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 September 30, 2004

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

For the transition period from to

Commission File number 1-7184

B. F. SAUL REAL ESTATE INVESTMENT TRUST

(Exact name of registrant as specified in its charter)


Maryland		52-6053341
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)


7501 Wisconsin Avenue, Bethesda, Maryland		20814
(Address of principal executive offices)		(Zip Code)

Registrant’s telephone number, including area code: (301) 986-6000

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


Title of each class		Name of each exchange on which registered
N/A		N/A

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

N/A

(Title of class)

Indicate by check mark whether 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 requires to file such reports), and (2) has been subject to such filing requirement 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 or any amendments to this Form 10-K. x

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

There were no Common Shares of Beneficial Interest held by non-affiliates of the registrant as of December 17, 2004.

The number of Common Shares of Beneficial Interest, $1 Par Value, outstanding as of December 17, 2004 was 4,807,510.

TABLE OF CONTENTS

PART I



ITEM 1. BUSINESS
Overview		3
Real Estate		3
Banking		3
Federal Taxation		34

ITEM 2. PROPERTIES		35
Real Estate		35
Banking		35

ITEM 3. LEGAL PROCEEDINGS		35

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS		35

PART II

ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASE OF EQUITY SECURITIES		36

ITEM 6. SELECTED FINANCIAL DATA		36

ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS		39

Financial Condition		40
Real Estate		40
Banking		41

Liquidity and Capital Resources		53
Real Estate		53
Banking		55

Results of Operations		57
Fiscal 2004 Compared to Fiscal 2003		58
Real Estate		58
Banking		59

Fiscal 2003 Compared to Fiscal 2002		64
Real Estate		64
Banking		65

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK		67

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA		67

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE		120

ITEM 9A. CONTROLS AND PROCEDURES		120

PART III

ITEM 10. TRUSTEES AND EXECUTIVES OFFICERS OF THE TRUST		120

Executive Officers of the Trust Who Are Not Directors		121
Committees of the Board of Trustees		121

ITEM 11. EXECUTIVE COMPENSATION		122

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS		125

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS		125

ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES		127

PART IV

ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES		128

PART I

ITEM 1.

BUSINESS

OVERVIEW

B.F. Saul Real Estate Investment Trust operates as a Maryland real estate investment trust. The Real Estate Trust began its operations in 1964 as an unincorporated business trust organized under a Declaration of Trust governed by District of Columbia law. The Real Estate Trust terminated its status as a qualified real estate investment trust for federal income tax purposes in 1978 and is now taxable as a corporation. On October 24, 1988, the Real Estate Trust amended its Declaration of Trust to qualify as a statutory real estate investment trust under Maryland law.

The principal business activities of the Trust are the ownership of 80% of the outstanding common stock of Chevy Chase Bank, F.S.B. (“Chevy Chase” or the “Bank”), whose assets accounted for 97% of the Trust’s consolidated assets at September 30, 2004, and the ownership and development of income-producing properties. By virtue of its ownership of a majority interest in Chevy Chase, the Trust is a savings and loan holding company and subject to regulation, examination and supervision by the Office of Thrift Supervision, also know as “OTS.” See “Banking—Holding Company Regulation.”

The Trust recorded net income of $76.7 million in the fiscal year ended September 30, 2004, compared to a net income of $45.9 million in the fiscal year ended September 30, 2003.

The Trust has prepared its financial statements and other disclosures on a fully consolidated basis. The term “Trust” used in the text and the financial statements included herein refers to the combined entity, which includes B.F. Saul Real Estate Investment Trust and its subsidiaries, including Chevy Chase and its subsidiaries. The term “Real Estate Trust” refers to B.F. Saul Real Estate Investment Trust and its subsidiaries, excluding Chevy Chase and its subsidiaries. The operations conducted by the Real Estate Trust are designated as “Real Estate,” while the business conducted by Chevy Chase and its subsidiaries is identified as “Banking.”

REAL ESTATE

The Real Estate Trust’s long-term objectives are to increase cash flow from operations and to maximize capital appreciation of its real estate. The properties owned by the Real Estate Trust are located predominantly in the mid-Atlantic and Southeastern regions of the United States and consist principally of hotels, office projects, and undeveloped land parcels.

The Real Estate Trust has significant relationships with B.F. Saul Company (“Saul Company”) and two of its wholly owned subsidiaries, B.F. Saul Advisory Company L.L.C., referred to in this report as the “Advisor,” and B.F. Saul Property Company, (“Saul Property Co.”). Saul Company, founded in 1892, specializes in commercial property management and leasing, hotel management, development and construction management, acquisitions, sales and financing of real estate property and insurance. Certain officers and trustees of the Real Estate Trust are also officers and/or directors of Saul Company, the Advisor and Saul Property Co. Other than uncompensated officers, the Real Estate Trust has no employees. See “Item 13. Certain Relationships and Related Transactions — Management Personnel.”

The Advisor acts as the Real Estate Trust’s investment advisor and manages the financial, accounting, legal and administrative affairs of the Real Estate Trust. Saul Property Co. acts as leasing and management agent for the income-producing properties owned by the Real Estate Trust, and plans and oversees the development of new properties and the expansion and renovation of existing properties.

BANKING

Chevy Chase Bank, F.S.B. is a federally chartered and federally insured stock savings bank which at September 30, 2004 was conducting business from 228 full-service branch offices, including 54 grocery store banking centers, and 859 automated teller machines in Maryland, Delaware, Virginia and the District of Columbia. The Bank has its home office in McLean, Virginia and its executive offices in Bethesda, Maryland, both suburban communities of Washington, DC. The Bank either directly or through a wholly owned subsidiary also maintains a commercial loan production office located in Baltimore, Maryland and six mortgage loan production offices in the mid-Atlantic region. In addition, the Bank utilizes third party originators in order to supplement its direct origination of loans. At September 30, 2004, the Bank had total assets of $13.3 billion, total deposits of $8.9 billion and total stockholders’ equity of $711.9 million. Based on total assets at September 30, 2004, Chevy Chase is the largest full-service bank headquartered in the Washington, DC metropolitan area.

Chevy Chase is a consumer oriented, full-service banking institution principally engaged in the business of attracting deposits from the public and using those deposits, together with borrowings and other funds, to make loans secured by real estate, primarily residential mortgage loans, and other consumer loans. The Bank also has an active commercial lending program. The Bank’s principal deposit and retail lending markets are located in the Washington, DC metropolitan area. The Bank’s wholesale activities include the acquisition of loans through third party originators. As a complement to its basic deposit and lending activities, the Bank provides related financial services to its customers, including securities brokerage and insurance products offered through its subsidiaries. In addition, the Bank offers a variety of investment products and provides fiduciary services to a primarily institutional customer base through its subsidiary, ASB Capital Management, Inc., and to a primarily high net worth customer base through another subsidiary, Chevy Chase Trust Company.

The Bank seeks to capitalize on its status as the largest full-service bank headquartered in the Washington, DC metropolitan area by expanding its community banking operations. Accordingly, the Bank continues to build its branch and alternative delivery systems, to maintain and expand its mortgage banking operations, and to offer a broad range of consumer products, including home equity loans and lines of credit and other consumer loans. In addition, the Bank continues to expand its commercial banking program, with an emphasis on businesses operating in the Washington, DC metropolitan area. The Bank also continues to further develop the fee-based services it provides to customers, including securities brokerage, trust, asset management and insurance products offered through its subsidiaries.

Chevy Chase recorded operating income of $231.2 million for the year ended September 30, 2004, compared to operating income of $146.2 million for the year ended September 30, 2003. At September 30, 2004, the Bank’s tangible, core, tier 1 risk-based and total risk-based regulatory capital ratios were 6.09%, 6.09%, 8.61% and 10.91%, respectively. The Bank’s regulatory capital ratios exceeded the requirements under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, also known as “FIRREA,” as well as the standards established for “well-capitalized” institutions under the prompt corrective action regulations established pursuant to the Federal Deposit Insurance Corporation Improvement Act of 1991, also known as “FDICIA.”

In October 2003, the Bank issued $125.0 million of its 8% Noncumulative Perpetual Preferred Stock, Series C (the “8% Preferred Stock”) and used the proceeds to redeem all of its 13% Noncumulative Perpetual Preferred Stock, Series A (the “13% Preferred Stock”) on October 31, 2003. On December 2, 2003, the Bank issued $175.0 million of its 6 7/8% subordinated debentures due 2013 (the “2003 Debentures”). The net proceeds of that offering, along with short-term borrowings, were used to redeem all of the Bank’s subordinated debentures due 2005 and 2008.

Chevy Chase is subject to comprehensive regulation, examination and supervision by the Office of Thrift Supervision (the “OTS”) and, to a lesser extent, by the Federal Deposit Insurance Corporation (the “FDIC”). The Bank’s deposit accounts are fully insured up to $100,000 per insured depositor by the FDIC.

REAL ESTATE

Real Estate Investments

The Real Estate Trust’s investment portfolio consists principally of seasoned operating properties. The Real Estate Trust expects to hold its properties as long-term investments and has no maximum period for retention of any investment. It may acquire additional income-producing properties, expand and improve its properties, or sell such properties, as and when circumstances warrant. The Real Estate Trust also may participate with other entities in property ownership, through joint ventures or other types of co-ownership.

The following tables set forth, at and for the periods indicated, certain information regarding the properties in the Real Estate Trust’s investment portfolio at September 30, 2004.

Hotels


			Average Occupancy ⁽²⁾						Average Room Rate
			Year Ended September 30,						Year Ended September 30,
Location	Name	Rooms ⁽¹⁾	2004		2003		2002		2004		2003		2002

COLORADO

Pueblo	Pueblo Holiday Inn ⁽³⁾	191	50	%	46	%	51	%	$	58.12	$	56.61	$	57.39

FLORIDA

Boca Raton	Boca Raton SpringHill Suites	146	64	%	55	%	59	%	$	79.78	$	73.84	$	71.72

Boca Raton	Boca Raton TownePlace Suites	91	73	%	67	%	74	%	$	68.70	$	64.61	$	69.43

Ft. Lauderdale	Ft. Lauderdale TownePlace Suites	95	83	%	71	%	75	%	$	65.20	$	64.69	$	64.23

MARYLAND

Gaithersburg	Gaithersburg Holiday Inn	300	63	%	58	%	57	%	$	82.91	$	84.39	$	88.94

Gaithersburg	Gaithersburg TownePlace Suites	91	78	%	71	%	76	%	$	77.63	$	71.82	$	69.44

MICHIGAN

Auburn Hills	Auburn Hills Holiday Inn Select	190	63	%	64	%	65	%	$	99.54	$	98.70	$	101.24

NEW YORK

Rochester	Rochester Airport Holiday Inn	279	62	%	66	%	59	%	$	71.66	$	70.46	$	67.80

OHIO

Cincinnati	Cincinnati Holiday Inn	275	51	%	54	%	55	%	$	71.05	$	68.66	$	67.66

VIRGINIA

Arlington	National Airport Crowne Plaza	308	65	%	63	%	62	%	$	129.50	$	124.04	$	116.20

Arlington	National Airport Holiday Inn	280	70	%	60	%	57	%	$	95.25	$	90.50	$	91.78

Herndon	Herndon Holiday Inn Express	115	71	%	61	%	55	%	$	89.69	$	81.08	$	84.70

McLean	Tysons Corner Courtyard	229	74	%	67	%	64	%	$	135.36	$	127.57	$	132.69

McLean	Tysons Corner Holiday Inn ⁽⁴⁾	316	60	%	54	%	63	%	$	106.07	$	91.53	$	95.66

Sterling	Dulles Airport Hampton Inn	123	71	%	62	%	54	%	$	87.90	$	76.26	$	81.71

Sterling	Dulles Airport Holiday Inn	297	70	%	63	%	60	%	$	89.27	$	79.36	$	82.60

Sterling	Dulles Airport TownePlace Suites	95	87	%	80	%	74	%	$	74.42	$	70.06	$	71.36

Sterling	Dulles Town Center Hampton Inn	152	78	%	69	%	62	%	$	90.48	$	80.06	$	80.36


		3,573	66	%	61	%	61	%	$	91.67	$	85.93	$	86.82

⁽¹⁾	Available rooms as of September 30, 2004.

⁽²⁾	Average occupancy is calculated by dividing the rooms occupied by the rooms available.

⁽³⁾	Asset held for sale as of September 30, 2004.

⁽⁴⁾	Under renovation during fiscal 2003/2004, completed July 1, 2004.

Office and Industrial


			Leasing Percentages						Expiring Leases ⁽¹⁾
			September 30,						Year Ending September 30,
Location	Name	Gross Leasable Area⁽¹⁾	2004		2003		2002		2005		2006

FLORIDA

Fort Lauderdale	Commerce Center—Phase II	61,149	82	%	85	%	92	%	11,488		9,408

GEORGIA

Atlanta	900 Circle 75 Parkway	345,502	82	%	78	%	82	%	68,236		56,726

Atlanta	1000 Circle 75 Parkway	89,412	84	%	88	%	97	%	22,087		3,765

Atlanta	1100 Circle 75 Parkway	269,049	91	%	90	%	95	%	68,927		56,379

MARYLAND

Laurel	Sweitzer Lane	150,020	100	%	100	%	100	%	NONE		NONE

VIRGINIA

McLean	8201 Greensboro Drive	360,854	93	%	75	%	81	%	47,098		20,066

McLean	Tysons Park Place	247,581	91	%	97	%	86	%	9,253		24,803

Sterling	Dulles North	59,886	100	%	100	%	100	%	NONE		NONE

Sterling	Dulles North Two	79,210	100	%	100	%	100	%	NONE		9,991

Sterling	Dulles North Four ⁽²⁾	100,207	100	%	100	%	100	%	NONE		NONE

Sterling	Dulles North Five	80,391	100	%	100	%	100	%	NONE		NONE

Sterling	Dulles North Six	53,517	100	%	100	%	100	%	NONE		NONE

Sterling	Loudoun Tech I ⁽³⁾	81,238	47	%	0	%	0	%	NONE		NONE


	Totals	1,978,016	90	%	85	%	86	%	227,089	⁽⁴⁾	181,138	⁽⁴⁾

⁽¹⁾	Square feet

⁽²⁾	Operational April 1, 2002.

⁽³⁾	Operational December 14, 2001.

⁽⁴⁾	Represents 11.5% and 9.2%, respectively, of the Real Estate Trust’s office and industrial portfolio in terms of square footage as of September 30, 2004.

Land Parcels


Location	Name	Acres	Zoning
FLORIDA Boca Raton Fort Lauderdale	Arvida Park of Commerce Commerce Center	6.5 1.6	Mixed Use Office and Warehouse
GEORGIA Atlanta	Circle 75	124.9	Office and Industrial
KANSAS Overland Park	Overland Park	161.9	Residential, Office and Retail
MICHIGAN Auburn Hills	Auburn Hills Holiday Inn	0.5	Commercial
NEW YORK Rochester	Rochester Airport Holiday Inn	2.9	Commercial
VIRGINIA McLean Sterling Sterling Sterling	Park Place II Cedar Green Church Road Sterling Boulevard	8.1 10.7 32.0 31.9	Office and Industrial Commercial Office and Industrial Industrial

	Total	381.0

Other Real Estate Investments

PURCHASE-LEASEBACK PROPERTIES⁽¹⁾


APARTMENTS

Location	Name	Number of Units
LOUISIANA
Metairie	Chateau Dijon	336
TENNESSEE
Knoxville	Country Club	232

	Total	568


SHOPPING CENTERS

Location	Name	Gross Leasable Area⁽²⁾
GEORGIA
Warner Robbins	Houston Mall	264,000

Other Real Estate


Location	Name	Gross Leasable Area⁽²⁾
GEORGIA
Atlanta	Old National	160,000

⁽¹⁾

The Real Estate Trust owns the land under certain income-producing properties and receives fixed ground rent, which is subject to periodic escalation, from the owners of the improvements. In certain instances, the Real Estate Trust also receives percentage rent based upon the income generated by the properties.

⁽²⁾	Square feet.

