Cohen & Co Inc. - Quarter Report: 2005 March (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended: March 31, 2005

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.

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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 Statements 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 (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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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 second 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.

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., Sunset Financial Statutory Trust I, 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.

Use of Estimates

In preparing consolidated financial statements in conformity with accounting principles generally accepted in the United States of America, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the consolidated balance sheet and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those 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.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with a maturity of three months or less. The carrying amount approximates fair market value.

Cash balances may also be subject to restrictions, such as when balances are pledged to meet margin calls related to derivative transactions or reverse repurchase agreements.

Investment Securities

The Company may at times have an investment portfolio. It will be utilized to deploy excess cash until the funds can be deployed into mortgage assets.

Generally, investment securities will be carried as available for sale with any mark to market adjustment shown in other comprehensive income.

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Mortgage Assets

The Company’s mortgage assets consist of residential mortgage assets (mortgage-backed securities, securitized mortgage loans, mortgage loans) and commercial mortgage bridge loans. The residential mortgage assets primarily have adjustable rates or hybrid adjustable rates (an initial fixed term of from one to seven years with the remaining term being floating). The commercial mortgage bridge loans are normally for a one year term with a fixed rate of interest.

Mortgage-Backed Securities

The Company’s mortgage-backed securities are held as available for sale with any mark to market adjustment being shown in other comprehensive income. Any premium or discount on these securities is amortized over the life of the asset in a method used to approximate a level yield.

Securitized Mortgage Loans

The Company utilized securitization as a method of increasing the financing options for its mortgage loans. When the loans are transferred to a securitization trust, they are reclassified on the balance sheet from loans to securitized loans reflecting the change in ownership structure. This transfer does not qualify as a sale and is made at book value due to the ownership interest the Company maintains in the beneficial interest of the securitized loans.

Securitized loans are carried on the balance sheet at historical cost. Any premium or discount on these assets is amortized over the life of the asset in a method used to approximate a level yield.

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).

Commercial Mortgage Bridge Loans

The Company invests in commercial mortgage bridge loans with an initial term of one year. These loans are carried on the balance sheet at historical cost. Any premium, discount, or fees are amortized over the term of the loan as a yield adjustment.

Valuation Methods

The fair value of residential mortgage securities is generally based on market prices provided by dealers who make a market in these types of assets. If a price is not available, the Company estimates a price based on the dealer information provided adjusted for the specifics of the asset. Residential mortgage loans are priced based on the information provided by dealers and adjusted for the loan specifics.

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, collateral values of properties securing loans and any remaining credit protection. Loan loss provision estimates are reviewed periodically and adjustments are reported in earnings when they become known. Loans delinquent in excess of 90 days are evaluated for charge-off. Loans are charged-off when, in the opinion of management, the balance is no longer collectable.

Commercial mortgage bridge loans, when they become delinquent, are evaluated for impairment in accordance with SFAS 114 “Accounting by Creditors for Impairment of a Loan—an amendment to FASB Statements No. 5 and 15”. Any provisions recorded are based on cash flow analysis, discounted at the loans effective interest rate, or, if the loan is collateral dependant, on the fair value of the collateral less the estimated costs to sell.

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Fixed Assets

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

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.

Hedging Activities

The Company enters into derivative financial instruments to manage interest rate risk and facilitate asset/liability management. All derivative financial instruments are recognized on the statement of condition as assets or liabilities at fair value as required by SFAS 133.

Derivative financial instruments that qualify under SFAS 133 for hedge accounting are designated, based on the exposure being hedged, as either fair value or cash flow hedges. Fair value hedge relationships mitigate exposure to the change in fair value of an asset, liability or firm commitment. Under the fair value hedging model, gains or losses attributable to the change in fair value of the derivative instrument, as well as the gains and losses attributable to the change in fair value of the hedged item, are recognized in earnings in the period in which the change in fair value occurs.

Cash flow hedge relationships mitigate exposure to the variability of future cash flows or other forecasted transactions. Under the cash flow hedging model, the effective portion of the gain or loss related to the derivative instrument is recognized as a component of other comprehensive income. The ineffective portion of the gain or loss related to the derivative instrument, if any, is recognized in earnings during the period of change. Amounts recorded in other comprehensive income are amortized to earnings in the period or periods during which the hedged item impacts earnings. For any derivative financial instruments not designated as fair value or cash flow hedges, gains and losses relate to the change in fair value are recognized in earnings during the period of change in fair value.

