10-K

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2005

OR

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File No. 001-32026

SUNSET FINANCIAL RESOURCES, INC.

(Exact name of registrant as specified in its charter)

MARYLAND	16-1685692
(State or other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

10245 Centurion Parkway North, Suite 305, Jacksonville, Florida 32256

(Address of principal executive offices including zip code)

(904) 425-4575

(Registrant’s telephone number and area code)

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, par value $0.001 per share	New York Stock Exchange
(Title of class)	(Name of exchange on which registered)

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Act.    Yes  ¨    No  x

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.    Yes  ¨    No  x

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K.  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Act.

Large accelerated filer  ¨    Accelerated filer  x    Non-accelerated filer  ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).    Yes  ¨    No  x

The aggregate market value of the voting common equity held by non-affiliates of the Registrant computed by reference to the price at which the common equity was last sold as of the last business day of the Registrant’s most recently completed second fiscal quarter was $99.1 million.

As of March 8, 2006, there were 10,516,600 shares of common stock outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

None

Table of Contents

Sunset Financial Resources, Inc.

FORM 10-K

For the Fiscal Year Ended December 31, 2005

INDEX

		Page
Part I
Item 1.	Business	4
Item 1A.	Risk Factors	13
Item 1B.	Unresolved Staff Comments	21
Item 2.	Properties	21
Item 3.	Legal Proceedings	21
Item 4.	Submission Of Matters to a Vote of Security Holders	22
Part II
Item 5.	Market for Registrant’s Common Equity, Related Stockholder Matters And Issuer Purchases of Equity Securities	23
Item 6.	Selected Financial Data	24
Item 7.	Management’s Discussion and Analysis of Financial Condition and Results of Operation	25
Item 7A.	Quantitative and Qualitative Disclosures about Market Risk	34
Item 8.	Financial Statements and Supplementary Data	37
Item 9.	Changes in and Disagreements with Accountants on Accounting and Financial Disclosure	37
Item 9A.	Controls and Procedures	37
Item 9B.	Other Information	37
Part III
Item 10.	Directors and Executive Officers of the Registrant	38
Item 11.	Executive Compensation	40
Item 12.	Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters	42
Item 13.	Certain Relationships and Related Transactions	44
Item 14.	Principal Accountant Fees and Services	44
Part IV
Item 15.	Exhibits and Financial Statement Schedules	45

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SPECIAL NOTE REGARDING FORWARD LOOKING STATEMENTS

Certain statements contained herein constitute forward-looking statements as such term is defined in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements are not guarantees of performance. Our future results, financial condition and business may differ materially from those expressed in these forward-looking statements. You can find many of these statements by looking for words such as “plans,” “intends,” “estimates,” “anticipates,” “expects,” “believes” or similar expressions in this annual report on Form 10-K. These forward-looking statements are subject to numerous assumptions, risks and uncertainties. Many of the factors that will determine these items are beyond our ability to control or predict.

For these statements, we claim the protection of the safe harbor for forward-looking statements contained in the Private Securities Litigation Reform Act of 1995. You are cautioned not to place undue reliance on our forward-looking statements, which speak only as of the date of this annual report on Form 10-K or the date of any document incorporated by reference. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. We do not undertake any obligation to release publicly any revisions to our forward-looking statements to reflect events or circumstances after the date of this Form 10-K.

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PART I

Item 1. Business

Unless the context otherwise requires, the terms “we,” “us” and “our” refer to Sunset Financial Resources, Inc., a Maryland corporation, and, where appropriate, its subsidiaries.

Company Overview

We are a self-managed real estate investment trust (REIT) that was formed as a Maryland corporation in October 2003 to acquire, on a leveraged basis, a portfolio of residential mortgage assets and commercial mortgage bridge loans (including loans that we own jointly with others) in the United States. We finance and manage a portfolio of mortgage assets that primarily consists of agency mortgage-backed and “AAA” rated securities, residential mortgage loans and commercial mortgage bridge loans. Our principal business objective is to generate income for distribution to our stockholders by earning a positive spread between the interest income on our assets and the interest expense (including hedge costs) on financing those assets.

We elected to be treated as a REIT for federal income tax purposes. In order to maintain our status as a REIT, we must comply with a number of requirements under the federal tax law, including the requirement to distribute at least 90% of our annual taxable income to our stockholders. For additional information, see “Taxation of our Company.”

We had limited operations until receiving the proceeds from the initial public offering of our common stock in March 2004, at which time we commenced the execution of our business strategy of investing in residential mortgage related securities and commercial bridge loans. Our common stock, par value $0.001 per share, is traded on the New York Stock Exchange under the symbol “SFO”. Our principal executive offices are located at 10245 Centurion Parkway North, Suite 305, Jacksonville, Florida 32256. Our telephone number is (904) 425-4575 and our website address is www.sunsetfinancial.net. You may obtain copies of SEC filings free of charge on our website.

In October, the special committee of our board of directors hired Banc of America Securities LLC to perform a review of our business plan and to advise the special committee regarding exploring other alternatives to maximize stockholder value. This process is ongoing, and no decision has been made to pursue any strategic alternative. There can be no assurance that the exploration of strategic alternatives will result in any definitive agreement or transaction.

Description of Our Assets

At December 31, 2005, our assets consisted of the assets set forth below in the following approximate amounts:

• $160.6 million in securitized residential mortgage loans;

• $294.0 million in “AAA” rated mortgage-backed securities;

• $648.9 million in agency mortgage-backed securities, issued by the Federal National Mortgage Association (known as FNMA or Fannie Mae); and

• $29.3 million in outstanding principal amount of commercial mortgage bridge loans (including commercial mortgage bridge loans that we own jointly with other interest holders).

We use a relative value approach in selecting our assets, targeting those with the best spread returns and least market value drift. Management evaluates several critical factors, including asset performance in differing interest rate environments, duration of the security, yield to maturity, potential for prepayment of principal, and the market price, in selecting assets.

We leverage our assets through the use of reverse repurchase agreements. Under these repurchase agreements, we sell securities or securitized loans to a lender and agree to repurchase the same instruments at a predetermined price and date. Although structured as a sale and repurchase obligation, a repurchase agreement operates as a financing under which we pledge assets as collateral to secure a loan which is equal in value to a specified percentage of the estimated fair value of the pledged collateral.

We use derivative hedges, typically simple interest rate swaps, to extend the duration of our liabilities to more closely match the expected duration of our assets, and to balance income generation with the protection of book value and market value. We typically pay a fixed rate of interest and receive a floating rate of interest to offset the floating nature of our reverse repurchase agreements, which effectively converts our variable-rate debt into fixed-rate debt over the life of the swap agreements. Our use of interest rate swaps mitigates, to a large degree, the risk of net interest margin compression. We may elect to use other derivative instruments in the future, including caps, floors, Eurodollar futures and options on swaps and treasuries, to further reduce this risk.

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Subject to the limitations imposed by our capital and leverage policy discussed below, we expect to finance the purchase of additional mortgage assets with borrowings under reverse repurchase agreements and potentially through future securitizations and other financing vehicles.

Residential Mortgage Assets. Our residential mortgage assets consist of mortgage-backed securities, securitized mortgage loans and mortgage loans, all of which are typically secured by pools of hybrid mortgage loans that have interest rates that are fixed for a specified period, usually three to seven years, and then generally reset annually for the remainder of the term of the loan (Hybrid ARMs). These assets are primarily securities issued or guaranteed as to principal and interest by an agency of the U.S. government, such as the Federal National Mortgage Association (Fannie Mae), or are non-agency AAA rated. Agency mortgage-backed securities consist of agency pass-through certificates and collateralized mortgage obligations, commonly known as CMOs, issued or guaranteed by an agency or a federally-chartered corporation. The residential loans are originated by or purchased from various sources throughout the United States such as savings and loan associations, banks, mortgage bankers, home builders, insurance companies, financial institutional dealers and other mortgage lenders.

Our board of directors has not established any limits upon the geographic concentration of mortgage loans to be acquired by us or the credit quality of suppliers of mortgage loans. Although we have only acquired agency mortgage-backed securities or securities with a “AAA” rating, our capital investment policy does not prohibit us from acquiring other classes of mortgage-backed securities. Our allocation of investments among the permitted investment types may vary from time to time based on our board of directors’ evaluation of economic and market trends, our perception of the relative values of these types of investments and our adherence to the risk management objectives within our operating and investment policies.

We acquire only those mortgage-backed securities that are consistent with our risk management objectives, that can be readily financed, and that fit with our management expertise. Future interest rates and mortgage prepayment rates are difficult to predict; therefore, we seek to acquire a diversified portfolio of mortgage-backed securities which we believe will provide acceptable returns over a broad range of interest rate and prepayment scenarios.

Mortgage-backed securities differ from other forms of traditional debt securities, which normally provide for periodic payments of interest in fixed amounts with principal payments at maturity or on specified call dates. Instead, mortgage-backed securities provide for a monthly payment, which consists of both interest and principal. In effect, these payments are a “pass-through” of the monthly interest and principal payments made by the individual borrowers on the underlying mortgage loans, net of any fees paid to the issuer or the guarantor of the securities. Additional payments result from prepayments of principal upon the sale, refinancing or foreclosure of the underlying residential property, net of fees or costs which may be incurred. This difference can result in significantly greater price and yield volatility than is the case with traditional fixed-income securities.

Various factors affect the rate at which mortgage prepayments occur, including changes in interest rates, general economic conditions, the age of the mortgage loan, the location of the property and other social and demographic conditions. Generally prepayments on mortgage-backed securities increase during periods of falling mortgage interest rates and decrease during periods of rising mortgage interest rates. We may reinvest prepayments at yields that are higher or lower than the yields on the prepaid investments, thus affecting the weighted average yield of our investments. During the quarter ended December 31, 2005, the annualized prepayment speeds (known as CPR, or constant prepayment rate) on our portfolio averaged 22%, which was comprised of 24% CPR on our agency portfolio and 20% CPR on our non-agency portfolio.

To the extent mortgage-backed securities are purchased at a premium, faster than expected prepayments result in faster than expected amortization of the premiums paid, and therefore, a faster recognition of expense. Conversely, if these securities were purchased at a discount, faster than expected prepayments accelerate our recognition of income.

CMOs may allow for shifting of prepayment risk from slower-paying tranches to faster-paying tranches. This is in contrast to mortgage pass-through certificates where all investors share equally in all payments, including all prepayments, on the underlying mortgages.

Mortgage-backed securities are designated as available for sale and carried at fair value, with any unrealized gains or losses included in “Other comprehensive income or loss” as a component of stockholders’ equity. At December 31, 2005, the outstanding balance of our mortgage-backed securities portfolio was $942.9 million.

Securitized mortgages include mortgage loans that have been transferred to a securitization trust. Although there has been a change in ownership structure, this transfer does not qualify as a sale, and was made at book value, since we maintain ownership interest in all the securities issued by the trust. These assets, carried on the balance sheet at historical cost, had a carrying value of $160.6 million at December 31, 2005.

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Residential mortgage loans are whole loans that are carried at historical cost. At December 31, 2005, we no longer held whole loans.

Commercial Mortgage Assets. Since inception, we have invested in commercial mortgage bridge loans typically with an initial term of one year and interest rates ranging from 10% to 13%. These loans are carried on the balance sheet at historical cost. Any premium, discount or fees are amortized over the term of the loan as a yield adjustment. At December 31, 2005, we held four commercial mortgage bridge loans totaling approximately $29.3 million in aggregate outstanding principal amount. These loans were secured by a first priority lien on one or more fee simple or leasehold interests in real properties located in the United States. Two of our loans are in default of terms of the loan agreements, and, based on our impairment analysis, we have recorded a bad debt allowance of $6.8 million against the principal balance of these loans.

Over the past several months we have focused our efforts on managing our existing commercial portfolio and have not entered into any new loans. However, we continue to evaluate commercial financing opportunities that would provide both an acceptable return and an acceptable credit risk.

Our Strategy

Our principal business objective is to maintain a portfolio of residential and commercial mortgage assets such that the interest income on our assets exceeds our costs to hedge and finance these assets. To obtain our business objective and generate distributions for our stockholders, our strategy is to:

• purchase first lien residential mortgage loans or mortgage-backed securities backed primarily by Hybrid ARMs with an initial fixed interest rate period of seven years or less, and an adjustable rate thereafter based on changes in short-term market interest rates;

• purchase or initiate commercial mortgage bridge loans that are generally at higher interest rates than rates on loans with longer terms;

• finance purchases of our residential mortgage assets and commercial mortgage bridge loans by utilizing leverage to increase potential returns to stockholders through securitizations, reverse repurchase agreements and various other types of borrowings;

• structure our financings, after consideration of any associated derivative financial instruments, to minimize the cost of borrowing against our assets, minimize counterparty credit risk and manage the leverage of the portfolio in changing market conditions to minimize liquidity risk;

• utilize derivative financial instruments, such as interest rate swaps, short sales, purchases of treasury options, interest rate caps, swaptions, mortgage-backed securities, futures, options, floors and similar products, to mitigate the risk of the costs of our variable rate liabilities increasing at a faster rate than the earnings on our assets; and

• seek to minimize prepayment risk by structuring a diversified portfolio that contains residential mortgage assets with a variety of characteristics, including varying prepayment penalties.

Operating and Investment Policies

Investment Committee and Credit Committee. We have an investment committee and a credit committee, both comprised of the Chief Executive Officer, Chief Financial Officer, Chief Investment Officer and Vice President of Commercial Lending. These committees oversee the day-to-day decisions regarding our acquisitions of assets and the terms of such acquisitions, hedging transactions and the disposition of assets. The committees, without the prior approval of the board of directors, may not:

• make any investment or take any other action that would prevent us from establishing and maintaining our qualification as a REIT for federal income tax purposes;

• leverage our portfolio of residential mortgage loans through borrowings, reverse repurchase agreements, securitizations or otherwise, such that the debt-to-equity ratio on our entire portfolio of residential mortgage loans exceeds 12:1;

• leverage our portfolio of commercial mortgage loans such that the debt-to-equity ratio on our entire portfolio of commercial mortgage loans exceeds 6:1;

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• make any investment or take any other action that would subject us to regulation under the Investment Company Act of 1940;

• acquire any residential mortgage loan that would cause the weighted average FICO score of our entire portfolio of residential mortgage loans to drop below 680;

• acquire any residential mortgage loan or commercial mortgage bridge loan that is not a first-lien mortgage loan secured by real estate;

• acquire any commercial mortgage bridge loan that has a greater than 65% loan-to-value ratio;

• acquire any commercial mortgage bridge loan that has an outstanding principal balance in excess of $10.0 million; or

• acquire any pool of loans that has an outstanding principal balance in excess of $75.0 million.

Our directors review our investment activities on a quarterly basis to ensure compliance with the operating and investment policies. Our directors rely substantially on information and analysis provided by management to evaluate our operating and investment policies, compliance therewith and other matters relating to our investments.

Policies. We conduct our investment operations according to the following policies:

• asset acquisition policy;

• asset/liability management policy;

• commercial loan policy; and

• credit risk management policy.

Asset Acquisition Policy. Our asset acquisition policy provides guidelines for acquiring investments and contemplates that we will acquire a portfolio of investments that can be grouped into specific categories. Assets purchased must fit within one of the following three categories:

• Adjustable or fixed-rate mortgage securities and short-term investments. Assets in this category will be rated within one of the two highest rating categories by at least one nationally recognized statistical rating organization, or if not rated, will be obligations guaranteed by the United States government or its agencies, Fannie Mae or Freddie Mac. All of the mortgage-backed securities we currently hold satisfy this criteria.

• Rated and unrated mortgage loans, non-investment grade mortgage-backed securities backed by residential mortgage assets. Our current residential mortgage loan portfolio, including the residential mortgage loans we have securitized, falls into this category.

• Assets that do not meet any of the above criteria. Among the types of assets generally assigned to this category are mortgage securities rated below investment grade and leveraged mortgage derivative securities, including all of our commercial mortgage assets. Under this category we may acquire other types of mortgage derivative securities, including, but not limited to, interest only, principal only or other mortgage-backed securities that receive a disproportionate share of interest income or principal. The only assets we currently own in this category are our commercial mortgage bridge loans.

We do not have established minimum or maximum allocation parameters for these asset categories. Accordingly, to the extent consistent with our ability to qualify as a REIT, we may have all or none of our assets in a particular category.

Interest rate changes will affect our ability to successfully implement our strategy to primarily invest in ARM-based mortgage assets. Interest rate changes can affect the availability and pricing of ARM-based mortgage assets, which affects our investment opportunities. During a rising interest rate environment, there may be less total loan origination and refinance activity, but a larger percentage of ARM products being originated, mitigating the impact of lower overall loan origination and refinance activity. Conversely, during a declining interest rate environment, consumers, in general, may favor fixed-rate mortgage products, but because there will likely be above average loan origination and refinancing volume in the industry, even a small percentage of ARM product volume may provide sufficient investment opportunities. Additionally, a flat yield curve may create an adverse environment for ARM products because there may be little incentive for a consumer to choose an ARM product over a 30-year fixed-rate mortgage loan, and conversely, in a steep yield curve environment, ARM products

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may enjoy an above average advantage over 30-year fixed-rate mortgage loans, increasing the available pool of ARM investment opportunities. The volume of ARM loans being originated industry-wide can also affect their investment yield. During periods when there is a shortage of ARM products, yields may decline due to market forces, and conversely, when there is an above average supply of ARM products, yields may improve due to the same market forces. Accordingly, the interest rate environment affects the types of assets we invest in at any given time.

During our fiscal year ended December 31, 2005, we invested most of our capital in agency guaranteed or “AAA” rated mortgage-backed securities. We had chosen to proceed with caution into the whole loan acquisition and securitization business. However, given the recent developments regarding our strategic alternatives review, we are not currently exploring investments in credit sensitive instruments beyond our current holdings of securitized whole loans.

Asset/Liability Management Policy. Our residential mortgage assets consist primarily of ARM-based mortgage assets, and to a lesser extent, fixed rate mortgage assets. Fixed rate assets and ARM-based mortgage assets lose value when market interest rates rise. We have implemented an asset/liability management program to lessen the effects of interest rate changes on the market value of our portfolio and to enable us to earn net income in periods of generally rising, declining or static interest rates. To the extent consistent with our objective to qualify as a REIT, we seek to affect these objectives through, among other means, the use of derivatives.

We will monitor carefully, and may have to limit, our asset/liability management program to assure that we do not realize excessive hedging income, or hold hedges having excess value in relation to mortgage-related assets, which could affect our REIT status. In addition, asset/liability management involves costs that increase dramatically as the period covered by hedging protection increases and that may increase during periods of fluctuating interest rates.

The asset/liability management framework includes the identification and management of the following:

• Market value risk as measured by sensitivity to the:

• level of interest rates, and

• shape of the yield curve;

• Prepayment risk;

• Spread / basis risk resulting from owning mortgage assets funded with liabilities, hedged with interest rate derivatives;

• Implied volatility or options price risk resulting from a change in prices of options;

• Model risk resulting from the use of prepayment and interest rate models used to measure the above risks;

• Earnings risk;

• Liquidity risk;

• Leverage risk and capital adequacy; and

• Credit risk.

The asset/liability management policy provides the following specific targets, among others, in the mitigation and management of the above risks:

• Duration Gap: The duration gap is the difference between the duration of the assets and the combined duration of liabilities and hedges weighted by market value. The gap value must be within a range of ± 1 year on a daily basis.

• Convexity Gap: Convexity is a measure of the sensitivity of the price of a security to changes in interest rates. The convexity gap is the difference between the convexity of the assets and the combined convexity of liabilities and hedges weighted by market value. The maximum negative convexity gap is -2.00.

• Market value sensitivity: The market value of equity is calculated as the market value of our assets and derivative instruments less the market value of our liabilities. Our goal is to maintain the market value of equity within 10% of its current value when the portfolio is stressed using a parallel interest rate shift of 50 basis points from current rate levels. We use interest rate and prepayment models in calculating the market value of the different components using the 50 basis point interest rate shifts.

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We believe that we have developed cost-effective asset/liability management policies. However, no strategy can completely insulate us from all risks. Further, as noted above, certain of the federal income tax requirements that we must satisfy to qualify as a REIT limit our options in hedging our interest rate risk.

We employ a leverage strategy to increase our returns by borrowing against existing mortgage-related assets and using the proceeds to acquire additional mortgage-related assets. We generally borrow between eight to twelve times the amount of our equity, although our borrowings may vary from time to time depending on market conditions and other factors deemed relevant by our management and our board of directors. We believe that this level of leverage leaves an adequate capital base to protect against interest rate environments in which our borrowing costs might exceed our interest income from mortgage-related assets.

Depending on the different cost of borrowing funds at different maturities, we may vary the maturities of our borrowed funds in an attempt to produce lower borrowing costs. Our mortgage-related assets are financed primarily at short-term borrowing rates through repurchase agreements. In the future, we may also employ borrowings under lines of credit and other collateralized financings that we may establish with approved institutional lenders.

Commercial Loan Policy. Our commercial loan policy provides guidelines for acquiring and funding commercial mortgage loans. For lending consideration, a potential loan generally must have:

• a first priority lien position on real estate assets;

• a principal balance of between $3.0 million and $5.0 million;

• a 12-month term; and

• a loan to value ratio of no greater than 65% at inception of the loan.

Although not required by our commercial loan policy, our primary geographic market is the southeastern United States.

New commercial loans are subject to stringent underwriting guidelines that include background checks on the borrowers and guarantors, analysis of project feasibility and review of the financial strength of the borrowers and guarantors.

Our directors review our lending activities on a quarterly basis to ensure compliance with the commercial loan policy. Our directors rely substantially on information and analysis provided by management to evaluate our operating and lending policies and compliance therewith.

Credit Risk Management Policy. We review credit risk and other risks of loss associated with each of our potential investments. In addition, we may diversify our portfolio of mortgage-related assets to avoid undue geographic, insurer, industry and certain other types of concentrations. We may reduce certain risks from sellers and servicers through representations and warranties.

Compliance with our credit risk management policy guidelines is determined at the time of purchase of mortgage assets, based upon the most recent valuation utilized by us. Such compliance is not affected by events subsequent to such purchase, including, without limitation, changes in characterization, value or rating of any specific mortgage assets or economic conditions or events generally affecting any mortgage-related assets of the type held by us.

Other Policies. We intend to invest and operate in a manner consistent with the requirements of the Internal Revenue Code to maintain our qualification as a REIT for federal income tax purposes, unless, due to changes in the tax laws, changes in economic conditions or other fundamental changes in our business environment, our board of directors determines that it is no longer in the best interest of our stockholders to qualify as a REIT. In order to maintain our REIT status, we generally intend to make distributions to our stockholders equaling at least 90% of our REIT taxable income each year.

Additionally, we intend to operate and invest in a manner that will not subject us to regulation under the Investment Company Act of 1940.

Financing

Our initial acquisition of residential mortgage loans and commercial mortgage bridge loans was financed with the proceeds from our initial public offering and from borrowings under our warehouse line of credit. Thereafter, our primary source of financing has been through reverse repurchase agreements, and to a lesser extent, under our warehouse line of credit. The warehouse line of credit was terminated in August 2005 due the expense involved relative to the need for such a facility.

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On March 15, 2005, Sunset Financial Statutory Trust I, a Delaware statutory trust (the Preferred Trust), a wholly-owned subsidiary of the Company, completed a private offering of $20 million of trust preferred securities. The Preferred Trust used the proceeds of the private offering, together with the Company’s $619,000 investment in the Preferred Trust common securities, to purchase $20.6 million aggregate principal amount of the Company’s junior subordinated notes.

The junior subordinated notes and the Preferred Securities each bear interest at a floating rate that resets on a quarterly basis at the 90-day LIBOR plus 4.15% (approximately 8.68% as of December 31, 2005) and generally may not be redeemed prior to March 30, 2010. After payment of costs associated with the issuance of approximately $640,000, the proceeds from the sale of the Preferred Securities were approximately $19.3 million.

We expect to continue to use repurchase agreements as our principal financing device to leverage our mortgage-backed securities portfolio. We anticipate that upon repayment of a reverse repurchase agreement, we will pledge the same collateral promptly to secure a new reverse repurchase agreement. At December 31, 2005, we had uncommitted repurchase agreements with nine lenders. Reverse repurchase agreements are structured as sale and repurchase obligations and have the economic effect of allowing a borrower to pledge purchased mortgage assets as collateral securing short-term loans to finance the purchase of such mortgage assets. Typically, the lender in a reverse repurchase arrangement makes a loan in an amount equal to a negotiated percentage of the market value of the pledged collateral. At maturity, the borrower is required to repay the loan and the pledged collateral is released. During the time the loan is outstanding, the pledged mortgage loans continue to pay principal and interest to the borrower. We enter into reverse repurchase agreements with financially sound institutions, including broker/dealers, commercial banks and other lenders that meet credit standards approved by our board of directors. Under the reverse repurchase agreements, we are required to deposit additional collateral in the event the value of the assets we have already pledged there under declines.

Securitizations

A securitization is the conversion of assets (usually forms of debt) into securities which can be traded more freely and cost-effectively than the underlying assets and generate better returns than if the individual assets were used as collateral for a loan. One example is mortgage-backed securities, which pool illiquid individual mortgages into a single tradable asset. In 2004, we completed a securitization of our initial residential mortgage loan portfolio. As payments are made on the underlying mortgage loans to a securitization trust, we are entitled to recognize as income amounts remaining after payment of the trust’s debt and expenses of the securitization, and any credit enhancement requirements.

Hedging

Our portfolio consists primarily of mortgage assets that have an initial fixed interest rate period of seven years or less, with an adjustable interest rate thereafter, known as a Hybrid ARMs, and to a much lesser extent, fixed rate mortgages. Fixed-rate mortgages and Hybrid ARMs, like other fixed-rate debt instruments, are subject to a loss in value when market interest rates rise. We are exposed to such losses, and in order to manage this risk of loss we use derivatives, primarily interest rate swaps associated with our short-term borrowings, which represent a mutual agreement to exchange interest payments.

We may also enter into one or more of the following other types of hedging transactions:

• Forward sales of treasuries, or treasury locks, represent an obligation to sell treasuries at a specific yield or price in the future. Therefore, its value increases as interest rates rise.

• Call options on treasury futures represent a right to buy a treasury futures contract at a specific price in the future. Therefore, its value increases as the benchmark treasury rate falls.

• Put options on treasury futures represent a right to sell a treasury futures contract at a specific price in the future. Therefore, its value increases as the benchmark treasury rate rises.

• Receiver swaptions represent a right to enter into a predetermined interest rate swap at a future date in which, upon exercise of its right, we would receive the fixed rate and pay the floating rate. Therefore, the contract increases in value as interest rates fall.

