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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

(Mark One)

or

COMMISSION FILE NUMBER 1-32340

AAMES INVESTMENT CORPORATION

(Exact name of registrant as specified in its charter)

350 SOUTH GRAND AVENUE, LOS ANGELES, CA 90071-3459

(Address of Registrant’s principal executive offices including zip code)

(323) 210-5000

(Registrant’s telephone number,

including area code)

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  ¨    No  x

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

At May 12, 2005 Registrant had 61,610,021 shares of common stock outstanding.

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AAMES INVESTMENT CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share data)

See accompanying notes to condensed consolidated financial statements.

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AAMES INVESTMENT CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED INCOME STATEMENTS

(UNAUDITED)

(In thousands, except per share data)

See accompanying notes to condensed consolidated financial statements.

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AAMES INVESTMENT CORPORATION AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(In thousands)

See accompanying notes to condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1.    General and Basis of Presentation

General

Aames Investment Corporation (the “Company” or “Aames Investment”), a Maryland corporation, was incorporated on February 24, 2004. On November 5, 2004, Aames Investment completed a $297.5 million initial public offering of 35.0 million common shares and a $39.5 million concurrent private placement of 5.0 million shares of common stock. Subsequently, on November 24, 2004, Aames Investment sold an additional 5.3 million shares of common stock in an over-allotment transaction. All of the common shares sold were priced at $8.50 per share, less certain discounts.

On November 9, 2004, Aames Investment completed its reorganization with Aames Financial Corporation, formerly Aames Investment’s parent company, and with two of Aames Investment’s wholly owned subsidiaries, each of which was created for the interim purpose of effecting the reorganization. As a result of the reorganization, the corporate successor of Aames Financial became a wholly owned subsidiary of Aames Investment, and changed its name to “Aames Financial Corporation.” The reorganization transaction was accounted for as a recapitalization-restructuring of entities under common control with no change in accounting basis. The common shares of Aames Financial that were previously publicly traded were fully redeemed and, accordingly, no longer trade on any public equity market. Aames Financial’s Series B, C and D Convertible Preferred Stock were also fully redeemed.

At March 31, 2005, Specialty Finance Partners (“SFP”), a partnership controlled by Capital Z Financial Services Fund, II, L.P., a Bermuda partnership (together with SFP, “Capital Z”) and others affiliated with Capital Z together owned 14,109,528 shares, or approximately 23.0% of the Company’s common shares outstanding. Representatives of Capital Z currently have two seats on the Company’s seven member Board of Directors.

Aames Investment expects to qualify as a real estate investment trust, or REIT, for U.S. federal income tax purposes when it files its December 31, 2004 tax return which are currently on extension. On a consolidated basis, Aames Financial and subsidiaries is the taxable REIT subsidiary of Aames Investment.

Aames Investment’s strategy to use its equity capital and funds borrowed under revolving warehouse and repurchase facilities to finance mortgage loan originations, and to use on-balance sheet securitizations to finance its REIT portfolio of mortgage loans. Aames Financial is a fifty-year old mortgage banking company focused primarily on originating, selling and servicing mortgage loans through both wholesale and retail channels under the name “Aames Home Loan.” Aames Investment will retain in its REIT portfolio a portion of these loans, largely hybrid/adjustable rate mortgage loans, which accounted for 80.5% of total mortgage loan production during the three months ended March 31, 2005. Aames Investment will sell the remainder, including a majority of the fixed-rate mortgage loans originated, on a whole loan servicing-released basis to third parties.

The Company’s principal market is borrowers whose financing needs are not being met by traditional mortgage lenders for a variety of reasons, including the need for specialized loan products or credit histories that may limit such borrowers’ access to credit. Mortgage loans originated are extended on the basis of equity in the borrower’s property and the creditworthiness of the borrower.

Basis of Presentation

The condensed consolidated financial statements included herein have been prepared by the Company, without audit, pursuant to the rules and regulations of the United States Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with accounting principles in the United States have been omitted.

The condensed consolidated financial statements include the accounts of the Company and all of its subsidiaries after eliminating all significant intercompany transactions and reflect all normal, recurring adjustments which are, in the opinion of management, necessary to present a fair statement of the results of

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operations of the Company in conformity with accounting principles generally accepted in the United States for the interim periods reported. The results of operations for the Company for the three months ended March 31, 2005 are not necessarily indicative of the results expected for the full calendar year.

Note 2.    Cash and Cash Equivalents

At March 31, 2005 and December 31, 2004, the Company had corporate cash and cash equivalents available of $128.4 million and $37.8 million, of which $29.5 million and $7.5 million were restricted, respectively. At March 31, 2005 and December 31, 2004, the Company had $65.0 million and $7.0 million of overnight investments, respectively.

The Company services mortgage loans in its portfolio of loans held for investment, in its securitization trusts, for others on a long-term basis and services mortgage loans on an interim basis, which consist of loans held for sale and loans subserviced for others. In such capacity, certain funds are collected from borrowers and placed in segregated trust accounts which totaled $60.5 million and $29.4 million at March 31, 2005 and December 31, 2004, respectively. These accounts and corresponding liabilities are not included in the accompanying consolidated balance sheets.

Note 3.    Loans Held for Investment, Net

The following table summarizes loans held for investment, net at March 31, 2005 and December 31, 2004 (in thousands):

Activity in the allowance for loan losses during the periods presented was as follows:

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Note 4.    Basic and Diluted Net (Loss) Per Common Share

The following table sets forth information regarding basic and diluted net income (loss) per common share for the periods presented (in thousands, except per share data):

Note 5.    Pro Forma Stock Based Compensation

Through June 30, 2004, the Company compensated employees through the issuance of common stock options in accordance with the Aames Financial Corporation Stock Option Plan dated February 10, 1999, as amended (the “1999 Plan”). The 1999 Plan provided for the issuance of options to purchase shares of the Company’s common stock to officers, key executives and consultants of the Company. The 1999 Plan was ultimately replaced by the 2004 Aames Investment Corporation Equity Incentive Plan (the “2004 EIP”) on November 9, 2004. Awards under the 2004 EIP have been restricted stock awards. Since November 9, 2004, there are no longer any stock options outstanding.

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As permitted by Financial Accounting Standards Board Statement No. 123, “Accounting for Stock-Based Compensation” (“FASB No. 123”), the Company recognized compensation expense using the intrinsic value method specified in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”. We do not expect that Financial Accounting Standards Board Statement No. 123R, “Share-Based Payment” will materially impact our financial statements upon adoption no later than in the fourth quarter of 2005. Had compensation been recorded in accordance with FASB No. 123, the Company’s net income and net income per common share data would have reflected the pro forma amounts indicated below (in thousands, except per share data):

The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:

The proforma stock based compensation cost, net of tax effects, was $0.5 million during the three months ended March 31, 2004.

Note 6.    Income Taxes

Aames Investment has elected to be treated as a real estate investment trust, or REIT, for U.S. federal tax purposes. As a REIT, Aames Investment Corporation is not subject to federal income taxes at the parent company level to the extent that it distributes its taxable income to its stockholders and complies with certain other requirements. Other requirements include distribution of at least 90% of the REIT’s taxable income, and meeting certain percentage requirements for assets and income that effectively serve to focus the REIT’s investments into mortgage loans secured by real estate, including mortgage-backed securities and other qualifying investments. Holdings of non-real estate and portfolio investments is limited, including no more than 20% of the value of Aames Investment’s total assets may consist of securities of one or more taxable REIT subsidiaries, discussed below. Aames Investment intends to distribute 100% of its REIT taxable income; therefore, no provision for income taxes has been made.

