss of 35%. These underlying assumptions and estimates are continually evaluated and updated to reflect management's current assessment of the value of the underlying

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collateral and other relevant factors impacting portfolio credit quality and inherent losses. Provision for losses is charged to our consolidated statements of operations as a reduction in net interest income. Losses incurred on mortgage loans held for investment are charged to the allowance at the time of liquidation or at the time the loan is transferred to real estate owned.

        We define the beginning of the loss emergence period for a mortgage loan to be the occurrence of a contractual delinquency greater than 30 days. On a monthly basis, loans meeting this criterion are included in a determination of the allowance for loan losses, which utilizes industry roll rate experience to assess the likelihood and severity of portfolio losses. We do not assess loans individually for impairment due to the homogeneous nature of the loans, which are collectively evaluated for impairment. If actual results differ from our estimates, we may be required to adjust our provision accordingly. Likewise, the use of different estimates or assumptions could produce different provisions for loan losses.

Amortization of Deferred Loan Origination Costs and Deferred Debt Issuance Costs

        Interest income on our mortgage loan portfolio is a combination of the accrual of interest based on the outstanding balance and contractual terms of the mortgage loans, adjusted by the amortization of net deferred origination costs related to originations in our investment portfolio, in accordance with Statement of Financial Accounting Standards No. 91, "Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases" (Statement No. 91). Our net deferred origination costs consist primarily of premiums, discounts and other net capitalized fees or costs associated with originating our mortgage loans. For our loans held for investment, these net deferred costs are amortized as adjustments to interest income over the estimated lives of the loans using the interest method. Because we hold a large number of similar loans for which prepayments are probable and for which we can reasonably estimate the timing of such prepayments, we currently factor in prepayment estimates in determining periodic amortization based on a model that considers actual prepayment experience to-date as well as forecasted prepayments based on the contractual interest rate on the loans, loan age, loan type, prepayment fee coverage and a variety of other factors. Mortgage prepayments are also affected by the terms and credit grades of the loans, conditions in the housing and financial markets and general economic conditions. Prepayment assumptions are reviewed regularly to ensure that actual company experience as well as industry data are supportive of prepayment assumptions used in our model. Updates that are required to be made to these estimates are applied as if the revised estimates had been in place since the origination of the loans and result in adjustments to the current period amortization recorded to interest income.

        Interest expense on our warehouse and securitization financing is a combination of the accrual of interest based on the contractual terms of the financing arrangements and the amortization of bond original issue discounts and issuance costs. The amortization of bond original issue discounts and issuance costs also considers estimated prepayments and is calculated using the interest method. The principal balance of the securitization financing is repaid as the related collateral principal balance amortizes, either through receipt of monthly mortgage payments or any loan prepayment. The deferred issuance costs and original issue discounts are amortized through interest expense over the estimated life of the outstanding balance of the securitization financing, utilizing the prepayment assumptions referenced above to estimate the average life of the related debt. Updates that are required to be made to these estimates are applied as if the revised estimates had been in place since the issuance of the related debt and result in adjustments to the period amortization recorded to interest expense.

        We have sought to minimize the effects caused by faster than anticipated prepayment rates by originating mortgage loans with prepayment fees. These fees typically expire two years after origination of a loan. As of March 31, 2005 and December 31, 2004, approximately 87% of our mortgage loan portfolio had active prepayment fee features. We anticipate that prepayment rates on a significant portion of our adjustable rate mortgage portfolio will increase as these predominately adjustable rate

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loans reach their initial adjustments during 2005 and 2006 due to the high concentration of two to three year hybrid loans we originated during 2003 and 2004. The constant prepayment rate, or CPR, currently used to project cash flows is based upon historical industry speeds for similar loan product and actual history to date. The forward-looking expected CPR used in our current assumptions averages 28 CPR during the first 12 months, averages 46 CPR through month 24 and declines to an average 42 CPR thereafter. If prepayment speeds increase, our net interest margin would decrease due to the additional yield adjustment amortization, which may be partially offset by an increase in prepayment fee income.