• Payor swaptions represent a right to enter into a predetermined interest rate swap at a future date in which, upon exercise of its right, we would pay the fixed rate and receive the floating rate. Therefore, the contract increases in value as interest rates rise.

• A cap is a contract whereby the seller agrees to pay to the purchaser, in return for an upfront premium or a series of annuity payments, the difference between a reference rate and an agreed strike rate when the reference exceeds the strike. Commonly, the reference rate is 3-month or 6-month LIBOR. A cap is therefore a strip of interest rate guarantees that allows the purchaser to take advantage of a reduction in interest rates and to be protected if they rise.

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• A floor is a contract whereby the seller agrees to pay to the purchaser, in return for an upfront premium or a series of annuity payments, the difference between a reference rate and an agreed strike rate when the reference drops below the strike.

Taxation of Our Company

General. We elected to be treated as a REIT for federal income tax purposes. Generally, if we meet certain detailed conditions imposed by the REIT provisions of the Internal Revenue Code, such as investing primarily in real estate and mortgage loans, we will not be taxed at the corporate level on the taxable income that we currently distribute to our stockholders. We can therefore avoid most of the “double taxation” (at the corporate level and then again at the stockholder level when the income is distributed) that we would otherwise experience if we were a corporation.

We are subject to corporate level taxation on any undistributed income. In addition, we face corporate level taxation due to any failure to make timely distributions on the built-in gain on assets acquired from a taxable corporation such as a taxable REIT subsidiary, on the income from any property that we take in foreclosure and on which we make a foreclosure property election, and on the gain from any property that is treated as “dealer property” in our hands.

If we do not qualify as a REIT in any given year, we would be subject to federal income tax as a domestic corporation, which would reduce the amount of the after-tax cash available for distribution to our stockholders. We believe that we have operated in accordance with the requirements for qualification as a REIT since the date of our initial public offering in March 2004. We intend at all times to continue to comply with the requirements for qualification as a REIT under the Internal Revenue Code, as described below.

Requirements for Qualification as a REIT. To qualify for tax treatment as a REIT under the Internal Revenue Code, we must meet certain tests, as described briefly below.

Ownership of Common Stock. For all taxable years after the first taxable year for which we elect to be a REIT, a minimum of 100 persons must hold shares of our common stock for at least 335 days of a 12-month year (or a proportionate part of a short tax year). In addition, at all times during the second half of each taxable year after the first taxable year for which we elect to be a REIT, no more than 50% in value of our capital stock may be owned directly or indirectly by five or fewer individuals. We are required to maintain records regarding the ownership of shares of our common stock and to demand statements from persons who own more than a certain number of shares of our common stock regarding their ownership. We must keep a list of those stockholders who fail to reply to such a demand.

We are required to use the calendar year as our taxable year for income tax purposes.

Nature of Assets. On the last day of each calendar quarter, at least 75% of the value of our assets must consist of real estate assets, cash, cash items and government securities. We expect that substantially all of our assets will continue to qualify under this test. On the last day of each calendar quarter, of the assets not included in the foregoing 75% assets test, the value of securities that we hold issued by any one issuer may not exceed 5% in value of our total assets and we may not own more than 10% of the vote or value of any one issuer’s outstanding securities (with an exception for a taxable REIT subsidiary or a qualified REIT subsidiary). The aggregate securities that we may hold in taxable REIT subsidiaries is limited to 20% of the value of our total assets. We monitor the purchase and holding of our assets in order to comply with the above asset tests.

We may from time to time, through one or more taxable REIT subsidiaries, hold assets or perform activities that, if we held or performed directly, could generate income that would have an adverse effect on our qualification as a REIT or on certain classes of our stockholders. We do not expect that the securities that we hold in such taxable REIT subsidiaries, in the aggregate, will exceed 20% of the value of our total assets.

Sources of Income. We must meet the following separate income-based tests each year:

1. The 75% Test. At least 75% of our gross income for the taxable year must be derived from certain real estate sources including interest (other than interest based in whole or in part on the income or profits of any person) on obligations secured by mortgages on real property or interests in real property. The investments that we have made and will continue to make will give rise primarily to mortgage interest qualifying under the 75% income test.

2. The 95% Test. In addition to deriving 75% of our gross income from the sources listed above, at least an additional 20% of our gross income for the taxable year must be derived from those sources, or from dividends,

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interest or gains from the sale or disposition of stock or other assets that are not dealer property. We intend to limit substantially all of our income to the types of income that will satisfy these income tests. Our policy to maintain REIT status may limit the amount and type of assets that we otherwise might acquire and the amount and type of income that we might otherwise produce.

Distributions. We must distribute to our stockholders on a pro rata basis each year an amount equal to at least (i) 90% of our taxable income, without the deduction for dividends paid and excluding net capital gain, plus (ii) 90% of the excess of the net income from foreclosure property over the tax imposed on such income, less (iii) any “excess noncash income.” We intend to make distributions to our stockholders in sufficient amounts to meet the distribution requirement.

Taxation of Stockholders. For any taxable year in which we are treated as a REIT for federal income purposes, the amounts that we distribute to our stockholders out of current or accumulated earnings and profits will be includable by the stockholders as ordinary income for federal income tax purposes unless properly designated by us as capital gain dividends. Our distributions will not be eligible for the dividends received deduction for corporations. Stockholders may not deduct any of our net operating losses or capital losses.

If we make distributions to our stockholders in excess of our current and accumulated earnings and profits, those distributions will be considered first a tax-free return of capital, reducing the tax basis of a stockholder in our common stock until the tax basis is zero. Distributions in excess of the tax basis will be taxable as gain realized from the sale of shares of our common stock. We will withhold 30% of dividend distributions to stockholders that we know to be foreign persons unless the stockholder provides us with a properly completed IRS form for claiming the reduced withholding rate under an applicable income tax treaty.

The provisions of the Internal Revenue Code are highly technical and complex. This summary is not intended to be a detailed discussion of the Internal Revenue Code or its rules and regulations, or of related administrative and judicial interpretations. We have not obtained a ruling from the IRS with respect to tax considerations relevant to our organization or operation or issuance of common stock. This summary is not intended to be a substitute for prudent tax planning and each of our stockholders is urged to consult his or her own tax advisor with respect to these and other federal, state and local tax consequences of the acquisition, ownership and disposition of common stock and any potential changes in applicable law.

Regulation

The Investment Company Act of 1940 excludes from regulation entities that are primarily engaged in the business of purchasing or otherwise acquiring “mortgages and other liens on and interests in real estate.” Under the current interpretations of the SEC, in order to qualify for this exemption, we must, among other things, maintain at least 55% of our assets directly in mortgage loans, qualifying pass-through certificates and certain other qualifying interests in real estate and an additional 25% of our assets in the same type of assets. We constantly monitor our assets to ensure our continued compliance with these requirements. However, if we fail to qualify for exemption from registration as an investment company, our ability to use leverage would be substantially reduced, and we would be unable to conduct our business as described in this Form 10-K.

In recent years, federal and several state and local laws, rules and regulations have been adopted, or are under consideration, that are intended to eliminate certain lending practices, often referred to as “predatory” lending practices, that are considered to be abusive. Many of these laws, rules and regulations restrict commonly accepted lending activities and impose additional costly and burdensome compliance requirements. The difficulty of managing the compliance risks presented by these laws, rules and regulations may decrease the availability of warehouse financing. Our goal is to avoid purchasing loans that meet or exceed the APR or “points and fees” threshold of these laws, rules and regulations. If we elect to relax our self-imposed restrictions on purchasing loans, subject to these laws, rules and regulations, we will be subject to greater risks for actual or perceived non-compliance with the laws, rules and regulations, including demands for indemnification or loan repurchases from the parties to whom we broker or sell loans, class action lawsuits, increased defenses to foreclosure of individual loans in default, individual claims for significant monetary damages, and administrative enforcement actions.

Industry Trends

The flattening yield curve was a hallmark of the market environment in 2004 and 2005 as the Federal Reserve methodically raised the Fed Funds target to its current level of 4.5%. This environment resulted in margin compression for numerous institutions that purchase and hold mortgage loans and mortgage securities such as banks and REITs. As a result of the yield curve flattening, the net interest spread on our portfolio declined from 64 basis points during the third quarter of 2005 to 58 basis points for the quarter ended December 31, 2005. While we lost interest spread during the year, our use of interest rate swaps helped to limit our margin compression. For additional quarterly margin information, see Results of Operations in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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Additionally, the health of the housing market has been a focus of the industry over the past year and continues to be so into 2006. While many analysts have affirmed the lack of a national house price bubble, several have concluded that certain urban markets on the East and West coasts exhibit bubble qualities. The performance of sub-prime mortgages has also been in the spotlight, particularly as loans reset from the initial fixed rate period to a higher floating rate.

Competition

We believe that our principal competitors are the numerous institutions that purchase and hold residential mortgage loans and mortgage-backed securities. Examples of these types of institutions are banks, investment banks, finance companies, mortgage companies, savings and loans, life insurance companies, mutual funds, pension funds, other REITs and other entities purchasing mortgage assets. Many of our competitors have greater financial resources and access to capital than we do. In addition, there is the possibility of additional entities entering the market to invest in residential mortgage loans and mortgage-backed securities resulting in higher prices for assets and lower yields.

Employees

As of December 31, 2005, we had 11 full-time employees. None of our employees are unionized. We outsource our internal audit department to a third-part provider. From time-to-time we engage contract employees, and had one such employee at December 31, 2005.

Available Information

Our Internet website address is www.sunsetfinancial.net. We make available through our website, free of charge, our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K, and any amendments to those reports that we file or furnish pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable after we electronically file such information with, or furnish it to, the Securities and Exchange Commission.

Materials we file with the SEC may be read and copied at the SEC’s Public Reference Room at 450 Fifth Street, N.W., Washington, D.C. 20549. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 800-SEC-0330. The SEC also maintains an Internet website at www.sec.gov that contains our reports, proxy and information statements, and other information regarding us that we will file electronically with the SEC.

Item 1A. Risk Factors

You should carefully consider all of the risks described in this Form 10-K before making an investment decision. If any of the risks described in this Form 10-K actually occur, our business, assets, liquidity, operating results, prospects and financial condition could be materially adversely affected.

Risks Related to Our Business and Operations

We might not be able to operate our business or implement our operating and investment policies successfully.

The results of our operations depend on many factors, including the availability of future opportunities for the acquisition of residential and commercial mortgage assets, the level and volatility of interest rates, readily accessible short-term and long-term funding alternatives in the financial markets and general economic conditions. Moreover, delays in investing the proceeds of any prepayments or repayments on our mortgage assets or the net proceeds of any future debt or equity offering may cause our performance to be weaker than other fully invested mortgage REITs pursuing comparable investment strategies. You will not have the opportunity to evaluate the manner in which we invest or the economic merits of particular assets to be acquired by us in the future prior to our investment. Furthermore, we face the risk that we might not successfully implement our operating and investment policies or operate our business as described in this Annual Report on Form 10-K for the year ended December 31, 2004.

An interruption or reduction in the securitization markets or change in terms offered by these markets could have a material adverse effect on our results of operations, financial condition and business prospects.

An important source of our funding is securitizations of mortgage loans. The securitization market is dependent upon a number of factors, including general economic conditions, the interest rate environment, conditions in the securities market generally and conditions in the mortgage-backed securities market specifically. In addition, poor performance of any loans we may securitize in the future could harm our future access to the securitization market. Accordingly, a decline in the securitization market or in our ability to obtain attractive terms could have a material adverse effect on our results of operations, financial condition and business prospects.

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Reverse repurchase agreements, which are our primary source of financing, involve the risk that the market value of the assets that we are required to repurchase may decline below the repurchase price of the assets we have sold.

We currently use reverse repurchase agreements as our primary source of financing. Reverse repurchase agreements involve sales by us of portfolio assets, concurrently with an agreement by us to repurchase these assets at a later date at a fixed price. During the reverse repurchase agreement period, we continue to receive principal and interest payments on these assets. At the maturity of the repurchase agreement, we are required to repay the loan and correspondingly receive back our collateral. These types of transactions involve the risk that the market value of the assets we sold but are obligated to repurchase will decrease below the amount of our repurchase obligation under the agreement. Reductions in the market value of the portfolio assets sold pursuant to a reverse repurchase agreement below the amount of our repurchase obligation may require us to sell additional assets or borrow additional funds to meet our repurchase obligations. In the event of our insolvency or bankruptcy, certain repurchase agreements may qualify for special treatment under the Bankruptcy Code, the effect of which, among other things, would be to allow the creditor under the agreement to avoid the automatic stay provisions of the Bankruptcy Code and to foreclose on the collateral agreement without delay. In the event of the insolvency or bankruptcy of a lender during the term of a repurchase agreement, the lender may be permitted, under applicable insolvency laws, to repudiate the contract, and our claim against the lender for damages may be treated simply as an unsecured creditor. In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act of 1970, or an insured depository institution subject to the Federal Deposit Insurance Act, our ability to exercise our rights to recover our securities under a repurchase agreement or to be compensated for any damages resulting from the lender’s insolvency may be further limited by those statutes. These claims would be subject to significant delay and, if and when received, may be substantially less than the damages we actually incur. As a result, these transactions could adversely affect our results of operations and cash available for distribution to our stockholders.

Failure to maintain adequate funding under warehouse facilities and reverse repurchase agreements may harm our results of operations.

We fund asset acquisitions primarily through reverse repurchase agreements and securitizations. Our inability to enter into reverse repurchase agreements at attractive terms or our inability to find other attractive sources of funding could harm our operations and our overall performance. An increase in the cost of financing in excess of any change in the income derived from our mortgage assets could also harm our earnings and reduce the cash available for distributions to our stockholders.

Our operations are highly leveraged, without limit as to the amount of debt we can incur and any debt incurred will increase our exposure to losses.

Leverage can reduce the net income available for distributions to stockholders. If the interest income on the assets we purchase with borrowed funds fails to cover the cost of the borrowings and any related hedges, we will experience net interest losses and may experience net losses and erosion or elimination of your equity.

If the value of the assets we pledge to secure loans declines, we will experience losses and may lose our REIT status.

A substantial portion of our borrowings are in the form of collateralized borrowings. If the value of the assets pledged to secure our borrowings were to decline, we would be required to post additional collateral, reduce the amount borrowed or suffer forced sales of the collateral. If sales were made at prices lower than the carrying value of the collateral, we would experience additional losses. If we are forced to liquidate qualified REIT real estate assets to repay borrowings, there can be no assurance that we will be able to maintain compliance with the REIT provisions of the Internal Revenue Code regarding asset and source of income requirements. If we are unable to maintain our status as a REIT, our distributions will not be deductible by us, and our income will be subject to taxation, reducing our earnings available for distribution.

Our use of repurchase agreements to borrow funds may give our lenders greater rights in the event that either we or any of our lenders file for bankruptcy.

Our borrowings under repurchase agreements may qualify for special treatment under the bankruptcy code, giving our lenders the ability to avoid the automatic stay provisions of the bankruptcy code and to take possession of and liquidate our collateral under the repurchase agreements without delay if we file for bankruptcy. Furthermore, the special treatment of repurchase agreements under the bankruptcy code may make it difficult for us to recover our pledged assets in the event that our lender files for bankruptcy. Thus, the use of repurchase agreements exposes our pledged assets to risk in the event of a bankruptcy filing by either our lender or us.

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Future revisions to our policies can be made without stockholder consent creating uncertainty for investors that may increase the risk and change the nature of your investment.

Our board of directors has established our operating and investment policies. Although our board of directors has no current intention to do so, these policies may be amended or revised at any time at the discretion of our board without a vote of our stockholders. A change in these policies may increase the risk and change the nature of your investment.

Complying with REIT requirements may force us to liquidate otherwise attractive investments.

In order to qualify as a REIT, we must ensure that at the end of each calendar quarter at least 75% of the value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets. The remainder of our investment in securities generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, generally, no more than 5% of the value of our assets can consist of the securities of any one issuer. If we fail to comply with these requirements, we must dispose of a portion of our assets within 30 days after the end of the calendar quarter or otherwise comply with applicable relief provisions in order to avoid losing our REIT status and suffering adverse tax consequences.

We use hedging strategies that involve risk and that may not be successful in insulating us from exposure to changing interest and prepayment rates.

From time to time, we enter into hedging transactions primarily to protect ourselves from the effect of interest rate fluctuations on our floating rate borrowings and also to protect our portfolio of mortgage assets from interest rate fluctuations. Because the decision to engage in particular hedging activities depends upon market conditions, we cannot quantify the extent to which any particular hedging activity will be utilized in the future. These hedging activities include, among other derivative securities, short sales, purchases of treasury options, mortgage-backed securities and futures, interest rate swaps, swaptions, caps and floors and other transactions involving derivative securities. There can be no assurance that our hedging activities will have the desired beneficial impact on our results of operations or financial condition. Moreover, no hedging activity can completely insulate us from the risks associated with changes in interest rates.

Our directors are responsible for reviewing the extent and effect of our hedging activities. The amount of income we may earn from our hedging instruments is subject to limitations under the REIT provisions of the Internal Revenue Code. These limitations may result in management electing to have us bear a level of interest rate risk that could otherwise be hedged when management believes, based on all relevant facts, that bearing such risk is advisable to maintain our status as a REIT.

Interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates, which could harm our results of operations.

During periods of rising and volatile interest rates, there is a higher demand for hedging transactions as parties seek to mitigate the risks associated with the interest rate environment. A greater demand for hedging transactions makes entering into those transactions more expensive, even though the potential benefits of hedging remain relatively constant. To the extent more parties seek to hedge interest rate risk, we may incur greater expense to enter into such transactions, which could adversely affect our results of operations.

Complying with REIT requirements may limit our ability to hedge effectively.

The existing REIT provisions of the Internal Revenue Code substantially limit our ability to hedge our mortgage loan assets. Under these provisions, our annual income from qualified hedges, together with any other income not generated from qualified REIT real estate assets, is limited to less than 25% of our gross income. In addition, we must limit our aggregate income from hedging and services from all sources, other than from qualified REIT real estate assets or qualified hedges, to less than 5% of our annual gross income. As a result, we might in the future have to limit our use of advantageous hedging techniques. This could leave us exposed to greater risks associated with changes in interest rates than we would otherwise want to bear. If we were to violate the 25% or 5% limitations, we might have to pay a penalty tax equal to the amount of our income in excess of those limitations, multiplied by a fraction intended to reflect our profitability. If we fail to satisfy the 25% or 5% limitations, unless our failure was due to reasonable cause and not due to willful neglect, we could lose our REIT status for federal income tax purposes.

We may not be able to achieve our leverage goals, which could cause us to experience losses or reduced profits.

Our ability to achieve our investment objectives depends to a significant extent on our ability to borrow money in sufficient amounts and at rates lower than the interest rates earned on our mortgage loans and mortgage-backed securities. We

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may not be able to achieve the degree of leverage we believe to be optimal due to decreases in the number of our mortgage assets we can borrow against, decreases in the market value of our mortgage assets, changes in the availability of financing in the market, conditions then applicable in the lending market and other factors. This may cause us to experience losses or reduced profits.

Risks Related to Mortgage Assets and Our Acquisition Activities

Interest rate fluctuations will affect the value of our mortgage assets, our net income and the market value of our net assets.

Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Interest rate fluctuations can adversely affect our income and the value of our common stock in many ways and present a variety of risks, including the risk that our borrowing rates exceed our asset yields.

Our operating results depend in large part on differences between the income from our assets (net of credit losses) and our borrowing costs. We anticipate that, in most cases, the income from our assets will respond more slowly to interest rate fluctuations than the cost of our borrowings, creating a potential mismatch between asset yields and borrowing rates. Consequently, increases in the cost of our borrowings will tend to decrease our net income and market value of our net assets. Interest rate fluctuations resulting in our interest expense exceeding interest income on our assets would result in our incurring operating losses.

Variances in the yield curve may adversely affect our net income and the market value of our net assets.

The relationship between short-term and long-term interest rates is often referred to as the “yield curve.” Ordinarily, short-term interest rates are lower than long-term interest rates. Over the past year short-term interest rates have risen disproportionately relative to long-term interest rates (a flattening of the yield curve), and our borrowing costs have therefore increased more rapidly than the interest income earned on our assets. Because our borrowings bear interest at short-term rates and our assets bear interest at medium-term to long-term rates, a flattening of the yield curve will tend to decrease our net income and market value of our net assets. Additionally, to the extent cash flows from long-term assets that return scheduled and unscheduled principal are reinvested, the spread between the yields of the new assets and available borrowing rates may decline and also may tend to decrease the net income and market value of our net assets. It is also possible that short-term interest rates may adjust relative to long-term interest rates such that the level of short-term rates exceeds the level of long-term rates (a yield curve inversion). In this case, our borrowing costs may exceed our interest income and we could incur operating losses.

Prepayment rates on our mortgage assets could increase, thus adversely affecting our yields.

The value of our mortgage assets may be affected by prepayment rates. Prepayment rates are influenced by changes in current interest rates and a variety of economic, geographic and other factors beyond our control, and consequently, prepayment rates cannot be predicted with certainty. In periods of declining mortgage interest rates, prepayments on mortgage assets generally increase. If general interest rates decline as well, the prepayment proceeds received during these periods are likely to be reinvested by us in assets yielding less than the yields on the investments that were prepaid. In addition, the market value of the mortgage assets may, because of the risk of prepayment, benefit less than other fixed-income securities from declining interest rates. Conversely, in periods of rising interest rates, prepayments on mortgage assets generally decrease, in which case we would not have the prepayment proceeds available to invest in assets with higher yields. Under certain interest rate and prepayment scenarios, we may fail to recoup fully our cost of acquisition of certain investments.

In addition, prepayments of loans receivable may affect our “spread” on any pools of mortgage loans that we securitize. Prepayments of mortgage loans that have higher interest rates negatively impact the value of our retained interests to a greater extent than prepayments of loans that have lower interest rates. Prepayments in excess of our assumptions will cause a decline in the value of our retained interests primarily relating to the excess funds expected from our securitization transactions.

We might experience reduced net interest income or a loss from holding fixed rate investments during periods of rising interest rates.

We may fund our acquisition of fixed rate mortgage assets with short-term floating rate debt instruments. During periods of rising interest rates, our costs associated with borrowings used to fund the acquisition of fixed rate mortgage assets are subject to increases while the income we earn from these assets remains substantially fixed. This would reduce and could eliminate the net interest spread between the fixed rate mortgage assets that we purchase and our borrowings used to purchase them, which would reduce our net interest income and could cause us to suffer a loss.

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We may be subject to the risks associated with inadequate or untimely services from loan-servicers, which may adversely affect our results of operations.

We do not service our residential loans or our securitized residential loans. This allows us to increase the volume of the assets we purchase without incurring the expenses associated with servicing operations. However, as with any external service provider, we are subject to the risks associated with inadequate or untimely services. Many borrowers require notices and reminders to keep their loans current and to prevent delinquencies and foreclosures. A substantial increase in our delinquency rate that results from improper servicing or mortgage loan performance in general could adversely affect our ability to securitize our mortgage loans in the future.

Our investment strategy includes acquiring commercial mortgage assets which generally involve a greater risk of loss than residential mortgage assets.

Commercial mortgage assets are considered to involve a higher degree of risk than residential mortgage assets because of a variety of factors, including generally larger loan balances, dependency for repayment on successful operation of the mortgaged property and non-owner tenant operators operating on the property, and loan terms that include balloon payments at stated maturity rather than periodic principal payments.

We have risk of loss on our mortgage assets.

The value of our residential and commercial mortgage assets may be affected adversely by a number of factors, including, but not limited to:

• national, regional and local economic conditions;

• changes or continued weakness in specific industry segments;

• declining real estate property values;

• geographic concentration of our mortgage loans and natural hazard risks affecting those regions;

• with respect to commercial property, perceptions by prospective tenants, retailers and shoppers of the safety, convenience, services and attractiveness of the property;

• with respect to commercial property, the willingness and ability of the property’s owner to provide capable management and adequate maintenance;

• construction quality, age and design;

• demographic factors;

• retroactive changes to building or similar codes; and

• increases in operating expenses (such as energy costs).

Our investment strategy includes investing in commercial mortgage bridge loans that are not secured by income producing real properties, which involves greater risks of loss.

We have acquired entire commercial mortgage bridge loans and those in which we share ownership with other interest holders, secured by property which is not income-producing. The loans involve a higher degree of risk than long-term senior mortgage loans secured by income-producing real property. This increased risk is due to of a variety of factors, including difficulties in finding suitable long-term financing and loan terms that often require little or no amortization.

We are subject to certain risks as the result of our commercial mortgage bridge loans that we own jointly with other interest holders.

At December 31, 2005, our portfolio contained a commercial mortgage bridge loan that we own jointly with other interest holders. A commercial mortgage bridge loan that we own jointly with other interest holders entitles us, as a holder of an interest to participate in the economic benefits and losses of the loan in proportion to the interest we hold. With respect to this loan all holders of interests share joint title to the loan. Therefore, we are a joint owner of a commercial mortgage bridge loan with third parties. Under certain circumstances, such joint ownership of a commercial mortgage bridge loan may involve

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risks not otherwise present with other methods of owning commercial mortgage bridge loans. Examples of these risks include the following:

• entities with which we own the loan may become insolvent or bankrupt;

• entities with whom we own the loan may have economic or other business interests or objectives that are inconsistent with our business interests or objectives, including inconsistent objectives relating to the foreclosure of property underlying a particular commercial mortgage bridge loan or the timing of the termination and liquidation of the joint business arrangement;

• we may incur liabilities (including unexpected liabilities) as the result of actions taken by entities with whom we own the loan; or

• entities with whom we own the loan may be in a position to take action contrary to our instructions or requests or contrary to our policies or objectives, including our policy with respect to qualifying and maintaining our qualification as a REIT.

If we have a right of first refusal or buy/sell right to buy out another owner’s interest in a commercial mortgage bridge loan, we may be unable to finance such a buy-out if it becomes exercisable or we may be required to purchase such interest at a time when it would not otherwise be in our best interest to do so. If our interest is subject to a buy/sell right, we may not have sufficient cash available, borrowing capacity or other capital resources to allow us to elect to purchase the interest of these co-owners subject to the buy/sell right, in which case we may be forced to sell our interest as the result of the exercise of such right when we would otherwise prefer to keep our interest. Finally, we may not be able to sell our interest in commercial mortgage bridge loans that we own jointly with other interest holders if we desire to exit for any reason or if our interest is likewise subject to a right of first refusal of the co-owners of the loan, our ability to sell such interest may be adversely impacted by such right.

Competition might prevent us from acquiring new mortgage assets at favorable yields, which would harm our results of operations.

