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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED March 31, 2004

OR

FOR THE TRANSITION PERIOD FROM              TO             

Commission file number 000-27437

PARAGON FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

5000 Sawgrass Village Circle Ponte Vedra Beach, FL

(Address of principal executive offices and zip code)

(904) 285-0000

(Registrant’s telephone number, including area code)

(Former name, former address and former fiscal year, if changed since last report)

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

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

The total number of shares of the registrant’s common stock outstanding as of March 31, 2004: 116,396,478.

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INDEX

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PART I – FINANCIAL INFORMATION

Item 1. Financial Statements.

PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

AS OF MARCH 31, 2004 AND DECEMBER 31, 2003

(Dollars in thousands, except share data)

See accompanying notes to consolidated financial statements.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE MONTHS ENDED MARCH 31, 2004 AND 2003

(Dollars in thousands, except share data)

See accompanying notes to consolidated financial statements.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE THREE MONTHS ENDED MARCH 31, 2004 AND 2003

(Dollars in thousands)

See accompanying notes to consolidated financial statements.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 1. PRINCIPLES OF CONSOLIDATION, BASIS OF PRESENTATION, AND SIGNIFICANT ACCOUNTING POLICIES

PRINCIPLES OF CONSOLIDATION – The accompanying condensed consolidated financial statements include the financial statements of our wholly-owned subsidiaries, PGNF Home Lending Corp. (formerly known as Mortgage Express, Inc. and referred to as “PGNF” in this Form 10-Q) and Paragon Homefunding, Inc. (referred to as “PHF” in this Form 10-Q). All material intercompany balances and transactions are eliminated in consolidation. The consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States of America.

BASIS OF PRESENTATION – The accompanying condensed consolidated financial statements of Paragon Financial Corporation and subsidiaries (sometimes referred to herein as “we”, “our” or the “Company”) are prepared in accordance with the Securities and Exchange Commission’s rules regarding interim financial statements, and therefore do not contain all disclosures required by accounting principles generally accepted in the United States of America for annual financial statements. Reference is made to the financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2003. Certain previously reported amounts have been reclassified to conform to the current period’s presentation. Such reclassifications had no effect on net loss or stockholders’ equity.

THE COMPANY – Paragon Financial Corporation (the “Company”) was incorporated in Delaware on August 27, 1999 under the name PRx Holdings, Inc. and operated as an online healthcare destination for commerce, content, and community. The Company closed its online health store in March 2001. Shortly thereafter, the Company began the process of liquidating its online health store and seeking a merger partner as an alternative to complete liquidation.

Paragon Homefunding, Inc. (“Paragon Delaware”), a privately-held, development-stage company based in Ponte Vedra Beach, Florida, was incorporated in Delaware on August 3, 2001, for the purpose of entering the financial services market through acquisitions. On May 31, 2002, the Company merged with Paragon Delaware.

Pursuant to the merger, the Company merged with and into Paragon Delaware, and issued 55,560,616 shares of common stock to the Paragon Delaware’s stockholders constituting 90% of the total shares of the Company’s common stock outstanding immediately after the merger. As a result of the merger, Paragon Delaware also assumed approximately $72 of the Company’s accrued liabilities, principally for legal services.

For financial reporting purposes, the merger has been accounted for as a recapitalization of Paragon Delaware with Paragon Delaware viewed as the accounting acquiror in what is commonly called a reverse acquisition. Accordingly, the financial statements presented before the merger are those of Paragon Delaware.

ACQUISITIONS - On January 31, 2003, the Company completed its merger with PGNF Home Lending Corp. (“PGNF”) (f/k/a Mortgage Express, Inc.), and as a result of the merger, PGNF became a wholly-owned subsidiary. PGNF has been in the business of originating residential mortgage loans since 1998. Subject to the terms of the merger agreement, at closing, all of the outstanding shares of PGNF’s common stock converted into 52,329,735 shares of the Company’s common stock valued at $6.4 million (or approximately $0.122 per share), or approximately 45.5% of the then outstanding common stock after the consummation of the merger. Additionally, the Company issued a promissory note in the amount of $1.8 million to an entity wholly-owned by the sole shareholder of PGNF. The promissory note accrued interest at 4.92% and was payable on July 31, 2004. On March 26, 2003, the holder of this note agreed to convert the note and accrued interest into 1,800 shares of our Series E preferred stock with a face value of $1,000 per share, and a 4% stated dividend payable in cash or shares of common stock, at the Company’s option. This series of preferred stock does not provide for redemption and is non-voting.

On February 2, 2003 the Company completed its merger with Paragon Homefunding, Inc. (“PHF”). PHF has been in the business of originating residential mortgage loans since 1998. Subject to the terms of the merger agreement, at closing, all of the outstanding shares of PHF’s common stock converted into 1,224,000 of shares of the Company’s common stock valued at

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 1. PRINCIPLES OF CONSOLIDATION, BASIS OF PRESENTATION, AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

$836 (approximately $0.6833 per share). Additionally, the Company issued promissory notes to the shareholders of PHF in the aggregate principal amount of $25. The promissory notes accrue interest at 4.92% and were payable on February 2, 2004. The former shareholders of PHF have agreed to extend the due date to June 30, 2004.

Both of these mergers were accounted for as acquisitions pursuant to SFAS No. 141, Accounting for Business Combinations (“SFAS 141”). Accordingly, the Company’s results of operations include the operating results of these companies from the effective date of these mergers, February 1, 2003.

FINANCIAL STATEMENT PRESENTATION - The consolidated financial statements and notes are representations of the Company’s management. The Company’s management is responsible for the integrity and objectivity of these financial statements. The Company prepares its financial statements using an unclassified balance sheet presentation as is customary in the mortgage banking industry.

USE OF ESTIMATES - In preparing financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that materially affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements, and revenues and expenses during the reporting period. Material estimates that are particularly susceptible to significant change in the near term relate to the determination of the allowance for loan repurchases and premium recapture. Actual results could differ from those estimates.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 1. PRINCIPLES OF CONSOLIDATION, BASIS OF PRESENTATION, AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

The determination of the adequacy of the allowance for loan repurchases and premium recapture losses is based on estimates that may be affected by significant changes in the economic environment and market conditions. The Company has obtained insurance to mitigate some of this risk.

CASH AND CASH EQUIVALENTS - For purposes of the statements of cash flows, the Company considers all highly liquid investments purchased with original maturities of three months or less on their acquisition date to be cash equivalents. Cash and cash equivalents include cash on hand and funds held in checking, money market, and savings accounts.

FEES RECEIVABLE - Fees receivable consist of fees due on loans closed prior to the balance sheet date. Fees receivable are typically collected within 30 to 60 days.

MORTGAGE LOANS RECEIVABLE HELD-FOR-SALE - - Mortgage loans receivable held-for-sale consist of loans made to individuals that are primarily collateralized by residential one to four unit family dwellings. Mortgage loans are recorded at the principal amount outstanding net of deferred origination costs and fees and any premium or discounts. These loans are carried at the lower of amortized cost or fair value as determined by outstanding commitments from investors or current investor-yield requirements, calculated on an aggregate basis. Interest on loans receivable held-for-sale is credited to income as earned. Interest is accrued only if deemed collectible.

ALLOWANCE FOR LOAN REPURCHASES AND PREMIUM RECAPTURE - The allowance for loan repurchases and premium recapture relates to expenses incurred due to the potential repurchase of loans or indemnification of losses based on alleged violations of representations and warranties which are customary to the mortgage banking industry. Provisions for losses are charged to gain on sale of loans and credited to the allowance. The allowance represents the Company’s estimate of the total losses expected to occur and is considered to be adequate by management based upon the Company’s evaluation of the potential exposure related to the loan sale agreements over the life of the associated loans sold. The Company has purchased insurance to cover third party broker fraud, which mitigates some of the risks.

OFFICE PROPERTY AND EQUIPMENT, NET - Office property and equipment, net, are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of the asset.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 1. PRINCIPLES OF CONSOLIDATION, BASIS OF PRESENTATION, AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

AVAILABLE-FOR-SALE SECURITIES AND COMPREHENSIVE LOSS - Securities available-for-sale are carried at fair value with unrealized gains and losses reported in other comprehensive income. Realized gains (losses) on securities available-for-sale are included in other income and, when applicable, are reported as a reclassification adjustment, net of tax, in other comprehensive income. Gains and losses on sales of securities are determined on the specific-identification method.

The Company does not purchase, sell, or utilize off-balance sheet derivative financial instruments or derivative commodity instruments.

GOODWILL - Goodwill represents the excess of the purchase price over the fair value of the net assets acquired in a purchase business combination. Goodwill and other intangible assets are stated on the basis of cost. See also “Impairment” which follows.

IMPAIRMENT - Long-lived assets, including certain identifiable intangibles and goodwill, are reviewed for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of the asset in question may not be recoverable including, but not limited to, a deterioration of profits for a business segment that has long-lived assets, and when other changes occur which might impair recovery of long-lived assets.

Recently, the residential mortgage market began experiencing increasing interest rates. During this increase in mortgage rates, large competitors in the subprime wholesale business have held the coupon rate constant on home mortgages they offer. The Company has determined that it must maintain the interest rate charged on its loans at similar levels. This has eroded the margin the Company receives upon the subsequent sale of loans thereby significantly eroding the profitability of the Company’s PGNF subsidiary. These large competitors have distribution channels other than loan sales that are not currently available to the Company. Further, these competitors have significant amounts of capital to offset any lost profitability on loan sales. Given the amount of capital these large competitors have, management has viewed this reduction in profitability as other than temporary.

Based upon this, management has reviewed the Company’s long-lived assets and has taken an impairment charge of $2,582 in the three months ended March 31, 2004, to reduce the carrying value of PGNF to estimated realizable value. The method used to determine the existence of an impairment would be generally measured by discounting operating cash flows over the remaining useful lives of the related long-lived assets. Impairment is measured as the difference between fair value and unamortized cost at the date impairment is determined.

GAIN ON SALES OF LOANS - Gains or losses resulting from sales of mortgage loans are recognized at the date of settlement and are based on the difference between the selling price of the mortgage loans sold and the carrying value of the related loans sold. Nonrefundable fees and direct costs associated with the origination of mortgage loans are deferred and recognized when the loans are sold. Loan sales are accounted for as sales when control of the loans is surrendered, to the extent that consideration other than beneficial interests in the loans transferred is received in the exchange.

ORIGINATION FEES - Origination fees are comprised of points and other fees charged on mortgage loans originated by the retail segment of the Company. Points and fees are primarily a function of the volume of mortgage loans originated by our retail segment. Origination fees on loans originated by the Company that are subsequently sold are deferred and recognized as part of the gain on sale of loans.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 1. PRINCIPLES OF CONSOLIDATION, BASIS OF PRESENTATION, AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

INCOME TAXES - The Company accounts for income taxes pursuant to Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” Under the asset and liability method specified thereunder, deferred taxes are determined based on the difference between the financial reporting and tax bases of assets and liabilities. Deferred tax liabilities are offset by deferred tax assets relating to net operating loss carryforwards and deductible temporary differences.