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The taxable income of Aames Financial, the taxable REIT subsidiary, is subject to regular corporate income taxes. Taxes are provided on substantially all income and expense items included in earnings, regardless of the period in which such items are recognized for tax purposes. The Company uses an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company’s financial statements or tax returns. In estimating future tax consequences, the Company generally considers all expected future events other than the enactment of changes in the tax law or rates.

During the three months ended March 31, 2005 and 2004, we recorded an income tax provision (benefit) of $0.8 million and $(0.1) million, respectively. Our $0.8 million tax provision for the three months ended March 31, 2005 differed from an expected federal benefit of $-0- million calculated at the marginal federal tax rate of 35.0% due to the $8.4 million benefit related to the non-taxability of the REIT earnings less the $9.9 million expense resulting from the increase in the tax valuation allowance, partially offset by the $0.7 million state tax benefit. Our $(0.1) million tax benefit for the three months ended March 31, 2004 differed from an expected federal tax expense of $7.3 million calculated at the federal marginal rate of 35.0% due to the $7.4 million decrease in valuation allowance.

At March 31, 2005, we had recognized $28.4 million of deferred tax assets based upon our determination that it is more likely than not that we will realize such assets in future periods. There was no change in our deferred tax assets from December 31, 2004.

The following table reconciles pretax accounting income of the parent company, Aames Investment, as determined for financial statement purposes to estimated taxable income for the three months ended March 31, 2005 (in thousands):

As previously announced, on April 19, 2005, the Company declared a cash dividend of $0.27 per common share for the quarter ended March 31, 2005, which was paid on May 9, 2005, to stockholders of record as of April 29, 2005.

Note 7.    Reclassifications

Certain amounts related to March 31, 2004 have been reclassified to conform to the March 31, 2005 presentation.

Note 8.    Commitments and Contingencies

Certain of our subsidiaries are defendants in Potteiger et. al. v. Aames Funding Corporation and Aames Financial Corporation, a collective action filed on approximately February 4, 2004 in the U.S. District Court of Minnesota, case 04-CV-65. Plaintiff, a former loan officer of ours, filed this action on behalf of himself and current and former loan officers employed by us, and seeks damages consisting of alleged unpaid overtime, statutory liquidated damages and attorneys’ fees and costs. Plaintiff alleges that during his employment, he and other loan officers worked in excess of 40 hours per week and that we willfully failed to pay overtime in violation of the Federal Fair Labor Standards Act. We filed an answer denying the claims and asserting various affirmative defenses. Initial discovery was recently completed and the matter is set for mediation in June 2005.

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On April 27, 2004, the Company received a civil investigative demand from the Federal Trade Commission, or the FTC, that, although not alleging any wrongdoing, sought documents and data relating to the Company’s business and lending practices. The demand was issued pursuant to an April 8, 2004 resolution of the FTC authorizing non-public investigations of various unnamed subprime lenders and loan brokers to determine whether there have been violations of certain consumer protection laws. The Company has cooperated and intends to continue to cooperate fully with the FTC in this investigation. Because the investigation is at an early stage, the Company cannot predict the outcome of the investigation and its effect, if any, on the Company’s business.

On September 7, 2004, Aames Financial received a Civil Investigative Demand and Notice to Proceed from the Office of the Attorney General of Iowa, that, although not alleging any wrongdoing, sought documents and data relating to its business and lending practices in Iowa. Aames Financial has cooperated and intends to cooperate fully with the Office of the Attorney General of Iowa in this investigation. Because the investigation is at an early stage, Aames Financial cannot predict the outcome of the investigation and its effect, if any on its business in Iowa, which approximated 0.02% and 0.2% of total mortgage loan production during the three months ended March 31, 2005 and the six months ended December 31, 2004.

In the ordinary course of its business, the Company is subject to various claims made against it by borrowers, private investors and others arising from, among other things, losses that are claimed to have been incurred as a result of alleged breaches of fiduciary obligations, misrepresentations, errors and omissions of employees and officers of the Company, incomplete documentation and failures by the Company to comply with various laws, such as consumer protection laws, employment laws and other federal and state laws, and regulations applicable to its business. The Company believes that liability with respect to any of these currently asserted claims or legal actions is not likely to be material to the Company’s consolidated financial position and results of operations; however, any claims asserted or legal action in the future may result in expenses which could have a material adverse effect on the Company’s consolidated financial position and results of operations.

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

Item 3.    Quantitative and Qualitative Disclosures About Market Risk

The following discussion includes Management’s Discussion and Analysis of Financial Condition and Results of Operations and Quantitative and Qualitative Disclosures about Market Risk. This section should be read in conjunction with Condensed Consolidated Financial Statements included in Item 1 of this Form 10-Q.

Special Note Regarding Forward-looking Information

This report may contain forward-looking statements under federal securities laws. These statements are based on management’s current expectations and beliefs and are subject to a number of trends and uncertainties that could cause actual results to differ materially from those described in the forward-looking statements. The risks and uncertainties that may cause our performance and results to vary include: (i) changes in overall economic conditions and interest rates; (ii) an inability to originate subprime hybrid/adjustable mortgage loans; (iii) increased delinquency rates in our portfolio; (iv) adverse changes in the securitization and whole loan market for mortgage loans; (v) declines in real estate values; (vi) limited cash flow to fund operations and dependence on short-term financing facilities; (vii) concentration of operations in California, Florida, New York and Texas; (viii) extensive government regulation; (ix) intense competition in the mortgage lending industry; and (x) an inability to comply with the federal tax requirements applicable to REITs and effectively operate within limitations imposed on REITs by federal tax rules. For a more complete discussion of these risks and uncertainties and information relating to the company, see the Form 10-K for the year ended December 31, 2004 and other filings with the SEC made by the company pursuant to the Securities Exchange Act of 1934. Aames Investment expressly disclaims any obligation to update or revise any forward-looking statements in this report.

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General

Aames Investment, a mortgage real estate investment trust, or REIT, was formed in February 2004 to build and manage a portfolio of high yielding subprime mortgage loans to offer its stockholders the opportunity for attractive dividend yields and earnings growth. In November 2004, we completed an initial public offering, and, concurrently with that offering, a reorganization with Aames Financial Corporation, formerly our parent company. As a result of the reorganization, Aames Financial became a wholly owned subsidiary of ours. Aames Financial is a 50 year old mortgage banking company focused primarily on originating, selling and servicing mortgage loans through both wholesale and retail channels under the name “Aames Home Loan.” Our strategy is to use our equity capital, including a portion of the net proceeds from our initial public offering, and funds borrowed under revolving warehouse and repurchase facilities to finance our mortgage loan originations, and to use those financing services together with on-balance sheet securitizations to finance our REIT portfolio of mortgage loans. We retain in our REIT portfolio some of our mortgage loan originations, largely hybird/adjustable rate mortgage loans or ARMs, which accounted for 80.5% of our loan production during the three months ended March 31, 2005. We sell the remainder, including a majority of the fixed-rate mortgage loans that we originate, on a whole loan servicing-released basis to third parties.

We are taxed as a REIT for U.S. federal income tax purposes in connection with the filing of our December 31, 2004 federal income tax return, and Aames Financial is our taxable REIT subsidiary, or TRS. As a REIT, we generally are not subject to U.S. federal income tax on the REIT income that we distribute to our stockholders. We distribute a majority of the earnings from our REIT portfolio of mortgage loans to our stockholders, while growing our equity capital base by retaining a portion of Aames Financial’s earnings. The taxable income generated by Aames Financial is subject to regular corporate income tax. This includes Aames Financial’s net interest income, gain on sale and fee income.