Investment in Saul Holdings Limited Partnership

On August 26, 1993, the Real Estate Trust consummated a series of transactions in which it transferred 22 shopping center properties and one of its office properties together with the debt associated with such properties, to a newly organized limited partnership, Saul Holdings Limited Partnership (“Saul Holdings Partnership”), and one of two newly organized subsidiary limited partnerships of Saul Holdings Partnership. In exchange for the transferred properties, the Real Estate Trust received securities representing a 21.5% limited partnership interest in Saul Holdings Partnership. Entities under common control with the Trust received limited partnership interests collectively representing a 5.5% partnership interest in Saul Holdings Partnership in exchange for the transfer of property management functions and certain other properties to Saul Holdings Partnership and its subsidiaries. Saul Centers, Inc., a newly organized, publicly held real estate investment trust (“Saul Centers”), received a 73.0% general partnership interest in Saul Holdings Partnership in exchange for the contribution of approximately $220.7 million to Saul Holdings Partnership. Affiliates of the Trust received certain cash distributions from Saul Holdings Partnership and purchased 4.0% of the common stock of Saul Centers in a private offering consummated concurrently with the initial public offering of such common stock. Certain officers and trustees of the Trust are also officers and/or directors of Saul Centers. See “Item 13. Certain Relationships and Related Transactions — Management Personnel.”

As of September 30, 2004 the Real Estate Trust owns, directly and through one of its wholly owned subsidiaries, 4,184,000 units of limited partnership interests in Saul Holdings Partnership, representing a 19.5% limited partnership interest. The Real Estate Trust owns rights enabling it to convert its limited partnership interests in Saul Holdings Partnership into shares of Saul Centers’ common stock on the basis of one share of Saul Centers’ common stock for each partnership unit. However, under the terms of the limited partnership agreement of Saul Holdings Partnership, at the current time, the units may not be converted into shares of Saul Centers’ common stock because the conversion would cause the Real Estate Trust and certain affiliates of the Trust to beneficially own collectively greater than 29.9% of the value of the outstanding equity securities of Saul Centers.

The shares of Saul Centers’ common stock are listed on the New York Stock Exchange under trading symbol “BFS.”

Saul Centers operates as a real estate investment trust for federal income tax purposes under Sections 856 through 860 of the Internal Revenue Code. Under the Internal Revenue Code, REITs are subject to numerous organizational and operational requirements. If Saul Centers continues to qualify as a REIT, it generally will not be subject to federal income tax, provided it makes certain distributions to its stockholders

and meets certain organizational and other requirements. Saul Centers has made and has announced that it intends to continue to make regular quarterly dividend distributions to its stockholders.

Allocations and Distributions of Saul Holdings Partnership. The net income or net loss of Saul Holdings Partnership for tax purposes generally will be allocated to Saul Centers and the limited partners in accordance with their percentage interests, subject to compliance with the applicable provisions of the Internal Revenue Code and the regulations promulgated thereunder. Net cash flow after reserves of Saul Holdings Partnership and after reimbursement of specified expenses will be distributed quarterly to the partners in proportion to their respective partnership interests.

Competition

As an owner of, or investor in, commercial real estate properties, the Real Estate Trust is subject to competition from a variety of other owners of similar properties in connection with their sale, lease or other disposition and use. Management believes that success in such competition is dependent upon the geographic location of the property, the performance of property managers, the amount of new construction in the area and the maintenance and appearance of the property. Additional competitive factors with respect to commercial and industrial properties are the ease of access to the property, the adequacy of related facilities such as parking, and the ability to provide rent concessions and additional tenant improvements while keeping rents competitive. Management believes that general economic circumstances and trends and new properties in the vicinity of each of the Real Estate Trust’s properties also will be competitive factors.

Environmental Matters

The Real Estate Trust’s properties are subject to various laws and regulations relating to environmental and pollution controls. The Real Estate Trust requires an environmental study to be performed with respect to a property that may be subject to possible environmental hazards prior to its acquisition to ascertain that there are no material environmental hazards associated with such property. Although the effect upon the Real Estate Trust of the application of environmental and pollution laws and regulations cannot be predicted with certainty, management believes that their application either prospectively or retrospectively will not have a material adverse effect on the Real Estate Trust’s property operations.

Holding Company Regulation

The Trust, the Saul Company, Chevy Chase Property Company, referred to in this report as “CCPC,” and CCPC’s wholly-owned subsidiary, Westminster Investing Corporation, collectively referred to in this report as the “Holding Companies,” are registered as “savings and loan holding companies” because of their direct or indirect ownership interests in the Bank, and are subject to regulation, examination and supervision by the OTS. The Bank is prohibited from making or guaranteeing loans or advances to or for the benefit of the Holding Companies or other affiliates engaged in activities beyond those permissible for bank holding companies and from investing in the securities of the Holding Companies or other affiliates. Transactions between the Bank and the Holding Companies must be on terms substantially the same, or at least as favorable to the Bank, as those that would be available to non-affiliates.

Recent revisions to the OTS’s Regulatory Handbook for Holding Companies suggest a more active role for the OTS in the direct regulation of thrift holding companies such as the Holding Companies. The current handbook places a greater emphasis on reviewing the adequacy of the Holding Companies’ capital, their level of debt, and their ability to fund outstanding debt obligations, and suggests that particular scrutiny will be given to holding companies that, like the Holding Companies, are engaged in real estate activities.

The Holding Companies must obtain OTS approval before acquiring any federally insured savings institution or any savings and loan holding company. The status of the Holding Companies as “unitary thrift holding companies” and the activities in which the Holding Companies may engage have been grandfathered under the Gramm-Leach-Bliley Act of 1999 (the “GLB Act”). As grandfathered unitary thrift holding companies, the Holding Companies are virtually unrestricted in the types of business activities in which they may engage provided the Bank continues to meet the QTL test. See “Banking—Qualified Thrift Lender (“QTL”) Test.” The GLB Act prohibits the sale of grandfathered unitary thrift holding companies such as the Holding Companies (together with their thrift subsidiaries) or their thrift subsidiaries alone to commercial companies. Corporate reorganizations are expressly permitted.

If the Holding Companies were to acquire one or more federally insured institutions and operate them as separate subsidiaries rather than merging them into the bank, the Holding Companies would become “multiple” savings and loan holding companies. As multiple savings and loan holding companies, the Holding Companies would be subject to limitations on the types of business activities in which they would be permitted to engage, unless the additional thrifts were troubled institutions acquired pursuant to certain emergency acquisition provisions and all subsidiary thrifts met the QTL test. The Holding Companies may acquire and operate additional savings institution subsidiaries outside of Maryland and Virginia only if the laws of the target institution’s state specifically permit such acquisitions or if the acquisitions are made pursuant to emergency acquisition provisions.

The Trust and the Saul Company entered into an agreement with OTS’s predecessor, the Federal Savings and Loan Insurance Corporation, to maintain the bank’s regulatory capital at the required levels, and, if necessary, to infuse additional capital to enable the bank to meet those requirements. Since the execution of this agreement, the OTS has changed its policy and no longer requires such agreements from companies acquiring thrift institutions. In addition, the regulatory capital requirements applicable to the bank have changed significantly as a result of FIRREA. The OTS has stated that capital maintenance agreements entered into prior to the modification of OTS policy and the enactment of FIRREA were not affected by those changes. The Trust and the Saul Company have not sought to modify the existing agreement.

To the extent the bank is unable to meet regulatory capital requirements in the future, the OTS could seek to enforce the obligations of the Trust and the Saul Company under the agreement.

If the bank were to become “undercapitalized” under the prompt corrective action regulations, it would be required to file a capital restoration plan with the OTS setting forth, among other things, the steps the bank would take to become “adequately capitalized.” The OTS could not accept the plan unless the Holding Companies guaranteed in writing the bank’s compliance with that plan. The aggregate liability of the Holding Companies under such a commitment would be limited to the lesser of:

•

an amount equal to 5.0% of the bank’s total assets at the time the bank became “undercapitalized,” and

•

the amount necessary to bring the bank into compliance with all applicable capital standards as of the time the bank fails to comply with its capital plan.

If the Holding Companies refused to provide the guarantee, the bank would be subject to the more restrictive supervisory actions applicable to “significantly undercapitalized” institutions. See “Banking—Prompt Corrective Action.”

BANKING

Regulation

Federal Home Loan Bank System. The Bank is a member of the Federal Home Loan Bank (the “FHLB”) of Atlanta, which is one of 12 FHLBs administered by the Federal Housing Finance Board, an independent agency within the executive branch of the federal government. The FHLBs serve as central credit facilities for their members. Their primary credit mission is to facilitate residential mortgage lending and support community and economic development activity in rural and urban communities. From time to time, the Bank obtains advances from the FHLB of Atlanta. At September 30, 2004, the Bank had outstanding advances of $2.7 billion. See Note 14 to the Consolidated Financial Statements in this report and “Deposits and Other Sources of Funds – Borrowings.”

As a member of the FHLB of Atlanta, the Bank is required to acquire and hold shares of capital stock in that bank in an amount equal to the greater of:

•

1.0% of mortgage-related assets;

•

$500; or

•

5.0% of outstanding advances.

The Bank had an investment of $139.3 million in the capital stock of the FHLB of Atlanta at September 30, 2004. The Bank earned dividends on that stock of $4.9 million and $4.3 million during the years ended September 30, 2004 and 2003, respectively. Since 1999, membership in the FHLB has been voluntary rather than mandatory for federal thrifts like the Bank. Because membership is required to obtain advances from the FHLB and the Bank continues to rely on FHLB advances as an important source of funds, the Bank currently intends to retain its voluntary membership in the FHLB of Atlanta.

Liquidity Requirements. The Bank is required to maintain sufficient liquidity to ensure its safe and sound operation. Failure to meet this requirement could subject the Bank to monetary penalties imposed by the OTS. Management believes that the Bank’s ratio of cash and cash equivalents and other liquid assets to deposits and short-term borrowings of 4.60% at September 30, 2004 was sufficient to ensure the Bank’s safe and sound operation.

Deposit Insurance Premiums. Under FDIC insurance regulations, the Bank is required to pay premiums to the Savings Association Insurance Fund (“SAIF”) for insurance of its deposit accounts. The FDIC uses a risk-based premium system in which an institution pays premiums for deposit insurance on its insured deposits based on supervisory evaluation and on the institution’s capital category under the OTS’s prompt corrective action regulations. See “Prompt Corrective Action.”

Although the FDIC insures commercial banks as well as thrifts, the insurance funds for commercial banks and thrifts have been segregated into the Bank Insurance Fund (the “BIF”) and the SAIF. The FDIC is required to maintain the reserve levels of both the BIF and SAIF at 1.25% of insured deposits. If the reserve level of an insurance fund falls below 1.25% the FDIC is required by law to impose a premium of at least 23 basis points on all institutions whose accounts are insured by that fund until its ratio is restored above the 1.25% minimum. The BIF’s reserve ratio was 1.32% and the SAIF’s reserve ratio was 1.37% as of September 30, 2004.

As a result of the Bank’s assumption of deposits from a small commercial bank in August, 2003, a small amount of the Bank’s deposits (less than 1%) are insured by the BIF.

Commercial banks and thrifts are required to share in the payment of interest due on Financing Corporation (“FICO”) bonds used to provide liquidity to the savings and loan industry in the 1980s. Annual FICO assessments added to deposit insurance premiums equaled 1.54 basis points for the first semi-annual period of 2004 and 1.47 basis points for the second semi-annual period of 2004.

Deposit insurance may be terminated by the FDIC, after notice and a 30-day corrective period, if the FDIC finds that the Bank has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or condition imposed by the FDIC. The 30-day period may be eliminated by the FDIC with the approval of the OTS.

Congress has recently been considering legislation that would reform the deposit insurance system by, among other things, (i) increasing FDIC insurance coverage from $100,000 to $130,000 per account (with certain retirement accounts generally receiving increased coverage) and indexing future coverage to accommodate inflation, (ii) merging the BIF and the SAIF into a single new Deposit Insurance Fund, (iii) permitting the Fund’s required reserve ratio to float in a designated range, (iv) eliminating the current prohibition against assessing risk-based premiums on well-capitalized institutions with high supervisory ratings, thus permitting the FDIC to assess ongoing premiums for all institutions based on their risk profile, and allowing gradual increases in those premiums if the new Fund’s ratio falls below the lower end of the designated range, (v) providing dividends to institutions if the ratio exceeds the upper end of the range, and (vi) providing refunds or credits towards future assessments based on an institution’s earlier contributions to the BIF or the SAIF. The Bank expects that these proposals will be considered again during the next session of Congress. Because it remains unclear at this time whether, or in what form, any such legislation ultimately may be enacted, the Bank is unable to assess the potential effects on the Bank.

Regulatory Capital

The Bank is subject to:

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a minimum tangible capital requirement;

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a minimum core (or leverage) capital requirement; and

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a minimum risk-based capital requirement.

Each of these requirements generally must be no less stringent than the capital standards for national banks. At September 30, 2004, the Bank’s tangible capital ratio was 6.09%, its core (or leverage) capital ratio was 6.09%, and its total risk-based capital ratio was 10.91%, compared to the minimum requirements of 1.50%, 4.00% and 8.00%, respectively.

The tangible capital requirement adopted by the OTS requires the Bank to maintain “tangible capital” in an amount not less than 1.5% of tangible assets. “Tangible capital” is defined as core capital less investments in certain subsidiaries and any intangible assets (including supervisory goodwill), plus qualifying servicing assets valued at the amount that can be included in core capital.

Under the minimum leverage capital requirement, Chevy Chase must maintain a ratio of “core capital” to tangible assets of not less than 4.0%. “Core capital” generally includes common shareholders’ equity, noncumulative perpetual preferred stock and minority interests in consolidated subsidiaries, less investments in certain subsidiaries and certain intangible assets.

Under OTS regulations, servicing assets can be included in core capital in an amount up to 100% of core capital. Non-mortgage servicing assets are subject to a sublimit of 25% of core capital. For these purposes, servicing assets are valued at the lesser of 90% of fair market value or 100% of the current unamortized book value. At September 30, 2004, the Bank had qualifying servicing assets with a carrying value of $140.7 million, which constituted 17.5% of core capital at that date.

The risk-based capital requirements imposed by the OTS vary the amount of capital required for an asset based on the degree of credit risk associated with that asset and include, in the asset base, off-balance sheet items used to compute the Bank’s risk-based capital ratio.

There are currently four categories of risk-weightings:

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0% for cash and similar assets;

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20% for qualifying mortgage-backed securities;

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50% for qualifying residential permanent real estate loans; and

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100% for other assets, including consumer loans, commercial real estate loans, loans more than 90 days past due, and real estate acquired in settlement of loans.

The Bank generally must maintain risk-based capital equal to 8.0% of risk-weighted assets, with at least half of that amount in the form of core capital.

Under OTS regulations, residential mortgage loans with negative amortization features that are initially assigned to the 50% risk-weighting may have to be reassigned to the 100% risk-weighting if, as a result of negative amortization, the loan-to-value ratios are

no longer “commensurate” with the risk associated with the loans. The OTS has indicated its intent to conduct a more comprehensive assessment of negatively amortizing loans and may issue supervisory guidance on their capital treatment.

Capital also must be maintained against assets sold with recourse despite the fact that the assets are accounted for as having been sold. The current rules:

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require that risk-based capital be held in an amount equal to the amount of residual interests (which include interest-only certificates and/or interest-only strips receivable (collectively “interest-only strips receivable”), spread accounts, cash collateral accounts, over-collateralization of receivables, retained subordinated interests and other similar forms of on-balance sheet assets that function as credit enhancements) that are retained on balance sheet following a securitization, net of any deferred tax liability (i.e., dollar-for-dollar), even if that amount exceeds the otherwise applicable capital requirement on the underlying loans;

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require a deduction from Tier 1 capital equal to the amount of credit enhancing interest-only strips receivable that exceeds 25% of Tier 1 capital; and

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apply a “ratings-based approach” that sets capital requirements for positions in securitizations according to their relative risk exposure.

For transactions entered into prior to January 1, 2002, previous capital rules regarding the treatment of residual interests applied until December 31, 2002; thereafter, the current rules apply.

At September 30, 2004, the Bank had credit enhancing interest-only strips receivable of $1.0 million, which constituted 0.1% of Tier 1 capital.

