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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q/A
(Amendment No. 1)
     
(Mark One)
þ
  QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
   
 
  For the quarterly period ended June 30, 2005
 
   
 
  OR
 
   
o
  TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 001-16577
FLAGSTAR BANCORP, INC.
(Exact name of registrant as specified in its charter)
     
Michigan   38-3150651
     
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
     
5151 Corporate Drive, Troy, Michigan   48098
     
(Address of principal executive offices)   (Zip Code)
(248) 312-2000
(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 thirty days. Yes þ No o.
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes þ No o.
As of August 3, 2005, 62,256,028 shares of the registrant’s Common Stock, $0.01 par value, were outstanding.
 
 

 


TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk
Item 4. Controls and Procedures
PART II — OTHER INFORMATION
Item 1. Legal Proceedings
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
Item 3. Defaults upon Senior Securities
Item 4. Submission of Matters to a Vote of Security Holders
Item 5. Other Information
Item 6. Exhibits
SIGNATURES
Exhibit Index
Section 302 Certification of Chief Executive Officer
Section 302 Certification of Chief Financial Officer
Section 906 Certification of Chief Executive Officer
Section 906 Certification of Chief Financial Officer


Table of Contents

EXPLANATORY NOTE
Statement regarding Review of Financial Statements
As previously disclosed, no procedures required by Rule 10-01(d) of Regulation S-X were performed by an independent registered public accountant on our financial statements for the fiscal quarter ended June 30, 2005 included in the Form 10-Q filed on August 9, 2005 (“Original Filing”) because Grant Thornton LLP, our previous independent registered public accounting firm, resigned on June 13, 2005 and our new independent registered public accounting firm, Virchow, Krause and Company, LLP, was not engaged until August 5, 2005. For additional information regarding the resignation of Grant Thornton LLP and our engagement of Virchow, Krause and Company, LLP, please refer to our Current Report on Form 8-K filed on June 15, 2005, our Current Report on Form 8-K/A filed on August 4, 2005, and our Current Report on Form 8-K filed August 8, 2005.
This Amendment on Form 10-Q/A (Amendment No. 1) (“Amended Filing”) sets forth the Original Filing in its entirety and is being filed to confirm that all procedures required by Rule 10-01(d) of Regulation S-X in connection with the filing of interim financial statements included in quarterly reports on Form 10-Q have now been completed by Virchow, Krause and Company, LLP. No information in the Original Filing is amended hereby, except that (i) Note 2 to the Consolidated Financial Statements (Unaudited) on page 8 has been amended to delete a reference to the fact that the Original Filing was not reviewed by an independent registered public accountant and (ii) the chart under the section entitled “FHLB Advances” on page 28 has been amended to change “March 31, 2005” to “December 31, 2004.” The Amended Filing has not been updated to reflect other events occurring after the Original Filing or to modify or update those disclosures affected by subsequent events. For information regarding subsequent events and developments, please refer to our subsequent filings under the Exchange Act with the Commission.
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
The unaudited condensed consolidated financial statements of the Registrant are as follows:
Consolidated Statements of Financial Condition — June 30, 2005 (unaudited) and December 31, 2004.
Unaudited Consolidated Statements of Earnings — For the three and six months ended June 30, 2005 and 2004.
Consolidated Statements of Stockholders’ Equity and Comprehensive Income – For the six months ended June 30, 2005 (unaudited) and for the year ended December 31, 2004.
Unaudited Consolidated Statements of Cash Flows — For the six months ended June 30, 2005 and 2004.
Unaudited Condensed Notes to Consolidated Financial Statements.
This report contains certain forward-looking statements with respect to the financial condition, results of operations, plans, objectives, future performance and business of the Company including statements preceded by, followed by or that include the words or phrases such as “believes,” “expects,” “anticipates,” “plans,” “trend,” “objective,” “continue,” “remain,” “pattern” or similar expressions or future or conditional verbs such as “will,” “would,” “should,” “could,” “might,” “can,” “may” or similar expressions, which are intended to identify “forward looking statement” within the meaning of the Private Securities Litigation Reform Act of 1995.
There are a number of important factors that could cause future results to differ materially from historical performance and these forward-looking statements. Factors that might cause such a difference include, but are not limited to: (1) significant increases in competitive pressures among depository institutions; (2) reduced net interest margins because of the changes in the interest rate environment; (3) prepayment speeds, loan origination and sale volumes, charge-offs and loan loss provisions; (4) general economic conditions, either national or in the states in which the Company does business, are less favorable than expected; (5) political developments, wars or other hostilities may disrupt, or increase volatility in, securities markets, or other economic conditions; (6) legislative or regulatory changes or actions adversely affect the businesses in which the Company is engaged; (7) changes and trends in the securities markets; (8) a delayed or incomplete resolution of regulatory issues; (9) the impact of reputational risk created by the developments discussed above on such matters as business generation and retention, funding and liquidity; and (10) the outcome of any regulatory and legal investigations and proceedings.
The Company does not undertake, and specifically disclaims any obligation, to update any forward-looking statements to reflect occurrences or unanticipated events or circumstances after the date of such statements.

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Flagstar Bancorp, Inc.
Consolidated Statements of Financial Condition
(in thousands)

 
                 
    At June 30,   At December 31,
    2005   2004
    (unaudited)        
ASSETS
               
Cash and cash equivalents
  $ 171,326     $ 156,457  
Mortgage-backed securities held to maturity
    17,842       20,710  
Investment securities
    20,662       18,391  
Mortgage loans available for sale
    1,961,977       1,506,311  
Investment loan portfolio
    11,784,482       10,558,463  
Less: allowance for losses
    (33,372 )     (37,627 )
 
               
Investment loan portfolio, net
    11,751,110       10,520,836  
 
               
Total earning assets
    13,751,591       12,066,248  
Accrued interest receivable
    43,731       35,047  
Repossessed assets, net
    35,809       37,823  
Repurchased assets, net
    15,786       17,099  
Federal Home Loan Bank stock
    262,477       234,845  
Premises and equipment, net
    188,807       180,095  
Mortgage servicing rights, net
    284,331       187,975  
Other assets
    162,769       209,899  
 
               
Total assets
  $ 14,916,627     $ 13,125,488  
 
               
 
               
LIABILITIES AND STOCKHOLDERS’ EQUITY
               
Liabilities
               
Deposits
  $ 7,887,028     $ 7,379,655  
Federal Home Loan Bank advances
    5,161,035       4,090,000  
Long term debt
    181,748       104,427  
 
               
Total interest-bearing liabilities
    13,229,811       11,574,082  
 
               
Accrued interest payable
    32,814       28,145  
Undisbursed payments on loans serviced for others
    477,083       496,210  
Escrow accounts
    285,033       176,424  
Liability for checks issued
    21,784       18,941  
Federal income taxes payable
    52,766       26,115  
Secondary market reserve
    15,600       19,002  
Other liabilities
    46,458       51,732  
 
               
Total liabilities
    14,161,349       12,390,651  
 
               
Commitments and contingencies
           
 
               
Stockholders’ Equity
               
Common stock — $.01 par value, 150,000,000 shares authorized; 62,243,888 and 61,357,614 shares issued and outstanding at June 30, 2005 and December 31, 2004, respectively
    623       614  
Additional paid in capital
    44,348       40,754  
Accumulated other comprehensive income
    5,520       5,343  
Retained earnings
    704,787       688,126  
 
               
Total stockholders’ equity
    755,278       734,837  
 
               
Total liabilities and stockholders’ equity
  $ 14,916,627     $ 13,125,488  
 
               
The accompanying notes are an integral part of these financial statements.

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Flagstar Bancorp, Inc.
Unaudited Consolidated Statements of Earnings
(in thousands, except per share data)

 
                                 
    For the three months ended   For the six months ended
    June 30,   June 30,
    2005   2004   2005   2004
Interest Income
                               
Loans and mortgage backed securities
  $ 165,617     $ 139,516     $ 328,306     $ 269,440  
Other
    494       698       931       1,615  
 
                               
Total
    166,111       140,214       329,237       271,055  
Interest Expense
                               
Deposits
    61,698       38,813       114,659       72,863  
FHLB advances
    41,138       34,794       82,190       71,536  
Other
    4,834       7,286       8,737       16,358  
 
                               
Total
    107,670       80,893       205,586       160,757  
 
                               
Net interest income
    58,441       59,321       123,651       110,298  
Provision for losses
    2,903       3,603       9,150       12,905  
 
                               
Net interest income after provision for losses
    55,538       55,718       114,501       97,393  
 
                               
Non-Interest Income
                               
Loan fees and charges, net
    3,213       6,017       5,835       10,088  
Deposit fees and charges
    4,400       3,291       7,977       6,159  
Loan administration, net
    1,669       5,590       7,614       13,822  
Net gain on loan sales
    31,177       7,513       40,933       39,645  
Net gain on sales of mortgage servicing rights
    2,262       37,248       6,510       59,033  
Other fees and charges
    12,148       11,380       21,561       20,373  
 
                               
Total
    54,869       71,039       90,430       149,120  
Non-Interest Expense
                               
Compensation and benefits
    31,620       29,298       62,339       56,407  
Occupancy and equipment
    18,048       16,514       34,446       33,611  
Communication
    1,563       1,846       3,116       3,704  
Other taxes
    2,463       3,096       4,531       6,047  
General and administrative
    13,380       12,583       26,364       25,947  
 
                               
Total
    67,074       63,337       130,796       125,716  
 
                               
Earnings before federal income taxes
    43,333       63,420       74,135       120,797  
Provision for federal income taxes
    15,533       22,230       26,557       42,650  
 
                               
Net Earnings
  $ 27,800     $ 41,190     $ 47,578     $ 78,147  
 
                               
 
                               
Net earnings per share — basic
  $ 0.45     $ 0.68     $ 0.77     $ 1.29  
 
                               
Net earnings per share — diluted
  $ 0.43     $ 0.65     $ 0.74     $ 1.22  
 
                               
The accompanying notes are an integral part of these financial statements.

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Flagstar Bancorp, Inc.
Consolidated Statements of Stockholders’ Equity and Comprehensive Income
(in thousands, except per share data)

 
                                         
                    Accumulated            
            Additional   Other           Total
    Common   Paid in   Comprehensive   Retained   Stockholders’
    Stock   Capital   Income   Earnings   Equity
Balance at December 31, 2003
  $ 607     $ 35,394     $ 2,173     $ 605,494     $ 643,668  
 
                                       
Net earnings
                      143,754       143,754  
Net realized gain on swap extinguishment
                2,650             2,650  
Net unrealized gain on swaps used in cash flow hedges
                520             520  
 
                                       
Total comprehensive income
                                    146,924  
Stock options exercised and grants issued, net
    7       3,311                   3,318  
Tax benefit from stock-based compensation
          2,049                   2,049  
Dividends paid ($1.00 per share)
                      (61,122 )     (61,122 )
 
                                       
 
                                       
Balance at December 31, 2004
(Unaudited)
    614       40,754       5,343       688,126       734,837  
Net earnings
                      47,578       47,578  
Reclassification of gain on swap extinguishment
                (668 )           (668 )
Net unrealized gain on swaps used in cash flow hedges
                845             845  
 
                                       
Total comprehensive income
                                    47,755  
Stock options exercised and grants issued, net
    9       3,594                   3,603  
Dividends paid ($0.50 per share)
                      (30,917 )     (30,917 )
 
                                       
 
                                       
Balance at June 30, 2005
  $ 623     $ 44,348     $ 5,520     $ 704,787     $ 755,278  
 
                                       
The accompanying notes are an integral part of these financial statements.

