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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED September 30, 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)

2207 Sawgrass Village Drive, Ponte Vedra Beach, FL 32082

(Address of principal executive offices and zip code)

(904) 285-0000

(Registrant’s telephone number, including area code)

5000 Sawgrass Village Circle, 3^rd Floor, Ponte Vedra Beach, FL 32082

(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 November 22, 2004: 64,391,743.

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PART I – FINANCIAL INFORMATION

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 SEPTEMBER 30, 2004 AND DECEMBER 31, 2003

(Dollars in thousands, except share data)

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

FOR THE THREE AND NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003

(Dollars in thousands, except share data)

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2004 AND 2003

(Dollars in thousands)

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE UNAUDITED 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

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 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 $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% per annum.

The merger was 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.

The Company’s unaudited condensed consolidated results of operations on a pro forma basis for the nine months ended September 30, 2003 as if it had consummated the merger with PHF and disposed of PGNF Home Lending Corp. (see Note 2) on January 1, 2003 are as follows (in thousands except per share data):

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE UNAUDITED 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)

PRINCIPLES OF CONSOLIDATION - The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. In consolidation, all material intercompany balances and transactions have been eliminated. Results of operations of companies acquired in transactions accounted for under the purchase method of accounting are included in the financial statements from the date of the acquisition. 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.

FINANCIAL STATEMENT PRESENTATION - The condensed 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.

Our consolidated financial statements for the three and nine months ended September 30, 2004 and 2003, have not been audited and do not include information or footnotes necessary for a complete presentation of consolidated financial condition, results of operations, and cash flows in conformity with accounting principles generally accepted in the United States of America. In management’s opinion, the accompanying consolidated financial statements contain all adjustments, which are of a normal recurring nature, necessary for a fair presentation. Our results of operations for the interim periods are not necessarily indicative of the results that may be expected for an entire year. The accounting policies followed by us are set forth in the consolidated financial statements for the year ended December 31, 2003, and are incorporated herein by reference.

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, goodwill, and loss on disposal of our discontinued segment. Actual results could differ from those estimates.

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.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE UNAUDITED 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)

CASH AND CASH EQUIVALENTS - For purposes of the statement 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 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 as follows:

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

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE UNAUDITED 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)

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.

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.

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.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE UNAUDITED 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)

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, accounts payable, notes payable, and convertible debentures payable. 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 the 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 maintains its cash in bank deposit accounts at high credit-quality financial institutions. At times during the nine months ended September 30, 2004, the Company’s cash balances exceeded the federally-insured limit. Management believes this policy will not adversely affect the Company.

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.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE UNAUDITED 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)

As of September 30, 2004, there were stock options outstanding for the purchase of 40,619,250 shares of the Company’s common stock. There were 19,100,000 stock options granted and 8,510,000 forfeited during the three months ended September 30, 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 nine months ended September 30, 2004 and 2003 (dollars in thousands, except per share amounts):

RECENT ACCOUNTING DEVELOPMENTS - - On March 9, 2004, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 105. Application of Accounting Principles of Loan Commitments (“SAB 105”). SAB 105 requires that when a company is recognizing and valuing a loan commitment at fair value, only differences between the guaranteed interest rate in the loan commitment and a market interest rate should be included. Any expected cash flows related to the consumer relationships or loan commitment and a market interest rate should be included. Any expected cash flows related to the consumer relationships or loan servicing should be excluded from the fair value measurement. The expected future cash flows that are excluded from the fair value determination include anticipated fees for servicing the funded loan, late payment charges, other ancillary fees, or other cash flows from servicing rights. The guidance in SAB 105 is effective for mortgage loan commitments that are accounted for as derivatives and are entered into after March 31, 2004, and is not expected to have a material impact on the results of future operations.

In December 2003, the FASB issued FASB Interpretation No. 46 (revised December 2003), Consolidation of Variable Interest Entities, 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. FIN 46R replaces FASB Interpretation No. 46, Consolidation of Variable Interest Entities, which was issued in January 2003. The Company will be required to apply FIN 46R to all entities subject to this Interpretation no later than the end of the first reporting period that ends after December 15, 2004. This interpretation must be applied to those entities that are considered to be special-purpose entities no later than as of the end of the first reporting period that ends after December 15, 2003.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE UNAUDITED 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.

