UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-K

(Mark One)

 

ý		Annual report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For fiscal year ended December 31, 2004
or
o		Transition report under Section 13 or 15(d) of the Securities Exchange Act of 1934
For the transition period from            to

 

Commission file number 0-22361

 

 

NetBank, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

Georgia		58-2224352
(State of incorporation)		(IRS Employer Identification No.)
11475 Great Oaks Way Alpharetta, Georgia		30022
(Address of principal executive offices)		(zip code)
(770) 343-6006
(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act: None.

 

Securities registered pursuant to Section 12(g) of the Act:

 

Common Stock, $.01 par value
Preferred Share Purchase Rights

(Title of Class)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act 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 past 90 days. Yes ý            No o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  Yes ý                                         No o

 

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

 

Aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant, computed by reference to the closing price of $10.93 of such common equity as of June 30, 2004: $470,855,853.

 

Number of shares outstanding of each of the issuer’s classes of common equity, as of the latest practicable date: 46,322,131 shares of Common Stock at March 7, 2005.

 

 

DOCUMENTS INCORPORATED BY REFERENCE

 

Portions of the Registrant’s Proxy Statement for the Annual Meeting of Shareholders, scheduled to be held on April 28, 2005 are incorporated by reference into Part III.

 

TABLE OF CONTENTS OF INFORMATION REQUIRED IN REPORT

 

Part I
Item 1.	Business
Item 2.	Property
Item 3.	Legal Proceedings
Item 4.	Submission of matters to a vote of security holders
Part II
Item 5.	Market for registrant’s common equity, related shareholder matters and issuer purchases of equity securities
Item 6	Selected financial data
Item 7.	Management’s discussion and analysis of financial condition and results of operation
Item 7A.	Quantitative and qualitative disclosures about market risk
Item 8.	Financial statements and supplementary data
Item 9.	Changes in and disagreements with accountants on accounting and financial disclosure
Item 9A.	Controls and procedures
Item 9B.	Other information
Part III
Item 10.	Directors and executive officers of the registrant
Item 11.	Executive compensation
Item 12.	Security ownership of certain beneficial owners and management
Item 13.	Certain relationships and related transactions
Item 14.	Principal accountant fees and services
Part IV
Item 15.	Exhibits and financial statement schedules
Signatures

 

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PART I

 

ITEM 1.     BUSINESS

 

General

 

NetBank, Inc. is a financial holding company engaged primarily in retail banking, mortgage banking, business finance and providing ATM and merchant processing services.  NetBank, Inc. wholly owns the outstanding stock of NetBank (“NetBank, FSB” or “the Bank”), a federal savings bank; MG Reinsurance Company (“MG Reinsurance”), a captive reinsurance company; NetInsurance, Inc. (“NetInsurance”), a licensed insurance agency; and NB Partners, Inc., a corporation involved in strategic partnering opportunities.  NB Partners, Inc. owns all of the outstanding stock of Financial Technologies, Inc., a corporation formed in 2004 to market transaction processing services to other financial services companies.  NetBank, FSB owns all of the outstanding stock of Market Street Mortgage Corporation (“Market Street”), a retail mortgage company, NetBank Payment Systems, Inc. (“NPS”), a provider of ATM and merchant processing services for retail and other non-bank businesses and Meritage Mortgage Corporation (“Meritage”), a wholesale non-conforming mortgage provider. The consolidated company is referred to herein as “we,” “our,”  “NetBank,” or “the Company”.

 

During the third quarter of 2004, Resource Bancshares Mortgage Group, Inc. (“Resource”) and Republic Leasing Company, Inc., both of which had been subsidiaries of NetBank, FSB, were legally consolidated into NetBank, FSB and ceased to exist as separate corporations.  Republic Leasing Company, Inc. now operates as the NetBank Business Finance division of NetBank, FSB.  In addition, during the fourth quarter of 2004, RBMG, Inc., formerly a subsidiary of NetBank, FSB, was legally consolidated into NetBank, FSB and ceased to exist as a separate corporation.  RBMG, Inc. now operates as the NetBank Funding division of NetBank, FSB.

 

NetBank was founded in October 1996 and completed its initial public offering of stock in July 1997. It is one of the pioneers of the Internet banking industry, and NetBank, FSB is recognized as one of the first successful internet-only banks. For further information and a description of the growth of the Company through recent acquisitions see note 2 of the notes to the consolidated financial statements included in this report.

 

All dollar figures are presented in thousands (000s), except per share data, unless otherwise noted.  Net income per share is presented on a diluted basis.  All of the Company’s operations and assets are located within the United States.

 

NetBank’s business model has three basic strategies:

 

Retail Banking—NetBank, FSB, through its Internet banking operations, operates as an FDIC-insured, federally chartered thrift institution that currently serves approximately 160,000 customers throughout the United States and in more than 80 foreign countries. NetBank, FSB delivers its products and services through remote delivery channels, such as the Internet, telephone and ATMs. It does not maintain a branch network to support its banking business. This branchless model provides it with an opportunity to operate with less overhead expense than traditional branch banks. Passing along part of this cost savings to customers through higher deposit rates and better technology has been the cornerstone of our value proposition. NetBank, FSB offers a full line of deposit and loan products, including checking and savings accounts, a small business banking program, online bill payment, auto loans, mortgages and financial planning services. Customers also enjoy continuous access to customer support — 24 hours a day, seven days a week.

 

Financial Intermediary—Through the Company’s various loan operations, it serves as an intermediary between consumers and institutional investors. The bulk of the Company’s business in this segment relates to mortgage lending, including both conforming and non-conforming products. We obtain mortgage loans by originating loans directly with consumers or through a nationwide network of brokers. We also buy closed loans from a network of correspondent banks, thrifts and independent mortgage companies. The majority of the loans are held for sale on the Company’s balance sheet prior to sale into the secondary market. The Company thus earns a long-term yield on an asset held short-term. We also earn origination fees and the opportunity for gains on the sale of the mortgages or resulting mortgage-backed securities.

 

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The Company recently diversified, through acquisition, its operations to include the origination of loans for recreational vehicles (RVs), boats and personal aircraft. The Company has not retained any of these loans, which have been sold to investors in the capital markets under the same intermediary strategy the Company employs in its mortgage businesses.

 

Transaction Processing— NetBank provides a variety of financial-related processing services to merchants, community banks and other organizations. The Company entered into these lines of business initially by leveraging core competencies from its other operating segments. These competencies were packaged and re-sold to other banks. NetBank has also been an active acquirer of small, profitable processing businesses that complement our overall business strategy. In late 2003, the Company acquired an ATM and merchant transaction processing operation. During 2004 we grew this operation through acquisition and internal growth, and we intend to continue this strategy in the future. This business now operates approximately 8,000 ATMs across the country, which the Company has made available to its banking customers on a surcharge-free basis. This network of ATMs currently ranks as the second largest bank-operated ATM network in the country.

 

Segmented Revenue Information

 

The tables in note 18 of the notes to the consolidated financial statements included in this report present a summary of the revenues and expenses for each of the Company’s business segments for each of the years ended December 31, 2004, 2003, and 2002, respectively.  The following represents the percentage and amount of total Company revenues contributed by the Company’s business segments for the years ended December 31, 2004, 2003, and 2002:

 

		2004					2003					2002
		Amount			Percentage		Amount			Percentage		Amount			Percentage
Retail banking		$	118,140		38	%	$	110,512		25	%	$	47,312		22	%
Financial intermediary		180,147			58	%	316,415			74	%	163,224			75	%
Transaction processing		31,907			10	%	20,685			5	%	6,616			3	%
Other/eliminations		(18,074		)	(6	)%	(18,832		)	(4	)%	828			0	%
Total revenues		$	312,120		100	%	$	428,780		100	%	$	217,980		100	%

 

Retail Banking Segment

 

The retail banking segment, through its Internet banking operations (“Internet Bank”), competes in a commoditized, highly competitive marketplace for personal and small business banking relationships. It offers a full line of deposit and loan products along with ancillary account services. It competes head-to-head with large national financial institutions, small community banks and credit unions, and, for certain product relationships, alternative providers, such as brokerages, insurance companies and credit card issuers.  The retail banking segment also includes the operations of Dealer Financial Services (“DFS”), NetBank, FSB’s indirect auto lending division; and NetBank Business Finance, NetBank, FSB’s business financing division.

 

Market Position

 

The Internet Bank operates a branchless business model. Its products and services are delivered through remote delivery channels, including the Internet, phone, ATM and overnight mail delivery. This branchless model provides it with an opportunity to operate with lower overhead expense than traditional branch banks. Its value proposition has been based historically on sharing its operating cost savings with customers through higher deposit rates, fewer fees and better technology.

 

When the Internet Bank began operations in 1996, it was one of the early movers in online banking. Its value proposition and product line was differentiated in the marketplace since few direct competitors existed. Its products and services were designed to appeal to a highly targeted group of technology-savvy consumers who seek both convenience and greater economic value.

 

 

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Its typical customer fits the following profile:

 

•                  Late 30s to early 40s in age

•                  Married with children

•                  Two income household

•                  Homeowner

•                  College educated

 

The market for online banking has grown exponentially since it helped pioneer the marketplace, and we believe that online banking has reached critical mass today. According to a November 2004 study by the Pew Internet and American Life Project, approximately 50% of all U.S. Internet users now bank online — making it the fastest growing online activity the annual survey measures. Jupiter Research estimates that 35 million or approximately one-third of all U.S. households banked online at the end of 2004.

 

The Internet Bank has seen increased competition as consumer demand has grown. Over the past several years, large national banks, such as Bank of America, Citibank and Wells Fargo, have deployed and aggressively promoted their own online banking platforms. These institutions were arguably motivated by the characteristics of the typical online banking customer. Independent market research continues to show that online banking customers tend to be more profitable than offline customers due to the simple fact that these customers are able to help themselves and conduct their transactions electronically without the assistance of a teller in a branch. In addition, online banking customers tend to have lower attrition rates than offline customers.

 

The increased competition from large national banks has affected the Internet Bank’s ability to differentiate itself in the marketplace. Previously, it was able to compete more effectively on convenience and price. Competitors have now closed the gap in terms of convenience since their online functionality rivals its. Despite increased competition, the Company still has an opportunity to differentiate its banking products and services in the marketplace. Management believes it can continue to compete effectively by combining its pricing advantages with focuses on 1) ease of use; 2) bundled product offerings; and 3) highly integrated technology. Its branding efforts and marketing campaigns will begin to reflect this refined positioning beginning in 2005.

 

Products & Services

 

The Company’s goal is to be a trusted, comprehensive financial services partner to its customers. It maintains a full line of financial products and services, from deposit and loan products to financial planning and investment services.

 

FDIC-insured products include:

•                  Individual and small business checking accounts

•                  Individual and small business money market accounts

•                  Individual and small business certificates of deposit

 

Additional products include:

•                  IRAs

•                  Mortgages

•                  Home equity loans and lines of credit

•                  Auto loans

•                  Boat and recreational vehicle loans

•                  Credit cards

•                  Overdraft protection

•                  Brokerage

•                  Financial planning

•                  Insurance

•                  Small business payroll services

•                  Business equipment leasing

 

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•                  Foreign currency exchange

 

Ancillary services include:

•                  Online bill payment and presentment

•                  Online check imaging

•                  Online statements

•                  Online account funding

•                  ATM cards

•                  ATM deposit-gathering

•                  VISA^® Check Card

•                  Wireless account access

•                  Account aggregation

•                  Consumer credit report monitoring

 

Many of the offerings listed above are provided on a proprietary basis. For non-core services, the Internet Bank partners with specialty providers to make them available to customers. For example, the Internet Bank works with CheckFree Corporation for online bill payment and presentment and with MBNA America Bank for credit card services.

 

The Internet Bank is able to extend its product and service offerings through these partnerships without the assumption of significant expense and operational risk, which might put its underlying value proposition at jeopardy. The partnerships also provide us with additional revenue opportunities. To mitigate some of the inherent reputation risk, it maintains service level agreements with substantially all of its specialty service providers and monitors the solvency of such providers on a periodic basis as part of its vendor management process.

 

Marketing Efforts

 

The Internet Bank presently attracts the majority of its new banking customers through highly targeted online advertising campaigns. It also relies on marketing alliances with other businesses to reach prospective customers.

 

The Internet Bank’s online advertising efforts tend to focus on key word searches in various search engines or high-traffic, financial-related sites. Campaigns on these sites are typically presented in banner advertisements that promote a specific product or service along with a cash incentive for first-time customers. Campaigns may also center on sponsorship of an area of the site or specific content.

 

The Internet Bank also has a sales force that pursues marketing alliances with other businesses. Its alliance partners agree to promote certain products and services to their customer bases in exchange for a fee on each successful lead they generate. These partnerships provide it with a highly cost-effective means of marketing to select, targeted groups of consumers. In turn, its partner is able to offer its customer value-added services while generating additional revenue.

 

Significant cross-selling opportunities also exist for the Internet Bank through the Company’s various lines of business. The Company’s mortgage and auto lending operations assist tens of thousands of customers each year. The Internet Bank actively promotes additional banking products and services through these channels whenever possible.

 

Security & Technology

 

The Company relies on state-of-the art technology and prevailing industry standards to ensure a safe, secure business environment. Data is encrypted and exchanged only over secure connections. The Internet Bank’s operating system does not connect directly to the Internet. It is isolated and protected by “firewalls” that comply with National Computer Security Association standards.

 

The Company uses a hybrid approach in acquiring technology to run its operations. Although it may develop proprietary applications for certain services, the Company typically partners with specialty technology providers and works to customize the partner’s existing solution to meet our needs. This outsourced approach is less capital intensive and allows us to take advantage of the partner’s larger infrastructure and operating scale. In addition, we are able to switch to another

 

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provider in the future if a competing, more compelling technology emerges.

 

The Internet Bank’s top technology partners include, but are not limited to: BISYS; Corillian; CheckFree; and NCR. We mitigate our exposure to security risks by continually testing our systems. These tests include annual disaster recovery exercises by the Company and its key vendors.

 

Lending & Investment Activity

 

The retail banking segment’s primary investment strategy for its deposits is to fund the origination of assets that can be sold into the capital markets. It lends money on an intra-company basis to several lending units in the financial intermediary segment. These operations include NetBank Funding, Market Street and Beacon Credit Services. These businesses originate residential mortgages, recreational vehicle (RV), marine and aircraft loans. Their production is typically sold into forward commitments within the secondary market.

 

The Company believes this investment strategy has numerous advantages. Credit and interest rate risks are reduced because loans are typically sold into the capital markets within 30 to 90 days, thereby limiting exposure to this period. Once the loans are sold, the proceeds can then be reinvested in new originations.

 

Additionally, the retail banking segment maintains a loan and investment portfolio separate from the funding lines for the lending operations. The retail banking segment chooses to retain loans made to its core customers. By retaining the loans or servicing rights, we can continue to own the relationship and ensure a more consistent, higher-quality customer experience. If the asset was sold to another provider, then we could not guarantee consistent service or prevent the other provider from cross-selling our customer its own products and services.

 

The retail banking segment also needs to invest excess liquidity that it cannot actively deploy through its lending operations. Management believes that deposits are likely to grow more quickly over time than the lending operations’ need for additional funding. Plus, consumer demand affects production within these businesses. In a rising interest rate environment, the lending operations tend to experience lower production levels and, therefore, have reduced funding needs. During these times, the retail banking segment must shift liquidity into other investments to attempt to offset the corresponding drop in earnings from the lending businesses.

 

Servicing Asset

 

The Company maintains a sizeable portfolio of mortgage servicing rights (“MSRs”), primarily with respect to agency-eligible loans that were securitized and sold by the Company as described below. This servicing asset is a natural economic hedge against the Company’s mortgage origination operations, since MSRs tend to increase in value in a rising interest rate environment when origination volumes tend to decline and mortgage lending profitability comes under pressure.