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Flagstar Bancorp, Inc.
Unaudited Consolidated Statements of Cash Flows
(in thousands)

 
                 
    For the six months ended
    June 30,
    2005   2004
Operating Activities
               
Net earnings
  $ 47,578     $ 78,147  
Adjustments to reconcile net earnings to net cash used in operating activities
               
Provision for losses
    9,150       12,905  
Depreciation and amortization
    52,036       60,845  
FHLB stock dividends
    (5,035 )     (4,869 )
Net gain on the sale of assets
    (1,062 )     (1,261 )
Net gain on loan sales
    (40,933 )     (39,645 )
Net gain on sales of mortgage servicing rights
    (6,510 )     (59,033 )
Proceeds from sales of loans available for sale
    11,343,851       15,766,701  
Originations and repurchase of loans, net of principal repayments
    (12,200,076 )     (17,027,099 )
Increase in accrued interest receivable
    (8,684 )     (1,489 )
Decrease (increase) in other assets
    49,739       (89,384 )
Increase in accrued interest payable
    4,669       1,436  
Increase in the liability for checks issued
    2,843       183  
Increase in federal income taxes payable
    25,529       6,824  
(Decrease) increase in other liabilities
    (8,676 )     29,268  
 
               
Net cash used in operating activities
    (735,581 )     (1,266,471 )
Investing Activities
               
Net change in investment securities
    (2,271 )     (1,208 )
Net change in mortgage backed securities
    2,868       4,528  
Origination of loans held for investment, net of principal repayments
    (817,377 )     (19,860 )
Purchases of Federal Home Loan Bank stock
    (22,597 )     (26,579 )
Investment in unconsolidated subsidiary
    2,321       2,328  
Proceeds from the disposition of repossessed assets
    22,567       19,641  
Acquisitions of premises and equipment, net of proceeds from sales
    (24,613 )     (16,772 )
Increase in mortgage servicing rights
    (162,286 )     (169,475 )
Proceeds from the sale of mortgage servicing rights
    36,262       207,295  
 
               
Net cash used in investing activities
    (965,126 )     (102 )
Financing Activities
               
Net increase in deposit accounts
    507,373       854,325  
Issuance of junior subordinated debt
    75,000        
Redemption of preferred securities
          (74,750 )
Net increase in Federal Home Loan Bank advances
    1,071,035       387,199  
Net (disbursement) receipt of payments of loans serviced for others
    (19,127 )     17,113  
Net receipt of escrow payments
    108,609       124,959  
Proceeds from the exercise of stock options
    3,603       2,397  
Dividends paid to stockholders
    (30,917 )     (30,442 )
 
               
Net cash provided by financing activities
    1,715,576       1,280,801  
 
               
Net increase in cash and cash equivalents
    14,869       14,228  
Beginning cash and cash equivalents
    156,457       148,417  
 
               
Ending cash and cash equivalents
  $ 171,326     $ 162,645  
 
               
The accompanying notes are an integral part of these financial statements.

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Flagstar Bancorp, Inc.
Unaudited Consolidated Statements of Cash Flows (continued)
(in thousands)

 
                 
Supplemental disclosure of cash flow information:
               
Loans receivable transferred to repossessed assets
  $ 19,446     $ 20,253  
 
               
Total interest payments made on deposits and other borrowings
  $ 200,917     $ 159,321  
 
               
Federal income taxes paid
  $     $ 36,000  
 
               
Loans held for sale transferred to loans held for investment
  $ 441,492     $ 1,901,750  
 
               
The accompanying notes are an integral part of these financial statements.

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Flagstar Bancorp, Inc.
Notes to Consolidated Financial Statements
(Unaudited)

 
Note 1. Nature of Business
Flagstar Bancorp, Inc. (“Flagstar” or the “Company”) is the holding company for Flagstar Bank, FSB (the “Bank”), a federally chartered stock savings bank founded in 1987. With $14.9 billion in assets at June 30, 2005, Flagstar is the largest savings institution and second largest banking institution headquartered in Michigan.
Flagstar is a consumer-oriented financial services organization. The Company’s principal business is obtaining funds in the form of deposits and borrowings and investing those funds in various types of loans. The acquisition or origination of single-family mortgage loans is the Company’s primary lending activity. The Company also originates consumer loans, commercial real estate loans, and non-real estate commercial loans.
A majority of the single-family mortgage loans originated that conform to underwriting standards of Fannie Mae, Freddie Mac or Ginnie Mae are securitized and sold on a servicing-retained basis. Any out-of-market servicing rights may then be sold in a separate transaction. The Company may also invest in a significant amount of its loan production for its own portfolio to maximize the Company’s leverage ability and to receive the interest spread between earning assets and paying liabilities.
The Bank is a member of the Federal Home Loan Bank System (“FHLB”) and is subject to regulation, examination and supervision by the Office of Thrift Supervision (“OTS”) and the Federal Deposit Insurance Corporation (“FDIC”). The Bank’s deposits are insured by the FDIC through the Savings Association Insurance Fund (“SAIF”).
Note 2. Basis of Presentation
The accompanying unaudited consolidated financial statements include the accounts of the Company, the Bank and their non-trust subsidiaries. All significant intercompany balances and transactions have been eliminated.
The unaudited consolidated financial statements of the Company have been prepared in accordance with generally accepted accounting principles for interim information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X as promulgated by the Securities and Exchange Commission. Accordingly, they do not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying interim financial statements are unaudited; however, in the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. The results of operations for the three and six month periods ended June 30, 2005 are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. For further information, refer to the consolidated financial statements and footnotes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.
Certain amounts within the accompanying consolidated financial statements and the related notes have been reclassified to conform to the 2005 presentation.
Note 3. Recent Accounting Developments
In May 2005, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 154, Accounting Changes and Error Corrections (“FAS 154”). FAS 154 replaces Accounting Principles Board (APB) Opinion No. 20, Accounting Changes and FAS No. 3, Reporting Accounting Changes in Interim Financial Statements. FAS 154 requires that a voluntary change in accounting principle be applied retrospectively with all prior period financial statements presented using the new accounting principle. FAS 154 also requires that a change in method of depreciation or amortizing a long-lived non-financial asset be accounted for prospectively as a change in estimate, and correction of errors in previously issued financial statements should be termed a restatement. FAS 154 is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. The implementation of FAS 154 is not expected to have a material impact on the Company’s financial statements.

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Note 4. Stock-Based Compensation
The Company has two stock incentive plans, the 1997 Employees and Directors Stock Option Plan and the 2000 Stock Incentive Plan (collectively, the “Plans”), which collectively provide for the granting of non-qualified stock options, incentive stock options, restricted stock awards, performance stock awards, stock bonuses and other awards to our employees (including officers and directors). Awards are granted at the average market price of the Company’s common stock on the grant date, vest over varying periods generally beginning six months from the date of grant, and expire ten years from the date of grant.
As currently permitted by SFAS 123, the Company continues to measure and recognize compensation expense using the intrinsic value method specified in APB Opinion No. 25, “Accounting for Stock Issued to Employees.As required under the provisions of SFAS 148, “Accounting for Stock-Based Compensation — Transition and Disclosure,” the following table discloses the pro forma net earnings and pro forma basic and diluted earnings per share had the fair value method been applied to all stock awards for the periods presented:
                                 
    For the three months   For the six months
    ended June 30,   ended June 30,
    2005   2004   2005   2004
Net earnings, as reported
  $ 27,800     $ 41,190     $ 47,578     $ 78,147  
 
                               
Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects
    (575 )     (719 )     (1,151 )     (1,437 )
 
                               
 
                               
Pro forma net earnings
  $ 27,225     $ 40,471     $ 46,427     $ 76,710  
 
                               
 
                               
Basic earnings per share
                               
As reported
  $ 0.45     $ 0.68     $ 0.77     $ 1.29  
Pro forma
  $ 0.44     $ 0.66     $ 0.75     $ 1.26  
 
                               
Diluted earnings per share
                               
As reported
  $ 0.43     $ 0.65     $ 0.74     $ 1.22  
Pro forma
  $ 0.42     $ 0.63     $ 0.72     $ 1.20  
Note 5. Segment Information
The Company’s operations can be categorized into two business segments: home lending and banking. Each business operates under the same banking charter, but is reported on a segmented basis for this report. Each of the business operations is complementary to each other.
The banking operation includes the gathering of deposits and investing those deposits in duration-matched assets primarily originated by the home lending operation. The banking group holds these loans in the investment portfolio in order to earn income based on the difference, or “spread,” between the interest earned on loans and the interest paid for deposits and other borrowed funds. All of the Company’s non-bank consolidated subsidiaries are included in the banking segment, and none are material to the Company’s operations.
The home lending operation involves the origination, packaging and sale of mortgage loans in order to receive transaction income. It also services mortgage loans for others and may sell mortgage servicing rights (“MSRs”) into the secondary market. Funding for the home lending operation is provided by deposits and borrowings obtained by the banking group.