The Bank may use supplementary capital to satisfy the risk-based capital requirement up to an amount equal to its core capital. Supplementary capital includes cumulative perpetual preferred stock, qualifying non-perpetual preferred stock, qualifying subordinated debt, non-withdrawable accounts and pledged deposits, and allowances for loan losses up to a maximum of 1.25% of risk-weighted assets. At September 30, 2004, the Bank had $37.8 million in its allowance for loan losses, all of which was includable as supplementary capital.

Subordinated debt may be included in supplementary capital with OTS approval subject to a phase-out based on its remaining term to maturity. The phase-out permits these instruments to be included in supplementary capital under one of two options:

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at the beginning of each of the last five years prior to the maturity date of the instrument, the Bank must reduce the amount eligible to be included by 20% of the original amount, or

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during the seven years immediately prior to an instrument’s maturity, the Bank may include only the aggregate amount of maturing capital instruments that mature in any one year that does not exceed 20% of its capital.

The Bank uses the second option for its 6 7/8% subordinated debentures due 2013 and must continue to use that option for any future issuances as long as the prior issuance remains outstanding. At September 30, 2004, the Bank had $175.0 million in maturing subordinated capital instruments, all of which was includable as supplementary capital. On December 2, 2003, the Bank issued $175.0 million of 2003 Debentures. The net proceeds of the offering, along with short-term borrowings, were used to redeem all of the 1993 Debentures and the 1996 Debentures. See “Deposits and Other Sources of Funds – Borrowings.”

All or a portion of the assets of each of the Bank’s subsidiaries are generally consolidated with the assets of the Bank for regulatory capital purposes unless all of the Bank’s investments in, and extensions of credit to, those subsidiaries are deducted from capital. The Bank’s investments in, and loans to, subsidiaries engaged in activities not permissible for a national bank are, with certain exceptions, deducted from capital under each of the three regulatory capital requirements. The Bank’s real estate development subsidiaries are its only subsidiaries engaged in activities not permissible for a national bank. At September 30, 2004, the Bank’s investments in, and loans to, these “non-includable subsidiaries” totaled approximately $1.1 million, of which $0.9 million constituted a deduction from tangible capital. The Bank has $0.2 million of valuation allowances maintained against its non-includable subsidiaries, which, pursuant to OTS guidelines, are available as a credit against the otherwise required deductions from capital.

OTS capital regulations also require a 100% deduction from total capital of all equity investments that are not permissible for national banks. At September 30, 2004, the Bank had one property with a book value of $2.4 million which was treated as an equity investment for regulatory capital purposes. Another property formerly treated as an equity investment with a book value of $21.9 million was sold on November 20, 2003.

OTS capital regulations provide a five-year holding period for real estate acquired in settlement of loans (“REO” or “real estate held for sale”) to qualify for an exception from treatment as an equity investment. The five-year period may be extended by the OTS. If an REO property is considered an equity investment, its then-current book value is deducted from total capital. Accordingly, if the Bank is unable to dispose of any REO property prior to the end of its applicable five-year holding period and is unable to obtain an extension of that five-year holding period from the OTS, the Bank could be required to deduct the then-current book value of such REO property from risk-based capital. In 2004, the Bank received from the OTS additional extensions through April 7, 2005, of the holding

periods for certain of its REO properties acquired through foreclosure in fiscal years 1990 and 1995. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Capital.”

In June 2004, the Basel Committee on Banking Supervision published a revised risk-based capital framework designed to replace its 1988 risk-based capital accord, which forms the basis for the risk-based capital requirements of the OTS and the other U.S. federal financial institution regulators. Key components of what has become known as the Basel II framework include:

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adding a fifth risk-weighting of 150 percent for loans to low-quality companies;

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using rating agency assessments to determine risk-weightings for claims on banks, commercial loans and securitization interests;

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liberalizing capital requirements for certain collateralized and guaranteed loans;

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authorizing regulators to use the supervisory review process to determine whether to impose increased capital requirements on individual institutions with high levels of interest-rate risk or to require reduction of that risk;

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establishing a methodology for requiring that capital be maintained against operational risk; and

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authorizing regulators to impose explicit capital requirements on managed or securitized assets.

In August 2003, the OTS, along with the other federal banking regulators, issued an Advance Notice of Proposed Rulemaking setting forth a framework for adoption of Basel II. Under the notice, only the largest U.S. banks would be subject to the new accord, which could adversely affect the competitive position of smaller institutions like the Bank that are generally expected to continue to operate under a somewhat revised version of the existing capital requirements. U.S. banking regulators have announced plans to publish proposed rules relating to Basel II in mid-2005, with final rules expected to be adopted in the second quarter of 2006 and to become fully effective in January 2008. They have also indicated that possible changes to capital requirements for institutions like the Bank that will not be subject to the Basel II framework will be considered and implemented during the same general timeframe. The Bank is unable to predict whether, or in what form, any final changes will be adopted by the OTS or other U.S. regulators, or their possible impact on the Bank.

The Bank’s ability to maintain capital compliance depends on a number of factors, including, for example, changes in regulatory requirements, general economic conditions and the condition of local markets. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Capital.” The OTS has the authority to require the Bank to maintain capital at levels above the minimum levels generally required, based on a variety of factors, including excessive exposure to interest rate risk, concentrations of credit risk, risks arising from non-traditional activities, and the Bank’s ability to manage those risks. However, the OTS has not imposed a higher requirement on the Bank.

Prompt Corrective Action. The OTS and the other federal banking agencies have adopted regulations which apply to every FDIC-insured commercial bank and thrift institution a system of mandatory and discretionary supervisory actions, which generally become more severe as the capital levels of an individual institution decline. The regulations establish five capital categories for purposes of determining an institution’s treatment under these prompt corrective action provisions.

An institution is categorized as “well capitalized” under the regulations if (i) it has a leverage ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0% and a total risk-based capital ratio of at least 10.0%, and (ii) is not subject to any written agreement, order, capital directive or prompt corrective action directive issued by the OTS to meet and maintain a specific capital level.

An institution is considered “adequately capitalized” if its leverage ratio is at least 4.0% (3.0% if rated in the highest supervisory category), its tier 1 risk-based capital ratio is at least 4.0% and its total risk-based capital ratio is at least 8.0%.

An institution with a leverage ratio below 4.0% (3.0% if rated in the highest supervisory category), a tier 1 risk-based capital ratio below 4.0% or a total risk-based capital ratio below 8.0% is considered “undercapitalized.” An institution with a leverage ratio or tier 1 risk-based ratio under 3.0% or a total risk-based ratio under 6.0% is considered “significantly undercapitalized.” Finally, an institution is considered “critically undercapitalized,” and subject to provisions mandating appointment of a conservator or receiver, if its ratio of “tangible equity” to total assets is 2.0% or less. “Tangible equity” generally includes core capital plus cumulative perpetual preferred stock.

An institution’s classification category can be downgraded if, after notice and an opportunity for a hearing, the OTS determined that the institution is in an unsafe or unsound condition or has received and has not corrected a less than satisfactory examination rating for asset quality, management, earnings or liquidity. The Bank has not received notice from the OTS of any potential downgrade.

At September 30, 2004, the Bank’s leverage ratio of 6.09%, its tier 1 risk-based ratio of 8.61%, and its total risk-based capital ratio of 10.91% exceeded the minimum ratios established for “well-capitalized” institutions.

Qualified Thrift Lender Test. The Bank must meet a Qualified Thrift Lender (“QTL”) test to avoid imposition of certain restrictions. The QTL test requires the Bank to maintain a “thrift investment percentage” equal to a minimum of 65%. The numerator of the percentage is the Bank’s “qualified thrift investments” and the denominator is the Bank’s “portfolio assets.” “Portfolio assets” is defined as total assets minus

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the Bank’s premises and equipment used to conduct the Bank’s business;

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liquid assets up to 20 percent of total assets; and

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intangible assets, including goodwill.

The QTL test must be met on a monthly average basis in nine out of every 12 months.

“Qualified thrift investments” consist of residential housing loans (including home equity loans and manufactured housing loans), mortgage-backed securities, FHLB and Fannie Mae stock, small business loans, credit card loans and educational loans. Portions of other assets can also be included, provided that the total does not exceed 20% of portfolio assets. Assets in this category include consumer loans (other than credit card and educational loans); 50% of residential housing loans originated and sold within 90 days; investments in real estate-oriented service corporations and 200% of mortgage loans for residences, churches, schools, nursing homes and small businesses in low- or moderate-income areas where credit demand exceeds supply. Intangible assets, including goodwill, are specifically excluded from qualified thrift investments.

The Bank had 91.4% of its assets invested in qualified thrift investments at September 30, 2004, and met the QTL test in each of the previous 12 months.

An institution that fails to meet the QTL test is subject to significant penalties. Immediately after failing the QTL test, the institution may not:

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make any new investment or engage directly or indirectly in any other new activity unless the investment or activity would be permissible for a national bank;

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establish any new branch office at any location at which a national bank could not establish a branch office;

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obtain new advances from the FHLB; or

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pay dividends beyond the amounts permissible if it were a national bank.

One year following an institution’s failure to meet the QTL test, the institution’s holding company parent must register and be subject to supervision as a bank holding company. Three years after failure to meet the QTL test, an institution may not retain any investments or engage in any activities that would be impermissible for a national bank. Failure to meet the QTL test also could limit the Bank’s ability to establish and maintain branches outside of its home state of Virginia.

Because the Bank is engaged in activities that are not currently permissible for national banks, such as investing in subsidiaries that engage in real estate development activities, failure to satisfy the QTL test would require the Bank to terminate these activities and divest itself of any prohibited assets held at such time. Based on a review of the Bank’s current activities, management of the Bank believes that compliance with these restrictions would not have a significant adverse effect on the Bank. However, the B.F. Saul Real Estate Investment Trust (the “Trust”), which owns 80% of the common stock of the Bank, is engaged in real estate ownership and development activities currently prohibited for bank and financial holding companies. As a result, failure by the Bank to meet the QTL test, in the absence of a significant restructuring of the Trust’s operations, would, in effect, require the Trust to reduce its ownership of the Bank to a level at which it no longer would be deemed to control the Bank.

The Bank has taken, and will continue to take, steps to meet the QTL test by structuring its balance sheet to include the required percentage of qualified thrift investments.

Dividends and Other Capital Distributions. OTS regulations limit the ability of the Bank to make “capital distributions.” “Capital distributions” include payment of dividends, stock repurchases, cash-out mergers, repurchases of subordinated debt and other distributions charged against the capital accounts of an institution. The regulations do not apply to interest or principal payments on debt, including interest or principal payments on the Bank’s outstanding subordinated debentures.

The Bank must notify the OTS before making any capital distribution. In addition, the Bank must apply to the OTS to make any capital distribution if the Bank does not qualify for expedited treatment under OTS regulations. If the Bank qualifies for expedited treatment, an application is required only if the total amount of all of the Bank’s capital distributions for the year exceeds the sum of the Bank’s net income for the year and its retained net income for the previous two years.

In considering a notice or application, the OTS will not permit a capital distribution if:

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the Bank would be undercapitalized following the distribution;

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the capital distribution raises safety and soundness concerns; or

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the capital distribution violates any statute, regulation, agreement with the OTS, or condition imposed by the OTS.

In October 2003, the Bank issued $125.0 million of its 8% Preferred Stock and used the proceeds to redeem all of the Bank’s then-outstanding 13% Preferred Stock on October 31, 2003. The OTS has conditioned the Bank’s recent payments of common stock dividends on the Bank’s maintaining its well-capitalized status and there can be no assurance that the OTS will not impose a similar condition on payment of dividends on the 8% Preferred Stock.

Dividends paid on the 10 3/8% Noncumulative Exchangeable Preferred Stock, Series A, (the “REIT Preferred Stock”) issued by the Chevy Chase Preferred Capital Corporation (the “REIT Subsidiary”) are not considered “capital distributions” provided the Bank is classified as “well capitalized.” However, if the Bank were not classified as “well capitalized,” the entire amount of the REIT Subsidiary preferred dividends would be treated as a capital distribution. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Capital.”

Failure of the Bank to remain well capitalized therefore could have a material adverse effect on the Bank’s ability to pay dividends on its common, preferred and REIT Preferred Stock.

In May 1988, in connection with the merger of a Virginia thrift into the Bank, the B.F. Saul Company (the “Saul Company”) and the Trust entered into a capital maintenance agreement in which they agreed not to cause the Bank, without prior written approval of the OTS, to pay dividends in any fiscal year in excess of 50% of the Bank’s net income for that fiscal year, provided that any dividends permitted under such limitation could be deferred and paid in a subsequent year.

The Bank is subject to other limitations on its ability to pay dividends. Under the indenture pursuant to which the Bank’s 2003 Debentures were issued, the Bank may not pay dividends on its stock unless, after giving effect to the dividend, no default or event of default has occurred and is continuing under the indenture and the Bank is in compliance with its regulatory capital requirements. In addition, the amount of the dividend (together with any other “restricted payments” under the indenture) may not exceed the sum of:

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$50.0 million;

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66 2/3% of the Bank’s consolidated net income (as defined) accrued on a cumulative basis commencing October 1, 2002; and

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the aggregate cash proceeds received by the Bank after October 1, 2002 from the sale of qualified capital stock or certain debt securities, minus the aggregate amount of any restricted payments (and certain amounts used to redeem securities) made by the Bank.

Dividends on the 8% Preferred Stock and the REIT Preferred Stock are excluded from this limit on restricted payments.

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Capital” and “Security Ownership of Certain Beneficial Owners and Management.”

The payment of any dividends on the Bank’s common stock and preferred stock will be determined by the Board of Directors based on the Bank’s liquidity, asset quality profile, capital adequacy and recent earnings history, as well as economic conditions and other factors that the Board of Directors determines are relevant, including applicable government regulations and policies. See “Deposits and Other Sources of Funds – Borrowings.”

Lending Limits. The Bank generally is prohibited from lending to one borrower and its related entities amounts in excess of 15% of unimpaired capital and unimpaired surplus. The Bank may lend an additional 10% for loans fully secured by readily marketable collateral. The Bank’s regulatory lending limit was approximately $152.9 million at September 30, 2004, and no group relationships exceeded this limit at that date.

Safety and Soundness Standards. The federal financial institution regulators have developed standards to evaluate the operations of depository institutions, as well as standards relating to asset quality, earnings and compensation. The operational standards cover internal controls and audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth and employee compensation. An institution that fails to meet a standard that is imposed through regulation may be required to submit a plan for corrective action within 30 days. If a savings association fails to submit or implement an acceptable plan, the OTS must order it to correct the deficiency, and may:

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restrict its rate of asset growth;

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prohibit asset growth entirely;

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require the institution to increase its ratio of tangible equity to assets;

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restrict the interest rate paid on deposits to the prevailing rates of interest on deposits of comparable amounts and maturities; or

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require the institution to take any other action the OTS determines will better carry out the purpose of prompt corrective action.

Imposition of these sanctions is within the discretion of the OTS in most cases, but is mandatory if the savings institution commenced operations or experienced a change in control during the 24 months preceding the institution’s failure to meet these standards, or underwent extraordinary growth during the preceding 18 months.

The asset quality standards require that the Bank establish and maintain a system to identify problem assets and prevent deterioration of those assets. The earnings standards require that the Bank establish and maintain a system to evaluate and monitor earnings and ensure that earnings are sufficient to maintain adequate capital and reserves.

Regulatory Assessments. The OTS imposes five separate fees to fund its operations:

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semi-annual assessments for all savings institutions;

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examination fees for certain affiliates of savings institutions;

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application fees;

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securities filing fees; and

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publication fees.

Of these fees, the semi-annual assessments are the most significant, totaling $1.9 million for the Bank for the 12 month period ending December 31, 2004.

The OTS formula for charging examination and supervisory assessments imposes a surcharge on institutions with a supervisory rating of 3, 4 or 5. Surcharges are also imposed on “complex institutions,” which the OTS defines as any institution with over $1 billion of off-balance sheet assets consisting of loans serviced for others, trust assets and recourse obligations or direct credit substitutes. The Bank is treated as a “complex institution” for these purposes.