 

To serve as a more effective hedge, the Company believes that the size of its servicing portfolio should approximate two-times peak or four-times trough of the Company’s annual mortgage production. This implies a general target range of $25 to $30 billion. The portfolio stood at $12.9 billion at year-end 2004.

 

While the Company services loans, it earns servicing revenue (usually stated as a percent of the outstanding principal balance). The Company earns late charges assessed to borrowers on payments not paid when contractually due. We also receive a float benefit from escrow accounts for taxes and insurance and for collections of principal and interest that have not yet been passed on to the investor.  The retail banking segment pays the transaction processing segment an inter-segment subservicing fee for the servicing of the underlying loans.

 

As a servicer of mortgage loans underlying mortgage-backed securities, the Company is obligated to make timely payments of principal and interest to security holders, whether or not such payments have been made by mortgagors on the underlying mortgage loans. Similarly, in the event of foreclosure, the Company is responsible for covering with its own funds principal and foreclosure costs to the extent not covered by FHA insurance or a VA guarantee.

 

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The following table shows the delinquency percentages (excluding bankruptcies and foreclosures) of the Company’s portfolio of MSRs (excluding loans serviced under subservicing agreements).

 

		December 31,
Days Delinquent		2004		2003		2002
30 days		3.70	%	2.99	%	3.87	%
60 days		0.90	%	0.71	%	0.94	%
90 + days		0.94	%	0.45	%	0.93	%
Total delinquencies		5.54	%	4.15	%	5.74	%

 

At December 31, 2004, the portfolio of MSRs had an underlying unpaid principal balance of $12.9 billion with book value of $173 million. The portfolio had a weighted average note rate of 5.96%.  As more fully described in note 3 of the notes to the consolidated financial statements included in this report, the Company accounts for all mortgage servicing rights at the aggregate of the lower of cost or market. For purposes of managing risk, the Company segregates its owned portfolio of MSRs into two tranches: available for sale and held for sale. The available for sale portfolio contains those rights which we intend to hold as longer-term investments.  The held for sale portfolio contains rights generated as a by-product of recent production which we intend to sell, generally within 120 days.  The held for sale portfolio is generally not as susceptible to changes in interest rates and other market factors as the available for sale portfolio since the held for sale rights are generally allocated to a specific forward sales contract.

 

The following tables provide information regarding of the Company’s available for sale portfolio of MSRs at December 31, 2004:

 

Year of Origination		Number of Loans		Percentage of Total Loans		Aggregate Unpaid Principal			Percentage of Unpaid Principal
1994 or earlier		3,284		3.3	%	$	124,755		1.0	%
1995		292		0.3	%	15,406			0.1	%
1996		412		0.4	%	30,620			0.2	%
1997		1,245		1.3	%	93,950			0.7	%
1998		2,481		2.5	%	202,427			1.6	%
1999		1,444		1.5	%	105,386			0.8	%
2000		251		0.3	%	18,520			0.2	%
2001		1,182		1.2	%	112,061			0.9	%
2002		15,621		15.8	%	1,895,156			14.9	%
2003		53,664		54.4	%	7,600,816			59.9	%
2004		18,683		19.0	%	2,500,838			19.7	%
Total		98,559		100.0	%	$	12,699,935		100.0	%

 

Loan Type		Number of Loans		Aggregate Unpaid Principal			Weighted Average Coupon		Weighted Average Service Fee
Conventional fixed		89,504		$	11,013,244		6.04	%	0.323
Conventional arms		3,926		620,733			4.87	%	0.289
FHA		2,028		224,937			5.95	%	0.553
VA		525		64,859			5.66	%	0.449
Jumbo		2,455		770,253			5.56	%	0.312
Seconds		106		5,223			7.42	%	0.407
Other		15		686			8.07	%	0.530
Total		98,559		$	12,699,935		5.95	%	0.325

 

Since the Company’s available for sale MSRs are held as longer-term investments, they are subject to interest rate

 

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(prepayment) risk.  During periods of declining interest rates, prepayments of mortgage loans increase as homeowners seek to refinance at lower rates, resulting in a decrease in value of the related MSRs.  Mortgage loans with higher interest rates are more likely to result in prepayments.  The following table sets forth certain information regarding the aggregate unpaid principal balance of mortgage loans underlying the Company’s tranche of available for sale MSRs. The table includes both fixed and adjustable rate loans at December 31, 2004:

 

 

The following table sets forth the geographic distribution of the aggregate unpaid principal balance of mortgage loans underlying the Company’s tranche of available for sale MSRs at December 31, 2004:

 

 

To help the Company manage risk related to prepayments in its portfolio of MSRs, the Company has purchased interest-rate floor contracts, which provide an interest rate differential on a fixed portion of the portfolio in the event interest rates fall below a certain level, interest rate caps, interest rate swap transactions, and forward purchase contracts on Fannie Mae mortgage backed securities (“FNMA TBA”).  For a more detailed discussion of derivative instruments purchased by the Company to hedge interest rate risk on its portfolio of MSRs see note 21 of the notes to the consolidated financial statements included in this report.

 

In those cases where the Company sells its MSRs on a flow basis or in bulk sales, the Company may temporarily subservice the loans until the servicing files are transferred to the acquiror of the MSRs.  Likewise, the Company subservices loans on behalf of other third parties pursuant to subservicing agreements.  Those agreements provide for

 

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compensation to the Company usually on a monthly per loan basis.  At December 31, 2004, the Company was subservicing 6,781 loans under such subservicing arrangements with an aggregate unpaid principal balance of $979 million.

 

Financial Intermediary Segment

 

The financial intermediary segment originates and purchases (for purposes of this discussion the term “originate” is used to describe both the origination and the purchase of loans) loans to be aggregated and re-sold into the secondary markets in the form of mortgage-backed securities or whole loans.  The servicing of such loans is sold on a flow or bulk sale basis to external and internal customers.  The financial intermediary segment principally originates 1-4 family, first and second mortgage loans.  Additionally, on a smaller scale, NetBank originates loans collateralized by boats, planes and other recreational vehicles through Beacon Credit Services, which it acquired in June of 2004, see note 2 of the notes to consolidated financial statements included in this report for additional details regarding this acquisition.

 

NetBank originates agency-eligible mortgages via its 75 retail branches, operated by its subsidiary Market Street, or its nationwide network of 7,291 brokers and 865 correspondents, operated by its NetBank Funding division.  We originate non-conforming mortgages through a nationwide network of 12,775 brokers, operated by its subsidiary Meritage.  For the year ended December 2004, NetBank originated $10.6 billion of conforming mortgage loans and $3.0 billion of non-conforming mortgages.

 

Agency-eligible mortgages are those mortgage loans that meet the size, documentation, borrower and credit standards to qualify to be pooled into mortgage-backed securities guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae.

 

After the sale or securitization of agency-eligible mortgage loan production, NetBank, in some cases, continues to service mortgages on behalf of the permanent investor. Servicing activities include collecting and remitting mortgage loan payments, accounting for principal and interest, holding escrow funds for payment of mortgage-related expenses such as taxes and insurance, making inspections of the mortgaged premises as required, making advances to cover delinquent payments, supervising foreclosures and property dispositions in the event of unremedied default, and generally administering agency-eligible mortgage loans.  Under the Company’s internal reporting structure, the servicing assets retained for internal investment are deemed to be “sold” to the retail banking segment, and the revenues generated from servicing activities are included in the transaction processing segment.

 

Non-conforming mortgages, which are not eligible to be securitized by the aforementioned government sponsored enterprises, are sold to private whole loan investors and private-label mortgage conduits.  NetBank does not retain an interest in non-conforming mortgages once they are sold.

 

NetBank also sells its entire range of mortgage competencies on a private-label basis to financial institutions that lack the knowledge or infrastructure to originate mortgages themselves.  NetBank has partnered with the Independent Community Bankers of America (ICBA) to offer mortgage services to its 5,000 community bank members.

 

Mortgage Loan Production Channels

 

Retail Production.    NetBank offers mortgage products directly to consumers through 75 retail branches located in 14 states. Market Street maintains relationships directly with realtors and builders to focus on purchase mortgage transactions (as opposed to refinancing transactions) business.  NetBank also offers construction-to-permanent loans enabling consumers to finance the construction and permanent financing of their new home in one seamless transaction.  Although production costs in its retail channel are higher than in the correspondent and broker channels, the retail channel offers higher margins than those channels.  Likewise, the retail channel offers a direct relationship with the customer, which allows for more potential cross-selling of other products and services to the customer.  Market Street’s production is less affected by cyclical trends that affect the volumes and margins in the correspondent and wholesale channels because a larger portion of Market Street’s volume comes from home purchase transactions.

 

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In its retail offices, Market Street’s representatives take mortgage applications, process and underwrite the loans, and fund the approved loans. At its home office in Clearwater, Florida, Market Street performs quality control tests, secondary marketing and loan shipping.

 

Correspondent Production.    NetBank Funding, acquires recently originated mortgages from a nationwide network of correspondent lenders. Correspondents are primarily mortgage lenders, mortgage brokers, savings and loan associations and small commercial banks. At December 31, 2004, the Company had approximately 865 correspondents originating mortgage loans in 48 states and the District of Columbia. Agency-eligible residential loan production by correspondents is widely dispersed, with the top 20 correspondents supplying the Company with 39% of its dollar volume of correspondent loans.

 

NetBank Funding attracts and maintains relationships with correspondents by offering a variety of services that provide incentives for the correspondents to sell NetBank Funding agency-eligible mortgage loans. NetBank Funding’s strategy with respect to its correspondents is to provide a high level of service rather than the lowest price.  Services provided include timely underwriting and approval or rejection of a loan, timely purchase of loans, seminars on how to process and prepare a loan application and updates on current underwriting practices. In addition, NetBank Funding provides correspondents with a variety of products and delivery capabilities and multiple means of funding loans.  NetBank Funding’s business-to-business Internet offering makes it easier for correspondents to interact with the Company by automating the flow of information between the correspondent and NetBank Funding.  The site allows correspondent lenders to upload/key files, register and lock a loan, submit a loan to Fannie Mae Desktop Underwriting, print out a fax cover with a bar code to be faxed and routed electronically, submit an electronic file to one of NetBank Funding’s regional operating centers for validation and request closing funds on-line. As the mortgage lending market increases in sophistication and loan-price differentials narrow among mortgage bankers, NetBank Funding believes that the level of service and commitment it provides to its correspondents will be paramount to its success.

 

Management believes that through correspondent lending it can manage risks and maintain good quality control. Correspondents have to meet established standards to be approved by the Veteran’s Administration (“VA”), the U. S. Department of Housing and Urban Development (“HUD”) or private mortgage insurance companies.  A correspondent qualifies to participate in NetBank Funding’s correspondent program only after a thorough review of its reputation and mortgage lending expertise, including a review of references and financial statements and a personal visit by one or more representatives of NetBank Funding.  After a correspondent qualifies for NetBank Funding’s program, NetBank Funding closely monitors the correspondent’s performance in terms of delinquency ratios, document exceptions and other pertinent data.  Furthermore, all mortgage loans purchased by NetBank Funding through correspondents are subject to various aspects of NetBank Funding’s underwriting criteria, and correspondents are required to repurchase loans or otherwise indemnify NetBank Funding for its losses in the event of fraud or misrepresentation in the origination process and for certain other reasons, including noncompliance with underwriting standards.

 

All loan applications are subject to NetBank Funding’s underwriting criteria and the guidelines set forth by the Federal Housing Authority (“FHA”), the VA, Ginnie Mae, Fannie Mae, Freddie Mac or private investors, as applicable. NetBank Funding or the correspondent, in the case of a correspondent with delegated underwriting authority, verifies, as appropriate for the loan type, each applicant’s income and bank deposits, as well as the accuracy of the other information submitted by the applicant, and obtains and reviews a credit report from a credit reporting agency, a preliminary title report and a real estate appraisal. Generally, delegated underwriting authority is granted by NetBank Funding to its larger correspondents that meet specified financial strength, delinquency ratio, underwriting and quality control standards.

 

With respect to FHA and VA loans, HUD and the VA, respectively, have established approval guidelines for the underwriting of loans to be covered by FHA insurance or a VA guaranty.  The Company is approved by both HUD and the VA to underwrite FHA and VA loans submitted by specified correspondents and wholesale brokers. The Company purchases FHA and VA loans only from those correspondents who are approved to underwrite FHA and VA loans and from those correspondents for whom the Company has been approved to underwrite FHA and VA loans.

 

NetBank Funding has implemented a quality control program to monitor compliance with its established lending and

 

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servicing policies and procedures, as well as with applicable laws and regulatory guidelines. NetBank Funding believes that the implementation and enforcement of its comprehensive underwriting criteria and its quality control program are significant elements in the Company’s efforts to purchase high-quality mortgage loans and servicing rights.  NetBank Funding’s quality control department examines loans in order to evaluate the loan purchasing function for compliance with underwriting criteria.  The quality control department also reviews loan applications for compliance with federal and state lending standards, which may involve re-verifying employment and bank information and obtaining separate credit reports and property appraisals.

 

Wholesale Production.    The wholesale division of NetBank Funding receives loan applications through brokers, underwrites the loans, funds the loans at closing and prepares all closing documentation.  Typically, mortgage brokers are responsible for taking applications and accumulating the information prior to NetBank Funding’s processing of the loans.  All loan applications processed by the wholesale division are subject to underwriting and quality control comparable to the standards used in NetBank Funding’s correspondent lending program.

 

NetBank Funding processes wholesale loans through regional operations centers.  At December 31, 2004, NetBank Funding had three regional operations centers serving approximately 7,291 brokers. These offices are located in Portland, Oregon; St. Louis, Missouri; and Jacksonville, Florida.  Although maintaining regional operations centers involves the incurrence of fixed expenses associated with maintaining those offices, wholesale operations generally provide for higher profit margins than correspondent loan production.  Additionally, each regional operations center can serve a relatively sizable geographic area by establishing relationships with large numbers of independent mortgage loan brokers who bear much of the cost of identifying and interacting directly with loan applicants.  NetBank Funding’s Internet site is also available to its brokers with the same features and benefits for brokers as enumerated above for the correspondent lending program.

 

Non-conforming Production.    Through Meritage, the Company originates mortgage loans that will not qualify to be pooled into agency-eligible mortgage-backed securities due to loan size, the extent of loan documentation, or borrower credit.  Meritage originates such non-conforming mortgages through a nationwide network of brokers.  Meritage underwrites and processes loans at two regional processing centers located in Portland, Oregon and Jacksonville, Florida, which are shared with the correspondent and wholesale production channels as described above.  All non-conforming loans are sold into the secondary market for cash, and Meritage retains no recourse risk beyond that associated with normal seller representations and warranties.

 

Non-conforming mortgage loans are more expensive to process than agency-eligible mortgage loans. However, the margin on sale makes these products generally the Company’s highest profit mortgage offering.  Likewise, the majority of the loans funded through Meritage’s non-conforming channel are home purchase mortgage loans as opposed to refinance transactions.  Accordingly, Meritage’s production volumes tend to be less cyclical than the volumes in NetBank’s correspondent and wholesale channels.

 

The following summarizes NetBank’s production volumes by channel:

 

		2004			2003			2002
Retail		$	2,510,558		$	3,059,215		$	2,449,319
Correspondent		4,871,980			8,239,984			5,066,168
Wholesale/broker		3,263,638			5,404,629			2,809,386
Total agency-eligible		10,646,176			16,703,828			10,324,873
Non-conforming		2,986,768			2,217,928			1,406,566
Total		$	13,632,944		$	18,921,756		$	11,731,439

 

NetBank purchases and originates a variety of mortgage loan products that are designed, in conjunction with the

 

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requirements of prospective purchasers of such loans, to respond to consumer needs and competitive factors. In addition to 15-year and 30-year conventional mortgage loans and 15-year and 30-year FHA loans and VA loans, NetBank purchases and originates products designed to provide lower interest rates to borrowers or lower principal and interest payments by borrowers, including balloon mortgage loans that have relatively short terms (i.e., five or seven years) and longer amortization schedules (i.e., 25 or 30 years) and adjustable rate mortgage loans.  The Company also purchases and originates mortgage loans featuring a variety of combinations of interest rates and discount points so that borrowers may elect to pay higher points at closing and less interest over the life of the loan, or pay a higher interest rate and reduce or eliminate points payable at closing. The portion of total loans held for sale at any time that consists of a particular product type depends, among other factors, primarily upon the interest rate environment at the time such loans are originated.