Business Strategy

Our goal is to maximize stockholder value and increase earnings by:

The strategies discussed above contain forward-looking statements. Such statements are based on current expectations and are subject to risks, uncertainties and assumptions, including those discussed under “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Risk Factors”, included in our Annual Report on Form 10-K for the year ended December 31, 2004. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, actual results may vary materially from those anticipated, estimated or projected. Thus, no assurance can be given that we will be able to accomplish the above strategies.

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Mortgage Portfolio Management

We invest in subprime one-to-four family, residential mortgage loans, operating as a long-term portfolio investor. We purchase loans originated by our subsidiary, Aames Financial, that we anticipate holding on our balance sheet, largely hybrid/adjustable rate loans. Aames Financial retains the servicing rights to those loans.

To provide us with long-term financing for the portfolio of mortgage loans that we hold on our balance sheet, we securitize substantially all of those loans through on-balance sheet transactions structured as financings rather than sales for both tax and financial accounting purposes. Accordingly, these loans will remain on our consolidated balance sheet as an asset and the underlying bonds issued through the securitization will be reported as a liability on our consolidated balance sheet. Thus, we will record interest income generated by the mortgage loans and recognize interest expense on the related financings over the life of the mortgage loan pool, rather than generate a gain or loss at the time of the securitization.

Managing Interest Rate Risk

Our hybrid/adjustable rate loans may have a fixed rate for two, three or five years prior to their first adjustment and may be financed with on-balance sheet securitization debt with rates that adjust monthly. As a result, our net interest income and cash flow could be negatively impacted by changes in short-term interest rates. To counteract this possibility, we may hedge the aggregate risk of interest rate fluctuations with respect to our borrowing index. We generally intend to hedge only the risk related to changes in the benchmark interest rate used in the variable rate index, usually a London Interbank Offered Rate, known as LIBOR, or a U.S. Treasury rate.

To reduce these risks, we may enter into interest rate cap agreements whereby, in exchange for a fee, we would be reimbursed for interest paid in excess of a certain capped rate. With respect to interest rate cap agreements any net payments under, or fluctuations in the fair value of, these cap agreements will be recorded in current income.

Derivative financial instruments contain credit risk to the extent that the institutional counterparties may be unable to meet the terms of the agreements. We expect to minimize this risk by using multiple counterparties and limiting them to major financial institutions with good credit ratings. In addition, we regularly monitor the potential risk of loss with any one party resulting from this type of credit risk. Accordingly, we do not expect any material losses as a result of default by other parties.

REIT Compliance

We are a REIT, for U.S. federal income tax purposes. Aames Financial has continued its operations as our primary mortgage origination and servicing subsidiary. To meet some of the REIT qualification requirements, we conduct our loan sales, as well as other servicing and origination functions, through Aames Financial, our taxable REIT subsidiary. All loans are sourced, underwritten and processed by Aames Financial. We purchase the loans that we anticipate holding on our balance sheet, largely hybrid/adjustable rate loans, and Aames Financial sells the remainder of the loans it originates, including a majority of its fixed-rate mortgage loans, to third parties. We are required to purchase loans from Aames Financial at fair market value and Aames Financial is subject to corporate income tax on any taxable gain it recognizes on the sale.

U.S. federal income tax law requires that a REIT distribute annually to its stockholders at least 90% of its taxable income, excluding the retained earnings of any taxable REIT subsidiary it owns. If we distribute all of our taxable income to our stockholders, we will not be subject to U.S. federal income tax and will not record income tax (benefit) expense. We intend to make regular quarterly distributions of all or substantially all of our REIT taxable income to our common stockholders. Any taxable income generated by Aames Financial will be subject to regular corporate income tax and Aames Financial will continue to record income tax (benefit) expense. However, we anticipate that Aames Financial will have substantially lower effective tax rates due to

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historical net operating loss carryforwards for U.S. federal income tax purposes. Subject to annual limitations, these losses are available to offset future income. Aames Financial may retain any income it generates net of any tax liability it incurs on that income without affecting the REIT distribution requirements. If Aames Financial chooses to pay a dividend to us, the dividend could be included in the REIT distribution. Any distributions that Aames Financial makes in the future will be at the discretion of its board of directors and will depend on, among other things, its actual results of operations and liquidity levels.

To qualify as a REIT, at least 75% or our assets must be qualified real estate assets, government securities and cash and cash items and no more than 20% of the value may be comprised of stock and other securities of Aames Financial or other taxable REIT subsidiaries. The need to comply with these asset ownership requirements may cause us to acquire other assets that are qualified real estate assets for purposes of these requirements—for example, mortgage-backed securities on a leveraged basis—that are not part of our overall business strategy.

Mortgage Originations

We originate primarily subprime, one-to-four family residential mortgage loans. These originations are significant to our financial results because we hold a majority of the loans we originate in our on-balance sheet portfolio of loans held for investment. The loans we originate that are not retained in our REIT portfolio of loans held for investment are sold to the secondary markets.

Our principal market is borrowers whose financing needs are not being met by traditional mortgage lenders for a variety of reasons, including the need for specialized loan products or credit histories that may limit such borrowers’ access to credit. These types of borrowers generally pay higher mortgage loan origination fees and interest rates than those charged by conventional lending sources. We believe these borrowers continue to represent an underserved niche of the residential mortgage loan market and present an opportunity to earn a superior return for the risk assumed. Our residential mortgage loans, which include fixed and hybrid/adjustable rate loans, are generally used by borrowers to consolidate indebtedness, finance other consumer needs, or purchase homes. We believe that while our loan origination volume is affected by general levels of interest rates, because a majority of our loan originations are cash-out refinancings and purchase money loans our loan origination volume is generally less cyclical than conventional mortgage lending which has a higher percentage of rate/term refinance loans.

Mortgage Loan Sales to Third Parties and Off-Balance Sheet Securitizations

Aames Financial will sell whole loans not retained for the REIT portfolio to third parties to capture any gain on sale of these loans and to grow our equity capital base on a consolidated basis. Aames Financial does not currently sell loans in off-balance sheet securitizations; however, after our on-balance sheet portfolio reaches its target level, Aames Financial may sell a portion of its loans in off-balance sheet securitizations depending on market conditions at that time. Aames Financial generally sells these loans within 45 days of funding and services these loans during the period between origination and transfer of servicing to the buyer, which is generally within 90 days after the sale of the loan. Aames Financial generates income primarily from:

Aames Financial uses the majority of the net proceeds of its loan sales to pay down its warehouse and repurchase facilities to increase capacity under these facilities for future funding of mortgage loans. Proceeds we receive from financings on loans held for investment are also used to pay down our warehouse and repurchase facilities.

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Mortgage Loan Servicing

Aames Financial services residential mortgage loans for itself and for others, and loan servicing remains an integral part of our business operation. We believe that maintaining contact with our borrowers is critical in managing credit risk and in borrower retention. Subprime borrowers are more likely to default on their obligations than conventional borrowers. By servicing our loans, we strive to identify problems with borrowers early and take quick action to address these problems. Borrowers may be more motivated to refinance their mortgage loans either by improving their personal credit or due to a decrease in interest rates. By keeping in close touch with borrowers, we can provide them with information about our products to encourage them to refinance with us. Mortgage servicing provides fee income for Aames Financial in the form of normal customer service and processing fees. We recognized $2.9 million and $2.2 million in loan servicing fee income during the three months ended March 31, 2005 and 2004, respectively.