The Company formally documents all hedging relationships between hedging instruments and the hedged item, as well as its risk management objective and strategy for entering into various hedge transactions. The Company performs an assessment, at inception and on an ongoing basis, whether the hedging relationship has been highly effective in offsetting changes in fair value or cash flows of hedged items and whether they are expected to continue to be highly effective in the future.

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The Company currently enters into interest rate swap transactions to extend the duration of its short-term liabilities funding mortgage related assets. These transactions are accounted for as cash flow hedges under SFAS 133. The Company utilizes regression analysis comparing the change in the LIBOR floating leg of its interest rate swaps to the changes in cost of its short term borrowing program. Effectiveness is measured by an R2 of between 0.80 and 1.25. Any ineffectiveness, or over hedging, is recognized in interest expense. If an effective hedge is terminated the resulting gain or loss is deferred and recognized over the remaining term of the hedge as a component of interest expense. If the anticipated short term borrowings being hedged are no longer expected to occur, the company will discontinue hedge accounting.

Collateralized Debt Obligations

The Company may in the future issue collateralized debt obligations where the collateral will be contributed to a trust. These transactions would provide long term funding for the Company’s mortgage related assets. The repayment of the debt would come from the cash flows produced by the underlying collateral and any associated derivative contracts in the trust.

Accumulated Other Comprehensive Income

The Company accounts for the mark to market on its available for sale securities and the effective portion of the mark to market on derivative financial instruments in other comprehensive income.

Other comprehensive income does not include the impact of market value changes of any assets or liabilities that are carried at cost, such as loans and securitized loans.

Interest and Fee Income

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 on residential loans it services when loans are contractually past due three months or more. For residential mortgages serviced by others, the accrual of interest is discontinued when the servicer has determined that the loan is not collectable and has discontinued providing an advance of the payment to the Company. The commercial mortgage bridge loans are evaluated for nonaccrual status on an individual basis when delinquent in excess of 60 days or sooner if deemed appropriate by the Company. In general, when a loan is placed on nonaccrual all accrued interest is reversed and any future income is recognized on a cash basis.

Loan fees are deferred and amortized over the expected life of the loan.

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” (SFAS 123).

The Company records an expense for the fair value of stock based awards. Awards to non-employee service providers are 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 is 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.

Income Taxes

The Company will elect to be taxed as a REIT under Sections 856 through 860 of the Internal Revenue Code and will be taxed as such beginning with the taxable year ended

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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.

Earnings per Share (EPS)

Earnings per share is calculated under SFAS Statement No. 128 “Earnings per Share.” As such, the dilutive effect of stock options and restricted stock is shown in the earnings per share calculation.

Recent Issued Accounting Pronouncements

In March 2004, the Emerging Issues Task Force (“EITF”) reached a consensus on Issue 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” The EITF reached a consensus on an other-than-temporary impairment model for debt and equity securities accounted for under SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” and cost method investments. The basic model developed to evaluate whether an investment within the scope of Issue 03-1 is other-than-temporarily impaired involves a three-step process including, determining whether an investment is impaired (fair value less than cost), evaluating whether the impairment is other-than-temporary and, if other-than-temporary, requiring recognition of an impairment loss equal to the difference between the investment’s cost and its fair value. The three-step model used to determine other-than-temporary impairments shall be applied prospectively to all current and future investments in interim or annual reporting periods beginning after June 15, 2004. In October 2004, the Financial Accounting Standards Board (“FASB”) issued FSP 03-1-1, Effective Date of Paragraphs 10-20 of EITF 03-1, The Meaning of Other Than Temporary Impairment, delaying the effective date for the recognition and measurement guidance of EITF 03-1 until certain implementation issues are addressed and final implementation guidance is issued. The required disclosures of EITF 03-1 remain in effect and are provided in the “Investment Securities” footnote.

NOTE C—INVESTMENT SECURITIES

The following table pertains to the Company’s available for sale mortgage-backed securities as of March 31, 2005, which are carried at fair value:

All of these securities were acquired subsequent to March 31, 2004.

The Company does not believe unrealized losses, individually or in the aggregate, as of March 31, 2005 represent an other-than-temporary impairment. The unrealized losses are primarily a result of changes in interest rates and will not prohibit the Company from receiving its contractual interest and principal payments. The Company has the ability and intent to hold these securities for a period necessary to recover the amortized cost.

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

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, five loans were past due 30 days totaling $1.5 million (or 0.78%) and one loan totaling $224,000 (or 0.12%) was delinquent in excess of 60 days.

In addition to residential mortgage loans, the Company invests in commercial mortgage bridge loans. The amounts in the table are the loan balances, which are gross of $94,000 of deferred fees. The characteristics of these loans are in the following table.

The commercial loan portfolio contains two nonaccrual loans that total $10.4 million (or 28% of the total). These loans have been evaluated for impairment under SFAS 114 “Accounting by Creditors for Impairment of a Loan—an amendment to FASB Statements No. 5 and 15”.

The Cemetery / Funeral Home loan is in default, having failed to pay principal and interest when due. Our participation represents approximately 18% of the total loan. One of the participants (who holds $14.0 million of the outstanding principal balance, or 44%) has a senior priority to us in the cash flows. We are on a pari passu basis with the other participant, who is the lead lender and servicer of the loan. Foreclosure proceedings have begun on this loan. At March 31, 2005, we concluded the loan was impaired and based on the estimated net realizable value of the collateral securing the loan determined that no impairment reserve was required.

The Multi-Sport Facility loan is delinquent in excess of 90 days as of March 31, 2005, and continues to experience cash flow shortfalls due to lower than expected lease income. At March 31, 2005, we concluded the loan was impaired and based on the estimated net realizable value of the collateral securing the loan determined that no impairment reserve was required.

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During the first quarter of 2005, the Company elected to accept a settlement offer under a title insurance policy related to the impaired loan secured by the Mansion/Conference center. Under this settlement, the Company received $5.9 million in cash on March 31, 2005 with an additional payment of $1.5 million to be paid on or before December 31, 2005.

In recording this settlement, the loan was retired, a $1.5 million insurance receivable was recorded in other assets on a discounted basis, $214,000 was recorded as interest income related to the impaired loan, and a charge-off of approximately $1.1 million was recorded against the allowance for loan losses.

The table shows the activity in the Company’s allowance for loan losses.

NOTE E—CASH AND CASH EQUIVALENTS

As of March 31, 2005, the Company had $22.6 million in cash and equivalents. This included both interest bearing and non-interest bearing bank balances. These balances along with other eligible collateral give the Company total liquidity, as defined, of $46.5 million exceeding the liquidity requirement of $12.5 million under the warehouse line of credit.

At March 31, 2005, none of the cash balances were pledged to support margin calls on derivatives or reverse repurchase agreements.

NOTE F—HEDGING

As of March 31, 2005, 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. For the period, no ineffectiveness was recognized. Swaps with a notional balance of $63 million were terminated at a net gain of $1.1 million during the first quarter of 2005. Any net gain or loss on terminated effective hedges is deferred and amortized into interest expense over the remaining term of the swaps. Total notional outstanding at March 31, 2005 was $749.2 million with a fair market value of $9.7 million.

As of March 31, 2005, 31 swaps were in a gain position totaling $9.8 million (shown net of $1.4 million in cash collateral posted by a counter party) and one swap was in a loss position totaling $6,000. The Company has counterparty credit risk related to its swaps that are in a gain position. At March 31, 2005 the Company’s maximum credit exposure to a single counterparty was $5.2 million. To mitigate this risk, the Company only enters into swap transactions with investment grade institutions.

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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 loans. The commercial loan secured by the Retail Mall is also eligible collateral under this facility. This facility bears interest at LIBOR plus a spread and includes a facility fee. This facility matures on March 20, 2006.

As of March 31, 2005, there were no amounts outstanding under this facility.

On March 15, 2005, the Company issued $20 million in trust preferred securities. This debt bears interest at 90 day LIBOR plus 4.15%. The current interest rate is 7.04%.

The Company has arrangements to enter into reverse repurchase agreements with 13 financial institutions under facilities totaling $2.4 billion. Outstanding at March 31, 2005 was $943 million with a weighted average rate of 2.83% and a weighted average remaining maturity of 60 days. Securities and securitized loans pledged had a face value of $989 million and a market value of $986 million as of March 31, 2005.

As of March 31, 2005, the reverse repurchase agreements mature from April 2005 to September 2005.

As of March 31, 2005, the Company had amounts outstanding under repurchase agreements with nine 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 single lender of approximately $9 million.

The following table summarizes the maturities of the Company’s reverse repurchase agreements.

NOTE H—STOCKHOLDERS’ EQUITY

During the quarter ended March 31, 2005, 25,000 shares of restricted stock vested. These share are now reflected as outstanding. The Company recognized expense of $58,000 and $61,000 in the quarters ended March 31, 2005 and March 31, 2004, respectively.

Options on 262,000 shares and warrants for 233,000 shares were outstanding to purchase Company common stock at $13 per share. These options and warrants were anti-dilutive, but may be dilutive in future periods. The Company recognized expense related to stock options of $18,000 and $6,000 in the quarters ended March 31, 2005 and March 31, 2004, respectively.

Other comprehensive income at March 31, 2005 consisted of a $9.4 million loss related to the mark to market of available for sale investment securities, a $9.7 million gain related to the mark to market of interest rate swaps, and $438,000 of net deferred gains on terminated effective cash flow hedges.

NOTE I—INCOME TAXES

The Company will elect to be taxed as a REIT commencing with the taxable year ended December 31, 2004.

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The Company’s dividend to stockholders is based on its taxable income. The schedule below is provided to reconcile GAAP net income to taxable income.

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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 as a Maryland Corporation in October 2003 to acquire a portfolio of residential mortgage loans and commercial mortgage bridge loans (including loans that we will own jointly with others) in the United States. We now focus on owning, managing and financing a portfolio of mortgage assets that primarily consists of agency mortgage-backed and “AAA” rated securities and residential mortgage and commercial mortgage bridge loans. Our principal business objective is to maintain a portfolio of residential and commercial mortgage assets such that the interest income on our assets exceeds our costs to hedge and finance these assets.

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

The quarter ended March 31, 2005 is the first quarter of our second year of operations. For the quarter, we had net income of $1.4 million or $0.14 per diluted share, and our board of directors declared a dividend of $0.18 per share payable on April 21, 2005 to shareholders of record on April 11, 2005.

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We completed our initial public offering in March of 2004. Our balance sheet comparisons show significant asset growth and most of the income statement comparisons are not meaningful due to the short period of time that we had earning assets in the prior year.

Items of note for our first quarter of 2005 were:

Critical Accounting Policies and Estimates

Our discussion and analysis of financial condition and results of operations 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, judgments and assumptions 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 judgments, estimates and assumptions 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 estimates, judgments and assumptions 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.

Our loan portfolio consists of residential loans and commercial mortgage bridge loans. Due to our brief operating history, we have limited historical data related to losses inherent in our portfolio. In establishing our loan loss provision and allowance policy, we utilized publicly available information regarding losses realized on similar types of assets. This resulted in our establishing initial provision rates of 10 basis points for our

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residential mortgage loans and 25 basis points for our commercial mortgage bridge loans. In addition to this general reserve for losses, commercial mortgages are evaluated individually for impairment. Any loan past due in excess of 60 days is evaluated, but other loans may be included in this analysis based on specific facts and circumstances. All impaired loans are evaluated in accordance with SFAS No. 114 “Accounting by Creditors for Impairment of a Loan.” SFAS No. 114 requires that impaired loans are evaluated based on a discounted cash flow analysis, or, if the loan is considered collateral dependent, on the fair value of the collateral less the estimated cost to sell. Any specific allowance is established as a component of the allowance for loan losses. The ultimate net realizable value of the collateral securing our mortgage loans may impact any actual losses incurred.

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

Total assets were $1.1 billion at March 31, 2005, which included earning assets of $1.0 billion. The earning assets break down into $1.0 billion, or 97%, related to residential mortgages and $36 million, or 3%, related to commercial mortgage bridge loans.

The residential assets are composed of $818 million of available for sale securities, $190 million of purchased loans that were subsequently securitized, and $2 million of whole loans.

Our investment portfolio consists of agency and AAA rated mortgage backed securities. The characteristics of the mortgage backed securities are outlined in the following tables.

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All of the securities were purchased during the last 12 months. We have reviewed the unrealized losses on the securities, and, in our opinion, none of these losses are other than temporary.

As of March 31, 2005, our residential loan portfolio (including securitized loans) totaled $192 million — $900,000 in fixed rate loans, $188 million in floating rate loans and net premium of $3 million.

The floating rate loan portfolio was comprised of loans with initial fixed rate interest periods of 3 years – 4%, 5 years – 35%, and 7 years (and other) – 61%.

As of March 31, 2005, the agency securities in our portfolio had an average of 49 months to reset and the non-agency securities had 52 months to reset.

In our residential portfolio, six loans or $1.7 million (or 0.90%) are delinquent.

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.

During the first quarter of 2005, we elected to accept a settlement offer under our title insurance policy related to our impaired loan secured by the Mansion/Conference center. Under this settlement, we received $5.9 million in cash on March 31, 2005 with an additional payment of $1.5 million to be paid on or before December 31, 2005.

In recording this settlement, the loan was retired, a $1.5 million insurance receivable was recorded in other assets on a discounted basis, $214,000 was recorded as interest income related to the impaired loan, and a charge-off of approximately $1.1 million was recorded against the allowance for loan losses.

As of March 31, 2005, two of the loans in our commercial loan portfolio were on nonaccrual status and had an aggregate balance of $10.4 million (28% of the total by principal balance). We have evaluated these loans for impairment under SFAS 114

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“Accounting by Creditors for Impairment of a Loan—an amendment to FASB Statements No. 5 and 15.” Based on our analysis, no specific impairment reserve is required.

The Cemetery / Funeral Home loan is in default, having failed to pay principal and interest when due. Our participation represents approximately 18% of the total loan. One of the participants (who holds $14.0 million of the outstanding principal balance, or 44%) has a senior priority to us in the cash flows. We are on a pari passu basis with the other participant, who is the lead lender and servicer of the loan. Foreclosure proceedings have begun on this loan. At March 31, 2005, we concluded the loan was impaired and based on the estimated net realizable value of the collateral securing the loan determined that no impairment reserve was required.

The Multi-Sport Facility loan is delinquent in excess of 90 days as of March 31, 2005, and continues to experience cash flow shortfalls due to lower than expected lease income. At March 31, 2005, we concluded the loan was impaired and based on the estimated net realizable value of the collateral securing the loan determined that no impairment reserve was required.

Our allowance for loan losses is to cover losses inherent in both our residential and commercial portfolios. Due to our brief operating history, we have limited historical data related to our specific loans. In establishing our loan loss provision and allowance policy, we utilized publicly available information regarding losses realized on similar types of assets. This resulted in our establishing initial provision rates of 10 basis points for our residential mortgage loans and 25 basis points for our commercial mortgages bridge loans. This general provision rate resulted in recording a provision of $76,000 for the first quarter of 2005 and $15,000 for the first quarter of 2004. In addition to this general reserve for losses, commercial mortgages are evaluated individually for impairment. Any loan past due in excess of 60 days is evaluated, but other loans may be included in this analysis based on specific facts and circumstances. During the first quarter of 2005, a $1.1 million charge-off was recorded in our settlement of the Mansion / Conference Center loan for which a specific reserve had been established. As of March 31, 2004 and 2005, we did not have any specific reserves for impaired loans.

On March 31, 2005, we had $22.6 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.

Securities and securitized loans are financed through the use of reverse repurchase agreements. We had lines with 13 financial institutions as of March 31, 2005 totaling $2.4 billion. We had borrowings with nine institutions totaling $943 million in reverse repurchase agreements outstanding with an average rate of 2.83% and an average remaining maturity of 60 days.

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

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characteristics of our borrowings. As of March 31, 2005, we had 32 fixed-pay interest rate swaps with a notional balance of $749 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. Thirty one of the swaps are in a gain position of approximately $9.8 million shown as an asset (net of any collateral posted by counterparties), and one of the swaps is in a loss position of approximately $6,000 shown as a liability.

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

We renewed our warehouse line of credit under substantially the same terms, except for the commercial mortgage sub-limit. The commercial sub-limit was not renewed, except for allowing the Retail Mall loan to remain as eligible collateral until the occurrence of specific events.

On March 15, 2005, we issued $20 million in trust preferred securities. This debt offering will be used to finance our commercial loans. This debt bears interest at 90 day LIBOR plus 4.15%. For the first three month period the interest rate is 7.04%.

RESULTS OF OPERATIONS

Our net income was $1.4 million for the first quarter of 2005 compared to a loss of $1.5 million in the first quarter of 2004. The primary reason for the change in results was the result of a full quarter of operations in the first quarter of 2005 versus the first quarter of 2004 where our initial public offering occurred late in the quarter.

Net interest income for the quarter totaled $3.5 million made up of $10.2 million of interest income offset by $6.7 million of interest expense. The following tables show average earning assets / yield and the average borrowings / cost for the first quarter of 2005 and the fourth quarter of 2004 for comparative purposes.

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No adjustment has been made to the average balances for nonaccrual loans.

Our loan loss provision of $76,000 and $15,000 for the first quarter of 2005 and 2004 respectively, was our general loan loss provision and did not reflect any impairment provision for impaired loans.

Operating expenses for the first quarter or 2005 totaled $2.0 million and compared to $1.5 million in the first quarter of 2004. A five quarter trend of our operating expenses is shown in the following table.