Cohen & Co Inc. - Quarter Report: 2004 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended: September 30, 2004

OR

For the transition period from              to             

Commission File Number: 001-32026

SUNSET FINANCIAL RESOURCES, INC.

(Exact name of registrant as specified in its governing instruments)

10245 Centurion Parkway, Third Floor

Jacksonville, FL 32256

(Address of principal executive offices, Zip Code)

Registrant’s telephone number, including area code: (904) 425-4099

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

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

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934).    Yes  ¨    No  x

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Index

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Sunset Financial Resources, Inc

Consolidated Balance Sheets

(dollar amounts in thousands)

See notes to consolidated financial statements.

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Sunset Financial Resources, Inc

Consolidated Statement of Operations (unaudited)

(dollar amounts in thousands, except per share amounts)

See notes to consolidated financial statements.

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Sunset Financial Resources, Inc

Consolidated Statement of Other Comprehensive Income (Loss) (unaudited)

(dollar amounts in thousands)

See notes to consolidated financial statements.

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Sunset Financial Resources, Inc

Consolidated Statement of Shareholders’ Equity (unaudited)

(dollar amounts in thousands)

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Sunset Financial Resources, Inc

Consolidated Statement of Cash Flows (unaudited)

(dollar amounts in thousands)

See notes to consolidated financial statements.

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Sunset Financial Resources, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note A – ORGANIZATION

Sunset Financial Resources, Inc. (the “Company”) was incorporated in Maryland on October 6, 2003 under the name of Sunset Capital Investments, Inc. but had limited operations until the first quarter of 2004.

On November 17, 2003, Sunset Capital Investments, Inc. filed amended articles of incorporation to change its name to Sunset Financial Resources, Inc. and to change the number of authorized shares of preferred stock from 15,000,000 to 50,000,000 and to change the number of authorized common shares from 50,000,000 to 100,000,000.

On November 28, 2003, the Company executed stock exchange agreements with its founding stockholders whereby the 1,999,400 shares of Sunset Capital Investments, Inc. common stock issued at formation were exchanged for 466,667 shares of Sunset Financial Resources, Inc. common stock.

On December 5, 2003, the Company granted 20,000 shares of restricted stock to its advisory board member. The shares vest one year from the date of completion of the Company’s initial public offering (March 17, 2005) and will be reflected as issued and outstanding for accounting purposes when vested.

On March 17, 2004, the Company completed its initial public offering of 10,000,000 shares of common stock. In conjunction with the issuance of stock to the public, founding stockholders surrendered 16,667 shares of stock, stock options on 262,000 shares of stock were granted to officers and directors, and warrants were issued to the Sapphire Group to acquire up to 233,000 shares of common stock.

Note B – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Basis of Presentation

The Company’s books and records are maintained on the accrual basis of accounting in accordance with accounting principles generally accepted in the United States and include all of the Company’s accounts and its 100% owned subsidiaries, Sunset Investment Vehicle, Inc. and SFR Subsidiary, Inc. The Company consolidates all entities in which it has a controlling interest as determined by a majority ownership interest in the common stock of such entities or the ability to exercise control and consolidates any variable interest entities for which it is the primary beneficiary. The financial statements reflect all adjustments management considers necessary, and all of these adjustments are of a normal and recurring nature. The Company’s fiscal year end is December 31 of each year.

Use of Estimates

The presentation of the financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from these estimates.

Profit and Loss Allocations and Distributions

As a REIT, the Company intends to declare regular quarterly distributions in order to distribute substantially all of its taxable income to stockholders each year.

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Investment Securities

The Company’s investment portfolio consists of mortgage-backed securities and in the future potentially other types of securities. The mortgage backed securities are securities that qualify as REIT assets. Proceeds of stock or debt offerings may be invested in other securities until the capital can be deployed into mortgage related assets.

In most cases, investment securities will be held as Available for Sale with any mark to market adjustment shown in other comprehensive income.

Mortgage Loans

The Company invests in mortgage loans and maintains a loan portfolio on its balance sheet. These loans are carried at historical cost with any initial premium or discount being amortized as a yield adjustment. The Company will primarily invest in hybrid adjustable rate mortgage loans (ARMs). These are loans that have an initial fixed term with the remaining term being floating. The initial fixed period ranges from one to seven years.