Hedging

        Hedging is a critical aspect of our business because of its interest rate sensitivity and the difficulty in estimating which interest rate locks will convert to closed loans as interest rates fluctuate. We use various financial instruments to hedge our exposure to changes in interest rates. The financial instruments typically include mandatory delivery forward sale contracts of mortgage-backed securities, mandatory and best efforts whole-loan sales agreements and treasury note forward sales contracts. These financial instruments are intended to mitigate the interest rate risk inherent in providing interest rate lock commitments to prospective borrowers to finance one-to-four family homes and to hedge the value of our loans held for sale prior to entering fixed price sale contracts.

        The interest rate locks for conforming loans and the mandatory forward sales, which are typically used to hedge the interest rate risk associated with these locks, are undesignated derivatives and are marked to market through earnings. For interest rate lock commitments related to conforming loans, mark to market adjustments are recorded from inception of the interest rate lock through the date the underlying loan funds. The funded loans have not been designated by us as a qualifying hedged asset in accordance with Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" (Statement 133). We record the funded loans on the consolidated statements of condition at the lower of cost or market value. The mandatory forward sales, which generally serve as an effective economic hedge from the inception of the interest rate lock through the time of the sale of the loans, remain subject to mark to market adjustments beyond the time the loan funds, and our reported earnings may reflect some non-economic volatility as a result of this differing treatment.

        The interest rate lock commitments associated with non-conforming loans held for sale and the treasury note forward sales contracts typically used to hedge the interest rate risk associated with these locks are also derivatives and are marked to market through earnings. Similar to the conforming loans, the funded non-conforming loans have not been designated as a qualifying hedged asset in accordance with Statement 133, and, accordingly, we record them at the lower of cost or market value on the consolidated statements of condition. The treasury note forward sales contracts, which do serve as an effective economic hedge prior to the sale of some of our non-conforming loans, remain subject to mark to market adjustments beyond the time the loans fund, and our reported earnings may reflect some non-economic volatility as a result of this differing treatment.

        We hedge the effect of interest rate changes on our cash flows relative to our loans held for investment as a result of changes in the benchmark interest rate, in this case, LIBOR, on which our interest payments on warehouse financing and securitization financing are based. These derivatives are not classified as cash flow hedges under Statement 133. We enter into interest rate swap agreements to hedge the financing on mortgage loans held for investment. The change in fair value of the derivative during the hedge period is reported as a component of "Other income (expense)—portfolio derivatives." The periodic net cash settlements and any gain or loss on terminated swaps are also reported as a component of "Other income (expense)—portfolio derivatives." We also entered into an interest rate cap agreement to hedge interest rate changes relative to our first securitization in the fourth quarter of 2003. The cap was not designated as a cash flow hedge instrument, and as such,

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realized and unrealized changes in its fair value are recognized in current period earnings during the period in which the changes occur.

        Changes in interest rates during a reporting period will affect the mark to market valuations on our undesignated derivatives. Increases in short-term interest rates will result in a non-cash credit being recognized for income reporting, while decreases in short-term rates will result in a non-cash charge to earnings.

Stock-Based Compensation

        We adopted the fair value method of accounting for stock options and shares of restricted stock as prescribed by Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation—Transition and Disclosure," which amends Statement of Financial Standards No. 123, "Accounting for Stock-Based Compensation" (Statement No. 123). Under this method, compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense on a straight-line basis over the award's vesting period. The fair value of awards of restricted stock is determined at the date of grant based on the market price of our common stock on that date. For both the stock options and restricted stock, the amount of compensation cost is adjusted for estimated annual forfeitures. The fair value of the stock options is determined using the Black Scholes option pricing model. Due to the subjective nature and estimates required under Statement No. 123, we consider this a critical accounting policy.

Reserve for Losses—Loans Sold

        We maintain a reserve for our representation and warranty liabilities related to the sale of loans and for 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. The representations and warranties generally relate to the accuracy and completeness of information related to the loans sold and to the collectibility of the initial payments following the sale of the loan. The reserve, which is recorded as a liability on our consolidated statements of condition, is established when loans are sold and is calculated as the fair value of losses estimated to occur over the life of the loan. The reserve for losses is established through a provision for losses, which is reflected as a reduction of the gain on the loans sold at the time of sale. We use an internally developed analysis of incurred historical losses, stratified by type of loss, by type of loan and by year of sale to forecast future losses on current sales. This analysis takes into consideration historical information regarding frequency and severity of losses, organized by loan product and year of sale. We estimate losses due to premium recaptures on early loan prepayments by reviewing loan product and rate, borrower prepayment fee, if any, and estimates of future interest rate volatility.