Our net income depends on our ability to acquire new mortgage assets at favorable spreads over our borrowing costs. In acquiring mortgage assets, we compete with other REITs, investment banking firms, savings and loan associations, banks, insurance companies, mortgage companies, mutual funds and other lenders and entities that purchase mortgage assets, many of which have greater financial resources than we do. As a result, we may not be able to acquire sufficient mortgage assets at favorable spreads over our borrowing costs, which would harm our results of operations.

We may not be successful in identifying suitable new acquisitions that meet our criteria, which may impede our growth and negatively affect our results of operations.

Our ability to expand through acquisitions of loan portfolios is integral to our business strategy and requires us to identify suitable acquisition candidates or investment opportunities that meet our criteria and are compatible with our growth strategy. We may not be successful in identifying suitable assets that meet our acquisition criteria or in consummating acquisitions on suitable terms. Failure to identify or consummate new acquisitions will reduce the number of acquisitions we complete and slow our growth, which could in turn adversely affect our stock price.

Our mortgage assets may be concentrated in specific geographic regions and any adverse market or economic conditions in those regions may have a disproportionately adverse effect on the ability of our customers to make their loan payments.

Our mortgage assets in our portfolio are and may continue to be concentrated in specific geographic regions. Adverse market or economic conditions in a particular region may disproportionately increase the risk that borrowers in that region are unable to make their mortgage payments. In addition, the market value of the real estate securing those mortgage loans could be adversely affected by adverse market and economic conditions in that region. Any sustained period of increased payment delinquencies, foreclosures or losses caused by adverse market or economic conditions in that geographic region could adversely affect both our net interest income from assets in our portfolio as well as our ability to sell and securitize loans, which would significantly harm our revenues and results of operations.

We may be required to repurchase mortgage loans that we have sold or to indemnify holders of our mortgage-backed securities.

If any of the mortgage loans that we securitize do not comply with the representations and warranties that we make about the characteristics of the loans, the borrowers and the properties securing the loans, we may be required to repurchase

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those loans that we have securitized, or replace them with substitute loans or cash. If this occurs, we may have to bear any associated losses directly. In addition, we may be required to indemnify the purchasers of such loans for losses or expenses incurred as a result of a breach of a representation or warranty made by us. Repurchased loans typically require an allocation of working capital to carry on our books, and our ability to borrow against such assets is limited, which could limit the amount by which we can leverage our equity. Any significant repurchases or indemnification payments could significantly harm our cash flow and results of operations.

New legislation may restrict our ability to acquire and sell mortgage loans, negatively impeding our revenues.

In recent years, federal and several state and local laws, rules and regulations have been adopted, or are under consideration, that are intended to eliminate certain lending practices, often referred to as “predatory” lending practices, that are considered to be abusive. Many of these laws, rules and regulations restrict commonly accepted lending activities and impose additional costly and burdensome compliance requirements. These laws, rules and regulations impose certain restrictions on loans on which certain points and fees or the annual percentage rate, or APR, meets or exceeds specified thresholds. Some of these restrictions expose a lender to risks of litigation and regulatory sanction regardless of how carefully a loan is underwritten. In addition, an increasing number of these laws, rules and regulations seek to impose liability for violations on the purchasers of mortgage loans, regardless of whether a purchaser knew of or participated in the violation. Accordingly, as a purchaser of mortgage loans, in certain states we may be subject to liability for any loans that do not comply with these laws, rules and regulations. In addition, the third parties that purchase or provide financing for our loans will not want and will not be contractually required, to purchase or finance loans that do not comply with these laws, rules and regulations.

The difficulty of managing the compliance risks presented by these laws, rules and regulations may decrease the availability of warehouse financing and the overall demand for the purchase of our loans. These laws, rules and regulations will increase our cost of doing business as we will be required to develop systems and procedures to ensure that we do not violate any aspect of these requirements.

Our goal is to avoid purchasing loans that meet or exceed the APR or “points and fees” threshold of these laws, rules and regulations. If we elect to relax our self-imposed restrictions on purchasing loans, subject to these laws, rules and regulations, we will be subject to greater risks for actual or perceived non-compliance with the laws, rules and regulations, including demands for indemnification or loan repurchases from the parties to whom we broker or sell loans, class action lawsuits, increased defenses to foreclosure of individual loans in default, individual claims for significant monetary damages, and administrative enforcement actions. Any of the foregoing could significantly harm our business, cash flow, financial condition, liquidity and results of operations.

Failure to maintain an exemption from the Investment Company Act would harm our results of operations.

We intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act of 1940, as amended. If we fail to qualify for this exemption, our ability to use leverage would be substantially reduced and we would be unable to conduct our business as described in this prospectus.

The Investment Company Act exempts entities that are primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on, and interests in, real estate. Under the current interpretation of the SEC staff, in order to qualify for this exemption, we must maintain at least 55% of our assets directly in these qualifying real estate interests. Mortgage-backed securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as separate from the underlying mortgage loans and, thus, may not qualify for purposes of the 55% requirement. Therefore, our ownership of these mortgage-backed securities is limited by the provisions of the Investment Company Act.

In satisfying the 55% requirement under the Investment Company Act, we treat as qualifying interests mortgage-backed securities issued with respect to an underlying pool as to which we hold all issued certificates. If the SEC or its staff adopts a contrary interpretation of such treatment, we could be required to sell a substantial amount of our mortgage-backed securities under potentially adverse market conditions. Further, in our attempts to ensure that we at all times qualify for the exemption under the Investment Company Act, we might be precluded from acquiring mortgage-backed securities if their yield is higher than the yield on mortgage-backed securities that could be purchased in a manner consistent with the exemption. These factors may lower or eliminate our net income.

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One-action rules may harm the value of the security interest.

Several states have laws that prohibit more than one action to enforce a mortgage obligation, and some courts have construed the term “action” broadly. In such jurisdictions, if the judicial action is not conducted according to law, there may be no other recourse in enforcing a mortgage obligation, thereby decreasing the value of the security interest.

Tax Risks.

If we fail to remain qualified as a REIT, our distributions will not be deductible by us, and our income will be subject to taxation, reducing our earnings available for distribution.

We intend to remain qualified as a REIT under the Internal Revenue Code, which will afford us significant tax advantages. The requirements for this qualification, however, are highly technical and complex and even a technical or inadvertent mistake could jeopardize our REIT status. If we fail to meet these requirements and lose our REIT qualification, our distributions will not be deductible by us and we will have to pay a corporate level tax on our income. This would substantially reduce our earnings, our cash available to pay distributions and your yield on your investment in our common stock. In addition, such a tax liability might cause us to borrow funds, liquidate some of our investments or take other steps which could negatively affect our operating results. Moreover, if our REIT status is terminated because of our failure to meet a technical REIT requirement or if we voluntarily revoke our election, we would not qualify as a REIT for the year in which we lost or revoked our REIT election and we would generally be disqualified from electing treatment as a REIT for the four taxable years following the year in which our REIT status was lost.

We may be unable to comply with the strict income distribution requirements applicable to REITs or compliance with such requirements could adversely affect our financial condition.

To obtain the favorable treatment associated with qualifying as a REIT, we must distribute to our stockholders with respect to each year at least 90% of our REIT taxable income. In addition, we are subject to a tax on the undistributed portion of our income at regular corporate rates and also may be subject to a non-deductible 4% excise tax on this undistributed income. We could be required to either sell assets or borrow funds on a short-term basis to meet the distribution requirements that are necessary to achieve the tax benefits associated with qualifying as a REIT, even if conditions are not favorable for borrowing, which could adversely affect our financial condition.

Our ability to satisfy the income and asset tests applicable to REITs depends on the nature of our assets, the sources of our income, and factual determinations, including the value of the real property underlying our loans.

As a REIT, 75% of our assets must consist of specified real estate related assets and other specified types of investments, and 75% of our gross income must be earned from real estate related sources and other specified types of income. If the value of the real estate securing each of our loans, determined at the date of acquisition of the loans, is less than the highest outstanding balance of the loan for a particular taxable year, then a portion of that loan will not be a qualifying real estate asset and a portion of the interest income will not be qualifying real estate income. Accordingly, in order to determine the extent to which our loans constitute qualifying assets for purposes of the REIT asset tests and the extent to which the interest earned on our loan constitutes qualifying income for purposes of the REIT income tests, we need to determine the value of the underlying real estate collateral at the time we acquire each loan. Although we seek to be prudent in making these determinations, there can be no assurance that the IRS might not disagree with our determinations and assert that a lower value is applicable, which could negatively impact our ability to qualify as a REIT. These considerations also might restrict the types of loans that we can make in the future. In addition, the need to comply with those requirements may cause us to acquire other assets that qualify as real estate that are not part of our overall business strategy and might not otherwise be the best investment alternative for us.

The tax on prohibited transactions limits our ability to engage in transactions, including certain methods of securitizing mortgage loans, that would be treated as sales for federal income tax purposes.

A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property, but including mortgage loans, held primarily for sale to customers in the ordinary course of business. We might be subject to this tax if we were to sell or securitize loans in a manner that was treated as a sale of the loans for federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans and may limit the structures we utilize for our securitization transactions even though such sales or structures might otherwise be beneficial for us.

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Even if we qualify as a REIT, the income earned by a taxable REIT subsidiary will be subject to federal income tax.

We formed a taxable REIT subsidiary on November 14, 2003 and may in the future own one or more additional taxable REIT subsidiaries. We expect that these entities will earn income that might otherwise jeopardize our status as a REIT. A taxable REIT subsidiary is taxed as a regular C corporation, and the income from the activities described above, and other income earned by our taxable REIT subsidiaries will therefore be subject to a corporate level tax, notwithstanding that we qualify as a REIT.

The REIT qualification rules impose limitations on the types of investments and activities that we may undertake which may preclude us from pursuing the most economically beneficial investment alternatives.

In order to qualify as a REIT, we must satisfy certain income and asset tests, which require that a specified percentage of our income and assets be comprised of certain types of income and assets. Satisfying these requirements might limit our ability to undertake investments and activities that would otherwise be beneficial to us. For example, hedging instruments are not qualifying assets for purposes of the REIT asset tests, and income from hedging instruments is not qualifying income for purposes of the 75% income test. Moreover, only income from hedging instruments that reduce the interest rate risk with respect to debt incurred by us to acquire or carry real estate assets is qualifying income for purposes of the 95% income test. Therefore, in order to maintain our qualification as a REIT, we may choose not to engage in certain hedging transactions, even though such transactions might otherwise be beneficial for us.

The “taxable mortgage pool” rules limit the manner in which we effect securitizations.

There is a significant likelihood that our securitizations would be considered to result in the creation of taxable mortgage pools. As a REIT, so long as we own 100% of the equity interests in the taxable mortgage pool, we are not adversely affected by the characterization of our securitizations as taxable mortgage pools (assuming that we do not have any stockholders who might cause a corporate income tax to be imposed upon us by reason of our owning a taxable mortgage pool). We are precluded, however, from selling to outside investors equity interests in our securitizations or from selling any debt securities issued in connection with the securitization that might be considered to be equity interests for tax purposes. These limitations preclude us from using certain techniques to maximize our returns from securitization transactions.

Recent change in taxation of corporate distributions may adversely affect the value of our shares.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 that was signed into law on May 28, 2003, among other things, generally reduces to 15% the maximum marginal rate of tax payable by domestic non-corporate taxpayers on distributions received from a regular C corporation. This reduced tax rate, however, will not apply to distributions made to individuals by a REIT on its stock, except for certain limited amounts. While the earnings of a REIT that are distributed to its stockholders will still generally be subject to less federal income taxation than earnings of a non-REIT C corporation that are distributed to its stockholders net of corporate-level income tax, this legislation could cause individual investors to view the stock of regular C corporations as more attractive relative to the stock of a REIT than was the case prior to the enactment of the legislation. This may be the case because the distributions from regular C corporations would generally be taxed at a lower rate while distributions from REITs will generally be taxed at the same rate as the individual’s other ordinary income. We cannot predict what effect, if any, the enactment of this legislation may have on the value of the stock of REITs in general or on our common stock in particular, either in terms of price or relative to other investments.

Item 1B. Unresolved Staff Comments

None.

Item 2. Properties

Our principal offices are located at 10245 Centurion Parkway North, Suite 305, Jacksonville, Florida 32256 where we lease approximately 7,500 square feet of space. This lease runs from March 2004 to June 2009, and has a current monthly rent, including common area maintenance, insurance and taxes, of approximately $11,000, which increases 3% annually.

Item 3. Legal Proceedings

On October 28, 2005, Western Investment Hedged Partners LP, et al., commenced an action against the Company. The plaintiffs allege that they own approximately 9.7% of our outstanding common stock. They contend that our board of directors breached its fiduciary duties and exceeded its authority under Maryland law by amending the Company’s bylaws on August 31, 2005 and October 5, 2005 (the Bylaw Amendments). The plaintiffs assert that the Bylaw Amendments were enacted for the purpose of impeding the plaintiffs’ democratic stockholder rights, and they have requested that the court:

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(a) declare the Bylaw Amendments null and void; (b) enjoin Sunset from implementing the Bylaw Amendments; and (c) award the plaintiffs unspecified damages, attorneys’ fees and expenses. We deny the plaintiffs’ allegations of wrongdoing and damages, and we are vigorously defending ourselves. On March 7, 2006, the court issued an order granting our motion for summary judgment and holding that the board of directors’ enactment of the Bylaw Amendments was valid as a matter of law.

On October 7, 2005, we filed a lawsuit against Owens Mortgage Investment Fund and Vestin Mortgage, Inc. for violation of certain provisions under the Intercreditor Agreement related to our commercial mortgage loan on cemetery/funeral home properties in Hawaii. We are requesting declaratory judgment that certain actions taken by Defendants constitute a breach of the Intercreditor Agreement, including the sale by Owen of its interest in the loan to Vestin, and that payments made by Vestin to Owen for accrued interest should be allocated and distributed to all parties pro rata.

In March 2005, we filed suit against Redevelopment Group V, a Pennsylvania limited liability company, for collection of a $4.7 million loan receivable. On January 31, 2006, the property collateralizing the loan was sold in a court-supervised transaction, and the net sales proceeds of $3.5 million were placed under court control. We have a motion for turnover scheduled with the court in mid March, and anticipate that the funds will be released to us within a few weeks following the hearing. We retained all of our rights and remedies under the original note agreement against the Guarantor as it relates to the deficiency arising from the sale of the loan collateral and non-performance by the borrower, including default interest, legal and other collection costs, and are pursuing collection. The outcome of such suit is unknown at this time.

On July 6, 2005, Redevelopment Group V filed a countersuit against us, which we intend to defend vigorously.

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

None.

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PART II

Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Market for our Common Stock

Prior to our initial public offering, our stock was not listed or quoted on any national exchange or market system. Commencing on March 18, 2004, our stock began trading on the New York Stock Exchange (NYSE) under the symbol “SFO.” The table below reflects the intra-day high and low sale prices of our common stock for each quarterly period.

	Stock Price
	High		Low
2005
Fourth quarter	$	8.60	$	7.40
Third quarter		9.51		7.95
Second quarter		9.84		9.16
First quarter		10.45		9.34
2004
Fourth quarter	$	10.84	$	10.00
Third quarter		10.67		9.34
Second quarter		12.68		9.89
First quarter (from March 18, 2004)		12.85		12.65

At March 8, 2006, we had 10,516,600 shares of common stock outstanding with 11 holders of record and approximately 1,350 beneficial owners holding our shares in “street” name.

In order to qualify as a REIT, we have to pay out substantially all of our taxable income to our stockholders. All of our dividends are at the discretion of our board of directors and will depend on our earnings, financial condition, and maintaining our status as a REIT. We declared and paid the following dividends on the Common Stock during the years ended December 31, 2005 and 2004, all of which were considered ordinary income for income tax purposes:

Declaration Date	Record Date	Payment Date	Dividend per Share
2005
November 14, 2005	November 21, 2005	December 5, 2005	$	0.03
August 15, 2005	August 22, 2005	September 2, 2005		0.03
March 30, 2005	April 11, 2005	April 21, 2005		0.18
March 10, 2005	March 21, 2005	March 31, 2005		0.20
			$	0.44
2004
November 9, 2004	November 29, 2004	December 13, 2004	$	0.05
August 11, 2004	August 27, 2004	September 24, 2004		0.015
			$	0.065

Equity Compensation Plan

Our Amended and Restated 2003 Share Incentive Plan allows for the granting of stock options or restricted stock to employees, directors, advisory board members, and consultants. This plan is administered by the compensation committee of our board of directors and utilized to encourage high levels of performance by individuals who are key to our success and to enable us to attract, motivate and retain talented and experienced individuals essential to our success. The following table sets forth certain information regarding our plan as of December 31, 2005:

	Number of securities to be issued upon exercise of outstanding options, warrants and rights	Weighted-average exercise price of outstanding options, warrants and rights		Number of securities remaining available for future issuance under equity compensation plans (excluding securities included in column (a)
Equity compensation plans approved by security holders	121,044	$	7.92	898,400
Equity compensation plans not approved by security holders	—		—	—
Total	121,044	$	7.92	898,400

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See Note 7 to our financial statement included in this Annual Report on Form 10K for further information regarding the Amended and Restated 2003 Share Incentive Plan.

Item 6. Selected Financial Data

The following selected financial data is derived from our audited financial statements for the years ended December 31, 2005, 2004 and 2003. The operations highlights for the prior period October 6, 2003 (date of inception) through December 31, 2003 included operating expenses during the formation period. The operations highlights for the period ended December 31, 2004 include formation expenses through the closing of our initial public offering on March 17, 2004, and operations for the remainder of the year. You should read this selected financial data together with the more detailed information contained in the Financial Statements and related Notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K.

(in thousands except per share data)	Year ended December 31, 2005			Year ended December 31, 2004			Period beginning October 6, 2003 and ending December 31, 2003
Operations Highlights:
Net interest income	$	11,568		$	8,391		$	—
Provision for loan losses		7,042			1,333			—
Net gain on sale of securities		(9	)		(734	)		—
Loss on sale of loans		59			48			—
Operating expenses		9,213			7,100			22
Net income (loss)		(4,737	)		644			(22	)
Per Share Data:
Basic earnings (loss) per share		(0.45	)		0.08			(.05	)
Diluted earnings (loss) per share		(0.45	)		0.07			(.05	)
Dividends declared per share		0.44			0.065			—
Book value per share (1)		10.17			11.41			—
(in thousands except per share data)	As of December 31, 2005			As of December 31, 2004			As of December 31, 2003
Balance Sheet Highlights:
Residential mortgage assets	$	1,103,502		$	817,866		$	—
Commercial mortgage assets		29,347			44,522			—
Total assets		1,162,260			893,492			315
Reverse repurchase agreements		1,031,831			761,205			—
Total liabilities		1,055,263			774,234			289
Accumulated other comprehensive income (loss)		(2,998	)		87
Total stockholders’ equity		106,997			119,258			26

(1) Book value per share is calculated as total stockholders’ equity divided by the number of shares issued and outstanding as of December 31, 2005 and 2004.

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operation

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

Executive Overview

We are a self-managed REIT that was formed as a Maryland corporation in October 2003 to acquire a portfolio of residential mortgage assets and commercial mortgage bridge loans (including loans that we own jointly with others) in the United States. We finance and manage a portfolio of mortgage assets that primarily consists of agency mortgage-backed and “AAA” rated securities and residential mortgage and commercial mortgage bridge loans. Our principal business objective is to generate income by earning a positive spread between the interest income on our assets and the interest expense (including hedge costs) on financing those assets. At December 31, 2005, our interest-earning assets consisted of the following:

$160.6 million of securitized residential mortgage loans carried at original cost;

$294.0 million of “AAA” rated mortgage-backed securities;

$648.9 million of agency mortgage-backed securities, issued by Fannie Mae; and

$29.3 million of commercial mortgage bridge loans (including a commercial mortgage bridge loan that we own jointly with other interest holders).

The results of our operations are affected by various factors, some of which are beyond our control, and depend on, among other things, the level of our net interest income, the market value of our assets and the supply of and demand for such assets. Our net interest income, which reflects the amortization of purchase premiums, varies primarily as a result of changes in interest rates, borrowing costs and prepayment speeds. Prepayment speeds and interest rates vary according to the type of investment, conditions in financial markets, competition and other factors, none of which can be predicted with any certainty. In general, as prepayment speeds on our mortgage-backed securities portfolio increase, related purchase premium amortization increases, which reduces our net yield on these assets. Since changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to effectively manage interest rate risks and prepayment risks while maintaining our status as a REIT.

Our use of interest rate swaps mitigates, to a large degree, the risk of net interest margin compression and the risk of market value deterioration. We may elect to use other derivative instruments in the future, including caps, floors, Eurodollar futures and options on swaps and treasuries, to further reduce this risk. Net interest margin can fluctuate over time for various reasons, including:

• Faster prepayments accelerate premium amortization, thereby reducing net interest margin.

• When the notional amount of our swaps is less that the amount of outstanding repurchase agreements, the difference is exposed to changing interest rates. As short-term interest rates rise, the exposed portion of our repurchase agreements will incur higher interest expense, thereby reducing net interest margin. Conversely, if short-term rates fall, overall debt costs would decrease, widening net interest margins. At December 31, 2005, we had $1.0 billion in reverse repurchase agreements and $980.4 million in notional pay-fixed swaps.

• As interest rates rise, the average lives of our assets increase. At the same time, hedging costs would also typically increase. To the extent that management elects to enter into longer-term swaps, our overall financing costs would increase.

2005 was a year when short term rates continued to increase more than longer term rates, a phenomenon referred to as a “flattening” of the yield curve. On June 30, 2004, the Federal Reserve began a series of Federal Funds Target Rate increases, which have resulted in the Federal Funds Target Rate increasing from 1.00% at June 30, 2004, to 4.25% at December 31, 2005. The Federal Reserve has continued its tightening into the first quarter of 2006 by raising the short term borrowing rate (the Federal Funds Target Rate) to 4.50% on January 31, 2006.

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The following table presents various rate increases during the year ended December 31, 2005:

Instrument	12-Month Increase		Rate at December 31, 2005
One-month LIBOR	1.99	%	4.39	%
On-the run 2-year Treasury Note	1.33	%	4.40	%
On-the run 5-year Treasury Note	0.74	%	4.35	%
On-the run 10-year Treasury Note	0.17	%	4.39	%

As the above rate table presents, since the beginning of 2005, the on-the-run Treasury ten year note is up in yield only 17 basis points as compared to the one month LIBOR rate which is up 199 basis points.

The yields on our portfolio of mortgage-backed securities are affected by movements in both short and long term rates. Conversely, our reverse repurchase agreement debt carries interest rates that are set based on short-term interest rates only (the short end of the yield curve). As the effect of Federal Reserve actions are reflected in higher LIBOR rates, our funding costs will increase as our repurchase agreements mature and are renewed at the then current rates. This could result in a tightening of our net interest spread. Despite a continued flattening in yield curve, our net interest income was $11.6 million for the year ended December 31, 2005, and declined only $200,000 from the third quarter of 2005 to the fourth quarter of 2005. This is largely due to our use of interest rate swaps that have mitigated the rise in interest rates in the short end of the yield curve.

Critical Accounting Policies and Estimates

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

Classification of Investment Securities

Our investments in mortgage-backed securities are classified as available-for-sale securities, which are carried on the balance sheet at their fair value. The classification of the securities as available-for-sale results in changes in fair value being recorded as adjustments to accumulated other comprehensive income or loss, which is a component of stockholders’ equity, rather than immediately through earnings. If available-for-sale securities were classified as trading securities, we could experience substantially greater volatility in income or loss from period to period.

Valuation of Mortgage Related Securities

Our mortgage-backed securities have fair values determined by management based on the average of third-party broker quotes received. Because the price estimates may vary to some degree between sources, management must make certain judgments and assumptions about the appropriate price to use to calculate the fair values for financial reporting purposes. Different judgments and assumptions could result in different presentations of value.

When the fair value of an available-for-sale security is less than amortized cost, we consider whether there is an other-than-temporary impairment in the value of the security. We consider several factors when evaluating securities for an other-than-temporary impairment, including the length of time and extent to which the market value has been less than the amortized cost, current market conditions and the continued intent and ability to hold the security for a period of time sufficient to allow for any anticipated recovery in market value. If we determine an other-than-temporary impairment exists, the cost basis of the security is written down to the then-current fair value, and the unrealized loss is recorded as a reduction of current earnings. The determination of other-than-temporary impairment is a subjective process, requiring the use of judgments and assumptions; therefore, different judgments and assumptions could affect the timing of loss realization.

Allowance for Loan Losses

Our mortgage assets consist of mortgage-backed securities, residential loans and commercial mortgage bridge loans. Due to the credit quality of our mortgage-backed securities, which are issued or guaranteed by an agency of the government,

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typically Fannie Mae, or are non-agency AAA rated, we do not establish a loss reserve on these securities. In establishing our allowance for loan loss policy on our securitized loan portfolio, we utilize publicly available information regarding losses realized on similar types of assets. In addition, our commercial mortgages are evaluated individually for impairment. Any loan past due in excess of 60 days is evaluated, but other loans may be included in this analysis based on specific facts and circumstances. All impaired loans are evaluated in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan – an amendment of FASB Statements No. 5 and 15,” which requires that impaired loans be evaluated based on a discounted cash flow analysis, or, if the loan is considered collateral dependent, on the fair value of the collateral less the estimated cost to sell. Any specific allowance is established as a component of the allowance for loan losses. The ultimate net realizable value of the collateral securing our mortgage loans may impact any actual losses incurred.

Revenue Recognition

Interest income on residential mortgage assets is accrued based on the actual coupon rate and the outstanding principal amount of the underlying mortgages, unless management considers the collection of interest to be uncertain. Premiums and discounts associated with the purchase of investment securities are amortized into interest income over the lives of the securities using the effective interest yield adjusted for the effects of estimated prepayments based on SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases – an amendment of FASB Statements No. 13, 60 and 65 and a rescission of FASB Statement No. 17”. Adjustments are made using the retrospective method to the effective interest computation each reporting period based on the actual prepayment experiences to date. Changes in the rate of future prepayment streams would affect the recognition of income related to the amortization of premiums and discounts.

Interest income on commercial mortgage loans is accrued based on the outstanding principal amount and the stated interest rate, unless management considers the collection of interest to be uncertain. Loans are evaluated for non-accrual status on an individual basis when delinquent in excess of 60 days, or sooner if deemed appropriate by the Company.

Accounting for Equity-Based Compensation

The Company accounts for stock based awards in accordance with the fair value recognition provisions of SFAS No. 123 (revised), “Share-Based Payment”. We record expenses for the estimated value of stock based awards for both employees and non-employees. These awards are valued using the Black-Scholes option pricing model. This model requires assumptions related to stock price volatility, dividend yield, expected option life, and a risk free rate of return. Changes in the volatility of our stock, or other assumption changes, would affect the amount of expense recorded on stock based awards.