 

The following is a summary of NetBank’s mortgage loan production for 2004, 2003 and 2002 by major product type.

 

 

The following table shows the geographic distribution of NetBank’s residential mortgage loan production volume for the top ten states for the year ended December 31, 2004:

 

 

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Sale of Residential Loans

 

NetBank customarily sells fixed rate agency-eligible mortgage loans that it originates, retaining the mortgage servicing rights, which may be sold separately or retained by NetBank.  Under ongoing programs established with Fannie Mae and Freddie Mac, NetBank aggregates such conforming conventional loans into pools that are assigned to Fannie Mae or Freddie Mac in exchange for mortgage-backed securities.  NetBank’s FHA mortgage loans and VA mortgage loans are generally pooled and sold in the form of Ginnie Mae mortgage-backed securities.  NetBank pays specified fees to Freddie Mac, Fannie Mae or Ginnie Mae, as applicable, in connection with these programs.  NetBank then sells Freddie Mac, Fannie Mae and Ginnie Mae mortgage-backed securities to securities dealers.  Substantially all of the Company’s agency-eligible mortgage loans qualify under the various Fannie Mae, Freddie Mac and Ginnie Mae program guidelines, which include specific property and credit standards, including a loan size limit.  Depending on market conditions for conforming loans and the related servicing rights, NetBank from time to time will sell a portion of its conventional loan production in whole loan sales to other conventional loan seller/servicers to optimize its overall execution into the secondary markets.  Depending on its appetite for earning assets, NetBank retains certain mortgages, primarily adjustable rate mortgages, second mortgages and home equity loans (“HELOCS”), for long-term investment.  During 2004, NetBank retained mortgages with principal balances aggregating $838 million.

 

The Company customarily sells non-conforming residential mortgage loans to private investors through whole loan sales for cash and retains no residual interests.

 

In the case of conventional loans, subject to the obligations of any primary mortgage insurer, NetBank is generally at risk for any mortgage loan default until the loan is sold (typically less than 90 days).  Once NetBank sells the loan, the risk of loss from mortgage loan default and foreclosure generally passes to the purchaser or insurer of the loan. In the case of FHA and VA loans, NetBank has, from the time such a loan is originated or purchased until the first borrower payment is due, a minimum of 31 days to request insurance or a guarantee certificate.  Once the insurance or the guarantee certificate is issued, NetBank has no risk of default, except with respect to certain losses related to foreclosures of FHA mortgage loans and losses that exceed the VA’s guarantee limitations.  In connection with NetBank’s loan exchanges and sales, NetBank makes representations and warranties customary in the industry relating to, among other things, compliance with laws, regulations and program standards and as to accuracy of information.  NetBank may become liable for certain damages or may be required to repurchase such loans and bear any potential related loss on the disposition of those loans.  Typically, with respect to loans that NetBank repurchases, NetBank corrects the flaws that had resulted in the repurchase, and the loans are resold in the market or are repurchased by the original correspondent pursuant to the prior agreement. The Company maintains a reserve for future expected repurchases such as these is maintained by the Company as described more fully in notes 3 and 19 of the notes to the consolidated financial statements contained included in this report.

 

The sale of mortgage loans may generate a gain or loss to NetBank.  Gains or losses result primarily from two factors.  First, NetBank may originate or purchase a loan at a price (i.e., interest rate and discount) that may be higher or lower than NetBank would receive if it immediately sold the loan in the secondary market.  These pricing differences occur principally as a result of competitive pricing conditions in the primary loan origination market.  Second, gains or losses upon the sale of loans may result from changes in interest rates, which cause changes in the market value of the loans, or commitments to originate loans, from the time the price commitment is given to the customer until the time that the loan is sold by NetBank to the investor.

 

To reduce the effects of changes in interest rates on NetBank’s inventory of mortgage loans and pipeline of commitments to fund mortgage loans, NetBank uses various hedging techniques.  As part of its hedging program, NetBank projects the portion of its commitments that it anticipates will close and assesses the associated risk.  The risk assessment is based upon a number of factors, including the remaining term of the commitment, the interest rate at which the commitment was provided, current interest rates and interest-rate volatility.  NetBank constantly monitors these factors and adjusts its hedging instruments when appropriate throughout each business day.  NetBank’s hedging strategy currently consists of utilizing a combination of mandatory forward sales commitments on mortgage-backed securities and mortgage loans and options on mortgage-backed securities.

 

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In connection with its agency-eligible mortgage loan sale program, which involves the sale of mortgage loans and mortgage-backed securities on a forward or other deferred delivery and payment basis, NetBank has credit risk exposure to the extent purchasers are unable to meet the terms of their forward purchase contracts. As is customary in the mortgage industry, none of the forward payment obligations of any of the Company’s counterparties is secured; however, NetBank attempts to limit its credit exposure on forward sales arrangements by entering into forward sales contracts solely with institutions that NetBank believes are sound credit risks and by limiting exposure to any single counterparty by selling to a number of investors.  For example, it is NetBank’s current policy that not more than the lesser of (i) $500 million or (ii) 30% of the total forward purchase contracts outstanding at any time be with any single counterparty.  All counterparties are obligated to settle such sales in accordance with the terms of the related forward sale agreement.

 

Transaction Processing Segment

 

The Company offers a growing line of financial related transaction processing services to merchants, community banks and other organizations. Many of these services are offered on a private-label basis.

 

Current offerings include:

•                  ATM services

•                  Point of Sale (“POS”) transaction processing

•                  Mortgage servicing

•                  Online banking programs

•                  Payment and deposit processing

 

The Company intensified its efforts to diversify into this segment in late 2003. Management had previously identified this segment as a significant growth prospect, since the segment has an attractive earnings profile with minimal capital requirements. Management believes investors will value income from this segment more favorably than earnings from the Company’s retail banking and financial intermediary segments over time, since transaction processing-related income tends to be more stable and predictable with a generally higher long-term cyclical growth rate.

 

The Company has made a number of strategic acquisitions increase the services it offers. In late 2003, the Company acquired an ATM and merchant processing business. This acquisition serves as the model for the types of transactions management will continue to pursue for this segment. This acquisition provided the Company with a new line of business that complemented its transaction processing strategy and dovetailed with the Company’s other operating segments. The Company has branded the majority of the approximately 8,000 ATMs in its ATM servicing network and made them available on a surcharge-free basis to the Company’s retail banking customers. This network ranks as the second-largest bank-operated network. According to internal research, the Company now provides its banking customer access to more surcharge-free machines than any other U.S. bank except one.

 

The Company was able to also develop its transaction processing operations by leveraging core competencies that already existed within its other segments. These competencies have simply been packaged and marketed to other banks or financial institutions on a business-to-business basis. The Company’s decision to market the small business online banking platform that it developed for its own banking customers is a good example of this approach.

 

Management does not believe its strategy of re-selling the Company’s core competencies will greatly undermine the ability for the Company’s own direct-to-consumer operations to compete and grow market share. The small community banks and credit unions that are interested in the Company’s transaction processing services generally cater to a different consumer demographic and market segment than the Company’s retail banking operations reach.

 

The overall landscape for the Company’s transaction processing initiatives is fairly crowded and competitive. Within each line of business, the Company competes against a few larger, well-known providers. However, the Company seeks to focus on an underserved niche of smaller businesses or banks that the larger competitors generally do not pursue on a proactive basis.  Management believes this focus will ultimately be successful.

 

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The transaction processing segment achieved profitability during 2004, contributing $2.3 million of pre-tax income.

 

Procedures for Determining the Adequacy of the Allowance for Credit Losses

 

The Company reviews large, heterogeneous loans for collectibility on a loan level basis. Specifically, the Company reviews collateral appraisals, current rent rolls, cash projections and financial statements for each property. Guarantor financial statements are reviewed where appropriate. The Company then classifies each loan as “Pass,” “Special Mention,” “Substandard,” “Doubtful” or “Loss”, as appropriate, and applies percentages or ranges of allowances to each classification.

 

The Company considers each of its portfolios of first mortgages, second mortgages, HELOCs, consumer loans, and auto loans as being respective portfolios of homogeneous assets. The Company evaluates the adequacy of its allowance for each of these portfolios based on the risk characteristics of each portfolio taken as a whole. Additionally, the Company reviews the delinquency status of each of the loans within the portfolio and classifies it as “Pass,” “Special Mention,” “Substandard,” “Doubtful” or “Loss” based on delinquency status. Allowance percentages are applied to each risk category. The Company generally provides allowances of 15%, 50% and 100% for loans classified “Substandard,” “Doubtful” and “Loss”, respectively. For “Pass” and “Special Mention” credits, the Company reviews loss estimates made by rating agencies for securitizations of loans of similar type and determines a range of life of loan losses for each group of mortgage loans and HELOCs. For auto loans, the Company provides, at a minimum, allowances based upon loss estimates for the succeeding twelve months for each vintage year of production. The Company selects its point estimate in that range based upon the seasoning of the groups of loans in its portfolio including the age of the respective portfolios, incidence of default, and loss severity to date. The Company maintains a data base of vintage year loss history on loans in its portfolio that it originated. When the Company’s vintage analysis has adequate statistical data on the loss behaviors of loans that it produced and retained, it will supplement the data used from rating agencies with its own experience and use the combined data to estimate expected losses.

 

For lease receivables, the Company uses its historic “vintage analysis” to estimate probable losses for leases originated by its NetBank Business Finance division.  In the past, the Company acquired certain leases from an outside third party that were guaranteed by various sureties. The Company is currently in litigation with the sureties on those leases. See Item 3. Legal Proceedings. and note 19 of the notes to the consolidated financial statements within this report for information related to those leases.

 

See the heading “Financial Condition - Asset Quality and Non-performing Assets” in Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations of this report for additional qualitative and quantitative information regarding the Company’s allowance for credit losses including information regarding management estimates as to the sufficiency of the allowance for credit losses.

 

Seasonality

 

While the Company as a whole is not materially influenced by seasonal trends, the residential mortgage banking industry, generally, and the Company’s Financial Intermediary segment are subject to seasonal trends.  These trends reflect the general pattern of resale of homes, which typically peaks during the spring and summer seasons and declines to lower levels from mid-November through January. Refinancings tend to be less seasonal and more closely related to changes in interest rates.

 

Competition

 

Retail Banking

 

The marketplace for general banking services is highly competitive and commoditized. The Company previously enjoyed a unique market position as one of the few online banking providers and had no head-to-head competitors. It also had the

 

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potential for a significant pricing advantage since it operated a branchless business model and did not have the fixed overhead expenses of its branch-based competitors. As a result, the Company was able to compete aggressively on convenience and price.

 

These advantages have diminished recently. Over the past several years, traditional branch banks began to offer online services. Initially, these banks charged a fee for their service since it represented an additional, incremental cost to the bank. Within the last 18 months, these banks have generally dropped these fees. Many of these banks now recognize that online banking customers tend to be more profitable than offline customers. Industry research has shown that online customers generally maintain higher balances, require less customer support and have lower attrition rates than their offline counterparts.

 

Today, the Company competes directly with large national banks, such as Bank of America, Citigroup and Wells Fargo, along with community banks, credit unions and non-traditional banking providers, such as E*Trade, Charles Schwab and others. As these institutions have closed the gap on the convenience front, the Company has found that it is competing more frequently on price alone. The Company does not consider price leadership a viable or prudent marketing strategy over the long term. Higher deposit rates may not be compelling enough to convince the average consumer to choose a branchless bank over a traditional bank that can provide branches and an online offering.

 

Management believes the Company has an opportunity to regain competitive advantage in the future by focusing on bundled product offerings, ease of use and highly integrated technology, but there can be no assurance that the Company’s efforts will be successful.

 

Financial Intermediary

 

The mortgage banking industry is highly competitive.  The Company competes with financial institutions, mainly mortgage banking companies, commercial banks and savings and loan associations and, to a lesser extent, credit unions and insurance companies. The Company competes principally by purchasing or originating a variety of mortgage loans, emphasizing the quality of its service and pricing the loans at competitive rates.  Many of the Company’s competitors may have greater financial resources, better operating efficiencies and longer operating histories than the Company.  Many of the nation’s largest mortgage banking companies and commercial banks have a significant number of branch offices in areas in which the Company’s correspondents and wholesale regional operations centers operate.  Increased competition for mortgage loans from larger lenders may result in a decrease in the volume of loans purchased or originated by the Company, thereby likely reducing the Company’s revenues.  At the same time, Fannie Mae and Freddie Mac are developing technologies and business practices that could reduce their reliance on large mortgage banking companies for loan production and enable them to directly access smaller producers for volume.  Due to the current highly competitive market-pricing environment, the Company may be unable to achieve its planned level of originations or consummate acquisitions of mortgage servicing rights at a satisfactory cost.  The Company does not have a significant market share of mortgage banking activities in the areas in which it conducts operations.

 

Due to the foregoing considerations, there can be no assurance that the Company will be able to continue to compete successfully in the markets it serves. Inability to compete successfully would have a material adverse effect on the results of operations and financial condition of the Company.

 

Transaction Processing

 

The transaction processing marketplace is highly competitive and fairly fractured, with a few large and well-known providers dominating in different areas of specialty. The Company is competing in a number of emerging markets, such as electronic deposit and payment clearing. However, larger providers are also targeting these markets for growth. The Company believes it can compete effectively by catering to smaller companies who are unlikely to attract the interest of these larger providers.

 

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The Company does operate in one marketplace that is generally more mature. The ATM processing industry is fairly saturated. In 2004, there was significant consolidation among providers. The Company’s ATM operation participated in the consolidation by acquiring the servicing contracts for a number of smaller, independent ATM networks. These additions led to greater scale and efficiency improvements, and the Company believes the operation is well positioned for continued growth. At year-end, the operation had 7,936 ATMs and 2,153 merchant processing terminals in deployment.

 

Intellectual Property and Proprietary Rights

 

NetBank regards the form and substance of its name and other intellectual property that it has developed as proprietary, and NetBank attempts to protect them by seeking court enforcement of its intellectual property rights. NetBank takes active measures to safeguard its name and other proprietary intellectual property. Policing unauthorized use of proprietary information is difficult, however, because of the uncertain and complicated nature of this kind of litigation. For a court ruling canceling NetBank’s federally registered service mark in the name “NetBank®,” see Item 3. Legal Proceedings included in this report.

 

NetBank owns the Internet domain name “netbank.com.” as well as other domain names related to the businesses the Company operates. Domain names in the United States and in foreign countries are regulated, but the laws and regulations governing the Internet are continually evolving. NetBank actively monitors the use of potentially infringing names on the Internet and takes action to protect its intellectual property rights.

 

Supervision and Regulation

 

Savings and loan holding companies and federal savings banks are extensively regulated under federal law, as are operating subsidiaries of federal savings banks. The following is a brief summary of certain statutes and rules and regulations that affect or may affect the Company and its major subsidiaries with regard to Savings and Loan Holding Company Regulation, Bank Regulation and Mortgage Banking Regulation. This summary is qualified in its entirety by reference to the particular statute and regulatory provision referred to below and is not intended to be an exhaustive description of the statutes or regulations applicable to the businesses of the Company and its subsidiaries.  Certain of the Company’s subsidiaries are subject to insurance laws and regulations.  Supervision, regulation and examination of the Company and its subsidiaries by the regulatory agencies are intended primarily for the protection of depositors and borrowers rather than shareholders and creditors of the Company. The terms savings association, federal savings bank and thrift are used interchangeably in this section.