Critical Accounting Policies

Owning a Portfolio of Hybrid/Adjustable Rate Loans.

We have a portfolio of loans held for investment in addition to Aames Financial’s portfolio of loans held for sale. Accordingly, the presentation of interest income and expense on these two portfolios has been modified from that which Aames Financial shows in its historical consolidated financial statements. We differentiate our interest income and expense into two components: “Interest income—loans held for sale” and “Interest income—loans held for investment.” Interest expense is also differentiated between “Interest expense—loans held for sale” and “Interest expense—loans held for investment.” We also record a provision for loan losses on loans held for investment, which increases our allowance for loan losses, based on an estimate of probable and inherent losses in our portfolio of loans held for investment.

Our investment portfolio of loans is shown on our balance sheet as “Loans held for investment.” Prior to our REIT reorganization, all loans were shown as “Loans held for sale, at lower of cost or market.” Because Aames Financial intends to sell a portion of its loans, we continue to show these loans as “Loans held for sale, at lower of cost or market.” Mortgage-backed bonds that we issue to finance our portfolio of loans held for investment are shown as “Financings on loans held for investment.” Warehouse financing of our loans held for sale and loans held for investment but not yet securitized are shown as “Revolving warehouse and repurchase facilities.”

Upon implementing our new business plan, we employed two critical accounting policies, one of which is related to our financing strategy of using on-balance sheet securitizations and one of which is related to our REIT conversion. These policies are:

Allowance for Losses on Mortgage Loans Held for Investment.

For mortgage loans held for investment, we maintain an allowance for loan losses based on our estimate of losses inherent and probable as of the balance sheet date. We evaluate the adequacy of this allowance quarterly, giving consideration to factors such as the current performance of the loans, historical performance of similar loans, credit characteristics of the portfolio, the value of the underlying collateral and the general economic environment. In order to estimate an appropriate allowance for losses on loans held for investment, we estimate losses using “static pooling,” which stratifies the loans held for investment into separately identified vintage pools. Using historic experience and taking into consideration the factors above, we estimate an allowance for loan losses, which we believe is adequate for probable and inherent losses in the portfolio of mortgage loans held for investment. Provisions for losses are charged to our consolidated statement of operations. Charge-offs of mortgage loans held for investment are charged to the allowance. While we use available information to recognize losses on loans held for investment, future additions to the allowance may be necessary based on changes in economic and other conditions.

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Accounting for Transfers and Servicing of Financial Assets.

We are generating a portfolio of loans held for investment through on-balance sheet securitizations and must comply with the provisions of FASB Statement No. 140 “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities,” or FAS 140, related to each securitization. FAS 140 is an accounting pronouncement that sets forth the criteria applicable to determining whether a transfer of financial assets is to be treated as a sale or a secured financing under generally accepted accounting principles, or GAAP. We intend for our on-balance sheet securitizations to be treated as secured financings and, accordingly, one of our critical accounting policies is compliance with the FAS 140 requirements necessary to obtain secured financing treatment for our securitizations. In addition, our strategy of retaining mortgage loans in our securitization pools on our balance sheet will reduce the number of loans we sell during the period in which we are building our retained portfolio. This will reduce the total gain on sale of loans until we build our retained portfolio and return to a pattern of selling loans.

Gain on Sale of Loans Held for Sale.

Our current loan disposition strategy relies on whole loan sales. We sell our loans in whole loan sale transactions on a cash basis. In whole loan sale transactions, the buyer acquires all future rights (including mortgage servicing rights) to the loans, without recourse except for standard representations and warranties. Gains and losses on whole loan sales are recognized when we surrender control over the loans (generally on the settlement date) based upon the difference between the proceeds received and the net carrying amount of the loans.

Accounting for Off-Balance Sheet Securitizations.

During the three months ended March 31, 2005, we did not dispose of any of our mortgage loans in off-balance sheet securitization transactions. Our retained residual interests relate to off-balance sheet securitizations which closed prior to and during the year ended June 30, 2000. The following discusses critical accounting policies which arise only in the context of off-balance sheet securitization transactions.

In an off-balance sheet securitization, we convey loans to a special purpose entity (such as a trust) in exchange for cash proceeds and a residual interest in the trust. The cash proceeds are raised through an offering of the pass-through certificates or bonds evidencing the right to receive principal payments and interest on the certificate balance or on the bonds. The non-cash gain on sale of loans represents the difference between the proceeds (including premiums) from the sale, net of related transaction costs, and the allocated carrying amount of the loans sold. The allocated carrying amount is determined by allocating the original cost basis of the loans (including premiums paid on loans purchased) between the portion sold and any retained interests (residual interests), based on their relative fair values at the date of transfer. The residual interests represent, over the estimated life of the loans, the present value of the estimated cash flows. These cash flows are determined by the excess of the weighted average coupon on each pool of loans sold over the sum of the interest rate paid to investors, the contractual servicing fee, a monoline insurance fee, if any, and an estimate for credit losses. Each agreement that we have entered into in connection with our securitizations requires the overcollateralization of the trust that may initially be funded by cash deposited by us. The amount and timing of the cash flows expected to be released from the securitization trusts considers the impact of the applicable delinquency and credit loss limits specified in the securitization agreements.

We determine the present value of the cash flows at the time each securitization transaction closes using certain estimates made by management at the time the loans are sold. These estimates include: (i) future rate of prepayment; (ii) credit losses; and (iii) discount rate used to calculate present value. The future cash flows represent management’s best estimate. Management monitors the performance of the loans, and any changes in the estimates are reflected in earnings. There can be no assurance of the accuracy of management’s estimates.

Our retained residual interests are recorded at estimated fair value and are marked to market through a charge (or credit) to earnings. On a quarterly basis, we review the fair value of our retained residual interests by

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analyzing our prepayment, credit loss and discount rate assumptions in relation to our actual experience and current rates of prepayment and credit loss prevalent in the industry. Additionally, on a quarterly basis we evaluate the effects, if any, that increasing or decreasing interest rates may have on the retained residual interests. We may adjust the value of our retained residual interests or take a charge to earnings related to the retained residual interests, as appropriate, to reflect a valuation or write-down, respectively, of our retained residual interests based upon the actual performance of the retained residual interests as compared to our key assumptions and estimates used to determine fair value. Although we believe that the assumptions used to estimate the fair value of the retained residual interests are reasonable, there can be no assurance as to the accuracy of the assumptions or estimates.

Rate of Prepayment.

The estimated life of the securitized loans depends on the assumed annual prepayment rate which is a function of estimated voluntary (full and partial) and involuntary (liquidations) prepayments. The prepayment rate represents management’s expectations of future prepayment rates based on prior and expected loan performance, the type of loans in the relevant pool (fixed or adjustable rate), the production channel which produced the loan, prevailing interest rates, the presence of prepayment penalties, the loan-to-value ratios and the credit grades of the loans included in the securitization and other industry data. The rate of prepayment may be affected by a variety of economic and other factors including, but not limited to, a declining mortgage interest rate environment.

Credit Losses.

In determining the estimate for credit losses on loans securitized, we use assumptions that we believe are reasonable based on information from our prior securitizations, the loan-to-value ratios and credit grades of the loans included in the securitizations, loss and delinquency information by origination channel, and information available from other market participants such as investment bankers, credit providers and credit agencies. On a quarterly basis, we re-evaluate our credit loss estimates.

Discount Rate.

In order to determine the fair value of the cash flow from the residual interests, we discount the cash flows based upon rates prevalent in the market.