When the Company securitizes loans and retains 100% of the beneficial interests, the loans are reclassified to securitized loans on the balance sheet. Securitized loans are carried at historical cost.

Retained Interests in Loan Securitizations

The Company uses securitization as a method of funding its mortgage loans. Securitization will either be used as described under Loans or to create Collateralized Debt Obligations that are shown as secured borrowings. For secured borrowings, both the loans and the debt will be reflected in the balance sheet. In either case, there will not be gain on sale accounting treatment.

Retained interests in securitizations (other than investment securities) will be accounted for as Available for Sale securities and carried at estimated fair value, with unrealized gains or losses included in stockholders’ equity (accumulated other comprehensive income or loss). The Company is not aware of an active market for the purchase and sale of these retained interests at this time; accordingly, we will estimate the fair value of the retained interest by calculating the present value of the estimated expected future cash flows received after being released by the securitization trust, using a discount rate commensurate with the risk involved. The cash flows being discounted will be adjusted for estimated net losses due to defaults or prepayments of the underlying loans.

Changes in the fair value of the retained interests resulting from changes in the timing of cash flows to be received or changes in market interest rates will be adjusted through other comprehensive income in shareholders’ equity. Reductions in the estimated aggregate cash flows to be received, caused by defaults or prepayments or the timing of expected future cash flows that result in a reduction to the fair value of the retained interests, will be considered an other than temporary impairment and will be recognized through a charge to expense in that period.

Accounting for Stock Compensation

The Company accounts for stock based awards in accordance with the fair value recognition provisions of SFAS Statement No. 123 “Accounting for Stock-Based Compensation” (FAS 123).

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The Company records an expense for the fair value of stock based awards. Awards to non-employee service providers will be measured on the earlier of (1) the performance commitment date or (2) the date the services required under the arrangement have been completed. The fair value will be measured using the Black-Scholes option pricing model over the contractual term of the award. If performance of services has already occurred, expense is recorded based on the fair value on the date of grant.

Interest on Loans

Interest is accrued monthly on outstanding principal balances unless management considers the collection of interest to be uncertain. The Company generally considers the collection of interest to be uncertain when loans are contractually past due three months or more.

Hedging Activities

The Company enters into interest rate swap transactions to extend the duration of its short-term liabilities funding mortgage related assets. These swaps are accounted for as cash flow hedges under Statement of Financial Accounting Standards No. 133 “Accounting for Derivative Instruments and Hedging Activities”, as amended (SFAS No. 133). The fair value of the hedge is recorded on the balance sheet, with the effective portion of the hedge being carried in other comprehensive income in shareholders’ equity. Any ineffectiveness is recognized through the income statement.

The Company may enter into certain other transactions, including short sales, purchases of treasury options, mortgage-backed securities and futures, interest rate swaps, caps and floors to mitigate the effect that changes in interest rates have on the fair value of its fixed rate loan and mortgage-backed securities portfolios. Periods of rising interest rates will generally decrease the fair value of the loan or mortgage-backed securities portfolio.

Income Taxes

The Company will elect to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code and, upon the election being made, will be taxed as such beginning with the taxable year ending December 31, 2004. To qualify as a REIT, the Company must meet certain organizational and operational requirements, including a requirement to currently distribute at least 90% of ordinary taxable income to stockholders. As a REIT, the Company generally will not be subject to federal income tax on taxable income that the Company distributes to its stockholders. If the Company fails to qualify as a REIT in any taxable year, it will then be subject to federal income taxes on taxable income at regular corporate rates starting with that year and will not be permitted to qualify for treatment as a REIT for federal income tax purposes for four years following the year during which qualification is lost unless the Internal Revenue Service were to grant relief under certain statutory provisions.

Allowance for Loan Losses

The Company provides an allowance for loan losses related to its loan portfolio. Loan loss provisions are based on an assessment of numerous factors affecting the portfolio of mortgage assets including, but not limited to, current and projected economic conditions, delinquency status, credit losses to date on underlying mortgages and any remaining credit protection. Loan loss provision estimates are reviewed periodically and adjustments are reported in earnings when they become known.