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Following is a presentation of financial information by segment for the periods indicated:
                                 
    For the three months ended June 30, 2005
    Banking   Home Lending        
    Operation   Operation   Elimination   Combined
Net interest income
  $ 41,845     $ 16,596     $     $ 58,441  
Gain on sale revenue
          33,439             33,439  
Other income
    11,707       9,723             21,430  
Total net interest income and non-interest income
    53,552       59,758             113,310  
Earnings before taxes
    24,083       19,250             43,333  
Depreciation and amortization
    3,049       25,807             28,856  
Capital expenditures
    14,024       2,212             16,236  
Identifiable assets
    13,852,498       2,534,129       (1,470,000 )     14,916,627  
Inter-segment income (expense)
    11,025       (11,025 )            
                                 
    For the six months ended June 30, 2005
    Banking   Home Lending        
    Operation   Operation   Elimination   Combined
Net interest income
  $ 91,994     $ 31,657     $     $ 123,651  
Gain on sale revenue
          47,443             47,443  
Other income
    21,198       21,789             42,987  
Total net interest income and non-interest income
    113,192       100,889             214,081  
Earnings before taxes
    54,336       19,799             74,135  
Depreciation and amortization
    5,071       46,963             52,036  
Capital expenditures
    19,597       4,971             24,568  
Identifiable assets
    13,852,498       2,534,129       (1,470,000 )     14,916,627  
Inter-segment income (expense)
    22,275       (22,275 )            
                                 
    For the three months ended June 30, 2004
    Banking   Home Lending        
    Operation   Operation   Elimination   Combined
Net interest income
  $ 43,884     $ 15,437     $     $ 59,321  
Gain on sale revenue
          44,762             44,762  
Other income
    17,119       9,158             26,277  
Total net interest income and non-interest income
    61,003       69,357             130,360  
Earnings before taxes
    39,312       26,108             63,420  
Depreciation and amortization
    1,646       30,521             32,167  
Capital expenditures
    797       7,075             7,872  
Identifiable assets
    9,460,830       2,987,835       (500,000 )     11,948,665  
Inter-segment income (expense)
    3,750       (3,750 )            
                                 
    For the six months ended June 30, 2004
    Banking   Home Lending        
    Operation   Operation   Elimination   Combined
Net interest income
  $ 85,455     $ 24,843     $     $ 110,298  
Gain on sale revenue
          98,678             98,678  
Other income
    33,051       17,391             50,442  
Total net interest income and non-interest income
    118,506       140,912             259,418  
Earnings before taxes
    63,925       56,872             120,797  
Depreciation and amortization
    3,292       57,748             61,040  
Capital expenditures
    8,260       8,651             16,911  
Identifiable assets
    9,460,830       2,987,835       (500,000 )     11,948,665  
Inter-segment income (expense)
    11,250       (11,250 )            

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Selected Financial Ratios (in thousands, except per share data)
                                 
    For the three months ended   For the six months ended
    June 30,   June 30,
    2005   2004   2005   2004
Return on average assets
    0.78 %     1.37 %     0.67 %     1.34 %
Return on average equity
    14.88 %     24.18 %     12.80 %     23.26 %
Efficiency ratio
    59.2 %     48.6 %     61.1 %     48.5 %
 
                               
Equity/assets ratio (average)
    5.27 %     5.66 %     5.25 %     5.74 %
 
                               
Mortgage loans originated or purchased
  $ 7,103,622     $ 9,054,958     $ 14,316,714     $ 18,543,272  
Mortgage loans sold
  $ 5,891,492     $ 8,085,479     $ 11,329,539     $ 15,726,216  
 
                               
Interest rate spread
    1.71 %     1.91 %     1.71 %     1.90 %
Net interest margin
    1.79 %     2.13 %     1.90 %     2.07 %
 
                               
Average common shares outstanding
    62,078       60,889       61,770       60,814  
Average diluted shares outstanding
    64,265       64,055       64,083       64,145  
 
                               
Charge-offs to average investment loans
    0.24 %     0.12 %     0.24 %     0.17 %
                                 
    June 30,   March 31,   December   June 30,
    2005   2005   31, 2004   2004
Equity to assets ratio
    5.06 %     5.21 %     5.60 %     5.85 %
Core capital ratio1
    6.07 %     6.24 %     6.19 %     6.36 %
Total risk based capital ratio1
    10.50 %     10.99 %     10.97 %     11.72 %
 
                               
Book value per share
  $ 12.13     $ 11.99     $ 11.98     $ 11.43  
Number of common shares outstanding
    62,244       62,006       61,358       61,141  
 
                               
Mortgage loans serviced for others
  $ 26,646,531     $ 22,518,180     $ 21,354,724     $ 26,667,308  
Value of mortgage servicing rights
    1.07 %     0.95 %     0.88 %     0.89 %
 
                               
Ratio of allowance to non-performing loans
    51.2 %     64.6 %     56.1 %     67.8 %
Ratio of allowance to held for investment loans
    0.28 %     0.33 %     0.36 %     0.48 %
Non-performing assets to total assets
    0.93 %     0.92 %     1.07 %     1.02 %
 
                               
Number of banking centers
    128       123       120       103  
Number of home lending centers
    114       109       112       137  
Number of salaried employees
    2,431       2,404       2,396       2,482  
Number of commissioned employees
    800       838       980       997  
 
1   Based on adjusted total assets for purposes of tangible capital and core capital, and risk-weighted assets for purposes of the risk-based capital and the total risk-based capital. These ratios are applicable to Flagstar Bank only.

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Results of Operations
Net Earnings
Net earnings during the three and six month periods ended June 30, 2005, constituted a return on average equity of 14.88% and 12.80% and a return on average assets of 0.78% and 0.67%, respectively, reflecting a flatter yield curve environment and also net interest margin compression. Returns in 2004 were 24.18% and 23.26% as of percentage of average equity and 1.37% and 1.34% of average assets, respectively.
Additional factors affecting net earnings in 2005 include:
    Lower net interest income due to an increase in interest rate paid on deposits which has not been matched by the increase in the average interest rate earned on our interest earning assets.
 
    Lower non-interest income due to a significant reduction in the sales of mortgage servicing rights based upon management’s determination of the absence of appropriate selling opportunities.
 
    Lower non-interest income due to a decrease in loan originations and the corresponding decrease in loans sold in the secondary market. During the three and six months ended June 30, 2005, loan originations were down 22.0% and 22.7%, respectively, compared to the same periods of 2004. To a large degree, the decrease in loan originations during 2005 is attributable to a decline in mortgage refinancings.
 
    Higher overhead costs in our banking group attributable in part to eight new banking centers that have been opened during the first six months of 2005.
     Three Months
Net earnings for the three months ended June 30, 2005 were $27.8 million ($0.43 per share-diluted), a $13.4 million decrease from the $41.2 million ($0.65 per share-diluted) reported in 2004. The decrease resulted from a $16.1 million decrease in non-interest income, an increase in non-interest expense of $3.8 million, and a decrease in net interest income of $0.9 million that was offset by a $0.7 million decrease in the provision for losses and a $6.7 million decrease in the provision for federal income taxes.
     Six Months
Net earnings for the six months ended June 30, 2005 were $47.6 million ($0.74 per share-diluted), a $30.5 million decrease from the $78.1 million ($1.22 per share-diluted) reported in 2004. The decrease resulted from a $58.7 million decrease in non-interest income and an increase in non-interest expense of $5.1 million that was offset by a $13.4 million increase in net interest income, a $3.8 million decrease in the provision for losses and a $16.1 million decrease in the provision for federal income taxes.
Segment reporting
Our operations can be categorized into two business segments: banking and home lending. Each business operates under the same banking charter, but is reported on a segmented basis for financial reporting purposes. The banking operation includes the gathering of deposits and investing those deposits in duration matched assets primarily originated by the home lending operation. The banking group holds these loans in the investment portfolio in order to earn interest spread income. The home lending operation involves the origination, packaging and sale of mortgage loans in order to receive transaction income. The home lending group also services mortgage loans for others and sells MSRs into the secondary market. Funding for our home lending group is provided by deposits and borrowings obtained by our banking group.
For certain financial information concerning the results of operations of our banking and home lending operations see Note 5 of the Notes to Consolidated Financial Statements, in Item 1, Financial Statements, herein.

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Banking operation
We provide a full range of banking services to consumers and small businesses in Michigan, Indiana and Georgia. At June 30, 2005, the Bank operated a network of 128 banking centers. We continue to focus on expanding our branch network in order to increase our access to retail deposit funding sources.
In each successive period, the banking operation has expanded its deposit portfolio and banking centers. Each new banking center has been opened on a de novo basis. The result has been that each year assets related to this operation have increased. Further expansion of the deposit branch network is planned. During 2005, we expect to expand our banking center network by up to 18 new banking centers. Also during 2005, we have entered our third state for deposit banking. We expect to open 14 branches over the next two years in the Atlanta, Georgia metropolitan area. During 2004, the Company opened 22 banking centers. During the first six months of 2005, eight banking centers were opened.
As we open new branches, we believe that the growth in deposits will occur over time, with FHLB advances, municipal deposits and those deposit accounts garnered through the secondary market providing sufficient operational funding in the interim.
     Three Months
During the three-month period ended June 30, 2005, total net interest income and non-interest income decreased 12.2%, while pre-tax earnings decreased 35.5% compared to the corresponding period in 2004. Additionally, identifiable assets increased 46.3% in 2005 from the corresponding period in 2004. Despite our growing banking operation and the large number of banking centers that are not mature, the banking operation was responsible for 47.3% of the total net interest income and non-interest income and 55.6% of pre-tax earnings during the three months ended June 30, 2005. During the three months ending June 30, 2004, the banking operation produced 46.8% of total net interest income and non-interest income and 58.8% of pre-tax earnings.
     Six Months
During the six-month period ended June 30, 2005, total net interest income and non-interest income decreased 4.5%, while pre-tax earnings decreased 15.0% compared to the corresponding period in 2004. The banking operation was responsible for 52.9% of total net interest income and non-interest income and 73.3% of pre-tax earnings during the six-month period ending June 30, 2005. In the corresponding period in 2004, the banking operation produced 52.9% of pre-tax earnings.
Home lending operation
Our home lending activities involve the origination of mortgage loans or the purchase of mortgage loans. Our personnel originate loans and conduct business from 114 loan origination centers in 26 states. Our personnel also originate loans from the Bank’s 128 banking centers. We purchase mortgage loans on a wholesale basis through a network of correspondents consisting of other banks, thrifts, mortgage companies, and mortgage brokers nationwide. The mortgage loans, the majority of which are subsequently sold on a servicing retained basis in the secondary mortgage market, conform to the underwriting standards of Freddie Mac or Fannie Mae or Ginnie Mae. The out-of-market servicing rights may be sold in separate transactions.
The home lending operation also involves the servicing of mortgage loans of others. The servicing portfolio, which totals $26.6 billion at June 30, 2005, generally becomes more valuable in a rising rate environment as prepayment risk declines and can provide counter-cyclical earnings protection for our home lending operation to the extent that market condition provides opportunity for sales at a gain. In our capacity as a mortgage loan servicer, we maintain escrow balances for our customers and we earn interest income on these escrow balances. At June 30, 2005, we held $762.1 million of escrow balances.
The home lending operation is a much more volatile source of earnings than the banking operation. This operation, for the most part, is reliant on the prevailing interest rate environment, which is outside of our control. The earnings volatility inherent in the mortgage banking operation is reflected in the significant fluctuations of net interest income and non-interest income and pre-tax earnings of the operation from period to period. The future net interest income and non-interest income, earnings, and profitability of this operation are significantly dependent on production volumes, servicing portfolio balances and the interest rate environment.