We closely monitor our residual interests. If the actual rate of prepayment and credit loss performance of loans in the securitized pools vary adversely in relation to the estimates and assumptions used to estimate fair value, we will adjust the fair value of the retained residual interests through a charge to earnings. During the three months ended March 31, 2005 and 2004, the actual performance of our retained residual interests as compared to the key assumptions and estimates used to evaluate their carrying value did not result in write-downs.

We called two of the remaining seven securitization trusts on February 15, 2005. No adjustments to the carrying value of the residual interests by calling these securitization trusts was deemed necessary. If we call any of the five remaining securitization trusts, we might be required to write down the value of the residual interests relating to the called securitization trusts. We expect to call the five remaining securitization trusts during calendar year 2005.

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The following table summarizes certain information about the securitization trusts in which we retained a residual interest at March 31, 2005 and December 31, 2004 (dollars in thousands):

Certain historical data and key assumptions and estimates used in our March 31, 2005 and December 31, 2004 review of the residual interests we retained were the following:

To estimate the effects of changes in interest rates on the coupon rates of the adjustable rate mortgage loans, we consider current underlying indices, periodic interest rate caps, lifetime interest rate caps and contractual interest rate floors. In determining the interest rates for the floating rate pass-through certificates in the securitization trusts, we use each certificates’ specific spread over the one-month LIBOR.

The total actual and estimated credit losses, as a percentage of original principal balance of securitized loans, in each securitization trust, ranged from 3.8% to 6.2% at March 31, 2005 and ranged from 3.8% to 6.5% at December 31, 2004. Actual and estimated credit losses vary between securitization trusts due to differing credit quality i.e., credit grade, production channel and other factors we considered when evaluating credit loss estimates.

Accounting for Income Taxes.    We have elected to be taxed as a REIT for federal tax purposes which means that generally we are not subject to U.S. federal income taxes on the REIT income that we distribute to our stockholders.

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Aames Financial’s taxable income is subject to regular corporate income tax. Taxes are provided on substantially all income and expense items included in earnings of Aames Financial regardless of the period in which such items are recognized for tax purposes. We use an asset and liability approach that requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in our financing statements or tax returns. In estimating future tax consequences, we generally consider all expected future events other than the enactment of changes in the tax law or rates.

Deferred income tax assets and liabilities are recognized by Aames Financial to reflect the future tax consequences of net operating loss carry forwards and differences between the tax basis and financial reporting basis of assets and liabilities. We have established a valuation allowance to reflect management’s determination that it is not more likely than not that certain deferred tax assets will be realized. The realization of deferred tax assets is evaluated by management quarterly and changes in realizability are reflected in the provision for income taxes.

Results of Operations

The following table sets forth information regarding our results of operations during the three months ended March 31, 2005 and 2004 (in thousands):

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Interest Income and Interest Expense

Interest income.    Interest income includes interest earned on loans held for investment and loans held for sale. To a lesser extent, interest income also includes interest on short-term overnight investments, discount accretion income recognized on our residual interests and the amortization of net deferred loan origination fees and costs on mortgage loans held for investment. The following table summarizes the components of interest income during the three months ended March 31, 2005 and 2004 (in thousands):

During the December 2004 quarter and in connection with our formation as a mortgage REIT, we began to build a portfolio of loans held for investment which, at March 31, 2005, was comprised of mortgage loans with an unpaid principal balance of $2.9 billion. We did not have a portfolio of loans held for investment at March 31, 2004. Our interest income increased $34.1 million to $51.8 million during the three months ended March 31, 2005 over $17.7 million during the three months ended March 31, 2004. The $34.1 million increase in interest income was due primarily to the $40.9 million of interest income earned on the portfolio of loans held for investment. To a lesser extent, the increase in interest income during the three months ended March 31, 2005 over the comparable three month period a year ago was due to increases of $2.7 million and $0.2 million of miscellaneous interest income and interest income earned on overnight investments, respectively. Substantially all of the $2.7 million of other interest income related to remittances to us from counterparties on in-the-money interest rate cap agreements used to hedge interest rate exposure to our REIT portfolio and related financings. Partially offsetting the increase in interest income during the three months ended March 31, 2005 over the comparable three month period a year ago were declines of $8.8 million and $1.0 million in interest income on loans held for sale and discount accretion on our residual interests. Interest income earned on loans held for sale declined due to our strategy of building a portfolio of loans held for investment which resulted in our holding a lower average balance of loans held for sale during the three months ended March 31, 2005 when compared to the average balance of loans held for sale outstanding during the three months ended March 31, 2004, partially offset by higher weighted average coupon rates on loans held for sale during the March 2005 quarter when compared to such rates during the March 2004 quarter. We have discontinued recognizing discount accretion income on our residuals in light of our expectation to call the remaining securitization trusts later in calendar 2005.

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Interest expense.    Interest expense includes interest borne on the balances outstanding of financings on loans held for investment and revolving warehouse and repurchase facilities and borrowings. Interest expense also includes fair value adjustments to derivative instruments used to hedge interest rate risk on our financings of mortgage loans held for investment, amortization of debt issuance expenses and debt discount on financings on mortgage loans held for investment and the amortization of commitment fees on revolving warehouse and repurchase facilities. The following table summarizes the components of interest expense during the three months ended March 31, 2005 and 2004 (in thousands):

Interest expense increased $5.3 million to $11.9 million during the three months ended March 31, 2005 over $6.6 million during the three months ended March 31, 2004. The increase in interest expense reported during the three months ended March 31, 2005 from levels reported during the comparable three month period a year ago was primarily due to increases of $12.2 million and $3.7 million in interest expense on financings on loans held for investment and revolving warehouse and repurchase facilities, respectively. At March 31, 2005, the unpaid principal balance of financings on loans held for investment was $2.3 billion. We had no financings on loans held for investment at March 31, 2004. During the three months ended March 31, 2005, average borrowings and interest rates associated with our revolving warehouse and repurchase facilities used to fund loans held for sale and loans held for investment not yet securitized were higher than such average balances and interest rates during the comparable three month period a year ago. These increases were offset partially by a $9.5 million credit to interest expense related to the positive mark to fair value at March 31, 2005 of open interest rate cap agreements in place to hedge interest rate risk exposure on our financings on loans held for investment. In addition, interest expense on borrowings declined by $1.0 million during the three months ended March 31, 2005 from the comparable period a year ago due to the lower balance outstanding of Aames Financial’s residual financing facility during the March 2005 quarter (during which it was fully redeemed) compared to the higher balance outstanding during the March 2004 quarter despite a higher interest rate applicable to the obligation during the March 2005 quarter than during the March 2004 quarter as the interest rate was indexed to one-month LIBOR.

Interest expense is expected to increase in future periods due to our business strategy of financing our loans held for investment through warehouse and repurchase facilities and on-balance sheet securitizations, our continued reliance on warehouse and repurchase facilities to fund mortgage loan production and expected continued upward pressure on the one-month LIBOR, the index used in our borrowing arrangements, in coming quarters.