Fixed Assets

The Company has capitalized costs related to long lived assets to be used in the business. These assets are depreciated or amortized over their estimated useful lives, which range from two to five years.

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Reverse Repurchase Agreements

The Company borrows money through the use of reverse repurchase agreements. Under these repurchase agreements, the Company sells securities or securitized loans to a lender and agrees to repurchase the same instruments at a predetermined price and date. Although structured as a sale and repurchase obligation, a repurchase agreement operates as a financing under which the Company pledges assets as collateral to secure a loan which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. The Company retains beneficial ownership of the pledged collateral. At the maturity of a repurchase agreement, the Company is required to repay the loan and concurrently receives back its pledged collateral from the lender or, with the consent of the lender, the Company may renew such agreement at the then prevailing financing rate. These repurchase agreements may require the Company to pledge additional assets to the lender in the event the estimated fair value of the existing pledged collateral declines.

Should a counter-party decide not to renew a repurchase agreement at maturity, the Company must either refinance elsewhere or be in a position to satisfy this obligation. If, during the term of a repurchase agreement, a lender should file for bankruptcy, the Company might experience difficulty recovering its pledged assets and may have an unsecured claim against the lender’s assets for the difference between the amount loaned to the Company and the estimated fair value of the collateral pledged to such lender. To reduce this risk, the Company enters into repurchase agreements only with investment grade institutions. At September 30, 2004, the Company had amounts outstanding under repurchase agreements with 8 lenders with a maximum net exposure (the difference between the amount loaned to the Company and the estimated fair value of the security pledged by the Company as collateral) to any singled lender of approximately $12.3 million.

Recently Issued Accounting Pronouncements

The implementation of EITF 03-01, Other-Than-Temporary Impairment has been delayed. This issue addresses when a decline in value of an investment security is to be recognized through the income statement and requires additional reporting related to the investment portfolio.

NOTE C – INVESTMENT SECURITIES

The following table pertains to the Company’s Available-for-Sale Mortgage-Backed Securities as of September 30, 2004, which are carried at fair value:

All of these securities were acquired during the six months ended September 30, 2004.

The following table shows the initial fixed interest periods for the investment securities portfolio.

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NOTE D – MORTGAGE LOANS

The loan balances, including securitized loans, by original fixed period are shown in the following table.

In the residential loan portfolio, three loans were past due 30 days totaling $717 thousand (0.33%) and one loan totaling $226 thousand (0.10%) was in foreclosure.

In addition to residential mortgage loans, the Company invests in commercial mortgage bridge loans. The characteristics of these loans are in the following table.

One loan totaling $5.7 million (9.5%) was delinquent in excess of 30 days.

NOTE E – CASH AND CASH EQUIVALENTS

As of September 30, 2004, the Company had $11.4 million in cash and equivalents. This included both interest bearing and non-interest bearing bank balances. These balances along with other eligible collateral of $15.9 million, exceed the liquidity requirement of $15 million under the warehouse line of credit.

NOTE F – HEDGING

As of September 30, 2004, the Company had hedged a portion of its interest rate risk by entering into interest rate swaps (designated as cash flow hedges) to extend the duration of its short term borrowings. Ineffectiveness of $3 thousand was recorded as a reduction of interest expense for the year to date period ended September 30, 2004. Swaps with a notional balance of $76 million were terminated at a net loss of $707 thousand during the quarter. The losses on these effective hedges are deferred and amortized into interest expense over the remaining terms of the swaps. During the quarter ended September 30, 2004, $8 thousand of this net loss was recognized. Total notional outstanding at September 30, 2004 was $346 million with a fair market value of ($1.5) million.

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NOTE G – DEBT

The Company has a $250 million warehouse line of credit that is used to finance the purchase of residential mortgage bridge loans. This facility also includes a sublimit of $18.75 million that can be used to finance specific types of commercial bridge loans. This facility bears interest at LIBOR plus a spread and includes a facility fee.

As of September 30, 2004, $10.5 million was outstanding under this facility related to commercial bridge loans.