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     Three Months
During the three months ended June 30, 2005, total net interest income and non-interest income related to home lending operations decreased 13.8%, while pre-tax earnings decreased 26.3% compared to the corresponding period in 2004. The primary causes for these changes was the $35.0 million decrease in gains on sales of mortgage servicing rights, which were partially offset by the $23.7 million increase in net gains on loan sales. Sales of mortgage servicing rights decreased due to management’s determination of the absence of appropriate selling opportunities.
     Six Months
During the six-month period ended June 30, 2005, total net interest income and non-interest income decreased 28.4%, while pre-tax earnings decreased 65.2% compared to the corresponding period in 2004. The primary cause for these decreases was the $52.5 million decrease in gains on sales of mortgage servicing rights due to management’s determination of the absence of appropriate selling opportunities.
Net Interest Income
     Three months
We recorded $58.4 million in net interest income for the three months ended June 30, 2005. This level of interest income decreased 1.5% from the $59.3 million recorded for the comparable 2004 period. These results include a $25.9 million increase in interest revenue, which was more than offset by a $26.8 million increase in interest expense. During the period, our average earning assets were approximately $2.0 billion higher than the same period of 2004, but average paying liabilities were approximately $2.4 billion higher then in the second quarter of 2004. Furthermore, earning assets as a whole repriced up only 6 basis points while our liabilities repriced up by 26 basis points during the period, primarily due to higher interest rates paid on deposits. These net changes are reflected in the decrease in our net interest spread of 20 basis points to 1.71% for the three months ended June 30, 2005 from 1.91% for the comparable 2004 period. It is also reflected in the decrease in the net interest margin of 34 basis points to 1.79% for the quarter ended June 30, 2005 from 2.13% for the same period in 2004. On a sequential quarter basis, we reported a 19 basis point decrease in the interest rate spread and 21 basis point decrease in the interest margin. As a result, we reported a $6.8 million, or 10.4%, decrease in net interest income during the current period versus the first quarter of 2005.
     Six months
We recorded $123.7 million in net interest income for the six months ended June 30, 2005 which represented an increased of 12.1% from the $110.3 million recorded for the comparable 2004 period. These results include a $58.1 million increase in interest revenue, which was offset by a $44.8 million increase in interest expense. During the period, our average earning assets were approximately $2.4 billion higher than the same period of 2004, but average paying liabilities were also approximately $2.4 billion higher than in the first half of 2004. However, earning assets as a whole repriced down by 4 basis points while our liabilities repriced up by 15 basis points during the period, primarily due to higher interest rates paid on deposits. This net decrease is reflected in the decrease in our net interest spread of 19 basis points to 1.71% for the six months ended June 30, 2005 from 1.90% for the comparable 2004 period. It is also reflected in the decrease in the net interest margin of 17 basis points to 1.90% for the six months ended June 30, 2005 from 2.07% for the same period in 2004.

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     Average Yields Earned and Rates Paid
The following tables present interest income from average earning assets, expressed in dollars and yields, and interest expense on average interest-bearing liabilities, expressed in dollars and rates. Interest income from earning assets includes the $8.4 million and $3.4 million of amortization of net premiums and the amortization of net deferred loan origination costs for the three months ended June 30, 2005 and 2004, respectively. For the six months ended June 30, 2005 and 2004, interest income from earning assets included $13.8 million and $6.7 million of amortization of net premiums and amortization of net deferred loan origination costs, respectively. Non-accruing loans were included in the average loan amounts outstanding.
                                                 
    Three months ended June 30,
    2005   2004
    (in thousands)
    Average           Yield/   Average           Yield/
    Balance   Interest   Rate   Balance   Interest   Rate
Interest-earning assets:
                                               
Loans receivable, net
  $ 12,982,651     $ 165,617       5.10 %   $ 11,013,067     $ 139,516       5.07 %
Other
    79,220       494       2.49 %     135,182       698       2.06 %
 
                                               
Total earning assets
    13,061,871     $ 166,111       5.09 %     11,148,249     $ 140,214       5.03 %
Other assets
    1,465,160                       887,353                  
 
                                               
Total assets
  $ 14,527,031                     $ 12,035,602                  
 
                                               
 
                                               
Interest-bearing liabilities:
                                               
 
                                               
Deposits
  $ 7,949,306     $ 61,698       3.11 %   $ 6,400,013     $ 38,813       2.44 %
FHLB advances
    4,532,299       41,138       3.64 %     3,632,353       34,794       3.85 %
Other
    314,241       4,834       6.17 %     408,607       7,286       7.17 %
 
                                               
Total interest-bearing liabilities
    12,795,846     $ 107,670       3.38 %     10,440,973     $ 80,893       3.12 %
Other liabilities
    983,733                       913,222                  
Stockholders’ equity
    747,452                       681,407                  
 
                                               
Total liabilities and Stockholders’ equity
  $ 14,527,031                     $ 12,035,602                  
 
                                               
 
                                               
Net interest-earning assets
  $ 266,025                     $ 707,276                  
 
                                               
 
                                               
 
                                               
Net interest income
          $ 58,441                     $ 59,321          
 
                                               
 
                                               
 
                                               
Interest rate spread1
                    1.71 %                     1.91 %
 
                                               
 
                                               
Net interest margin2
                    1.79 %                     2.13 %
 
                                               
 
                                               
Ratio of average interest- earning assets to interest-bearing liabilities
                    102 %                     107 %
 
                                               
 
1   Interest rate spread is the difference between the average yield earned on interest-earning assets and the average rate of interest paid on interest-bearing liabilities.
 
2   Net interest margin is net interest income divided by average interest-earning assets.

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Table of Contents

                                                 
    Six months ended June 30,
    2005   2004
    (in thousands)
    Average           Yield/   Average           Yield/
    Balance   Interest   Rate   Balance   Interest   Rate
Interest-earning assets:
                                               
Loans receivable, net
  $ 13,024,404     $ 328,306       5.04 %   $ 10,608,919     $ 269,440       5.08 %
Other
    83,995       931       2.22 %     96,270       1,615       3.36 %
 
                                               
Total earning assets
    13,108,399     $ 329,237       5.02 %     10,705,189     $ 271,055       5.06 %
Other assets
    1,062,191                       947,299                  
 
                                               
Total assets
  $ 14,170,590                     $ 11,652,488                  
 
                                               
 
                                               
Interest-bearing liabilities:
                                               
 
                                               
Deposits
  $ 7,765,514     $ 114,659       2.99 %   $ 6,130,176     $ 72,863       2.39 %
FHLB advances
    4,512,715       82,190       3.68 %     3,644,309       71,536       3.95 %
Other
    298,325       8,737       5.92 %     450,764       16,358       7.30 %
 
                                               
Total interest-bearing liabilities
    12,576,554     $ 205,586       3.31 %     10,225,249     $ 160,757       3.16 %
Other liabilities
    850,418                       758,153                  
Stockholders’ equity
    743,618                       669,086                  
 
                                               
Total liabilities and Stockholders’ equity
  $ 14,170,590                     $ 11,652,488                  
 
                                               
 
                                               
Net interest-earning assets
  $ 531,845                     $ 479,940                  
 
                                               
 
                                               
 
                                               
Net interest income
          $ 123,651                     $ 110,298          
 
                                               
 
                                               
 
                                               
Interest rate spread1
                    1.71 %                     1.90 %
 
                                               
 
                                               
Net interest margin2
                    1.90 %                     2.07 %
 
                                               
 
                                               
Ratio of average interest- earning assets to interest-bearing liabilities
                    104 %                     105 %
 
                                               
 
1   Interest rate spread is the difference between the average yield earned on interest-earning assets and the average rate of interest paid on interest-bearing liabilities.
 
2   Net interest margin is net interest income divided by average interest-earning assets.

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     Rate/Volume Analysis
The following tables present the dollar amount of changes in interest income and interest expense for the components of earning assets and interest-bearing liabilities, which are presented in the preceding tables. The tables below distinguish between the changes related to average outstanding balances (changes in volume while holding the initial rate constant) and the changes related to average interest rates (changes in average rates while holding the initial balance constant).
                         
    Three months ended June 30,
    2005 versus 2004
    Increase (Decrease) due to:
    Rate   Volume   Total
    (in thousands)
Earning Assets:
                       
Loans receivable, net
  $ 1,137     $ 24,964     $ 26,101  
Other
    84       (288 )     (204 )
     
Total
  $ 1,221     $ 24,676     $ 25,897  
Interest Bearing Liabilities:
                       
Total deposits
  $ 13,434     $ 9,451     $ 22,885  
FHLB advances
    (2,318 )     8,662       6,344  
Other
    (760 )     (1,692 )     (2,452 )
     
Total
  $ 10,356     $ 16,421     $ 26,777  
     
Change in net interest income
  $ (9,135 )   $ 8,255     $ (880 )
     
                         
    Six months ended June 30,
    2005 versus 2004
    Increase (Decrease) due to:
    Rate   Volume   Total
    (in thousands)
Earning Assets:
                       
Loans receivable, net
  $ (2,487 )   $ 61,353     $ 58,866  
Other
    (478 )     (206 )     (684 )
     
Total
  $ (2,965 )   $ 61,147     $ 58,182  
Interest Bearing Liabilities:
                       
Total deposits
  $ 22,255     $ 19,542     $ 41,796  
FHLB advances
    (6,497 )     17,151       10,654  
Other
    (2,058 )     (5,564 )     (7,621 )
     
Total
  $ 13,700     $ 31,129     $ 44,829  
     
Change in net interest income
  $ (16,665 )   $ 30,018     $ 13,353  
     
Provision for Losses
     Three months
The provision for losses was $2.9 million for the three months ended June 30, 2005 down from $3.6 million during the same period in 2004. The 2005 period included net charge-offs of $6.6 million. The 2004 period included net charge-offs of $2.6 million. Net charge-offs were an annualized 0.24% and 0.12% of average investment loans outstanding during the three months ended June 30, 2005 and 2004, respectively. The provision reflects management’s assessment of existing risks within its expanding loan portfolio, taking into account enhanced underwriting procedures, collection rates for older loans and ongoing remediation efforts.
     Six months
The provision for losses was $9.2 million for the six months ended June 30, 2005 down from $12.9 million during the same period in 2004. The 2005 period included net charge-offs of $13.4 million. The 2004 period included net charge-offs of $7.1 million. Net charge-offs were an annualized 0.24% and 0.17% of average investment loans outstanding during the six months ended June 30, 2005 and 2004, respectively.