Other Income

Gain on Sale of Loans.    Gain on sale of loans includes gain from whole loan sale transactions, recognized and deferred loan origination fees and costs, provisions for representation, warranty and other miscellaneous losses, gains and losses on derivative instruments and miscellaneous costs related to loan sale activities. Gain on

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sale of loans is impacted by the timing and mix of loan origination and sales as net, pursuant to FAS 91, loan origination fees and costs related to mortgage loans originated and held for sale are deferred and recognized in gain on sale of loans at the time the mortgage loans are sold. The deferral of net loan origination fees and costs was not material to our consolidated financial statements at and during the three months ended March 31, 2004. The components of gain on sale of loans during the three months ended March 31, 2005 and 2004 are summarized in the following table (in thousands):

Gain on sale of loans decreased $48.9 million, or 89.6%, to $5.7 million during the three months ended March 31, 2005 from $54.6 million during the comparable three month period a year ago. The $48.9 million decrease was due primarily to a $66.9 million decrease in gain on sale from whole loan sale transactions, partially offset by an increase of $10.5 million in net loan origination fees and costs, and a $7.6 million decrease in the provision for representation, warranty and other miscellaneous losses.

The $66.9 million decrease in gain on sale was due primarily to our strategy of retaining the majority of our hybrid/adjustable rate loan production in our REIT portfolio which resulted in a $1.4 billion, or 81.8%, decrease in mortgage loan sales to third parties during the three months ended March 31, 2005 from mortgage loan sales to third parties during the comparable three month period a year ago. Because we sold only fixed rate first-lien loans and second-lien loans to third parties during the March 2005 quarter, gain on sale also declined due to lower gain on sale rates realized on whole loan sales during the three months ended March 31, 2005 compared to such rates during the comparable 2004 period. Due to the change in the mix in the composition of loans originated and sold during three months ended March 31, 2005 from the same period a year ago, realized net loan origination fees were $2.1 million during the March 2005 quarter compared to realized net loan origination costs of $8.3 million during the three months ended March 31, 2004. During the three months ended March 31, 2005, realized net loan origination fees were $2.1 million compared to realized net loan origination costs of $8.3 million during the three months ended March 31, 2004. Due to the change in the mix in the composition of loans originated and sold during the three months ended March 31, 2005 from the same period a year ago. Finally, during the three months ended March 31, 2005, we charged $0.8 million to gain on sale of loans for estimated contractual representation and warranty obligations on loans previously sold and for loans held for sale that are delinquent, have collateral deficiencies or have other attributes that affect their sale potential. This $7.6 million decrease from the $8.4 million provided during the three months ended March 31, 2004 was due principally to fewer loans having been sold in whole loan sales during the three months ended March 31, 2005 when compared to the same three month period a year ago.

Loan Servicing.    Loan servicing revenue consists of prepayment fees, late charges and other fees we retain and servicing fees earned on securitized pools, reduced by subservicing costs related to servicing advance arrangements. See “Critical Accounting Policies.” Loan servicing revenue increased $0.7 million to $2.9 million during the three months ended March 31, 2005 from $2.2 million during the three months ended March 31, 2004. The increase was primarily due to an increase in late and prepayment fees of $1.7 million partially offset by decreases of $0.9 million and $0.2 million in servicing and beneficiary demand fees, respectively.

Total Operating Expenses

General.    Total operating expenses decreased $5.1 million to $42.0 million during the three months ended March 31, 2005 from $47.1 million during the three months ended March 31, 2004. The decrease in total

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expenses during the three months ended March 31, 2005 from total expenses during the comparable period in 2004 was attributable to decreases of $3.0 million, $1.5 million and $0.6 million in personnel expense, production, and general and administrative expense, respectively.

Personnel.    Personnel expense includes salaries, payroll taxes and medical and other employee benefits. Personnel expense also includes commissions that are generally related to our loan origination volume, as retail and broker account executives earn incentives on funded loans. Pursuant to FAS 91, direct personnel costs incurred on mortgage loans originated but not yet sold are deferred to future periods and recognized as a charge to gain on sale at the time the mortgage loans are sold.

The following table summarizes the components of personnel expense during the periods presented (in thousands):

Personnel expense decreased $3.0 million during the three months ended March 31, 2005 from personnel expense during the comparable three-month period a year ago. The $3.0 million decrease was comprised of decreases of $7.5 million and $0.3 million in compensation and medical and other benefits, respectively, partially offset by a $4.7 million decrease in net deferred loan origination costs and a $0.1 million increase in miscellaneous personnel expense. The $7.5 million decrease in compensation resulted from a $5.5 million decline in commissions, bonuses and incentives, coupled with a $2.0 million decrease in management bonus incentives. The $5.5 million decrease in commissions, bonuses and incentives during the three months ended March 31, 2005 from those reported during the comparable three month period during 2004 was due to the $504.6 million, or 27.0%, decrease in total loan originations reported during the three months ended March 31, 2005 when compared to the same three month period a year ago. Net deferred personnel costs on mortgage loans originated but not yet sold decreased $4.7 million during the three months ended March 31, 2005 over those reported a year ago due primarily to the mix in the composition of loans originated and sold during the 2005 period when compared to those originated and sold during the 2004 period. The $0.3 million decrease in health, medical and other benefit costs during the three months ended March 31, 2005 from the amount reported during the comparable period a year ago was attributable to decreased staff levels.

Production.    Production expense decreased $1.5 million, or 14.8%, to $8.8 million during the three months ended March 31, 2005 from $10.3 million during the three months ended March 31, 2004. The $1.5 million decrease in production expense was due primarily to a $0.4 million decrease in advertising expense, a $0.7 million decrease in appraisal costs, a $0.1 million decrease in travel and entertainment expenses, coupled with a $0.3 million decrease in sales incentives relative to the $504.6 million, or 27.0%, decrease in our loan production volumes during the three months ended March 31, 2005 from production volumes during the three months ended March 31, 2004.

Production expense when expressed as a percentage of total loan origination volume for the three months ended March 31, 2005 increased to 0.7% from 0.6% at March 31, 2004 primarily due to a larger decrease in loan production than in production expense during the three months ended March 31, 2005 from amounts reported during the three months ended March 31, 2004.

General and Administrative.    General and administrative expense decreased $0.6 million, or 0.5%, to $10.8 million during the three months ended March 31, 2005 from $11.4 million during the three months ended March

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31, 2004. The $0.6 million decrease in general and administrative expense was due primarily to decreases of $0.2 million, $0.5 million and $0.3 million in professional, communication and depreciation expenses, respectively. These decreases were partially offset by increases of $0.3 million and $0.2 million in occupancy and corporate related insurance respectively.

During the three months ended March 31, 2005 and 2004, we paid total rent of $2.8 million and $2.4 million, respectively, and received total sublease payments of $0.1 million during both the three months ended March 31, 2005 and 2004.

Financial Condition

Loans Held for Sale.    Our portfolio of loans held for sale decreased to $383.5 million at March 31, 2005 from $485.0 million at December 31, 2004 due primarily to total loan sales and transfers of mortgage loans to loans held for investment exceeding total loan originations during the three months ended March 31, 2005.

Loans Held for Investment, Net.    At March 31, 2005, our portfolio of loans held for investment, net was $2.9 billion, an increase of $1.2 billion over the $1.7 billion portfolio of loans held for investment at December 31, 2004. During the three months ended March 31, 2005, we completed a $1.2 billion on-balance sheet securitization. At March 31, 2005, the portfolio of loans held for investment was comprised of $2.3 billion and $0.6 billion of loans securitized and loans not yet securitized, respectively. In comparison, at December 31, 2004, the $1.7 billion portfolio of loans held for investment was comprised of $1.2 billion and $0.5 billion of securitized loans held for investment and loans held for investment not yet securitized, respectively.

The portfolio of loans held for investment at March 31, 2005 and December 31, 2004 of $2.9 billion and $1.7 billion, respectively, were net of an $8.4 million and $1.9 million allowance for loan losses, respectively. During the three months ended March 31, 2005, we recorded a provision for loan losses of $6.5 million and no loan charge-offs were recorded.