 

Savings and Loan Holding Company Regulation

 

The Company is a registered holding company under both the Savings and Loan Holding Company Act (the “SLHCA”) set forth in Section 10 of the Home Owners Loan Act (“HOLA”) and the Financial Institutions Code of Georgia (“FICG”). The Company is regulated under such acts by the Office of Thrift Supervision (the “OTS”) and by the Georgia Department of Banking and Finance (the “Georgia Department”), respectively. As a savings and loan holding company, the Company is required to file with the OTS an annual report and such additional information as the OTS may require pursuant to the SLHCA. The OTS also conducts annual safety and soundness and information technology examinations of the Company.

 

Savings and loan holding companies and their subsidiaries are prohibited from engaging in any activity or rendering any services for or on behalf of their savings institution subsidiaries for the purpose or with the effect of evading any law or regulation applicable to the institution. This restriction is designed to prevent the use of holding company affiliates to evade requirements of the SLHCA that are designed to protect the holding company’s savings institution subsidiaries. However, if the holding company owns only one insured institution (a unitary holding company) and was in existence prior to May 4, 1999, the SLHCA and the FICG impose no such restrictions on the activities of its non-bank subsidiaries, provided that the lone savings institution satisfies the qualified thrift lender test (discussed below). Moreover, a unitary holding company that satisfies these requirements is not restricted to any statutory prescribed list of permissible activities. However, the Financial Services Modernization Act of 1999 (the “FSM Act”) provides that, while existing unitary

 

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holding companies retain these unrestricted powers, if the unitary holding company is then acquired by another party, its powers are restricted to those permitted for financial holding companies under the Act. The Company is currently a unitary holding company that satisfies these requirements.

 

The SLHCA and the FICG makes it unlawful for any savings and loan holding company, directly or indirectly, or through one or more subsidiaries or one or more transactions, to acquire control of another savings association or another savings and loan holding company without prior approval from the OTS and the Georgia Department, respectively. The acquisition of more than 25% of any class of voting stock of a savings association or holding company is deemed to be conclusive evidence of control. Savings and loan holding companies are allowed to acquire or to retain as much as 5% of the voting shares of an unaffiliated savings institution or savings and loan holding company without regulatory approval. On December 7, 2000, Congress passed the American Homeownership and Economic Opportunity Act of 2000, which permits savings and loan holding companies to acquire or to retain a 5% to 25% non-controlling interest in an unaffiliated savings institution or savings and loan holding company with prior regulatory approval.

 

An acquisition by merger, consolidation or purchase of assets of such an institution or holding company or of substantially all of the assets of such an institution or holding company is also prohibited without prior OTS or Georgia Department approval. When considering an application for such an acquisition, the OTS and the Georgia Department take into consideration the financial and managerial resources and future prospects of the prospective acquiring company and the institution involved. This includes consideration of the competence, experience and integrity of the officers, directors and principal shareholders of the acquiring company and savings institution. In addition, the OTS and the Georgia Department consider the effect of the acquisition on the institution, the insurance risk to the Savings Association Insurance Fund (“SAIF”), the convenience and needs of the community to be served and any possible anti-competitive effect.

 

The OTS may not approve an acquisition that would result in the formation of certain types of interstate holding company networks. The OTS is precluded from approving an acquisition that would result in the formation of a multiple holding company controlling institutions in more than one state unless the acquiring company or one of its savings institution subsidiaries is authorized to acquire control of an institution or to operate an office in the additional state pursuant to a supervisory acquisition authorized under Section 13(k) of the Federal Deposit Insurance Act or unless the statutes of the state in which the institution to be acquired is located permits such an acquisition.

 

In connection with the March 31, 2002 acquisition of Resource by the Company, the regional director of the OTS and the Company entered into a side letter agreement providing that the Company, on a consolidated basis, maintain a minimum common equity capital-to-total assets ratio of 10.0% through December 31, 2004.                 Subsequently, the OTS approved excluding from this calculation capital held against forward sold conforming mortgages, for which required capital would be the greater of 5% or $50,000, provided that the total capital to total assets would not fall below 8%.  Additionally, NetBank, FSB was required to maintain a minimum of 6% core capital and 12% total risk-based capital ratios through December 31, 2004.  While NetBank, FSB was not in compliance with the terms of the side letter agreement on December 31, 2004, it expired on January 1, 2005 and therefore, the Company and NetBank, FSB are no longer subject to its restrictive terms. The Company is not aware of any negative consequences associated with the expired side letter agreement. NetBank, FSB was categorized as well-capitalized with a total risk-based capital ratio of 11.30% as of December 31, 2004. See note 20 of the notes to the consolidated financial statements included in this report for additional details regarding NetBank’s capital.

 

The Georgia Department requires that savings and loan holding companies, such as the Company, maintain a 5% Tier 1 leverage ratio on a consolidated basis.

 

Bank Regulation

 

General.    The Bank is a federal savings bank organized under the laws of the United States. The Bank and its operating subsidiaries are subject to annual examination by the OTS for safety and soundness, for compliance with consumer protection laws and regulations and for information technology. The OTS regulates all areas of the Bank’s operations including reserves, loans, mergers, payment of dividends, interest rates, establishment of branches, and other aspects of

 

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operations. OTS regulations generally provide that federal savings banks and their operating subsidiaries must be examined no less frequently than every 12 months, with certain exceptions. The Bank is subject to assessments by the OTS to cover the costs of such examinations.

 

The Bank is also insured and regulated by the Federal Deposit Insurance Corporation (the “FDIC”). The major functions of the FDIC with respect to insured federal savings banks include paying depositors to the extent provided by law in the event an insured bank is closed without adequately providing for payment of the claims of depositors. The FDIC also works to prevent the development and continuance of unsound and unsafe banking practices.

 

Subsidiary institutions of a savings and loan holding company, such as the Bank, are subject to certain restrictions imposed by the Federal Reserve Act on any extension of credit to the holding company or any of its subsidiaries, on investment in the stock or other securities thereof, and on the taking of such stock or securities as collateral for loans to any borrower.  See the section entitled “Transactions with Affiliates Restriction” below for greater detail.  In addition, a holding company and its subsidiaries are prohibited from engaging in certain tying arrangements in connection with any extension of credit or provision of any property or services.

 

Capital Requirements.    OTS regulations require that federal savings banks maintain (i) ”tangible capital” in an amount of not less than 1.5% of total assets, (ii) ”core capital” in an amount not less than 4.0% of total assets, and (iii) a level of risk-based capital equal to 8% of risk-weighted assets. Under OTS regulations, the term “core capital” generally includes common stockholders’ equity, noncumulative perpetual preferred stock and related surplus, and minority interests in the equity accounts of consolidated subsidiaries less unidentifiable intangible assets (other than certain amounts of supervisory goodwill) and certain investments in certain subsidiaries plus 90% of the fair market value of readily marketable purchased mortgage servicing rights (“PMSRs”) and purchased credit card relationships (subject to certain conditions). “Tangible capital” generally is defined as core capital minus intangible assets and investments in certain subsidiaries, except PMSRs.

 

In determining total risk-weighted assets for purposes of the risk-based requirement, (i) each off-balance sheet asset must be converted to its on-balance sheet credit equivalent amount by multiplying the face amount of each such item by a credit conversion factor ranging from 0% to 100% (depending upon the nature of the asset), (ii) the credit equivalent amount of each off-balance sheet asset and each on-balance sheet asset must be multiplied by a risk factor ranging from 0% to 200% (depending upon the nature of the asset) and (iii) the resulting amounts are added together and constitute total risk-weighted assets. “Total capital,” for purposes of the risk-based capital requirement equals the sum of core capital plus supplementary capital (which, as defined, includes the sum of, among other items, perpetual preferred stock not counted as core capital, limited life preferred stock, subordinated debt, and general loan and lease loss allowances up to 1.25% of risk-weighted assets) less certain deductions. The amount of supplementary capital that may be counted towards satisfaction of the total capital requirement may not exceed 100% of core capital, and OTS regulations require the maintenance of a minimum ratio of core capital to total risk-weighted assets of 4%.

 

OTS regulations also include an interest-rate risk component in the risk-based capital requirement. Under this regulation, an institution is considered to have excess interest rate-risk if, based upon a 200-basis point change in market interest rates, the market value of an institution’s capital changes by more than 2%. This requirement does not have any material effect on the ability of the Bank to meet the risk-based capital requirement. The OTS also revised its risk-based capital standards to ensure that its standards provide adequately for concentration of credit risk, risk from nontraditional activities and actual performance and expected risk of loss on multi-family mortgages.

 

Capital requirements higher than the generally applicable minimum requirement may be established for a particular savings association if the OTS determines that the institution’s capital was or may become inadequate in view of its particular circumstances.

 

Prompt Corrective Action.    The Federal Deposit Insurance Corporation Improvement Act of 1991 establishes a system of prompt corrective action to resolve the problems of undercapitalized financial institutions. Under this system, the federal banking regulators have established five capital categories (“well capitalized,” “adequately capitalized,”

 

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“undercapitalized,” “significantly undercapitalized” and “critically undercapitalized”) in which all institutions are placed. Federal banking regulators are required to take some mandatory supervisory actions and are authorized to take other discretionary actions, with respect to institutions in the three undercapitalized categories. The severity of the action depends upon the capital category in which the institution is placed. Generally, subject to a narrow exception, the banking regulator must appoint a receiver or conservator for an institution that is critically undercapitalized. The federal banking agencies have specified by regulation the relevant capital level for each category.

 

An institution that is categorized as undercapitalized, significantly undercapitalized, or critically undercapitalized is required to submit an acceptable capital restoration plan to its appropriate federal banking agency. A holding company must guarantee that a subsidiary depository institution meets its capital restoration plan, subject to certain limitations. The controlling holding company’s obligation to fund a capital restoration plan is limited to the lesser of 5% of an undercapitalized subsidiary’s assets or the amount required to meet regulatory capital requirements. An undercapitalized institution is also generally prohibited from increasing its average total assets, making acquisitions, establishing any branches or engaging in any new line of business, except under an accepted capital restoration plan or with regulatory approval. An institution may be downgraded to a lower capital category based on supervisory factors other than capital.

 

FDIC Insurance Assessments.    The FDIC has adopted a risk-based assessment system for insured depository institutions that takes into account the risks attributable to different categories and concentrations of assets and liabilities. The system assigns an institution to one of three capital categories: (1) well capitalized; (2) adequately capitalized; and (3) undercapitalized. These three categories are substantially similar to the prompt corrective action categories described above, with the “undercapitalized” category including institutions that are undercapitalized, significantly undercapitalized, and critically undercapitalized for prompt corrective action purposes. The FDIC also assigns an institution to one of three supervisory subgroups within each capital group. The supervisory subgroup to which an institution is assigned is based on a supervisory evaluation that the institution’s primary federal regulator provides to the FDIC and information that the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance funds. The FDIC then determines an institution’s insurance assessment rate based on the institution’s capital category and supervisory category. Under the risk-based assessment system, there are nine combinations of capital groups and supervisory subgroups to which different assessment rates are applied. Assessments range from $0.0 to $0.27 cents per $100 of deposits, depending on the institution’s capital group and supervisory subgroup.

 

In addition, effective January 1, 1997, the FDIC imposed assessments to help pay off the $780 million in annual interest payments on the $8 billion Financing Corporation bonds issued in the late 1980s as part of the government rescue of the thrift industry. The assessment is adjusted quarterly and is set at 1.54 cents per $100 of deposits (the same assessment rate that is imposed on commercial banks) for the first quarter of 2004.

 

The FDIC may terminate its insurance of deposits if it finds that the institution has engaged in unsafe and unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order, or condition imposed by the FDIC.

 

Community Reinvestment Act.    The Community Reinvestment Act (“CRA”) requires that, in connection with examinations of financial institutions within their respective jurisdictions, the federal banking regulators shall evaluate the record of each financial institution in meeting the credit needs of its local community, including low and moderate income neighborhoods. These facts are also considered in evaluating mergers, acquisitions, and applications to open a branch or facility. Failure to adequately meet these criteria could impose additional requirements and limitations on the Bank. The CRA requires that the board of directors of financial institutions, such as the Bank, adopt a CRA statement for each assessment area that, among other things, describes its efforts to help meet community credit needs and the specific types of credit that the institution is willing to extend. The Bank’s CRA performance will be assessed pursuant to the following criteria: (1) the Bank’s loan to deposit ratio, adjusted for seasonal variation and, as appropriate, other related lending activities such as loan originations for sale to the secondary markets, community development loans and qualified investments; (2) the percentage of loans and, as appropriate, other lending related activities located in the Bank’s assessment area; (3) the Bank’s record of lending to and, as appropriate, engaging in other lending related activities for borrowers of different income levels and businesses and farms of different sizes; (4) the geographic distribution of the

 

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Bank’s loans; and (5) the Bank’s record of taking action if warranted in response to written complaints about its performance in helping to meet credit needs in its assessment area. Additionally, the terms of any CRA-related agreements must be publicly disclosed.

 

Capital Distributions.    An OTS rule requires prior notice of all capital distributions by savings associations that are subsidiaries of a holding company (including dividends, stock repurchases and cash-out mergers). An institution that both before and after a proposed capital distribution has net capital equal to or in excess of its capital requirements may, subject to any otherwise applicable statutory or regulatory requirements or agreements entered into with the regulators, without an application to the OTS make capital distributions in any calendar year up to 100% of its net income to date during the calendar year to date plus the retained net income for the two preceding calendar years.

 

An institution that either before or after a proposed capital distribution fails to meet its then applicable minimum capital requirement or that has been notified that it needs more than normal supervision may not make any capital distributions without the prior written approval of the OTS. In addition, the OTS may prohibit a proposed capital distribution, which would otherwise be permitted by the regulation, if the OTS determines that such distribution would constitute an unsafe or unsound practice.

 

Equity Investments.    The OTS has revised its risk-based capital regulation to modify the treatment of certain equity investments and to clarify the treatment of other equity investments. Equity investments that are permissible for both savings banks and national banks will no longer be deducted from savings associations’ calculations of total capital over a five-year period. Instead, permissible equity investments will be placed in the 100% risk-weight category, mirroring the capital treatment prescribed for those investments when made by national banks under the regulations of the Office of the Comptroller of the Currency. Equity investments held by savings associations that are not permissible for national banks must still be deducted from assets and total capital.

 

Qualified Thrift Lender Requirement.    A federal savings bank is deemed to be a “qualified thrift lender” (“QTL”) as long as its “qualified thrift investments” equal or exceed 65% of its “portfolio assets” on a monthly average basis in nine out of every 12 months. Qualified thrift investments generally consist of (i) various housing related loans and investments (such as residential construction and mortgage loans, home improvement loans, mobile home loans, home equity loans and mortgage-backed securities), (ii) certain obligations of the FDIC and (iii) shares of stock issued by any Federal Home Loan Bank (“FHLB”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”) or the Federal National Mortgage Association (“Fannie Mae”). In addition, the following assets may be categorized as qualified thrift investments in an amount not to exceed 20% in the aggregate of portfolio assets: (i) 50% of the dollar amount of residential mortgage loans originated and sold within 90 days of origination; (ii) investments in securities of a service corporation that derives at least 80% of its income from residential housing finance; (iii) 200% of loans and investments made to acquire, develop or construct starter homes or homes in credit needy areas (subject to certain conditions); (iv) loans for the purchase or construction of churches, schools, nursing homes and hospitals; and (v) consumer loans (in an amount up to 20% of portfolio assets). For purposes of the QTL test, the term “portfolio assets” means the savings institution’s total assets minus goodwill and other intangible assets, the value of property used by the savings institution to conduct its business, and liquid assets held by the savings institution in an amount up to 20% of its total assets.