The Company has arrangements to enter into reverse repurchase agreements with ten financial institutions under facilities totaling $1.7 billion. Outstanding at September 30, 2004 was $552 million with a weighted average rate of 1.83% and a weighted average remaining maturity of 69 days. Securities pledged had a face value of $584 million as of September 30, 2004.

As of September 30, 2004, the reverse repurchase agreements mature from October 2004 to August 2005.

NOTE H – SHAREHOLDERS’ EQUITY

On March 17, 2004, the Company priced its initial public offering of 10,000,000 shares of common stock. The net proceeds of $118.7 million are reflected in shareholders’ equity.

Diluted earnings per share assumes the recognition of $121 thousand of expense related to 25,000 shares of restricted stock that will be recognized over the remaining vesting period, and that this dollar amount will be used to purchase approximately 12 thousand and 11 thousand shares of treasury stock as of the beginning of the period for the third quarter and year to date periods, respectively.

NOTE I – STOCK-BASED INCENTIVE COMPENSATION PLAN

The Company adopted the 2003 Share Incentive Plan which permits the granting of stock options, dividend equivalent rights and restricted stock awards. The terms of the plan stipulate that the exercise price of the options may not be less than fair market value of the stock on the date the options are granted. The Company has reserved 1,045,000 shares of common stock for issuance under the plan.

Options granted vest according to their terms and expire 10 years from the date of grant. The Company granted options to purchase 262,000 shares of common stock to executive officers and independent directors of the Company effective on the closing of the initial public offering. The options are exercisable at the initial offering price. An expense was recorded based on the fair value of the options on the grant date in accordance with FAS 123, measured using the Black-Scholes option pricing model over the options’ expected life and amortized over the vesting period of three years. The options were valued at $.82 per share using a stock price volatility of 30%, an expected life of 10 years, a dividend yield of 10%, and a risk free rate of return of 4.16%.

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The Company also granted warrants to purchase 233,000 shares of common stock to Sapphire Advisors Group (Sapphire), a founding shareholder. The warrants were granted to Sapphire in connection with its role in assisting the Company from and after the date of its formation. Sapphire assisted in the formation of the Company and its taxable subsidiary, the recruiting of officers and directors, identifying underwriters, and identifying and negotiating credit facilities. These warrants were granted effective on the closing of the initial public offering and are exercisable at the initial offering price. The warrants were fully vested at the date of grant and will expire 10 years from the date of grant. An expense was recorded for the warrants’ fair value in accordance with FAS 123, measured using the Black-Scholes option pricing model. The warrants were valued at $.82 per share using a stock price volatility of 30%, an expected life of 10 years, a dividend yield of 10%, and a risk free rate of return of 4.16%.

On December 5, 2003, the Company granted 20,000 shares of restricted stock to its sole advisory board member. The shares vest one year from the date of the initial public offering, March 17, 2004, and will be recorded at fair value, which was based on the value at the time of the initial public offering ($13 per share). The shares will be reflected as outstanding when vested, and were purchased by the recipient at par value.

Upon completion of the initial public offering, the Company granted 5,000 shares of restricted stock to an officer of the Company. The shares vest one year from the date of grant and were valued at $13 per share based on the initial public offering price of the stock. The shares will be reflected as outstanding when vested, and vested shares may be purchased by the recipient at par value.

NOTE J – EMPLOYEE BENEFIT PLANS

The board of directors has approved the 2004 incentive plan for executive officers of the Company. The plan’s payout is based on return on equity targets approved by the Compensation Committee of the Board of Directors and phased in over the remainder of 2004. These targets will be reviewed on a quarterly basis by the Compensation Committee of the Board in connection with their normal meetings.

Effective May 1, 2004, the Company adopted a tax-qualified employee savings plan (the Savings Plan). Pursuant to section 401(k) of the Code, eligible employees are able to make deferral contributions, subject to limitations under applicable law. Participant’s accounts are self-directed and the Company bears all costs. The Savings Plan provides for an up to 4% company match and Company contributions vest 100% at the time of contribution.