Advances and Other Receivables.    Advances and other receivables are comprised of interest and servicing advances, servicing and miscellaneous fees, cash due from the off-balance sheet securitization trusts, accrued interest receivable and other miscellaneous receivables. The level of servicing advances, in any given period, depends upon portfolio delinquencies, the level of real estate owned and loans in the process of foreclosure, and the timing and remittance of cash collections on mortgage loans in the securitization trusts. We fund advances on a recurring basis not otherwise covered by our financing arrangements and recover those advances on a periodic basis.

Advances and other receivables increased $1.9 million to $24.6 million at March 31, 2005 from $22.7 million at December 31, 2004. The increase was due primarily to increases of $7.0 million and $1.3 million in advances, accrued interest and other receivables and principal and interest advances, respectively, partially offset by decreases of $6.2 million and $0.3 million in interest and servicing advances and cash due from securitization trusts, respectively.

The $7.0 million increase in accrued interest and other receivables at March 31, 2005 over the balance at December 31, 2004 is due primarily to a $5.6 million increase in accrued interest relative to the increase in the balance of loans held for investment together with a $1.4 million increase in amounts due from counterparties. The $1.3 million increase in principal and interest advances is due to the advances made to bond holders in our on-balance sheet securitizations. The $6.2 million decrease in interest and servicing advances at March 31, 2005 from December 31, 2004 was primarily due to recoveries of prior advances as a result of the call of two of our off-balance sheet securitizations. The $0.2 million decline in cash due from securitization trusts at March 31, 2005 from December 31, 2004 is due primarily to a decline in estimated cash flows on lower residual balances at March 31, 2005 when compared to the balance at December 31, 2004.

Residual Interests.    Residual interests decreased to $18.9 million at March 31, 2005 from $39.1 million at December 31, 2004, reflecting $20.2 million of cash received from the securitization trusts. Of the $20.2 million

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of cash received from the securitization trusts, $18.3 million was received in connection with our calling two securitization trusts during the three months ended March 31, 2005. We have elected not to recognize discount accretion on the remaining residual interests in light of our expectation to call our remaining five securitization trusts during calendar 2005.

Equipment and Improvements, Net.    Equipment and improvements, net, increased to $9.1 million at March 31, 2005 from $8.8 million at December 31, 2004 reflecting capitalization of new equipment and improvement acquisitions outpacing depreciation and amortization during the three months ended March 31, 2005.

Prepaid and Other Assets.    Prepaid assets decreased to $20.9 million at March 31, 2005 from $22.1 million at December 31, 2004. The decrease was due to decreases of $2.8 million, $0.6 million, $0.4 million and $3.7 million in licensing, permit and performance bond desposits, unamortized commitment fees on revolving warehouse and repurchase facilities, prepaids, security deposits and other deferred charges, and defunded loans, respectively, offset partially by increases of $6.3 million in unamortized debt issuance costs related to the on-balance sheet securitization.

Derivative Financial Instruments.    At March 31, 2005, we have notional amounts of $4.2 billion compared to $2.5 billion at December 31, 2004 of interest rate cap agreements in place to hedge rate risk exposure to our portfolio of mortgage loans held for investment and related financings. We carry out derivative financial instruments at estimated fair value which at March 31, 2005 was $52.0 million compared to $31.9 million at December 31, 2004. Included in interest expense during the three months ended March 31, 2005, was a $9.5 million credit related to the mark-to-market of our interest rate cap agreements at March 31, 2005. At and during the three months ended March 31, 2004, we did not have any hedge instruments in place.

Financing on Loans Held for Investment.    Amounts outstanding under our financing on loans held for investment increased to $2.3 billion at March 31, 2005 from $1.2 billion at December 31, 2004 resulting from the on-balance sheet securitization that closed during the quarter ended March 31, 2005.

Borrowings.    On March 15, 2005, we fully repaid the remaining balance outstanding under Aames Financial’s residual financing facility which, at December 31, 2004, was $7.7 million.

Revolving Warehouse and Repurchase Facilities.    Amounts outstanding under revolving warehouse and repurchase facilities increased to $854.4 million at March 31, 2005 from $809.2 million at December 31, 2004 primarily as a result of increased reliance on the facilities to fund loans held for investment prior to their securitization. Proceeds from whole loan sales and securitizations are used first to reduce balances outstanding under our revolving warehouse and repurchase facilities, and then used to satisfy corporate operating requirements.

MORTGAGE PORTFOLIO MANAGEMENT

On February 24, 2005, we completed a securitization totaling $1.2 billion, our second securitization as a REIT. This securitization was structured as an on-balance sheet securitization for accounting purposes under SFAS No. 140. Prior to our reorganization, Aames Financial’s securitizations were structured as sales for both tax and financial accounting purposes. We did not complete any securitizations during the three months ended March 31, 2004. Once we have built our REIT portfolio to its target range, we expect net interest income from our portfolio of mortgage loans to generate a substantial portion of our earnings.

We expect to purchase most of Aames Financial’s mortgage loan originations while we build our REIT portfolio. We have not established a limit on the amount of leverage we may incur, but generally we plan to leverage our stockholders’ equity 10 to 14 times. Once we have built our REIT portfolio to its target range, we anticipate purchasing a smaller portion of Aames Financial’s originations to maintain our target leverage ratio. Aames Financial will then sell the remainder of its loan originations, including a portion of its hybrid/adjustable rate mortgage loans, to third parties in the secondary market.

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A significant risk to our operations that relates to our REIT portfolio management is the risk that interest rates on our assets will not adjust at the same time or amount as the rates on our liabilities adjust. This is because the interest on the underlying hybrid/adjustable rate mortgage loans is based on fixed rates payable on the underlying loans for the first two or three years from origination while the holders of the applicable securities are generally paid based on an adjustable one-month LIBOR-based yield. Moreover, even after the initial fixed period, our loans generally adjust every six months and are subject to periodic rate caps, whereas the bonds adjust monthly based primarily on LIBOR. Therefore, an increase in one-month LIBOR generally reduces the net interest income we receive from our securitized loan portfolio. We attempt to mitigate a portion of this net interest margin variability by purchasing derivative financial instruments referred to as interest rate cap agreements. In addition, the net interest income we receive from securitizations will be reduced if there are a significant amount of loan defaults or loan prepayments, especially on loans with interest rates that are high relative to the rest of the securitized mortgage loan pool.

We do not use formalized hedge accounting for our derivative financial instruments as set forth in generally accepted accounting principles in the United States. Instead, we are required to record the change in the value of the derivatives as a component of earnings even though they may reduce our interest risk. In times where short-term rates drop significantly, the value of our interest rate caps will decrease; in times where short-term rates increase, the value of the interest rate caps will increase. The interest rate caps are designed to exchange the cost of our variable rate liabilities to fixed rates for the first two years of its estimated duration thereby better matching our interest-bearing fixed rate assets.

INVESTMENT AND OPERATIONAL POLICIES

Our investment strategy is subject to change if and when our board of directors determines that a change is in our stockholders’ best interest. Neither stockholder approval nor notification is required prior to changing our investment strategy.

Mortgage Loans

In general, our strategy is to build a portfolio of mortgage loans primarily originated by Aames Financial. Our mortgage loans are generally underwritten in accordance with the categories and criteria described in our underwriting guidelines. See “Underwriting Standards.”

Mortgage-backed Securities

Our current REIT portfolio consists of mortgage loans originated by Aames Financial that collateralize mortgage-backed securities and mortgage loans originated by Aames Financial that will collateralize future mortgage-backed securitizations.