Environmental Regulation. The Bank’s business and properties are subject to federal and state laws and regulations governing environmental matters, including the regulation of hazardous substances and wastes. Under the federal Comprehensive Environmental Response, Compensation and Liability Act of 1980, as amended (“CERCLA”), and under some state laws, owners of properties and secured lenders which take a deed-in-lieu of foreclosure, purchase a mortgaged property at a foreclosure sale, or operate a mortgaged property may become liable in some circumstances for the costs of cleaning up hazardous substances regardless of whether they have contaminated the property. These costs could exceed the original or unamortized principal balance of a loan or the value of the property securing a loan. The Bank is eligible in many instances for an exemption from CERCLA liability as a secured creditor, provided the Bank does not participate in the management of a property and only acts to protect its security interest in the property. Under this exemption, the Bank may foreclose on a mortgaged property, purchase it at a foreclosure sale or accept a deed-in-lieu of foreclosure, provided it seeks to sell the mortgaged property at the earliest practicable commercially reasonable time on commercially reasonable terms. Other federal and state environmental laws may impose additional liabilities in certain circumstances, including certain state laws that impose environmental liens that could be senior to the Bank’s prior recorded liens. These laws may influence the Bank’s decision whether to foreclose on property that is found to be contaminated. The Bank’s general policy is to obtain an environmental assessment prior to foreclosing on commercial property.

Other Regulations and Legislation. The Bank must obtain prior approval of the OTS before merging with another institution or before acquiring insured deposits through certain transactions. Also, as a SAIF-insured institution, the Bank is subject to limitations on its ability to buy or sell deposits from or to, or to combine with, a BIF-insured institution. Despite these restrictions, SAIF-insured thrifts may be acquired by banks or by bank holding companies under certain circumstances.

The federal agencies regulating financial institutions possess broad enforcement authority over the institutions they regulate, including the authority to impose civil money penalties of up to $1 million per day for violation of laws and regulations.

Federally chartered thrifts like Chevy Chase generally are permitted to operate branches anywhere in the United States, provided that they meet the QTL test and their regulatory capital requirements and have at least a satisfactory rating under the Community Reinvestment Act (“CRA”).

Amounts realized by the FDIC from the liquidation or other resolution of any insured depository institution must be distributed to pay claims (other than secured claims to the extent of any such security) in the following order of priority:

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administrative expenses of the receiver;

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any deposit liability of the institution;

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any other general or senior liability of the institution (which is not an obligation described below);

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any obligation subordinated to depositors or general creditors which is not a stockholder obligation; and

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any obligation to stockholders arising as a result of their status as stockholders.

In response to the September 11, 2001 terrorist attacks, on October 26, 2001, President Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act (the “USA Patriot Act”). Title III of the USA Patriot Act amends the Bank Secrecy Act and contains provisions designed to detect and prevent the use of the U.S. financial system for money laundering and terrorist financing activities by, among other things, imposing new compliance obligations on savings associations, trust companies and securities broker-dealers. Several of these compliance obligations focus on transactions between U.S. financial institutions and non-U.S. banks, entities and individuals, and therefore will not have a significant impact on the Bank’s operations. However, other anti-money laundering and related compliance obligations impact the Bank more directly, and regulatory scrutiny and enforcement of these obligations has increased significantly. The Bank has taken steps to enhance its anti-money laundering policies and procedures following enactment of the USA Patriot Act and continues to monitor developments regarding implementation of the Act and evolving regulatory policies and to make further adjustments to those policies and procedures as appropriate.

Federal Reserve System

The Federal Reserve Board requires the Bank to maintain reserves against its transaction accounts and certain non-personal deposit accounts. Because reserves generally must be maintained in cash or non-interest-bearing accounts, the effect of the reserve requirement is to decrease the Bank’s earnings.

Prior to November 25, 2003, the first $6.0 million of the Bank’s transaction accounts were subject to a 0% reserve requirement. The next $36.1 million in net transaction accounts were subject to a 3% reserve requirement and any net transaction accounts over $42.1 million were subject to a 10% reserve requirement. Effective November 25, 2003, the FRB increased the amount of transaction accounts subject to a 0% reserve requirement from $6.0 million to $6.6 million and increased the “low reserve tranche” from $36.1 million to $38.8 million, which brings the net transaction amount that was subject to the 10% reserve requirement to amounts over $45.4 million. For net transaction accounts in 2005, the first $7.0 million will be exempt from reserve requirements. A 3% reserve ratio will be applied to net transaction accounts over $7.0 million up to and including $47.6 million. A 10% reserve ratio will be applied to net transaction accounts in excess of $47.6 million. The Bank met its reserve requirements for each period during the year ended September 30, 2004.

The Bank may borrow from the Federal Reserve’s “discount window.” FDICIA imposes limitations on the ability of the Federal Reserve to lend to undercapitalized institutions through the discount window.

Community Reinvestment Act

Under the CRA and OTS regulations, the Bank has a continuing and affirmative obligation to help meet the credit needs of its local communities, including low- and moderate-income neighborhoods and low- and moderate-income individuals and families, consistent with the safe and sound operation of the institution. The OTS is required to assess the institution’s record in satisfying the intent of the CRA in connection with its examination of the Bank. In addition, the OTS is required to take into account the Bank’s record of meeting the credit needs of its community in determining whether to grant approval for certain types of applications.

The Bank is committed to fulfilling its CRA obligation by providing access to a full range of credit-related products and services to all segments of its community. Based on the last OTS examination covering the period from January 2000 through December 2002, the Bank received an “outstanding” CRA rating. The Bank anticipates that its next CRA examination will take place in the first half of 2005.

Other Aspects of Federal Law

The Bank is also subject to federal statutory provisions covering matters such as security procedures, currency transactions reporting, insider and affiliated party transactions, management interlocks, truth-in-lending, electronic funds transfers, funds availability, equal credit opportunity and privacy of consumer information.

Holding Company Regulation

The Trust, the Saul Company, Chevy Chase Property Company, and Westminster Investing Corporation (collectively, the “Holding Companies”) are registered as “savings and loan holding companies” because of their direct or indirect ownership interests in the Bank, and are subject to regulation, examination and supervision by the OTS. The Bank is prohibited from making or guaranteeing loans or advances to or for the benefit of the Holding Companies or other affiliates engaged in activities beyond those permissible for bank holding companies and from investing in the securities of the Holding Companies or other affiliates. Transactions between the Bank and the Holding Companies must be on terms substantially the same, or at least as favorable to the Bank, as those that would be available to non-affiliates.

Recent revisions to OTS guidelines for holding company supervision suggest a more active role for the OTS in the direct regulation of thrift holding companies such as the Holding Companies. The current guidelines place a greater emphasis on reviewing the adequacy of the Holding Companies’ capital, their level of debt, and their ability to fund outstanding debt obligations, and suggest that particular scrutiny will be given to holding companies that, like the Holding Companies, are engaged in real estate activities.

The Holding Companies must obtain OTS approval before acquiring any federally insured savings institution or any savings and loan holding company. The status of the Holding Companies as “unitary thrift holding companies” and the activities in which the Holding Companies may engage have been grandfathered under the Gramm-Leach-Bliley Act of 1999 (the “GLB Act”). As grandfathered unitary thrift holding companies, the Holding Companies are virtually unrestricted in the types of business activities in which they may engage provided the Bank continues to meet the QTL test. See “Qualified Thrift Lender Test.” The GLB Act prohibits the sale of grandfathered unitary thrift holding companies such as the Holding Companies (together with their thrift subsidiaries) or their thrift subsidiaries alone to commercial companies. Corporate reorganizations are expressly permitted.

If the Holding Companies were to acquire one or more federally insured institutions and operate them as separate subsidiaries rather than merging them into the Bank, the Holding Companies would become “multiple” savings and loan holding companies. As multiple savings and loan holding companies, the Holding Companies would be subject to limitations on the types of business activities in which they would be permitted to engage, unless the additional thrifts were troubled institutions acquired pursuant to certain emergency acquisition provisions and all subsidiary thrifts met the QTL test. The Holding Companies may acquire and operate additional savings institution subsidiaries outside of Maryland and Virginia only if the laws of the target institution’s state specifically permit those acquisitions or if the acquisitions are made pursuant to emergency acquisition provisions.

The Trust and the Saul Company entered into an agreement with OTS’s predecessor, the Federal Savings and Loan Insurance Corporation, to maintain the Bank’s regulatory capital at the required levels, and, if necessary, to infuse additional capital to enable the Bank to meet those requirements. Since the execution of this agreement, the OTS has changed its policy and no longer requires such agreements from companies acquiring thrift institutions. In addition, the regulatory capital requirements applicable to the Bank have changed significantly as a result of FIRREA. The OTS had stated that capital maintenance agreements entered into prior to the modification of OTS policy and the enactment of FIRREA were not affected by those changes. The Trust and the Saul Company have not sought to modify the existing agreement. To the extent the Bank is unable to meet regulatory capital requirements in the future, the OTS could seek to enforce the obligations of the Trust and the Saul Company under the agreement.

If the Bank were to become “undercapitalized” under the prompt corrective action regulations, it would be required to file a capital restoration plan with the OTS setting forth, among other things, the steps the Bank would take to become “adequately capitalized.” The OTS could not accept the plan unless the Holding Companies guaranteed in writing the Bank’s compliance with that plan. The aggregate liability of the Holding Companies under such a commitment would be limited to the lesser of:

•

an amount equal to 5.0% of the Bank’s total assets at the time the Bank became “undercapitalized,” or

•

the amount necessary to bring the Bank into compliance with all applicable capital standards as of the time the Bank fails to comply with its capital plan.

If the Holding Companies refused to provide the guarantee, the Bank would be subject to the more restrictive supervisory actions applicable to “significantly undercapitalized” institutions. See “Regulation – Prompt Corrective Action.”

Adoption of New Accounting Standard

In January 2003, the Financial Accounting Standards Board (“FASB”) issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”). FIN 46 is an Interpretation of Accounting Research Bulletin No. 51 and addresses consolidation by business enterprises of variable interest entities (“VIEs”). FIN 46 is based on the theory that an enterprise controlling another entity through interests other than voting interests should consolidate the controlled entity. Business enterprises are required under the provisions of FIN 46 to identify VIEs, based on specified characteristics, and then determine whether they should be consolidated. An enterprise that holds a majority of the variable interests in another enterprise is considered the primary beneficiary of that enterprise and, therefore, should consolidate the VIE. The primary beneficiary of a VIE is also required to include various disclosures in interim and annual financial statements. Additionally, an enterprise that holds a significant variable interest in a VIE, but that is not the primary beneficiary, is also required to make certain disclosures. The Bank is the primary beneficiary of one VIE, which holds the ground lease under the Bank’s executive offices. The Bank adopted FIN 46 effective July 1, 2003 and, as a result, recorded a gain of $0.9 million as a cumulative effect of a change in accounting principle, net of tax. In addition, upon adoption, the Bank recorded $31.4 million each in property and equipment and minority interest related to the ground lease. See Note 33.

Market Area

The Bank’s principal deposit and lending markets are located in the Washington, DC metropolitan area. Service industries and federal, state and local governments employ a significant portion of the Washington, DC area labor force, while a substantial number of the nation’s 500 largest corporations have some presence in the area. The Washington, DC area’s seasonally unadjusted unemployment rate is generally below the national rate and was 3.1% in September 2004, compared to the national rate of 5.4%.

Chevy Chase historically has relied on retail deposits originated in its branch network as its primary funding source. See “Deposits and Other Sources of Funds.” Chevy Chase’s principal market for deposits consists of Montgomery and Prince George’s Counties in Maryland and Fairfax County in Virginia. Approximately 4.7% of the Bank’s deposits at September 30, 2004 were obtained from depositors residing outside of Maryland, Virginia and the District of Columbia. Chevy Chase had the largest market share of deposits in Montgomery County, ranked third in market share of deposits in Prince George’s County and ranked eighth in market share in Fairfax County at June 30, 2004, according to the most recently published industry statistics. The per capita incomes of Montgomery and Fairfax Counties rank among the highest of counties and equivalent jurisdictions nationally. These two counties are also the Washington, DC area’s largest suburban employment centers, with a substantial portion of their labor force consisting of federal, state and local government employees. Private employment is concentrated in service and retail trade centers. The unemployment rate in each of Montgomery, Prince George’s and Fairfax Counties in September 2004 was 2.2%, 4.3% and 1.8%, respectively, each of which was below the national rate of 5.4%. The individual state rates were 3.9% for Maryland and 3.3% for Virginia for the same month.

The Bank historically has concentrated its lending activities in the Washington, DC metropolitan area. In recent years, the Bank has expanded its lending activities outside the Washington, DC metropolitan area. See “Lending Activities.”

Investment and Other Securities

The Bank is required by OTS regulations to maintain sufficient liquidity to ensure its safe and sound operations. See “Regulation – Liquidity Requirements.” To meet this requirement, the Bank maintains a portfolio of cash, federal funds, treasury securities and other readily marketable fixed-income securities. Management’s objective is to maintain liquidity at a level sufficient to assure adequate funds to meet expected and unexpected balance sheet fluctuations.

The Bank classifies its U.S. Government securities and mortgage-backed securities as either “held-to-maturity,” “available-for-sale” or “trading” at the time such securities are acquired. All U.S. Government securities and mortgage-backed securities were classified as held-to-maturity at September 30, 2004 and 2003.

As part of its mortgage banking activities, the Bank exchanges loans held for sale for mortgage-backed securities and then sells the mortgage-backed securities, which are classified as trading securities, to third party investors in the month of issuance. Gains and losses on sales of trading securities are determined using the specific identification method. There were no mortgage-backed securities classified as trading securities at September 30, 2004 and 2003.

Lending and Leasing Activities

Loan Portfolio Composition. At September 30, 2004, the Bank’s loan portfolio totaled $10.5 billion, which represented 79.2% of its total assets. All references in this report to the Bank’s loan portfolio refer to loans, whether they are held for sale and/or securitization or for investment, and exclude mortgage-backed securities. Loans collateralized by single-family residences constituted 85.1% of the loan portfolio and 66.9% of total assets at that date. The following table sets forth information concerning the Bank’s loan portfolio, net of unfunded commitments, for the periods indicated.

Loan Portfolio

(Dollars in thousands)


	September 30,
	2004					2003					2002					2001					2000
	Balance			% of Total		Balance			% of Total		Balance			% of Total		Balance			% of Total		Balance			% of Total
Single family residential ⁽¹⁾	$	7,166,935		68.6	%	$	5,761,993		64.7	%	$	4,545,519		59.0	%	$	4,519,269		60.9	%	$	4,870,474		62.9	%
Home equity ⁽¹⁾⁽²⁾		1,721,999		16.5			1,336,776		15.0			1,090,325		14.1			646,390		8.7			427,399		5.5
Real estate construction and ground ⁽²⁾		223,447		2.1			234,356		2.6			260,199		3.4			267,303		3.6			296,705		3.8
Commercial ⁽²⁾		920,178		8.8			888,847		10.0			803,168		10.4			769,443		10.4			596,384		7.7
Automobile loans ⁽¹⁾		300,516		2.9			589,024		6.6			855,735		11.0			1,021,523		13.9			1,393,487		18.0
Other		108,690		1.1			104,041		1.1			160,800		2.1			183,453		2.5			161,968		2.1

		10,441,765		100.0	%		8,915,037		100.0	%		7,715,746		100.0	%		7,407,381		100.0	%		7,746,417		100.0	%

Unearned premiums and discounts		894					1,428					1,690					2,445					3,814
Net deferred loan origination costs		116,124					80,320					57,627					40,554					34,833
Allowance for loan losses		(37,750	)				(58,397	)				(66,079	)				(57,018	)				(52,518	)

		79,268					23,351					(6,762	)				(14,019	)				(13,871	)

Total loans receivable	$	10,521,033				$	8,938,388				$	7,708,984				$	7,393,362				$	7,732,546

⁽¹⁾	Includes loans held for securitization and/or sale, if any.

⁽²⁾	Net of undisbursed portion of loans.

The Bank adjusts the composition of its loan portfolio in response to a variety of factors, including regulatory requirements and asset and liability management objectives. See “Regulation – Regulatory Capital,” “Qualified Thrift Lender Test” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Asset and Liability Management.”

Contractual Principal Repayments of Loans. The following table shows the scheduled contractual principal repayments of the Bank’s loans at September 30, 2004. The entire balance of loans held for securitization and/or sale is shown in the year ending September 30, 2005, because such loans are expected to be sold in less than one year.