Accounting for Hedging Activities

The Company enters into derivative financial instruments as a means of mitigating the Company’s interest rate risk on forecasted interest expense. All derivative financial instruments are carried on the balance sheet as assets or liabilities at fair value as required by SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.”

The Company formally documents all hedging relationships between hedging instruments and the hedged item, as well as its risk management objective and strategy for entering into various hedge transactions. The Company performs an assessment, at inception and on an ongoing basis, whether the hedging relationship has been highly effective in offsetting changes in fair value or cash flows of hedged items and whether they are expected to continue to be highly effective in the future. Any ineffectiveness, or over hedging, is recognized in interest expense. If management decided not to designate the interest rate swaps as hedges and to monitor their effectiveness as hedges, changes in the fair values of these instruments would be recorded in our statement of operations, potentially resulting in increased volatility in our earnings. Additionally, to the extent that we hedge more or less of our floating rate debt, there would be an effect on interest expense.

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

Financial Condition

Assets

Total assets at December 31, 2005, of $1.2 billion, were acquired with the proceeds of our initial public offering in March 2004, the proceeds from the issuance of junior subordinated notes to the Preferred Trust in March 2005, and the use of leverage. Virtually all of these assets were interest-bearing and were comprised of residential mortgage-related securities and commercial bridge loans.

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Residential Mortgage Assets

At December 31, 2005, our residential assets included $942.9 million of mortgage backed available for sale securities and $160.6 million remaining balance of purchased loans that were securitized in 2004 and carried at amortized cost. The mortgage backed securities portfolio consists of AAA rated securities and agency securities that are issued or guaranteed by an agency of the U.S. government. Other characteristics of these securities at December 31, 2005 and December 31, 2004 are outlined in the following table:

	December 31, 2005									December 31, 2004
(in thousands)	Agency Securities			Non Agency Securities			Total			Agency Securities			Non Agency Securities			Total
Par value	$	653,711		$	297,189		$	950,900		$	510,347		$	96,013		$	606,360
Unamortized premium		6,915			1,960			8,875			8,778			788			9,566
Unamortized discount		(1,687	)		(440	)		(2,127	)		(689	)		(21	)		(710	)
Amortized cost		658,939			298,709			957,648			518,436			96,780			615,216
Gross unrealized gains		—			2			2			709			14			723
Gross unrealized losses		(10,034	)		(4,716	)		(14,750	)		(1,456	)		(329	)		(1,785	)
Estimated fair value	$	648,905		$	293,995		$	942,900		$	517,689		$	96,465		$	614,154

During the year ended December 31, 2005, we purchased mortgage backed securities with a par value at time of purchase of $617.1 million. These purchases were financed primarily with cash from principal and interest payments plus the use of reverse repurchase agreements. During the year we also sold securities with a par value of $32.4 million for a net gain of $9,000. At December 31, 2005, our agency securities had a weighted average coupon of 4.74% with an average of 48 months to reset, and the non-agency securities had a weighted average coupon of 4.74% with an average of 47 months to reset.

At December 31, 2005, the mortgage backed securities portfolio had unrealized losses of $14.8 million, of which 8.1 million had been in a continuous loss for 12 months or more. We have reviewed the unrealized losses on the securities, and do not believe the losses, individually or in the aggregate, represent an other-than-temporary impairment. The unrealized losses are primarily a result of changes in interest rates and will not prohibit us from receiving our contractual interest and principal payments. We have the ability and intent to hold these securities for a period necessary to recover the amortized cost. All of the mortgage-backed securities have an actual or implied “AAA” rating, or are guaranteed by an agency of the U.S. Government.

At December 31, 2005 and December 31, 2004, the Company’s residential mortgage loans, including securitized loans, consisted primarily of hybrid adjustable rate mortgages and were carried on the balance sheet at historical cost, less premium amortization. The loan balances by original fixed period are summarized in the following table:

	December 31, 2005						December 31, 2004
Initial Fixed Term (in thousands)	Loan Balance		Premium/ Deferred Costs		Book Value		Loan Balance		Premium/ Deferred Costs		Book Value
Fixed rates	$	—	$	—	$	—	$	1,017	$	28	$	1,045
3 year fixed		4,893		149		5,042		10,336		297		10,633
5 year fixed		53,550		1,492		55,042		71,735		1,997		73,732
7 year fixed (and other)		99,867		446		100,313		117,389		653		118,042
Total		158,310		2,087		160,397		200,477		2,975		203,452
Deferred loan costs		—		205		205		—		260		260
Total	$	158,310	$	2,292	$	160,602	$	200,477	$	3,235	$	203,712

During the year ended December 31, 2005, we sold loans with a book value of $2.1 million at a loss of $59,000. These loans were not part of our securitized loan portfolio. At December 31, 2005, the securitized residential mortgage loan portfolio had a weighted average coupon of 4.58% with an average of 51 months to reset and a fair value of $154.6 million. Two securities were in a gain position totaling $59,000 and seven securities were in a loss position totaling $5.8 million, and had been in such an unrealized loss position for 12 months or more. Additionally, two loans totaling $600,000, or 0.38% of the securitized loan balance, were 30 days past due and one loan for $68,000 was in bankruptcy.

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We do not believe unrealized losses, individually or in the aggregate as of December 31, 2005 and 2004, represent an other-than-temporary impairment. The unrealized losses are primarily a result of increases in interest rates and will not prohibit us from receiving our contractual interest and principal payments. We have the ability and intent to hold these securities for a period necessary to recover the amortized cost. Additionally, the securitization is comprised of prime mortgage pools with original credit scores of greater than 700 and an original weighted average loan-to-value ratio of less than 75%, and has not experienced any credit losses to date.

Commercial Assets

In addition to the residential loans, we have a portfolio of commercial mortgage bridge loans. These loans are carried at par, less unamortized deferred fees. During 2005, we entered into two new commercial bridge loans. In June, we closed and funded a $5.0 million retail development loan related to a Florida development, and in July 2005, we closed on a $3.5 million loan commitment related to an equestrian facility located in Bethany, West Virginia, which subsequently was paid in full on October 4, 2005. Additionally, in order to enhance our collateral position, we increased our participation on a resort development loan by $5.6 million in June 2005.

The following table outlines the relevant characteristics of the commercial loans as of December 31, 2005 and 2004:

Type of Property (in thousands)	Interest Rate		Location	Participation	Maturity	December 31, 2005			December 31, 2004
Retail mall	11	%	FL	No	—	$	—		$	14,735
Resort development	13	%	NC	No	Jun. 2006		16,647			9,975
Mansion/conference center	11	%	FL	No	—		—			8,166
Cemetery/funeral home	10	%	HI	Yes	Matured		5,658			5,658
Multi-sport facility	12	%	NJ	No	Matured		4,700			4,700
Apartments	11	%	IL	No	—		—			1,500
Retail development	11	%	FL	No	Jun. 2006		2,739			—
							29,744			44,734
Deferred fees							(397	)		(212	)
Commercial mortgage balance						$	29,347		$	44,522

We evaluate loans for possible impairment under SFAS No. 114. At December 31, 2005, two loans were considered impaired, as discussed further below.

Cemetery/Funeral Home Loan. We have a participation interest (approximately 20%) in a loan collateralized by cemetery/funeral home properties in Hawaii. At December 31, 2004, the loan was in default and was evaluated under SFAS No. 114 for impairment. At the time of the analysis, foreclosure proceedings had begun on the property, and we concluded that the estimated net realizable value of the collateral was sufficient to support the loan value and no impairment was recorded. During the second quarter of 2005, we learned that significant funds were missing from the cemetery/funeral home trust fund. Until the investigation of the missing funds is resolved, the Attorney General for the State of Hawaii has expressed opposition to the issuance of a license to operate the facilities. This additional information resulted in our decision to take an impairment equal to the outstanding balance of $5.7 million on the loan at June 30, 2005. At December 31, 2005, our analysis concluded that the loan continued to be fully impaired. For the year ended December 31, 2005, no interest income was recorded on this loan. For the year ended December 31, 2004, interest income of $171,000 was recognized.

We continue to incur legal fees of approximately $25,000 monthly related to the collection of this loan, which are expensed as incurred. Under terms of the Intercreditor Agreement, the Company may also be responsible for its respective portion of future expenses related to preservation of collateral. At December 31, 2005, we estimated that future expenditures related to the preservation of collateral were not material.

On October 7, 2005, we filed suit against the other two participating creditors in the loan, Owens Mortgage Investment Fund and Vestin Mortgage, Inc., for violation of certain provisions under the Intercreditor Agreement. The outcome of this suit is unknown at this time.

Multi-Sport Facility Loan. This loan went into default during the first quarter of 2005. Due to the absentee nature of the property owner, a court-ordered receiver was put in place, which allowed us to market the property for sale under court supervision. On November 4, 2005, we received a signed contract from a willing buyer. Using the contracted price, and accounting for carrying costs, commission and other transactions costs, we concluded that the net realizable value of the collateral securing the loan was less than the carrying value of the loan, and an impairment charge of $1.2 million was recorded during the period ended September 30, 2005.

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On January 31, 2006, the sale of the property was completed, and the net sales proceeds of $3.5 million were placed under court control. We have a motion for turnover scheduled with the court in mid March, and anticipate that the funds will be released to us within a few weeks following the hearing. The carrying value of the loan at December 31, 2005, net of impairment, approximated the net proceeds from the court-approved sale of the property. The Company retains all of its rights and remedies under the original note agreement against the Guarantor as it relates to the deficiency arising from the sale of the loan collateral. In March 2005, we filed suit against the owner of the property for default under the terms of the loan agreement. We continue to pursue this suit for possible collection of the deficiencies we incurred, including default interest, legal and other collection costs. The outcome of such suit is unknown at this time.

Mansion/Conference Center. At December 31, 2004, we concluded that this loan was impaired and recorded an allowance for loan loss of $1.1 million. During the first quarter of 2005, we elected to accept a settlement offer under a claim on the title insurance policy. Under terms of the settlement, we received $5.9 million in cash on March 31, 2005, and were due to be paid the remaining $1.5 on or before December 31, 2005. The $1.1 million allowance was charged off at March 31, 2005, and the $1.5 million remaining balance due was received on December 15, 2005.

Allowance for Loan Losses

In addition to a specific review of each commercial loan as discussed above, we provide for loan losses by making a general assessment of the securitized loan portfolio, taking into consideration any delinquencies or bankruptcies on the underlying mortgages, as well as industry statistics on similar pools of loans.

The following table reflects the activity in our allowance for loan losses for the years ended December 31, 2005 and 2004:

(in thousands)	2005			2004
Balance at beginning of period	$	1,333		$	—
Provision		7,042			1,333
Charge-offs		(1,054	)		—
Balance at end of period	$	7,321		$	1,333

The overall provision rate and the related allowance are evaluated on a quarterly basis to insure that, in our opinion, the allowance is adequate for losses in the portfolio. A provision for loan losses is not recorded for mortgage-backed securities, which are generally rated AAA or are agency secured. These securities are carried on the balance sheet at market value and any impairment that would be deemed to be other than temporary would be recorded as a direct write-down of the asset.

Cash and Cash Equivalents

As of December 31, 2005, we had $17.6 million in cash and cash equivalents. This included both interest bearing and non-interest bearing bank balances. These balances along with the leverage available through our counterparties on our fully-paid securities provided us with total liquidity of $36.3 million. At December 31, 2005, none of the cash or cash equivalents was pledged to support margin calls on derivatives or reverse repurchase agreements.

Liabilities

Our securities and securitized loans are financed primarily through the use of reverse repurchase agreements. At December 31, 2005, we had lines with 14 financial institutions, and had borrowings outstanding with nine of these institutions totaling $1.0 billion with an average interest rate of 4.36% and an average remaining maturity of 92 days.

Our borrowings generally have a shorter maturity than our assets which creates an interest rate mismatch. Additionally, we typically pay floating rates of interest on our reverse repurchase agreement and typically receive fixed rates of interest on our securities. We use derivative instruments to extend the interest rate characteristics of our borrowings and to convert a substantial portion of our borrowings to a fixed rate of interest. As of December 31, 2005, we had 33 fixed-pay interest rate swaps with a notional balance of $980.4 million outstanding. These swaps were accounted for as cash flow hedges of our forecasted borrowings and were reflected on the balance sheet at fair market value. Thirty of the swaps were in a gain position and reflected as assets at December 31, 2005, and three of the swaps were in a loss position and reflected as liabilities.

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

	December 31,
	2005				2004
(in thousands)	Notional		Avg. Fixed Rate		Notional		Avg. Fixed Rate
Maturing in less than one year	$	299,700	3.00	%	$	—	—	%
Maturing between one and two years		235,560	3.72			362,700	2.79
Maturing between two and three years		89,000	4.22			61,060	3.50
Maturing between three and five years		356,100	4.43			169,800	4.00
Total	$	980,360	3.81	%	$	593,560	3.21	%

On March 15, 2005, the Company completed a private offering of $20 million of trust preferred securities through the Preferred Trust. The Preferred Trust used the proceeds of the private offering, together with the Company’s $619,000 investment in the Preferred Trust common securities, to purchase $20.6 million aggregate principal amount of the Company’s subordinated notes with terms that parallel the terms of the trust preferred securities.

The trust preferred securities and the Subordinated Notes bear interest at 90-day LIBOR plus 4.15% (approximately 8.68% at December 31, 2005) and generally may not be redeemed prior to March 30, 2010.

Results of Operations

Comparison of the year ended December 31, 2005 to the year ended December 31, 2004

For the year ended December 31, 2005, net loss was $4.7 million as compared to net income of $644,000 for the year ended December 31, 2004. Net interest income for the year was $11.6 million, an increase of $3.2 million from the year ended December 31, 2004. This represented a net interest margin on our average interest earning assets of 1.1% for the year ended December 31, 2005. Prior to the receipt of proceeds from our initial public offering in March 2004, our operations were limited. Therefore, during the first quarter of 2004, there was virtually no revenue. Beginning in the second quarter of 2004, we began investing in mortgage-related securities and commercial bridge loans. This investment activity continued to ramp up into the first quarter of 2005, when our earning assets reached $1.0 billion.

The increase in net interest income during 2005 was due to the increase in the balance of our interest earning assets, offset somewhat by the increase in our interest bearing liabilities, coupled with rising interest rates on our floating rate debt throughout the year. The average balance of our interest earning assets during 2005 was $1.1 billion, an increase of $390.1 million, or 57.8%, over the average balance of $675.2 million for the last half of 2004. The average yield on our assets was 4.35% during 2005 as compared to 4.46% for the last half of 2004. The average balance of our interest bearing liabilities during 2005 was $961.7 million, an increase of $399.3 million, or 71.0%, over the average balance of $562.4 million for the last half of 2004. The average cost on our liabilities in 2005 was 3.6% as compared to 3.0% for the last half of 2004.

Year-over-year, the provision for loan losses increased $5.7 million to $7.0 million, as compared to $1.3 million for the year ended December 31, 2004. The provision recorded during 2005 was related to impairment charges on two loans in our commercial loan portfolio of $6.8 million and $230,000 related to our estimate of loss on our securitized loan portfolio.

Operating expenses for the year ended December 31, 2005, totaled $9.2 million as compared to $7.1 million in 2004. Some of this increase was attributed to the business being in operation for a full year during 2005, relative to a short year in 2004 due there being virtually no operations prior to the initial public offering in March 2004. The significant components of the $2.1 million year-over-year increase were as follows:

• A $1.8 million increase in professional fees, comprised of the following items:

• $1.1 million increase in legal fees. During 2005, we incurred legal fees related to the departure of three executive-level officers, the addition of two executive officers, the defense preparation for a shareholder lawsuit and the costs related to the engagement by the special committee of our board of directors of Banc of America Securities for a strategic analysis of our business. Additionally, during 2005 we incurred approximately $390,000 in legal expenses related to workout, modification, collection and litigation on certain loans in the commercial portfolio;

• $260,000 in fees related to our Sarbanes-Oxley initiatives, including fees paid to an outsourced internal audit group which primarily focused on Sarbanes-Oxley, as well as other internal audit initiatives as directed by the audit committee of our board of directors;

• $190,000 in fees related to a compensation study and other strategic advisory services; and

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• $50,000 increase in outside audit fees related primarily to first year audit of internal controls pursuant to the Sarbanes-Oxley Act.

• A $453,000 increase in other operating expenses, which was primarily due to having 12 months of expense for standard monthly items, such as rent, utilities, and monthly service fees, during 2005 relative to approximately 9 months during 2004. Additionally, depreciation and amortization expense increased $177,000 due to additions made late in 2004 plus the impact of a full year of expense in 2005 compared to approximately nine months of expense in 2004. Finally, board of directors’ fees increased $230,000 due to an increase in the number of meetings throughout 2005 related to several items, including the turnover on our board of directors, the turnover in management, the shareholder lawsuit and the strategic alternatives review. This fee increase was partially offset by a $94,000 reduction in board-related stock compensation expense.

• A $476,000 increase in severance expense. During 2005, three executive officers left the Company and were subject to severance arrangements totaling $841,000. During 2004, three officers left the Company and were subject to severance arrangements totaling $365,000.

• A $576,000 reduction in salaries and employee benefits, which was comprised of the following components:

• $325,000 reduction in bonus expense. During 2004, bonuses of $325,000 were recorded. There was no bonus expense for the year ended December 31, 2005;

• $128,000 reduction in relocation expense. During 2004, we relocated a member of senior management to Florida;

• $94,000 reduction in payroll due to the elimination of management-level positions; and

• $44,000 reduction in share-based compensation. During 2004, the management team was awarded stock options and restricted stock in conjunction with the initial public offering, resulting in share-based expense of $114,000. During 2005, a number of those individuals left the Company and forfeited their shares. Employee-related share-based compensation was $70,000 for the year ended December 31, 2005.

From the time of our inception in October 2003 until our initial public offering in March 2004, we had limited operations. Therefore, a comparison of the results for the year ended 2004 to the period from October through December 2003 is not meaningful. During 2003, we had no income, and incurred $22,000 in expenses.

The following tables show average earning assets and their respective yields, along with the average borrowings and their respective costs for each of the last six quarters (in thousands):

Quarter	Average Residential Assets		Average Commercial Assets (1)		Average Total Interest Earning Assets		Average Repurchase Agreements		Average Subordinated Notes Borrowing (2)		Average Total Interest Bearing Liabilities
Dec. 31, 2005	$	1,079,736	$	29,550	$	1,119,736	$	1,003,271	$	20,000	$	1,023,890
Sept. 30, 2005		1,046,413		32,355		1,093,332		967,436		20,000		987,436
Jun. 30, 2005		1,074,277		28,850		1,114,511		992,197		20,000		1,012,197
Mar. 31, 2005		878,454		44,457		933,880		814,864		3,556		823,171
Dec. 31, 2004		754,493		52,839		815,065		691,943		—		701,938
Sept. 30, 2004		476,388		42,003		535,385		422,445		—		422,786

Quarter	Income on Residential Assets		Income on Commercial Assets		Total Income on Earning Assets		Interest on Repurchase Agreements		Interest on Derivative Agreements			Interest on Subordinated Notes (1)		Total Expense on Interest Bearing Liabilities
Dec. 31, 2005	$	11,474	$	873	$	12,438	$	10,474	$	(1,020	)	$	423	$	9,877
Sept. 30, 2005		10,946		906		11,945		8,693		22			396		9,181
Jun. 30, 2005		11,039		692		11,802		7,611		900			362		9,031
Mar. 31, 2005		9,112		975		10,171		5,270		1,155			64		6,699
Dec. 31, 2004		8,066		1,026		9,142		3,691		1,381			—		5,347
Sept. 30, 2004		4,842		1,081		5,989		1,676		1,280			—		3,118

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Quarter	Yield on Residential Assets		Yield on Commercial Assets		Total Yield on Interest Earning Assets		Cost on Repurchase Agreements		Cost/Income on Derivative Agreements		Cost on Trust Preferred		Total Cost on Interest Bearing Liabilities
Dec. 31, 2005	4.22	%	11.72	%	4.41	%	4.14	%	(0.40	)%	8.15	%	3.83	%
Sept. 30, 2005	4.15	%	11.11	%	4.33	%	3.57	%	0.01	%	7.86	%	3.69	%
Jun. 30, 2005	4.12	%	9.62	%	4.25	%	3.08	%	0.36	%	7.26	%	3.58	%
Mar. 31, 2005	4.21	%	8.89	%	4.42	%	2.62	%	0.57	%	7.30	%	3.30	%
Dec. 31, 2004	4.25	%	7.72	%	4.46	%	2.12	%	0.79	%	—		3.03	%
Sept. 30, 2004	4.04	%	10.24	%	4.45	%	1.58	%	1.21	%	—		2.93	%

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

(2) Information on the junior subordinated notes is shown net of amounts related to the investment in common stock of the Trust Preferred.

Liquidity and Capital Resources

The Company is organized as a mortgage REIT to invest in residential mortgage related securities and commercial bridge loans, and to distribute to stockholders, in the form of cash distributions, a substantial portion of its net cash flow generated from its mortgage activities. We manage liquidity to ensure that we have the continuing ability to maintain cash flows that are adequate to fund operations on a timely and cost-effective basis. On December 31, 2005, we had cash and cash equivalents of $17.6 million and fully-paid (unleveraged) mortgage-backed securities with a market value of $19.3 million. Cash, combined with the leverage available through our counterparties on our fully-paid securities, provided us with total liquidity of $36.3 million.

Our primary cash requirements during 2006 are expected to be for payment of dividends, purchases of securities, repayments on reverse repurchase agreements and interest payments on financing arrangements. Management and the board of directors review estimated taxable income on a quarterly basis in advance of declaring each quarterly dividend. Accordingly, the amount of cash required for 2006 dividends cannot be estimated at this time. Securities purchases are generally made by reinvesting cash received from monthly prepayments on our securities portfolio, combined with leveraging the securities with reverse repurchase agreements. As reverse repurchase agreements mature, we typically renew them with the same pledged collateral. All reverse repurchase agreements that have matured since December 31, 2005 have been refinanced under our current facilities.

Because we borrow money under the reverse repurchase agreements based on the fair value of our assets, and because changes in interest rates can negatively impact the valuation of our assets, our borrowing ability under these agreements may be limited and lenders may initiate margin calls in the event interest rates change or the value of our assets declines for other reasons. At December 31, 2005, we had posted additional securities with a market value of $377,000 as collateral to cover a margin call on reverse repurchase agreements with one counterparty. External disruptions to credit markets might also impair access to additional liquidity and, therefore, we might be required to sell certain mortgage assets in order to maintain liquidity. If required, such sales might be at prices lower than the carrying value of the assets, which would result in losses. At December 31, 2005, the fair value of our mortgage-backed securities was $942.9 million, which was less than the amortized cost basis due to net unrealized losses in the portfolio of $14.7 million. We have determined that the unrealized losses are temporary impairments due to changes in market interest rates and, based upon review of credit ratings, delinquency data and other information, are not reflective of credit deterioration. As we have the ability and intent to hold the assets until recovery, the losses are not considered to be other than temporary impairments. In addition, we have the ability to terminate our hedges for liquidity purposes. At December 31, 2005, we had 30 swaps in a gain position totaling $12.2 million.

Throughout the year ended December 31, 2005, we had adequate liquidity to meet our requirements for normal recurring operating expenses, as well dividend payments, interest payments, securities purchases and refinancings, and we believe our operations, including our ability to leverage our securities portfolio, will continue to provide sufficient liquidity to meet our future cash requirements.

Operating Activities

We generated cash from operations during 2005 of $2.4 million. While we ended the year with a net loss of $4.7 million, there were significant non-cash items included therein, including a $7.0 million provision for credit losses (which pertained substantially to impairments on two of our commercial loans), and amortization of net premium on our securities portfolio of $3.3 million. These non-cash add-backs to the net loss were offset in part by $1.1 million of non-cash interest income that increased the respective commercial loan balances, and $2.3 million increase in accrued interest.

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Investing Activities

We used $287.2 million for investing activities during 2005. We continued to increase our mortgage assets during 2005 by purchasing $617.1 million of mortgage-backed, available for sale securities and funding $13.4 million of commercial loans. We received principal payments on our securities and loans of $301.5 million, and sold securities and loans for net proceeds of $34.4 million. In addition, we received $7.4 million from an insurance settlement on one of our commercial loans.

Financing Activities

We generated $276.7 million in cash from financing activities during 2005. Our primary source of financing during 2005 consisted of reverse repurchase agreements. As of December 31, 2005, we had reverse repurchase lines with 14 financial institutions with a total capacity of $2.5 billion. We increased borrowings under these agreements by $270.6 million during the year to an outstanding balance of $1.0 billion at year-end with nine institutions with a weighted average rate of 4.36% and a weighted average remaining maturity of 92 days.

In March 2005, we issued junior subordinated notes to the Preferred Trust for net proceeds of $19.3 million. This facility is not redeemable prior to March 30, 2010 and has a maturity date in 2035. The proceeds from this issuance were used, in part, to fund the commercial loans made during the year.

Effective August 9, 2005, the Company terminated its warehouse lending facility with JP Morgan due to the expense involved relative to the need for such a facility. Terminating this line eliminated an annual commitment fee of approximately $625,000, as well as removed a number of financial and non-financial restrictions related to the company and its operations. The balance prior to termination was $9.7 million.

We also used cash of $4.6 million during 2005 to pay dividends of $0.44 per common share to our stockholders.

Contractual Obligations

As of December 31, 2005, we had the following contractual obligations:

Contractual obligations (in thousands)

(in thousands)	Payments due by period
	Total		<1 yr.		1-3 yrs.		3-5 yrs.		>5 yrs.
Long-term debt obligations	$	20,619	$	—	$	—	$	—	$	20,619
Operating lease obligations		259		71		149		39		—
Purchase obligations (1)		805		670		135		—		—

(1) Purchase obligations related to risk management and technology service agreements.

Inflation

Virtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors drive our performance far more than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our financial statements are prepared in accordance with generally accepted accounting principles and our dividends based upon our net income as calculated for tax purposes; in each case, our activities and balance sheet are measured with reference to historical cost or fair market value without considering inflation.

Other Matters

Subsequent to December 31, 2005, we received principal payments of $671,000 on our commercial loan for the Florida retail development property, and $2.0 million (net of interest advances) on the commercial loan for the North Carolina resort development property. Outstanding principal balances on these two loans subsequent to these payments were $2.0 million and $14.5 million, respectively.