If we change our investment strategy, the new strategy may entail more risk than our current investment strategy. Alternative strategies that our board of directors may choose to put in place include:

Leverage Policy

We employ a leverage strategy by securitizing existing mortgages in transactions that we believe will be treated as borrowings for accounting and tax purposes. We generally intend to borrow approximately 10 to 14 times the amount of our consolidated equity capital, although our actual debt to equity ratio may vary from time to time depending on market conditions and other factors that our management and board of directors deem

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relevant. In general, our credit facilities limit our total debt-to-equity ratio to a level of 15.0 to 1.0. However, each of our credit facility lenders disregards nonrecourse financing, including the bonds underlying our on-balance sheet securitizations, in computing our adjusted leverage ratio which is limited to 5.5 to 1.0. Our actual total and adjusted leverage ratios were 8.9 to 1.0 and 2.6 to 1.0 at March 31, 2005, respectively.

Hedging Policy

To mitigate the adverse effects from interest increases on our mortgage loans held for sale or investment, we use several tools and risk management strategies to monitor and address interest rate risk. We believe that these tools allow us to monitor and evaluate our exposure to interest rates and to manage the risk profile of our mortgage loan portfolio in response to changes in market conditions. As part of our interest rate risk management process, we have used derivative financial instruments, such as interest rate cap agreements, interest rate swap agreements, Treasury futures and options on interest rates. We can also use other hedging instruments including mortgage derivative securities, when necessary. Hedging strategies also involve transaction and other costs. Because we use derivative financial instruments more than we did prior to the REIT reorganization, the aggregate costs to us of entering into contracts for these instruments is significantly higher than in the past.

We currently use derivative financial instruments such as interest rate cap agreements. It is not our policy to use derivatives to speculate on interest rates. These derivative instruments have an active secondary market and are intended to provide supplemental income and cash flow to offset potential reduced interest income and cash flow in certain interest rate environments. We report our derivative financial instruments on our consolidated balance sheets at their fair value with any changes in fair value reported as either a charge or credit to the consolidated statement of operations.

Financing Policy

We may raise funds through additional equity offerings, debt financings, retention of cash flow, or a combination of these methods subject to Internal Revenue Code provisions regarding distribution requirements and taxability of undistributed REIT taxable income. If our board of directors decides to raise additional equity capital, it has the authority to issue additional common or preferred stock, in any manner and on terms it deems appropriate, up to the amount authorized in our articles of incorporation without stockholder approval.

Currently, our borrowings consist primarily of funds borrowed under revolving warehouse and repurchase facilities and financings on loans held for investment. Borrowings going forward may be in the form of bank borrowings, secured or unsecured, and publicly or privately placed debt instruments, purchase money obligations to the sellers of assets, long-term, tax-exempt bonds or other publicly or privately placed debt instruments, financing from banks, institutional investors or other lenders, and securitizations, including collateralized debt obligations, any of which may be unsecured or secured by mortgages or other interests in the assets. This indebtedness may entail recourse to all or any part of our assets or may be limited to the particular assets to which the indebtedness relates.

We enter into collateralized borrowings only with institutions that we believe are financially sound and that are rated investment grade by at least one nationally recognized statistical rating organization.

MORTGAGE ORIGINATIONS

As at March 31, 2005 Aames Financial originated loans in 47 states through its retail and wholesale channels. Its wholesale channel operated five regional wholesale operations centers throughout the United States and originated loans through a nationwide network of approximately 4,400 independent mortgage brokers who submit mortgage loans to it. Its retail channel had a network of 94 retail branch offices directly serving borrowers throughout the United States.

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The following table shows our total originations by retail and wholesale channels for the three months ended March 31, 2005 and 2004 (in thousands):

A significant risk to our mortgage originations operations is liquidity risk—the risk that we will not have the financing facilities and cash available to fund and hold loans prior to their sale or securitization. We maintain committed borrowing facilities with large banking and investment institutions to reduce this risk.

Our Retail Channel

We generate applications for loans through our retail loan office network principally through a direct response marketing program, which relies primarily on the use of direct mailings to homeowners, telemarketing and Internet generated leads and through referrals from our customers, real estate agents and others. We generate customer leads for the retail network based upon models that we have derived and commercially developed customer lists. Our direct mail invites prospective borrowers to call us to apply for a loan. We also generate leads through several commercially available Internet sites as well as through our own retail Internet web site “Aames.net”. We believe that our marketing efforts establish name recognition and serve to distinguish us from our competitors. We continually monitor the source of our applications to determine the most effective methods and manner of marketing. Whether generated through direct mail or the Internet, leads are generally followed up with telephone calls to potential customers. On the basis of an initial screening conducted at the time of the call, our loan officers at the local retail loan office make a determination of whether the customer and the property generally meet our lending criteria. The loan officer may complete the application over the telephone or schedule an appointment with the retail loan office most conveniently located to the customer or in the customer’s home, depending on the customer’s needs.

The retail loan officer assists the applicant in completing the loan application, arranges for an appraisal, orders a credit report from an independent, nationally recognized credit reporting agency and performs various other tasks in connection with the completion of the loan package. The loan package is underwritten for loan approval on a centralized basis. If we approve the loan package, the loan is funded. Our loan officers are trained to structure loans that meet the applicant’s needs while satisfying our lending guidelines.

We continually monitor our retail operations in the markets in which we operate and evaluate existing and potential retail offices on the basis of selected demographic statistics, marketing analyses and other criteria that we have developed in order to further enhance our mortgage loan production capabilities. As previously disclosed, as part of this evaluation process, we have closed 11 retail branches in April 2005 in markets where it was not financially feasible to continue to service the market area in this manner. However, we continue to service these areas through our wholesale channel and the Internet.

Our Wholesale Channel

During the three months ended March 31, 2005, we originated loans through our network of approximately 4,400 independent wholesale mortgage brokers throughout the United States, none of which accounted for more than 5.0% of total wholesale originations.

The broker’s role is to identify the applicant, assist in completing the loan application, gather necessary information and documents, submit the application requesting the interest rate and terms of the loan, and serve as

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our liaison with the borrower through the lending process. We review and underwrite the applications submitted by the broker in accordance with our underwriting guidelines and then approve or deny the application. If the loan is approved, we approve or counter the requested interest rate and other terms of the loan and, upon acceptance by the borrower and satisfaction of all conditions imposed by us, we fund the loan. Because brokers conduct their own marketing and employ their own personnel to complete loan applications and maintain contact with borrowers, originating loans through our wholesale network allows us to increase our loan volume without incurring the higher marketing and employee costs associated with retail originations.

Because mortgage brokers generally submit loan files to several prospective lenders simultaneously, competitive pricing, consistent underwriting, quick response times and personal service are critical to successfully producing loans through independent mortgage brokers. To meet these requirements, we strive to provide quick response time to the loan application (generally within 24 hours). In addition, the loans are processed and underwritten in regional offices, and loan consultants, loan processors and underwriters are available to answer questions, assist in the loan application process and facilitate ultimate funding of the loan.

We use telemarketing and the Internet to increase our wholesale loan production and further penetrate the subprime home equity wholesale market through our “Broker Direct” program. Through Broker Direct, we make outbound telemarketing calls to brokers that have been inactive for the past 90 days and brokers who are not currently doing business with us or are outside the geographic areas served by the loan officers. We also obtain leads through our wholesale Internet web site “AamesDirect.com.”

The following table presents certain information about our mortgage loan production at or during the three months ended March 31, 2005 and 2004 and December 31, 2004: