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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q

[X]    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended June 30, 2004

OR

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

For the Transition Period from ____________ to ______________

Commission File Number: 000-33485

SAXON CAPITAL, INC.
(Exact name of Registrant as specified in its charter)

4860 COX ROAD, SUITE 300
GLEN ALLEN, VIRGINIA
(Address of principal executive offices)

23060
(Zip Code)

(804) 967-7400
(Registrant’s telephone number, including area code)

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

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

As of August 3, 2004 there were 28,773,200 shares of our common stock, par value $0.01 per share, outstanding.

SAXON CAPITAL, INC.

Table of Contents

Table of Contents

Part I. Financial Information

Item 1. Financial Statements

Saxon Capital, Inc.
Condensed Consolidated Balance Sheets
(dollars in thousands, except for share data)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

Table of Contents

Saxon Capital, Inc.
Condensed Consolidated Statements of Operations
(dollars in thousands, except for share data)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

Table of Contents

Saxon Capital, Inc.
Condensed Consolidated Statement of Shareholders’ Equity
(dollars in thousands, except share data)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

Table of Contents

Saxon Capital, Inc.
Condensed Consolidated Statements of Cash Flows
(dollars in thousands)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

Table of Contents

Notes to Unaudited Condensed Consolidated Financial Statements

(1) Organization and Summary of Significant Accounting Policies

        The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with the instructions to Form 10-Q and Article 10, Rule 10-01 of Regulation S-X for interim financial statements. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America, or GAAP, for complete financial statements.

        In the opinion of management, the accompanying unaudited condensed consolidated financial statements contain all adjustments, consisting of normal recurring accruals, necessary for a fair presentation. The results of operations and other data for the three and six months ended June 30, 2004 are not necessarily indicative of the results that may be expected for any other interim periods or the entire year ending December 31, 2004. The unaudited condensed consolidated financial statements presented herein should be read in conjunction with the audited consolidated financial statements and related notes thereto included in Saxon Capital, Inc.‘s Annual Report on Form 10-K, as amended for the year ended December 31, 2003.

        Saxon Capital, Inc. (the “Company”) (NASDAQ: SAXN) was formed on April 23, 2001. The Company acquired all of the issued and outstanding capital stock of SCI Services, Inc. (“Predecessor”) from Dominion Capital, Inc. (“Dominion Capital”) on July 6, 2001. The Company had no activities between April 23, 2001 and the acquisition of Predecessor.

        The Company, through its wholly-owned subsidiaries Saxon Mortgage, Inc. (“Saxon Mortgage”) and America’s MoneyLine, Inc. (“America’s MoneyLine”), is licensed to originate loans or is exempt from licensing requirements, in 49 states. Its activities consist primarily of originating and purchasing single-family residential mortgage loans and home equity loans through three production segments — wholesale, correspondent, and retail. The Company may also, as servicer of record, purchase loans from prior securitizations pursuant to the clean-up call provisions of the trusts. Loans originated or purchased by the Company are secured by a mortgage on the borrower’s property. The Company then either sells these loans or accumulates such loans until a sufficient volume has been reached to securitize them. In addition, the Company, through its wholly-owned subsidiary Saxon Mortgage Services, Inc. (“Saxon Mortgage Services”), services and sub-services single-family mortgage loans throughout the country that primarily have been purchased or originated by the Company. The Company, headquartered in Glen Allen, Virginia, has operation centers of its subsidiaries in Fort Worth, Texas and Foothill Ranch, California and 25 branch offices located throughout the country at June 30, 2004. The focus of the Company is on originating and purchasing loans to homebuyers who generally do not meet the underwriting guidelines of one of the government-sponsored entities such as the Federal Home Loan Mortgage Corporation, (“Freddie Mac”), the Federal National Mortgage Association, (“Fannie Mae”), and the Government National Mortgage Association, (“Ginnie Mae”). Use of the term “Company” throughout these Unaudited Notes to Condensed Consolidated Financial Statements shall be deemed to refer to or include the applicable subsidiaries of the Company.

        The unaudited condensed consolidated financial statements of the Company include the accounts of all wholly owned subsidiaries. All inter-company balances and transactions have been eliminated in consolidation.

        The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amount of revenues and expenses during the reporting period. Actual results could differ from those estimates. The recorded balances most affected by the use of estimates are net interest income, the allowance for loan loss, valuation of servicing rights, hedging activities, and income taxes.

        The Company has elected to follow the intrinsic value method, in accounting for its stock options issued to employees and non-employee directors. Accordingly, the Company does not recognize compensation expense upon the issuance of its stock options because the option terms are fixed and the exercise price equals the market price of the underlying stock on the grant date. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value method to options granted to employees using the Black-Scholes option pricing model.

        Certain amounts for 2003 have been reclassified to conform to presentations adopted in 2004.

(2)     Subsequent Events

         On July 13, 2004, the Company closed a new servicing advance facility, Saxon Advance Receivables Note Trust.  The facility allows for the issuance of multiple series of notes to finance principal, interest and other servicing advances that the Company is required to make for its owned portfolio as well as those related to certain third party servicing contracts.   The initial Series 2004-1 Notes issued under the facility allow cumulative borrowings up to $160.0 million.  >The initial amount financed under the Series 2004-1 Notes amounted to $109.2 million.  The terms of the Series 2004-1 Notes require the Notes to begin to amortize at various dates through October 2006.   In conjunction with the new facility, the existing Saxon Advance Receivables Backed Certificates 2002-A and Saxon Advance Receivables Backed Certificates 2003-A facilities were both terminated.

        On July 16, 2004, the Company’s $150.0 million repurchase facility with Greenwich Capital Financial Products, Inc. was amended extending the termination date of the facility to September 1, 2004.

        On July 14, 2004 and on August 3, 2004, the Company’s subsidiary formed for the purpose of effecting the proposed real estate investment trust (“REIT”) conversion, Saxon REIT, Inc., filed pre-effective amendment numbers 4 and 5, respectively, to its S-4 registration statement (File No. 333-112834). with the SEC. On August 5, 2004, Saxon REIT, Inc. filed the definitive proxy statement/prospectus with the SEC pursuant to Rule 424(b)(3) under the Securities Act. The Company plans to present the merger agreement that effectuates the proposed REIT conversion to its shareholders for approval at its annual meeting, which will be held on September 13, 2004. If approved, the Company expects the proposed REIT conversion to be completed before the end of 2004.