Item 7A. Quantitative and Qualitative Disclosures about Market Risk

Market Risks

As a financial institution that has only invested in U.S.-dollar denominated instruments, primarily residential mortgage instruments, and has only borrowed money in the domestic market, we are not subject to foreign currency exchange or commodity price risk, but rather our market risk exposure is limited solely to interest rate risk. Interest rate risk is defined as the sensitivity of our current and future earnings to interest rate volatility, variability of spread relationships, the difference in

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re-pricing intervals between our assets and liabilities and the effect that interest rates may have on our cash flows, especially hybrid ARM portfolio prepayments. Interest rate risk impacts our interest income, interest expense and the market value on a large portion of our assets and liabilities.

Effects of Changes in Interest Rates

Changes in interest rates will impact our portfolio in various ways. We are currently invested primarily in hybrid ARM assets, which have an initial fixed rate period ranging from 36 to 84 months. A description of the different types of interest rate risk and their impact on our portfolio is provided below:

Yield curve risk: To the extent that these assets are financed with shorter duration liabilities, rising short-term interest rates may temporarily negatively affect our earnings, and, conversely, falling short-term interest rates may temporarily increase our earnings. This may occur as our borrowings react to changes in interest rates sooner than our hybrid ARM assets because the weighted average next re-pricing dates of the borrowings may be shorter time periods than that of the hybrid ARM assets. We use plain vanilla swaps to extend the duration of our liabilities to the expected duration of our assets. We typically pay a fixed rate and receive a floating rate to offset the floating nature of our reverse repurchase agreements. Interest rate swaps thus have the effect of converting the Company’s variable-rate debt into fixed-rate debt over the life of the swap agreements. Management has selected interest rate swaps such that the combined Effective Duration of its borrowings and interest rate swaps closely matches the Effective Duration of the Hybrid ARM assets, the difference being the Effective Duration Gap. Management operates under a board-advised Effective Duration Gap limit of 1 year (or -1 year as the case may be) and has targeted a zero Effective Duration Gap during the year ended December 31, 2005.

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

Re-pricing risk: At times, the notional amount on our swaps may not match the amount of outstanding repurchase agreements. This results in a portion of our short term liabilities being exposed to rises in interest rates. As short term interest rates rise, the portion of our short term debt not covered by swaps will increase our overall debt costs, squeezing margins. Conversely, if short term rates fall, overall debt costs will decrease, widening margins. Management actively manages this gap and minimizes the impact of rising rates using longer term repurchase agreements and by purchasing floating rate assets whose coupons reset with rising short term rates. As of December 31, 2005, the company had $1.0 billion in reverse repurchase agreements and $980.4 million in notional of pay-fixed swaps. As of December 31, 2005, the company had $60.2 million in floating rate assets.

Extension risk: As interest rates rise, the average lives of our assets increase. In order to maintain the targeted Effective Duration gap it may become necessary to use additional pay-fixed swaps in a rising rate environment. These additional interest rate swaps would reduce the net interest margin.

Cap risk: The Company invests in hybrid adjustable-rate mortgage-backed securities, which are based on mortgages that are typically subject to periodic and lifetime interest rate caps and floors, which limit the amount by which a hybrid adjustable-rate mortgage-backed security’s interest yield may change during any given period after the fixed period has expired. However, the Company’s borrowing costs pursuant to its repurchase agreements will not be subject to similar restrictions. Hence, in a period of increasing interest rates, interest rate costs on the Company’s borrowings could increase without limitation by caps, while the interest-rate yields on the Company’s hybrid adjustable-rate mortgage-backed securities would effectively be limited by caps. This problem will be magnified to the extent the Company acquires adjustable-rate mortgage-backed securities that are not based on mortgages which are fully indexed. Further, the underlying mortgages may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. This could result in the Company’s receipt of less cash income on its adjustable-rate and hybrid adjustable-rate mortgage-backed securities than it needs in order to pay the interest cost on its related borrowings. These factors could lower the Company’s net interest income or cause a net loss during periods of rising interest rates, which would negatively impact the Company’s financial condition, cash flows and results of operations. The Company currently mitigates this risk through the use of interest rate swaps and expects to use caps, floors and options to further reduce the impact of periodic caps. The Company also has chosen to invest primarily in hybrid adjustable-rate securities backed by loans with initial caps at reset that are 5% or 6% higher than the rate during the fixed period which further limits the inherent cap risk.

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Spread risk: The use of interest rate swaps to lengthen the maturities of the Company’s short term liabilities also has an effect on the fair value of the portfolio. To the extent that interest rates rise, the value of the hybrid adjustable-rate mortgage backed securities will decline. This decline may be offset for the most part by gains in the value of the pay-fixed interest rate swaps. However, if yields of hybrid adjustable-rate mortgage-backed securities move to a greater extent than treasury or swap rates – a phenomenon known as “spread widening” – the fair value of the securities will decline more than the gain on the corresponding hedges, resulting in a decline in the overall fair value of the portfolio. Conversely, if spreads tighten, the portfolio will experience a fair value gain. We view spread risk as inherent in owning a portfolio of mortgage assets and do not attempt to hedge this risk explicitly.

Risk to Investment opportunities: During a rising interest rate environment, there may be less total loan origination and refinance activity. At the same time, a rising interest rate environment may result in a larger percentage of hybrid ARM products being originated, mitigating the impact of lower overall loan origination and refinance activity. Conversely, during a declining interest rate environment, consumers, in general, may favor fixed rate mortgage products, but there may be above average loan origination and refinancing volume in the industry such that even a small percentage of hybrid ARM product volume may result in sufficient investment opportunities. Additionally, a flat yield curve may be an adverse environment for hybrid ARM production because there may be little incentive for a consumer to choose an ARM product over a 30 year fixed-rate mortgage loan, and conversely, in a steep yield curve environment, ARM production may enjoy an above average advantage over 30 year fixed-rate mortgage loans, increasing the pool of available ARM investment securities. The availability and fluctuations in the volume of hybrid ARM loans being originated can also affect their yield to us as an investment opportunity. During periods of time when there is a shortage of ARM products, their yield as an investment may decline due to market forces and conversely, when there is an above average supply of ARM products, their yield to us as an investment may improve due to the same market forces.

The most important measure we use in measuring interest rate risk is the Effective Duration Gap, which reflects the combined Effective Duration of our borrowings and interest rate swaps and the Effective Duration of our Hybrid ARM assets. While modified duration measures the price sensitivity of a bond to movements in interest rates, effective duration captures both the movement in interest rates and the fact that cash flows to a mortgage related security are altered when interest rates move. Accordingly, when the contract interest rate on a mortgage loan is substantially above prevailing interest rates in the market, the effective duration of securities collateralized by such loans can be quite low because of expected prepayments. Conversely, in a period of rising rates, when the contract rate is below prevailing rates, the effective duration increases, reflecting expectations for lower prepayments.

The Effective Duration measure is calculated by a third party provider utilizing a Monte Carlo simulation of 200 to 500 interest rate scenarios. At December 31, 2005, our Effective Duration Gap was -0.05 years. The effective duration of mortgage assets changes as interest rates change, because the cash flows of the mortgage securities we own are dependent on the realized path of interest rates. In general, as interest rates decline, the effective duration of our mortgage assets decline and vice versa. Because models do not always capture market forces, particularly those driven by technical rather than fundamental forces, in our opinion, duration of between plus or minus 0.15 approximates zero duration. In addition to Effective Duration, the Company monitors the Effective Convexity, which is the rate of change of duration for a given change in interest rates, as well as several sensitivity measures around points in the yield curve called Key Rate Duration measures. As of December 31, 2005, the Effective Convexity Gap of the portfolio was -0.57 years.

In addition to our Effective Duration Gap, we monitor the projected market value of our interest sensitive assets and liabilities. We calculate the fair market value in a variety of scenarios, some of which are the instantaneous parallel shift in the yield curve of plus or minus 50 and 100 basis points. We assume that mortgage spreads in these scenarios are unchanged from that in the base case (interest rates unchanged).

The following table reflects the market value changes of these assets for the parallel shifts in the yield curve as a percent equity and as a percent of the fair market value of our interest earning assets as of December 31, 2005.

Instantaneous parallel shift in yield curve	Change in Net Assets (in thousands)			Change as a % of Equity		Change as a % of Fair Value of Assets
Down 100 basis points	$	(4,075	)	(3.81	)%	(0.36	)%
Down 50 basis points		(1,074	)	(1.0	)	(0.09	)
Up 50 basis points		(558	)	(0.52	)	(0.05	)
Up 100 basis points		(2,311	)	(2.16	)	(0.20	)

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Item 8. Financial Statements and Supplementary Data

The financial statements of the Company, the related notes and schedules to the financial statements, together with the Reports of Independent Registered Public Accounting Firms thereon, are set forth beginning on Page F-1 in this Form 10-K.

Item 9. Changes In and Disagreements with Accountants on Accounting and Financial Disclosure

On August 22, 2005, Ernst & Young LLP resigned as our independent registered public accounting firm. Ernst & Young served as our certifying accountant for the period from October 6, 2003 (inception) through December 31, 2003, the fiscal year ended December 31, 2004 and the interim periods through June 30, 2005.

On October 20, 2005, our audit committee engaged Hancock Askew & Co. LLP as its new independent registered public accounting firm.

Item 9A. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We have established disclosure controls and procedures to ensure that material information relating to the Company, including its consolidated subsidiaries, is made known to the officers who certify the Company’s financial reports and to other members of senior management and the board of directors. Under the supervision, and with the participation of our Chief Executive Officer and Chief Financial Officer, management has evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) of the Securities and Exchange Act of 1934) as of December 31, 2005. Based on that evaluation, the principal executive officer and the principal financial officer concluded that our disclosure controls and procedures were effective at December 31, 2005.

Management’s Report on Internal Control over Financial Reporting

The Company’s management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined under the Securities Exchange Act of 1934 (Exchange Act) Rule 13a - 15(f). The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States of America.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. In making this assessment, Management used the criteria set forth in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on that assessment, management concluded that the Company’s internal control over financial reporting was effective as of December 31, 2005.

Management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005 has been audited by Hancock Askew & Co. LLP, an independent registered public accounting firm, as stated in their report which is included on page F-2 herein.

Item 9B. Other Information

None.

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PART III

Item 10. Directors and Executive Officers of the Registrant

Directors of the Company

Rodney E. Bennett, age 65, was elected to serve as director on October 15, 2003, and was appointed Chairman of the Board in October 2005. Mr. Bennett is also a member of the Special Committee and serves as Chairman of the Audit Committee. From January 2004 to the present, he has served as the Chief Financial Officer and Director of Harvin Carter and Associates, Inc., a privately owned fire sprinkler contractor doing business in five southeastern states. From January 1998 to September 2003, he founded and served as the Chief Executive Officer of Saltilla Community Bank in St. Marys, Georgia. From July 1991 to the present, Mr. Bennett has acted as a consultant to various Georgia banks and private companies. Director since October 2003.

Joseph P. Stingone, age 69, was elected to serve as a director on January 22, 2004, and is a member of the Compensation Committee, the Special Committee and is Chairman of the Nominating and Corporate Governance Committee. Since 2002, Mr. Stingone has managed his personal investments. Mr. Stingone served as Chairman of Flagship Capital Corporation from January 1, 2000 to July 2002. Director since January 2004.

G. Steven Dawson, age 48, joined our board on January 11, 2005, and is a member of the Compensation Committee, the Nominating and Corporate Governance Committee and serves as the Chairman of the Special Committee. He served as Chief Financial Officer of Camden Property Trust or its predecessors from 1990 to 2003. Currently, Mr. Dawson serves on the boards of directors of five other companies, including Trustreet Properties, Inc. (NYSE: TSY), an Orlando-based owner of approximately 3,000 fast-food and casual dining restaurants and gas station/convenience stores, AmREIT, Inc. (AMEX: AMY), a Houston-based owner and developer of retail properties (audit committee chairman), Medical Properties Trust, a Birmingham, Alabama-based REIT specializing in the ownership of acute care facilities, medical office buildings and related medical properties (audit committee chairman), Desert Capital REIT, a Las Vegas-based mortgage REIT (audit committee chairman), and American Campus Communities (NYSE: ACC), an Austin-based equity REIT focused on student housing (audit committee chairman). Director since January 2005.

George O. Deehan, age 63, was elected to serve as a director on March 24, 2005, and was named our Chief Operating Officer on August 8, 2005 and on October 4, 2005 was named our Chief Executive Officer. From November 2004 to March 2005, Mr. Deehan served as a director of Paragon Financial Corporation. From August 2003 until November 2004, he served as the Chairman and Chief Executive Officer of Paragon Financial Corporation. From August 2000 to March 2002, he served as President of eOriginal Company, a software development company. From August 1998 to August 2000, he served as the Chief Executive Officer of Advanta Leasing Services. Mr. Deehan is on the board and is compensation committee chairman and on the audit committee of NYFIX Corporation (NASDAQ: NYFX). Director since March 2005.

Charles W. Wolcott, age 53, was elected to serve as a director on September 26, 2005, and is a member of the Audit Committee and Special Committee. Currently, he is the president and chief executive officer of Tecon Corporation, a diversified business operator. From 1993 to 2001, he was the president and chief executive officer of American Industrial Properties REIT, a NYSE-listed real estate REIT. From 1984 to 1992, Mr. Wolcott served in various capacities at Trammell Crow Company, including president and CEO of Trammell Crow Asset Services, where he oversaw a $10 billion portfolio of real estate assets. Mr. Wolcott received his MBA from Harvard Business School in 1977. Director since September 2005.

Charles D. Van Sickle, age 64, was elected to serve as a director on October 5, 2005, and is a member of the Audit Committee, the Nominating and Corporate Governance Committee and serves as Chairman of the Compensation Committee. Most recently, Mr. Van Sickle was a founder and director of KVI Capital, a privately held specialty finance company, from its inception in 2000 through the time of its sale in August of 2005 to Private Business, Inc. (NASDAQ: PBIZ). Prior to that, Mr. Van Sickle was at AT&T Capital for more than 13 years, where he retired as Group President, responsible for overseeing $18 billion in assets. He had complete oversight in 25 countries, oversaw the company’s listing on the New York Stock Exchange and orchestrated its sale to Nomura Securities in 1998. Mr. Van Sickle also serves on the Board of Directors of Paragon Financial Corporation, a mortgage banking company in Ponte Vedra Beach, Florida. Director since October 2005.

Executive Officers of the Company

George O. Deehan. See “Directors of the Company” for biographical information.

Byron L. Boston, age 47, has served as our Executive Vice President - Chief Investment Officer since February 5, 2004. From June 1997 until January 2004, he was the Vice President and Co-Manager of The Mortgage Portfolio Group of Federal Home Loan Mortgage Corporation (Freddie Mac). While employed at Freddie Mac, Mr. Boston served on the Freddie Mac Thrift/401K Savings Plan Retirement Committee (“Freddie Mac Retirement Committee”). From June 1993 to June 1997, he

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was Vice President, Pass-Through Trader at CS First Boston, where he acted as a market maker for all pass-through securities. Prior to that, he also held various positions dealing with mortgage-backed and pass-through securities at Lehman Brothers and CS First Boston. Mr. Boston received his MBA from the University of Chicago and an AB degree from Dartmouth College.

Stacy M. Riffe, age 40, became Chief Financial Officer effective September 13, 2005 and was elected Secretary and Treasurer. From 2002 to 2005, Ms. Riffe was the Chief Financial Officer of U.S. Restaurant Properties, Inc., which later merged with CNL Restaurant Properties to form Trustreet Properties, Inc. (NYSE: TSY), a self-advised restaurant real estate investment trust (REIT). From 1998 to 2002, Ms. Riffe held senior-level finance positions at two private companies, The Mail Box and Pinnacle Restaurant Group LLC. From 1996 through 1997, she was the Chief Financial Officer of Casa Ole Restaurants, Inc. (NADAQ: CASA). Prior to that, she served in several finance capacities, including Controller and Treasurer, over a five-year period at Spaghetti Warehouse, Inc., which operated as a public entity during Ms. Riffe’s tenure. From 1987 to 1991, Ms. Riffe, a Certified Public Accountant, worked in the Dallas audit practice of KPMG Peat Marwick.

Compliance with Section 16(a) of the Exchange Act

Section 16(a) of the Securities Exchange Act of 1934 requires our directors and executive officers and persons who own more than 10% of our common stock (“reporting persons”) to file reports of ownership and changes in ownership with the SEC. Reporting persons are also required by SEC regulations to furnish us with copies of all Section 16(a) forms filed by them with the SEC. The report with respect to the election of Stacy Riffe as our Chief Financial Officer on September 13, 2005 was not reported on Form 3 until December 20, 2005. The reports with respect to the elections of Charles Wolcott and Charles Van Sickle as directors on September 26, 2005 and October 5, 2005, respectively, were not reported on Form 3 until December 20, 2005. In addition, the reports with respect to the granting of restricted shares of common stock to Messrs. Boston, Wolcott and Van Sickle on July 21, 2005, September 26, 2005 and October 5, 2005, respectively, were not reported on Form 4 until January 13, 2006, November 8, 2005 and November 1, 2005, respectively. Based solely on our review of the copies of the Section 16(a) forms received by us or upon written representations from certain of these reporting persons as to compliance with the Section 16(a) regulations, we are of the opinion that during the 2005 fiscal year, all other reports required by Section 16(a) were filed on a timely basis.

Code of Ethics

We have adopted a code of business and ethics for directors, officers and employees, known as the Code of Business Conduct and Ethics, which is available on our website at www.sunsetfinancial.net. Stockholders may request a free copy of the Code of Business Conduct and Ethics from:

Sunset Financial Resources, Inc.

10245 Centurion Parkway North

Suite 305

Jacksonville, Florida 32256

(904) 425-4575

www.sunsetfinancial.net

We have also adopted a Code of Conduct for Senior Financial Officers setting forth a code of ethics applicable to our principal executive officer, principal financial officer and financial managers, which is filed as Exhibit 14.1 to this Form 10-K.

Governance Guidelines

We have adopted Corporate Governance Guidelines, which are available on our website at www.sunsetfinancial.net. Stockholders may request a free copy of the Corporate Governance Guidelines from the address and phone number set forth above under “Code of Ethics.”

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Item 11. Executive Compensation

Compensation of Directors

Employee directors receive no compensation for board service. During 2005, our non-employee directors received the following compensation:

Annual Retainer Fees
Board Member	$	30,000
Audit Committee Chair		5,000
Compensation Committee Chair		5,000
Nominating and Corporate Governance Committee Chair		3,000
Special Committee Chair		10,000
Meeting Fees
Board meeting attended in person	$	1,000
Board meeting attended telephonically		500
Audit, Compensation or Nominating Committee meeting attended in person		1,000
Audit, Compensation or Nominating Committee meeting attended telephonically		500
Special committee meeting attended in person		3,500
Special committee meeting attended telephonically		2,500

Additionally, upon election to the board, each non-employee director receives a stock option to purchase 5,000 shares of common stock at the then fair market value. The option vests in full one year from the date of grant. Each non-employee director is granted 2,000 shares of restricted stock upon re-election to the board each year. These shares vest in full one year from the grant date. The non-employee directors are also reimbursed for travel expenses incurred in connection with attending meetings and other activities related to serving on our board of directors.

Compensation of Executive Officers

The following table sets forth information with respect to annual and long-term compensation for the period ended December 31, 2005, paid or accrued with respect to each of our executive officers (dollars in thousands):

	Year	Annual Compensation				Long-Term Compensation Awards				All Other Compensation
Name and Principal Position		Salary ($)		Bonus ($)		Restricted Share Awards ($)			Securities Underlying Options/SARs (#)
George O. Deehan	2005	$	118,327	$	—	$	64,800	(2)	5,000	$	17,487	(3)
Chief Executive Officer	2004		—		—		—		—		—
J. Bert Watson	2005		274,039		—		—		—		397,740	(1)(4)
Former Chairman, Chief Executive Officer and President	2004		475,962		110,000		—		117,000		8,200	(11)
Byron L. Boston	2005		300,000		—		71,100	(5)	—		8,881	(1)(6)
Executive Vice President – Chief Investment Officer	2004		276,923		10,000		65,000	(12)	50,000		166,347	(11)(13)
Stacy M. Riffe	2005		64,615		—		80,100	(7)	—		2,946	(1)(8)
Chief Financial Officer, Secretary and Treasurer	2004		—		—		—		—		—
Michael L. Pannell	2005		125,307		—		—		—		376,270	(1)(9)
Former Chief Financial Officer and Treasurer	2004		141,346		10,000				25,000		4,846	(3)(11)
Jeffrey S. Betros	2005		177,240		—		—		—		90,995	(1)(10)
Former Executive Vice President – Chief Marketing Officer and Secretary	2004		274,039		107,000				25,000		6,750	(3)(11)

(1) Includes matching contributions made by the Company pursuant to its 401(k) plan for the accounts of Messrs. Watson, Boston, Pannell, Betros, and Ms. Riffe in the amounts of $8,400, $8,162, $5,412, $7,203 and $2,584, respectively.

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(2) Includes 7,000 shares of unvested restricted stock with a value of $59,360 based on the closing price of our common stock of $8.48 on December 31, 2005. The value shown in the table is calculated based on the closing price of our common stock on the date of grant. 2,000 of these shares vest in May 2006 and the remaining 5,000 vest 1/3 in each of 2006, 2007 and 2008.

(3) Includes $16,610 in fees paid to Mr. Deehan in his capacity as a non-employee member of the board of directors prior to August 2005, $420 in dividends paid on restricted stock and $457 for group term life insurance.

(4) Mr. Watson’s employment with us terminated on September 27, 2005. This amount includes a lump-sum payment of $375,000, estimated payments of $13,774 for COBRA premiums, and $566 for group term life insurance.

(5) Includes 7,500 shares of unvested restricted stock with a value of $63,800 based on the closing price of our common stock of $8.48 on December 31, 2005. The value shown in the table is calculated based on the closing price of our common stock on the date of grant. These shares vest 1/3 in each of 2006, 2007 and 2008.

(6) Includes $450 in dividends paid on restricted stock and $269 for group term life insurance.

(7) Includes 9,444 shares of unvested restricted stock with a value of $80,085 based on the closing price of our common stock of $8.48 on December 31, 2005. The value shown in the table is calculated as the shares granted during the year multiplied by the closing price of our common stock on the date of grant. These shares vest 1/36 each month through October 2008.

(8) Includes $300 in dividends paid on restricted stock and $62 for group term life insurance.

(9) Mr. Pannell’s employment with us terminated on September 12, 2005. This amount includes one payment of $175,000, a second payment of $20,192, 10 payments of $6,731 and a final payment of $87,500, for a total of $350,000. Also included are estimated payments of $20,661 for COBRA premiums and $197 for group term life insurance.

(10) Mr. Betros’ employment with us terminated on August 31, 2005. This amount includes one payment of $6,730 and eight payments of $9,615, for a total of $83,654. Also included is $138 for group term life insurance.

(11) Includes matching contributions made by the Company pursuant to its 401(k) plan for the accounts of Messrs. Watson, Boston, Pannell and Betros in the amounts of $8,200, $7,692, $4,846 and $6,750.

(12) As of December 31, 2004, Mr. Boston had 5,000 shares of restricted stock, with a value of $52,050, based on the closing price of our common stock of $10.41 on December 31, 2004. The value shown in the table is calculated based on the closing price of our common stock on the date of grant which was $13.00 per share. These shares have vested. Dividends have been paid on these shares of restricted stock totaling $325.

(13) Includes $166,347 in moving expenses incurred in 2004 and reimbursed by us in 2005 (including a gross-up for taxes).

Option Grants

No options were granted to Executive Officers under the Amended and Restated Share Incentive Plan during 2005. An option for 5,000 shares of common stock was granted to George O. Deehan upon joining the board of directors in March 2005 as a non-employee director. Mr. Deehan became an employee of the Company in August 2005 when he was named Chief Operating Officer.

Option Exercises, Year-end Option Values and Stock Grants

The following table sets forth certain information concerning option exercises during the 2005 fiscal year and the value of the unexercised options at December 31, 2005 held by the Executive Officers.

AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR

AND FISCAL YEAR-END OPTION VALUES

	Shares Acquired On Exercise	Realized Value		Number of Securities Underlying Unexercised Options at Fiscal Year-End		Value of Unexercised in-the-Money Options at Fiscal Year-End (1)
Name				Exercisable	Unexercisable	Exercisable		Unexercisable
George O. Deehan	—	$	—	—	5,000	$	—	$	—
Byron L. Boston	—	$	—	16,667	33,333	$	—	$	—

(1) The fair market value on December 31, 2005 of the common stock underlying the options was $8.48 per share.

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Employment Contracts and Termination of Employment and Change-in-Control

We entered into an employment agreement with Mr. Deehan as of August 8, 2005, as amended on October 3, 2005. The agreement is for a term of two years and automatically renews for one year terms unless notice of non-renewal is given by either party at least 180 days prior to the expiration of the renewal term.

The employment agreement provides that in the event of a change of control and the termination of Mr. Deehan’s employment on or before the first anniversary of the change in control (other than for cause), he shall receive a severance payment equal to 2.0 times his then current base salary. The agreement also provided for the granting of 5,000 shares of restricted stock pursuant to our Amended and Restated 2003 Share Incentive Plan. The shares were granted on August 8, 2005, and vest at a rate of 1/3 each year beginning on the first anniversary of the grant. The agreement also provides for a bonus of $100,000 upon the occurrence of certain events, and provides for an additional grant of 20,000 shares of restricted common stock upon the occurrence of certain events.

We entered into an employment agreement with Ms. Riffe as of October 28, 2005. The employment agreement is for a term of two years and automatically renews for one year terms unless notice of non-renewal is given by either party at least 180 days prior to the expiration of the renewal term or the agreement is otherwise terminated pursuant to its provisions.

The employment agreement provides that, in the event of a termination without cause or for a disability, a resignation for good reason, or a change of control and the termination of Ms. Riffe’s employment on or before the first anniversary of the change in control (other than for cause), she shall receive a severance payment equal to 2.0 times her then current base salary. The agreement also provided for the granting of 10,000 shares of restricted stock pursuant to our Amended and Restated 2003 Share Incentive Plan. The shares were granted on October 28, 2005, and vest at a rate of 1/36 each month over a period of 36 months following the date of grant.

We entered into an employment agreement with Mr. Boston in 2004 which provides that in the event of a change of control and the termination of the his employment on or before the first anniversary of the change in control (other than for cause), he shall receive a severance payment equal to 2.99 times his then current base salary plus an amount equal to the full bonus the executive was eligible to receive for the year of his termination.

Compensation Committee Interlocks and Insider Participation

No member of the compensation committee has any interlocking relationship with any other company that requires disclosure under this item.

Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

The following table and the notes thereto set forth certain information with respect to the beneficial ownership of shares of our common stock by (1) each person known by us to own beneficially more than 5% of our outstanding common stock, (2) each current director, (3) each named executive officer, and (4) all current directors and executive officers as a group. The number of shares beneficially owned by each entity, person, director or executive officer is determined under the rules of the SEC, and the information is not necessarily indicative of beneficial ownership for any other purpose. Under such rules, beneficial ownership includes any stock as to which the individual has the sole or shared voting power or investment power and also any stock that the individual has a right to acquire as of May 15, 2005 (60 days after March 16, 2005) through the exercise of any share option or other right. Unless otherwise indicated, each person has sole voting and investment power (or shares such powers with his spouse) with respect to the stock set forth in the following table.

Name	Amount and Nature of Beneficial Ownership		Percent of Class (1)
Western Investment LLC 2855 East Cottonwood Parkway Suite 110 Salt Lake City, UT 84121	1,016,300	(2)	9.7	%
Thomas Bruce Akin c/o Talkot Crossover Fund, L.P. 2400 Bridgeway, Suite 300 Sausalito, CA 94965	966,500	(3)	9.2	%
NWQ Investment Management Company, LLC 2049 Century Park East 16th Floor Los Angeles, CA 90067	901,377	(4)	8.6	%
Teachers Insurance and Annuity Association of America 730 Third Avenue      New York, NY 10017	622,299	(5)	5.9	%
Byron L. Boston	60,833	(6)	*
George O. Deehan	12,000	(7)	*
Stacy M. Riffe	10,000	(8)	*
Rodney E. Bennett	7,000	(9)	*
Joseph P. Stingone	8,000	(9)	*
G. Steven Dawson	7,000	(9)	*
Charles W. Wolcott	—		*
Charles D. Van Sickle	—		*
All directors and executive officers as a group (8 persons)	104,833		1.0	%

 * Beneficial ownership of less than 1% of the class is omitted.

42

(1) The percentages of shares owned provided in the table is based on 10,516,600 shares outstanding as of March 8, 2005. Percentage of beneficial ownership by a person as of a particular date is calculated by dividing the number of shares beneficially owned by such person by the sum of the number of shares of common stock outstanding as of such date and the number of unissued shares as to which such person has the right to acquire voting and/or investment power within 60 days.

(2) Western Investment LLC, (“WILLC”), Arthur D. Lipson, Western Investment Hedged Partners LP, (“WIHP”), Western Investment Institutional Partners LLC, a Delaware limited liability company (“WIIP”), and Western Investment Activism Partners LLC (“WIAP”), jointly reported their stock ownership. WILLC has sole voting and investment power over WIHP’s, WIIP’s, and WIAP’s security holdings and Mr. Lipson, in his role as the managing member of WILLC, controls WILLC’s voting and investment decisions. WIHP, WIIP and WIAP beneficially owned 305,300, 633,300 and 77,700 shares respectively. WILLC beneficially owned 1,016,300 shares. Based solely on Schedule 13D filed December 5, 2005.

(3) Thomas Akin is the direct beneficial owner of 543,100 shares of our common stock, and is the managing general partner of Talkot Crossover Fund, L.P. (Fund), which is the direct beneficial owner of 423,400 shares of our common stock. By virtue of the relationship between Mr. Akin and the Fund, Mr. Akin may be deemed to possess indirect beneficial ownership of the shares of common stock beneficially owned by the Fund. Based solely on Schedule 13D filed September 27, 2005.

(4) Shares are beneficially owned by clients of NWQ Investment Management (“NWQ”), an investment advisor, which clients may include investment companies registered under the Investment Company Act and/or employee benefit plans, pension funds, endowment funds or other institutional clients. NWQ has the sole power to dispose of or to direct the disposition of 901,377 shares, and the sole power to vote or direct the vote of 845,077 shares. Based solely on Schedule 13G dated December 31, 2005.

(5) Teachers Insurance and Annuity Association of America (“TIAA”) holds 303,820 shares of our common stock for the benefit of TIAA Real Estate Account, a separate account of TIAA. In addition, TIAA, as the parent of two registered investment advisers, may be deemed to have indirect voting or investment discretion over 318,479 shares of our common stock that are beneficially owned by three registered investment companies – College Retirement Equities Fund (“CREF”), TIAA-CREF Institutional Mutual Funds (“Institutional Funds”), and TIAA-CREF Life Funds (“Life Funds”) – whose investment advisers are TIAA-CREF Investment Management, LLC (in the case of CREF) and Teachers Advisors, Inc. (in the case of Institutional Funds and Life Funds), both of which are wholly owned subsidiaries of TIAA. TIAA is reporting the combined holdings of these entities for the purpose of administrative convenience. These shares were acquired in the ordinary course of business, and not with the purpose of effect of changing or influencing control of the Company. TIAA should not be construed, for the purpose of Sections 13 or 16 of the Securities Exchange Act of 1934, as the beneficial owner of these shares. Based solely on Schedule 13G dated December 31, 2005.

43

(6) Includes options to purchase 33,333 shares of common stock, and 7,500 non-vested restricted shares.

(7) Includes options to purchase 5,000 shares of common stock, and 5,000 non-vested restricted shares.

(8) Includes 8,333 non-vested restricted shares.

(9) Includes options to purchase 5,000 shares of common stock.

Item 13. Certain Relationships and Related Transactions

None.

Item 14. Principal Accountant Fees and Services

The Company’s former principal accountant, Ernst & Young LLP, resigned effective August 22, 2005. The Company engaged Hancock Askew & Co., LLP on October 20, 2005 as principal accountant to perform the audit for the year ended December 31, 2005.

Aggregate fees billed to the Company for the years ended December 31, 2005 and 2004 were as follows:

Services Rendered	2005		2004
Audit Fees	$	374,686	$	326,000
Audit-Related Fees		7,253		—
Tax Fees		78,984		48,000
All Other Fees		38,500		49,000
Total Fee	$	499,423	$	423,000

All fees billed during 2004 were by Ernst & Young LLP, and during 2005, all audit-related, tax and other fees were billed by Ernst & Young LLP. Of the 2005 audit fees, $41,579 of the fees were for services provided by Ernst & Young LLP through the date of their resignation in August 2005, and $333,107 of the fees were for services provided by Hancock Askew & Co. LLP from the time of their engagement in October 2005, including the audit of the December 31, 2005 financial statements.

The audit fees above represent fees for professional services rendered for the audits and quarterly reviews of the consolidated financial statements of the Company. The audit-related fees above represent fees related to an SEC filing. The tax fees above represent professional fees for compliance services in connection with the Company’s federal and state tax filings and advisory services related the Company’s status as a REIT. All other fees represent fees for professional services related to compensation advisory services to the compensation committee of the board of directors.

The audit committee’s charter provides that the committee will pre-approve all audit services and all permissible non-audit services to be performed for the Company by its independent auditors. The audit committee has preapproved all services performed by Ernst & Young LLP and Hancock Askew & Co., LLP, and determined the provisions of the services to be compatible with maintaining the principal accountant’s independence.

44

PART IV

Item 15. Exhibits and Financial Statement Schedules

				Page
(a)	Documents filed as a part of this report
	(1)	The following Financial Statements of the Company are included in Part II, Item 8 of this Annual Report on Form 10-K:
		(i)	Reports of Independent Registered Public Accounting Firms	F-1
		(ii)	Consolidated Balance Sheets as of December 31, 2005 and 2004	F-4
		(iii)	Consolidated Statement of Operations for the Years ended December 31, 2005, 2004, and 2003	F-5
		(iv)	Consolidated Statement of Comprehensive Income (Loss) for the Years Ended December 31, 2005, 2004 and 2003	F-6
		(v)	Consolidated Statement of Stockholders Equity for the Years Ended December 31, 2005, 2004 and 2003	F-7
		(vi)	Consolidated Statement of Cash Flows for the Years December 31, 2005, 2004 and 2003	F-8
		(vii)	Notes to the Consolidated Financial Statements	F-9
	(2)	Schedules to Consolidated Financial Statements.
		II.	Valuation and Qualifying Accounts	F-24
		IV.	Mortgage Loans on Real Estate	F-25
			All other schedules have been omitted because the required information of such other schedules is not present, or is not present in amount sufficient to require submission of the schedule.
	(3)	Exhibits.
		(i)	The exhibits listed on the Exhibit Index (following the Signatures section of this report) are included, or incorporated by reference, in this annual report	47

45

SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

SUNSET FINANCIAL RESOURCES, INC.

/s/ GEORGE O. DEEHAN

George O. Deehan

Chief Executive Officer (Principal Executive Officer)

Date: March 14, 2006

Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

/s/ GEORGE O. DEEHAN George Deehan	Chief Executive Officer (Principal Executive Officer)	March 14, 2006
/s/ STACY M. RIFFE Stacy M. Riffe	Chief Financial Officer (Principal Financial and Accounting Officer)	March 14, 2006
/s/ RODNEY E. BENNETT Rodney E. Bennett	Chairman of the Board and Director	March 14, 2006
/s/ G. STEVEN DAWSON G. Steven Dawson	Director	March 14, 2006
/s/ JOSEPH P. STINGONE Joseph P. Stingone	Director	March 14, 2006
/s/ CHARLES D. VAN SICKLE Charles D. Van Sickle	Director	March 14, 2006
/s/ CHARLES W. WOLCOTT Charles W. Wolcott	Director	March 14, 2006

46

EXHIBIT INDEX

The exhibits to this report required to be filed pursuant to Item 15(c) are listed below.

Exhibit No.
3.1	Second Articles of Amendment and Restatement (incorporated by reference to Amendment No. 1 to the Form S-11 filed by us on February 6, 2004)
3.2	Amended Bylaws (incorporated by reference to Exhibit 3.1 to the Form 8-K filed by us on October 11, 2005)
4.1	Form of Common Stock Certificate (incorporated by reference to Exhibit 4.1 to Amendment No. 4 to the Form S-11 filed by us on March 11, 2004).
10.1	Strategic Alliance Agreement dated October 15, 2003, by and among Sunset Financial Resources, Inc. (Sunset Financial), Sunset Mortgage Company, L.P., Sunset Direct Lending, L.L.C. and Sunset Commercial Group LLC (incorporated by reference to Amendment No. 1 to the Form S-11 filed by us on February 6, 2004)
10.2	Employment Agreement dated February 6, 2004, by and between Sunset Financial and Byron L. Boston (incorporated by reference to Amendment No. 1 to the Form S-11 filed by us on February 6, 2004)
10.3	Amended and Restated 2003 Share Incentive Plan (incorporated by reference to Amendment No. 1 to the Form S-11 filed by us on February 6, 2004)
10.4	Form of Incentive Stock Option Agreement under the 2003 Share Incentive Plan (incorporated by reference to Amendment No. 1 to the Form S-11 filed by us on February 6, 2004)
10.5	Form of Nonqualified Stock Option Agreement under the 2003 Share Incentive Plan (incorporated by reference to Amendment No. 1 to the Form S-11 filed by us on February 6, 2004)
10.6	Form of Restricted Stock Agreement under the 2003 Share Incentive Plan (incorporated by reference to Amendment No. 1 to the Form S-11 filed by us on February 6, 2004)
10.7	Form of Dividend Equivalent Right Agreement under the 2003 Share Incentive Plan (incorporated by reference to Amendment No. 1 to the Form S-11 filed by us on February 6, 2004)
10.8	Agreement of Lease executed on January 26, 2004 to be effective February 15, 2004, by and between Sunset Financial and Liberty Property Limited Partnership (incorporated by reference to Amendment No. 1 to the Form S-11 filed by us on February 6, 2004)
10.9	Purchase Agreement by and between Sunset Mortgage Company, L.P. and Sunset Financial dated February 19, 2004, as amended by that certain Amendment dated February 26, 2004 (incorporated by reference to Exhibit 10.15 to Amendment No. 3 to the Form S-11 filed by us on February 27, 2004).
10.10	Letter Agreement regarding purchase of loans by and between J.P. Morgan Mortgage Acquisition Corp. and Sunset Financial dated February 20, 2004. (incorporated by reference to Exhibit 10.16 to Amendment No. 3 to the Form S-11 filed by us on February 27, 2004).
10.11	Letter Agreement regarding purchase of loans by and between Morgan Stanley Mortgage Capital Inc. and Sunset Financial dated February 18, 2004 (incorporated by reference to Exhibit 10.17 to Amendment No. 3 to the Form S-11 filed by us on February 27, 2004).
10.12	Letter of Intent regarding purchase of loans by and between Bridge Capital (USVI), LLC and Sunset Financial dated February 20, 2004 (incorporated by reference to Exhibit 10.18 to Amendment No. 3 to the Form S-11 filed by us on February 27, 2004).
10.13	Letter of Loan Commitment regarding sale of loans from Asset Lenders Group dated February 2, 2004 (incorporated by reference to Exhibit 10.19 to Amendment No. 3 to the Form S-11 filed by us on February 27, 2004).
10.14	Mortgage Loan Flow Purchase, Sale & Servicing Agreement, dated April 29, 2003, between J.P. Morgan Mortgage Acquisition Corporation, as purchaser, and Cendant Mortgage Corporation and Bishop’s Gate Residential Mortgage Trust, as Sellers, as amended by Amendment No. 1 dated September 1, 2003 (incorporated by reference to Exhibit 10.20 to Amendment No. 4 to the Form S-11 filed by us on March 11, 2004).
10.15	Flow Master Seller’s Warranties and Servicing Agreement, dated and effective as of February 24, 2004, between J.P. Morgan Mortgage Acquisition Corp. and National City Mortgage Co. (incorporated by reference to Exhibit 10.21 to Amendment No. 4 to the Form S-11 filed by us on March 11, 2004).

47

Exhibit No.
10.16	Flow Mortgage Loan Sale and Servicing Agreement between Bank of America, N.A., as seller and servicer, and Morgan Stanley Mortgage Capital Inc., as purchaser dated October 1, 2003 (incorporated by reference to Exhibit 10.22 to Amendment No. 4 to the Form S-11 filed by us on March 11, 2004).
10.17	Mortgage Loan Flow Purchase, Sale & Servicing Agreement, dated as of November 13, 2003, between Morgan Stanley Mortgage Capital, Inc., as purchaser, and Cendant Mortgage Corporation and Bishop’s Gate Residential Mortgage Trust, as sellers (incorporated by reference to Exhibit 10.23 to Amendment No. 4 to the Form S-11 filed by us on March 11, 2004).
10.18	Mortgage Loan Sale and Servicing Agreement between Greenpoint Mortgage Funding, Inc., as seller and servicer, and Morgan Stanley Mortgage Capital Inc., as purchaser, dated as of September 1, 2003 (incorporated by reference to Exhibit 10.24 to Amendment No. 4 to the Form S-11 filed by us on March 11, 2004).
10.19	Amended and Restated Master Servicing Agreement, dated February 1, 2004, between Morgan Stanley Mortgage Capital Inc. and Morgan Stanley Dean Witter Credit Corporation (incorporated by reference to Exhibit 10.25 to Amendment No. 4 to the Form S-11 filed by us on March 11, 2004).
10.20	Second Amended and Restated Master Mortgage Loan Purchase Agreement, dated as of February 1, 2004, between Morgan Stanley Mortgage Capital Inc. and Morgan Stanley Dean Witter Capital Corporation (incorporated by reference to Exhibit 10.26 to Amendment No. 4 to the Form S-11 filed by us on March 11, 2004).
10.21	Bridge Capital Agreement dated March 10, 2004 (incorporated by reference to Exhibit 10.27 to Amendment No. 4 to the Form S-11 filed by us on March 11, 2004).
10.22	Warrant to Purchase Common Stock of Sunset Financial dated March 22, 2004 granting Sapphire Advisors LLC the right to purchase shares of common stock of Sunset Financial (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.23	Incentive Stock Option Agreement dated March 22, 2004 by and between Sunset Financial and Byron L. Boston (incorporated by reference to Exhibit 10.3 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.24	Non-Qualified Stock Option Agreement dated March 22, 2004 by and between Sunset Financial and Rodney E. Bennett (incorporated by reference to Exhibit 10.7 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.25	Non-Qualified Stock Option Agreement dated March 22, 2004 by and between Sunset Financial and Byron L. Boston (incorporated by reference to Exhibit 10.9 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.26	Non-Qualified Stock Option Agreement dated March 22, 2004 by and between Sunset Financial and Joseph P. Stingone (incorporated by reference to Exhibit 10.14 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.27	Indemnification Agreement dated March 17, 2004 by and between Sunset Financial and Rodney E. Bennett (incorporated by reference to Exhibit 10.16 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.28	Indemnification Agreement dated March 17, 2004 by and between Sunset Financial and Jeffrey S. Betros (incorporated by reference to Exhibit 10.17 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.29	Indemnification Agreement dated March 17, 2004 by and between Sunset Financial and Byron L. Boston (incorporated by reference to Exhibit 10.18 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.30	Indemnification Agreement dated March 17, 2004 by and between Sunset Financial and Hugh H. Jones, Jr. (incorporated by reference to Exhibit 10.19 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.31	Indemnification Agreement dated March 17, 2004 by and between Sunset Financial and Thomas G. Manuel (incorporated by reference to Exhibit 10.20 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.32	Indemnification Agreement dated March 17, 2004 by and between Sunset Financial and George A. Murray (incorporated by reference to Exhibit 10.21 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.33	Indemnification Agreement dated March 17, 2004 by and between Sunset Financial and Michael L. Pannell (incorporated by reference to Exhibit 10.22 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.34	Indemnification Agreement dated March 17, 2004 by and between Sunset Financial and Joseph P. Stingone (incorporated by reference to Exhibit 10.23 to the Current Report on Form 8-K filed by us on March 25, 2004).

48

Exhibit No.
10.35	Indemnification Agreement dated March 17, 2004 by and between Sunset Financial and John Bert Watson (incorporated by reference to Exhibit 10.24 to the Current Report on Form 8-K filed by us on March 25, 2004).
10.36	Senior Secured Credit Agreement dated March 22, 2004 by and between Sunset Financial and JPMorgan Chase Bank, N.A. (incorporated by reference to Exhibit 10.1 to the Current Report on Form 8-K filed by us on April 7, 2004).
10.37	Risk Analytics Services Agreement dated April 1, 2004 between Blackrock Financial Management, Inc. and Sunset Financial (incorporated by reference to Exhibit 10.1 to the Quarterly Report on Form 10-Q filed by us on May 10, 2004).
10.38	Pooling and Servicing Agreement dated as of June 1, 2004, among J.P. Morgan Acceptance Corporation I, a Delaware corporation (the “Depositor”), Wells Fargo Bank, N.A., as Master Servicer and Securities Administrator, and Wachovia Bank, National Association, as trustee (the “Trustee”) of J.P. Morgan Mortgage Trust 2004-A3 (the “Trust”) (incorporated by reference to Exhibit 10.2 to the Current Report on Form 8-K filed by us on July 9, 2004).
10.39	Assignment, Assumption and Recognition Agreement dated as of June 1, 2004, among the Depositor, the Trustee, the Trust, Sunset Financial and Bank of America, N.A., a national banking association (incorporated by reference to Exhibit 10.3 to the Current Report on Form 8-K filed by us on July 9, 2004).
10.40	Assignment, Assumption and Recognition Agreement dated as of June 1, 2004, among the Depositor, the Trustee of the Trust, Sunset Financial, Cendant Mortgage Corporation and Bishop’s Gate Residential Mortgage Trust, with Cendant Mortgage Corporation as the servicer (incorporated by reference to Exhibit 10.4 to the Current Report on Form 8-K filed by us on July 9, 2004).
10.41	Assignment, Assumption and Recognition Agreement dated as of June 1, 2004, among the Depositor, the Trustee of the Trust, Sunset Financial, Cendant Mortgage Corporation and Bishop’s Gate Residential Mortgage Trust, with Cendant Mortgage Corporation as the servicer (incorporated by reference to Exhibit 10.5 to the Current Report on Form 8-K filed by us on July 9, 2004).
10.42	Assignment, Assumption and Recognition Agreement dated as of June 1, 2004, among the Depositor, the Trustee of the Trust, Sunset Financial, and National City Mortgage Co. (incorporated by reference to Exhibit 10.6 to the Current Report on Form 8-K filed by us on July 9, 2004).
10.43	Assignment, Assumption and Recognition Agreement dated as of June 1, 2004, among the Depositor, the Trustee of the Trust, Sunset Financial, and Greenpoint Mortgage Funding, Inc. (incorporated by reference to Exhibit 10.7 to the Current Report on Form 8-K filed by us on July 9, 2004).
10.44	Indemnification Agreement dated as of June 29, 2004 between Sunset Financial and the Depositor (incorporated by reference to Exhibit 10.8 to the Current Report on Form 8-K filed by us on July 9, 2004).
10.45	Purchase Agreement dated February 24, 2005 among Sunset Financial, Sunset Financial Statutory Trust I, and Taberna Preferred Funding I, Ltd. (incorporated by reference to Exhibit 10.61 to the Form 10-K filed by us on March 31, 2005).
10.46	Junior Subordinated Indenture dated as of March 15, 2005 between Sunset Financial and JPMorgan Chase Bank, N.A. (incorporated by reference to Exhibit 10.62 to the Form 10-K filed by us on March 31, 2005).
10.47	Amended and Restated Agreement dated as of March 15, 2005 among Sunset Financial, JPMorgan Chase Bank, N.A., Chase Bank USA, N.A., and certain administrative trustees named therein (incorporated by reference to Exhibit 10.63 to the Form 10-K filed by us on March 31, 2005).
10.48	Amendment to Employment Agreement dated October 3, 2005, by and between Sunset Financial Resources, Inc. and George Deehan (incorporated by reference to Exhibit No. 10.2 to the Form 8-K filed by us on August 8, 2005).
10.49	Employment Agreement dated October 28, 2005, by and between Sunset Financial Resources, Inc. and Stacy M. Riffe (incorporated by reference to Exhibit No. 10.1 to the Form 8-K filed by us on November 2, 2005).
14.1	Code of Ethics (incorporated by reference to Exhibit 14.1 to Amendment No. 4 to the Form S-11 filed by us on March 11, 2004).
16.1	Letter re Change in Certifying Accountant (incorporated by reference to Form 8-K filed by us on August 22, 2005).
21.1*	List of Subsidiaries.
31.1*	Chief Executive Officer certification under Section 302 of the Sarbanes-Oxley Act of 2002.
31.2*	Chief Financial Officer certification under Section 302 of the Sarbanes-Oxley Act of 2002.

49

Exhibit No.
32.1+	Chief Executive Officer certification under Section 906 of the Sarbanes-Oxley Act of 2002.
32.2+	Chief Financial Officer certification under Section 906 of the Sarbanes-Oxley Act of 2002.

* Filed herewith.

+ Furnished herewith.

50

SUNSET FINANCIAL RESOURCES, INC

INDEX TO FINANCIAL STATEMENTS

FOR THE YEAR ENDED

DECEMBER 31, 2005

Reports of Independent Registered Public Accounting Firms	F-1
Consolidated Balance Sheets as of December 31, 2005 and 2004	F-4
Consolidated Statements of Operations for the years ended December 31, 2005, 2004 and 2003	F-5
Consolidated Statements of Comprehensive Income for the years ended December 31, 2005, 2004 and 2003	F-6
Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2005, 2004 and 2003	F-7
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2004 and 2003	F-8
Notes to the Consolidated Financial Statements	F-9
Schedules to Consolidated Financial Statements	F-24

51

Report of Independent Registered Public Accounting Firm

The Stockholders and Board of Directors

Sunset Financial Resources, Inc.

We have audited the accompanying consolidated balance sheet of Sunset Financial Resources, Inc. as of December 31, 2005, and the related consolidated statements of operations, stockholders’ equity, comprehensive income and cash flows for the year then ended. Our audit also included the financial statement schedules listed in the index. These consolidated financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and schedules based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sunset Financial Resources, Inc. as of December 31, 2005, and the consolidated results of its operations and its cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.

We also have audited, an accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Sunset Financial Resources, Inc.’s internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 13, 2006 expressed an unqualified opinion on management’s assessment of internal control over financial reporting and an unqualified opinion on the effectiveness of internal control over financial reporting.

Respectfully Submitted,

Hancock Askew & Co., LLP

Savannah, Georgia

March 13, 2006

F - 1

Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders

Sunset Financial Resources, Inc.

We have audited management’s assessment, included in Management’s Report on Internal Control Over Financial Reporting, that Sunset Financial Resources, Inc. maintained effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Sunset Financial Resources, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.

A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

In our opinion, management’s assessment that Sunset Financial Resources, Inc. maintained effective internal control over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also in our opinion, Sunset Financial Resources, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet and the related consolidated statements of operations, stockholders’ equity, comprehensive income, and cash flows of Sunset Financial Resources, Inc., as of December 31, 2005 and for the year then ended and our report dated March 13, 2006 expressed an unqualified opinion.

Respectfully Submitted,

Hancock Askew & Co., LLP

Savannah, Georgia

March 13, 2006

F - 2

Report of Independent Registered Public Accounting Firm

The Stockholders and Board of Directors

Sunset Financial Resources, Inc.

We have audited the accompanying consolidated balance sheets of Sunset Financial Resources, Inc. as of December 31, 2004 and 2003, and the related consolidated statements of operations, shareholders’ equity, and cash flows for the year ended December 31, 2004 and the period beginning October 6, 2003 (inception) and ended December 31, 2003. Our audit also included the financial statement schedules listed in the index. These financial statements and schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedules based on our audits.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Sunset Financial Resources, Inc. at December 31, 2004, and the consolidated results of their operations and their cash flows for the year ended December 31, 2004 and the period beginning October 6, 2003 (inception) and ended December 31, 2003 in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.

Jacksonville, Florida

March 22, 2005

F - 3

Sunset Financial Resources, Inc

Consolidated Balance Sheets

(in thousands, except share data)

	December 31, 2005			December 31, 2004
Assets
Mortgage assets
Mortgage-backed securities, available for sale	$	942,900		$	614,154
Securitized hybrid adjustable rate mortgages		160,602			201,381
Hybrid adjustable rate residential mortgages		—			1,286
Fixed rate residential mortgages		—			1,045
Commercial mortgages		29,347			44,522
Total mortgage assets		1,132,849			862,388
Allowance for loan losses		(7,321	)		(1,333	)
Net mortgage assets		1,125,528			861,055
Cash and cash equivalents		17,570			25,700
Interest receivable		4,542			2,676
Fixed assets, net		521			861
Other assets		1,853			484
Interest rate swap agreements		12,246			2,716
Total assets	$	1,162,260		$	893,492
Liabilities
Whole loan financing facility	$	—		$	9,718
Reverse repurchase agreements		1,031,831			761,205
Junior subordinated notes due to Sunset Financial Statutory Trust I		20,619			—
Interest rate swap agreements		137			944
Accrued liabilities		2,676			2,367
Total liabilities		1,055,263			774,234
Commitments and contingencies
Stockholders’ equity
Preferred stock, $.001 par value, authorized 50,000,000; no shares outstanding		—			—
Common stock, $.001 par value, authorized 100,000,000; 10,516,600 and 10,450,000 outstanding, respectively		11			10
Additional paid in capital		119,391			119,219
Accumulated other comprehensive income (loss)		(2,998	)		87
Accumulated deficit		(9,407	)		(58	)
Total stockholders’ equity		106,997			119,258
Total liabilities and stockholders’ equity	$	1,162,260		$	893,492

See accompanying notes to consolidated financial statements.

F - 4

Sunset Financial Resources, Inc

Consolidated Statements of Operations

(in thousands, except per share data)

	For the Year Ended December 31,
	2005			2004			2003
Interest and fee income	$	46,356		$	18,233		$	—
Interest expense		34,788			9,842			—
Net interest income		11,568			8,391			—
Provision for loan losses		7,042			1,333			—
Net interest income after provision		4,526			7,058			—
Net gain on sale of securities		9			734			—
Loss on sale of loans		(59	)		(48	)		—
Operating expenses
Salaries and employee benefits		2,288			2,864			—
Professional fees		2,911			1,151			—
Other		3,173			2,720			22
Severance		841			365			—
Total operating expenses		9,213			7,100			22
Net income (loss)	$	(4,737	)	$	644		$	(22	)
Basic earnings (loss) per share	$	(0.45	)	$	0.08			(0.05	)
Diluted earnings (loss) per share	$	(0.45	)	$	0.07			(0.05	)
Weighted average basic shares		10,470			8,377			467
Weighted average diluted shares		10,470			8,397			467

See accompanying notes to consolidated financial statements.

F - 5

Sunset Financial Resources, Inc

Consolidated Statements of Other Comprehensive Income (Loss)

(in thousands)

	Year ended December 31, 2005			Year ended December 31, 2004			Year ended December 31, 2003
Net income (loss)	$	(4,737	)	$	644		$	(22	)
Components of other comprehensive income (loss):
Net unrealized loss on available for sale securities arising during the period		(13,686	)		(1,062	)		—
Net unrealized gain on hedging instruments arising during the period		11,405			1,110			—
Amortization/accretion of net deferred (gain) loss on terminated effective hedges		(804	)		39			—
Other comprehensive income (loss)	$	(7,822	)	$	731		$	(22	)

See accompanying notes to consolidated financial statements.

F - 6

Sunset Financial Resources, Inc

Consolidated Statements of Stockholders’ Equity

(in thousands)

	Common Stock				Paid in Capital		Accumulated Other Comprehensive Income (Loss)			Accumulated Deficit			Total
	Shares	Par Value
Balance at October 6, 2003	—	$	—		$	—	$	—		$	—		$	—
Issuance of common stock	467		2			29								31
Conversion of shares in reincorporation			(1	)		1								—
Share-based compensation expense under stock plans						17								17
Net loss											(22	)		(22	)
Balance at December 31, 2003	467		1			47		—			(22	)		26
Net proceeds of initial public offering	9,983		9			118,671								118,680
Issuance of stock warrants						191								191
Share-based compensation expense under stock plans						310								310
Unrealized net gain on cash flow hedges								1,772						1,772
Unrealized net deferred loss on terminated effective cash flow hedges								(662	)					(662	)
Amortization of net deferred loss on terminated effective cash flow hedges								39						39
Unrealized loss on available for sale securities								(1,062	)					(1,062	)
Dividends declared of $0.065 per share											(680	)		(680	)
Net income											644			644
Balance at December 31, 2004	10,450		10			119,219		87			(58	)		119,258
Proceeds from grant of restricted stock	67		1											1
Share-based compensation expense under stock plans						172								172
Unrealized net gain on cash flow hedges								10,337						10,337
Unrealized net deferred gain on terminated effective cash flow hedges								1,068						1,068
Accretion of net deferred gain on terminated effective cash flow hedges								(804	)					(804	)
Unrealized net loss on available for sale securities								(13,686	)					(13,686	)
Dividends declared of $0.44 per share											(4,612	)		(4,612	)
Net loss											(4,737	)		(4,737	)
Balance at December 31, 2005	10,517	$	11		$	119,391	$	(2,998	)	$	(9,407	)	$	106,997

See accompanying notes to consolidated financial statements.

F - 7

Sunset Financial Resources, Inc

Consolidated Statements of Cash Flows

(in thousands)

	Year Ended December 31,
	2005			2004			2003
Cash flows from operating activities:
Net income (loss)	$	(4,737	)	$	644		$	(22	)
Adjustment to reconcile net income to net cash provided from operations:
Share based compensation expense		172			501			17
Provision for credit losses		7,042			1,333			—
Interest income accreted to loan balance (negative amortization)		(1,064	)		(943	)
Depreciation and amortization of fixed assets		365			188			—
Amortization of premium/discount		3,342			902			—
Amortization of net deferred hedge cost		(804	)		39			—
Amortization of deferred offering and securitization costs		74			—			—
Gain on sale of securities		(9	)		(734	)		—
Loss on sale of loans		59			48			—
Loss on disposal of fixed assets		5			—			—
Increase in accrued interest		(2,255	)		(2,676	)		—
Increase in other assets		(100	)		(229	)		(255	)
Increase in accrued liabilities		345			2,223			144
Net cash provided by (used in) operating activities		2,435			1,296			(116	)
Cash flows from investing activities:
Purchases of available for sale securities		(617,123	)		(842,597	)		—
Principal payments on available for sale securities		239,342			31,748			—
Proceeds from sales of available for sale securities		32,373			196,150			—
Purchases/funding of loans and securitized loans		(13,414	)		(302,567	)		—
Principal payments on loans		62,192			49,850			—
Proceeds from sale of loans		2,028			4,687			—
Proceeds from insurance settlement		7,406			—			—
Purchases of fixed assets		(30	)		(1,033	)		(16	)
Net cash used in investing activities		(287,226	)		(863,762	)		(16	)
Cash flows from financing activities:
Net borrowings from reverse repurchase agreements		270,626			761,205			—
Net (payments) borrowings on financing facility		(9,718	)		9,718			—
Net (payments) borrowings on stockholder notes		—			(145	)		145
Net proceeds from stock offering and restricted grants		1			118,680			31
Net proceeds from issuance of junior subordinated notes		19,332			—			—
Net proceeds from swap terminations		1,032			(656	)		—
Dividends paid on common stock		(4,612	)		(680	)		—
Net cash provided by financing activities		276,661			888,122			176
Net increase (decrease) in cash		(8,130	)		25,656			44
Cash and cash equivalents at the beginning of the period		25,700			44			—
Cash and cash equivalents at the end of the period	$	17,570		$	25,700		$	44
Supplemental disclosure:
Interest paid	$	31,060		$	8,565		$	—
Non-cash investing and financing activities:
Investment in unconsolidated subsidiary with subordinated note	$	619		$	—		$	—

See accompanying notes to consolidated financial statements.

F - 8

Sunset Financial Resources, Inc

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

Note 1 – Organization

Sunset Financial Resources, Inc. (the Company) was incorporated in Maryland on October 6, 2003, under the name of Sunset Capital Investments, Inc. and on November 17, 2003, filed amended articles of incorporation to change its name to Sunset Financial Resources, Inc. On March 17, 2004, the Company completed its initial public offering of common stock. The Company has elected to be taxed as a real estate investment trust (REIT) under the Internal Revenue Code of 1986, as amended. The Company had limited operations until receiving the proceeds from its initial public offering, at which time it began executing the business strategy of investing in residential mortgage related securities and commercial bridge loans.

Note 2 – Summary of Significant Accounting Policies

Basis of Presentation

The accompanying consolidated financial statements have been prepared on the accrual basis of accounting in accordance with accounting principles generally accepted in the United States of America. The consolidated financial statements reflect the accounts of the Company, and its wholly-owned subsidiaries, Sunset Investment Vehicle, Inc. and SFR Subsidiary, Inc. The Company’s wholly-owned subsidiary, Sunset Financial Statutory Trust I (the Preferred Trust), does not qualify for consolidation under FASB Interpretation No. 46(R), “Consolidation of Variable Interest Entities, an interpretation of ARB No. 51” (FIN No. 46), as the Company is not considered the primary beneficiary of the Preferred Trust, and has therefore been excluded from the accompanying consolidated financial statements.

Use of Estimates

The preparation of consolidated financial statements, in conformity with accounting principles generally accepted in the United States of America, requires management to make estimates and assumptions that affect reported amounts of certain assets, liabilities, contingent assets and liabilities, revenues and expenses as of and for the reporting periods. Actual results may differ from such estimates.

Cash and Cash Equivalents

Cash and cash equivalents include cash on hand and highly liquid investments with a maturity of three months or less. The carrying amount approximates fair market value. From time to time, cash balances may be subject to restrictions, such as when balances are pledged to meet margin calls related to derivative transactions or reverse repurchase agreements.

Investment Securities

The Company may at times have a non-mortgage investment portfolio for the purpose of deploying excess cash until the funds can be deployed into mortgage assets. Generally, investment securities would be carried at fair market value as available for sale securities with any fair market value adjustment shown in other comprehensive income.

Mortgage Assets

Residential Mortgage Assets

The Company’s residential mortgage assets consist of mortgage-backed securities, securitized mortgage loans and mortgage loans, which are primarily hybrid adjustable-rate mortgages with an initial interest rate that is fixed for a certain period, usually three to seven years, and then adjusts annually for the remainder of the term of the loan. These assets are primarily securities issued or guaranteed as to principal and interest by an agency of the U.S. government, such as the Federal National Mortgage Association (Fannie Mae), or are non-agency AAA rated.

Statement of Financial Accounting Standards (SFAS) No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” requires that investments in securities be designated as either “held-to-maturity,” “available-for-sale” or “trading” at the time of acquisition. Mortgage-backed securities are designated as available for sale and carried at fair value, with any unrealized gains or losses included in “Other comprehensive income or loss” as a component of stockholders’ equity.

Securitized mortgages include mortgage loans that have been transferred to a securitization trust. Although there has been a change in ownership structure, this transfer does not qualify as a sale, and is made at book value, since the Company

F - 9

maintains ownership interest in the trust. These assets are carried on the balance sheet at historical cost. Premiums or discounts are amortized or accreted into interest income over the lives of the securities using the effective yield method adjusted for the effects of estimated prepayments based on SFAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases – an amendment of FASB Statements No. 13, 60 and 65 and a rescission of FASB Statement No. 17”.

Residential mortgage loans are whole loans and are carried at historical cost. Premiums or discounts are amortized or accreted into interest income over the lives of the securities using the effective yield method adjusted for the effects of estimated prepayments based on SFAS No. 91.

Management evaluates securities for other-than-temporary impairment. Generally, securities that have been in a continuous loss position may be evaluated for other-than-temporary impairment. However, other factors, such as government-sponsored agency guarantees, credit risk and the Company’s ability and intent to hold investments until a forecasted recovery of fair value, are also considered in the evaluation.

Commercial Mortgage Assets

The Company invests in commercial mortgage loans typically with an initial term of one year, although loans with longer terms may be considered. These loans are typically secured by a first lien on the underlying property and are carried on the balance sheet at historical cost. Any premium, discount, or fees are amortized over the term of the loan as a yield adjustment.

Valuation Methods

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

Allowance for Loan Losses

The Company provides an allowance for loan losses related to its loan portfolio. Loan loss provisions are based on an assessment of numerous factors affecting the portfolio of mortgage assets, including, but not limited to, current economic conditions, delinquency status, credit losses to date on underlying mortgages, collateral values of properties securing loans and any remaining credit protection. Loan loss provision estimates are reviewed periodically and adjustments are reported in earnings when they become known. Loans are charged-off when, in the opinion of management, the balance is no longer collectable.

Commercial mortgage loans are evaluated for impairment on a specific identification basis in accordance with SFAS No. 114, “Accounting by Creditors for Impairment of a Loan – an amendment of FASB Statements No. 5 and 15,” when, based upon current information and events, it is probable that the Company will be unable to collect principal and interest according to contractual terms of the agreement. Any provisions recorded are based on cash flow analysis, discounted at the loan’s effective interest rate, or, if the loan is collateral dependant, on the fair value of the collateral less the estimated costs to sell.

Fixed Assets

Long-lived assets to be used in the business generally consist of furniture, fixtures, computer equipment, software and leasehold improvements. These assets are depreciated or amortized on a straight line basis over their estimated useful lives, which range from two to five years. Leasehold improvements are amortized over the shorter of the estimated life of the asset or the life of the lease.

Reverse Repurchase Agreements

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

F - 10

Should a counterparty decide not to renew a repurchase agreement at maturity, the Company must either refinance elsewhere or be in a position to satisfy this obligation. To mitigate risk, the Company enters into repurchase agreements only with investment grade institutions.

Hedging Activities

The Company enters into derivative financial instruments as a means of mitigating the Company’s interest rate risk on forecasted interest expense. All derivative financial instruments are carried on the balance sheet as assets or liabilities at fair value.

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

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

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

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

Accumulated Other Comprehensive Income (Loss)

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

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

Interest and Fee Income

Interest income on residential mortgage assets is accrued based on the actual coupon rate and the outstanding principal amount of the underlying mortgages, unless management considers the collection of interest to be uncertain. Premiums and discounts associated with the purchase of investment securities are amortized into interest income over the lives of the securities using the effective interest yield method adjusted for the effects of estimated prepayments based on SFAS No. 91. Adjustments are made using the retrospective method to the effective interest computation each reporting period based on the actual prepayment experiences to date.

Interest income on commercial mortgage loans is accrued based on the outstanding principal amount and the stated interest rate, unless management considers the collection of interest to be uncertain. Loans are evaluated for non-accrual status on an individual basis when payments in accordance with contractual terms are delinquent in excess of 60 days, or sooner if deemed appropriate by the Company. In general, when a loan is placed on nonaccrual, interest accrued during that period is reversed, and any future income is recognized on a cash basis. Loan fees are deferred and amortized over the expected life of the loan.

F - 11

Accounting for Share-Based Compensation

The Company accounts for share-based compensation in accordance with SFAS No. 123(R), “Share-Based Payment,” which requires an entity to recognize in the income statement the grant-date fair value of equity-based compensation issued to employees. Total compensation cost, including Board-related compensation, recognized was $172,000 and $501,000 in 2005 and 2004, respectively.

Income Taxes

The Company has elected to be taxed as a Real Estate Investment Trust (REIT) under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, and has been taxed as such beginning with the taxable year ended December 31, 2004. To qualify as a REIT, the Company must meet certain organizational and operational requirements, including a requirement to currently distribute at least 90% of ordinary taxable income to stockholders. As a REIT, the Company generally will not be subject to federal income tax on taxable income that the Company distributes to its stockholders. If the Company fails to qualify as a REIT in any taxable year, it will then be subject to federal income taxes on taxable income at regular corporate rates starting with that year and will not be permitted to qualify for treatment as a REIT for federal income tax purposes for four years following the year during which qualification is lost unless the Internal Revenue Service were to grant relief under certain statutory provisions.

Earnings per Share (EPS)

Earnings per share is calculated under SFAS No. 128, “Earnings per Share.” Basic earnings per share is computed on the basis of the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed on the basis of the weighted average number of common shares outstanding during the period plus the effect of dilutive potential common shares outstanding using the treasury stock method. Dilutive potential shares include stock options, restricted stock and warrants.

Concentrations of Credit Risk

The Company’s investments are concentrated in securities that pass through collections of principal and interest from underlying mortgages, and there is a risk that some borrowers on the underlying mortgages will default. However, the Company mitigates this credit risk by holding securities that are either guaranteed by government or government-sponsored agencies or have actual or implied AAA credit ratings. At December 31, 2005 and 2004, 59.1% and 63.7%, respectively, of the Company’s residential securities, including loans, as measured by fair value, were agency-guaranteed.

The Company also has investments in commercial bridge loans, which are collateralized with real estate. Management periodically evaluates collateral adequacy, and any shortage is reviewed for impairment. During 2005, management concluded that the collateral supporting two commercial loans was not sufficient to support the principal balance on the loans. Impairments related to these loans were reflected in the allowance for loan losses at December 31, 2005. The Company has not entered into any new commercial loans since July 2005.

The Company enters into reverse repurchase agreements and swap agreements with various counterparties, and also has cash deposits with financial institutions that exceed federally insured amounts. In the event the counterparties and financial institutions do not fulfill their obligations, the Company could be exposed to risk of loss. To mitigate this risk, the Company only enters into agreements with creditworthy institutions. The Company also looks to establish netting arrangements with those counterparties providing both financing and hedging as a mechanism to mitigate credit risk. Under such an arrangement, any value captured in the hedge is applied towards satisfying expected margin calls due to a drop in the financed position’s market value.

The Company’s securities portfolio and financing instruments are impacted by changes in interest rates. To mitigate a portion of the volatility caused by changing rates, the Company enters into derivative instruments, typically swaps, to hedge the portfolio.

Reclassifications

Certain prior year amounts have been reclassified to conform with current year presentation.

F - 12

Note 3 – Mortgage Securities

At December 31, 2005 and 2004, the Company’s mortgage-backed securities were classified as available-for-sale and carried at estimated fair value which was determined based on the average of third-party broker quotes received. The following table presents the components of the Company’s mortgage-backed securities portfolio:

	December 31, 2005									December 31, 2004
(in thousands)	Agency Securities			Non Agency Securities			Total			Agency Securities			Non Agency Securities			Total
Par value	$	653,711		$	297,189		$	950,900		$	510,347		$	96,013		$	606,360
Unamortized premium		6,915			1,960			8,875			8,778			788			9,566
Unamortized discount		(1,687	)		(440	)		(2,127	)		(689	)		(21	)		(710	)
Amortized cost		658,939			298,709			957,648			518,436			96,780			615,216
Gross unrealized gains		—			2			2			709			14			723
Gross unrealized losses		(10,034	)		(4,716	)		(14,750	)		(1,456	)		(329	)		(1,785	)
Estimated fair value	$	648,905		$	293,995		$	942,900		$	517,689		$	96,465		$	614,154

The following table presents the mortgage-backed securities which were in an unrealized loss position at December 31, 2005 and 2004:

	December 31, 2005					December 31, 2004
(in thousands)	Security Count	Amortized Cost		Unrealized Loss		Security Count	Amortized Cost		Unrealized Loss
Agency	54	$	658,939	$	10,034	20	$	425,761	$	1,456
Non Agency	15		281,650		4,716	4		67,456		329
	69	$	940,589	$	14,750	24	$	493,217	$	1,785

The Company reviews the securities portfolio for continuous losses. If a security is in an unrealized gain position at any time during a quarterly reporting period, it is not considered to be in a continuous loss for that reporting period. The following table presents the Company’s mortgage-backed securities that have been in a continuous unrealized loss position, aggregated by investment category and length of time, as of December 31, 2005:

	Less than 12 Months				12 Months or More				Total
(in thousands)	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses
Agency	$	253,274	$	3,119	$	284,651	$	6,874	$	537,925	$	9,993
Non Agency		227,896		3,534		49,039		1,182		276,935		4,716
Total temporarily impaired securities	$	481,170	$	6,653	$	333,690	$	8,056	$	814,860	$	14,709

The following table presents the Company’s mortgage-backed securities that have been in a continuous unrealized loss position, aggregated by investment category and length of time, as of December 31, 2004:

	Less than 12 Months				12 Months or More				Total
(in thousands)	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses
Agency	$	108,167	$	370	$	—	$	—	$	108,167	$	370
Non Agency		—		—		—		—		—		—
Total temporarily impaired securities	$	108,167	$	370	$	—	$	—	$	108,167	$	370

F - 13

The Company does not believe unrealized losses, individually or in the aggregate as of December 31, 2005 and 2004, represent an other-than-temporary impairment. The unrealized losses are primarily a result of increases in interest rates and will not prohibit the Company from receiving its contractual interest and principal payments. The Company has the ability and intent to hold these securities for a period necessary to recover the amortized cost. All of the mortgage-backed securities have an actual or implied “AAA” rating, or are guaranteed by an agency of the U.S. Government.

The following table reflects the par value of the portfolio by original fixed interest periods and average months to reset for the investment securities portfolio at December 31, 2005. The Company’s $60.2 million in floating rate mortgage-backed securities are backed by loans indexed off one-month LIBOR and the 12-month Moving Treasury Average Index.

	Agency Securities			Non-Agency Securities
Original interest reset profile (in thousands)	Par Value		Avg. Months to Reset	Par Value		Avg. Months to Reset
Floating	$	15,212	—	$	44,942	—
Less than 36 months		22,436	25		26,784	20
36 – 60 months		557,408	45		210,200	48
61 – 84 months		58,655	81		15,263	75
Total	$	653,711	48	$	297,189	47

Actual maturities of mortgage-backed securities are generally shorter than stated contractual maturities. The remaining fixed interest periods presented in the tables above represent the contractual fixed-rate periods of Hybrid Arms, and do not include the mortgage duration after the interest rate reset date. The actual lives of the securities could be longer or shorter than the lives in the tables above depending on the actual prepayments rates experienced over the lives of the applicable securities.

During the year ended December 31, 2005, securities with a carrying value of $13.3 million were sold for proceeds of $13.3 million, resulting in a gain of $29,000. Securities with a carrying value of $19.0 million were sold for proceeds of $19.0 million, resulting in a loss of $20,000. During the year ended December 31, 2004, securities with a carrying value of $195.5 million were sold for a gain of $734,000. The cost basis of securities sold is determined by specific identification.

Note 4 – Residential and Commercial Mortgage Loans

Residential Mortgage Loans

At December 31, 2005 and December 31, 2004, the Company’s residential mortgage loans were classified as held-to-maturity and carried at historical cost, net of unamortized premium or discount and fees. The loan balances, including securitized loans, by original fixed period are summarized in the following table:

	December 31, 2005						December 31, 2004
Initial Fixed Term (in thousands)	Loan Balance		Premium/ Deferred Costs		Book Value		Loan Balance		Premium/ Deferred Costs		Book Value
Fixed rates	$	—	$	—	$	—	$	1,017	$	28	$	1,045
3 year fixed		4,893		149		5,042		10,336		297		10,633
5 year fixed		53,550		1,492		55,042		71,735		1,997		73,732
7 year fixed (and other)		99,867		446		100,313		117,389		653		118,042
Total		158,310		2,087		160,397		200,477		2,975		203,452
Deferred loan costs		—		205		205		—		260		260
Total	$	158,310	$	2,292	$	160,602	$	200,477	$	3,235	$	203,712

At December 31, 2005, the average months to reset for the 3-year, 5-year and 7-year categories were 11 months, 35 months and 62 months, respectively. The total residential mortgage loan portfolio at December 31, 2005, had an average remaining fixed period of 51 months.

F - 14

During the year ended December 31, 2005, loans with a carrying value of $2.1 million were sold for proceeds of $2.0 million, resulting in a loss of $59,000. During the year ended December 31, 2004, loans with a carrying value of $4.7 million were sold at a loss of $48,000. The cost basis of securities sold is determined by specific identification.

At December 31, 2005, two loans totaling $600,000, or 0.38% of the securitized loan balance, were 30 days past due, and one loan for $68,000 was in bankruptcy. At December 31, 2004, three loans totaling $1.6 million, or 0.80% of the securitized loan balance, were past due over 30 days, and one loan totaling $159,000, or 0.08% of the securitized loan balance, was delinquent in excess of 90 days.

At December 31, 2005, the estimated fair value of the Company’s securitized residential mortgage portfolio was $154.6 million. Two securities were in a gain position totaling $59,000 and seven securities were in a loss position totaling $5.8 million. At December 31, 2004, the estimated fair value of the Company’s residential mortgage loans, including securitized loans, was $198.8 million. Three loans were in a gain position totaling $44,000 and ten loans were in a loss position, totaling $4.7 million.

The Company reviews the securitized loan portfolio for continuous losses. If a security is in a gain position at any time during a quarterly reporting period, it is not considered to be in a continuous loss for that reporting period. The following table presents the Company’s residential mortgage loan securities that have been in a continuous unrealized loss position and length of time as of December 31, 2005:

	Less than 12 Months				12 Months or More				Total
(in thousands)	Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses		Fair Value		Gross Unrealized Losses
Temporarily impaired securities at December 31, 2005	$	—	$	—	$	153,708	$	5,842	$	153,708	$	5,842
Temporarily impaired securities at December 31, 2004	$	196,128	$	4,688	$	—	$	—	$	196,128	$	4,688

The Company does not believe unrealized losses, individually or in the aggregate as of December 31, 2005 and 2004, represent an other-than-temporary impairment. The unrealized losses are primarily a result of increases in interest rates and will not prohibit the Company from receiving its contractual interest and principal payments. The Company has the ability and intent to hold these securities for a period necessary to recover the amortized cost. Additionally, the securitization is comprised of prime mortgage pools with an original weighted average credit score of greater than 700 and a weighted average original loan-to-value ratio of less than 75%, and has not experienced any credit losses to date.

Commercial Mortgage Loans

The Company invests in commercial mortgage loans, which typically have an initial term of one year. These loans are carried on the balance sheet at historical cost, which, net of allowance for loan losses, approximates fair value, and are summarized as follows:

Type of Property (in thousands)	Interest Rate		Location	Participation		Maturity	December 31, 2005			December 31, 2004
Retail mall	11	%	FL	No		—	$	—		$	14,735
Resort development	13	%	NC	No	(1)	Jun. 2006		16,647			9,975
Mansion/conference center	11	%	FL	No		—		—			8,166
Cemetery/funeral home	10	%	HI	Yes		Matured		5,658			5,658
Multi-sport facility	12	%	NJ	No		Matured		4,700			4,700
Apartments	11	%	IL	No		—		—			1,500
Retail development	11	%	FL	No		Jun. 2006		2,739			—
								29,744			44,734
Deferred fees								(397	)		(212	)
Commercial mortgage balance							$	29,347		$	44,522

(1) At December 31, 2004, this loan was a participation loan. During 2005, we purchased the other participant’s interest in the loan at face value.

F - 15

In July 2005, the Company closed on a $3.5 million loan commitment related to an equestrian facility located in Bethany, West Virginia. Deferred loan fees of $35,000 were recorded at the inception of the loan. On October 4, 2005, this loan was repaid in full, and the remaining loan fees were recorded into income.

Allowance for Loan Losses

Management evaluates commercial loans for possible impairment under SFAS No. 114 on a specific identification basis. At December 31, 2005, two loans were considered impaired, and at December 31, 2004, one loan was impaired.