Results of Operations

Three Months Ended March 31, 2005 Compared to Three Months Ended March 31, 2004

Net Income

        Net income increased $45.9 million, to $42.1 million, for the three months ended March 31, 2005, from $(3.8) million for the three months ended March 31, 2004. The increase was primarily the result of increased net interest income on our loans held for investment reflecting the growth in our portfolio balance, and an increase in the fair value of our interest rate swap and cap agreements compared to a decrease in cap and swap fair value in the first quarter of 2004. Our average balance of loans held for investment was $4.9 billion for the three months ended March 31, 2005 as compared to $1.7 billion for the three months ended March 31, 2004. The increase in the ending valuation of the swaps and cap resulted from an increasing interest rate environment in 2005. Our interest rate swaps and caps are not designated as cash flow hedges and, therefore, the change in the periodic mark to market of the future

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value of the interest rate swaps and caps is reported in current period earnings. These increases were offset by lower gains on sales of mortgage loans, net, in 2005 as compared to 2004, because we sold fewer loans and earned lower sale margins in the first quarter of 2005 as compared to the same period in 2004.

Revenues

Net Interest Income after Provision for Loan Losses

        The following are the components of net interest income after provision for loan losses for the three months ended March 31, 2005 and 2004 (in thousands):

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        The following table presents the average balances for our loans held for investment and loans held for sale and our warehouse and securitization financing, with the corresponding annualized yields for the three months ended March 31, 2005 and 2004 (in thousands).

(1)

Calculated as the annualized interest income divided by the average daily balance of the mortgage loans.

(2)

Calculated as the annualized interest expense divided by the average daily balance of the related debt.

(3)

Calculated as the annualized net interest income divided by the average daily balance of mortgage loans. The net yield on loans will not equal the difference between the yield on loans and the cost of financing due to the difference in the denominators of the two calculations.

        The increase in our net interest income after provision for loan losses from the three months ended March 31, 2004 to the three months ended March 31, 2005 was attributable primarily to the increase in our portfolio of loans held for investment, partially offset by the increased interest costs on the higher securitization debt financing the portfolio, as interest rates rose throughout 2004 and 2005. We expect net interest income to increase throughout the remainder of 2005 as we continue to grow the portfolio. Prepayment fee income collected in 2005 was substantially offset by the amortization of deferred origination costs on the loans. We expect prepayment fee income will continue to increase in

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2005, reflecting the growth and maturation of the portfolio. The decrease in the net yield on loans held for investment after provision for loan losses during the three months ended March 31, 2005 compared to the same period in 2004, reflects the increase in the cost of financing the warehouse and securitization debt due to rising interest rates. Both the net yield on loans held for sale and loans held for investment in 2004 and 2005 reflect the use of the proceeds from our 2003 equity offering to finance loan fundings during 2004 and 2005. We anticipate that interest expense related to both warehouse and securitization financing will continue to increase in 2005 as we continue to build our investment portfolio by issuing additional mortgage-backed securities. The provision for loan losses increased in 2005, consistent with expectations, due to the increase in delinquent loans in our portfolio as the portfolio continues to season.

        The net interest income after provision for loan losses does not include the $0.3 million and $3.6 million of net cash settlements paid in the three months ended March 31, 2005 and 2004, respectively, under the terms of the swap and cap agreements used to economically hedge the financing costs of our investment portfolio. The regular monthly swap and cap settlement amounts, plus any cash paid or received at termination of the agreements prior to maturity, are included in the line item "Other income (expense)—portfolio derivatives." We expect that net interest income after provision for loan losses will increase in 2005, reflecting the anticipated growth in our portfolio of loans held for investment, partially offset by margin decreases as our portfolio financing costs rise due to current as well as continued anticipated increases in the LIBOR interest rate to which they are indexed.

Gains on Sales of Mortgage Loans, net

        The components of the gains on sale of mortgage loans, net, are illustrated in the following table for the three months ended March 31, 2005 and 2004 (in millions)*:

*

Loan fees collected, premiums paid and direct origination costs are deferred at funding and recognized at loan sale.

(1)

Loan fees collected represent points and fees collected from borrowers.

(2)

Premiums paid represent fees paid to brokers for wholesale loan originations.

(3)

Direct origination costs primarily are commissions and direct salary costs.