Contractual Principal Repayments

(In thousands)


	Principal Balance Outstanding at September 30, 2004⁽¹⁾
			Approximate Principal Repayments Due in Years Ending September 30,
			2005		2006		2007		2008-2009		2010-2014		2015-2019		2020 and Thereafter
Single family residential	$	5,232,551	$	38,742	$	43,895	$	47,811	$	125,399	$	480,002	$	621,786	$	3,874,916
Home equity		1,721,605		14,431		14,828		15,264		35,461		143,511		128,062		1,370,048
Real estate construction and ground		223,447		205,274		9,518		8,403		252		—		—		—
Commercial		920,178		693,599		19,682		12,209		36,981		72,673		85,034		—
Automobile loans		300,516		128,316		88,632		59,294		24,274		—		—		—
Other		108,690		11,566		12,288		8,832		33,969		33,241		6,536		2,258
Loans held for securitization and/or sale		1,934,778		1,934,778		—		—		—		—		—		—

Total loans receivable⁽²⁾	$	10,441,765	$	3,026,706	$	188,843	$	151,813	$	256,336	$	729,427	$	841,418	$	5,247,222

Fixed-rate loans	$	1,630,150	$	564,849	$	148,741	$	109,781	$	139,870	$	230,579	$	240,199	$	196,131
Adjustable-rate loans		6,876,837		527,079		40,102		42,032		116,466		498,848		601,219		5,051,091
Loans held for securitization and/or sale		1,934,778		1,934,778		—		—		—		—		—		—

Total loans receivable⁽²⁾	$	10,441,765	$	3,026,706	$	188,843	$	151,813	$	256,336	$	729,427	$	841,418	$	5,247,222

⁽¹⁾	Of the total amount of loans outstanding at September 30, 2004, which were due after one year, an aggregate principal balance of approximately $1.1 billion had fixed interest rates and an aggregate principal balance of approximately $6.3 billion had adjustable interest rates.

⁽²⁾	Before deduction of allowance for loan losses, unearned premiums and discounts and deferred loan origination fees (costs).

Actual payments may not reflect scheduled contractual principal repayments due to the effect of loan refinancings, prepayments and enforcement of due-on-sale clauses. Although the Bank’s single-family residential loans historically have had stated maturities of generally 30 years, those loans normally have remained outstanding for substantially shorter periods because of these factors. Due-on-sale clauses give the Bank the right to declare a “conventional loan” — one that is neither insured by the Federal Housing Administration nor partially guaranteed by the Veterans’ Administration — immediately due and payable in the event, among other things, that the borrower sells the property securing the loan without the consent of the Bank. At September 30, 2004, excluding loans held for securitization and/or sale, aggregate principal repayments of $1.1 billion against all loans are contractually due within the next year. Of this amount, $564.8 million is due on fixed-rate loans and $527.1 million is due on adjustable-rate loans.

Origination, Purchase and Sale of Real Estate Loans. The Bank has general authority to make loans secured by real estate located throughout the United States. The following table shows changes in the composition of the Bank’s real estate loan portfolio and the net change in mortgage-backed securities.

(In thousands)


	For the Year Ended September 30,
	2004			2003			2002
Real estate loan originations and purchases:
Single family residential	$	9,137,785		$	9,009,575		$	5,036,548
Home equity ⁽¹⁾		1,165,108			1,032,924			902,845
Commercial real estate and multifamily		20,400			1,231			—
Real estate construction and ground ⁽¹⁾		253,078			274,856			259,858

Total originations and purchases		10,576,371			10,318,586			6,199,251

Principal repayments		(2,211,833	)		(2,767,214	)		(2,512,055	)
Sales		(5,795,564	)		(3,753,682	)		(2,043,630	)
Loans transferred to real estate acquired in settlement of loans		(3,377	)		(3,019	)		(4,174	)

		(8,010,774	)		(6,523,915	)		(4,559,859	)

Transfers to mortgage-backed securities ⁽²⁾		(767,226	)		(2,358,732	)		(1,186,436	)

Increase in real estate loans	$	1,798,371		$	1,435,939		$	452,956

⁽¹⁾	Net of undisbursed portion of loans.

⁽²⁾	Represents real estate loans which were pooled and exchanged for mortgage-backed securities.

Single-Family Residential Real Estate Lending (Excluding Home Equity Lending). The Bank originates a variety of loans secured by single-family residences. At September 30, 2004, $8.9 billion, or 85.1%, of the Bank’s loan portfolio consisted of loans secured by first or second mortgages on such properties, as compared to $7.1 billion, or 79.7%, at September 30, 2003. Of these amounts, $9.4 million and $44.4 million consisted of FHA-insured or VA-guaranteed loans at September 30, 2004 and 2003, respectively. At September 30, 2004 and 2003, the Bank had $2.0 billion and $1.4 billion, respectively, of single-family residential loans held for securitization and/or sale to investors. Approximately 31.4% of the principal balance of the Bank’s single-family residential real estate loans at September 30, 2004 were secured by properties located in California.

The Bank originates VA, FHA and a wide variety of conventional residential mortgage loans through its wholly owned mortgage banking subsidiary, B.F. Saul Mortgage Company, and through Chevy Chase Mortgage, a division of the Bank. The Bank currently offers fixed-rate loans with maturities of 10 to 30 years and adjustable-rate residential mortgage loans principally with maturities of 30 years.

Most of the Bank’s single-family residential mortgage loans are originated by third parties. The Bank determines the specific loan products and rates under which the third party originates the loan, and subjects the loan to the Bank’s underwriting criteria and review. During the year ended September 30, 2004, approximately $7.4 billion of loans settled under this program.

Interest rates on the majority of the Bank’s ARMs are adjusted based on changes in either (a) yields on U.S. Treasury securities or (b) the London Interbank Offered Rate (“LIBOR”) of varying maturities. The interest rate adjustment provisions of the Bank’s ARMs may contain limitations on the frequency and/or maximum amount of interest rate adjustments. These limitations are determined by a variety of factors, including mortgage loan competition in the Bank’s markets.

The Bank has significantly expanded its origination of residential ARMs with interest rates that adjust monthly, semi-annually and annually, some of which provide a borrower with a below-market introductory interest rate and a variety of monthly payment options.

Certain of these loans have a payment option that could result in interest being added to the principal of the loan, or “negative amortization.” During fiscal years 2004 and 2003, the Bank originated $6.7 billion and $3.9 billion, respectively, of these ARMs, of which $4.1 billion and $2.4 billion, respectively, contained terms that permit negative amortization. At September 30, 2004, loans with this negative amortization option totaled $3.5 billion, which includes approximately $0.7 million of outstanding principal in excess of the original principal balance of those loans. Each loan contains terms which limit the amount of negative amortization to a percentage of the original loan amount. The Bank monitors the risks associated with these ARM products, and has established terms for loans it originates (including caps on the amount of negative amortization) designed to minimize credit risk without adversely affecting the Bank’s competitive position. Increased emphasis on these ARM products is a key part of management’s efforts to focus on originating mortgage loans with interest rates that adjust more frequently in order to reduce the Bank’s interest-rate risk in the event market interest rates continue to rise from their current market levels. At September 30, 2004, 95.8% of the Bank’s single-family residential loans were comprised of ARMs and 65.0% of the Bank’s single-family residential loans were comprised of ARMs that have interest rates which adjust annually or more frequently.

Loan securitizations and/or sales provide the Bank with liquidity and additional funds for lending, enabling the Bank to increase the volume of loans originated and thereby increase loan interest and fee income as well as gains on sales of loans. In fiscal year 2004, sales of mortgage loans originated or purchased for securitization and/or sale totaled $6.5 billion compared to $6.0 billion during fiscal year 2003. The marketability of loans, loan participations and mortgage-backed securities depends on purchasers’ investment limitations, general market and competitive conditions, mortgage loan demand and other factors.

The Bank’s conforming fixed-rate, single-family loans are originated on terms which conform to Federal Home Loan Mortgage Corporation, Federal National Mortgage Association or Government National Mortgage Association guidelines in order to facilitate the securitization and/or sale of those loans. In order to manage its exposure to interest rate risk, the Bank hedges its held for sale mortgage loan pipeline by entering into whole loan and mortgage-backed security forward sale commitments. Sales of residential mortgage loans are generally made without recourse to the Bank.

From time to time, as part of its capital and liquidity management plans, the Bank may consider “swapping” loans held in its portfolio for lower risk-weighted mortgage-backed securities and retaining those securities in its portfolio rather than selling them. During fiscal years 2004 and 2003, the Bank exchanged $108.6 million and $88.5 million, respectively, of single-family residential loans held in its portfolio for mortgage-backed securities, which the Bank retained for its own portfolio. The Bank did not exchange any of the loans held in its portfolio for mortgage-backed securities during fiscal year 2002.

When the Bank sells a residential loan or loan participation and retains servicing, or purchases mortgage servicing assets from third parties, it collects and remits loan payments, makes certain insurance and tax payments on behalf of borrowers and otherwise services the loans. The servicing fee generally ranges from 0.25% to 0.50% per year of the outstanding loan principal amount. The Bank also typically derives income from temporary investment for its own account of loan collections pending remittance to the participation or loan purchaser. At September 30, 2004 and 2003, the Bank was servicing residential loans totaling $11.3 billion and $8.0 billion, respectively, for other investors. See “Loan Servicing.”

Sales of Mortgage-Backed Securities. The Bank originates and sells mortgage-backed securities pursuant to its normal mortgage banking operations. The securities are generally sold in the same month as they are issued. The securities are formed from conforming mortgage loans originated for sale or from conforming mortgage loans resulting from the borrower’s election to convert from an adjustable-rate loan to a fixed-rate loan. Mortgage-backed securities held for sale in conjunction with mortgage banking activities are classified as trading securities. During the years ended September 30, 2004 and 2003, the Bank originated and sold $668.5 million and $2.3 billion, respectively, of mortgage-backed securities and recognized gains of $7.6 million and $37.8 million, respectively. As a result of the sale of trading securities in the month such securities are formed, the Consolidated Statements of Cash Flows in this report reflect significant proceeds from the sales of trading securities, even though there are no balances of such securities at September 30, 2004.

Home Equity Lending. The Bank makes home equity loans and credit line loans, the majority of which are secured by a first or a second mortgage on the borrower’s home. Home equity credit line loans provide revolving credit, bear interest at a variable rate that adjusts monthly based on changes in the applicable interest rate index and generally are subject to a maximum annual interest rate of between 18.0% and 24.0%. Generally, except for any amortization of principal that may occur as a result of monthly payments, there are no required payments of principal until maturity. Home equity loans have fixed rates of interest and amortize over their term, which ranges from five to 20 years.

From time to time, the Bank may purchase home equity and credit line loans from other lenders as a way to supplement its direct origination of these loans. During fiscal years 2004 and 2003, the Bank made no such purchases.

From time to time, the Bank securitizes and sells home equity credit line receivables to enhance liquidity and to maintain compliance with regulatory capital requirements. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition.” The Bank transferred $3.9 million and $11.5 million of home equity credit line receivables in existing

trusts to investors and recognized gains of $0.2 million and $0.5 million during the years ended September 30, 2004 and 2003, respectively.

Commercial Real Estate and Real Estate Construction Lending. Commercial real estate, real estate construction and ground loans are originated directly by the Bank. Aggregate balances of residential and commercial construction, ground and commercial real estate and multifamily were $262.0 million and $253.8 million at September 30, 2004 and 2003, respectively. The Bank provides financing, at market rates, to certain purchasers of its real estate owned. Additionally, the Bank finances the construction of residential real estate, principally single-family detached homes and townhouses, but generally only when a home is under contract for sale by the builder to a consumer. Loan concentrations among types of real estate are reviewed and approved by the Bank’s Credit Risk Management Committee.

Commercial Lending. The Bank makes loans to business entities for a variety of purposes, including working capital and acquisitions of real estate, machinery and equipment or other assets. A wide variety of products are offered, including revolving lines of credit, term loans, cash management services and other deposit and investment products. Concentrations among industries and structure types, such as syndications, are reviewed and approved by the Bank’s Credit Risk Management Committee.

Business development efforts of the Bank’s Commercial Banking Group have been concentrated in the major industry groups in the metropolitan Washington, DC and Baltimore areas, as well as a broad base of businesses and community service organizations. In addition, management believes that the ability to offer a broader variety of investment products and fiduciary services to institutional customers through the Bank’s subsidiaries, ASB Capital Management, Inc. and Chevy Chase Trust Company, will continue to enhance the operations of the Commercial Banking Group. Commercial loans increased $31.3 million (or 3.5%) during fiscal year 2004 to $920.2 million at September 30, 2004 from $888.8 million at September 30, 2003.

At September 30, 2004, the Bank held $168.2 million (18.3% of total commercial loans) of participations or syndications in commercial loans originated by other financial institutions, a decrease from $186.9 million (21.0% of total commercial loans) at September 30, 2003.

Federal laws and regulations limit the Bank’s commercial loan portfolio to 20% of assets, with at least 10% consisting of small business loans. At September 30, 2004, the Bank complied with this limit.

Other Consumer Lending Activities. Effective March 2003, the Bank stopped originating indirect automobile loans. The Bank continues its collection efforts on the existing portfolio, and continues to serve its customers by making direct prime automobile loans. In addition to the types of loans described above, Chevy Chase currently offers a variety of other consumer loans, including overdraft lines of credit and other unsecured loans for traditional consumer purchases and needs. The Bank does not offer its own credit card loans, but has an agreement with another financial institution pursuant to which that institution issues credit cards in the Bank’s name to the Bank’s local customers. The Bank’s portfolios of prime automobile loans, home improvement and related loans and overdraft lines of credit and other consumer loans totaled $271.7 million, $34.2 million and $36.0 million, respectively, at September 30, 2004, which accounted for a combined 3.3% of total loans at that date.

The Bank stopped originating subprime automobile loans in November 2000. The Bank’s subprime automobile lending portfolio, which totaled $28.8 million at September 30, 2004, represents 3.6% of its Tier 1 capital. The Bank continues its collection efforts on the remaining portfolio.

Federal laws and regulations limit the Bank’s secured and unsecured consumer loans to 35% of its total assets. Home improvement, secured deposit account and educational loans are not included in the 35% limit. At September 30, 2004, the Bank complied with this limit.

Automobile Leasing. Effective March 2003, the Bank also stopped originating indirect automobile leases. The Bank continues its collection efforts on the existing portfolio. At September 30, 2004 and 2003, the Bank’s portfolio of automobiles subject to lease totaled $435.3 million and $855.4 million, respectively. In addition to credit risk associated with a lessee’s possible default under the lease, the Bank is exposed to the risk that the value of the vehicle at maturity of the lease may be less than the future residual value as estimated by the Bank at the inception of the lease. To reduce that risk, the Bank (a) purchased insurance in the full amount of the estimated residual value to protect the Bank against possible future decreases in residual values, and (b) used estimates of residual value that did not exceed published industry estimates unless that excess was also insured. Although the Bank insured residual values, limitations in the insurance policy, and other factors, have resulted and may continue to result in losses at lease maturity that may not be fully covered by that insurance.

Real Estate Loan Underwriting. In the loan approval process, Chevy Chase assesses both the borrower’s ability to repay the loan and the adequacy of the proposed security. The Board of Directors has delegated credit approval authority to the Officers Loan Committee, Executive Loan Committee and certain senior officers. Generally, all construction and commercial real estate loans originated by the Bank’s commercial lending group are reviewed and approved by either the Officers Loan Committee or the Executive

Loan Committee, or both, depending on the size of the loan. Any significant loan not conforming to the Bank’s approved policies must be approved by the Executive Loan Committee or the Chief Executive Officer. All credit exposures in excess of $30 million are presented to the Board of Directors for final approval.

The approval process for all types of real estate loans includes appraisals or evaluations of the properties securing the loans and a review of all applicants’ and guarantors’ financial information and credit and payment history.

In an effort to minimize the increased risk of loss associated with construction and development loans, Chevy Chase considers the reputation of the borrower and the contractor, reviews pre-construction sale and leasing information, and requires an independent inspecting engineer or architect to review the progress of multifamily and commercial real estate projects. In addition, the Bank generally requires personal guarantees of developers for all development loans and, if a general contractor is used by the developer, may require the posting of a performance bond.