 

OTS regulations provide that any savings association that fails to meet the definition of a QTL must either convert to a national bank charter or limit its future investments and activities (including branching and payments of dividends) to those permitted for both savings associations and national banks. Further, within one year of the loss of QTL status, a holding company of a savings association that does not convert to a bank charter must register as a bank holding company and will be subject to all statutes applicable to bank holding companies. In order for the Bank to exercise the powers granted to federally chartered savings associations and for the Company to retain the power of a unitary holding company, the Bank must meet the definition of a QTL. As of December 31, 2004 NetBank, FSB was deemed to be a QTL.

 

Loans to One Borrower Limitations.    HOLA generally requires savings associations to comply with the loans to one borrower limitations applicable to national banks. National banks generally may make loans to a single borrower in amounts up to 15% of their unimpaired capital and surplus, plus an additional 10% of capital and surplus for loans secured

 

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by readily marketable collateral. HOLA provides exceptions under which a savings association may make loans to one borrower in excess of the generally applicable national bank limits. A savings association may make loans to one borrower in excess of such limits under one of the following circumstances: (i) for any purpose, in any amount not to exceed $500,000; or (ii) to develop domestic residential housing units, in an amount not to exceed the lesser of $30 million or 30% of the savings association’s unimpaired capital and unimpaired surplus, provided other conditions are satisfied. The Federal Institutions Reform, Recovery, and Enforcement Act of 1989 provided that a savings association could make loans to one borrower to finance the sale of real property acquired in satisfaction of debts previously contracted in good faith in amounts up to 50% of the savings association’s unimpaired capital and unimpaired surplus. The OTS, however, has modified this standard by limiting loans to one borrower to finance the sale of real property acquired in satisfaction of debts to 15% of unimpaired capital and surplus. That rule provides, however, that purchase money mortgages received by a savings association to finance the sale of such real property do not constitute “loans” (provided no new funds are advanced and the savings association is not placed in a more detrimental position holding the note than holding the real estate) and, therefore, are not subject to the loans to one borrower limitations.

 

Commercial Real Property Loans.    HOLA limits the aggregate amount of commercial real estate loans that a federal savings association may make to an amount not in excess of 400% of the savings association’s capital.

 

Federal Home Loan Bank System.    The FHLB System consists of 12 regional FHLBs, each subject to supervision and regulation by the Federal Housing Finance Board (the “FHFB”). The FHLBs provide a central credit facility for member savings associations. The maximum amount that the FHLB of Atlanta will advance fluctuates from time to time in accordance with changes in policies of the FHFB and the FHLB of Atlanta, and the maximum amount generally is reduced by borrowings from any other source. The Financial Services Modernization Act has enabled the FHLB to expand the credit window for members by expanding the purposes for which FHLB’s may make secured advances and the types of collateral eligible to secure these advances, as well as eliminating restrictions on advances to thrifts not meeting the QTL test.

 

Federal Reserve System.    The Federal Reserve Board has adopted regulations that require savings associations to maintain non-earning reserves against their transaction accounts (primarily NOW and regular checking accounts). Because required reserves must be maintained in the form of cash or a non-interest-bearing account at a Federal Reserve Bank, the effect of this reserve requirement is to reduce the amount of the Bank’s interest-earning assets.

 

Savings institutions also have the authority to borrow from the Federal Reserve “discount window.” Federal Reserve Board regulations, however, require savings associations to exhaust all FHLB sources before borrowing from a Federal Reserve bank.

 

Privacy.    Financial institutions are regulated by federal law and federal regulatory agency rules that are designed to protect the privacy rights of its customers who obtain goods or services from the institution that are to be used primarily for personal, family or household purposes.  State legislatures and agencies are increasingly active in the same regard.  In general, this body of law requires the institutions to disclose their policies for collecting, sharing and protecting the confidential information of their customers.  Under the Gramm-Leach Bliley Act of 1999 (the “GLBA”), for example, customers generally may prevent financial institutions from sharing nonpublic personal financial information with nonaffiliated third parties except under certain circumstances, such as in the course of processing a transaction requested by the customer, in connection with the institution’s joint sponsorship of a product or service with a nonaffiliated third party, or when required to do so under various state or federal laws (i.e., complying with a subpoena).  Additionally, the GLBA provides that financial institutions generally may not disclose consumer account numbers to any nonaffiliated third party for use in telemarketing, direct mail marketing or other marketing to consumers.  Customer’s rights to privacy are also protected by the Fair Credit Reporting Act, addressed below in “Consumer Credit Reporting.”

 

Regulatory agencies, including the OTS and the FDIC, jointly published a Privacy Rule that establishes information security safeguards, including a requirement for annual risk assessments and other administrative, technical and physical safeguards.  Such safeguards are to insure the security of the customers’ records in light of potential threats, hazards or unauthorized access to or use of such records that could harm the customer.

 

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Consumer Credit Reporting.    On December 4, 2003, and in part due to the growing threat of identity theft in our society, President George W. Bush signed the Fair and Accurate Credit Transactions Act (the “FACT Act”), amending the federal Fair Credit Reporting Act (the “FCRA”). Most of the amendments to the FCRA (the “FCRA Amendments”) were to have become effective in late 2004, depending on implementing regulations to be issued by the Federal Trade Commission and the federal bank regulatory agencies.

 

The FCRA Amendments include, among other things:

 

•                  new requirements for financial institutions to develop policies and procedures to identify potential identity theft and, upon the request of a consumer, place a fraud alert in the consumer’s credit file stating that the consumer may be the victim of identity theft or other fraud;

 

•                  new consumer notice requirements for lenders that use consumer report information in connection with risk-based credit pricing programs;

 

•                  new notice requirement when negative information about the consumer is reported to a credit reporting agency;

 

•                  a new requirement for mortgage lenders to disclose credit scores and related information to consumers;

 

•                  a new requirement prohibiting users of consumer reports that contain identity theft and military alerts from taking certain actions until a reasonable belief of the identity of the requester has been established;

 

•                  restrictions on the sale or transfer of debt caused by identity theft; and

 

•                  for entities that furnish information to consumer reporting agencies, new requirements to implement procedures and policies regarding the accuracy and integrity of the furnished information and regarding the correction of previously furnished information that is later determined to be inaccurate.

 

The FCRA Amendments also prohibit a business that receives consumer information from an affiliate from using that information for marketing purposes unless the consumer is first provided a notice and an opportunity to direct the business not to use the information for such marketing purposes (the “opt-out”), subject to certain exceptions. While the FCRA Amendments will limit NetBank’s ability to share information with its affiliates for marketing purposes, the actual impact of these limitations will depend on the extent to which our customers elect to prohibit the use of their personal information for marketing purposes. We have no basis at this time to predict the volume of consumer “opt-outs.”

 

NetBank and its subsidiaries have implemented policies and procedures for those provisions with a mandatory compliance date on or before December 1, 2004.  Prior to the effective date of the remaining FCRA Amendments, NetBank and its subsidiaries will implement policies and procedures to comply with the new rules.

 

Anti-Money Laundering and Anti-Terrorism Legislation.    The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism (“USA PATRIOT”) Act of 2001, signed by the President on October 26, 2001, imposed new requirements and limitations on specified financial transactions and account relationships, intended to guard against money laundering and terrorism. Most of these requirements and limitations took effect in 2002. Additional “know your customer” rules became effective in June 2003, requiring NetBank’s banking, mortgage banking, and insurance subsidiaries to establish a customer identification program under Section 326 of the USA PATRIOT Act. NetBank and these subsidiaries implemented procedures and policies to comply with these rules prior to the effective date of each of the rules.

 

The Bank Secrecy Act and its implementing regulations, designed to fight drug trafficking, money laundering, and other federal crimes require financial institutions to keep extensive records for possible use in criminal, tax, and regulatory investigations or proceedings.  Financial institutions are required to report and/or retain records of various types of transactions, for example, currency transaction reports if transactions involve more than $10,000 in currency, certain cash purchases of monetary instruments,  known or suspected crimes and suspicious activities, and certain wire (funds)

 

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transfers,  creating a “paper trail” to track certain financial transactions.

 

Executive Order 13224 was signed by the President on September 23, 2001, blocking property and prohibiting transactions with persons who commit, threaten to commit, or support terrorism. All U.S. persons are prohibited from making or receiving any contribution of funds, goods, or services to or for the benefit of a blocked person.

 

In addition, The Office of Foreign Assets Control (“OFAC”)  require financial institutions to block or otherwise freeze accounts and certain other assets of sanctioned countries, entities, and individuals identified as being hostile to U.S. foreign policy and a threat to national security.  Unlicensed trade and financial transactions are also prohibited.  Transactions involving target countries or Specially Designated Nationals subject to economic sanctions or persons associated with international narcotics trafficking or terrorism must be reported.

 

Check Cashing for the 21^st Century Act.  The “Check 21 Act,” which became effective on October 28, 2004, authorizes substitute checks to replace paper checks if they contain the same information as the original and meet certain other conditions.  The Check 21 Act enables institutions to process checks electronically.  The rules do not require institutions to send or receive electronic images.  However, once a properly created substitute check is created or presented by a financial institution, the substitute check is deemed to be warranted by such financial institution, becomes the legal equivalent of the original check and must be accepted by all persons for all purposes.

 

Flood Disaster Protection.  The Flood Disaster Protection Act prohibits a lender from making, renewing, or extending loans secured by property or inventory located in a FEMA designated special flood hazard area unless the loan is covered its entire term by flood insurance.

 

Consumer Protection Laws and Regulations—Loan Operations.    Interest and other charges collected or contracted for by the Bank and its operating subsidiaries are subject to various laws concerning interest rates and disclosures. In addition, their loan operations are also subject to various laws applicable to credit transactions, such as:

 

•                  The federal Truth-In-Lending Act and Regulation Z, requiring disclosure of the costs of credit, providing for the right to rescind certain transactions, and error resolution procedures for open-end transactions. Regulation Z also implements HOEPA requiring expanded disclosures and prohibiting certain practices with regard to high cost home loans to consumer borrowers;

 

•                  The Home Mortgage Disclosure Act and Regulation C, requiring financial institutions and other mortgage lenders to collect and report certain data in connection with home purchase and home improvement loans, including refinancings. This information can be used by the public and public officials to help determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves, assist in the distribution of public sector investments, and assist in identifying possible discriminatory lending patterns and enforcing anti-discrimation statutes;

 

•                  The Equal Credit Opportunity Act and Regulation B, promoting the availability of credit to all credit worthy applicants and prohibiting discrimination against a borrower or potential borrowers on the basis of race, color, religion, national origin, sex, marital status, age, the receipt of public assistance income, or the exercise of a consumer protection right;

 

•                  The Fair Housing Act prohibiting discrimination in the sale or rental of housing, including financing and advertising, on the basis of race, color, religion, sex, handicap or familial status;

 

•                  The Real Estate Settlement Procedures Act and HUD’s Regulation X, which requires the disclosure of certain basic information to mortgagors concerning settlement costs and prohibits the charging of unearned fees and certain “kickbacks” or other fees for referrals in connection with a residential mortgage settlement service;

 

•                  The Soldiers’ and Sailors Civil Relief Act of 1940, recently revised by the Servicemembers Civil Relief Act governing the repayment terms of, and property rights underlying, secured obligations while persons are in active

 

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military service;

 

•                  The Fair Credit Reporting Act, governing consumer reports by consumer reporting agencies; the reporting of information to consumer reporting agencies; making prescreened offers of credit; the sharing of consumer report information among affiliated and unaffiliated third parties; and requirements for users of consumer report information;

 

•                  The Fair Debt Collection Practices Act, governing the manner in which consumer debts may be collected and prohibiting certain practices considered abusive; and

 

•                  As applicable, the rules and regulations of the various state and federal supervisory and enforcement agencies charged with the responsibility of implementing and enforcing compliance for such laws.

 

Consumer Protection Laws and Regulations—Deposit Operations.  The deposit operations of the Bank are subject to:

 

•                  The Electronic Funds Transfer Act and Regulation E issued by the Federal Reserve to implement that act, which governs automatic deposits to and withdrawals from deposit accounts and customers’ rights and liabilities arising from the use of automated teller machines and other electronic banking services;

 

•                  The Truth In Savings Act and Regulation DD, requires depository institutions to provide certain account related advertising and account opening disclosures to consumers so that they can meaningfully compare products among depository institutions. Subsequent disclosures must also be provided prior to changing terms or prior to the maturity of certain time accounts;

 

•                  Interest on Deposits—Regulation Q prohibits paying interest on demand deposits such as checking accounts, or other deposits having a maturity of seven days or less; and

 

•                  The Expedited Funds Availability Act and Regulation CC requires depository institutions to make deposited funds available within certain timeframe, provide disclosures of their funds availability policies, and post notices at ATMs and other places where consumer deposits are taken.

 

Marketing, Sales and Credit Practices

 

Unfair or Deceptive Acts or Practices and Regulation AA.    These laws prohibit banks from engaging in unfair and deceptive credit practices involving consumer credit transactions.  In addition, Section 5(a) of the FTC Act prohibits unfair and deceptive trade practices including, but not limited to misrepresentation in advertising.

 

Do Not Call/Do Not Fax.   The FTC and the FCC’s telemarketing rules prohibit placing telemarketing sales calls to a telephone number on the FTC’s Do Not Call Registry, except where there is an established business relationship or the consumer has given their expressed written authority to call.  These rules also require maintenance of company specific Do Not Call lists, and prohibits sending marketing related faxes to consumer or business prospects without their written consent.

 

CAN-SPAM Act of 2003.  CAN-SPAM went into effect on January 1, 2004 preempting most state laws governing the same.  It requires senders of commercial electronic messages whose primary purpose is promotion of a commercial product or service, to clearly and conspicuously identify the message as an advertisement or solicitation, include an clear and conspicuous notice to the recipient that they can opt-out of receiving future commercial e-mail messages from the sender,  and provide an electronic way for them to exercise that option.   It also prohibits certain practices like falsifying header information or using deceptive subject lines.

 

Mortgage Banking Regulation

 

The mortgage banking operations of the Company are subject to extensive regulation by federal governmental authorities.

 

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The Company’s mortgage operations are also subject to various laws, including those discussed above under the heading “Consumer Protection Laws and Regulations—Loan Operations” and judicial and administrative decisions that, among other things, regulate credit-granting activities, require disclosures to customers, govern secured transactions and establish collection, repossession and claims handling procedures and other trade practices. The Company’s mortgage operations are also subject to the rules and regulations of the FHA, Freddie Mac, Fannie Mae, Ginnie Mae, HUD and the VA with respect to originating, processing, underwriting, selling, securitizing and servicing mortgage loans.

 

In addition, there are other federal and state statutes and regulations, as well as judicial decisions, affecting such activities. Those rules and regulations, among other things, impose licensing obligations on the Company, establish eligibility criteria for mortgage loans, prohibit discrimination and establish underwriting guidelines that include provisions for inspections and appraisals, require credit reports on prospective borrowers and fix maximum loan amounts, and with respect to VA loans, fix maximum interest rates. Moreover, lenders such as the Company are required to submit annually to the FHA, Freddie Mac, Fannie Mae, Ginnie Mae and the VA audited financial statements, and each regulatory entity has its own financial requirements. The Company’s mortgage operations also are subject to examination by the FHA, Freddie Mac, Fannie Mae, Ginnie Mae and the VA at all times to assure compliance with applicable regulations, policies and procedures. Many of the aforementioned requirements are designed to protect the interests of consumers, while others protect the owners or insurers of mortgage loans. Failure to comply with these requirements can lead to loss of approved status, termination of servicing contracts without compensation to the servicer, demands for indemnification or loan repurchases, class-action lawsuits and administrative enforcement actions. Such regulatory requirements are subject to change from time to time and may in the future become more restrictive, thereby making compliance more difficult or expensive or otherwise restricting the ability of the Company to conduct its business as such business is now conducted.

 

There are various state and local laws and regulations affecting the Company’s mortgage operations. The Company’s mortgage businesses are in possession of licenses in all states in which they do business if such licenses are required and the requirement for such license is not preempted by federal law. Some of the Company’s mortgage loans also may be subject to state usury statutes.