The Company has a participation interest (approximately 20%) in a loan collateralized by cemetery/funeral home properties in Hawaii. At December 31, 2004, the loan was in default and was evaluated under SFAS No. 114 for impairment. At the time of the analysis, foreclosure proceedings had begun on the property, and management concluded that the estimated net realizable value of the collateral was sufficient to support the loan value and no impairment was recorded. During the second quarter of 2005, the Company learned that significant funds were missing from the cemetery/funeral home trust fund. Until the investigation of the missing funds is resolved, the Attorney General for the State of Hawaii has expressed opposition to the issuance of a license to operate the facilities, which impedes foreclosure or sale of the property. This additional information resulted in management’s decision to take a full impairment of $5.7 million on the loan at June 30, 2005. At December 31, 2005, management’s analysis concluded that the loan continued to be fully impaired. For the year ended December 31, 2005, no interest income was recorded on this loan. For the year ended December 31, 2004, interest income of $171,000 was recorded.

The Company continues to incur legal fees of approximately $25,000 monthly related to the collection of this loan, which are expensed as incurred. Under terms of the Intercreditor Agreement, the Company may also be responsible for its respective portion of future expenses related to preservation of collateral. At December 31, 2005, management anticipated that future expenditures related to the preservation of collateral were not material.

On October 7, 2005, the Company filed suit against the other two participating creditors in the loan, Owens Mortgage Investment Fund and Vestin Mortgage, Inc., for violation of certain provisions under the Intercreditor Agreement.

The multi-sport facility loan has been in default since the first quarter of 2005. A court-appointed receiver was put in place during the year, and the Company was permitted to market the property for sale under court supervision. On November 4, 2005, the Company received a signed contract, subject to court approval, from a willing buyer. Using the contracted price, and accounting for carrying costs, commission and other transactions costs, management concluded that the net realizable value of the collateral securing the loan was less than the carrying value of the loan, and an impairment charge of $1.2 million was required for the period ended September 30, 2005. For the year ended December 31, 2005, no interest income was recorded on this loan. For the year ended December 31, 2004, interest income of $143,000 was recorded.

On January 31, 2006, the multi-sport facility was sold, and the net proceeds of $3.5 million were placed under court control. The Company has filed a motion for turnover with the court, and anticipates that the funds will be released to the Company following the hearing. The carrying value of the loan at December 31, 2005, net of impairment, approximated the net proceeds from the sale of the collateral. The Company retained all of its rights and remedies under the original note agreement against the Guarantor as it relates to the deficiencies incurred while holding the loan and from the sale of the loan collateral.

At December 31, 2004, management concluded that the mansion/conference center loan was impaired and recorded an allowance for loan loss of $1.1 million. During the first quarter of 2005, the Company elected to accept a settlement offer under a claim on the title insurance policy. Under terms of the settlement, the Company received $5.9 million in cash on March 31, 2005, and received the remaining $1.5 on December 15, 2005. The $1.1 million allowance was charged off at March 31, 2005.

In addition to a specific review of each commercial loan, the Company provides for loan losses by making a general assessment of the overall loan portfolio. The following table reflects the activity in the Company’s allowance for loan losses for the years ended December 31, 2005 and 2004:

(in thousands)	2005			2004
Balance at beginning of period	$	1,333		$	—
Provision		7,042			1,333
Charge-offs		(1,054	)		—
Balance at end of period	$	7,321		$	1,333

F - 16

Note 5 – Hedging

During 2004 and 2005, the Company hedged the majority of its interest rate risk by entering into interest rate swaps (designated as cash flow hedges) to extend the duration of its short term borrowings. For both 2004 and 2005, no ineffectiveness was recognized.

During the year ended December 31, 2005, swaps with a notional balance of $248.9 million were terminated at a net gain of $1.1 million. During the year ended December 31, 2004, swaps with a notional balance of $121.0 million were terminated at a net loss of $662,000. The net gain or loss on terminated effective hedges is deferred and amortized into interest expense over the remaining original term of the swaps. The Company estimates that $172,000 of net gain will be amortized into earnings within the next twelve months.

Total notional outstanding at December 31, 2005 and 2004 was $980.4 million and $593.6 million, respectively, with a fair market value of $12.1 million and $1.8 million, respectively, maturing as follows:

	2005				2004
(in thousands)	Notional		Avg Fixed Rate		Notional		Avg. Fixed Rate
Maturing in less than one year	$	299,700	3.00	%	$	—	—	%
Maturing between one and two years		235,560	3.72			362,700	2.79
Maturing between two and three years		89,000	4.22			61,060	3.50
Maturing between three and five years		356,100	4.43			169,800	4.00
Total	$	980,360	3.81	%	$	593,560	3.21	%

As of December 31, 2005, three swaps were in a loss position totaling $137,000 and 30 swaps were in a gain position totaling $12.2 million. The Company has counterparty credit risk related to the swaps in a gain position. At December 31, 2005, the Company’s maximum net credit exposure to a single counterparty was $5.5 million. To mitigate this risk, the Company only enters into swap transactions with investment grade institutions. Additionally, at December 31, 2005, one counterparty had posted collateral with a fair value of $3.0 million with the Company.

As of December 31, 2004, 16 swaps were in a gain position totaling $2.7 million and seven swaps were in a loss position totaling $944,000. At December 31, 2004, the Company’s maximum credit exposure to a single counterparty was $2.0 million.

Note 6 – Debt

Junior Subordinated Notes

On March 15, 2005, Sunset Financial Statutory Trust I, a Delaware statutory trust (the Preferred Trust) and a wholly-owned subsidiary of the Company, completed a private offering of $20 million of trust preferred securities. The Preferred Trust used the proceeds of the private offering, together with the Company’s $619,000 investment in the Preferred Trust common securities, to purchase $20.6 million aggregate principal amount of the Company’s Junior Subordinated Notes with terms that mirror the terms of the trust preferred securities.

The trust preferred securities and the subordinated notes bear interest at 90-day LIBOR plus 4.15% (approximately 8.68% at December 31, 2005), payable quarterly in arrears, and generally may not be redeemed prior to March 30, 2010. The maturity date of subordinated notes is March 30, 2035.

The Preferred Trust is a variable interest entity pursuant to FIN No. 46(R) because the holders of the equity investment at risk do not have adequate decision making ability over the Trust’s activities. Because the Company’s investment in the Preferred Trust’s common shares was financed directly by the Preferred Trust as a result of its loan of the proceeds to the Company, that investment is not considered to be an equity investment at risk pursuant to FIN No. 46(R), and the Company is not the primary beneficiary of the Preferred Trust. Therefore, the financial statements of the Preferred Trust are not consolidated with the Company’s financial statements, and the Company’s financial statements present the subordinated notes issued to the Preferred Trust as a liability, and the investment in the Preferred Trust as an asset. As of December 31, 2005, no events had occurred that might have a significant adverse effect on the carrying value of the Company’s $619,000 investment in the Preferred Trust.

F - 17

Reverse Repurchase Agreements

The Company has arrangements to enter into reverse repurchase agreements with 14 financial institutions under facilities totaling $2.5 billion. At December 31, 2005, the Company had amounts outstanding under repurchase agreements with nine lenders totaling $1.0 billion with a weighted average rate of 4.36% and a weighted average remaining maturity of 92 days. Securities and securitized loans pledged as collateral on the reverse repurchase agreements had a carrying value of $1.1 billion and a market value of $1.1 billion as of December 31, 2005. The reverse repurchase agreements had maturity dates ranging from January 2006 to September 2006.

At December 31, 2004, the Company had amounts outstanding under repurchase agreements with eight lenders totaling $761.2 million with a weighted average rate of 2.40% and a weighted average remaining maturity of 104 days. Securities and securitized loans pledged as collateral on the reverse repurchase agreements had a face value of $791.6 million and a market value of $798.2 million as of December 31, 2004.

At December 31, 2005, the Company had a maximum net exposure (the difference between the amount loaned to the Company and the estimated fair value of the security pledged by the Company as collateral) of $44.6 million to all nine lenders, of which 51.5% was with two counterparties. The Company had posted additional securities as collateral with a market value of $377,000 with one counterparty at December 31, 2005. At December 31, 2004, the Company had a maximum net exposure of $2.6 million to a single lender. At December 31, 2005 and 2004, none of the cash or cash equivalents was pledged to support margin calls on derivatives or reverse repurchase agreements.

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

Maturing (in thousands)	December 31, 2005		December 31, 2004
Overnight	$	—	$	—
Within 30 days		423,860		319,100
30 to 90 days		128,948		56,500
Over 90 days		479,023		385,605
Total	$	1,031,831	$	761,205

Warehouse Credit Facility

During 2004, the Company entered into a $250 million warehouse line of credit that was used to finance the purchase of residential mortgage loans. This facility also included a sublimit of $18.75 million that could be used to finance specific types of commercial bridge loans. This facility bore interest at LIBOR plus a spread and included a facility fee and had an original maturity date in March 2006.

At December 31, 2004, the outstanding balance on the facility was $9.7 million. In August 2005, the facility was terminated due to non-use.

Note 7 – Stockholders’ Equity and Share-Based Payment

Accumulated other comprehensive income (loss) at December 31, 2005 consisted of a $14.7 million accumulated loss related to the mark to market of available-for-sale investment securities, a $12.1 million accumulated gain related to the mark to market of interest rate swaps, and a $359,000 accumulated net deferred loss related to terminated effective cash flow hedges.

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

Stock Options. Options granted vest according to their terms and expire 10 years from the date of grant. Each non-employee director, upon election to the board, receives a stock option to purchase 5,000 shares of common stock at the then fair market value. The board options vest in full one year from the date for grant. Effective with the Company’s initial public offering, options for 20,000 shares of stock were granted to the four non-employee directors at the initial public offering price of $13.00. The Company also granted options to purchase 242,000 shares of common stock to executive officers of the Company effective on the closing of the initial public offering. The options are exercisable at the initial offering price of $13.00, and vest over three years. An expense was recorded based on the fair value of the options on the grant date in accordance with SFAS No. 123, measured using the Black-Scholes option pricing model over the options’ expected life and

F - 18

amortized over the vesting period of three years for executive officers and one year for independent directors. The options were valued at $0.82 per share using a stock volatility of 30%, an expected life of 10 years, a dividend yield of 10%, and a risk-free rate of return of 4.16%. The Company recognized expense of $60,000 related to stock options during the year ended December 31, 2004.

During 2005, an option to purchase 5,000 shares of stock was awarded to each of the four new independent directors. The exercise price for these options is equal to the closing trading price on the day prior to grant, and range from $8.00 to $9.77 per share. The options vest in full on the first anniversary of grant. An expense was recorded based on the fair value of the options on the grant date in accordance with SFAS No. 123, measured using the Black-Scholes option pricing model over the options’ expected life and amortized over the vesting period of one year. The options were valued using an average stock volatility of 17% (based on common stock price movement since March 2004), an expected life of 5.5 years (based on the midpoint between vest period and contractual life), a dividend yield of 10%, and an average risk-free rate of return of 4.22% (based on U. S. Treasury bond rates). Additionally, options representing 202,000 shares of stock were forfeited during the year. During the year ended December 31, 2005, the company recognized expense of $26,000 related to stock options.

The following table sets forth activity relating to the Company’s stock option awards:

	2005					2004
	Weighted Average Exercise Price at Grant		Weighted Average Fair Value at Grant		Number	Weighted Average Exercise Price at Grant		Weighted Average Fair Value at Grant		Number
Options outstanding at beginning of year	$	13.00	$	0.82	262,000					—
Granted during the year		8.92		0.29	20,000	$	13.00	$	0.82	262,000
Forfeited during the year		13.00		0.82	202,000		—		—	—
Expired during the year		—		—	—		—		—	—
Exercised during the year		—		—	—		—		—	—
Options outstanding at end of year	$	10.98	$	0.69	80,000	$	13.00	$	0.82	262,000
Options exercisable at end of year	$	13.00	$	0.82	26,667	$	—	$	—	—

At December 31, 2005, the weighted average remaining contractual life of options outstanding and options exercisable was 8.6 years and 8.3 years, respectively. Additionally, the total compensation cost related to non-vested awards not yet recognized is anticipated to be $23,000 and will be recognized over the remaining weighted average vesting period of 1.1 years.

Restricted Stock. Grants of restricted stock vest according to their terms and expire 10 years from the date of grant. On December 5, 2003, the Company granted 20,000 shares of restricted stock to its sole advisory board member. The Company also granted 5,000 shares of restricted stock to an executive officer on the closing of the initial public offering. These grants were purchased at par ($0.001 per share), and vested 100% on the anniversary of the initial public offering. Additionally, each non-employee director receives 2,000 shares of restricted common stock upon re-election to the board. The shares are restricted as to trading, but otherwise carry the benefits of ownership. The restriction expires one year after grant. The Company from time-to-time may grant restricted shares to employees, which would vest over three years.

During 2005, the Company granted 10,000 shares of restricted stock to re-elected directors, of which 2,000 shares were forfeited prior to year-end. The Company also granted 53,900 shares of restricted stock to employees, of which 20,300 were forfeited prior to year-end.

For the year ended December 31, 2005 and 2004, the Company recognized expense related to restricted stock awards of $146,000 and $250,000, respectively.

F - 19

The following table sets forth activity relating to the Company’s restricted stock awards:

	2005			2004
	Weighted Average Fair Value at Grant		Number	Weighted Average Fair Value at Grant		Number
Unvested restricted shares at beginning of year	$	13.00	25,000	$	—	—
Granted during the year		9.20	63,900		13.00	25,000
Forfeited during the year		9.46	22,300		—	—
Vested during the year		13.00	25,000
Unvested restricted shares at end of year	$	11.04	41,600	$	13.00	25,000

Warrants. The Company granted warrants to purchase 233,000 shares of common stock to Sapphire Advisors Group (Sapphire), a founding stockholder, for its role in assisting the Company during its formation. These warrants were granted effective on the closing of the initial public offering and are exercisable at the initial offering price of $13.00. The warrants were fully vested at the date of grant and will expire 10 years from the date of grant. An expense of $191,000 was recorded in 2004 for the warrants’ fair value in accordance with SFAS No. 123, measured using the Black-Scholes option pricing model. The warrants were valued at $.82 per share using a stock price volatility of 30%, an expected life of 10 years, a dividend yield of 10%, and a risk free rate of return of 4.16%. The warrants continue to be outstanding and unexercised.

Note 8 – Earnings per Share

Basic earnings per share are computed based upon the weighted average number of common shares outstanding. Diluted earnings per share reflect the dilutive effect of stock options and restricted stock. A reconciliation of the basic and diluted weighted average shares is as follows:

(in thousands except per share data)	2005			2004		2003
Net income allocable to common stockholders	$	(4,737	)	$	644	$	(22	)
Weighted average common shares outstanding (basic)		10,470			8,377		47
Assumed shares issued under treasury stock method for stock options and restricted stock		—			20		—
Adjusted weighted average common shares outstanding (diluted)		10,470			8,397		47
Basic net income (loss) per common share	$	(0.45	)	$	0.08	$	(0.05	)
Diluted net income (loss) per common share	$	(0.45	)	$	0.07	$	(0.05	)
Antidilutive common stock equivalents excluded:
Common stock options and restricted stock		68			205		—
Common stock warrants		233			182		—

Note 9 – Employee Benefit Plans

Effective May 1, 2004, the Company adopted a tax-qualified employee savings plan (the Savings Plan). Pursuant to section 401(k) of the Code, eligible employees are able to make deferral contributions, subject to limitations under applicable law. Participant’s accounts are self-directed and the Company bears all costs. The Savings Plan provides for an up to 4% Company match and Company contributions vest 100% at the time of contribution. The Company expense under this plan was $57,000 in each of the years ended December 31, 2005 and 2004.

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Note 10 – Fair Value of Financial Instruments

The following table presents the carrying amounts and estimated fair values of the Company’s financial instruments at December 31, 2005 and 2004:

	2005				2004
Description (in thousands)	Carrying Value		Fair Value		Carrying Value		Fair Value
Assets:
Mortgage-backed securities, available for sale	$	942,900	$	942,900	$	614,154	$	614,154
Securitized hybrid adjustable rate mortgages		160,602		154,615		201,381		196,516
Hybrid adjustable rate mortgages		—		—		1,286		1,243
Fixed rate mortgages		—		—		1,045		1,045
Commercial mortgages		29,347		22,921		44,522		43,422
Interest rate swap agreements		12,246		12,246		2,716		2,716
Liabilities:
Whole loan financing facility	$	—	$	—	$	9,718	$	9,718
Reverse repurchase agreements		1,031,831		1,031,831		761,205		761,205
Interest rate swap agreements		137		137		944		944

The fair value of financial instruments is based on market prices where available. For certain securities where quoted prices are not available, management uses market information for securities with similar characteristics to determine market value. Due to the short-term nature or the floating interest-rate component of balance sheet items not presented in the above table, the fair value at December 31, 2005 and December 31, 2004 approximates cost.

Note 11 – Severance Costs

The Company recorded $841,000 in severance expense and related benefits cost during 2005 related to the departure of three executive-level employees. At December 31, 2005, the remaining liability related to the severance cost was $182,000, which is expected to be paid during the first quarter of 2006.

During the year ended December 31, 2004, the Company recorded $365,000 in severance related costs. Substantially all of those costs were paid during 2005.

Note 12 – Income Taxes

The Company elected to be taxed as a REIT commencing with the tax year ended December 31, 2004. In order to maintain qualification as a REIT, the Company is required to distribute dividends to the stockholders in an amount at least equal to 90% of REIT taxable income. For the year ended December 31, 2005, the Company declared and paid dividends of $4.6 million, or $0.44 per common share, of which $3.2 million was applicable to the 90% dividend provision for the 2005 tax year. For the year ended December 31, 2004, the Company declared and paid dividends of $680,000, or $0.065 per common share. All distributions during 2005 and 2004 were classified as ordinary income to stockholders for income tax purposes.

The schedule below is provided to reconcile GAAP net income to estimated taxable income for the years ended December 31, 2005 and 2004:

(in thousands)	2005			2004
GAAP net income	$	(4,737	)	$	644
Provision for loan losses		7,042			1,333
Charge-off against provision		(1,054	)		—
Capital loss carryover		1,065			—
Non-accrued interest income on commercial loans		1,407			—
Stock option deduction		(102	)		501
Other		(324	)		257
Estimated taxable income	$	3,297		$	2,735

There was no tax provision included for the years ended December 31, 2005 and 2004, as the Company satisfied the REIT taxation requirements for each of those years.

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Note 13 – Commitments and Contingencies

The Company has a noncancelable lease for office space, which commenced in March 2004 and expires in June 2009. The future minimum lease payments for the next five years are $71,000 for 2006, $73,000 for 2007, $76,000 for 2008, and $39,000 for 2009. There are no commitments beyond 2009.

The Company incurred rent expense, including common area maintenance, taxes and insurance, related to office space of $124,000 and $93,000 in 2005 and 2004, respectively.

The Company enters into agreements with various service and technology providers in the ordinary course of business. The terms of these agreements range from one to three years. At December 31, 2005, only one such agreement was considered material. The commitments under this agreement are $502,000 for 2006 and $126,000 for 2007.

We are a party to various legal proceedings which arise in the ordinary course of our business. We are not currently involved in any litigation nor to our knowledge, is any litigation threatened against us, the outcome of which would, in our judgment based on information currently available to us, have a material adverse effect on our financial position or results of operations.

Note 14 – Related Parties

On October 15, 2003, the Company entered into a strategic relationship with Sunset Mortgage Company, L.P. and two of its affiliates, Sunset Direct LLC and Sunset Commercial Group LLC (collectively Sunset Mortgage). The arrangement provides the Company the right of first offer on the purchase of all residential mortgage loans and commercial mortgage bridge loans originated by these companies. The agreement is for a term of three years and automatically renews for one year terms unless either party gives notice of non-renewal at least 30 days prior to the expiration of the applicable renewal term. James Porter, the Chairman and Chief Executive Officer of Sunset Mortgage, was the founding member of the Company’s advisory board, and received 20,000 shares of restricted stock for a total purchase price of $20 (par value) prior to the initial public offering.

During 2005, the Company entered into one commercial bridge loan which was directed to the Company from Sunset Mortgage. The Company did not directly compensate Sunset Mortgage for these loans. However, Sunset Mortgage received fees equal to 2% of the loan amount at closing directly from the borrower. During 2005, the Company incurred expense for fees related to Mr. Porter’s advisory role of $15,000. The advisory position was terminated in October 2005. Additionally, in 2005, $47,000 was expensed related to the 2003 restricted stock grant.

During 2004, the Company entered into two commercial bridge loans which were directed to the Company from Sunset Mortgage. The Company did not directly compensate Sunset Mortgage for these loans. However, Sunset Mortgage received fees equal to 2% of the loan amounts at closing directly from the borrower. During 2004, the Company incurred expense for fees related to Mr. Porter’s advisory role of $20,000. Additionally, $196,000 was expensed related to the 2003 restricted stock grant.

Note 15 – Subsequent Events

Subsequent to December 31, 2005, the Company received principal payments of $671,000 on the commercial loan for the Florida retail development property, and $2.0 million (net of interest advances) on the commercial loan for the North Carolina resort development property. Outstanding principal balances on these two loans subsequent to these payments were $2.0 million and $14.5 million, respectively.

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Note 16 – Summarized Quarterly Results (unaudited)

The selected quarterly data is provided for the years ended December 31, 2005 and 2004. Because the Company did not have any significant operations prior to its initial public offering in March 2004, quarterly data for 2003 has been omitted.

	2005
(in thousands except per share data)	Quarter Four			Quarter Three			Quarter Two			Quarter One
Interest and fee income	$	12,438		$	11,945		$	11,802		$	10,171
Interest expense		9,877			9,181			9,031			6,699
Net interest income		2,561			2,764			2,771			3,472
Provision for loan losses		60			1,184			5,722			76
Net gains on sale of securities		(1	)		—			(8	)		—
Net loss on sale of loans		59			—			—			—
Operating expenses		2,150			2,119			2,150			1,953
Severance		(12	)		853			—			—
Net income (loss)	$	305		$	(1,392	)	$	(5,093	)	$	1,443
Basic earnings per share	$	0.03		$	(0.13	)	$	(0.49	)	$	0.14
Diluted earnings per share	$	0.03		$	(0.13	)	$	(0.49	)	$	0.14
	2004
(in thousands except per share data)	Quarter Four			Quarter Three			Quarter Two			Quarter One
Interest and fee income	$	9,142		$	5,989		$	3,058		$	44
Interest expense		5,347			3,118			1,345			32
Net interest income		3,795			2,871			1,713			12
Provision for loan losses		1,184			85			49			15
Net gains on sale of securities		(331	)		(403	)		—			—
Net loss on sale of loans		48			—			—			—
Operating expenses		1,946			1,756			1,493			1,540
Severance		365			—			—			—
Net income (loss)	$	583		$	1,433		$	171		$	(1,543	)
Basic earnings per share	$	0.06		$	0.14		$	0.02		$	(0.73	)
Diluted earnings per share	$	0.05		$	0.13		$	—		$	(0.73	)

F - 23

Item 15(a)(2). Schedules II and IV

Schedule II

Sunset Financial Resources, Inc.

Valuation and Qualifying Accounts

(in thousands)	Securitized and Commercial Mortgages
Balance at October 6, 2003	$	—
Provision		—
Charge-offs		—
Balance at December 31, 2003		—
Provision		1,333
Charge-offs		—
Balance at December 31, 2004		1,333
Provision		7,042
Charge-offs		(1,054	)
Balance at December 31, 2005	$	7,321

F - 24

Schedule IV

Sunset Financial Resources, Inc.

Mortgage Loans on Real Estate

(dollars in thousands)

Description	Interest rate		Final maturity date	Periodic payment terms	Prior liens		Face amount of mortgages		Carrying amount of mortgages			Principal amount of loans subject to delinquent principal or interest
Securitized loans
Certificate SF-1 securitized 3 year ARM loans	3.72	%	2034	Monthly	$	—	$	4,893	$	5,042		$	—
Certificate SF-2 securitized 5 year ARM loans	4.63	%	2034	Monthly		—		53,550		55,042			221
Certificate SF-3 securitized 7 year ARM loans	4.60	%	2034	Monthly		—		92,392		93,716			379
Certificates SB-1 through SB-6 subordinated tranches	4.57	%	2034	Monthly		—		7,475		6,802			—
Commercial mortgage bridge loans
Resort development	13.00	%	2006	Interest monthly		—		16,647		16,300			—
Cemetery/funeral home	10.00	%	2004	Interest monthly		—		5,658		5,658			5,658
Multi-sports facility	12.00	%	2005	Interest monthly		—		4,700		4,672			4,700
Retail development	11.00	%	2006	Interest monthly		—		2,739		2,717			—
Total							$	188,054	$	189,949		$	10,958
Balance at beginning of period									$	248,234
Additions during period
New mortgage loans										14,478
Deductions during period
Collections of principal										(70,311	)
Cost of mortgages sold										(2,081	)
Amortization of premium										(371	)
Balance at close of period									$	189,949

F - 25

EX-21.1

Exhibit 21.1

LIST OF SUBSIDIARIES

SUNSET FINANCIAL RESOURCES, INC.

Subsidiaries of the Registrant, Sunset Financial Resources, Inc., a Maryland Corporation

As of December 31, 2005

SFR Subsidiary, Inc., a Delaware corporation

Sunset Investment Vehicle, Inc., a Delaware corporation

Sunset Financial Statutory Trust I, a Delaware statutory trust

EX-31.1

Exhibit 31.1

CERTIFICATIONS

I, George O. Deehan, certify that:

1. I have reviewed this Annual Report on Form 10-K of Sunset Financial Resources, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 14, 2006

/s/ GEORGE O. DEEHAN

President and Chief Executive Officer

(Principal Executive Officer)

EX-31.2

Exhibit 31.2

CERTIFICATIONS

I, Stacy M. Riffe, certify that:

1. I have reviewed this Annual Report on Form 10-K of Sunset Financial Resources, Inc.;

2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4. The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

(c) Evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5. The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Date: March 14, 2006

/s/ STACY M. RIFFE

Chief Financial Officer

(Principal Financial and Accounting Officer)

EX-32.1

Exhibit 32.1

SUNSET FINANCIAL RESOURCES, INC.

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of Sunset Financial Resources, Inc. (the “Company”), on Form 10-K for the period ended December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, George O. Deehan, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ GEORGE O. DEEHAN

George O. Deehan

President and Chief Executive Officer

(Principal Executive Officer)

March 14, 2006

EX-32.2

Exhibit 32.2

SUNSET FINANCIAL RESOURCES, INC.

CERTIFICATION PURSUANT TO

18 U.S.C. SECTION 1350,

AS ADOPTED PURSUANT TO

SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Annual Report of Sunset Financial Resources, Inc. (the “Company”), on Form 10-K for the period ended December 31, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Stacy M. Riffe, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:

(1) The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

/s/ STACY M. RIFFE

Stacy M. Riffe

Chief Financial Officer

(Principal Financial and Accounting Officer)

March 14, 2006