The Bank generally makes residential mortgage loans in amounts up to 95% of the appraised value of owner-occupied single-family homes. In some circumstances, the Bank originates a first and second residential mortgage loan simultaneously, provided that the aggregate loan amount does not exceed 95% of the appraised value of the residential property. The Bank generally also lends up to 95% of the lesser of the acquisition cost or the appraised value of the completed project to finance the construction of homes. The loan-to-value (“LTV”) ratio generally applied by the Bank to commercial real estate loans and multifamily residential loans has been 80% of the appraised value of the completed project. Currently, the Bank offers home equity loans and credit line loans up to 100% maximum LTV ratio. However, the Bank plans to insure all newly originated home equity loans and credit lines with an LTV ratio equal to or greater than 90%.

LTV ratios are determined at the time a loan is originated. Consequently, subsequent declines in the value of a loan’s collateral or increases in the balance of the loan, or both, could expose the Bank to losses. Loans with LTV ratios which exceed the established supervisory LTV limits, without mortgage insurance, may not exceed 100 percent of the Bank’s total risk-based capital.

OTS regulations require institutions to adopt internal real estate lending policies, including LTV limitations conforming to specific guidelines established by the OTS. The Bank’s current lending policies conform to these regulations.

On all loans secured by real estate, other than home improvement and related loans and certain home equity credit line loans, Chevy Chase requires title insurance policies protecting the priority of the Bank’s liens. The Bank requires fire and casualty insurance for permanent loans, including home equity credit line loans, and fire, casualty and builders’ risk insurance for construction loans. The borrower selects the insurance carrier, subject to Chevy Chase’s approval. Generally, for any residential first mortgage loan in an amount exceeding 80% of the value of the security property, Chevy Chase requires mortgage insurance from an unaffiliated mortgage insurance company. The majority of the Bank’s mortgage insurance is currently placed with four carriers.

Substantially all fixed-rate mortgage loans originated by the Bank contain a due-on-sale clause which provides that the Bank may declare a loan immediately due and payable in the event, among other things, that the borrower sells the property securing the loan without the consent of the Bank. The Bank’s ARMs generally are assumable, subject to certain conditions.

Commercial Loan Underwriting. All commercial loan applications are underwritten and approved under authorities granted to specified committees and individuals as outlined in the Bank’s credit policies. All credit exposures in excess of $30 million are presented to the Board of Directors for final approval. The scope and depth of the underwriting for a particular request are generally dictated by the size and complexity of the proposed transaction. Generally, commercial loans for amounts greater than $100,000 are assigned a risk rating at inception, based on a risk-rating system established in the Bank’s credit policies.

Subsequent to origination, all commercial loans with credit exposures of $1 million or more are reviewed at least annually. Changes in the credit quality of the loans are noted and the risk ratings are modified as appropriate.

Other Consumer Loan and Lease Underwriting. Other consumer loans, which include direct automobile loans, home improvement and related loans and overdraft lines of credit are originated or purchased by the Bank after a review in accordance with established underwriting procedures.

The underwriting procedures are designed to provide a basis for assessing the borrower’s ability and willingness to repay the loan. In conducting this assessment, the Bank considers the borrower’s ratio of debt to income, various credit scoring models and an evaluation of the borrower’s credit history through a review of a credit report compiled by a recognized consumer credit reporting bureau. The borrower’s equity in the collateral and the terms of the loan are also considered. The Bank’s guidelines are intended only to provide a basis for lending decisions, and exceptions to the guidelines may, within certain limits, be made based upon the credit judgment of the Bank’s lending officer. The Bank periodically conducts audits to ensure compliance with its established underwriting policies and procedures.

The Bank purchased residual value insurance on vehicles subject to lease to reduce the risk that the vehicle’s value at maturity of the lease may be less than the estimated future residual value at the inception of the lease. The Bank periodically conducts audits of its vehicle lease files to ensure compliance with the requirements of the residual value insurance policies.

Loan Originations, Securitizations and Sales – Retained Interest and Servicing Assets. In connection with its loan origination, securitization and sale activities, the Bank generally retains various interests in the sold loans, including servicing assets, interest only certificates, and interest-only strips receivable. From time to time, the Bank may also purchase servicing assets related to loans originated by third parties. The Bank records these interests as assets on its financial statements. In some cases, the Bank determines the carrying value of the asset based on expected future cash flows to be received by the Bank from the underlying asset. Some of these cash flows are payable to the Bank before the claims of others, while other cash flows are subordinated to the claims of others. The tables below summarize the carrying value of these assets at September 30, 2004 and 2003.


	September 30, 2004
	Not Subordinated		Subordinated		Total
	(In thousands)
Servicing assets	$	147,856	$	—	$	147,856
Interest-only certificates		184,305		—		184,305
Interest-only strips receivable		102,495		1,040		103,535
Overcollateralization of loans		—		1,519		1,519
Reserve accounts		6,726		12,257		18,983

Total	$	441,382	$	14,816	$	456,198


	September 30, 2003
	Not Subordinated		Subordinated		Total
	(In thousands)
Servicing assets	$	96,268	$	—	$	96,268
Interest-only certificates		27,465		—		27,465
Interest-only strips receivable		104,299		8,017		112,316
Overcollateralization of loans		—		4,678		4,678
Reserve accounts		—		19,034		19,034

Total	$	228,032	$	31,729	$	259,761

Loan Servicing. The Bank’s investment in servicing assets is periodically evaluated for impairment. The Bank stratifies its servicing assets for purposes of evaluating impairment by taking into consideration relevant risk characteristics, including loan type and note rate. The Bank evaluates its servicing assets for impairment based on fair value. To measure the fair value of its servicing assets, the Bank uses either third party market prices or discounted cash flow analyses using market-based assumptions for servicing fee income, servicing costs, prepayment rates and discount rates.

If actual prepayment or default rates significantly exceed the estimates used to calculate the carrying values of the servicing assets, the actual amount of future cash flow could be less than the expected amount and the value of the servicing assets, as well as the Bank’s earnings, could be negatively impacted. No assurance can be given that underlying loans will not experience significant increases in prepayment or default rates or that the Bank may not have to write down the value of its servicing assets. See Note 1 and Note 7 to the Consolidated Financial Statements in this report.

The Bank receives income through servicing of loans and fees in connection with loan origination, loan modification, late payments, prepayments, changes of property ownership and miscellaneous services related to its loans. Servicing income, earned on (a) single-family residential mortgage loans owned by third parties and (b) the Bank’s securitization and servicing of home equity, automobile and home loan receivables portfolios, is a source of substantial earnings for the Bank. Income from these activities varies with the volume and type of loans originated and sold.

The following table sets forth certain information relating to the Bank’s servicing portfolio and servicing income as of or for the years indicated.


	As of or for the Year Ended September 30,
	2004		2003		2002
	(In thousands)
Residential	$	11,319,875	$	8,025,206	$	6,918,984
Home equity		10,815		38,675		86,279
Automobile		150,957		393,333		803,852
Home improvement loans		—		18,363		35,410

Total amount of loans serviced for others ⁽¹⁾	$	11,481,647	$	8,475,577	$	7,844,525

Servicing and securitization income	$	201,139	$	103,422	$	84,160

⁽¹⁾	The carrying value of the Bank’s servicing assets and interest-only strips receivable at September 30, 2004, 2003 and 2002 was $435.7 million, $236.0 million and $149.7 million, respectively.

The Bank’s level of servicing and securitization income varies based in large part on the amount of the Bank’s securitization activities with respect to these loan types. As the Bank securitizes and sells assets, acquires servicing assets either through origination or purchase, or sells mortgage loans and retains the servicing rights on those loans, the level of servicing and securitization income generally increases. During fiscal year 2004, the Bank securitized and sold $4.9 billion of loan receivables through new securitization trusts compared to $2.6 billion during fiscal year 2003.

Interest-Only Strips Receivable. Interest-only strips receivable are carried at fair value. The Bank estimates fair value by computing the present value of estimated future cash flows to be generated by the underlying loans. The carrying value is adjusted and the adjustment is recognized as a gain or loss in the statement of operations in the period the change occurs. The present value is computed based on management’s estimates of loan prepayments, default rates and the discount rate.

If actual prepayments or default rates significantly exceed the estimates used to calculate the values of the interest-only strips receivable, the actual future cash flow could be less than expected and the value of the interest-only strips receivable, as well as the Bank’s earnings, could decline. No assurance can be given that underlying loans will not experience significant increases in prepayments or default rates or that the Bank may not have to write down the interest-only strips receivable value. See Note 3 and Note 17 to the Consolidated Financial Statements in this report.

Overcollateralization of Loans and Reserve Accounts. Overcollateralization of loans and reserve accounts represent assets of the Bank which have been pledged to certain securitization trusts and which are subordinated to the interests of the investors in those trusts. The Bank carries these assets at their estimated fair value, which is equal to the net present value of the future cash flows expected to be received from these assets.

Delinquencies, Foreclosures and Allowances for Losses

Delinquencies and Foreclosures. When a borrower fails to make a required payment on a mortgage loan, the loan is considered delinquent and, after expiration of the applicable cure period, the borrower is charged a late fee. The Bank follows practices customary in the banking industry in attempting to cure delinquencies and in pursuing remedies upon default. Generally, if the borrower does not cure the delinquency within 90 days, the Bank initiates foreclosure action. If the loan is not reinstated, paid in full or refinanced, the security property is sold. In some instances, the Bank may be the purchaser. Thereafter, the acquired property is treated as real estate acquired in settlement of loans until it is sold. Deficiency judgments generally may be enforced against borrowers in Maryland, Virginia and the District of Columbia, but may not be available or may be subject to limitation in other jurisdictions in which loans are originated by the Bank.

See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Asset Quality – Delinquent Loans” for a discussion of the Bank’s delinquent loan portfolio at September 30, 2004.

Allowance for Losses. The allowance for loan losses represents management’s estimate of credit losses inherent in the Bank’s loan portfolios as of the balance sheet date. The Bank’s methodology for assessing the appropriate level of the allowance consists of several key elements, which include the allocated allowance, specific allowances for identified loans and the unallocated allowance. Management reviews the adequacy of the valuation allowances on loans using a variety of measures and tools including historical loss performance, delinquent status, current economic conditions, internal risk ratings and current underwriting policies and procedures.

The allocated allowance is assessed on both homogeneous and non-homogeneous loan portfolios. The range is calculated by applying loss and delinquency factors to the outstanding loan balances of these portfolios. Loss factors are based on analyses of the historical performance of each loan category and an assessment of portfolio trends and conditions, as well as specific risk factors impacting the loan portfolios. Each homogeneous portfolio, such as single-family residential loans or automobile loans, is evaluated collectively.

Non-homogeneous type loans, such as commercial loans and non-residential real estate loans, are analyzed and segregated by risk according to the Bank’s internal risk rating system. These loans are reviewed by the Bank’s credit and loan review groups on an individual loan basis to assign a risk rating. Industry loss factors are applied based on the risk rating assigned to the loan. Industry loss factors are used because of the Bank’s lack of history of losses in these portfolios. A specific allowance may be assigned to non-homogeneous type loans that have been individually determined to be impaired. Any specific allowance considers all available evidence including, as appropriate, the present value of payments expected to be received or, for loans that are solely dependent on collateral for repayment, the estimated fair value of the collateral.

The unallocated allowance is based upon management’s evaluation and judgment of various conditions that are not directly measured in the determination of the allocated and specific allowances. The conditions evaluated in connection with the unallocated allowance may include existing general economic and business conditions affecting the key lending areas of the Bank, credit quality trends, collateral values, loan volumes and concentrations, seasoning of the loan portfolio, specific industry conditions within portfolio segments, recent loss experience in particular segments of the portfolio, regulatory examination results and findings of the Bank’s internal credit evaluations.

The allowance for losses is based on estimates and ultimate losses may vary from current estimates. As adjustments to the allowances become necessary, provisions for losses are reported in operations in the periods they are determined to be necessary.

REO is carried at the lower of cost or fair value, less selling costs. To date, sales of REO, non-residential mortgage loans, commercial loans and loans classified as investments in real estate have resulted in no material additional aggregate loss to the Bank above the amounts already reserved. However, these results do not necessarily assure that the Bank will not suffer losses in the future beyond its level of allowances.

The Bank’s review of its various asset portfolios takes place within the Asset Classification Committee, which meets quarterly. The Asset Classification Committee reviews risk performance trends within the Bank’s loan and REO portfolios and economic trends and conditions which might impact those portfolios. This Committee also reviews the status of individual criticized and classified assets of $500,000 or more and the allowance for loan losses.

The Federal Financial Institutions Examination Council (“FFIEC”), which is composed of the OTS and the other federal banking agencies, has issued guidelines regarding the appropriate levels of general valuation allowances that should be maintained by insured institutions and guidance on the design and implementation of loan loss allowance methodologies and supporting documentation practices. The Bank believes that its levels of general valuation allowances at September 30, 2004, and its procedures, comply with the guidelines.

The Bank’s assets are subject to review and classification by the OTS upon examination. Based on those examinations, the Bank could be required to establish additional valuation allowances or incur additional charge-offs.

Deposits and Other Sources of Funds

General. Deposits are the primary source of the Bank’s funds for use in lending and for other general business purposes. In addition to deposits, Chevy Chase receives funds from loan repayments and loan sales. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows are influenced by general interest rates and money-market conditions. Borrowings may be used to compensate for reductions in normal sources of funds, such as deposit inflows at less than projected levels or deposit outflows, or to support the Bank’s operating or investing activities, or planned growth. In recent years, the Bank has relied to a greater degree on borrowed funds, particularly FHLB advances, to fund its planned asset growth. This source of funding is generally more volatile and expensive than traditional core deposits.

Deposits. Chevy Chase offers a variety of deposit accounts with a range of interest rates and maturities designed to attract both long-term and short-term deposits. Deposit programs include money market, savings, checking, certificates of deposit, and special programs for retirement accounts.

Chevy Chase attracts deposits through its branch network and advertisements, and offers depositors access to their accounts through 859 ATMs, including 206 ATMs located in grocery stores. These ATMs significantly enhance the Bank’s position as a leading provider of convenient ATM service in its primary market area. The Bank is a member of the “STAR”^{^®}ATM network which offers nationwide access, and the “PLUS”^{^®}ATM network, which offers worldwide access. In addition, the Bank has a partnership agreement with a regional grocery store chain that authorizes the Bank to provide in-store banking centers at potentially all of its Maryland, Virginia, Delaware and Washington, DC area stores. As of September 30, 2004, the Bank operates 54 in-store banking centers as part of this agreement.

The Bank obtains deposits primarily from customers residing in Montgomery and Prince George’s Counties in Maryland and in Northern Virginia. Approximately 36.1% of the Bank’s deposits at September 30, 2004 were obtained from depositors residing outside of Maryland, with approximately 24.0% from depositors residing in Virginia.

The following table shows the amounts of Chevy Chase’s deposits by type of account at the dates indicated.

Deposit Analysis

(Dollars in thousands)


	September 30,
	2004				2003				2002				2001				2000
	Balance		% of Total		Balance		% of Total		Balance		% of Total		Balance		% of Total		Balance		% of Total
Demand accounts	$	1,181,722	13.3	%	$	951,844	11.8	%	$	779,634	10.5	%	$	642,490	8.5	%	$	559,320	7.9	%
NOW accounts		2,244,724	25.4			1,951,281	24.0			1,656,522	22.3			1,428,486	18.9			1,289,883	18.4
Money market deposit accounts		2,364,768	26.7			2,321,026	28.7			1,953,312	26.3			1,570,297	20.8			1,156,829	16.4
Savings accounts		1,042,777	11.8			997,686	12.3			893,093	12.0			780,655	10.3			779,344	11.1
Other deposit accounts		171,530	1.9			152,758	1.9			135,169	1.8			117,207	1.5			113,245	1.6
Certificate accounts, less than $100		1,238,733	14.0			1,207,728	14.9			1,416,739	19.0			2,361,174	31.2			2,524,769	35.9
Certificate accounts, $100 or more		610,864	6.9			518,182	6.4			603,116	8.1			662,161	8.8			614,399	8.7

Total deposits	$	8,855,118	100.0	%	$	8,100,505	100.0	%	$	7,437,585	100.0	%	$	7,562,470	100.0	%	$	7,037,789	100.0	%

Average Cost of Deposits


	Year Ended September 30,
	2004		2003		2002
Demand deposits	0.21	%	0.26	%	0.31	%
Money market deposits	0.74	%	1.01	%	1.74	%
Savings deposits	0.27	%	0.45	%	0.96	%
Time deposits	1.91	%	2.55	%	4.14	%
Total deposits	0.79	%	1.15	%	2.15	%

The range of deposit account products offered by the Bank through its extensive branch and ATM network allows the Bank to competitive in obtaining funds from its local retail deposit market. At the same time, however, as customers have increasingly responded to changes in interest rates, the Bank has experienced some fluctuations in deposit flows. Chevy Chase’s ability to attract and maintain deposits, and its cost of funds, will continue to be significantly affected by market conditions and its pricing strategy.

The following table sets forth Chevy Chase’s deposit flows during the periods indicated.


	Year Ended September 30,
	2004			2003			2002
	(In thousands)
Deposits to accounts	$	53,155,374		$	45,309,516		$	48,432,739
Withdrawals from accounts		(52,459,012	)		(44,726,718	)		(48,701,536	)

Net cash to (from) accounts		696,362			582,798			(268,797	)
Interest credited to accounts		58,251			80,122			143,912

Net increase (decrease) in deposit balances	$	754,613		$	662,920		$	(124,885	)

Deposit growth may be moderated by the Bank from time to time either to take advantage of lower cost funding alternatives or in response to more modest expectations for loan and other asset growth.

The following table sets forth, by weighted average interest rates, the type and amounts of deposits as of September 30, 2004, which will mature during the fiscal years indicated.

Weighted Average Interest Rates of Deposits

(Dollars in thousands)


	Demand, NOW and Money Market Deposit Accounts				Statement Savings Accounts				Other Core Accounts				Certificate Accounts				Total


Maturing During Year Ending September 30,	Amount		Weighted Average Rate		Amount		Weighted Average Rate		Amount		Weighted Average Rate		Amount		Weighted Average Rate		Amount		Weighted Average Rate


2005	$	5,791,269	0.45	%	$	1,042,777	0.28	%	$	171,530	0.25	%	$	1,296,842	1.62	%	$	8,302,418	0.60	%
2006		—	—			—	—			—	—			379,172	3.14			379,172	3.14
2007		—	—			—	—			—	—			55,188	3.67			55,188	3.67
2008		—	—			—	—			—	—			33,023	3.13			33,023	3.13
2009		—	—			—	—			—	—			85,317	3.70			85,317	3.70

Total	$	5,791,269	0.45	%	$	1,042,777	0.28	%	$	171,530	0.25	%	$	1,849,542	2.12	%	$	8,855,118	0.77	%

The following table summarizes maturities of certificate accounts in amounts of $100,000 or greater as of September 30, 2004.


Year Ending September 30,	Amount		Weighted Average Rate
	(Dollars in thousands)
2005	$	428,722	1.60	%
2006		106,817	3.32	%
2007		11,237	3.98	%
2008		8,427	3.11	%
2009		55,661	3.73	%

Total	$	610,864	2.16	%

The following table represents the amounts of deposits by various interest rate categories as of September 30, 2004 maturing during the fiscal years indicated.

Maturities of Deposits by Interest Rates

(In thousands)


	Accounts Maturing During Year Ending September 30,
Interest Rate	2005		2006		2007		2008		2009		Total
Demand deposits (0%)	$	1,182,161	$	—	$	—	$	—	$	—	$	1,182,161
0.01% to 1.99%		6,924,347		52,764		2,756		—		—		6,979,867
2.00% to 2.99%		143,277		168,284		11,850		6,745		248		330,404
3.00% to 3.99%		14,285		52,136		12,642		26,276		68,471		173,810
4.00% to 4.99%		7,618		95,198		26,608		—		16,598		146,022
5.00% to 5.99%		6,030		6,316		1,332		2		—		13,680
6.00% to 7.99%		24,700		4,474		—		—		—		29,174

Total	$	8,302,418	$	379,172	$	55,188	$	33,023	$	85,317	$	8,855,118

Borrowings. The FHLB system functions as a central reserve bank providing credit for member institutions. As a member of the FHLB of Atlanta, Chevy Chase is required to own capital stock in that FHLB and is authorized to apply for advances on the security of that stock and certain of its mortgages and other assets, principally securities which are obligations of, or guaranteed by, the United States or its agencies, provided certain standards related to creditworthiness have been met.

Under the credit policies of the FHLB of Atlanta, credit may be extended to creditworthy institutions based upon their financial condition and the adequacy of collateral pledged to secure the extension of credit. Extensions of credit may be obtained pursuant to several different credit programs, each of which has its own rate and range of maturities. Advances from the FHLB of Atlanta must be secured by certain types of collateral with a value, as determined by the FHLB of Atlanta, at least equal to 100% of the borrower’s outstanding advances. The Bank had outstanding FHLB advances of $2.7 billion at September 30, 2004.

From time to time the Bank enters into repurchase agreements, which are treated as financings. The Bank sells securities, which are usually mortgage-backed securities, and agrees to buy back the same securities at a specified time, which is generally within seven to 90 days. The Bank pays a stated interest rate for the use of the funds for the specified time period. The obligation to repurchase

the securities sold is reflected as a liability and the securities underlying the agreements are included in assets in the Consolidated Balance Sheets in this report. These arrangements are, in effect, borrowings by the Bank secured by the securities sold. The Bank had outstanding repurchase agreements of $21.9 million at September 30, 2004.

The following table sets forth a summary of the repurchase agreements of the Bank as of the dates and for the years indicated.


	September 30,
	2004			2003
	(Dollars in thousands)
Securities sold under repurchase agreements:
Balance at year-end	$	21,878		$	5,816
Average amount outstanding during the year		23,994			268,870
Maximum amount outstanding at any month-end		87,871			506,065
Weighted average interest rate during the year		0.87	%		1.44	%
Weighted average interest rate on year-end balances		0.98	%		0.77	%

On December 2, 2003, the Bank issued $175.0 million aggregate principal amount of its 2003 Debentures. The net proceeds of the offering, along with short-term borrowings, were used to redeem all of the 9¼% Subordinated Debentures due 2005 and 2008. The OTS approved the inclusion of the 2003 Debentures in the Bank’s regulatory capital and the redemption of the 9¼% Subordinated Debentures due 2005 and 2008.

The Bank may redeem some or all of the 2003 Debentures at any time on or after December 1, 2008 at the following redemption prices plus accrued and unpaid interest:


If redeemed during the 12-month period beginning December 1,	Redemption Price
2008	103.4375	%
2009	102.2917	%
2010	101.1458	%
2011 and thereafter	100.0000	%

Under OTS capital regulations, redemption of the 2003 Debentures prior to their stated maturity requires prior approval of the OTS unless the debentures are redeemed with the proceeds of, or replaced by, a like amount of “a similar or higher quality” capital instrument.

Subsidiaries

OTS regulations generally permit the Bank to make investments in service corporation subsidiaries in an amount not to exceed 3.0% of the Bank’s assets, provided that any investment in excess of 2.0% of assets serves primarily community, inner city or community development purposes. These regulations also permit the Bank to make “conforming loans” to those subsidiaries and joint ventures in an amount not to exceed 50% of the Bank’s regulatory capital. At September 30, 2004, 2.0% and 3.0% of the Bank’s assets was equal to $265.7 million and $398.6 million, respectively, and the Bank had $27.9 million invested in its service corporation subsidiaries.

The Bank may establish operating subsidiaries to engage in any activities in which the Bank may engage directly. There are no regulatory limits on the amount the Bank can invest in operating subsidiaries. The Bank is required to provide 30 days advance notice to the OTS and to the FDIC before establishing a new subsidiary or conducting a new activity in an existing subsidiary. The Bank engages in a variety of other activities through its subsidiaries, including those described below.

Real Estate Development Activities. Manor Investment Company, a subsidiary of the Bank, was engaged in certain real estate development activities commenced prior to the enactment of FIRREA and continues to manage the remaining property it holds. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Asset Quality.”

Securities Brokerage Services. Chevy Chase Securities, Inc., is a wholly owned subsidiary of Chevy Chase Financial Services Corporation (“CCFS”), which is a wholly owned direct subsidiary of Chevy Chase. Chevy Chase Securities is a licensed broker-dealer, which sells securities on a retail basis to the general public, including customers and depositors of the Bank.

Insurance Services. Chevy Chase Insurance Agency, Inc. (“CCIA”), a wholly owned subsidiary of CCFS, is a licensed insurance broker offering a variety of “personal line” property and casualty and life insurance programs to the general public, including customers and depositors of the Bank. CCIA’s primary programs consist of homeowner and automobile insurance in the property and casualty sector and mortgage and credit life and disability insurance in the life insurance sector.

Lending Subsidiaries. Chevy Chase engages in significant mortgage lending activities through B.F. Saul Mortgage Company. See “Lending Activities.” CFC – Consumer Finance Corporation previously engaged in subprime automobile lending. In November 2000, the Bank stopped the origination of subprime automobile loans. The Bank continues its collection efforts on the existing portfolio.

REIT Subsidiary. Chevy Chase Preferred Capital Corporation invests in real estate loans, mortgage-backed securities and related assets and issued preferred stock to outside investors, which is included as Tier 1 capital of the Bank.

Investment, Management and Fiduciary Services. The Bank offers investment, management and fiduciary services through two wholly owned subsidiaries: Chevy Chase Trust Company, a licensed fiduciary and registered investment adviser, which serves primarily high net worth individuals, and ASB Capital Management, Inc., a registered investment adviser, which serves primarily institutional customers.

Special Purpose Subsidiaries. At September 30, 2004, Chevy Chase Real Estate, LLC, (“CCRE”) a wholly owned subsidiary of Chevy Chase, held 100% of the common stock of 11 subsidiaries, seven of which are active, and a majority of which were formed for the sole purpose of acquiring title to various real estate projects pursuant to foreclosure or deed-in-lieu of foreclosure. The Bank’s aggregate investment in these subsidiaries was $19.9 million at September 30, 2004. CCRE is an operating subsidiary and, therefore, the Bank’s investment in CCRE is not subject to the 3.0% service corporation investment limit discussed above.

Employees

The Bank and its subsidiaries had 3,553 full-time and 493 part-time employees at September 30, 2004. The Bank provides its employees with a comprehensive range of employee benefit programs, including group health benefits, life insurance, disability insurance, paid sick leave, certain free deposit services and certain loan discounts. See “Executive Compensation” for a discussion of certain compensation programs available to the Bank’s executive officers. None of the Bank’s employees is represented by a collective bargaining agent. The Bank believes that its employee relations are good.

Competition

Chevy Chase encounters strong competition both in attracting deposits and making loans in its markets. The Bank’s most direct competition for deposits comes from other thrifts, commercial banks and credit unions, as well as from money market funds and corporate and government securities. In addition to offering competitive interest rates, Chevy Chase offers a variety of services, convenient ATM locations and convenient office locations and business hours to attract deposits. Competition for real estate and other loans comes principally from other thrifts, banks, mortgage banking companies, insurance companies and other institutional lenders.

Chevy Chase competes for loans through interest rates, loan fees and the variety and quality of products and services provided to borrowers and brokers.

The Bank’s major competition comes from local, regional, national and international financial institutions and other providers of financial services. The GLB Act amended federal law to permit broader affiliations among commercial banks, securities firms, insurance companies, and other financial services providers.

The Bank competes with numerous depository institutions in its deposit-taking activities in the Washington, DC metropolitan area. The Bank also competes with these institutions in the origination of single-family residential mortgage loans and home equity credit line loans. According to the most recently published industry statistics, at June 30, 2004, Chevy Chase had the largest market share, with approximately 24.3% of deposits, in Montgomery County, Maryland, ranked third in market share, with approximately 15.2% of deposits, in Prince George’s County, Maryland and ranked fifth in market share, with approximately 8.6% of deposits, in the Washington, DC metropolitan area, excluding single branch institutions. Based on publicly available information, Chevy Chase estimates that, in the Washington, DC metropolitan area, it is one of the leaders in market share of single-family residential mortgage and home equity credit line loans.

Federal Taxation

Savings institutions, such as the Bank, generally are taxed in the same manner as other corporations. There are, however, several special rules that apply principally to savings institutions and, in some cases, other financial institutions. Certain significant aspects of the federal income taxation of the Bank are discussed below:

General. The Bank and its subsidiaries are included in the consolidated federal income tax return filed by the Trust on a fiscal year basis. Each member of an affiliated group of corporations which files consolidated income tax returns is liable for the group’s federal income tax liability.

Bad Debt Reserve. In 1996, Congress repealed the thrift bad debt provisions of the Internal Revenue Code effective for taxable years beginning after December 31, 1995. As a result, the Bank can deduct only those bad debts actually incurred during the respective taxable years and was required to recapture and pay income tax on bad debt reserves accumulated since 1987 over a six year period, beginning with the Bank’s tax year ended September 30, 1999. Accumulated bad debt reserves since 1987 that were subject to recapture were $101.3 million. As of September 30, 2004, all of the bad debt reserves have been recaptured.

Consolidated Tax Returns; Tax Sharing Payments. Generally, the operations of the Trust have generated significant net operating losses and the Bank’s taxable income generally has been sufficient to fully utilize the losses of the Trust. Under the terms of a tax sharing agreement dated June 28, 1990, as amended, the Bank is obligated to make payments to the Trust based on its taxable income, as explained more fully below.

The tax sharing agreement generally provides that each member of the Trust’s affiliated group is required to pay the Trust an amount equal to 100% of the tax liability that the member would have been required to pay to the IRS if the member had filed on a separate return basis. These amounts generally must be paid even if the affiliated group has no overall tax liability or the group’s tax liability is less than the sum of those amounts. Under the tax sharing agreement, the Trust, in turn, is obligated to pay to the appropriate tax authorities the overall tax liability, if any, of the group. In addition, to the extent the net operating losses or tax credits of a particular member reduce the overall tax liability of the group, the Trust is required to reimburse that member on a dollar-for-dollar basis, thereby compensating the member for the group’s use of its net operating losses or tax credits. Under the tax sharing agreement, the Bank and its subsidiaries are treated as a single member of the Trust’s affiliated group.

The Bank made tax sharing payments of $8.8 million in fiscal year 2004. It is expected that the Bank will have taxable income in future years and additional operating losses of the Trust will be utilized to reduce the overall tax liability of the group which would otherwise arise from that taxable income of the Bank or from the taxable income of other members of the Trust’s affiliated group.

In general, if the Bank has net operating losses or unused tax credits in any taxable year, under the tax sharing agreement the Trust is obligated to reimburse the Bank in an amount generally equal to (1) the tax benefit to the group of using those tax losses or unused tax credits in the group’s consolidated federal income tax return for that year, plus (2) to the extent those losses or credits are not used by the group in that year, the amount of the tax refunds which the Bank would otherwise have been able to claim if it were not included in the consolidated federal income tax return of the group, but not in excess of the net amount paid by the Bank to the Trust pursuant to the tax sharing agreement. There is no assurance that the Trust would be able to fulfill this obligation. If the Trust did not make the reimbursement, the OTS could attempt to characterize the nonpayment as an extension of credit by the Bank to the Trust which, as described above under “Holding Company Regulation,” is prohibited under current law. The tax sharing agreement itself does not provide for any specific remedies upon a breach by any party of its obligations under the agreement.

The Bank, as a member of an affiliated group of corporations filing consolidated income tax returns, is liable under the Internal Revenue Code for the group’s tax liability. Although the Bank would be entitled to reimbursement under the tax sharing agreement for income tax paid with respect to the income of other members of the affiliated group, there can be no assurance that the Trust or other members would be able to fulfill this obligation.

State Taxation

Many states, most significantly Maryland, do not allow the filing of combined or consolidated income tax returns, and thus the Trust and its subsidiaries, which includes the Bank and its subsidiaries, that are subject to income taxes in those states are required to file separately. The Trust and its subsidiaries are also subject to income taxes in certain other states, some of which allow or require combined or consolidated filings.

ITEM 2.

PROPERTIES

REAL ESTATE

A list of the investment properties of the Real Estate Trust is set forth under “Item 1. Business—Real Estate—Real Estate Investments.”

The Trust conducts its principal business from its executive offices at 7501 Wisconsin Avenue, Suite 1500, Bethesda, Maryland. The Saul Company leases all office facilities on behalf of the Trust.