 

Effect of Governmental Monetary Polices

 

The Company’s earnings are affected by domestic economic conditions and the monetary and fiscal policies of the United States government and its agencies. The Federal Reserve Bank’s monetary policies have had, and are likely to continue to have, an important impact on the operating results of financial institutions through its power to implement national monetary policy in order, among other things, to curb inflation or combat a recession. The monetary policies of the Federal Reserve Board have major effects upon the levels of bank loans, investments and deposits through its open market operations in United States government securities and through its regulation of the discount rate on borrowings of member banks and the reserve requirements against member bank deposits. Likewise, the monetary policies of the Federal Reserve can dramatically impact the level of overall mortgage industry volumes and the volumes of mortgages produced and servicing prepayments experienced by the Company’s mortgage banking operations. It is not possible to predict the nature or impact of future changes in monetary and fiscal policies.

 

Transactions with Affiliates Restrictions

 

The Bank and its subsidiaries are subject to the provisions of Section 23A of the Federal Reserve Act. Section 23A places limits on:

 

•                  The amount of loans or extensions of credit to affiliates;

 

•                  The amount of investment in affiliates;

 

•                  The amount of the purchase of assets from affiliates, except for real and personal property exempted by the Federal Reserve;

 

•                  The amount of loans or extensions of credit to third parties collateralized by the securities or obligations of

 

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affiliates; and

 

•                  The amount of any guarantee, acceptance or letter of credit issued on behalf of an affiliate.

 

For purposes of Section 23A, an “affiliate” generally includes a bank’s parent and all other affiliates, except the bank and its subsidiaries. The aggregate of all of the above transactions is limited in amount, as to any one affiliate, to 10% of a savings bank’s capital and surplus and, as to all affiliates combined, to 20% of a bank’s capital and surplus. In addition to the limitation on the amount of these transactions, each of the above transactions must also meet specified collateral requirements. The Bank and its subsidiaries must also comply with certain provisions designed to avoid the taking of low-quality assets from affiliates.

 

The Bank and its subsidiaries are also subject to the provisions of Section 23B of the Federal Reserve Act which, among other things, prohibits an institution from engaging in certain transactions with affiliates, including the above types, unless the transactions are on terms substantially the same, or at least as favorable to the institution or its subsidiaries, as those prevailing at the time for comparable transactions with nonaffiliated companies.

 

The Bank is also subject to restrictions on extensions of credit to its executive officers, directors, certain principal shareholders and their related interests. Generally, these extensions of credit (1) must be made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with third parties, and (2) must not involve more than the normal risk of repayment or present other unfavorable features.

 

Proposed Legislation and Regulatory Action

 

New regulations and statutes are regularly proposed that contain wide-ranging proposals for altering the structures, regulations and competitive relationships of the nation’s financial institutions. The Company cannot predict whether or in what form any proposed regulation or statute will be adopted or the extent to which its business may be affected by any new regulation or statute. Legislation that would eliminate the federal savings bank charter is under discussion from time to time. If such legislation is enacted, the Bank would be required to convert its federal savings bank charter to either a national bank charter or to a state depository institution charter. Various legislative proposals in recent years would have resulted in the restructuring of federal regulatory oversight, including, for example, consolidation of the OTS into another agency, or creation of a new Federal banking agency to replace the various agencies which presently exist. The Company is unable to predict whether such legislation will be enacted or, if enacted, whether it will contain relief as to bad debt deductions previously taken. In addition, certain recent and proposed state and local legislation and regulations designed to protect consumers from predatory lending practices of unscrupulous lenders has had and may continue to have the unintended consequence of imposing unrealistic barriers on legitimate lenders’ ability to make mortgage loans and of restricting a consumer’s access to mortgage credit.

 

Insurance Regulation

 

NetInsurance and MG Reinsurance are subject to insurance laws and regulations governing their activities in the jurisdictions where they operate.

 

Risks Relating to NetBank’s Business

 

Changes in Economic Conditions

 

NetBank’s business is subject to various business risks, including competition from other financial institutions and other mortgage banking companies. Economic conditions affect the consumer’s decision to buy or sell residences as well as the number of residential mortgage loan delinquencies and foreclosures, the value of collateral supporting loan portfolios, administrative costs in evaluating and processing mortgage loan applications, and the cost and availability of funds that lending companies rely upon to make or purchase loans. Changes in the level of consumer confidence, tax laws, real

 

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estate values, prevailing interest rates and investment returns expected by the financial community could make mortgage loans of the types originated or purchased by the Company less attractive to borrowers or investors. Competition also may be affected by fluctuations in interest rates and general and local economic conditions.

 

The Company continues to face the same challenges as other companies within the banking and mortgage banking industries and, therefore, is not immune to significant volume declines, primarily in its mortgage banking operations, precipitated by changes in interest rates or other factors beyond its control.

 

Interest Rate Risks

 

NetBank’s principal businesses are retail banking and the origination and purchase of mortgage loans.  These businesses are funded by customer deposits and, to the extent necessary, other borrowed funds. Consequently, a significant portion of NetBank’s assets and liabilities are monetary in nature and fluctuations in interest rates will affect NetBank’s future net interest income and cash flows.  Changes in long-term interest rates that do not correlate to changes in short-term interest rates can cause disproportionate changes in the value of NetBank’s interest-earning assets and interest-bearing liabilities or the shrinkage or widening of the spread NetBank expects to earn by holding interest-earning assets.  A decrease in the spread would have a negative impact on NetBank’s earnings and cash flow.

 

Litigation in Mortgage Banking

 

In recent years, the mortgage banking industry has been subject to class action lawsuits that allege violations of federal and state laws and regulations, including the propriety of collecting and paying various fees and charges and the calculation of escrow amounts. Class action lawsuits have been commenced against various mortgage banking companies, including the Company, alleging, inter alia, that the payment of certain fees to mortgage brokers violates the anti-kickback provisions of RESPA.

 

Recent interpretations by HUD together with several subsequent appellate court decisions have indicated that class actions regarding a lender’s compensation to brokers are inappropriate for resolution of the issue. So far, all of the cases have been resolved favorably for the mortgage banking industry, but if any of these cases are resolved against the lenders, it may cause an industry-wide change in the way independent mortgage brokers are compensated. Such a change could have a material adverse effect on the Company and the entire mortgage lending industry. The Company’s broker compensation and table-funded correspondent purchase programs permit such payments. Although the Company believes these programs comply with all applicable laws and are consistent with long-standing industry practice and regulatory interpretations, in the future new regulatory interpretations or judicial decisions may require the Company to change its broker compensation and table-funded correspondent purchase practices. Class action lawsuits may continue to be filed in the future against the mortgage banking industry generally.

 

Legislation Regarding Escrow Funds

 

Certain states require that interest be paid to mortgagors on escrow funds deposited by them to cover mortgage-related payments such as property taxes and insurance premiums. Federal legislation has in the past been introduced that would, if enacted, revise current escrow regulations and establish a uniform interest payment requirement in all states. If such federal legislation were enacted or if additional states enact legislation relating to payment of, or increases in the rate of interest on escrow balances, or if such legislation were retroactively applied to loans in the Company’s servicing portfolio, the Company’s earnings would be adversely affected.

 

Delinquency and Default

 

The Company’s profitability may be negatively impacted by economic downturns because, during such periods, the frequency of loan delinquencies and defaults tends to increase, thereby increasing defaults and loan losses on loans held in portfolio for long-term investment and increasing the cost to service the loans in the Company’s servicing portfolio. Also, the Company is generally at risk for delinquency or default of newly originated or purchased loans. In the case of conventional loans, the Company is generally at risk for any mortgage loan default from origination or purchase by the

 

29

 

Company, as the case may be, until the loan is sold (typically less than 90 days). Once the Company sells the loan, the risk of loss from mortgage loan default and foreclosure generally passes to the purchaser or insurer of the loan. The Company has from the time an FHA or VA mortgage loan is originated or purchased until the first payment is due, a minimum of 31 days, to request insurance or a guarantee certificate from the FHA and the VA, respectively. Once the insurance or the guarantee certificate is issued, the Company has no risk of default or foreclosure except with respect to certain losses related to foreclosures of FHA mortgage loans and losses that exceed the VA’s guarantee limitation.

 

Moreover, under certain types of servicing contracts, particularly contracts to service loans that have been pooled or securitized, the servicer must advance all or part of the scheduled payments to the owner of the loan, even when loan payments are delinquent. Also, to protect their liens on mortgaged properties, owners of mortgage loans usually require the servicer to advance mortgage and hazard insurance and tax payments on schedule even if sufficient escrow funds are unavailable.

 

Prior to the liquidation of a loan, the servicer must absorb the cost of funds advanced during the time the advance is outstanding. Further, the servicer must bear the increased costs of attempting to collect on delinquent and defaulted mortgage loans. The servicer generally is reimbursed for such advances ultimately by the mortgage loan owner or from liquidation proceeds. In addition, if a default is not cured, the mortgage loan will be extinguished as a result of foreclosure proceedings, and any servicing income will cease. As a consequence, the Company will forego servicing income from the time such loan becomes delinquent until it is foreclosed upon or is brought current. The Company maintains a reserve for possible losses at a level considered adequate to provide for known and inherent risks related to foreclosure and disposition losses. The Company’s evaluation of an adequate level of foreclosure reserves considers past loss experience, industry loss experience, geographic and product concentrations, delinquency trends, economic conditions and other relevant factors. The Company uses currently available information to make such evaluation; therefore, future adjustments to the foreclosure reserve will be required as conditions and assumptions are revised in response to changes in trends and the other factors and assumptions relevant to the Company’s evaluation.

 

With respect to VA loans, the VA guarantees the initial losses on a loan. The guaranteed amount generally ranges from 20% to 35% of the original principal balance. Before each foreclosure sale, the VA determines whether to bid to purchase the foreclosed loan by comparing the estimated net sale proceeds to the outstanding principal balance and the servicer’s accumulated reimbursable costs and fees. If this amount is a loss and exceeds the guaranteed amount, the VA typically issues a no-bid and pays the servicer the guaranteed amount. Whenever a no-bid is issued, the servicer absorbs the loss, if any, in excess of the sum of the guaranteed principal and amounts recovered at the foreclosure sale. The Company’s historical delinquency and foreclosure rate experience on VA loans has generally been consistent with that of the industry.

 

In the case of loans insured by the FHA, the Company will not be reimbursed for certain amounts if foreclosure becomes necessary. Such amounts include interest on the mortgage loan for the first two months subsequent to the loan becoming delinquent and a portion of the costs of foreclosure (generally the unreimbursed amount of such costs is limited to one-third of such costs).

 

Changes in the Market for Mortgage Loans and Mortgage Servicing Rights

 

Volume of Mortgage Loans Produced. During periods of declining interest rates, the Company typically experiences an increase in loan originations because of increased home purchases and, particularly, increased refinancing activity. Increases in interest rates typically adversely affect refinancing activity, which has an adverse effect on the Company’s origination revenues. For the year ended December 31, 2004, 37% of the Company’s mortgage loan production was attributable to refinancings, compared to 48% during 2003.

 

Sales of Mortgage Loans.  Gains or losses on sales of mortgage loans may result from changes in interest rates from the time the interest rate on a customer’s mortgage loan application is established to the time the Company sells the loan. At any given time, the Company has committed to sell substantially all of its agency-eligible mortgage loans that are closed and a percentage of the agency-eligible mortgage loans that are not yet closed but for which the interest rate has been established (“rate locks”). To manage the interest rate risk of the Company’s rate locks, the Company continuously

 

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projects the percentage of the rate locks it expects to close and, on the basis of such projections, enters into forward sales commitments to sell such loans. To reduce the effect of such interest rate changes, the Company employs a variety of techniques, currently consisting of a combination of mandatory forward sales commitments for mortgage-backed securities and put and call option contracts on U.S. Treasuries.

 

If interest rates make an unanticipated change, the actual percentage of rate locks that close may differ from the projected percentage. A sudden increase in interest rates can cause a higher percentage of rate locks to close than projected. To the degree that this may not have been anticipated, the Company may not have made forward sales commitments to sell these additional loans and consequently may incur significant losses upon their sale at current market prices, adversely affecting results of operations. Likewise, if a lower percentage of rate locks close than was projected, due to a sudden decrease in interest rates or otherwise; the Company may have committed to sell more than actually close and as a result may incur significant losses in fulfilling these commitments, adversely affecting results of operations. This risk is greater during times of interest rate volatility.

 

Value of Mortgage Servicing Rights.  The value of the Company’s servicing portfolio may be adversely affected if mortgage interest rates decline and loan refinancings and prepayments increase. In periods of declining interest rates, the economic advantages to borrowers of refinancing their mortgage loans become greater. Increases in the rate of mortgage loan prepayments reduce the period during which the Company receives servicing income from such loans. The Company capitalizes the cost of the acquisition of servicing rights from third parties and capitalizes a value for the servicing rights on loans that it originates. The value of servicing rights is based upon the net present value of estimated future cash flows. If the rate of prepayment of the related loans exceeds the rate assumed by the Company, due to a significant reduction in interest rates or otherwise, the value of the Company’s servicing portfolio will decrease and accelerated amortization of servicing rights or recognition of an impairment provision may become necessary, thereby decreasing earnings. The Company attempts to mitigate these risks with respect to the value of its servicing rights by maintaining a portfolio of interest rate option and other derivative contracts whose value tends to increase in periods of declining interest rates, thus mitigating the decline in value typical during the same period with respect to servicing rights. However, there can be no assurance that the Company’s efforts to mitigate these risks will prevent value loss or impairment provisions.

 

Sales of Mortgage Servicing Rights.  The prices obtained by the Company upon the sale of its mortgage servicing rights depend upon a number of factors, including the general supply of and demand for mortgage servicing rights, as well as prepayment and delinquency rates on the portfolio of mortgage servicing rights being sold. Interest rate changes can affect the ability to sell, or the profitability of a sale of, mortgage servicing rights. Purchasers of mortgage servicing rights analyze a variety of factors, including prepayment sensitivity of loans underlying servicing rights, to determine the purchase price they are willing to pay. Thus, in periods of declining interest rates, sales of mortgage servicing rights related to higher interest rate loans may be less profitable than sales of mortgage servicing rights related to lower interest rate loans because it is possible that the loans bearing higher interest rates will be refinanced. Because these factors are largely beyond the control of the Company, there can be no assurance that the current level of profitability from the sale of mortgage servicing rights will be maintained.

 

Liabilities Under Representations and Warranties

 

In the ordinary course of business, the Company makes representations and warranties to the purchasers and insurers of its mortgage loans and the purchasers of mortgage servicing rights regarding compliance with laws, regulations and program standards and as to accuracy of information. Under certain circumstances, the Company may become liable for certain damages or may be required to repurchase a loan if there has been a breach of representations or warranties. The Company generally receives similar representations and warranties from the correspondents from whom it purchases loans. However, in the event of breaches of such representations and warranties, the Company is subject to the risk that a correspondent may not have the financial capacity to repurchase loans when called upon to do so by the Company or otherwise may not respond to demands made by the Company. The Company estimates its liability with respect to such representations and warranties based upon a vintage analysis of repurchases of loans by year of production. Since the Company no longer services the vast majority of loans and servicing sold in prior years, the Company is unable to calculate the amount of loans still outstanding for which such representations and warranties relate. For example,

 

31

 

increases or decreases in prepayments of loans and servicing previously sold can have a favorable or unfavorable impact on the amount of representation and warranty claims ultimately asserted. Therefore, there is no assurance that future claims for representations and warranties will be similar to the Company’s experience as depicted in its vintage analysis. See note 19 of the notes to the consolidated financial statements included in this report for additional details regarding the Company’s liabilities under representations and warranties, including the past repurchase and current reserve information.

 

Environmental Matters

 

In the course of its business, through the foreclosure process, the Company has acquired, and may acquire in the future, properties securing loans that are in default. Although the Company lends to owners of residential properties, there is a risk that the Company could be required to investigate and clean up hazardous or toxic substances or chemical releases at such properties after its acquisition and might be held liable to a governmental entity or to third parties for property damage, personal injury and investigation or cleanup costs incurred by such parties in connection with the contamination.

 

To date, the Company has not been required to perform any investigation or cleanup activities of any material nature, nor has the Company been subject to any environmental claims. No assurance can be given, however, that this will remain the case in the future.

 

Dependence Upon Independent Mortgage Brokers and Mortgage Bankers

 

The Company depends largely upon independent mortgage bankers, including smaller mortgage companies and commercial banks, and, to a lesser extent, upon independent mortgage brokers, for its originations and purchases of mortgage loans. Substantially all of the independent mortgage brokers and mortgage bankers with whom the Company does business deal with multiple loan originators for each prospective borrower. Wholesale lenders compete for business based upon pricing, service, loan fees and costs and other factors. The Company’s competitors also seek to establish relationships with the same independent mortgage bankers and mortgage brokers with whom the Company seeks to do business, none of whom is obligated by contract or otherwise to continue to do business with the Company. Future operating and financial results of the Company will be susceptible to fluctuations in the volume and cost of its broker and mortgage banker-sourced loans resulting from, among other things, competition from other purchasers of such loans.

 

Possible Changes in Accounting Estimates

 

In preparing the Company’s financial statements, management is required to make estimates based on available information that can affect the reported amounts of assets, liabilities and disclosures as of the balance sheet date and revenues and expenses for the related periods. Such estimates relate principally to the Company’s reserves for foreclosure losses and repurchased loans, its reserve for representation and warranty claims for previous sales of loans and mortgage servicing rights, and its allowances for credit losses on its loan and lease receivables. Additionally, estimates concerning the fair values of mortgage loans held for sale, servicing rights, servicing hedges and the Company’s other hedging instruments are all relevant to ensuring that mortgage loans are carried at the lower of cost or market, and that potential impairments of servicing rights are recognized as and if required. Because of the inherent uncertainties associated with any estimation process and due to possible future changes in market and economic conditions that will affect fair values, it is possible that actual future results in realization of the underlying assets and liabilities could differ significantly from the amounts reflected as of the balance sheet date. See the heading “Critical Accounting Policies” in Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in this report.

 

Federal Programs: Availability of Active Secondary Market

 

The Company’s ability to generate revenue through sales of mortgage-backed securities is largely dependent upon the continuation of programs administered by Fannie Mae, Freddie Mac and Ginnie Mae, which facilitate the issuance of such securities, as well as the Company’s continued eligibility to participate in such programs.  The Company anticipates that it will continue to remain eligible to participate in such programs, but any significant impairment of such eligibility would materially adversely affect its operations. In addition, the mortgage loan products eligible for such programs may be changed from time to time by the sponsor. The profitability of specific types of mortgage loan products may vary

 

32

 

depending on a number of factors, including the administrative costs to the Company of originating or purchasing such types of mortgage loans.  Proposals are being considered in Congress and by various regulators that would affect the manner in which these agencies conduct their businesses.  These proposals include establishing a new independent regulatory authority to regulate these agencies, increasing the authority of the Securities and Exchange Commission over these agencies, and reducing or limiting the benefits these agencies receive from the federal government.  In addition, the accounting practices employed by these agencies are being investigated, and to some extent have been alleged to be improper, by various regulatory authorities.  These proposals, if enacted, and the results of these investigations could have an adverse impact on these agencies and in turn on the Company’s business.

 

Employees

 

At December 31, 2004, NetBank had 2,373 regular employees, substantially all of whom were full-time employees, and 319 contract temporary employees. None of NetBank’s employees are represented by a union. NetBank considers its relations with employees to be good.

 

Available Information

 

The Company’s Internet address is www.netbankinc.com. Information can also be accessed via the Bank’s Internet site www.netbank.com. The Company makes its annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports available free of charge through its Web site as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission.

 

ITEM 2.                                                     PROPERTY

 

The Company leases 48,916 square feet of office space at 11475 Great Oaks Way, Suite 100, Alpharetta, Georgia 30022. This property houses the Company’s Retail Banking operations and corporate headquarters. It is subject to a renewable lease that expires on June 30, 2006.  The Company leases 131,181 square feet of office space at 9710 Two Notch Road, Columbia, South Carolina 29223 and 59,500 square feet at 7215 Financial Way, Jacksonville, Florida 32256.  These properties house the correspondent and wholesale mortgage operations of the Company’s financial intermediary segment. These leases expire on May 30, 2009 and December 31, 2006, respectively.  Meritage leases 44,900 square feet of office space at 6000 S.W. Meadows Road, Suite 500, Lake Oswego, Oregon 97035 and 45,179 square feet at 9300 S.W. Gemini Drive, Suite 100, Beaverton, Oregon 97008. These properties house the majority of nonconforming mortgage operations of the Company’s financial intermediary segment.  The properties are subject to renewable leases that expire September 30, 2006 and May 31, 2005, respectively.  Market Street leases a facility located at 2650 McCormick Drive, Clearwater, Florida 33759, which houses the headquarters of the retail mortgage operations of the Company’s financial intermediary segment. This property is 36,853 square feet and the lease expires on April 30, 2009.  NPS leases 13,200 square feet of office space at 5712 Briarwood West Drive, Jackson, Mississippi 39286, which houses the operations of the Bank’s ATM and merchant processing operations. The lease expires on December 31, 2006. The Company leases 12,122 square feet of office space at 100 Executive Drive Center, Suite 101, Columbia, SC 29210. This property houses the Bank’s Business Finance division. The lease expires on September 30, 2008. At December 31, 2004, the Bank either utilized or sublet all of its facilities with the exception of 12,933 square feet of space in closed offices.

 

ITEM 3.                                                     LEGAL PROCEEDINGS

 

Illinois Union Insurance Co. v. Commercial Money Center, Inc., et al., Case No. CV-01-0685-KJD-RJJ (District Court of Nevada) and related cases now pending in In re Commercial Money Center, Inc. Equipment Lease Litigation in the United States District Court for the Northern District of Ohio, Eastern Division, MDL Case No. 1:02-CV-16000, the pending bankruptcy proceedings of Commercial Money Center, Inc. and In re Commercial Money Center, Inc., Debtor

 

33

 

(Kipperman v. NetBank, FSB), Bankruptcy No. 02-09721; In the United States Bankruptcy Court for the Southern District of California

 

As reported in previous filings, NetBank, FSB, filed a complaint in January 2002 against Commercial Money Center, Inc. (“CMC”), the originator, seller, and subservicer of equipment leases purchased by NetBank, FSB, and against Illinois Union Insurance Company (“Illinois Union”), Safeco Insurance Company of America (“Safeco”), and Royal Indemnity Company (“Royal,” with Illinois Union, Safeco and Royal, collectively, referred to as the “Sureties”), the insurance companies that issued surety bonds and insurance policies guaranteeing payment of the income stream from the leases and that also served as master servicers of the leases.  The NetBank, FSB action alleges several claims, including claims for breach of contract, fraud, and bad faith, and seeks, among other things, payment under and enforcement of surety bonds and insurance policies issued by the insurance and surety companies.  The Judicial Panel on Multi-District Litigation has consolidated the actions involving NetBank, FSB with more than 35 other cases pending around the country involving other banks and financial institutions that were seeking to enforce surety bonds and insurance policies relating to leases sold by CMC.  All pre-trial activity is currently being held in the United States District Court for the Northern District of Ohio (the “MDL Court”).

 

As reported in previous filings, NetBank, FSB had joined with the other claimants in a motion for judgment on the pleadings, which motion was filed on January 31, 2003, and is still pending before the MDL Court.  Meanwhile, discovery in the case has been proceeding and fact discovery is now complete.  Amendments to the pleadings are currently due 14 days after the MDL Court rules on the motions for judgment on the pleadings.  NetBank, FSB has prepared an amendment and supplement to its complaint to include additional claims against the Sureties based on discovery adduced and events that have occurred to date and plans to file the amendment prior to the final date fixed by the MDL Court for filing amendments.  Furthermore, NetBank, FSB has withdrawn its motion for judgment on the pleadings and now intends to file a motion for summary judgment based in part on such discovery.  The Company believes that based on the overall facts and circumstances, the defenses asserted by the Sureties will fail and that NetBank, FSB will ultimately prevail on its claims.

 

Also, as reported in previous filings, on May 30, 2002, CMC filed for bankruptcy protection.  The bankruptcy proceeding is not a part of the consolidation of cases in Ohio.  On June 11, 2003, the Bankruptcy Court in California approved an amended settlement agreement (the “NetBank Agreement”) among NetBank, FSB, Lakeland Bank and the Trustee.   The NetBank Agreement resolves all claims of the Trustee with respect to the lease payments that were guaranteed by surety bonds and insurance policies issued by Safeco and Illinois Union, as well as all claims related to the surety bonds and insurance policies.  In addition to approving the NetBank Agreement, the Bankruptcy Court approved a settlement agreement between the Trustee and Royal (the “Royal Agreement’).  Under the Royal Agreement, Royal has agreed, among other things, to fund litigation by the Trustee against NetBank, FSB to avoid its interests in the leases that were guaranteed by surety bonds issued by Royal, as well as NetBank, FSB’s interests in the surety bonds themselves.  On September 4, 2003, the Trustee filed a Complaint against NetBank, FSB as contemplated by the Royal Agreement, seeking to avoid NetBank, FSB’s interest in the leases and surety bonds relating to the Royal guaranteed lease pools.  On May 6, 2004, NetBank, FSB filed a motion for partial summary judgment against the Trustee.  The Trustee filed a motion for partial summary judgment against NetBank, FSB on June 18, 2004.

 

At a status conference on July 15, 2004, the Bankruptcy Court ordered a stay in the bankruptcy proceedings pending a hearing on July 30, 2004.  At that hearing the Bankruptcy Court continued the stay as to all adversary proceedings and requested the parties to attempt to mediate their disputes.   At a status conference on October 1, 2004, the Bankruptcy Court lifted the stay of the adversary proceeding against NetBank, FSB.  A hearing on NetBank, FSB’s and the Trustee’s motions for partial summary judgment was held on December 14, 2004.  On January 27, 2005, the Bankruptcy Court entered its Memorandum Decision granting the Trustee’s motion for partial summary judgment and denying NetBank, FSB’s motion for partial summary judgment.  An order to that effect was entered by the Bankruptcy Court on February 28, 2005.    NetBank, FSB intends to appeal the decision of the Bankruptcy Court.  In the meantime, the parties to the bankruptcy action have continued to mediate and resolve their disputes.    Any resolution of disputes in the bankruptcy proceedings would not affect the decision entered by the Bankruptcy Court regarding the motions for partial summary judgment.

 

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NetBank, FSB intends to vigorously pursue its claims against all the Sureties, including claims for any loss associated with the claims brought by the Trustee against NetBank, FSB.  At this time, the Company is unable to express an opinion as to the likelihood of loss, or the amount or range of potential loss, with regard to this matter.

 

Clayton v. Commercial Money Center, Inc., Case No. BC 253169 (CA Sup, Ct., Los Angeles County)

 

On June 27, 2001, several lessees of equipment leased from CMC filed suit in Los Angeles Superior Court against CMC and several John Doe defendants alleging that the leases violated California usury laws, the California Financial Code, and the California Unfair Business Practices Act.  The plaintiff lessees were seeking to rescind or reform their obligations under the leases and were seeking to recover statutory damages and attorney’s fees.  The plaintiffs subsequently amended their complaint to name NetBank, FSB, several other investor banks, and several surety companies as co-defendants in the action.  After CMC filed for bankruptcy, the action was removed to the bankruptcy court in the Central District of California, but the plaintiffs subsequently agreed to withdraw their claims against CMC and were successful in their motion to remand the case back to state court.

 

On March 15, 2004, the Superior Court sustained demurrers and motions to quash filed by NetBank, FSB and various other defendants on certain of the plaintiffs’ claims.  The Superior Court sustained the demurrers under the California Financial Code, without leave to amend.  The Superior Court also sustained demurrers on the Unfair Business Practices Act, with leave to amend the claims to add greater specificity to the claims, but without leave to amend as to unnamed representatives of the alleged class of plaintiffs harmed.  The Superior Court also granted motions to strike: (1) plaintiffs’ claims under the California Unfair Business Practices Act as to unnamed representative plaintiffs; (2) plaintiffs’ request for restitution (the named plaintiffs may amend to establish individual entitlement to restitution); (3) plaintiffs’ request for disgorgement; (4) plaintiffs’ request for punitive damages; (5) plaintiffs’ request for compensatory damages under the California Unfair Business Practices Act; and (6) plaintiffs’ request for attorneys’ fees.

 

On April 29, 2004, the plaintiffs served an amended complaint against NetBank, FSB alleging claims for, among other things, violations of another section of the California Financial Code, unfair competition under Section 17200 of the California Business and Professions Code and usury.  On October 26, 2004, the court overruled the defendants’ demurrers to the third amended complaint.  However, on December 13, 2004, the court issued a stay in the action pending a decision by the appeals court on the plaintiffs’ claims that were dismissed without leave to amend.  No discovery has been taken in this case and there will be no other movement on these surviving claims pending the outcome of plaintiffs’ appeal.    The Company intends to vigorously defend the amended claims in the Clayton action and to pursue recovery against Safeco Insurance Company, Royal Indemnity Company, and Illinois Union Insurance Company in the Company’s existing action against them for any damages and costs incurred in this case.

 

interstate NetBank v. NetBank, Inc. and NetBank, Case No. 1:01-CV-1324(JBS) (District of New Jersey)

 

On June 27, 2001, the Company was served with a complaint for a declaratory judgment filed by interState NetBank in the District of New Jersey challenging the “NETBANK®” service mark.  The Company answered and counterclaimed for trademark infringement on July 13, 2001.  Discovery was stayed pending a ruling on interState NetBank’s November 19, 2001 motion for summary judgment, which claimed that “NETBANK” is generic for all banking services delivered over the Internet.  On September 22, 2002, the District Court ruled that “NETBANK” is generic for online banking services but did not cancel the Company’s existing service mark registration at that time.  The Company filed a motion for reconsideration of the District Court’s decision.  On June 23, 2003, the District Court denied the Company’s motion for reconsideration but clarified that two of the Company’s counterclaims remained in the case: (1) a claim for infringement of the Company’s “NETBANK®” service mark to the extent that it covers online bill-payment services (as opposed to online banking services in general) and (2) a claim for unfair competition under New Jersey law.  The parties completed fact discovery on February 27, 2004.

 

On April 30, 2004, interState NetBank filed a second motion for summary judgment, seeking the dismissal of the remaining two claims brought by NetBank, as well as an award of attorneys’ fees.  On December 14, 2004, the District Court granted interState Net Bank’s second motion for summary judgment, dismissing the Company’s claims for

 

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infringement and unfair competition.  The District Court also canceled the Company’s service mark registration.  The District Court did not award interState NetBank its attorneys’ fees as requested in its motion for summary judgment, finding that the Company litigated its claims in good faith.  The Company has decided not to appeal the District Court’s rulings on both motions for summary judgment.

 

The Company believes it has built value in the “NetBank” brand.  The Court’s ruling does not prohibit the Company from continuing to use and develop national recognition of the brand.  While the Company will not be able to restrict others from using the term “netbank” in a generic sense, the Court’s ruling does not prevent the Company from seeking to block others who unfairly compete through their use of the name “netbank.”

 

ITEM 4.                                                     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None.

 

PART II

 

ITEM 5.                  MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED SHAREHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

Market Information

 

NetBank’s common stock is quoted on the Nasdaq Stock Market under the symbol “NTBK.” The Company had approximately 404 registered shareholders of record as of February 15, 2005. The following table shows, for the periods indicated, the high and low closing prices per share of NetBank’s common stock as reported by the Nasdaq Stock Market.

 

 

Dividends

 

The dividends paid on the Company’s common stock for each quarter of the last two fiscal years are set forth above. On February 2, 2005, the Company’s Board of Directors declared a cash dividend of $.02 per share of common stock to shareholders of record on February 15, 2005.  The dividend will be paid on March 15, 2005.  Funds for the dividend will come from sources other than earnings of the Bank.  Under current OTS regulations, generally, the Bank may pay dividends and make other capital distributions to the Company after giving notice to the OTS.  For further information, see the heading “Supervision and Regulations – Bank Regulation – Capital Distribution” in Item 1. “Business” included in this report.

 

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Issuer Repurchase of Equity Securities

 

In August 2002, the Board of Directors approved a plan to repurchase up to 1 million shares of the Company’s common stock.  The plan was subsequently increased by 1 million shares in October 2002, 2 million shares in January 2003 and 1 million shares in April 2004.  During 2004 1,456,336 shares of common stock were repurchased at a weighted average cost of $11.28 per share.  As summarized below, repurchase activity for fourth quarter 2004 included 223,600 shares repurchased at a weighted average cost of $9.75 per share.  At December 31, 2004, 663,964 shares remained available for repurchase under current Board authority.

 

The following table sets forth information with respect to repurchases by the Company of shares of its common stock during the quarter ended December 31, 2004:

 

Period		Total Number of Shares Purchased		Average Price Paid Per Share			Total Number of Shares Purchased as Part of Publicly Announced Plans		Maximum Number of Shares that May Yet Be Purchased Under the Plans
Balance as of September 30, 2004		—		—			—		887,564
October 1 through October 31, 2004		211,200		$	9.77		211,200		676,364
November 1 through November 30, 2004		12,400		$	9.34		12,400		663,964
December 1 through December 31, 2004		—		$	—		—		663,964
Total		223,600		$	9.75		223,600		663,964

 

Equity Compensation Plan Information

 

The NetBank, Inc. 1996 Stock Incentive Plan (the “Plan”) was originally adopted by the Board of Directors on November 25, 1996, and approved by the shareholders of the Company on January 10, 1997.  Through initial approval and subsequent amendments, as of December 31, 2004, 9,500,000 shares of the Company’s common stock are reserved for issuance pursuant to awards granted under the Plan.  As of December 31, 2004, 5,253,833 shares of common stock are subject to outstanding Stock Incentives granted under the Plan.  The committee appointed by the Board of Directors has not yet made any determination as to which eligible participants will be granted Stock Incentives under the Plan in the future.

 

The following table provides information regarding compensation plans under which equity securities of the Company are authorized for issuance.  The following data is presented as of December 31, 2004.

 

		(a)		(b)			(c)
Plan Category		Number of Securities To Be Issued Upon Exercise of Outstanding Options, Warrants and Rights		Weighted-Average Exercise Price of Outstanding Options, Warrants and Rights			Number of Securities Remaining Available for Future Issuance Under Equity Compensation Plans (Excluding Securities Reflected in Column (a)
Equity Compensation Plans Approved by Security Holders:
1996 Stock Incentive Plan		5,253,833		$	11.27		2,248,704
Employee Stock Purchase Plan		N/A		N/A			747,491
Equity Compensation Plans Not Approved by Security Holders:
None		N/A		N/A			N/A
TOTAL		5,253,833		$	11.27		2,996,195

 

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See note 14 of the notes to the consolidated financial statements included in this report for additional details regarding stock options.

 

Recent Sales of Unregistered Securities

 

On July 1, 2004, the Company acquired the principal operating assets of Beacon Credit Services, LLC (“Beacon”), a privately held provider of RV, boat and personal aircraft financing.  The consideration paid consisted of 194,217 shares of the Company’s common stock and cash of $4,952,289.  The shares of the Company’s common stock were issued to Beacon’s three members in private placement pursuant to Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”), and the issuance was therefore exempt from the registration requirements of Section 5 of the Securities Act.

 

ITEM 6.                                                     SELECTED FINANCIAL DATA

 

Income Statement Data (000s except share and per share data)		2004 (1)			2003 (1)			2002 (1)			2001			2000
Interest income		$	232,163		$	210,630		$	166,755		$	151,516		$	116,320
Interest expense		92,617			85,386			103,519			100,617			78,564
Net interest income		139,546			125,244			63,236			50,899			37,756
Provision for credit losses		34,777		(2)	7,008			22,417		(2)	585			393
Net interest income after provision for credit losses		104,769			118,236			40,819			50,314			37,363
Non-interest income		207,351			310,544			177,161			27,599			18,872
Non-interest expense		305,790			348,727			244,017			67,438			43,181
Net income (loss) before income taxes		6,330			80,053			(26,037		)	10,475			13,054
Income tax (expense) benefit		(2,110		)	(29,539		)	10,180			(3,874		)	(4,461		)
Net income (loss)		$	4,220		$	50,514		$	(15,857	)	$	6,601		$	8,593
Net income (loss) per common share-basic		$	0.09		$	1.05		$	(0.36	)	$	0.23		$	0.29
Net income (loss) per common share-diluted		$	0.09		$	1.04		$	(0.36	)	$	0.22		$	0.28
Weighted average shares outstanding-basic		46,862			47,963			44,407			29,210			29,667
Weighted average shares outstanding-diluted		47,214			48,645			44,407			29,770			30,340
Dividends paid per common share – basic		$	0.08		$	0.08		$	0.00		$	0.00		$	0.00
Balance Sheet Data-at Period End:
Total assets		$	4,622,181		$	4,734,805		$	3,527,552		$	2,879,533		$	1,842,690
Total deposits		$	2,639,441		$	2,539,427		$	2,044,922		$	1,493,819		$	980,752
Total debt		$	1,323,348		$	1,432,879		$	912,996		$	1,038,908		$	590,926
Shareholders’ equity		$	414,027		$	430,350		$	401,590		$	255,454		$	250,607
Book value per share outstanding		$	8.90		$	9.04		$	8.25		$	8.80		$	8.62
Dividend payout ratio		88.8		%	7.6		%	n/a			n/a			n/a
Percentage of net income (loss) to:
Average total assets (ROA)		0.09		%	1.17		%	(0.45		)%	0.28		%	0.55		%
Average shareholders’ equity (ROE)		0.98		%	12.11		%	(4.30		)%	2.48		%	3.51		%
Average shareholders’ equity to average total assets		8.93		%	9.68		%	10.56		%	11.45		%	15.77		%

 

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(1)           Reference is made to Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for additional details regarding the impact on the figures presented in the above table regarding the July 2004 acquisition of Beacon Credit Services, LLC, the December 2003 acquisition of NetBank Payment Systems, Inc. and the March 2002 acquisition of Resource Bancshares Mortgage Group, Inc.

 

(2)           The increase in provision expense during 2002 and 2004 is principally a result of non-performing leases in the Company’s CMC lease portfolio. See Item 3. “Legal Proceedings” and notes 5 and 6 of the notes to the consolidated financial statements included in this report for additional details.

 

ITEM 7.                  Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion may include forward-looking statements. Forward-looking statements regarding the intent, belief or current expectations of NetBank, Inc. or its officers and directors can be identified by the use of forward-looking terms such as “may,” “will,” “should,” “believe,” “expect,” “anticipate,” “estimate,” “continue,” or other comparable terminology. Various internal and external factors could cause the Company’s actual results to differ materially from those anticipated by the forward-looking statements. These factors include, but are in no way limited to, 1) the evolving nature of the market for Internet banking and financial services generally; 2) the public’s perception of the Internet as a secure, reliable channel for transactions; 3) the success of new products and lines of business considered critical to the Company’s long-term strategy, such as small business banking and transaction processing services; 4) potential difficulties in integrating the Company’s operations across its multiple lines of business; 5) the cyclical nature of the mortgage banking industry generally; 6) a possible decline in asset quality; 7) the possible adverse effects of unexpected changes in the interest rate environment; 8) adverse legal rulings, particularly in the Company’s litigation over leases originated by the Commercial Money Center, Inc.; and/or 9) increased competition and regulatory changes. Item 1.”Business” of this 10-K filing includes additional information on these risks and others that have the potential to impact the Company in a material way. All forward-looking statements in this report are based on information available at the time of filing. The Company has no obligation to update any forward-looking statement included herein. Forward-looking statements are made in reliance upon the safe harbor provisions of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.

 

General

 

NetBank, Inc. is a financial holding company engaged primarily in retail banking, mortgage banking, business finance and providing ATM and merchant processing services.  NetBank, Inc. wholly owns the outstanding stock of NetBank (“NetBank, FSB” or “the Bank”), a federal savings bank; MG Reinsurance Company (“MG Reinsurance”), a captive reinsurance company; NetInsurance, Inc. (“NetInsurance”), a licensed insurance agency; and NB Partners, Inc., a corporation involved in strategic partnering opportunities.  NB Partners, Inc. owns all of the outstanding stock of Financial Technologies, Inc., a corporation formed in 2004 to market transaction processing services to other financial services companies.  NetBank, FSB owns all of the outstanding stock of Market Street Mortgage Corporation (“Market Street”), a retail mortgage company, NetBank Payment Systems, Inc. (“NPS”), a provider of ATM and merchant processing services for retail and other non-bank businesses and Meritage Mortgage Corporation (“Meritage”), a wholesale non-conforming mortgage provider. The consolidated company is referred to herein as “we,” “our,”

 

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“NetBank,” or “the Company”.

 

During the third quarter of 2004, Resource Bancshares Mortgage Group, Inc. (“Resource”) and Republic Leasing Company, Inc., both of which had been subsidiaries of NetBank, FSB, were legally consolidated into NetBank, FSB and ceased to exist as separate corporations.  Republic Leasing Company, Inc. now operates as the NetBank Business Finance division of NetBank, FSB.  In addition, during the fourth quarter of 2004, RBMG, Inc., formerly a subsidiary of NetBank, FSB, was legally consolidated into NetBank, FSB and ceased to exist as a separate corporation.  RBMG, Inc. now operates as the NetBank Funding division of NetBank, FSB.

 

All dollar figures are presented in thousands (000s), except per share data, unless otherwise noted.  Net income per share is presented on a diluted basis.  All of NetBank’s operations and assets are located within the United States.

 

Executive Summary

 

Net income for the year ended December 31, 2004 was $4,220 or $0.09 per share, compared to net income of $50,514 or $1.04 per share, for 2003.  During 2004, NetBank recorded a $29,000 provision for loss on its investment in leases originated by CMC.  In the absence of such charge, reported earnings and earnings per share would have been $22,200 and $0.47, respectively.  See Item 3. “Legal Proceedings” and the heading “Material Pending litigation” below and notes 5 and 6 of the notes to the consolidated financial statements included in this report for additional details regarding the Company’s loan and lease receivables, including its investment in the CMC lease portfolio, the associated litigation and the associated allowance for credit losses.

 

NetBank’s management capitalized on the favorable interest rate environment in 2003 to post strong revenues from its financial intermediary segment.  In contrast, rising interest rates and interest rate volatility during 2004 adversely affected the results reported from the financial intermediary segment.  Mortgage production within the financial intermediary segment dropped from $18.9 billion to $13.6 billion, while sales of mortgages dropped from $18.3 billion to $14.1 billion comparing 2003 to 2004, respectively.  NetBank also experienced pressure on its margins in the financial intermediary segment from increasing competition, especially in the correspondent channel.  The financial intermediary segment’s pre-tax income, as a result, went from $158,079 in 2003 to $23,241 in 2004.

 

As a result of the potential volatility in its financial intermediary segment, NetBank announced in 2002 its intention to diversify its sources of revenue.  It set a long-term goal of achieving an equal balance of earnings between its retail banking, financial intermediary and transaction processing segments.  Although the volatility in the financial intermediary segment manifested itself during 2004, resulting in reduced earnings on a consolidated basis, the company made significant progress in growing the earnings and earnings capabilities of the other two segments.

 

During 2002 and 2003, the retail banking segment implemented a number of strategies to improve earnings.  It restructured its portfolio of assets away from higher to lower risk loans.  It prepaid a large number of higher costing, term FHLB advances.  It became a warehouse bank for the financial intermediary segment, and it commenced hedging a portion of the interest rate risk of its servicing assets on balance sheet with agency mortgage-backed securities held available for sale.  As a result, the retail banking segment’s pre-tax results improved by $49,942 to $(11,076) for the year ended December 31, 2004 compared with the same period in 2003.  In the absence of the $29,000 provision on the leases acquired from CMC, the reported improvement would have been $78,942.

 

The transaction processing segment reported an improvement in pre-tax earnings of $6,308.  This resulted from improved expense control and an increase in average loans serviced by its servicing operations.  Likewise, the acquisition of NPS late in 2003 added $1,977 of pre-tax earnings to the transaction processing segment’s results for 2004.

 

Future Outlook

 

The Company is excited about the progress that it has made in becoming a premier provider of financial products and

 

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services to its targeted market segments.  NetBank’s strategy is multi-faceted, involving:

 

Retail Banking. NetBank, FSB operates as an FDIC-insured, federally chartered thrift institution that currently serves over 160,000 customers throughout the United States and in more than 80 foreign countries.  NetBank, FSB operates a totally branchless model and passes on a portion of the cost savings to its customers in the form of attractive yields on deposits.  NetBank, FSB’s array of products and services are available to its customers 24 hours per day, seven days a week, and all 365 days during the year.

 

Financial Intermediary. Through its mortgage banking operations, the Company serves as an intermediary between consumers and institutional investors.  The Company obtains mortgage loans by originating loans directly with consumers or through brokers or by buying closed loans from a network of correspondent banks, thrifts and independent mortgage companies.  The majority of these loans are held for sale on the Company’s balance sheet prior to delivery into the secondary market.  The Company thus earns a long-term yield, on an asset held short-term, and also earns origination and servicing revenues and gains on the sale of the mortgages or resulting mortgage-backed securities.

 

Transaction Processing.  The following summarizes NetBank’s transaction processing initiatives:

 

•                  NetBank runs a servicing factory that services over 120,000 loans for internal and external customers.

 

•                  Late in 2003, the Company expanded its transaction processing capabilities by acquiring NPS.  NPS is one of the top five providers of ATM services for retail and non-bank businesses, and NetBank has the 2^nd largest bank ATM network in the country.  At December 31, 2004, through organic growth and acquisition, NPS serviced approximately 8,000 ATM machines and 2,600 merchant processing terminals.

 

•                  “Check 21” legislation was passed by Congress in the fall of 2003, and it became effective on October 28, 2004.  Banks may now clear checks through substitutes such as digital images.  The checks may be truncated, customers may be provided images of checks, and banks may exchange data instead of physical checks.  NetBank has built a new processing engine that can do ACH and Check 21 clearing.  NetBank plans to offer these payment processing services to community banks.  NetBank already offers mortgage processing services to community banks.

 

Late in 2002, NetBank announced its strategy to diversify its earnings so that one third of its earnings are provided by each of its principal operating segments:  retail banking, financial intermediary and transaction processing.  The following summarizes pre-tax income by segment for the years ended December 31, 2003 and 2004.  The retail banking segment results for 2004 includes a $29.0 million provision for credit losses on its CMC lease portfolio as discussed below.

 

		Retail banking			Financial intermediary			Transaction processing			Other / eliminations			Total
2003		$	(61,018	)	$	158,079		$	(3,984	)	$	(13,024	)	$	80,053
2004		$	(11,076	)	$	23,241		$	2,324		$	(8,159	)	$	6,330

 

Absent the $29 million charge for CMC, the retail banking segment would have contributed $17,924 of pre-tax income.

 

NetBank is pleased with the progress made in 2004 in expanding its earnings from its retail banking and transaction processing segments.

 

NetBank believes that its deposit base will continue to grow as Internet usage and Internet-based commerce grow. NetBank believes that it can continue to invest those deposits profitably in mortgage loans held temporarily for sale and loans held for investment.  NetBank also believes that its non-interest earnings in the form of fees and gain on sale resulting from its financial intermediary and transaction processing activities will provide a better diversity of earnings than the traditional banking model.

 

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