NOTE K – INCOME TAXES

The Company will elect to be taxed as a REIT commencing with the taxable year ending December 31, 2004. For the tax year ended December 31, 2003, the Company was taxed as a C corporation. The Company had a net operating loss carryforward of approximately $22,000 for which a valuation allowance has been recorded for the entire deferred tax asset. Due to the election to be taxed as a REIT in future years, the Company does not expect to be able to utilize the NOL carry forward prior to expiration in 2023.

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion should be read in conjunction with the consolidated financial statements and notes thereto appearing elsewhere in this Form 10-Q. Historical results and trends which might appear should not be taken as indicative of future operations. Our results of operations and financial condition, as reflected in the accompanying statements and related footnotes, are subject to management’s evaluation and interpretation of business conditions, changing capital market conditions, and other factors.

Forward Looking Statements

Certain statements in this Form 10-Q constitute “forward-looking statements” and involve risks, uncertainties and other factors, which may cause our actual performance to be materially different from the performance expressed or implied by such statements. These risks include our failure to successfully execute our business plan, gain access to additional financing, the availability of additional loan portfolios for future acquisition, continued qualification as a REIT, the cost of capital, as well as the additional risks and uncertainties detailed in the our periodic reports and registration statements filed with the Securities and Exchange Commission.

Executive Overview

We are a self-managed REIT that was formed in October 2003 to acquire a portfolio of high quality residential mortgage loans and commercial mortgage bridge loans (including loans that we will own jointly with others) in the United States. We will derive our revenues primarily from interest on loans acquired with our equity capital and borrowed funds. Our principal business objective is to generate net income for distribution to our stockholders from the spread between interest income on our mortgage assets and the costs of financing the acquisition of these assets. We expect that this spread, net of operating expenses, will provide both operating capital and distributable income.

Our fiscal year end is December 31. We intend to elect to be taxed as a REIT for federal income tax purposes commencing with our taxable year ending December 31, 2004, thereby generally avoiding federal income taxes on our taxable income that we distribute currently to our stockholders.

The quarter ended September 30, 2004 was our second full quarter of operations. We had net income of $1.4 million or $0.13 per diluted share, and our board of directors declared a dividend of $0.05 per share payable on December 13 to shareholders of record on November 29.

Other items of note for our second quarter of operations were:

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Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operation is based on our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgment that affect the reported amounts of assets, liabilities and contingencies as of the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. We evaluate our assumptions and estimates on an on-going basis. We base our estimates on assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.

The financial statements reflect all adjustments we consider necessary, and all of these adjustments are of a normal and recurring nature.

Although we invest in high quality residential loans and secured commercial mortgage bridge loans, we have established an allowance for loan losses and a provision that reflects the estimated losses in the portfolios. The allowance is evaluated on a quarterly basis and any necessary adjustments are made at that time.

We record expenses for the estimated value of stock based awards for both employees and non-employees. These awards are valued using the Black-Scholes option pricing model. This model requires assumptions related to stock price volatility, dividend yield, expected option life, and a risk free rate of return.

We also make estimates related to any hedging transactions that we enter. For our cash flow hedges of forecasted transactions, we have estimated the level of short term financing needed in the future.

For additional information on accounting policies see “Notes to Consolidated Financial Statements”.

Financial Condition

During the first quarter of 2004, we completed our initial public offering (IPO). The offering of 10 million shares was priced at $13 per share on March 17, 2004 and the proceeds (net of underwriting fees, attorney’s fees, accounting fees, and printing cost) were subsequently received. After deducting additional offering related costs, the net increase to stockholders’ equity was $118.7 million.

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Total assets were $684 million at September 30, 2004, which included earning assets of $669 million. The earning assets break down into $610 million , or 91%, related to residential mortgages and $59 million, or 9%, related to commercial mortgage bridge loans.

The residential assets are composed of $391 million of available-for-sale securities, $211 million of purchased loans that were subsequently securitized, and $7 million of whole loans.

During the first nine months of our fiscal year, we established our investment portfolio through the purchase of agency and AAA rated mortgage backed securities. The characteristics of the mortgage backed securities are outlined in the following tables.

All of the securities were purchased during the current year. We have reviewed the unrealized losses on the securities, and, in our opinion, none of these losses are other than temporary.