ADVERTISING - The Company’s advertising costs are expensed as incurred.

RECLASSIFICATIONS - Certain reclassifications have been made to the 2003 financial statements in order to conform to the presentation adopted for 2004. These reclassifications had no effect on net income or retained earnings.

FAIR VALUE OF FINANCIAL INSTRUMENTS - Financial instruments of the Company consist of cash and cash equivalents, receivables for fees, mortgage loans, notes receivable, securities, accounts payable, notes payable, convertible debentures payable, warehouse lines of credit, and derivatives. The carrying amount of financial instruments approximates fair value.

CONCENTRATIONS OF RISKS - The Company is required by Statement of Financial Accounting Standards No. 105 to disclose concentrations of credit risk regardless of the degree of such risk. The Company’s operations are concentrated in single-family first mortgage residential real estate market. The Company operates in a heavily regulated environment. The operations of the Company are subject to changes in laws, administrative directives and rules and regulations of federal, state, and local governments and regulatory agencies. Such changes may occur with little notice of time for compliance. Further, the Company performs credit evaluations of its customers’ financial condition, performs its operations under contracts and requires deposits when deemed necessary. Historically, the Company has not incurred any significant credit losses.

The Company’s ability to continue to originate loans is dependent, in part, upon the ability to sell loans in the secondary market in order to generate cash proceeds for new originations. The value of and market for our loans is dependent upon a number of factors, including general economic conditions, interest rates, and governmental regulations. Adverse changes in such factors may affect the Company’s ability to sell loans for acceptable prices within reasonable periods of time.

The Company maintains its cash in bank deposit accounts at high credit-quality financial institutions. At times during the period ended March 31, 2004, the Company’s cash balances exceeded the federally-insured limit. Management believes this policy will not adversely affect the Company.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 1. PRINCIPLES OF CONSOLIDATION, BASIS OF PRESENTATION, AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

STOCK-BASED COMPENSATION – The Company has elected to follow Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), and related interpretations, in accounting for employee stock options rather than the alternative fair value accounting allowed by FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). APB 25 provides that compensation expense relative to the Company’s employee stock options is recorded on the date of grant only if the current market price of the underlying stock exceeds the exercise price. Under SFAS 123, the fair value of stock options at the date of grant is recognized in earnings over the vesting period of the options. In December 2002, FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure” (“SFAS 148”), which amends SFAS 123 to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation. In addition, SFAS 148 amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method on reported results. The Company will continue to report stock based compensation under APB 25 but has adopted the interim reporting requirements of SFAS 148.

As of March 31, 2004, there were stock options outstanding for the purchase of 44,573,750 shares of the Company’s common stock. There were 3,835,000 stock options granted and none forfeited during the quarter ended March 31, 2004. The following table shows the pro forma net loss as if the fair value method of SFAS No. 123 had been used to account for stock-based compensation expense for the three months ended March 31, 2004 and 2003 (dollars in thousands, except per share amounts):

RECENT ACCOUNTING PRONOUNCEMENT – In December 2003, the FASB revised FASB Interpretation No. 46 (originally issued in January 2003), “Consolidation of Variable Interest Entities” (“FIN 46R”), which addresses how a business enterprise should evaluate whether it has a controlling financial interest in an entity through means other than voting rights and accordingly should consolidate the entity. This Interpretation became effective January 1, 2004, for special-purpose entities. The Company currently has no entities considered to be special-purpose entities. The Company will be required to apply FIN 46R to all other entities subject to this Interpretation no later than the end of the first reporting period that ends after December 15, 2004.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 1. PRINCIPLES OF CONSOLIDATION, BASIS OF PRESENTATION, AND SIGNIFICANT ACCOUNTING POLICIES (Continued)

For any variable interest entities (VIEs) that must be consolidated under FIN 46R that were created before January 1, 2004, the assets, liabilities and noncontrolling interests of the VIE initially would be measured at their carrying amounts with any difference between the net amount added to the balance sheet and any previously recognized interest being recognized as the cumulative effect of an accounting change. If determining the carrying amounts is not practicable, fair value at the date FIN 46R first applies may be used to measure the assets, liabilities and noncontrolling interest of the VIE. The application of this Interpretation is not expected to have a material effect on the Company’s financial statements.

In December 2003, the Accounting Standards Executive Committee issued Statement of Position 03-3, “Accounting for Certain Loans or Debt Securities Acquired in a Transfer” (“SOP 03-3”). SOP 03-3 addresses accounting for differences between contractual cash flows and cash flows expected to be collected from an investor’s initial investment in loans or debt securities (loans) acquired in a transfer if those differences are attributable, at least in part, to credit quality. SOP 03-3 includes loans acquired in purchase business combinations, but does not apply to loans originated by the entity. SOP 03-3 is effective for loans acquired in fiscal years beginning after December 15, 2004, although earlier adoption is encouraged. The adoption of this new statement of position is not expected to have a material impact on the consolidated financial position or results of operations of the Company.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 2. GOING CONCERN

As shown in the accompanying unaudited consolidated financial statements, the Company incurred net losses of $3,352 in the three months ended March 31, 2004, and cumulative losses of $7,315. At March 31, 2004, stockholders’ equity was $4,454 due primarily to the issuance of equity securities as a result of the acquisitions of PGNF and PHF, which resulted in recognition of $6,054, net of impairment of $2,582, in goodwill. These factors raise substantial doubt about the Company’s ability to continue as a going concern. The accompanying financial statements do not include any adjustments that might result from the outcome of this uncertainty. The Company’s continued existence depends on a number of factors, including but not limited to, the ability to fund loans, to sell the funded loans, to secure adequate sources of capital and to locate and fund acquisitions of suitable companies. However, there can be no assurance that the Company will be able to continue as a going concern.