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Non-Interest Income
Non-interest income consists primarily of loan fees and charges in connection with loan originations, deposit fees and charges, loan administration fees earned for servicing loans for others, and the net gain or loss realized from the sale of loans and MSRs. During the three months ended June 30, 2005, non-interest income decreased $16.1 million to $54.9 million from $71.0 million in the comparable 2004 period. During the six months ended June 30, 2005, non-interest income decreased $58.7 million to $90.4 million from $149.1 million in the comparable 2004 period. As explained below, the decrease in non-interest income in both periods was largely a result of a significant decrease in the sales of MSRs in 2005 compared with 2004. In addition, fewer loan fees and charges were earned in 2005 due to a substantial reduction in loan originations resulting from fewer refinancings of existing loans. Finally, loan administration income decreased during the 2005 period compared to 2004 due to the fact that we were servicing fewer loans, on average, in the 2005 period, despite an increase from December 31, 2004. Countering these declines in gains from MSR sales, loan fees and loan administration income were an increase in gains from loan sales and higher deposit fees and charges.
  Loan fees and charges
     Three months
Net loan fees collected during the three months ended June 30, 2005 totaled $3.2 million compared to $6.0 million collected during the comparable 2004 period. This decrease is principally the result of a decrease in total loan production of $1.7 billion to $7.5 billion for the quarter ended June 30, 2005, compared to $9.2 billion in the same 2004 period.
     Six months
Net loan fees collected during the six months ended June 30, 2005 totaled $5.8 million compared to $10.1 million collected during the comparable 2004 period. This decrease is the result of a decrease in total loan production of $3.7 billion to $15.1 billion for the six months ended June 30, 2005, compared to $18.8 billion in the same 2004 period.
  Deposit fees and charges
     Three months
During the three months ended June 30, 2005, we collected $4.4 million in deposit fees versus $3.3 million collected in the comparable 2004 period. This increase is attributable to the increase in our deposits as our banking franchise continues to expand.
     Six months
During the six months ended June 30, 2005, we collected $8.0 million in deposit fees versus $6.2 million collected in the comparable 2004 period. This increase is attributable to the increase in our deposits as our banking franchise continues to expand.
  Loan Administration
     Three months
Net loan administration fee income decreased to $1.7 million during the three months ended June 30, 2005, from $5.6 million in the 2004 period. This $3.9 million decrease was the result of an $8.2 million decrease in the servicing fee revenue which was only partially offset by the $4.3 million decrease in amortization of MSRs. Loan servicing fees are calculated as a percentage of outstanding loan balances. As of June 30, 2005, the weighted average servicing fee was 0.348% (34.8 basis points) per annum. The average servicing fee percentage does not fluctuate significantly from period to period. Accordingly, the decrease in the servicing fee revenue resulted from a decline in the average outstanding balances of loans serviced for others from $29.9 billion during the three months ended June 30, 2004 to $24.5 billion during the second quarter of 2005, reflecting sales of MSRs during the remainder of 2004. At June 30, 2005, the unpaid principal balance of loans serviced for others was $26.6 billion versus $21.4 billion serviced at December 31, 2004, and $26.7 billion serviced at June 30, 2004 reflecting sales of MSRs during 2004 but significantly fewer sales through March 31, 2005 and no sales during the three months ended June 30, 2005.

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     Six Months
Net loan administration fee income decreased to $7.6 million during the six months ended June 30, 2005, from $13.8 million in the 2004 period. This $6.2 million decrease was the result of the $15.1 million decrease in the servicing fee revenue which was not offset by the $8.9 million decrease in amortization of the mortgage servicing rights (“MSR”). The decrease in the servicing fee revenue was the result of loans serviced for others averaging $23.6 billion during the six months ended June 30, 2005 versus $29.5 billion during the comparable 2004 period.
  Net Gain on Loan Sales
Our recognition of gain or loss on the sale of loans is accounted for in accordance with SFAS 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” SFAS 140 requires that a transfer of financial assets in which we surrender control over the assets be accounted for as a sale to the extent that consideration other than beneficial interests in the transferred assets is received in exchange. The carrying value of the assets sold is allocated between the assets sold and the retained interests based on their relative fair values. In our loan sale transactions, the only interests that are generally retained are the mortgage servicing rights created when the underlying loan is sold.
The variance in the amount of gain on sale recognized is attributable to the volume of mortgage loans sold and the gain on sale spread achieved. The volatility in the gain on sale spread is attributable to market pricing, which changes with demand and the general level of interest rates. Typically, as the volume of acquirable loans increases in a lower or falling interest rate environment, we are able to pay less to acquire loans and are then able to achieve higher gains on the eventual sale of the acquired loans. In contrast, when interest rates rise, the volume of acquirable loans decreases and therefore we may need to pay more in the acquisition phase, thus decreasing our net gain achievable.
Also included in loan sales is the recording of mark to market pricing adjustments recorded in accordance with SFAS 133, “Accounting for Derivative Instruments” (“FASB 133”) and the recording of our secondary market reserve, which is recorded to offset anticipated losses resulting from loans sold but expected to be repurchased from secondary market investors. At June 30, 2005, we had forward contracts to sell mortgage-backed securities of $3.0 billion and interest rate lock commitments to originate loans of $3.7 billion.
As part of our routine sales of loans to the secondary market, we make customary representations and warranties to the purchasers about various characteristics of each loan, such as the manner of origination, the nature and extent of underwriting standards applied and the types of documentation being provided. We are not required to reimburse purchasers for any missed loan payments or for any reduced income as a result of a loan being prepaid. If any loans do not comply with the representations and warranties, we may repurchase the loans or else indemnify the purchaser for any related losses.

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The following table provides a reconciliation of the net gain on sale recorded on loans sold within the periods shown (in thousands):
                                 
    For the three months ended June 30,   For the six months ended June 30,
    2005   2004   2005   2004
Net gain on loan sales
  $ 31,177     $ 7,513     $ 40,933     $ 39,645  
Plus: FASB 133 adjustment
    (5,866 )     159       (9,001 )     (6,545 )
Plus: Secondary Market Reserve
    2,452       5,849       3,454       13,916  
 
                               
Gain on loan sales
  $ 27,763     $ 13,521     $ 35,386     $ 47,016  
 
                               
Loans sold
  $ 5,891,492     $ 8,085,479     $ 11,329,539     $ 15,726,216  
Sales spread
    0.47 %     0.17 %     0.32 %     0.30 %
     Three months
For the three months ended June 30, 2005, net gain on loan sales increased $23.7 million, to $31.2 million, from $7.5 million in the 2004 period. The 2005 period reflects the sale of $5.9 billion in loans versus $8.1 billion sold in the 2004 period. The interest rate environment and the Company’s emphasis on increasing its spread rather loan volume in the 2005 period resulted in a lower mortgage loan origination volume ($7.1 billion in the 2005 period vs. $9.1 billion in the 2004 period) and a larger gain sale spread (47 basis points in the 2005 period versus 17 basis points in the 2004 period) recorded when the loans were sold. The interest rate environment in the 2005 period allowed a lesser amount of refinances (48.8% in the 2005 period vs. 61.9% in the 2004 period). The decline in the secondary market reserve provision during 2005 is a result of the improvement in our underwriting processes in the recent past, and, to an extent, the large number of refinancings which tend to be less prone to repurchase. The decline also reflects our recent enhanced efforts to obtain indemnification from mortgage brokers and mortgage investment companies resulting in recent but short-term increases in recoveries.
     Six months
For the six months ended June 30, 2005, net gain on loan sales increased $1.3 million, to $40.9 million, from $39.6 million in the 2004 period. The 2005 period reflects the sale of $11.3 billion in loans versus $15.7 billion sold in the 2004 period. The interest rate environment and continued intense competition for mortgage loans in the 2005 period resulted in a lower mortgage loan origination volume ($14.3 billion in the 2005 period vs. $18.5 billion in the 2004 period) but a larger sale spread. The interest rate environment in the 2005 period resulted in a lower number of refinances (54.0% in the 2005 period vs. 66.1% in the 2004 period).
  Net Gain on the Sale of Mortgage Servicing Rights
The volatility in the level of net gains on mortgage servicing rights is attributable to the variance in the gain on sale spread and the volume of MSRs sold. The spread is attributable to market pricing which changes with demand and the general level of interest rates. Upon the sale of the underlying mortgage loan, the MSR is created and is capitalized at the fair value of the MSR created. If the MSR is sold in a flow transaction shortly after its creation, little to no gain is recorded on the sale. If the MSR has any seasoning at the time it is sold, the MSR capitalized in a lower interest rate environment generally will have an increased market value whereas the MSR capitalized in a higher interest rate environment will generally sell at a market price below the original fair value recorded. The MSRs are sold in a separate transaction from the sale of the underlying loans.
Management periodically tests the MSR portfolio for impairment and obtains a third-party valuation annually. Impairment in a MSR portfolio is typically created by a sudden and unexpected change in the interest rate environment. Since the interest rate environment is beyond the control of management, there can be no assurances made that we will be able to avoid an impairment charge in the future.

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     Three months
For the three months ended June 30, 2005, the net gain on the sale of mortgage servicing rights decreased from $37.2 million during the 2004 period to $2.3 million in the three months ended June 30, 2005.
We did not sell any MSRs in a bulk package or flow basis during the three months ended June 30, 2005 versus $8.4 billion during the comparable 2004 period. We did reflect a gain during the 2005 quarter attributable to cash received on sales held in a prior period for which certain contingencies were resolved. We did not sell any bulk servicing packages in the 2005 period versus a $4.8 billion package in the 2004 period. During 2005, we did not sell any servicing rights on a flow basis. During 2004, we sold $3.6 billion of newly originated servicing rights on a flow basis. Management has determined to continue evaluating selling opportunities in light of current economic conditions. The decline in MSR sales in 2005 is attributable to lower spreads available in the current interest rate environment.
During the quarter ended June 30, 2005, we sold $0.3 billion of loans on a servicing released basis compared to $0.2 billion of loans sold on a servicing released basis during the same period in 2004.
     Six months
For the six months ended June 30, 2005, the net gain on the sale of mortgage servicing rights decreased from $59.0 million during the 2004 period to $6.5 million. The gain on sale in the 2004 period was higher than the gain recorded in the 2005 period because of the better spread achieved in 2004 and the reduction in the sales volume in 2005.
We sold MSR’s with underlying loans totaling $2.5 billion during the six months ended June 30, 2005 compared with $14.5 billion during the six months ended June 30, 2004. During the six months ended June 30, 2005, we sold $2.5 billion in bulk servicing packages compared to the $8.8 billion in the comparable 2004 period. During 2005, we did not sell any servicing rights on a flow basis and during the same period in 2004, we sold $5.7 billion of newly originated servicing rights on a flow basis.
For the six months ended June 30, 2005, we did sell $0.8 billion of loans on a servicing released basis compared to $0.5 billion of loans sold on a servicing released basis during the same period in 2004.
Other fees and charges
     Three months
During the three months ended June 30, 2005, other fees and charges increased $0.7 million, or 6.1% to $12.1 million from $11.4 million recorded in the same period in 2004. During the three months ended June 30, 2005, we recorded $2.7 million in dividends received on FHLB stock, compared to the $2.3 million received during the three months ended June 30, 2004. At June 30, 2005 and 2004, we owned $262.5 million and $234.8 million of FHLB stock, respectively. We also recorded $1.2 million in subsidiary income for the three months ended June 30, 2005 versus $1.1 million recorded during the same period in 2004.
     Six months
During the six months ended June 30, 2005, other fees and charges increased $1.2 million, or 5.9% to $21.6 million from $20.4 million recorded in the same period in 2004. During the six months ended June 30, 2005, we recorded $5.2 million in dividends received on FHLB stock, compared to the $4.9 million received during the six months ended June 30, 2004. We also recorded $2.4 million in subsidiary income for the six months ended June 30, 2005 versus $2.3 million recorded during the six months ended June 30, 2004.

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Non-Interest Expense
The following table sets forth the components of our non-interest expense, along with the allocation of expenses related to loan originations that are deferred pursuant to SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.” As required by SFAS No. 91, mortgage loan fees and certain direct origination costs (principally compensation and benefits) are capitalized as an adjustment to the basis of the loans originated during the period. Certain other expenses associated with loan production, however, are not required or allowed to be capitalized. These expense amounts are reflected on our statement of earnings.
                                 
    For the three months ended June 30,   For the six months ended June 30,
    2005   2004   2005   2004
    (in thousands)
Compensation and benefits
  $ 38,477     $ 40,306     $ 76,032     $ 78,743  
Commissions
    22,887       28,389       43,967       52,058  
Occupancy and equipment
    18,302       16,935       34,953       34,464  
Advertising
    2,111       2,407       4,236       4,797  
Federal insurance premium
    284       250       580       513  
Communication
    1,563       1,845       3,116       3,704  
Other taxes
    2,463       3,096       4,531       6,047  
General and administrative
    11,860       11,501       23,299       23,832  
 
                               
Total
    97,947       104,730       190,714       204,158  
Less: capitalized direct costs of loan closings
    (30,873 )     (41,393 )     (59,918 )     (78,442 )
 
                               
Net Amount
  $ 67,074     $ 63,337     $ 130,796     $ 125,716  
 
                               
Efficiency ratio1
    59.2 %     48.6 %     61.1 %     48.5 %
     Three months
Non-interest expense, excluding the capitalization of direct loan origination costs, decreased $6.8 million to $97.9 million during the three months ended June 30, 2005, from $104.7 million for the comparable 2004 period.
The following are factors affecting non-interest expense during the quarter:
§   The retail banking operation conducted business from 25 more facilities at June 30, 2005 than at June 30, 2004.
 
§   We conducted business from 23 fewer retail loan origination offices at June 30, 2005 than at June 30, 2004.
 
§   The home lending operation originated $7.1 billion in residential mortgage loans during the 2005 quarter versus $9.1 billion in the comparable 2004 quarter.
 
§   We employed 2,431 salaried employees at June 30, 2005 versus 2,482 salaried employees at June 30, 2004.
 
§   We employed 133 full-time national account executives at June 30, 2005 versus 135 at June 30, 2004.
 
§   We employed 667 full-time retail loan originators at June 30, 2005 versus 862 at June 30, 2004.
The decreased compensation and benefits expense of $1.8 million is the direct result of the decreased personnel count utilized in the home lending operation offset by the staff that was required to support the additional banking centers.
The largest change occurred in commissions paid to the commissioned sales staff. On a period over period basis there was a $5.5 million decrease in these commissions which was a direct result of the decreased mortgage loan originations during the period. During the 2005 period commissions were 32.2 basis points of loan originations versus 31.4 basis points during the 2004 period.
The majority of the $1.0 million increase in occupancy and equipment costs is directly attributable to an increase in banking centers.
 
1   Total operating and administrative expenses divided by the sum of net interest income and non-interest income

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During the three months ended June 30, 2005, we capitalized direct loan origination costs of $30.9 million, a decrease of $10.5 million from $41.4 million for the comparable 2004 period. This decrease is a result of the decrease in mortgage loan production during the 2005 period versus the 2004 production. The 2005 deferral equates to a capitalization of $826 per loan versus $796 per loan in the 2004 period.
     Six months
Non-interest expense, excluding the capitalization of direct loan origination costs, decreased $13.5 million to $190.7 million during the six months ended June 30, 2005, from $204.2 million for the comparable 2004 period.
The decreased compensation and benefits expense of $2.7 million is the direct result of the decreased personnel count utilized in the home lending operation offset by the salary increases given to the remaining employees and the staff that was required to support the additional banking centers.
The largest change occurred in commissions paid to the commissioned sales staff. On a year over year basis there was an $8.1 million decrease as a direct result of the decreased mortgage loan originations during the period. During the 2005 period commissions were 30.7 basis points of loan originations versus 28.1 basis points during the 2004 period. During the six months ended June 30, 2005, we capitalized direct loan origination costs of $59.9 million, a decrease of $18.5 million from $78.4 million for the comparable 2004 period. This decrease is a result of the decrease in mortgage loan production during the 2005 period versus the 2004 production. The 2005 deferral equates to a capitalization of $788 per loan versus $743 per loan in the 2004 period.
Financial Condition
Assets
Our assets totaled $14.9 billion at June 30, 2005, an increase of $1.8 billion, or 13.7%, as compared to $13.1 billion at December 31, 2004. This increase was primarily due to an increase in earning assets at June 30, 2005.
     Cash and cash equivalents
Cash and cash equivalents increased from $156.5 million at December 31, 2004 to $171.3 million at June 30, 2005.
     Mortgage-backed securities held to maturity
Mortgage-backed securities decreased from $20.7 million at December 31, 2004 to $17.8 million at June 30, 2005. The decrease was attributed to payoffs received. There were no additions to the portfolio in the six months ended June 30, 2005.
     Investment securities
Our investment securities increased from $18.4 million at December 31, 2004 to $20.7 million at June 30, 2005. The investment portfolio is limited to a small portfolio of contractually required collateral, regulatory required collateral, and investments made by non-bank subsidiaries.
     Loans available for sale
Mortgage loans available for sale increased $0.5 billion, or 33.3%, to $2.0 billion at June 30, 2005, from $1.5 billion at December 31, 2004. This increase is primarily attributable to the timing of the loan sales.

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     Investment loan portfolio
The investment loan portfolio at June 30, 2005 increased $1.3 billion from December 31, 2004. The increase included a $0.6 billion increase in single family mortgage loans and a $0.3 billion increase in consumer loans.
                         
    June 30, 2005   December 31, 2004   June 30, 2004
    (in thousands)
Loans held for investment:
                       
Single family mortgage
  $ 9,341,981     $ 8,657,293     $ 7,369,787  
Second mortgage
    293,582       196,518       133,769  
Construction
    67,749       67,640       67,793  
Commercial real estate
    846,706       751,730       575,458  
Warehouse
    289,244       249,291       237,343  
Commercial
    7,716       8,415       8,250  
Consumer
    937,504       627,576       330,675  
 
                       
Total
  $ 11,784,482     $ 10,558,463     $ 8,723,075  
 
                       
     Allowance for losses
The allowance for losses totaled $33.4 million at June 30, 2005 and $37.6 million at December 31, 2004, respectively. The allowance for losses as a percentage of non-performing loans was 51.2% and 56.1% at June 30, 2005 and December 31, 2004, respectively. Our non-performing loans totaled $65.2 million and $56.9 million at June 30, 2005 and December 31, 2004, respectively. The allowance for losses as a percentage of investment loans was 0.28% and 0.36% at June 30, 2005 and December 31, 2004, respectively. The allowance for losses is considered adequate based upon management’s assessment of relevant factors, including the types and amounts of non-performing loans, historical, and current loss experience on such types of loans, and the current economic environment. The following table provides the amount of delinquent loans at the date listed. At June 30, 2005, 72.0% of all delinquent loans are loans in which we had a first lien position on residential real estate.
                         
Days Delinquent   June 30, 2005   December 31, 2004   June 30, 2004
30
  $ 28,728     $ 33,918     $ 29,529  
60
    24,155       13,247       15,639  
90
    65,168       56,885       59,556  
 
                       
Total
  $ 118,051     $ 104,050     $ 104,724  
 
                       
Investment loans
  $ 11,784,482     $ 10,558,463     $ 8,723,075  
 
                       
Delinquency %
    1.00 %     0.99 %     1.20 %
 
                       

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The following shows the activity in the allowance for loan losses during the indicated periods (in thousands):
Activity Within the Allowance For Loan Losses
                         
    June 30, 2005   June 30, 2004   December 31, 2004
Beginning balance
  $ 37,627     $ 36,017     $ 36,017  
Provision for losses
    9,150       12,905       16,077  
Charge-offs
                       
Mortgage
    (9,733 )     (7,530 )     (14,629 )
Consumer
    (1,927 )     (507 )     (1,150 )
Commercial
    (4,474 )     (72 )     (290 )
Construction
                (2 )
Other
    (91 )     (167 )     (717 )
 
                       
Total
    (16,225 )     (8,276 )     (16,788 )
Recoveries
                       
Mortgage
    463       339       1,081  
Consumer
    137       180       242  
Commercial
    2,193       539       998  
Other
    27              
 
                       
Total
    2,820       1,058       2,321  
 
                       
 
                       
Ending balance
  $ 33,372     $ 41,704     $ 37,627  
 
                       
Net charge-off ratio
    0.24 %     0.24 %     0.17 %
 
                       
     Accrued interest receivable
Accrued interest receivable increased from $35.0 million at December 31, 2004 to $43.7 million at June 30, 2005 as our total loan portfolio increased. We typically collect loan interest in the following month after it is earned.
     FHLB stock
Our investment in FHLB stock increased from $234.8 million at December 31, 2004 to $262.5 million at June 30, 2005. The investment is required to permit the Bank to borrow from the Federal Home Loan Bank of Indianapolis and to maintain our current line of credit.
     Repossessed assets
Repossessed assets decreased from $37.8 million at December 31, 2004 to $35.8 million at June 30, 2005. This decrease was caused by a reduction in the amount of loans in a foreclosed status that are yet to be sold.
     Repurchased assets
We routinely sell residential mortgage loans to the secondary market. As part of these sales, we make customary representations and warranties to the purchasers about various characteristics of each loan, such as the manner of origination, the nature and extent of underwriting standards applied and the types of documentation being provided. We are not required to reimburse purchasers for any missed loan payments or for any reduced income as a result of a loan being prepaid. If any loans do not comply with representations and warranties, we may repurchase the loans or else indemnify the purchaser for any related losses. In order to account for the repurchase and indemnification exposure that results from our representations and warranties, we maintain a secondary market reserve.
These repurchased assets are typically non-performing and totaled a net $17.1 million at December 31, 2004 and $15.8 million at June 30, 2005. The assets have been adjusted by a specific reserve of $3.5 million at December 31, 2004 and $3.7 million at June 30, 2005. During all of 2004, we repurchased $68.7 million in non-performing loans. During the three months ended June 30, 2004 and 2005, we repurchased $29.3 million and $13.0 million in non-performing loans, respectively. In the six months ended June 30, 2004 and 2005, we repurchased $43.9 million and $27.6 million in non-performing loans, respectively.

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Mortgage servicing rights
MSRs totaled $284.3 million at June 30, 2005, an increase of $96.3 million from the $188.0 million reported at December 31, 2004. During the six months ended June 30, 2005, we capitalized $162.3 million, amortized $36.2 million, and sold $29.8 million in mortgage servicing rights. The capitalized value of the mortgage servicing rights as a percentage of the unpaid principal balance of the underlying loans was 1.07% at June 30, 2005 and 0.88% at December 31, 2004.
At June 30, 2005, the fair value of the MSRs was approximately $327.1 million based on an internal valuation model which utilized an average discounted cash flow equal to 9.2%, an average cost to service of $45 per conventional loan and $55 per government or adjustable rate loan, and a weighted constant prepayment assumption equal to 22.5%.
The principal balance of the loans serviced for others stands at $26.6 billion at June 30, 2005 versus $21.4 billion at December 31, 2004. The portfolio contained 198,102 loans, had a weighted average interest rate of 6.03%, a weighted remaining term of 313 months, and had been seasoned 14 months.
Activity of Mortgage Loans Serviced for Others (in thousands):
                                          
    For the three months ended June 30,   For the six months ended June 30,
    2005   2004   2005   2004
Beginning Balance
  $ 22,518,180     $ 29,858,203     $ 21,354,724     $ 30,395,079  
Loans Sold
    5,891,492       8,085,479       11,329,539       15,726,216  
 
                               
Subtotal
    28,409,672       37,943,682       32,684,263       46,121,295  
 
                               
Loans sold servicing released
    291,663       206,448       806,215       496,544  
Servicing sold (flow basis)
          3,587,110             5,656,232  
Servicing sold (bulk basis)
          4,806,014       2,475,832       8,804,850  
 
                               
Subtotal
    291,663       8,599,572       3,282,047       14,957,626  
Loan prepayments and amortization
    1,471,477       2,676,802       2,755,684       4,496,361  
 
                               
Ending balance
  $ 26,646,532     $ 26,667,308     $ 26,646,532     $ 26,667,308  
 
                               
Other assets
Other assets decreased $47.1 million, or 22.4%, to $162.8 million at June 30, 2005, from $209.9 million at December 31, 2004. The majority of this decrease was attributable to the collection of receivables in conjunction with the sale of residential mortgage loan servicing rights during the later portion of 2004 and the first quarter of 2005. Upon the sale of the mortgage servicing rights a receivable is recorded for a portion of the sale proceeds. The balance due is normally received within 180 days after the sale date.
Liabilities
Our total liabilities increased $1.8 billion, or 14.5%, to $14.2 billion at June 30, 2005, from $12.4 billion at December 31, 2004. The majority of this increase was found in our interest bearing liabilities.
     Deposit accounts
Our deposit accounts increased $0.5 billion to $7.9 billion at June 30, 2005, from $7.4 billion at December 31, 2004. Within that increase, a significant movement of deposits occurred from demand and savings accounts to money markets accounts and certificates of deposit. This movement reflected the increase in rates on the money market accounts and certificates of deposit as short-term money rates offered on these instruments increased nationwide during the period.
Demand deposit accounts decreased $44.7 million to $331.8 million at June 30, 2005, from $376.5 million at December 31, 2004.
Savings deposit accounts decreased $495.8 million to $388.3 million at June 30, 2005, from $884.1 million at December 31, 2004.
Money market deposits increased $167.5 million to $1,027.1 million at June 30, 2005, from $859.6 million at December 31, 2004.
Certificates of deposits increased $0.7 billion to $2.8 billion at June 30, 2005, from $2.1 billion at December 31, 2004.

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The municipal deposit channel now totals $1.5 billion. The account totals increased $0.2 billion during the three months ended June 30, 2005. These deposits have been garnered from local government units within our retail market area.
National deposit accounts decreased $0.1 billion to $1.8 billion at June 30, 2005, from $1.9 billion at December 31, 2004. These deposits have a weighted maturity of 21.4 months and are used for interest rate risk management.
Deposit Portfolio
(in thousands)
                                                 
    June 30, 2005   December 31, 2004
    Balance   Rate   %   Balance   Rate   %
Demand deposits
  $ 331,842       0.69 %     4.2 %   $ 376,506       0.71 %     5.1 %
Savings deposits
    388,363       1.78       4.9       884,117       2.13       12.0  
Money market deposits
    1,027,099       2.77       13.0       859,573       1.98       11.6  
Certificates of deposits
    2,819,086       3.67       35.8       2,056,608       3.51       27.9  
 
                                               
Total retail deposits
    4,566,390       3.09       57.9       4,176,804       2.65       56.6  
 
                                               
Municipal deposits
    1,463,333       3.41       18.6       1,264,225       2.37       17.1  
National deposits
    1,857,305       3.28       23.5       1,938,626       3.05       26.3  
 
                                               
Total deposits
  $ 7,887,028       3.19 %     100.0 %   $ 7,379,655       2.71 %     100.0 %
 
                                               
     FHLB advances
The portfolio of FHLB advances contain fixed rate term advances, floating rate daily adjustable advances, and fixed rate putable advances. The following is a breakdown of the advances outstanding (in thousands):
                                 
    June 30, 2005   December 31, 2004
    Amount   Rate   Amount   Rate
Floating rate daily advances
  $ 1,505,035       3.46 %   $ 620,000       1.95 %
Fixed rate putable advances
    700,000       4.49 %     1,120,000       5.15 %
Fixed rate term advances
    2,956,000       3.52 %     2,350,000       3.53 %
 
                               
Total
  $ 5,161,035       3.64 %   $ 4,090,000       3.74 %
 
                               
FHLB advances increased $1.1 billion to $5.2 billion at June 30, 2005, from $4.1 billion at December 31, 2004. We rely upon such advances as a source of funding for the origination or purchase of loans for sale in the secondary market and for providing duration specific medium-term financing. The outstanding balance of FHLB advances fluctuates from time to time depending upon our current inventory of loans available for sale and the availability of lower cost funding from our retail deposit base and our escrow accounts. We have an approved line with the FHLB of $5.5 billion at June 30, 2005. During the six months ended June 30, 2005, $420 million of putable advances with an average rate of 6.25% matured.
     Long term debt
Our long-term debt principally consists of junior subordinated notes related to trust preferred securities. A portion of the notes bear interest at floating three month LIBOR plus 2.00%. The remainder of the notes bears interest at fixed rates ranging from 4.55% to 6.75%. The notes mature in 30 years from issuance, are callable after five years, pay interest quarterly, and the interest expense is deductible for federal income tax purposes. Our long-term debt amounted to $181.7 million at June 30, 2005 and $104.4 million at December 31, 2004. The increase in our long-term debt arises from the issuance of junior subordinated notes related to trust preferred securities in the first quarter of 2005.
     Accrued interest payable
Our accrued interest payable increased $4.7 million to $32.8 million at June 30, 2005, from $28.1 million at December 31, 2004. The increase is due to a 13.8% increase in interest-bearing liabilities for the period.

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     Undisbursed payments on loans serviced for others
Undisbursed payments on loans serviced for others decreased $19.1 million to $477.1 million at June 30, 2005, from $496.2 million at December 31, 2004. These amounts represent payments received from borrowers for interest, principal and related loan charges, which have not yet been remitted to the respective investors. These balances fluctuate with the size of the servicing portfolio and may increase during a time of high payoff or refinance volume.
     Escrow accounts
Customer escrow accounts increased $108.6 million to $285.0 million at June 30, 2005, from $176.4 million at December 31, 2004. These amounts represent payments received from borrowers for taxes and insurance payments, which have not been remitted to the tax authorities or insurance providers. These balances fluctuate with the size of the servicing portfolio and during the year before and after the remittance of scheduled payments. A large amount of escrow payments are made in July and December to local school and municipal agencies.
     Liability for checks issued
Liability for checks issued increased $2.9 million to $21.8 million at June 30, 2005, from $18.9 million at December 31, 2004. These amounts represent checks issued to acquire mortgage loans that have not cleared for payment. These balances fluctuate with the size of the mortgage pipeline.
     Federal income taxes payable
Federal income taxes payable increased $26.7 million to $52.8 million at June 30, 2005, from $26.1 million at December 31, 2004. This increase is attributable to the increase in the deferred tax liability created by timing differences in the recognition of revenue from a financial statement basis versus a federal income tax basis offset by any estimated payments made during the first six months of 2005.
     Secondary Market Reserve
We routinely sell residential mortgage loans to the secondary market. As part of these sales, we make customary representations and warranties to the purchasers about various characteristics of each loan, such as the manner of origination, the nature and extent of underwriting standards applied and the types of documentation being provided. We are not required to reimburse purchasers for any missed loan payments or for any reduced income as a result of a loan being prepaid. If any loans do not comply with representations and warranties, we may repurchase the loans or else indemnify the purchaser for any related losses.
In order to account for the repurchase and indemnification exposure that results from our representations and warranties, we maintain a secondary market reserve. The reserve is a function of expected losses net of actual recoveries and is based on repurchase requests, historical experience and volume of loan sales. The reserve is maintained at a level that is based on management’s analysis of the probable losses related to the repurchase of loans that were sold during the prior sixty-month period. Our experience indicates that deficiencies in representations and warranties that require repurchase of a loan are usually raised within the first sixty months following the sale of the loan. There can be no assurance that the Company will not sustain losses that exceed the reserve, or that subsequent evaluation will not require adjustments to the reserve. Any increase in this reserve would decrease the earnings in the period in which the increase is recorded. Such an increase is charged to net gains on loan sales.

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For the sixty-month period ending June 30, 2005, the amount of loans we sold into the secondary market was $168.1 billion. The table below shows the activity in the Secondary Market Reserve during the three and six-month periods ended June 30, 2005.
                 