As of September 30, 2004, our residential loan portfolio (including securitized loans) totaled $218 million — $6 million in fixed rate loans and $212 million in floating rate loans. The total net premium on residential loans was $3.6 million.

The floating rate loan portfolio was comprised of loans with initial fixed rate interest periods of 3 years – 6%, 5 years – 38%, and 7 years (and other) – 56%.

In addition to the residential loans, we had a portfolio of commercial mortgage bridge loans. These loans are all carried at par. The following table outlines their relevant characteristics. The loan amounts are shown before the deduction of any deferred fees.

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The allowance for loan losses totaled $149 thousand at September 30, 2004. This has been established to absorb losses in the loan portfolios. In the residential loan portfolio, three loans were past due 30 days totaling $717 thousand (or 0.33%) and one loan totaling $226 thousand (or 0.10%) was in foreclosure.

One commercial loan participation totaling $5.7 million (total first mortgage of $31.6 million) is past due on its interest payments in excess of 30 days. A forbearance agreement has been entered into by the borrowers that included the hiring of a controller acceptable to the lenders and expense reductions related to the current operations. In addition to the first mortgage, there is a subordinated mortgage loan on this property totaling $15 million.

Our principal and interest payments are subordinated to another participant in the first mortgage with a participation interest of approximately 44% of the total first mortgage. We are on a pari passu basis with the remaining first mortgage participants.

Under SFAS 114, this loan is impaired. No specific valuation reserve has been established based on a discounted cash flow analysis. In addition, the collateral value supports the loan balance. Interest will be recorded on this loan on a cash basis. Interest income for the current quarter was reduced by $118 thousand related to the nonaccrual status of this loan.

On September 30, 2004, we had $11.4 million in cash and cash equivalents. These balances were maintained in available balances to meet our liquidity requirements under our borrowing arrangements and to meet our operating requirements.

Borrowings under a warehouse line of credit were used to finance the residential loans until they were securitized. The maximum amount outstanding during the year under the warehouse line was $186 million. As of the end of the quarter, there was $10.5 million outstanding under the warehouse line secured by pledged commercial mortgages. The warehouse line has a commercial sub-limit of $18.75 million with an advance rate of fifty percent of the mortgage balance.

Securities and securitized loans are financed through the use of reverse repurchase agreements. We had lines with ten financial institutions as of September 30, 2004 totaling $1.7 billion. We had borrowings with eight institutions totaling $552 million in reverse repurchase agreements outstanding with an average rate of 1.83% and an average remaining maturity of 69 days.

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Our borrowings generally have a shorter maturity than our assets which creates an interest rate mismatch. We use derivative instruments to extend the interest rate characteristics of our borrowings. As of September 30, 2004, we had 16 fixed-pay interest rate swaps with a notional balance of $346 million outstanding. These swaps are accounted for as cash flow hedges of our forecasted borrowings.

The fair market value of the swaps is recorded on the balance sheet as a hedging asset or liability. Three of the swaps are in a gain position of approximately $0.9 million shown as an asset, and 13 of the swaps are in a loss position of approximately $2.4 million shown as a liability.

The maturity characteristics and average rate by maturity characteristic are shown in the following table.

Results of Operations

Our net income was $1.4 million for the third quarter and $61 thousand for the year to date period. The net income for the year-to-date period shows that we have earned back the loss incurred in the first quarter prior to our initial public offering. The increasing net income quarter over quarter is the result of the continuing to build out our operations. The first quarter loss was attributable to operating expenses for the entire first quarter (operations began in October 2003) while our initial loans were not acquired until March 30, 2004.

Net interest income for the quarter totaled $2.9 million made up of $6.0 million of interest income offset by $3.1 million of interest expense. The following table shows average earning assets / yield and the average borrowings / cost for the third quarter. The second quarter table is also presented to show the growth as we continue to leverage the proceeds of the IPO.

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The impact of interest rate swaps is included in interest expense since the swaps are associated with our short term borrowings program.

Although we focus on high quality residential mortgage related assets and secured commercial bridge loans, a provision for loan losses has been recorded. The provision totaled $85 thousand for the quarter ended September 30, 2004 and $149 thousand year-to-date. Based on the asset quality, the initial provision rates have been set at an annual rate of 10 basis points on residential loans and 25 basis points on the commercial mortgage bridge loans. This provision rate and the related allowance are evaluated on a quarterly basis to insure that, in management’s opinion, the allowance is adequate for losses in the portfolio. A provision for loan losses is not recorded related to the mortgage backed securities. Securities are carried at market value with any other than temporary decline in value being recorded as a direct write-down of the asset.

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Operating expenses for the quarter totaled $1.8 million. The components of expenses for the current year are shown in the following table.

The current quarter’s operating expenses are all of a normal and recurring nature and reflect the continued build-out of our operations.

Liquidity and Capital Resources

We manage liquidity to ensure that we have the continuing ability to maintain cash flows that are adequate to fund operations on a timely and cost-effective basis. On September 30, 2004, we had liquidity of $25.8 million, consisting of eligible ARM assets and cash and cash equivalents. We believe that our liquidity level as of September 30, 2004 fully meets our current operating requirements.

Our primary sources of funds for the quarter ended September 30, 2004 consisted of reverse repurchase agreements and principal and interest payments, and for the year to date period consisted of our offering proceeds, a whole loan financing facility, reverse repurchase agreements, and principal and interest payments. In the future, we expect to utilize these sources as well as the issuance of debt or equity securities.

On March 17, 2004, we completed a public offering of 10,000,000 shares of common stock and received net proceeds of $118.7 million.

Our whole loan financing facility has a committed borrowing capacity of $250 million and matures in March 2005. The interest rate on the whole loan financing facility is indexed to one-month LIBOR and is subject to daily adjustment. As of September 30, 2004, we had $10 million outstanding under the commercial sub limit of our whole loan financing facility.

The whole loan financing facility contains both financial and non-financial covenants. Significant covenants include limitations on our ability to incur indebtedness beyond specified levels, certain financial covenants and restrictions on our ability to incur liens on assets. As of September 30, 2004, we are in compliance with all financial and non-financial covenants on our whole loan financing facility.

As of September 30, 2004, we had reverse repurchase lines with ten financial institutions with a total capacity of $1.7 billion. We had outstanding borrowings of $552 million with eight of these institutions.

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At September 30, 2004, our internal allocation showed 53% of our equity was supporting the residential portfolio, 42% was supporting the commercial portfolio, and 5% was supporting our general operations. The leverage associated with this equity stood at 8.8 times for residential, 0.2 times for commercial.

We continue to evaluate leverage opportunities related to the commercial portfolio and ways to more efficiently deploy our capital in support of the business. These are areas of focus for us in the coming months and quarters.

Market Risks

As a financial institution that has only invested in U.S.-dollar denominated instruments, primarily residential mortgage instruments, and has only borrowed money in the domestic market, we are not subject to foreign currency exchange or commodity price risk, but rather our market risk exposure is limited solely to interest rate risk. Interest rate risk is defined as the sensitivity of our current and future earnings to interest rate volatility, variability of spread relationships, the difference in re-pricing intervals between our assets and liabilities and the effect that interest rates may have on our cash flows, especially hybrid ARM portfolio prepayments. Interest rate risk impacts our interest income, interest expense and the market value on a large portion of our assets and liabilities.

Effects of changes in Interest Rates

Changes in interest rates will impact our earnings in various ways. We are currently invested primarily in hybrid ARM assets, which have an initial fixed rate period ranging from 36 to 84 months. To the extent that these assets are financed with shorter duration liabilities, rising short-term interest rates may temporarily negatively affect our earnings, and, conversely, falling short-term interest rates may temporarily increase our earnings. This may occur as our borrowings react to changes in interest rates sooner than our hybrid ARM assets because the weighted average next re-pricing dates of the borrowings may be shorter time periods than that of the hybrid ARM assets.

Interest rate changes may also affect our net return, both positively and negatively, given their impact on the level of prepayments experienced. In a declining rate environment (all else being equal), prepayments on mortgage-related assets tend to accelerate. This could potentially result in: having to redeploy the additional funds at lower yield levels, weighting more heavily the amount of our fixed rate financings, and accelerating any remaining unamortized premiums paid.