NOTE 2. DISCONTINUED OPERATIONS

On June 30, 2004, we closed the sale of our PGNF Home Lending Corp. (“PGNF”) subsidiary effective May 31, 2004. Pursuant to the agreement, the Company exchanged the common stock of PGNF, as well as the assumption of all of PGNF’s liabilities, contingent and otherwise, for 52,329,735 shares of our common stock valued at $3,140 (based upon the closing price of $0.06 on May 31, 2004) and 1,800 shares of our Series E preferred stock plus accrued dividend valued at $1,813. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for Impairment or Disposal of Long-Lived Assets,” the assets and liabilities of the PGNF have been classified as discontinued operations, with its operating results in the current and prior periods reported in discontinued operations for the three-month period ended September 30, 2003 and nine-month periods ended September 30, 2004 and 2003.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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

NOTE 2. DISCONTINUED OPERATIONS (continued)

A summary of the operating results of the discontinued operations for the nine months ended September 30, 2004 and 2003 is as follows.

The following is a summary of the assets and liabilities of our discontinued operations as of December 31, 2003:

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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

NOTE 3. GOING CONCERN

As shown in the accompanying unaudited condensed consolidated financial statements, the Company incurred net losses of $4,434 in the nine months ended September 30, 2004, and cumulative losses of $8,397. At September 30, 2004, we had a deficit in stockholders’ equity of $1,526. 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 originate 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.

NOTE 4. OFFICE PROPERTY AND EQUIPMENT

Office property and equipment from continuing operations as of September 30, 2004 and December 31, 2003 are summarized as follows:

Depreciation expense for the nine months ended September 30, 2004 and 2003 was $33 and $15, respectively.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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

NOTE 5. GOODWILL

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

NOTE 6. OTHER ASSETS

Other assets from continuing operations at September 30, 2004 and December 31, 2003 were:

NOTE 7. SEGMENT DATA

The Company previously operated in two separate business segments: wholesale and retail. With the disposal of PGNF (Note 2), the Company is currently operating in one business segment: retail mortgage brokering.

NOTE 8. DEBT

The Company’s debt from continuing operations as of September 30, 2004 and December 31, 2003 was as follows:

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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

NOTE 8. DEBT (continued)

NOTE 9. 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 September 30, 2004.

Supervisory Regulation - The Company’s mortgage brokering 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’s subsidiary, PHF, maintain a minimum net worth of $63. As of September 30, 2004, PHF was 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 its Orlando location as well as leases for certain office equipment. The Company pays taxes, insurance, other operating expenses, and general maintenance for all lease arrangements.

Litigation – On October 15, 2004, the Company was served with a summons on an eviction action by its landlord seeking unpaid rent and other damages of $268. The Company has an agreement in principal whereby it has vacated the office space it occupied in forgiveness of unpaid rents under the lease and forfeiture of its deposit of $25. Based upon this agreement in principal, the Company does not believe that this action will have a material impact upon its operating cash flow or operating results.

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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

NOTE 9. COMMITMENTS AND CONTINGENCIES (continued)

On September 24, 2004, the Company defaulted on its promissory note dated June 4, 2003 to Bank of America, N.A. (“BoA”) being unable to repay this note in full when demanded to do so by BoA. BoA has commenced legal action against the Company and other guarantors of the indebtedness for repayment. The Company is currently negotiating with BoA a standstill agreement, but no assurance can be made that the Company will be successful in negotiating such and agreement.

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 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

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PARAGON FINANCIAL CORPORATION AND SUBSIDIARIES

NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS

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

NOTE 9. COMMITMENTS AND CONTINGENCIES (continued)

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 10. SUPPLEMENTAL CASH FLOW INFORMATION

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

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:

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

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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 retail mortgage broker in the one-to-four family residential mortgage market. We conduct business in the state of Florida.

Overview

Our business relies on our ability to originate mortgage loans at a reasonable cost. The mortgage 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 also fluctuated, also 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.

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 us.

Loan Origination Costs

We also measure and monitor the cost to originate our loans. Such costs include the fees we may pay to appraisers, credit bureaus and are net of fees we receive from borrowers.

Loan Originations

As of September 30, 2004, we originated loans through our location in 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, particularly goodwill and loss of our discontinued segment, 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.

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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:

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 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.

Discontinued Operations

In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (SFAS 144), a component classified as held for sale is reported in discontinued operations when the following conditions are met: (a) the operations and cash flows of the component have been (or will be) eliminated from the ongoing operations of the entity as a result of the disposal transaction and (b) the entity will not have any significant continuing involvement in the operations of the component after the disposal transaction. In a period in which a component of an entity either has been disposed of or is classified as held for sale, the income statement for current and prior periods reports the results of operations of the component, including any gain or loss recognized in accordance with SFAS 144 paragraph 37, in discontinued operations. The results of discontinued operations, less applicable income taxes (benefit), is reported as a separate component of income before extraordinary items and the cumulative effect of accounting changes (if applicable). The assets and liabilities of a disposal group classified as held for sale is presented separately in the asset and liability sections, respectively, of the statement of financial position.

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Results of Operations

Three Months Ended September 30, 2004 Compared with Three Months Ended September 30, 2003

Continuing Operations

Loan Originations. Loan originations decreased $7,677, or 26.9%, to $20,854 for the three months ended September 30, 2004 compared to $28,531 for the three months ended September 30, 2003. This decrease was due to the hurricanes that hit Florida as well as a general decline in the volume of refinance market.

Revenues

Loan origination fees. Loan origination fees decreased $177, or 27.0%, to $479 for the three months ended September 30, 2004 compared to $656 for the three months ended September 30, 2003. This decrease was due primarily to the decrease in the volume of mortgage loans originated. Expressed as a percentage of loan origination volume, origination fees were 2.3% for both the three months ended September 30, 2004 and 2003.

Operating Expenses

Salaries, commissions and benefits. Salaries, commissions and benefits decreased $368, or 47.5%, to $407 for the three months ended September 30, 2004 compared to $775 for the three months ended September 30, 2003. This decrease was due primarily to the elimination of our corporate officers’ salaries in the three months ended September 30, 2004 compared to the three months ended September 30, 2003.

Loan production costs. Loan production costs decreased $37, or 84.1%, to $7 for the three months ended September 30, 2004 compared to $44 for the three months ended September 30, 2003. This decrease was due primarily to the higher pull through rate at our PHF subsidiary in the three months ended September 30, 2004 compared to the three months ended September 30, 2003.

General and administrative expenses. General and administrative expenses decreased $77, or 36.3%, to $135 for the three months ended September 30, 2004 compared to $212 for the three months ended September 30, 2003. This decrease was primarily due to reductions of expenses at our corporate headquarters associated with headcount reductions at our corporate headquarters.

Operating loss. The operating loss decreased by $305, or 81.3%, to $70 for the three months ended September 30, 2004 compared to $375 for the three months ended September 30, 2003. This decrease was due primarily to factors discussed above.

Interest expense. Interest expense decreased $63, or 60.6%, to $41 for the three months ended September 30, 2004 compared to $104 for the three months ended September 30, 2003. This decrease was due primarily to the beneficial conversion feature of our convertible debentures being amortized into interest expense in the three months ended September 30, 2003.

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Net loss. The net loss from continuing operations decreased $368, or 76.8%, to $111 for the three months ended September 30, 2004 compared to $479 for the three months ended September 30, 2003. This decrease was primarily due to the factors discussed above.

Nine Months Ended September 30, 2004 Compared with Nine Months Ended September 30, 2003

Loan Originations. Loan originations increased $11,518, or 19.0%, to $72,213 for the nine months ended September 30, 2004 compared to $60,695 for the nine months ended September 30, 2003. This increase was primarily due to the internal growth of our Orlando, Florida office as well as our acquisition of PHF being included in our operating results only for eight months in period ended September 30, 2003.

Revenues

Loan origination fees. Loan origination fees increased $227, or 15.4%, to $1,698 for the nine months ended September 30, 2004 compared to $1,471 for the nine months ended September 30, 2003. This increase was due to the increased number of loan originations in the nine months ended September 30, 2004 compared to September 30, 2003 and the effective date of our acquisition of PHF, February 1, 2003. These fees represent points and other fees charged on mortgage loans we originate. Expressed as a percentage of loan origination volume, origination fees were 2.35% and 2.42% of loan originations for the nine months ended September 30, 2004 and 2003, respectively.

Operating Expenses

Salaries, commissions and benefits. Salaries, commissions and benefits increased $8, or 0.5%, to $1,776 for the nine months ended September 30, 2004 compared to $1,768 for the nine months ended September 30, 2003. This increase was primarily due to higher commissions paid by PHF for loans originated in the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003 (which included only eight months in 2003), offset in part by the reduction in our corporate officers’ salaries.

Loan production costs. Loan production costs decreased $49, or 47.6%, to $54 for the nine months ended September 30, 2004 compared to $103 for the nine months ended September 30, 2003. This decrease was due primarily to the higher pull through rate at our PHF subsidiary and reductions in costs associated with originating loans in the nine months ended September 30, 2004 compared to September 30, 2003.

General and administrative expenses. General and administrative expenses decreased $225, or 28.0%, to $578 for the nine months ended September 30, 2004 compared to $803 for the nine

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months ended September 30, 2003. This decrease was primarily due to reduced operating expenses resulting at our corporate headquarters in the nine months ended September 30, 2004 compared to the nine months ended September 30, 2003.

Operating loss. The operating loss decreased by $493, or 41.0%, to $710 for the nine months ended September 30, 2004 compared to $1,203 for the nine months ended September 30, 2003. This decrease was due primarily to factors discussed above.

Interest expense. Interest expense decreased $229, or 73.2%, to $84 for the nine months ended September 30, 2004 compared to $313 for the nine months ended September 30, 2003. This decrease was due primarily to the beneficial conversion feature of our convertible debentures being amortized into interest expense in the nine months ended September 30, 2003.

Loss on disposal of segment. Loss on the disposal of PGNF was $102 for the nine months ended September 30, 2004. This represents the non-cash loss we incurred in disposing of PGNF. There was no such loss in the nine months ended September 30, 2003.

Net loss from continuing operations. The net loss from continuing operations decreased $620, or 40.9%, to $896 for the nine months ended September 30, 2004 compared to $1,516 for the nine months ended September 30, 2003. This decrease was primarily due to the factors discussed above.

Loss from discontinued operations. The loss from discontinued operations increased $3,766, or 1,651.8%, to $3,538 for the nine months ended compared to net income of $228 for the nine months ended September 30, 2003.

Net loss. The net loss increased $3,146, or 244.3%, to $4,434 for the nine months ended September 30, 2004 compared to $1,288 for the nine months ended September 30, 2003. This increase was due to the factors discussed above.

Liquidity and Capital Resources

Our primary source of liquidity is closing fees earned from originating mortgage loans.

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 $96 at September 30, 2004.

Subordinated notes payable: On May 31, 2004, we executed two subordinated promissory notes with PGNF in the amounts of $1,051 and $480, respectively. These promissory notes reflect the amounts advanced by PGNF to fund corporate expenses and are subordinated to all creditor

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claims. Under these notes, interest is deferred to December 31, 2004 with initial principal payments of $20 beginning January 1, 2005. We intend to seek extensions of principal payments under these notes, but no assurances can be given that we will be successful in obtaining extensions under these notes.

FUTURE ACCOUNTING PRONOUNCEMENTS

There are currently no pronouncements issued that are scheduled for implementation during 2004 that are expected to have any significant impact on the accounting policies of the Company.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

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.

Market Risk

Our market risk is the risk of economic loss resulting from adverse changes in market prices of mortgage loans and interest rates. When interest rates rise, 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 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. 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 fees 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.

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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 September 30, 2004.

There have been no significant changes in our market risk exposure since December 31, 2003.

Item 4. Control and Procedures.

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, former Chairman and Chief Executive Officer and current member of the board of directors, 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

Item 1. Legal Proceedings.

Refer to Part I, Footnote 9 – Commitments and Contingencies for a discussion of our ongoing litigation. In addition to the specific items discussed therein, 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.

Item 2. Changes in Securities and Use of Proceeds.

None.

Item 3. Defaults Upon Senior Securities.

As we disclosed in Part I, Footnote 9 – Commitments and Contingencies, we are in default of under our promissory note with Bank of America, because we did not repay the promissory note when demanded. As explained therein, we are attempting to negotiate a settlement of BoA’s demand.

Item 4. Submission of Matters to a Vote of Security Holders.

On June 30, 2004, we received consent from holders of 97,647,656 shares (or 83.89%) of our common stock on a pre-PGNF Transaction basis to sell our PGNF subsidiary and completed this sale. After affecting the number of outstanding shares resulting from the PGNF Transaction, we received consent from holders of 45,317,921 shares (or 70.74%) of our common stock.

Item 5. Other Information.

On November 19, 2004, George Deehan resigned as our Chief Executive Officer and Chairman of the Board of Directors and was retained as a member of the Board of Directors. Paul Danner assumed the position as our Chief Executive Officer and Chairman of the Board of Directors.

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Item 6. Exhibits and Reports on Form 8-K.

(a) Exhibits: The following exhibits are hereby filed as part of this Quarterly Report on Form 10-Q.

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(b) Reports of Forms 8-K

On July 14, 2004, we filed a Current Report on Form 8-K for an event dated June 30, 2004 related to our completion of the sale of our PGNF Homelending Corp. subsidiary.

On August 23, 2004, we amended our previous filing of July 14, 2004 on Form 8-K to include proforma financial information

On September 13, 2004, we filed a Current Report on Form 8-K announcing the signing of a letter of intent to acquire First Charleston Mortgage, LLC.

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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.

PARAGON FINANCIAL CORPORATION

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