    For the three months   For the six months
    ended June 30, 2005   ended June 30, 2005
    (in thousands)
     
Beginning balance
  $ 15,162     $ 19,002  
Provision
    2,452       3,454  
Charge-offs, net of recoveries
    (2,014 )     (6,856 )
 
               
Ending balance
  $ 15,600     $ 15,600  
 
               
     Other liabilities
Other liabilities decreased $5.2 million to $46.5 million at June 30, 2005, from $51.7 million at December 31, 2004. This increase was caused by changes in the timing of the payment of liabilities associated with the employee payroll and our mortgage production.
Liquidity and Capital
     Liquidity
Liquidity refers to the ability or the financial flexibility to manage future cash flows in order to meet the needs of depositors and borrowers and fund operations on a timely and cost-effective basis. We have no other significant business than that of our wholly owned subsidiary, Flagstar Bank, FSB.
Our primary sources of funds are customer deposits, loan repayments and sales, advances from the FHLB, cash generated from operations and customer escrow accounts. Additionally, during the past seven years, we and our affiliates have issued securities in seven separate offerings to the capital markets, generating over $300 million in gross proceeds. While these sources are expected to continue to be available to provide funds in the future, the mix and availability of funds will depend upon future economic and market conditions. We do not foresee any difficulty in meeting our liquidity requirements.
Consumer deposits increased $0.5 billion from $7.4 billion at December 31, 2004, or 6.8%, to $7.9 billion at June 30, 2005.
Mortgage loans sold during the six months ended June 30, 2005 totaled $11.3 billion, a decrease of $4.4 billion from the $15.7 billion sold during the same period in 2004. This decrease in mortgage loan sales was attributable to a $4.2 billion decrease in mortgage loan originations as compared to the same period in 2004. We sold 79.1% and 84.9% of our mortgage loan originations during the six-month periods ended June 30, 2005 and 2004, respectively.
We typically use FHLB advances to fund our daily operational liquidity needs and to assist in funding loan originations. We will continue to use this source of funds until a lower cost source of funds becomes available such as consumer deposits. We had $5.2 billion outstanding at June 30, 2005. Such advances are repaid with the proceeds from the sale of mortgage loans. We currently have an authorized line of credit equal to $5.5 billion at June 30, 2005. This line is collateralized by non-delinquent mortgage loans. To the extent that the amount of retail deposits or customer escrow accounts can be increased, we expect to replace FHLB advances.
At June 30, 2005, we had outstanding rate-lock commitments to lend $3.7 billion in mortgage loans, along with outstanding commitments to make other types of loans totaling $285.9 million. Because such commitments may expire without being drawn upon, they do not necessarily represent future cash commitments. Also, at June 30, 2005, we had outstanding commitments to sell $3.0 billion of mortgage loans. These commitments will be funded within 90 days. Total commercial and consumer unused lines of credit totaled $1.8 billion at June 30, 2005. Such commitments include $1.1 billion of unused warehouse lines of credit to various mortgage companies. We had advanced $289.2 million at June 30, 2005.
     Regulatory Capital Adequacy
At June 30, 2005, the Bank exceeded all applicable bank regulatory minimum capital requirements. The Company is not subject to any such requirements.

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     Critical Accounting Policies
Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular we have identified five policies, that, due to the judgments, estimates and assumptions inherent in those policies, are critical to an understanding of our financial statements. These policies relate to (a) the methodology for determining our allowance for loan losses; (b) the valuation of our mortgage servicing rights; (c) the accounting for our derivatives; (d) the valuation of our secondary market reserve, and (e) the recognition of gain or loss on the sale of loans. We believe that the judgments, estimates and assumptions used in the preparation of our consolidated financial statements are appropriate given the factual circumstances at the time. However, given the sensitivity of our consolidated financial statements to these critical accounting policies, the use of other judgments, estimates and assumptions could result in material differences in our results of operations or financial condition. For further information on our critical accounting policies refer to our Annual Report on Form 10-K for the year ended December 31, 2004.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
In our home lending operations, we are exposed to market risk in the form of interest rate risk from the time the interest rate on a mortgage loan application is committed to by us through the time we sell or commit to sell the mortgage loan. On a daily basis, we analyze various economic and market factors and, based upon these analyses, project the amount of mortgage loans we expect to sell for delivery at a future date. The actual amount of loans sold will be a percentage of the number of mortgage loans on which we have issued binding commitments (and thereby locked in the interest rate) but have not yet closed (“pipeline loans”) to actual closings. If interest rates change in an unanticipated fashion, the actual percentage of pipeline loans that close may differ from the projected percentage. The resultant mismatching of commitments to fund mortgage loans and commitments to sell mortgage loans may have an adverse effect on the results of operations in any such period. For instance, a sudden increase in interest rates can cause a higher percentage of pipeline loans to close than projected. To the degree that this is not anticipated, we will not have made commitments to sell these additional pipeline loans and may incur losses upon their sale as the market rate of interest will be higher than the mortgage interest rate committed to by us on such additional pipeline loans. To the extent that the hedging strategies utilized by us are not successful, our profitability may be adversely affected.
Management believes there has been no material change in either interest rate risk or market risk since December 31, 2004.
Item 4. Controls and Procedures
a) Disclosure Controls and Procedures. A review and evaluation was performed by our principal executive and financial officers regarding the effectiveness of our disclosure controls and procedures as of June 30, 2005, pursuant to Rule 13a-15(b) of the Securities Act of 1934. Based on that review and evaluation, the principal executive and financial officers have concluded that our current disclosure controls and procedures, as designed and implemented, are not operating effectively as a result of the material weaknesses reported in Item 9A-Controls and Procedures to our Annual Report of Form 10-K for the year ended December 31, 2004.
b) Changes in Internal Controls. During the quarter ended June 30, 2005, we have implemented changes to our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) of the Securities Act of 1934 in order to address each of the six areas of material weaknesses identified in Item 9A-Controls and Procedures of our Annual Report on Form 10-K for the year ended December 31, 2004. The changes implemented during the quarter are:
    Weakness related to our accounting for derivative activities. We are implementing an ongoing continuing education program for accounting personnel that includes the areas of derivatives, allowance for loan losses and transfers and servicing of financial assets.
 
    Weakness related to recording of accrued interest receivable. We have refined our processes relating to the calculation and recording of accrued interest on mortgage loans.
 
    Weaknesses related to the documentation of the evaluation of the appropriateness of accounting estimates. We have enhanced documentation of significant accounting estimates.
 
    Weaknesses surrounding the recording of non-routine journal entries. We have enhanced documentation of controls surrounding the recording of non-routine journal entries. We have also engaged an outside accounting consultant to provide additional guidance with respect to non-routine transactions and entries.
 
    Weaknesses related to validation and evaluation of data. We are implementing controls over the validation and evaluation of data used to support certain transactions and estimates including the valuation of interest rate lock commitments.

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    Weakness related to company-level controls. We have taken the following steps to enhance company-level controls:
    Implementation of an accounting system wide automation process to reduce manual processes;
 
    Adding experienced personnel to the accounting department;
 
    Establishment of a financial internal audit department as a separate unit from the operational, regulatory and compliance internal audit functions;
 
    Hiring additional financial internal auditors;
 
    Adding additional expertise to the audit committee;
 
    Engaging an outside consultant to assist with improving our internal control methodologies and testing in conjunction with the Sarbanes Oxley Act of 2002;
 
    Establishment of a formal disclosure committee process for periodic review of financial statements;
 
    Complete development of a comprehensive program to review, evaluate and improve security covering user access rights to certain critical applications.
Although we believe that each of the weaknesses will be remediated, there can be no assurance that the remediation will be completed by December 31, 2005.

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PART II — OTHER INFORMATION
Item 1. Legal Proceedings
     None.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
     The company made no unregistered sales of its common stock or repurchases of its common stock during the quarter ended June 30, 2005.
Item 3. Defaults upon Senior Securities
     None.
Item 4. Submission of Matters to a Vote of Security Holders
The 2005 Annual Meeting of Shareholders of the Company was held on May 27, 2005.
(a) Under Proposal I the following directors were re-elected for a term of two years:
                 
    For   Withheld
Mark T. Hammond
    49,945,074       3,499,444  
Michael W. Carrie
    49,888,747       3,555,771  
James D. Coleman
    51,120,683       2,323,835  
Richard S. Elsea
    49,449,658       3,994,860  
Robert O. Rondeau Jr.
    49,858,365       3,586,153  
(b) The following Proposals were adopted:
                                 
Proposals   For   Withheld   Abstain   Non-Vote
II — Increase in Authorized Shares
    36,615,738       4,863,232       146,116       11,819,317  
 
                               
III — Increase in the Number of Board Seats
    52,252,059       1,068,697       123,762       0  
 
                               
IV — Increase the Number of Shares Available for Issuance Under the Option Plan
    31,454,233       9,978,408       192,377       11,819,317  
 
                               
V — Set the Maximum Number of Incentive Option Shares Available for Issuance
    39,084,458       2,317,502       222,450       11,819,317  
 
                               
VI — Increase the Number of Shares Available for Issuance Under the 2000 Stock Incentive Plan
    32,320,747       9,072,675       231,729       11,819,317  
 
                               
VII — Ratification of the Incentive Compensation Plan
    37,717,828       3,685,284       222,038       11,819,318  
Item 5. Other Information
     None.

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Item 6. Exhibits
     (a) Exhibits
     
Exhibit 3.1
  Second Restated Articles of Incorporation (previously filed as Exhibit 16.1 to the Company’s Quarterly Report on Form 10-Q filed on August 9, 2005 and incorporated herein by reference)
 
   
Exhibit 3.2
  Amended By-Laws (previously filed as Exhibit 16.1 to the Company’s Quarterly Report on Form 10-Q filed on August 9, 2005 and incorporated herein by reference)
 
   
Exhibit 11.
  Computation of Net Earnings per Share (previously filed as Exhibit 16.1 to the Company’s Quarterly Report on Form 10-Q filed on August 9, 2005 and incorporated herein by reference)
 
   
Exhibit 31.1
  Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
 
   
Exhibit 31.2
  Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
 
   
Exhibit 32.1
  Section 1350 Certification, as furnished by the Chief Executive Officer pursuant to SEC. Release No. 34-47551
 
   
Exhibit 32.2
  Section 1350 Certification, as furnished by the Chief Financial Officer pursuant to SEC. Release No. 34-47551

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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.
     
 
  FLAGSTAR BANCORP, INC.
 
   
Date: September 7, 2005
  /S/ Mark T. Hammond
 
   
 
  Mark T. Hammond
 
  President and
 
  Chief Executive Officer
 
  (Duly Authorized Officer)
 
   
 
  /S/ Paul D. Borja
 
   
 
  Paul D. Borja
 
  Executive Vice President and
 
  Chief Financial Officer
 
  (Principal Financial Officer)

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Exhibit Index
     
Exhibit No.   Description
 
3.1
  Second Restated Articles of Incorporation (previously filed as Exhibit 16.1 to the Company’s Quarterly Report on Form 10-Q filed on August 9, 2005 and incorporated herein by reference)
 
   
3.2
  Amended By-Laws (previously filed as Exhibit 16.1 to the Company’s Quarterly Report on Form 10-Q filed on August 9, 2005 and incorporated herein by reference)
 
   
11.
  Computation of Net Earnings per Share (previously filed as Exhibit 16.1 to the Company’s Quarterly Report on Form 10-Q filed on August 9, 2005 and incorporated herein by reference)
 
   
31.1
  Rule 13a-14(a)/15d-14(a) Certification of Chief Executive Officer
 
   
31.2
  Rule 13a-14(a)/15d-14(a) Certification of Chief Financial Officer
 
   
32.1
  Section 1350 Certification, as furnished by the Chief Executive Officer pursuant to SEC. Release No. 34-47551
 
   
32.2
  Section 1350 Certification, as furnished by the Chief Financial Officer pursuant to SEC. Release No. 34-47551

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