As explained in Note 8 – Warehouse Lines of Credit, the Company was in violation of certain covenants under its warehouse credit facilities and its agreements with investors that purchase its loans. Management is seeking waivers of these covenant violations from its lenders and investors; however, there is no assurance that one or more of the lenders or investors will not terminate their agreements prior to maturity, or that additional credits lines will be negotiated when existing lines terminate or additional investors will be found to purchase its loans. Either occurrence would adversely affect the Company’s wholesale operations.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 3. MORTGAGE LOANS RECEIVABLE HELD-FOR-SALE

Mortgage loans receivable held-for-sale includes loan production costs which, pursuant to SFAS No. 91, have been deferred and added to the basis of mortgage loans receivable held-for-sale. These capitalized costs are offset against net gains on mortgage loan sales and fees when the loans are sold or amortized as a yield adjustment in the case of loans held for investment.

A summary of mortgage loans receivable held-for-sale, at the lower of cost or market at March 31, 2004 and December 31, 2003, follows:

The Company has entered into loan sale agreements with investors in the normal course of business that include representations and warranties customary to the mortgage banking industry. Violations of these representations and warranties may require the Company to repurchase loans previously sold or to reimburse investors for losses incurred. In the opinion of management, the potential exposure related to the Company’s loan sale agreements is adequately provided for in the allowance for loan repurchases and premium recapture. The activity in the allowance for loan repurchases and premium recapture for the three months ended March 31, 2004, follows:

During the three months ended March 31, 2004, mortgage loans held-for-sale on which the accrual of interest had been discontinued were not material.

NOTE 4. OFFICE PROPERTY AND EQUIPMENT

Office property and equipment as of March 31, 2004 and December 31, 2003 are summarized as follows:

Depreciation expense for the three months ended March 31, 2004 and 2003 was $74 and $47, respectively.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 5. AVAILABLE-FOR-SALE SECURITIES

The Company has investments in certain marketable securities and partnership interests. During the first quarter of 2004, the Company sold substantially all of its investments, which yielded a gain on the sale of securities of $203. At March 31, 2004, the Company’s investments in a partnership totaled $13.

NOTE 6. GOODWILL

Goodwill represents the excess of the merger consideration over the fair value of the net assets of PGNF and PHF on January 31, 2003. A summary of goodwill recognized follows:

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 7. PREPAID AND OTHER ASSETS

Other assets at March 31, 2004 and December 31, 2003:

NOTE 8. WAREHOUSE LINES OF CREDIT

The Company has mortgage warehouse facilities with commercial banks of $30 million in the aggregate. These warehouse credit facilities are used to fund mortgage loans, are collateralized by the mortgage loans funded, and do not require material compensating balances. warehouse lines of credit consisted of the following at March 31, 2004:

The Company’s warehouse lines contain provisions whereby the lender can unilaterally terminate the agreement without cause with certain notice requirements. Also, certain restrictive financial and other covenants exist that require the Company to, among other requirements, restrict dividends, maintain certain levels of net worth, liquidity, available borrowing capacity, and debt-to-net worth ratios and to comply with regulatory and investor requirements. At March 31, 2004, the Company was in violation of certain of these restrictive covenants. Management is seeking waivers of these covenant violations from lenders; however, there is no assurance that one or more of the lenders will not terminate their agreements prior to maturity, or that additional lines will be negotiated when existing lines terminate. Either occurrence would adversely affect the Company’s wholesale operations.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 9. SEGMENT DATA

The Company provides a broad range of mortgage products through its wholesale and retail segments. Management measures the revenue streams of each of its lending segments separately. The table below provides revenue and expense data by business segment for the three months ended March 31, 2004 and 2003 (dollars in thousands):

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

NOTE 10. COMMITMENTS AND CONTINGENCIES

Off-Balance Sheet Risks - The Company enters into commitments to extend credit in the normal course of business. These commitments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized in the balance sheet. Commitments to fund loans are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. One-to-four family residential properties, if funded, would collateralize the commitments. The Company evaluates each customer’s creditworthiness and obtains appraisals to support the value of the underlying collateral. Also, external market forces affect the probability of commitments being exercised; therefore, total commitments outstanding do not necessarily represent future cash requirements. The Company quotes interest rates to borrowers, which are generally subject to change by the Company. Although the Company typically honors such interest rate quotes, the quotes do not constitute interest rate locks, minimizing the potential interest rate risk exposure. The Company had no binding commitments to fund loans at March 31, 2004.

Supervisory Regulation - The Company’s mortgage banking business is subject to the rules and regulations of the Department of Housing and Urban Development (“HUD”) and various state and federal agencies with respect to originating, processing, and selling mortgage loans as a nonsupervised correspondent lender. Those rules and regulations require, among other things, that the Company maintain a minimum net worth. As of March 31, 2004, the Company was not in compliance with these requirements. The Company currently does not service loans for other investors or federal agencies.

Minimum Operating Lease Commitments - The Company is party to real estate leases for its corporate headquarters and other wholesale locations as well as leases for certain office equipment. The Company pays taxes, insurance, other operating expenses, and general maintenance for all lease arrangements.

Letter Of Credit - On October 1, 2003, PGNF entered into a letter of credit with a commercial bank in the amount of $100. At March 31, 2004, no amounts were outstanding under this letter of credit.

Deferred Compensation - PGNF has a nonqualified deferred compensation plan for a former employee. This plan is non-funded.

Litigation - In mid-2001, the Company, and certain of its former directors and officers were named as defendants in class action complaints alleging violations of the federal securities laws in the United States District Court for the Southern District of New York. In mid-2002, the complaints against the Company were consolidated into a single action.

The essence of the complaint is that in connection with the Company’s initial public offering in October 1999 (“IPO”), the defendants issued and sold the Company’s common stock pursuant to a registration statement which did not disclose to investors that certain underwriters in the

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands, except share and per share amounts)

offering had solicited and received excessive and undisclosed commissions from certain investors acquiring the Company’s common stock in connection with the IPO. The complaint also alleges that the registration statement failed to disclose that the underwriters allocated Company shares in the IPO to customers of the underwriters in exchange for the customers’ promises to purchase additional shares in the aftermarket at pre-determined prices above the IPO price. The action seeks damages in an unspecified amount.

The action is being coordinated with approximately 300 other nearly identical actions filed against other companies that had initial public offerings of securities between 1997 and 2000 same time period.

The Company has approved a Memorandum of Understanding (“MOU”) and related agreements which set forth the terms of a settlement between the Company, the plaintiff class and the vast majority of the other approximately 300 issuer defendants. Among other provisions, the settlement contemplated by the MOU provides for a release of the Company and the individual defendants for the conduct alleged in the action to be wrongful. The Company would agree to undertake certain responsibilities, including agreeing to assign away, not assert, or release certain potential claims the Company may have against its underwriters.

It is anticipated that any potential financial obligation of the Company to plaintiffs pursuant to the terms of the MOU and related agreements will be covered by existing insurance. Therefore, the Company does not expect that the settlement will involve any payment by the Company. The MOU and related agreements are subject to a number of contingencies, including the negotiation of a settlement agreement and its approval by the Court. The Company cannot opine as to whether or when a settlement will occur or be finalized. Whether or not the settlement is ultimately approved, the Company believes the resolution of this matter will not have a material adverse effect on the Company.

The Company is also party to various legal proceedings arising out of the ordinary course of the Company’s business. Management believes that any liability with respect to these legal actions, individually or in the aggregate, will not have a material adverse effect on the Company’s consolidated financial position and results of operations.

NOTE 11. SUPPLEMENTAL CASH FLOW INFORMATION

NOTE 12. COMPREHENSIVE INCOME

The components of comprehensive income (loss) for the three months ended March 31, 2004 and 2003 are listed below (dollars in thousands):

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Special Note Regarding Forward-Looking Information

Certain information contained in this Report may include “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, and is subject to the safe harbor created by that act. We caution readers that certain important factors may affect our actual results and could cause such results to differ materially from any forward-looking statements which may be deemed to have been made in this Report or which are otherwise made by or on behalf of us. For this purpose, any statements contained in this Report that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, words such as “may,” “will,” “expect,” “believe,” “explore,” “consider,” “anticipate,” “intend,” “could,” “estimate,” “annualized,” “plan,” or “continue” or the negative variations of those words or comparable terminology are intended to identify forward-looking statements. Factors that may affect our results include, but are not limited to the risks and uncertainties associated with:

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future attacks, police and military activities overseas, and other disruptive worldwide political events.

We are also subject to other risks detailed from time to time in our Securities and Exchange Commission filings. Any one or more of these uncertainties, risks and other influences could materially affect our results of operations and whether forward-looking statements made by us ultimately prove to be accurate. Our actual results, performance, and achievements could differ materially from those expressed or implied in these forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements, whether from new information, future events, or otherwise.

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes contained elsewhere herein.

General

We are headquartered in Ponte Vedra Beach, Florida and were incorporated in Delaware in August 1999. We are a mortgage banker and mortgage broker in the one-to-four family residential mortgage market. We conduct business in 24 states and the District of Columbia.

Overview

Our business relies on our ability to originate mortgage loans at a reasonable cost, and our ability to sell those loans in the secondary mortgage market at prices allowing us to earn a gain on sale. We measure the gain on sale as the sum of the price we receive for our loans, plus the interest we earn for the period of time we hold the loans, less the cost to originate the loans.

The mortgage banking industry is generally subject to seasonal trends, and loan origination volumes in our industry have historically fluctuated from year to year and are affected by such external factors as home values, the level of consumer debt and the overall condition of the economy. In addition, the premiums we receive from the secondary market for our loans have fluctuated, influenced by the overall condition of the economy and, more importantly, the interest rate environment. As a consequence, the business of originating and selling loans is cyclical.

Gain on Sale of Loans

Gain on sale of loans is affected by the condition of the secondary market for our loans. This market has been very strong in the past year, partly as a result of the interest rate environment characterized by low short-term rates relative to long-term rates, also known as a steep yield curve. The strength of the secondary market has also been enhanced by an increase in the number of buyers of our loan products.

In March, the residential mortgage market began experiencing an increase in interest rates. While the general market for interest rates increased, 2004 large competitors in the subprime wholesale business have held the coupon rates on home mortgages they offer constant. This has eroded the

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margin the Company receives on the subsequent sale of loans thereby significantly eroding the profitability of our wholesale operations.

Origination Fees

Origination fees are comprised of points and other fees charged on mortgage loans originated by our retail channel and brokered through other banks and financial institutions. Retail points and fees are primarily a function of the volume of mortgage loans originated by our retail channel. Origination fees on loans originated by our retail channel which are subsequently sold are deferred and recognized as part of the gain on sale of loans.

Interest Income and Interest Expense

We typically hold our mortgage loans held-for-sale for a period of 30 to 45 days before they are sold in the secondary market. During that time, we earn the coupon rate of interest paid by the borrower, and we pay interest to the lenders that provide our warehouse credit facilities. During the three months ended March 31, 2004, the difference between these interest rates was typically in excess of 2%. During the three months ended March 31, 2004, the difference between the interest rate on our mortgage loans and the interest rate on our warehouse facilities was typically in excess of 2%. The interest rate on our warehouse facilities have not been impacted by the general market increase in interest rates as they are primarily based on rates which have not increased during this period.

Loan Origination Costs

We also measure and monitor the cost to originate our loans. Such costs include the points and fees we may pay to brokers, net of fees we receive from borrowers, plus our operating expenses associated with the origination business.

Loan Originations

As of March 31, 2004, our wholesale division originated loans through our office in Westmont, Illinois, and our retail division originated loans through our locations in Westmont, Illinois and Orlando, Florida.

Critical Accounting Policies

We have established various accounting policies which govern the application of accounting principles generally accepted in the United States of America in the preparation of our financial statements. Certain accounting policies require us to make significant estimates and assumptions that may have a material impact on certain assets and liabilities, as well as our operating results, and we consider these to be critical accounting policies. The estimates and assumptions we use are based on historical experience and other factors which we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates and assumptions, which could have a material impact on the carrying value of assets and liabilities and our results of operations.

We believe the following are critical accounting policies that require the most significant estimates and assumptions that are subject to significant change in the preparation of our consolidated financial statements:

Provision For Loan Repurchases And Premium Recapture

For mortgage loans sold, we provide for an allowance for loan repurchases and premium recapture based on our estimate of the potential repurchase of loans or indemnification of losses

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based on alleged violations of representations and warranties which are customary to the mortgage banking industry. We purchase fraud insurance on the loans originated by our wholesale segment to mitigate this risk. The allowance represents our estimate of the total uninsured losses expected to occur and is considered to be adequate. Provisions for losses are charged to gain on sale of loans and credited to mortgage loans receivable held-for-sale.

Gain On Sale Of Loans

We recognize gains or losses resulting from sales at the date of settlement based on the difference between the selling price for sales and the carrying value of the related loans sold. Such gains and losses may be increased or decreased by the amount of any servicing-released premiums received. We defer recognition of non-refundable fees and direct costs associated with the origination of mortgage loans until the loans are sold.

Impairment of Goodwill

Long-lived assets, including certain identifiable intangibles and goodwill, are reviewed for impairment annually or whenever events or changes in circumstances indicate that the carrying amount of the asset in question may not be recoverable including, but not limited to, a deterioration of profits for a business segment that has long-lived assets, and when other changes occur which might impair recovery of long-lived assets. We test impairment on an annual basis or more frequently if circumstances indicate a potential impairment. At the beginning of 2004, management believed that the projected operating results of the Company’s subsidiaries would validate the amount of goodwill on the financial statements.

As discussed elsewhere in this Form 10-Q, in March 2004, management observed deteriorations in the marketplace for loan sales as a result of the general increase in interest rates. These movements were thought to be temporary. This deterioration has continued into May, and given competitive pressures within the residential mortgage market, may continue for an extended period of time adversely impacting the profitability of our wholesale operations.

Based upon the view that these changes, management determined that an interim impairment test was necessary. Based upon its review of the Company’s long-lived assets, management determined that impairment has occurred and recorded an impairment charge of $2,582 in the three months ended March 31, 2004 to reduce the carrying value of the PGNF to estimated realizable value. The method used to determine the existence of an impairment would be generally measured by discounting operating cash flows over the remaining useful lives of the related long-lived assets. Impairment is measured as the difference between fair value and unamortized cost at the date impairment is determined.

Income Taxes

We file a consolidated federal income and combined state franchise tax returns. We utilize the asset and liability method of accounting for income taxes, under which deferred income taxes are recognized for the future tax consequences attributable to the differences between the financial statement values of existing assets and liabilities and their respective tax bases. We measure deferred tax assets and liabilities using enacted tax rates we expect to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. We

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recognize the effect on deferred taxes of a change in tax rates in income in the period that includes the enactment date.

In determining the possible realization of deferred tax assets, we consider future taxable income from the following sources: (a) the reversal of taxable temporary differences, (b) future operations exclusive of reversing temporary differences, and (c) tax planning strategies that, if necessary, would be implemented to accelerate taxable income into periods in which net operating losses might otherwise expire.

Results of Operations

Three Months Ended March 31, 2004 Compared with Three Months Ended March 31, 2003

The discussion below should be read in conjunction with the Paragon Financial Corporation and Subsidiaries (the “Company”, “we”, “our” or “us”) Unaudited Condensed Consolidated Financial Statements and Notes appearing elsewhere in this report. The results of operations for PGNF and PHF are included since February 1, 2003, the effective date of our mergers with them.

Loan originations. We originated $104,167 in loans for the three months ended March 31, 2004 compared to $85,896 for the three months ended March 31, 2003. The increase in our loan originations was due to our acquisitions of PGNF and PHF in 2003 being effective February 1, 2003 and included in our operating results only for two months in period ended March 31, 2003. Wholesale loan originations were $63,063, or 60.5%, of total originations for the three months ended March 31, 2004 compared to $35,281, or 41.1%, of total originations for the three months ended March 31, 2003. Retail loan originations were $41,104, or 39.5%, of total originations for the three months ended March 31, 2004 compared to $50,615, or 58.9%, of total originations for the three months ended March 31, 2003.

Loan sales. We sold loans totaling $76,834 and $43,475 for the three months ended March 31, 2004 and 2003, respectively. The increase in loan sales for the three months ended March 31, 2004 compared to 2003 was primarily due to the effective date of our acquisition of PGNF being February 1, 2003 and included in our operating results only for two months in period ended March 31, 2003.

Revenues

Gain on sale. Gain on sale of loans increased $742, or 106.2%, to $1,441 for the three months ended March 31, 2004 compared to $699 for the three months ended March 31, 2003. This increase was due to the effective date of our acquisition of PGNF, February 1, 2003, and it being included in our operating results only for two months in period ended March 31, 2003.

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Loan origination fees. Loan origination fees increased $12, or 1.4%, to $888 for the three months ended March 31, 2004 compared to $876 for the three months ended March 31, 2003. This increase was due to the effective dates of our acquisitions of PGNF and PHF, February 1, 2003, and their being included in our operating results only for two months in period ended March 31, 2003. These fees represent points and other fees charged on mortgage loans originated by our retail channel. Expressed as a percentage of retail loan origination volume, origination fees were 2.16% and 1.73% of retail loan originations for the three months ended March 31, 2004 and 2003, respectively.

Interest income. For the three months ended March 31, 2004, interest income increased $75, or 27.7%, to $346 compared to $271 for the three months ended March 31, 2003. This increase was due to the effective date of our acquisition of PGNF, February 1, 2003, and it being included in our operating results only for two months in period ended March 31, 2003.The interest income relates primarily to the interest income we earn on the mortgage loans funded prior to their sale in the secondary market.

Operating Expenses

Salaries, commissions and benefits. Salaries, commissions and benefits increased $563, or 35.5%, to $2,148 for the three months ended March 31, 2004 compared to $1,585 for the three months ended March 31, 2003. This increase was due primarily to the effective dates of our acquisitions of PGNF and PHF, February 1, 2003, and their being included in our operating results only for two months in period ended March 31, 2003.

Loan production costs. Loan production costs decreased $39, or 15.8%, to $208 for the three months ended March 31, 2004 compared to $247 for the three months ended March 31, 2003. This decrease was due primarily to a reduction in our retail origination volume at PGNF and our closing a higher percentage of the loan applications at PGNF in the three months ended March 31, 2004 compared to the three months ended March 31, 2003.

General and administrative expenses. General and administrative expenses increased $312, or 46.6%, to $982 for the three months ended March 31, 2004 compared to $670 for the three months ended March 31, 2003. This increase was due primarily to the effective dates of our acquisitions of PGNF and PHF, February 1, 2003, and their being included in our operating results only for two months in period ended March 31, 2003.

Impairment charge. The impairment charge of $2,582 reflects management’s assessment that the reduction in profits at our PGNF subsidiary is other than temporary.

Interest expense. Interest expense increased $34, or 13.1%, to $293 for the three months ended March 31, 2004 compared to $259 for the three months ended March 31, 2003. This increase was due primarily to the effective dates of our acquisitions of PGNF and PHF, February 1, 2003, and their being included in our operating results only for two months in period ended March 31, 2003.

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Realized loss on derivative. The realized loss on derivative increased $15, or 60%, to $40 for the three months ended March 31, 2004 compared to $25 in the three months ended March 31, 2003. This increase was due primarily to the effective dates of our acquisitions of PGNF and PHF, February 1, 2003, and their being included in our operating results only for two months in period ended March 31, 2003.

Unrealized gain on derivative. The unrealized gain on derivative increased $11, or 64.7%, to $28 for the three months ended March 31, 2004 compared to $17 for the three months ended March 31, 2003. This increase was due primarily to the effective dates of our acquisitions of PGNF and PHF, February 1, 2003, and their being included in our operating results only for two months in period ended March 31, 2003.

Operating loss. The operating loss increased by $2,627, or 284.6%, to $3,550 for the three months ended March 31, 2004 compared to $923 for the three months ended March 31, 2003. This decrease was due primarily to factors discussed above.

Other income. Other income was $198 for the three months ended March 31, 2004. This other income relates to the realization of a gain on the sale of marketable securities. There was no other income for the three months ended March 31, 2003.

Net loss. The net loss increased $2,429, or 263.2%, to $3,352 for the three months ended March 31, 2004 compared to $923 for the three months ended March 31, 2003. This increase was primarily due to the factors discussed above.

Liquidity and Capital Resources

Our primary sources of liquidity are:

Our operations require continued access to short-term and long-term sources of cash. Our primary operating cash requirements include:

We had cash and cash equivalents of approximately $912 at March 31, 2004.

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The Sale of Mortgage Loans. As a fundamental part of our business and financing strategy, we sell mortgage loans to third party investors in the secondary markets as market conditions allow. Generally, we seek to dispose of all of our loan production within 30 to 45 days. We apply the net proceeds of the loan sales to pay down our warehouse facilities in order to make capacity available for future funding of mortgage loans. We sell the loans under agreements with third party investors. These agreements are standard for the industry and contain indemnification provisions requiring the repurchase of loans under certain circumstances. In addition, these agreements have certain financial covenants related to the maintenance of tangible net worth. We are currently in violation of certain financial covenants under these agreements and are seeking waivers from these investors. No assurances can be made that we will be successful in our efforts to obtain waivers from these investors or that the investors will continue to purchase our loans. Our ability to sell loans in the secondary market on acceptable terms is essential for the continuation of our wholesale loan origination operations and our ability to continue as a going concern.

Warehouse Credit Facilities. We rely on our revolving warehouse facilities to originate mortgage loans and hold them prior to sale. At March 31, 2004, we had committed revolving warehouse facilities in the amount of $30 million (subject to certain lender restrictions on the aggregate extensions to all warehouse lenders). Generally, our revolving warehouse facilities have 364-day terms and are renewed on an annual basis. No assurances can be made that we will be successful in our efforts to continue to renew our warehouse facilities upon their expiration.

Certain of our warehouse facility lenders advance less than 100% of the principal balance of the mortgage loans, requiring us to use working capital to fund the remaining portion of the principal balance of the mortgage loans. All of the our revolving warehouse facilities contain provisions requiring we meet certain periodic financial covenants, which establish, among other things, liquidity, stockholders’ equity, leverage, and net income levels.

At March 31, 2004, we were in violation of certain financial covenants under our warehouse credit facilities related principally to the maintenance of tangible net worth. We are currently seeking waivers of these financial covenants with our lenders. If we are unable to meet these financial covenants going forward, and are unable to obtain subsequent amendments or waivers, if required, or for any other reason are unable to maintain existing warehouse lines or renew them when they expire, we would have to cease our wholesale operations which would jeopardize our ability to continue to operate as a going concern.

Other Credit Facilities. On June 13, 2003, we entered into a revolving line of credit with a commercial bank in the amount of $250. This revolving line of credit has an interest rate of prime, is secured by a general lien on our assets, is guaranteed by our subsidiaries, and requires monthly interest payments. This line of credit is due on demand. Currently, we have drawn $245 on this line of credit.

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Impact of Inflation

Inflation affects us most significantly in the area of loan originations and can have a substantial effect on interest rates. Interest rates normally increase during periods of high inflation and decrease during periods of low inflation. Profitability may be directly affected by the level and fluctuation in interest rates that affect our ability to earn a spread between interest received on its loans and the costs of its borrowings. Our profitability is likely to be adversely affected during any period of unexpected or rapid changes in interest rates. A substantial and sustained increase in interest rates could adversely affect our ability to originate loans and affect the mix of first and second-lien mortgage loan products. Generally, first-lien mortgage production increases relative to second-lien mortgage production in response to low interest rates and second-lien mortgage production increases relative to first-lien mortgage production during periods of high interest rates. Fluctuating interest rates may also affect the net interest income earned by us resulting from the difference between the yield to us on loans held pending sales and the interest paid by us for funds borrowed under our warehouse lines of credit.

Market Risk

Our market risk is the risk of economic loss resulting from adverse changes in market prices of mortgage loans and interest rates. We rely heavily on borrowings under our warehouse credit facilities to conduct our wholesale origination business. Borrowings under these credit facilities are done at variable rates that will increase as interest rates rise. Additionally, when interest rates rise, loans held-for-sale and any applications in process with locked-in rates decrease in value. This risk of loss can be reflected in diminished current market values and/or reduced potential net interest income in future periods.

When interest rates decline, customers may withdraw their mortgage loan applications. In those instances, we may be required to reduce our interest rates to meet the market demands. Our wholesale segment operates primarily in the subprime credit market. This market is less sensitive than the prime credit markets are to the daily fluctuations in mortgage rates.

When interest rates rise, fallout may occur due to customers that are not locked into a rate withdrawing their applications, and, as a result, we may suffer a reduction in the volume of loan originations. We may be required to reduce our interest rates to entice these customers in order to close their loans.

We do not maintain a trading account nor are we subject to currency exchange risk or commodity price risk. Responsibility for monitoring interest rate risk rests with senior management. Senior management regularly reviews our interest rate risk position and adopts balance sheet strategies that are intended to optimize operating earnings while maintaining market risk within acceptable guidelines.

While we monitor interest rates and may, from time to time, employ a strategy designed to hedge some of the risks associated with changes in interest rates, no assurance can be given that our results of operations and financial condition will not be adversely affected during periods of fluctuations in interest rates. There were no open hedging positions at March 31, 2004.

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As of the end of the period covered by this report, we evaluated the effectiveness of the design and operation of our disclosure controls and procedures. Our disclosure controls and procedures are designed to provide reasonable assurance that the information that we must disclose in our reports filed under the Securities and Exchange Act is communicated and processed in a timely manner. George Deehan, Chairman and Chief Executive Officer, and Scott Vining, Chief Financial Officer and Treasurer, participated in this evaluation.

Based on such evaluation, Mr. Deehan and Mr. Vining concluded that, as of the date of such evaluation, our disclosure controls and procedures were effective. During the most recent fiscal quarter, there have not been any significant changes in our internal controls or in other factors that could significantly affect those controls.

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PART II—OTHER INFORMATION

From time to time, we become involved in a variety of mortgage lending related claims and other matters incidental to its business in addition to the matters described above. In our opinion, the resolution of any of these matters is not expected to have a material adverse effect on our consolidated financial position and results of operations.

None.

See Note 8 to the Condensed Consolidated Financial Statements.

None.

None.

We filed a Current Report on Form 8-K for an event dated February 2, 2004, in which we issued a press release announcing that the holders of the Company’s outstanding Convertible Notes agreed to amend the maturity date of the Convertible Notes to December 31, 2004.

EXHIBIT NO. DESCRIPTION

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

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