Conversely, in a rising rate environment (all else being equal), prepayments tend to decelerate. This could potentially result in: having fewer funds to redeploy at higher yield levels, weighting more heavily the amount of our floating rate financings, and extending any remaining unamortized premiums paid.

We attempt to mitigate any negative effects by managing our funding sources (fixed vs. floating) and use of the derivatives market (primarily interest rate swaps).

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Interest rate changes can also impact our investment opportunities. During a rising interest rate environment, there may be less total loan origination and refinance activity. At the same time, a rising interest rate environment may result in a larger percentage of hybrid ARM products being originated, mitigating the impact of lower overall loan origination and refinance activity. Conversely, during a declining interest rate environment, consumers, in general, may favor fixed rate mortgage products, but there may be above average loan origination and refinancing volume in the industry such that even a small percentage of hybrid ARM product volume may result in sufficient investment opportunities.

Additionally, a flat yield curve may be an adverse environment for hybrid ARM products because there may be little incentive for a consumer to choose an ARM product over a 30 year fixed-rate mortgage loan and, conversely, in a steep yield curve environment, ARM products may enjoy an above average advantage over 30 year fixed-rate mortgage loans, increasing our investment opportunities. The availability and fluctuations in the volume of hybrid ARM loans being originated can also affect their yield to us as an investment opportunity. During periods of time when there is a shortage of ARM products, their yield as an investment may decline due to market forces and conversely, when there is an above average supply of ARM products, their yield to us as an investment may improve due to the same market forces.

The most important measure we use in measuring interest rate risk is the duration gap, which reflects the weighted average duration of our assets minus the weighted average duration of our liabilities. The duration measure itself is calculated by BlackRock Solutions utilizing Monte Carlo simulation of 200 interest rate scenarios. At the end of the third quarter, our duration was 0.37 years. This duration changes on a daily basis as interest rates and prepayment assumptions change. We have a targeted duration gap of 0.5 years.

Other Matters

The Internal Revenue Code of 1986, as amended (the Code), requires that at least 75% of our total assets must be Qualified REIT Assets, as defined by the Code. The Code also requires that we meet a defined 75% source of income test and a 90% source of income test. As of September 30, 2004, we calculated that we were in compliance with each of these requirements. We also met all REIT requirements regarding the ownership of our common stock and the distributions of our net income. Therefore, as of September 30, 2004, we believe that we continue to qualify as a REIT under the provisions of the Code.

We intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act of 1940, as amended. If we were to become regulated as an investment company, our use of leverage would be substantially reduced. The Investment Company Act exempts entities that are “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate” (Qualifying Interests). Under current interpretation of the staff of the SEC, in order to qualify for this

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exemption, we must maintain at least 55% of our assets directly in Qualifying Interests. In addition, unless certain mortgage securities represent all the certificates issued with respect to an underlying pool of mortgages, such mortgage securities may be treated as securities separate from the underlying mortgage loans and, thus, may not be considered Qualifying Interests for purposes of the 55% requirement. Our calculations indicate that we are in compliance with this requirement.

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Item 3 QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The information called for by Item 3 is incorporated by reference from the information in Part I, Item 2 under the caption “Market Risks.”

Item 4. CONTROLS AND PROCEDURES

Under the supervision, and with the participation of our Chief Executive Officer and Chief Financial Officer management has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934) as of September 30, 2004. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that our disclosure controls and procedures were effective at September 30, 2004. There have been no changes to internal controls over financial reporting during the quarter ended September 30, 2004 that has materially affected, or is reasonably likely to affect our internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

As of September 30, 2004 there were no pending legal proceedings to which we were a party or of which any of our property was subject.

Item 2. Changes in Securities and Use of Proceeds

Not Applicable

Item 3. Defaults Upon Senior Securities

Not Applicable

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

None

Item 5. Other Information

None

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

The Company furnished or filed the following Current Reports on Form 8-K after June 30, 2004 and prior to September 30, 2004:

(i) Current Report on Form 8-K furnished on August 11, 2004 regarding issuance of a press release announcing Sunset Financial Resources second quarter earnings.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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Exhibit Index

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