        On July 22, 2004, Saxon REIT, Inc. filed amendment number 1 to its S-11 registration statement (File No. 333-116028) with the SEC.

        In July 2004, the Company purchased $1.6 billion in third party servicing rights for approximately $12 million.

        On July 26, 2004, the Company closed a $1.2 billion asset backed securitization, which will be accounted for as debt for both tax and financial reporting purposes.

        On July 26, 2004, the Company called $50.5 million of mortgage loans from the SAST 1998-4 securitization pursuant to the clean-up call provision of the trust.

        On July 29, 2004, the Company closed operations in the Nashville, Tennessee and Merriam, Kansas retail branches.

        On August 6, 2004, the Company’s $400.0 million repurchase facility with Merrill Lynch Mortgage Capital, Inc. was amended extending the termination date of the facility to November 19, 2004.

(3)     Earnings Per Share

        Basic earnings per share is based on the weighted average number of common shares outstanding, excluding any dilutive effects of options, warrants, or restricted stock units. Diluted earnings per share is based on the weighted average number of common shares, dilutive stock options, dilutive stock warrants, and dilutive restricted stock units outstanding during the year. Computations of earnings per common share were as follows:

(4)     Mortgage Loan Portfolio

        The Company’s subsidiaries purchase and originate fixed-rate and adjustable-rate mortgage loans that have a contractual maturity of up to 30 years. These mortgage loans are secured by single-family residential properties (which may include manufactured homes affixed to and classified as real property under applicable law), condominiums and one-to-four unit properties, and are recorded at amortized cost. Most of these mortgage loans are pledged as collateral for a portion of the warehouse financing and securitization financing.

        Approximately 22% of the property securing the Company’s mortgage loan portfolio was located in the state of California at both June 30, 2004 and December 31, 2003, respectively. No other state comprised more than 8% and 9% of the Company’s mortgage loan portfolio at June 30, 2004 and December 31, 2003, respectively.

        Mortgage loans reflected on the Company’s condensed consolidated balance sheets as of June 30, 2004 and December 31, 2003 were comprised of the following:

        From time to time, the Company may choose to sell certain mortgage loans rather than securitize them. The following chart summarizes the Company’s activity with respect to sold mortgage loans during the periods presented.

(5)     Allowance for Loan Loss

        The Company is exposed to risk of loss from its mortgage loan portfolio and establishes the allowance for loan loss taking into account a variety of criteria including the contractual delinquency status and historical loss experience. The allowance for loan loss is evaluated monthly and adjusted based on this review.

        Activity related to the allowance for loan loss for the mortgage loan portfolio for the three and six months ended June 30, 2004 and 2003 is as follows:

(6)     Mortgage Servicing Rights

        Mortgage servicing rights, or MSRs, are initially recorded at cost and subsequently amortized in proportion to and over the period of the anticipated servicing income to arrive at the carrying value. The amount recorded on the condensed consolidated balance sheets represents the carrying value less any temporary impairments of the Company’s servicing portfolio. As of June 30, 2004, the fair value of the mortgage servicing rights in total, based on independent appraisals, was measured at $70.6 million, compared to $46.8 million at December 31, 2003. The following table summarizes activity in mortgage servicing rights for the three and six months ended June 30, 2004 and 2003:

        The following table summarizes the activity of our valuation allowance:

        As of June 30, 2004, the following table summarizes the remaining estimated projected amortization expense for the carrying value of the mortgage servicing rights for each of the five succeeding years and thereafter:

(7)     Warehouse Financing, Securitization Financing and Note Payable

A summary of the amounts outstanding and available under these agreements at June 30, 2004 and December 31, 2003 is as follows:

The following table summarizes our contractual obligations at June 30, 2004:

        A summary of interest expense and the weighted average cost of funds is as follows:

        During the six months ended June 30, 2004, the Company completed one securitization of mortgage loans, ($1.1 billion in principal balances and $20.1 million in unamortized basis adjustments). During the six months ended June 30, 2003, the Company completed the final funding of Saxon Asset Securities Trust (“SAST”) 2002-3 ($300.2 million in principal balances and $4.4 million in unamortized basis adjustments) and two additional securitizations of mortgage loans ($1.3 billion in principal balances and $19.2 million in unamortized basis adjustments).

        Under its borrowing agreements, the Company is subject to certain debt covenants and is required to maintain or satisfy specified financial ratios and tests, as well as other customary covenants, representations and warranties, and events of default. In the event of default, the Company may be prohibited from paying dividends and making distributions under certain of its financing facilities without the prior approval of its lenders. At June 30, 2004, the Company was in compliance with all its covenants under the respective borrowing agreements.

(8)     Derivatives

        The Company accounts for its derivative financial instruments as cash flow hedges, which hedge the Company’s variable rate debt. At June 30, 2004 and December 31, 2003, the fair value of the Company’s derivatives totaled $15.0 million and $5.7 million, respectively. The derivative fair value is held on the condensed consolidated balance sheet as part of other assets. As of June 30, 2004 and December 31, 2003, the mark to market adjustment on effective hedges recorded in accumulated other comprehensive income (loss) was $2.5 million with a tax expense of $1.0 million and $(7.7) million with a tax benefit of $(3.0) million, respectively. Accumulated other comprehensive income (loss) relating to cash flow hedging is amortized into earnings through interest expense as the hedged risk affects earnings. The expected effect of amortization of the accumulated other comprehensive income on earnings for the next twelve months is $0.3 million of income, depending on future performance. Hedge ineffectiveness associated with hedges resulted in $28.2 thousand of income and $270.9 thousand of expense for the three months ended June 30, 2004 and 2003, respectively and resulted in $8.5 thousand of expense and $502.4 thousand of expense for the six months ended June 30, 2004 and 2003, respectively.

        At June 30, 2004 and December 31, 2003, the Company had $35.2 million and $46.3 million, respectively of basis adjustments on mortgage loans related to fair value hedging activity. The basis adjustment is amortized into earnings through interest income based on the life of the previously hedged loans.

(9)     Commitments and Contingencies

        Mortgage Loans

        At June 30, 2004 and December 31, 2003, the Company’s subsidiaries had commitments to fund mortgage loans with agreed-upon rates of approximately $344.6 million and $144.3 million, respectively. These amounts do not necessarily represent future cash requirements, as some portion of the commitments are likely to expire without being drawn upon or may be subsequently declined for credit or other reasons.

        In connection with the approximately $0.9 billion of mortgage loans securitized in off balance sheet transactions from May 1996 to July 5, 2001, and which are still outstanding as of June 30, 2004, and in connection with the sales of mortgage loans to nonaffiliated parties, the Company’s subsidiaries made representations and warranties about certain characteristics of the loans, the borrowers, and the underlying properties. In the event of a breach of these representations and warranties, the Company may be required to remove loans from a securitization and replace them with cash or substitute loans, and to indemnify parties for any losses related to such breach. At June 30, 2004 the Company neither has nor expects to incur any material obligation to remove any such loans, or to provide any such indemnification.

        The Company is subject to premium recapture expenses in connection with the sale of residential mortgage loans. Premium recapture expenses represent repayment of a portion of certain loan sale premiums to investors on previously sold loans which are repaid within six months of the loan sale. The Company accrues an estimate of the potential refunds of premium received on loan sales based upon historical experience. At both June 30, 2004 and December 31, 2003, the liability recorded for premium recapture expense was $0.2 million.

        Mortgage Servicing Rights

        The Company expects to purchase third party servicing rights for an additional $4.7 billion of mortgage loans through the third quarter of 2004, of which $1.6 billion were purchased in July 2004 for approximately $12.0 million.

        Legal Matters

        Because the business of the Company’s subsidiaries involves the collection of numerous accounts, the validity of liens and compliance with various state and federal lending laws, the Company or its subsidiaries are subject, in the normal course of business, to various legal proceedings. The resolution of these lawsuits, in management’s opinion, will not have a material adverse effect on the financial position or the results of operations of the Company.

        America’s MoneyLine is named in a case brought as a class action in Illinois. This is a class action suit alleging consumer fraud and unjust enrichment under Illinois law and similar laws of other states. The plaintiff alleges that she was improperly charged a fee for overnight delivery of mortgage loan documents. In December 2002, the Company filed a Petition to Compel Arbitration in the United States District Court for the Southern District of Illinois. The Motion to Compel Arbitration in federal court was denied on jurisdictional grounds. The Company appealed the District Court’s decision to the United States Court of Appeals for the Seventh Circuit. The Court of Appeals affirmed the District Court’s decision. The Company has filed a motion to compel arbitration in state court. If the plaintiff achieves nationwide class certification and the case is decided adversely to America’s MoneyLine, the potential loss could materially and adversely affect the Company’s business. At this time, the Company cannot predict the outcome of this matter and cannot reasonably estimate a range of possible loss given the current status of the litigation; accordingly, no amounts have been accrued in the Company’s accompanying condensed consolidated financial statements.

        Saxon Mortgage Services, was named in a matter filed in the United States District Court for the Northern District of Illinois, Eastern Division as a class action. The plaintiffs alleged that Saxon Mortgage Services collected prepayment penalties on loans that had been accelerated, constituting violations of the Illinois Interest Act, the Illinois Consumer Fraud Act, similar laws, if any, in other states, and a breach of contract. The claims of one of the named plaintiffs have been settled, and the claims of the remaining named plaintiff against Saxon Mortgage Services have been dismissed without prejudice. The remaining named plaintiff re-filed the action in State Court. On the Company’s motion, the action was removed to Federal Court. The parties have agreed to a settlement that would require the Company to pay approximately $0.2 million to a group of 27 former Illinois borrowers and their attorneys in exchange for a dismissal. Accordingly, the Company accrued $0.2 million in the Company’s consolidated financial statements for the year ended December 31, 2003. The Court has entered an order approving the settlement, and we are in the process of performing our obligations under the settlement agreement. Each of the 27 former borrowers may choose to opt out of the settlement and may pursue individual actions against us. The settlement would not preclude former borrowers in other states from bringing similar claims, or attempting to assert similar claims as a class action.

        Insurance Policies

        As of June 30, 2004, the Company carried a primary directors and officers liability insurance policy for $10 million, excess directors and officer’s liability insurance policies totaling $40 million and key man insurance policies in the amount of $9.6 million. In addition, the Company carried a banker’s professional/lender’s liability policy, a fiduciary liability policy and an employment practices liability policy for $10 million each; a financial institutions bond, a mortgage protection policy, and a commercial umbrella coverage for $15 million each; a commercial general liability policy and a property insurance policy for $1 million per occurrence; and a business auto policy and worker’s compensation policy for $1 million per occurrence. For the three months ended June 30, 2004 and 2003, insurance expense amounted to $0.8 million and $0.5 million, respectively. For the six months ended June 30, 2004 and 2003, insurance expense amounted to $1.9 million and $1.1 million, respectively.

(10)     Segments

        The operating segments reported below are the segments of the Company for which separate financial information is available and for which net revenues and net operating income amounts are evaluated regularly by management in deciding how to allocate resources and in assessing performance.

        The portfolio segment uses the Company’s equity capital and borrowed funds to invest in its mortgage loan portfolio, thereby producing net interest income. The servicing segment services loans, seeking to ensure that loans are repaid in accordance with their terms. The wholesale segment purchases and originates non-conforming residential mortgage loans through relationships with various mortgage companies and mortgage brokers. The correspondent segment purchases mortgage loans from correspondent lenders following a complete re-underwriting of each mortgage loan. The retail segment originates non-conforming mortgage loans directly to borrowers through its 25 branch offices.

        Segment net revenues and net operating income amounts include the following:

        Portfolio Segment

• net interest income after provision for mortgage loan losses,
• gain on sale of mortgage assets, and
• general and administrative expenses.

        Servicing Segment

• servicing income,
• general and administrative expenses, and
• other income and expense.

        Wholesale, Correspondent, and Retail Segments

• general and administrative expenses, and
• other income and expense.

        The wholesale, correspondent, and retail segments collect revenues, such as origination and underwriting fees and other certain nonrefundable fees, that are deferred and recognized over the life of the loan as an adjustment to interest income recorded in the portfolio segment. As such, these fees are not included below in the wholesale, correspondent, and retail segments.

        Management evaluates assets only for the servicing and portfolio segments. Assets not identifiable to an individual segment are corporate assets, which are comprised of cash and other assets.

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

        This discussion should be read in conjunction with the unaudited condensed consolidated financial statements, notes and tables included elsewhere in this report and in the Saxon Capital, Inc. Annual Report on Form 10-K, as amended for the year ended December 31, 2003, or the 2003 Form 10-K, filed with the Securities and Exchange Commission, or the SEC. Certain information contained in this Report constitutes forward-looking statements under Section 27 of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Generally, forward-looking statements can be identified by the use of forward-looking terminology including, but not limited to, “may,” “will,” “expect,” “intend,” “should,” “anticipate,” “estimate,” “is likely to,” “could,” “are confident that,” or “believe” or comparable terminology. All statements contained in this item as well as those discussed elsewhere in this Report addressing our operating performance, events, or developments that we expect or anticipate will occur in the future, including statements relating to net interest income growth, earnings or earnings per share growth, and market share, as well as statements expressing optimism or pessimism about future operating results, are forward-looking statements. The forward-looking statements are based upon management’s views and assumptions, as of the date of this Report, regarding future events and operating performance, and are applicable only as of the dates of such statements. By their nature, all forward-looking statements involve risk and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements for a number of reasons. Factors which might cause actual results to differ from our plans and expectations and which could have a material adverse affect on our operations and future prospects include, but are not limited to:

• changes in overall economic conditions or unanticipated changes in interest rates;
• our ability to successfully implement our growth strategy;
• greater than expected declines in consumer demand for residential mortgages, particularly non-conforming loans;
• our ability to sustain loan origination growth at levels sufficient to absorb costs of production and operational costs;
• continued availability of financing facilities and access to the securitization markets or other funding sources;
• deterioration in the credit quality of our loan portfolio;
• lack of access to the capital markets for additional funding;
• challenges in successfully expanding our servicing platform and technological capabilities;
• failure to complete the proposed Real Estate Investment Trust, or REIT, conversion or difficulty in satisfying complex rules in order for us to qualify as a real estate investment trust, or REIT, for federal income tax purposes;
• the ability of certain of our subsidiaries to qualify as taxable REIT subsidiaries for federal income tax purposes;
• our ability and the ability of our subsidiaries to operate effectively within the limitations imposed by the federal income tax laws and regulations applicable to REITs;
• changes in federal income tax laws and regulations applicable to REITs;
• future litigation developments; and
• increased competitive conditions or changes in the legal and regulatory environment in our industry.

        These risks and uncertainties should be considered in evaluating forward-looking statements and undue reliance should not be placed on such statements. We undertake no obligation to update publicly any of these statements in light of future events except as required in subsequent periodic reports we file with the SEC.

        The following sets forth the table of contents for Management’s Discussion and Analysis.

Executive Summary

Industry Overview

        According to the Mortgage Bankers Association of America’s, or MBAA, website as of April 14, 2004, lenders in the United States originated $3.8 trillion in single-family mortgage loans in 2003. Approximately 66% of the loan originations in 2003 were attributable to mortgage loan refinancings by customers taking advantage of the decline in interest rates during 2003. As of July 14, 2004, lenders in the United States are expected to originate approximately $2.5 trillion in single-family mortgage loans in 2004. We believe that the projected decline is largely attributable to a reduction in refinancing of conforming loans as interest rates rise. Generally, we believe sub-prime borrowers are not solely motivated by fluctuations in interest rates; thus, we do not expect the same level of decline in the non-conforming market, as discussed in “Mortgage Loan Portfolio by Borrower Purpose.”

Company Overview

        We are in the business of originating, securitizing, and servicing non-conforming mortgage loans, including sub-prime residential mortgage loans. We operate through five business segments. These segments are:

• Portfolio Management, or our portfolio segment;
• Mortgage Loan Servicing, or our servicing segment;
• Wholesale Loan Production, or our wholesale segment;
• Retail Loan Production, or our retail segment; and
• Correspondent Loan Production, or our correspondent segment.

        We originate or purchase mortgage loans for our portfolio segment through our wholesale, retail, and correspondent segments. We earn our revenues from the interest income from those mortgages through our portfolio segment and from servicing loans for other companies through our servicing segment. We pay interest to finance our mortgage loan portfolio and we incur general and administrative expenses to operate our business. We maintain a provision for mortgage loan losses that may occur from impaired mortgage loans that are in our portfolio. When we securitize our mortgage loans, we structure those transactions as financing transactions. As such, the mortgage loans and related debt to finance those loans remain on our balance sheet. We fund our mortgage loan originations through short-term warehouse lines of credit and through repurchase facilities. These short-term facilities are replaced by permanent financing when we securitize the loans.

        In general, the primary factors in our business that affect our revenues are changes in interest rates and changes in the size of our mortgage loan portfolio and servicing portfolio. Decreases in interest rates generally result in a decrease in the interest rates we charge on the mortgage loans we originate, but also result in growth in our mortgage loan portfolio. Decreases also lead to increases in loan prepayments, which result in increases in prepayment penalty income, but decrease servicing income. In addition, decreases in interest rates reduce our cost to borrow, but because loan originations tend to rise during periods of decreased interest rates, generally lead to increases in our borrowings.

        Conversely, increases in interest rates generally result in an increase in the interest rates we charge on the mortgage loans we originate. Increases in interest rates also lead to decreases in loan prepayments, reducing prepayment penalty income, but increasing servicing income. In addition, increases in interest rates increase our cost to borrow, but because loan originations tend to decline during periods of increased interest rates, generally lead to decreases in our borrowings.

        In general, the primary factors in our business that lead to increased expenses are the volume and credit mix of mortgage loans we originate or purchase, the number of retail branches we open and operate, the number of sales representatives we employ, and the cost of being a public company. As our loan production and loan portfolio increase we would generally expect to hire additional employees and we would also expect our variable expenses to increase. Also, we may incur additional marketing and advertising expenses in order to achieve our production goals. We would also expect to incur higher expenses in years where we open additional retail branches, which would result in increased office rent, equipment rent and insurance costs that would be incurred. There are also increased cash requirements that are associated with being a public company, such as investor relations responsibilities and expending the resources necessary to ensure that we have met the requirements set forth by Sarbanes-Oxley, the SEC and others by hiring outside consultants and additional employees when required. From time to time, we may also be required to upgrade existing computer systems and focus on other beneficial projects, and during those periods we will experience increased expenses.

        For the three months ended June 30, 2004 and 2003, we originated or purchased approximately $0.9 billion and $0.7 billion, respectively, and securitized approximately $0.5 billion and $0.6 billion of residential mortgage loans, respectively. For the six months ended June 30, 2004 and 2003, we originated, purchased or called approximately $1.7 billion and $1.5 billion, respectively, and securitized approximately $1.1 billion and $1.6 billion of residential mortgage loans, respectively. Called loans occur upon exercise of the clean-up call option by us, as servicer or master servicer, of the securitized pools of our predecessor for which Dominion Capital retained residual interests. A clean-up call option is an option to acquire all remaining mortgage loans, and any real estate owned, referred to as REO, in a securitized pool that arises at the time the aggregate unpaid scheduled principal balance of the loans declines to an amount that is less than 10% of the aggregate unpaid scheduled principal balance of the total pool at the time of securitization. In some cases the rights to exercise the call option, as well as the pool of called loans, may be owned by an unaffiliated third party.

        We intend to continue accessing the asset-backed securitization market to provide long-term financing for our mortgage loans. We finance the loans initially under one of several different secured and committed warehouse financing facilities on a recourse basis. These loans are subsequently financed using asset-backed securities issued through securitization trusts. From May 1996 to June 30, 2004, we securitized approximately $16.5 billion in mortgage loans. Since July 6, 2001, we have structured our securitizations as financing transactions for financial reporting purposes under accounting principles generally accepted in the United States of America, or GAAP. Accordingly, following a securitization, (1) the mortgage loans we originate or purchase remain on our condensed consolidated balance sheet; (2) the securitization indebtedness replaces the warehouse debt associated with the securitized mortgage loans; and (3) we record interest income on the mortgage loans and interest expense on the securities issued in the securitization over the life of the securitization, instead of recognizing a gain or loss upon completion of the securitization. This accounting treatment more closely matches the recognition of income with the receipt of cash payments on the individual loans.

Description of Other Data

        In this Management’s Discussion and Analysis of Financial Condition and Results of Operations, we present certain data that we consider helpful in understanding our financial condition and results of operations. Descriptions of these financial measures are set forth below.

        Net Cost to Produce. Our net cost to produce is calculated as our general and administrative costs and premium paid, net of fees collected at origination, divided by the number of loans originated.

        Net Cost per Loan. Our net cost per loan is calculated as our general and administrative costs and premium paid, net of fees collected at origination, divided by the number of loans originated.

        Net Interest Margin. Net interest margin is calculated as the difference between our interest income and interest expense divided by our average interest-earning assets. Average interest-earning assets are calculated using a daily average balance over the time period indicated.

        Reconciliation of trust losses and charge-offs. We present a reconciliation of securitization trust losses and charge-offs because management believes that it is meaningful to show both measures of losses since it is a widely accepted industry practice to evaluate losses on a trust level and the information is provided on a monthly basis to the investors in each securitization. However, these losses are recorded as charge-offs in our condensed consolidated financial statements. GAAP requires losses to be recognized immediately upon a loan being transferred to REO, whereas a trust does not recognize a loss on REO until the loan is sold. This causes a timing difference between charge-offs and trust losses. In addition, the trust losses exclude losses resulting from delinquent loan sales.

        Efficiency ratio. Our efficiency ratio is calculated as our total operating expenses (which is composed of payroll and related expenses, general and administrative expenses, and other expense) divided by our total net revenues, excluding provision for mortgage loan losses and gain on sale of mortgage assets.

        Operating expenses as a percentage of average assets. Operating expenses as a percentage of average assets is calculated based on our total operating expenses for the period indicated divided by our average assets for the same period. Average assets are calculated as a simple average over the time period indicated.

        Working capital. It is common business practice to define working capital as current assets less current liabilities. We do not have a classified balance sheet and therefore calculate our working capital using our own internally defined formula, which is generally calculated as unrestricted cash and investments as well as unencumbered mortgage loans and servicing advances that can be pledged against existing committed facilities and converted to cash in five days or less.

        Descriptions of certain components of our revenues and expenses are set forth in more detail in our 2003 Form 10-K.

Outlook

        REIT Conversion

        On January 26, 2004, we announced that our board of directors had authorized us to convert to a REIT, subject to shareholder approval and other conditions. If approved, we expect the proposed REIT conversion to be completed before the end of 2004.

        The proposed REIT conversion contemplates us becoming a subsidiary of Saxon REIT, Inc., by means of a merger. Saxon REIT will become a publicly traded company and elect REIT status. We plan to present the merger agreement to our shareholders for approval at our annual meeting, which will be held on September 13, 2004. Shareholders and investors are urged to read the definitive proxy statement/prospectus because it contains important information, including detailed risk factors, about Saxon and the proposed transaction. A copy of the definitive proxy statement/prospectus filed by Saxon REIT relating to this transaction and other relevant documents are available free of charge at the SEC’s website (www.sec.gov) or can be obtained by contacting us at the address listed above.

        After the REIT conversion, our strategy will be to accumulate in our REIT or in other qualified REIT subsidiaries a portfolio of non-conforming mortgage loans that we originate in our qualified REIT subsidiary or taxable REIT subsidiaries to produce stable net interest income and dividends to our shareholders. We also intend to sell loans in our taxable REIT subsidiaries and to generate origination fees and servicing income in those subsidiaries, enabling us to increase our capital by retaining the after tax income in those subsidiaries, subject to the limitations imposed by REIT tax rules.

        After the REIT conversion, our principal elements of revenues are expected to be interest income generated from our portfolio of non-conforming mortgage loans at our REIT or our qualified REIT subsidiaries. Additional components of revenues are expected to be gains on sale from the sale of loans, servicing income, and loan origination fees, all initially expected to be generated at our taxable REIT subsidiaries. Our primary components of expenses are expected to be interest expense on our warehouse lines and repurchase facilities and securitizations and general and administrative expenses and payroll and related expenses arising from our origination and servicing businesses. With the exception of the impact of taxes and dividends following the proposed REIT conversion, we expect that our historical results of operations will be comparable to our results of operations following the proposed REIT conversion.

        There can be no assurance that the proposed REIT conversion will be consummated, and if it is not consummated, we will continue to operate our business as we have been doing so in the past and we will record as a charge to income the expenses we have incurred pursuing the REIT conversion strategy.

        We expect to experience increased costs primarily related to additional staffing to ensure compliance with REIT qualification rules in connection with the REIT conversion in 2004. However, we expect the benefits of the conversion will compensate for such increased costs.

        In addition, as part of the proposed REIT conversion, Saxon REIT intends to raise additional capital, which we currently expect to be a minimum of $380 million, in a public offering. The net proceeds from this offering are expected to be used to retire a $25 million 8% promissory note of Saxon, to pay the cash component of the merger consideration, to purchase assets from Saxon, to repay a portion of the outstanding balances under our warehouse facilities, and for working capital purposes. Earnings of our taxable REIT subsidiaries will be taxed and retained in the subsidiaries as retained earnings. To the extent that our taxable REIT subsidiaries do not dividend these retained earnings to us, these earnings will not be distributed as dividends to our shareholders. We anticipate that we will be able to grow shareholder equity through the retained earnings of our taxable REIT subsidiaries.

        Revenue Growth and Increased Expenses

        In 2004, we expect market interest rates to rise. In addition, because of our intent to focus to some extent on higher interest rates, lower credit grade products, the credit characteristics of our mortgage loan production may be lower than we experienced in 2003. As a result, we expect to earn higher interest rates on the loans we originate in 2004 than the interest rates earned on loans we originated in 2003; however, we may also experience more delinquencies and defaults, the risk of which is typically greater with lower credit quality loans.

        In addition, we intend to continue to grow our mortgage loan portfolio and servicing portfolio, which will produce higher levels of net interest income, increase our provision for mortgage loan losses, and produce higher levels of servicing income. With our expected increase in our mortgage loan portfolio and servicing portfolio in 2004, we expect to incur higher levels of payroll and related expenses and general and administrative expenses compared to 2003.

Critical Accounting Estimates

        Management’s Discussion and Analysis of Financial Condition and Results of Operations discusses our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of these consolidated financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. On an on-going basis, management evaluates its estimates and judgments. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates and the estimates will change under different assumptions or conditions.

        Critical accounting estimates are defined as those that reflect significant judgments and uncertainties and potentially result in materially different outcomes under different assumptions and conditions. Our critical accounting estimates are discussed below and consist of:

• accounting for net interest income;
• allowance for loan loss;
• mortgage servicing rights valuation;
• accounting for hedging activities;
• deferral of direct loan origination fees and costs; and
• accounting for income taxes.

        With the exception of accounting for income taxes, we do not expect to change our critical accounting estimates as a result of the proposed REIT conversion.

Accounting for Net Interest Income

        Net interest income is calculated as the difference between our interest income and interest expense. Interest income on our mortgage loan portfolio is a combination of accruing interest based on the outstanding balance and contractual terms of the mortgage loans and the amortization of yield adjustments using the interest method, principally the amortization of premiums, discounts, and other net capitalized fees or costs associated with originating our mortgage loans. These yield adjustments are amortized against interest income over the lives of the assets using the interest method adjusted for the effects of estimated prepayments. Management does not currently use the payment terms required by each loan contract in the calculation of amortization. Because we hold a large number of similar loans for which prepayments are probable, we currently use a prepayment model to project loan prepayment activity based upon loan age, loan type and remaining prepayment penalty coverage. Estimating prepayments and estimating the remaining lives of our mortgage loan portfolio requires management judgment, which involves consideration of possible future interest rate environments and an estimate of how borrowers will behave in those environments. Reasonableness tests are performed against past history, mortgage asset pool specific events, current economic outlook and loan age to verify the overall prepayment projection. If these mortgage loans prepay faster than originally projected, GAAP requires us to write down the remaining capitalized yield adjustments at a faster speed than was originally projected, which would decrease our current net interest income.

        Interest expense on our warehouse and securitization financings is a combination of accruing interest based on the contractual terms of the financing arrangements and the amortization of premiums, discounts, bond issuance costs, and accumulated other comprehensive income relating to cash flow hedging using the interest method.

        Mortgage prepayments generally increase on our adjustable rate mortgages when fixed mortgage interest rates fall below the then-current interest rates on outstanding adjustable rate mortgage loans. Prepayments on mortgage loans are also affected by the terms and credit grades of the loans, conditions in the housing and financial markets and general economic conditions. We have sought to minimize the effects caused by faster than anticipated prepayment rates by lowering premiums paid to acquire mortgage loans and by purchasing and originating mortgage loans with prepayment penalties. Those penalties typically expire two to three years from origination. We anticipate that prepayment rates on a significant portion of our adjustable rate mortgage portfolio will increase as these predominately adjustable rate loans reach their initial adjustments during 2004 and 2005 due to the high concentration of two to three year hybrid loans we originated or purchased during 2002 and 2003. The constant prepayment rate, or CPR, currently used to project cash flows is 37 twelve month annual CPR. Actual prepayment penalty income is recorded as cash is collected and is not recorded based on CPR assumptions. Therefore, in instances where our CPR increases, we anticipate also having an increase in prepayment penalty income.

Allowance for Loan Loss

        The allowance for loan loss is established through the provision for mortgage loan losses, which is charged to earnings on a monthly basis. The accounting estimate of the allowance for loan loss is considered critical as significant changes in the mortgage loan portfolio, which includes both securitized and unsecuritized mortgage loans, and/or economic conditions may affect the allowance for loan loss and our results of operations. The assumptions used by management regarding these key estimates are highly uncertain and involve a great deal of judgment.

        Provisions are made to the allowance for loan loss for currently impaired loans in the outstanding mortgage loan portfolio. We define a mortgage loan as impaired at the time the loan becomes 30 days delinquent under its payment terms. Charge-offs to the allowance are recorded at the time of liquidation or at the time the loan is transferred to REO. The allowance for loan loss is regularly evaluated by management for propriety by taking into consideration factors such as changes in the nature and volume of the loan portfolio; trends in actual and forecasted portfolio performance and credit quality, including delinquency, charge-off and bankruptcy rates; and current economic conditions that may affect a borrower’s ability to pay. An internally developed roll rate analysis, static pool analysis and historical losses are the primary tools used in analyzing our allowance for loan loss. Our roll rate analysis is defined as the historical progressing of our loans through the various delinquency statuses. Our static pool analysis provides data on individual pools of loans based on year of origination. These tools take into consideration historical information regarding delinquency and loss severity experience and apply that information to the portfolio. Loss severity is defined as the total loss amount divided by the actual unpaid principal balance at the time of liquidation. Total loss amounts include all accrued interest and interest advances, fees, principal balances, all basis adjustments, all costs of liquidating and all other servicing advances for taxes, property insurance, and other servicing costs incurred and invoiced to us within 90 days following the liquidation date. If actual results differ from our estimates, we may be required to adjust our provision accordingly. Likewise, the use of different estimates or assumptions could produce different provisions for loan losses.

Mortgage Servicing Rights Valuation

        The valuation of mortgage servicing rights, or MSRs, requires that we make estimates of numerous market assumptions. Interest rates, prepayment speeds, servicing costs, discount rates, and the payment performance of the underlying loans significantly affect our ongoing valuations and the rate of amortization of MSRs. In general, during periods of declining interest rates, the value of MSRs decline due to increasing prepayments attributable to increased mortgage refinancing activity.

        The carrying values of the MSRs are amortized in proportion to, and over the period of, the anticipated net servicing income. MSRs are assessed periodically to determine if there has been any impairment to the carrying value, based on the fair value at the date of the assessment and by stratifying the MSRs based on underlying loan characteristics, including the date of the related securitization. We obtained an independent third-party valuation to determine the fair value of our MSRs at June 30, 2004 and December 31, 2003. We regularly obtain valuations for our MSRs.

        Due to subsequent changes in economic and other relevant conditions, the actual rates of prepayments and defaults and the value of collateral generally differ from our initial estimates, and these differences are sometimes material. If actual prepayment and default rates were higher than those assumed, we would earn less mortgage servicing income, which would adversely affect the value of the MSRs. As demonstrated above, significant changes in prepayment speeds, delinquencies, and losses may result in impairment of most of our MSRs, and would be recorded in our consolidated statements of operations.

Accounting for Hedging Activities

        We incorporate the use of derivative instruments to manage certain risks. We have qualified for hedge accounting treatment for all of our derivative instruments, which are accounted for as cash flow hedges. This is because on the date a derivative instrument agreement is entered into, we designate it as a hedge of a forecasted transaction or of the variability of cash flows to be paid related to a recognized liability. In accordance with GAAP, the effective portions of the changes in fair value of our derivative instruments are reflected in accumulated other comprehensive income and is amortized or accreted into earnings through interest expense as the hedged transaction affects interest expense. To qualify for hedge accounting, we must demonstrate initially, and on an ongoing basis, that our derivative instruments are expected to be and are, respectively, highly effective at offsetting the designated risk. The determination of effectiveness is the primary assumption and estimate used in accounting for our hedge transactions. In instances where we use swaps as a hedge, the swap rate is fixed and compared monthly to the one-month London Inter-Bank Offered Rate, or LIBOR, index. The payment of interest on our bonds issued in a securitization transaction is also based on LIBOR. Therefore, we consider the swaps to be an effective hedge against interest rate risk. Likewise, when we use options as a hedge, such as caps and floors, they also are considered to be effective hedges because these options are based on the LIBOR index. In the case where we may use Eurodollar futures, correlation analysis is necessary since a slight amount of basis risk can occur. The correlation calculation for Eurodollars is calculated by capturing historic swap rates and the corresponding Eurodollar prices, and then calculating a financing rate, for the maturity deemed necessary. The impact of market changes on the hedged item and the derivative are recorded over the relevant hedging periods and correlation statistics are evaluated. The difference between a 100% correlation result and our actual correlation percentage is used to calculate any ineffective portion related the Eurodollar futures; which is recorded as an expense in the income statement.

Deferral of Direct Loan Origination Fees and Costs

        We collect certain nonrefundable fees associated with our loan origination activities. In addition, we incur certain direct loan origination costs in connection with these activities. The net of such amounts is recognized over the life of the related loans as an adjustment of yield, as discussed above in the section relating to our critical accounting estimate with respect to accounting for net interest income.

        The amount of deferred nonrefundable fees is determined based on the amount of such fees collected at the time of loan closing. We determine the amount of direct loan origination costs to be deferred based on an estimate of the standard cost per loan originated. The standard cost per loan is based on the amount of time spent and costs incurred by loan origination personnel in the performance of certain activities directly related to the origination of funded mortgage loans. These activities include evaluating the prospective borrower’s financial condition, evaluating and recording collateral and security arrangements, negotiating loan terms, processing loan documents and closing the loan. Management believes these estimates reflect an accurate cost structure related to successful loan origination efforts for the six months ended June 30, 2004. Management periodically reviews its time and cost estimates to determine if updates and refinements to the deferral amounts are necessary. Updates would be considered necessary if it was determined that the time spent and/or costs incurred related to performing the above activities had significantly changed from the previous period. This estimate is made for all loans originated by our wholesale and retail segments. Correspondent originations are not included, as we purchase these loans as closed loans and therefore, loan origination costs related to these purchases are recorded as incurred.

Accounting for Income Taxes

        Significant management judgment is required in developing our provision for income taxes, including the determination of deferred tax assets and liabilities and any valuation allowances that might be required against the deferred tax asset. As of June 30, 2004, we had not recorded a valuation allowance on our deferred tax assets based on management’s belief that operating income will, more likely than not, be sufficient to realize the benefit of these assets over time. The evaluation of the need for a valuation allowance takes into consideration our recent earnings history, current tax position, and estimates of taxable income in the near term. The tax character (ordinary versus capital) and the carryforward periods of certain tax attributes such as capital losses and tax credits must also be considered. Significant judgment is required in considering the relative impact of negative and positive evidence related to the ability to realize deferred tax assets. In the event that actual results differ from these estimates or if our current trend of positive operating income changes, we may be required to record a valuation allowance on our deferred tax assets, which could have a material adverse effect on our consolidated financial condition and results of operations. We recognize all of our deferred tax assets if we believe that it is more likely than not, given all available evidence, that all of the benefits of the carryforward losses and other deferred tax assets will be realized. Management believes that, based on the available evidence, it is more likely than not that we will realize the benefit from our deferred tax assets.

        Subject to shareholder approval of the merger agreement which is required in connection with our proposed REIT conversion, we expect to elect to be taxed as a REIT beginning at the conversion date and intend to comply with the REIT provisions of the Internal Revenue Code of 1986, as amended, which we refer to as the Code. Accordingly, we will not be subject to federal or state income tax on net income that is distributed to shareholders to the extent that our annual distributions to shareholders are equal to at least 90% of our REIT taxable income (determined without regard to the deduction for dividends paid and by excluding any net capital gain) for a given year and as long as certain asset, income and stockownership tests are met. In the event that we do not qualify as a REIT in any year, we will be subject to federal income tax as a domestic corporation and the amount of our after-tax cash available for distribution to our shareholders will be reduced. However, our taxable REIT subsidiaries will be subject to federal income tax and we intend to continue to employ the accounting policy described above with respect to our taxable REIT subsidiaries.

        For further information on our critical accounting estimates, refer to our 2003 Form 10-K for the year ended December 31, 2003.

Consolidated Results

Three and Six Months Ended June 30, 2004 versus Three and Six Months Ended June 30, 2003

    Overview.        Net income increased $2.0 million, or 13%, to $17.4 million for the three months ended June 30, 2004, from $15.4 million for the three months ended June 30, 2003. Net income increased $8.8 million, or 31%, to $37.1 million for the six months ended June 30, 2004, from $28.3 million for the six months ended June 30, 2003. The increase was primarily the result of increased net interest income after provision for mortgage loan losses, due to growth in and increased credit quality of our mortgage loan portfolio. This increase was partially offset by a decrease in servicing income, net of amortization and impairment, and an increase in total operating expenses during the three and six months ended June 30, 2004. Due to the higher rated credit quality mix, we continue to see lower weighted average coupons on our mortgage loan portfolio and we continue to experience lower delinquencies in the 2002 and 2003 portfolio compared to the 2001 portfolio. In addition, lower interest rates caused higher refinance activity, which generated higher prepayment penalty income during the first six months of 2004 compared to the first six months of 2003. To the extent interest rates continue to rise in the second half of 2004, we would expect an increase in the interest rates we charge on the mortgage loans we originate, decreases in our loan prepayments, and increases in our servicing income. In addition, because of our intent to focus to some extent on higher interest rates, lower credit grade products, the credit characteristics of our mortgage loan production may be lower than we experienced in 2003. As a result, we expect to charge higher interest rates on the loans we originate in 2004 than the interest rates earned on loans we originated in 2003; however, we may also experience more delinquencies and defaults, the risk of which is typically greater with lower credit quality loans

        Total Net Revenues. Total net revenues increased $8.9 million, or 17%, to $60.1 million for the three months ended June 30, 2004, from $51.2 million for the three months ended June 30, 2003. Total net revenues increased $22.8 million, or 23%, to $121.5 million for the six months ended June 30, 2004, from $98.7 million for the six months ended June 30, 2003. Our increase in total net revenues was due to an increase in total net interest income after provision for mortgage loan losses resulting from the continued growth of our owned portfolio and increase in prepayment penalty income, partially offset by a decrease in servicing income, net of amortization and impairment, resulting from an increase in temporary impairment of our MSRs recorded during the first six months of 2004.

        Payroll and Related Expenses. Payroll and related expenses increased $4.2 million, or 31%, to $17.6 million for the three months ended June 30, 2004, from $13.4 million for the three months ended June 30, 2003. Payroll and related expenses increased $5.5 million, or 20%, to $33.2 million for the six months ended June 30, 2004, from $27.7 million for the six months ended June 30, 2003. Specifically:

        Salary and bonus expenses primarily increased because of the increase in employees from the second quarter of 2003 to the second quarter of 2004. The increase in salary expense was also attributed to normal merit increases granted year over year. Deferred payroll and related expenses, as they related to direct loan origination costs, increased $2.5 million, or 36%, to $9.4 million for the three months ended June 30, 2004, from $6.9 million for the three months ended June 30, 2003, mainly due to an increase in production during the second quarter of 2004. Deferred payroll and related expenses, as they related to direct loan origination costs, increased $3.6 million, or 28%, to $16.5 million for the six months ended June 30, 2004, from $12.9 million for the six months ended June 30, 2003, mainly due to an increase in production during the three and six months ended June 30, 2004.

        We expect payroll and related expenses to continue to increase as we continue to grow our staffing to support further loan production growth, third party servicing acquisitions, and to ensure compliance with REIT qualification rules. We employed 1,173 predominantly full time employees as of June 30, 2004, compared to 1,154 as of June 30, 2003.

        General and Administrative Expenses. General and administrative expenses increased $2.0 million, or 18%, to $13.4 million for the three months ended June 30, 2004, from $11.4 million for the three months ended June 30, 2003. General and administrative expenses increased $3.6 million, or 16%, to $26.1 million for the six months ended June 30, 2004, from $22.5 million for the six months ended June 30, 2003. The following factors contributed to the increase in general and administrative expenses:

        Selected Ratios. As we continue to build our marketplace and our relationships as well as continue to grow our mortgage loan portfolio, we anticipate improvements in our efficiency ratio. The increase in our efficiency ratio for the three and six months ended June 30, 2004 compared to the three and six months ended June 30, 2003 was primarily a result of severance and executive compensation expense recorded during the second quarter of 2004. Our efficiency ratio and our operating expenses as a percentage of average assets were the following for the three and six months ended June 30, 2004 compared to the three and six months ended June 30, 2003:

Selected Ratios For the Three and Six Months Ended June 30, 2004 and 2003

        Effective Tax Rate. We experienced a 33.8% effective tax rate for the three months ended June 30, 2004, compared to a 38.5% effective tax rate for the three months ended June 30, 2003. We experienced a 34.5% effective tax rate for the six months ended June 30, 2004, compared to a 38.4% effective tax rate for the six months ended June 30, 2003. On January 1, 2003, we elected REIT status for one of our subsidiaries, which was deemed to be a captive REIT, that resulted in a lower effective tax rate for 2004 compared to 2003. We expect a significant decrease in our future tax expense if we consummate our proposed REIT conversion and we continue to satisfy the requirements for taxation as a REIT going forward.

Business Segment Results