BANKING

At September 30, 2004, the Bank conducted its business from its home office at 7926 Jones Branch Drive, McLean, Virginia and its executive offices at 7501 Wisconsin Avenue, Bethesda, Maryland; its operations centers at 6151 and 6200 Chevy Chase Drive, and 14601 Sweitzer Lane, Laurel, Maryland; its office facilities at 1919 M Street, NW, Washington, DC; and 228 full-service offices located in Maryland, Virginia, Delaware and the District of Columbia. On that date, the Bank owned the building and land for 38 of its branch offices and leased its remaining 190 branch offices. Chevy Chase leases the office facilities at 7926 Jones Branch Drive, 6200 Chevy Chase Drive, 14601 Sweitzer Lane and 1919 M Street, NW. Chevy Chase owns the building and leases the land at 7501 Wisconsin Avenue. In addition, the Bank leases office space in which its subsidiaries are housed. The office facility leases have various terms expiring from fiscal years 2005 to 2023 and the ground leases have terms expiring from fiscal years 2029 to 2081. The Bank also owns the building and land at 6151 Chevy Chase Drive, Laurel, Maryland. The Bank also owns the building and leases the land at 7700 Old Georgetown Road, Bethesda, Maryland. The Bank also leases the office facilities at 7735 Old Georgetown Road, Bethesda, Maryland. Both of these office facilities were occupied by Bank personnel prior to the consolidation into the Bank’s corporate headquarters. The Bank has leased or is in the process of leasing or subleasing these facilities to third parties. See Note 11 to the Consolidated Financial Statements in this report for lease expense and commitments.

At September 30, 2004, the net book value of the Bank’s office facilities, including leasehold improvements, was $297.9 million, net of accumulated depreciation of $121.4 million. The Bank owns additional assets, including furniture and data processing equipment. At September 30, 2004, these other assets had a book value of $192.3 million, net of accumulated depreciation of $156.2 million. The Bank also has operating leases, primarily for certain data processing equipment and software. Those leases have month-to-month or year-to-year terms. See Note 18 to the Consolidated Financial Statements in this report.

As of September 30, 2004, the Bank had received OTS approval to open 13 additional full-service branch offices. The branches, five in Virginia, six in Maryland and two in Washington, DC, are scheduled to open during fiscal year 2005.

The Bank also owns automobiles which are leased to third parties. The leases are accounted for as operating leases with lease payments recognized as rental income. At September 30, 2004, automobiles subject to lease had a book value $435.3 million, net of accumulated depreciation of $238.6 million.

ITEM 3.

LEGAL PROCEEDINGS

In the normal course of business, the Trust is involved in litigation, which may include litigation arising out of the collection of loans, the enforcement or defense of the priority of its security interests, the continued development and marketing of certain of its real estate properties, disputes with tenants and certain employment claims. In the opinion of management, litigation which is currently pending will not have a material adverse impact on the financial condition or future operations of the Trust.

ITEM 4.

SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended September 30, 2004.

PART II

ITEM 5.

MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

There currently is no established public trading market for Common Shares. At December 17, 2004, there were seven corporate holders of record of Common Shares. All holders of Common Shares at such date were affiliated with the Trust. The Trust paid a dividend on its Common Shares of approximately $0.092 per share, totaling approximately $440,000, in September 2004. No other Common Share dividends were paid during the past two fiscal years. See “Item 12. Security Ownership of Certain Beneficial Owners and Management.”

ITEM 6.

SELECTED FINANCIAL DATA

The selected financial data of the Trust herein have been derived from the Consolidated Financial Statements of the Trust. The data should be read in conjunction with “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the Consolidated Financial Statements included elsewhere in this report.

SELECTED FINANCIAL DATA


	Year Ended September 30,
*(In thousands, except per share amounts and other data)*	2004			2003			2002			2001			2000
STATEMENT OF OPERATIONS DATA:
Real Estate:
Revenues	$	136,256		$	125,528		$	125,610		$	140,239		$	129,667
Operating expenses		170,175			154,885			153,150			158,322			141,968
Equity in earnings of unconsolidated entities, net		7,788			7,248			8,811			7,169			7,291
Impairment loss on investments		—			(998	)		(188	)		(296	)		—
Gain on sales of property		2,769			9,079			—			11,077			994

Real estate operating loss		(23,362	)		(14,028	)		(18,917	)		(133	)		(4,016	)

Banking:
Interest income		441,271			451,551			541,399			721,324			710,353
Interest expense		163,022			205,479			273,186			422,744			394,400

Net interest income		278,249			246,072			268,213			298,580			315,953
Provision for loan losses		14,522			(18,422	)		(51,367	)		(59,496	)		(47,940	)

Net interest income after provision for loan losses		292,771			227,650			216,846			239,084			268,013

Other income:
Deposit servicing fees		129,107			122,473			113,640			101,482			88,253
Servicing and securitization income		211,947			138,213			96,827			61,231			31,967
Automobile rental income		157,034			235,360			242,646			167,379			64,142
Other		41,406			43,795			35,789			45,184			25,863

Total other income		539,494			539,841			488,902			375,276			210,225

Operating expenses		601,050			621,301			602,166			518,713			408,092

Banking operating income		231,215			146,190			103,582			95,647			70,146

Total Company:
Income from continuing operations before income taxes and minority interest		207,853			132,162			84,665			95,514			66,130
Income tax provision		70,232			46,523			23,364			27,275			18,744

Income from continuing operations before minority interest		137,621			85,639			61,301			68,239			47,386
Minority interest held by affiliates		(23,070	)		(13,926	)		(9,671	)		(8,660	)		(4,961	)
Minority interest — other		(37,195	)		(26,160	)		(25,313	)		(25,313	)		(25,313	)

Income from continuing operations		77,356			45,553			26,317			34,266			17,112
Discontinued real estate operations, net of income taxes		(656	)		(563	)		(410	)		(347	)		(211	)
Extraordinary item		—			—			—			—			(166	)
Cumulative effect of change in accounting principle, net of income taxes		—			897			—			—			—

Total company net income	$	76,700		$	45,887		$	25,907		$	33,919		$	16,735

Net income available to common shareholders	$	71,282		$	40,469		$	20,489		$	28,501		$	11,317

Net income (loss) per common share:
Income from continuing operations	$	14.96		$	8.33		$	4.32		$	5.98		$	2.41
Discontinued operations		(0.14	)		(0.12	)		(0.08	)		(0.07	)		(0.04	)
Extraordinary item		—			—			—			—			(0.03	)
Cumulative effect of change in accounting principle		—			0.19			—			—			—

Net income per common share (Basis and Diluted)	$	14.82		$	8.40		$	4.24		$	5.91		$	2.34

Continued on following page.

SELECTED FINANCIAL DATA

(Continued)


	Year Ended September 30,
(In thousands, except per share amounts and other data)	2004			2003			2002			2001			2000
BALANCE SHEET DATA:
Assets:
Real estate assets	$	458,169		$	429,285		$	437,514		$	442,104		$	433,189
Income-producing properties, net ⁽¹⁾		273,292			275,005			285,308			282,984			238,249
Land parcels		41,722			42,425			44,020			40,835			39,716
Banking assets		13,270,847			11,779,440			11,273,252			11,408,707			10,724,725
Total company assets		13,729,016			12,208,725			11,710,766			11,850,811			11,157,914
Liabilities:
Real estate liabilities		676,301			652,856			663,376			667,176			665,838
Mortgage notes payable ⁽¹⁾		311,316			322,437			326,232			331,114			313,746
Notes payable - secured		250,000			203,800			201,750			202,500			200,000
Notes payable - unsecured		56,428			55,349			55,156			50,717			47,463
Banking liabilities		12,400,167			11,039,425			10,614,255			10,780,154			10,121,386
Minority interest held by affiliates		114,933			98,062			88,137			82,048			77,006
Minority interest - other		296,013			249,698			218,307			218,307			218,307
Total company liabilities		13,487,414			12,040,041			11,584,075			11,747,685			11,082,537
Shareholders’ equity		241,602			168,684			126,691			103,126			75,377

OTHER DATA:
Hotels:
Number of hotels		18			18			18			18			16
Number of guest rooms		3,573			3,574			3,578			3,578			3,196
Average occupancy		66	%		61	%		61	%		66	%		71	%
Average room rate	$	91.67		$	85.93		$	86.92		$	94.32		$	89.16
Office properties:
Number of properties		13			13			13			11			10
Leasable area (square feet)		1,978,016			1,978,016			1,978,016			1,796,571			1,684,425
Leasing percentages		90	%		85	%		86	%		92	%		98	%
Land parcels:
Number of parcels		10			10			10			10			9
Total acreage		381			381			389			389			399

⁽¹⁾	Includes real estate held for sale.

ITEM 7.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The Trust has prepared its financial statements and other disclosures on a consolidated basis. The term “Trust” used in the text and the financial statements included herein refers to the combined entity, which includes B. F. Saul Real Estate Investment Trust and its subsidiaries, including Chevy Chase and its subsidiaries. The term “Real Estate Trust” refers to B. F. Saul Real Estate Investment Trust and its subsidiaries, excluding Chevy Chase and its subsidiaries. The operations conducted by the Real Estate Trust are designated as “Real Estate,” while the business conducted by the bank and its subsidiaries is identified by the term “Banking.”

CRITICAL ACCOUNTING POLICIES

The Trust’s accounting policies are in conformity with accounting principles generally accepted in the United States (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to use judgment in the application of accounting policies, including making estimates and assumptions. These judgments affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the Trust’s financial statements and the reported amounts of revenue and expenses during the reporting periods. If judgment or interpretation of the facts and circumstances relating to the various transactions had been different, it is possible that different accounting policies would have been applied resulting in a different presentation of the financial statements. Below is a discussion of accounting policies which the Trust considers critical in that they may require judgment in their application or require estimates about matters which are inherently uncertain. Additional discussion of accounting policies which the Trust considers significant, including further discussion of the critical accounting policies described below, can be found in the Notes to the Consolidated Financial Statements.

REAL ESTATE

Real Estate Properties: Income producing properties are stated at the lower of depreciated cost (except those which were acquired through foreclosure or equivalent proceedings, the carrying amounts of which are based on the lower of cost or fair value at the time of acquisition) or net realizable value. Management believes that these assets have generally appreciated in value and, accordingly, the aggregate current value exceeds their aggregate net book value and also exceeds the value of the Real Estate Trust’s liabilities as reported in these financial statements. Because these financial statements are prepared in conformity with GAAP, they do not report the current value of the Real Estate Trust’s real estate assets.

Long-lived assets and certain identifiable intangibles to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If the sum of the expected cash flows (undiscounted and without interest charges) is less than the carrying amount of the asset, the Real Estate Trust recognizes an impairment loss. Measurement of an impairment loss for long-lived assets and identifiable intangibles that the Real Estate Trust expects to hold and use is based on the fair value of the asset. Long-lived assets and certain intangibles to be disposed of are generally reported at the lower of carrying amount or fair value less the cost to sell.

Interest, real estate taxes and other carrying costs are capitalized on projects under construction. Once construction is completed and the assets are placed in service, rental income, direct operating expenses, and depreciation associated with such properties are included in current operations. The Real Estate Trust considers a project to be substantially complete and held available for occupancy upon completion of tenant improvements, but no later than one year from the cessation of major construction activity. Substantially completed portions of a project are accounted for as separate projects. Expenditures for repairs and maintenance are charged to operations as incurred.

Depreciation is calculated using the straight-line method and the estimated useful lives of 28 to 50 years for buildings and up to 20 years for certain other improvements. Tenant improvements are amortized on a straight-line basis over the lesser of their estimated useful lives or the term of the related lease.

Long-lived assets to be held and used are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If the sum of the expected cashflows (undiscounted and without interest charges) is less than the carrying amount of the asset, the Trust recognizes an impairment loss. Measurement of an impairment loss for long-lived assets that the Trust expects to hold and use is based on the fair value of the asset. Long-lived assets to be disposed of are generally reported at the lower of carrying amount or fair value less costs to sell.

Income Recognition: The Real Estate Trust derives room and other revenues from the operations of its hotel portfolio. Hotel revenue is recognized as earned. The Real Estate Trust derives rental income under noncancelable long-term leases from tenants at its commercial properties. Commercial property rental income is recognized on a straight-line basis.

BANKING

General: The Bank has identified four policies that, due to estimates and assumptions inherent in those policies, involve a relatively high degree of judgment and complexity.

Allowance for Losses: The Bank maintains allowances for possible losses on its loans at levels it believes to be adequate to absorb estimated losses inherent in the loan portfolio at the balance sheet date. Management reviews the adequacy of the allowance for losses using a variety of measures and tools appropriate for the asset type, including historical loss performance, delinquent status, current economic conditions, internal risk ratings, current underwriting policies and practices and market values for similar assets.

Derivative Instruments: The Bank uses a variety of derivative financial instruments in order to mitigate its exposure to changes in market interest rates. To mitigate the risk that the value of mortgage loans held for sale will change as interest rates change, the Bank generally enters into mortgage-backed security forward sales contracts. In addition, the Bank issues commitments to make fixed-rate mortgage loans in which the customer “locks in” the interest rate before closing on the loan. These interest rate locks are treated as derivative instruments in the financial statements. All derivative instruments are recorded on the balance sheet at their fair value, which generally represents the amount of money the Bank would receive or pay if the item were sold or bought in a current transaction. Fair market values are based on market quotes when they are available. If market quotes are not available, fair values are based on market or dealer prices of similar items or discounted cash flows using market estimates of interest rates, prepayment speeds and other assumptions.

When determining the extent to which interest rate exposures should be hedged, the Bank makes certain estimates and judgments relating to, among other things, the probability that the interest-rate lock will become a loan, the timing of the loan closing and the timing of the subsequent sale of the loan transaction. To the extent that the actual results are different from the Bank’s assumptions, the hedging strategy may not be effective in offsetting the changes in the values of the hedged items, and the Bank’s earnings may decline.

Interest-Only Strips Receivable: From time to time, the Bank sells loans and retains an interest-only strip receivable related to the sold items. The interest-only strips receivable are initially recorded by allocating the previous carrying value of the assets involved in the transactions between the assets sold and the interests retained, including the interest-only strips receivable. Subsequently, the interest-only strips receivable are carried at their fair values, with changes in fair value reflected in income. Fair value of these interest-only strips receivable is based on discounted expected future cash flows, which are determined using market assumptions such as discount rates and prepayment speeds, and, in certain circumstances, an estimate of credit losses based on the Bank’s historical experience. The Bank also engages an independent firm that has expertise in this area to evaluate these assets and render an opinion on their fair value. If actual prepayment or default rates significantly exceed the estimates, the actual amount of future cash flow could be less than the expected amount and the value of the interest-only strips receivable, as well as the Bank’s earnings, could decline.

Mortgage Servicing Rights: The Bank sells mortgage loans and retains the right to service those loans (“originated MSR”). Originated MSR are initially recorded by allocating the previous carrying value of the loans between the portion sold and the retained originated MSR. Also, the Bank has purchased the right to service mortgage loans originated by third parties (“purchased MSR” and, together with originated MSR, “MSR”). Purchased MSR are initially recorded at their acquisition cost. Subsequent to origination or purchase, MSR are carried at the lower of their amortized cost or at fair value. Fair value of MSR is based on discounted expected future income, net of related expenses, to be generated by servicing the underlying loans. When determining fair value, the Bank uses several assumptions, the most significant of which are the estimated rate of repayment of the underlying loans and the discount rate. The Bank also engages an independent firm that has expertise in this area to evaluate these assets and render an opinion on their fair value. If actual repayment rates significantly exceed the estimates, the actual amount of future cash flow could be less than the expected amount and the value of the MSR, as well as the Bank’s earnings, could decline.

The Bank believes that the judgments, estimates and assumptions used in the preparation of the Consolidated Financial Statements are appropriate given the factual circumstances at the time. However, given the sensitivity of our Consolidated Financial Statements to these items, the use of other judgments, estimates and assumptions, as well as differences between actual results and the estimates and assumptions, could result in material differences in our results of operations and financial condition.

FINANCIAL CONDITION

REAL ESTATE

The Real Estate Trust’s investment portfolio at September 30, 2004 consisted primarily of hotels, office projects, and land parcels. See “Item 1. Business — Real Estate — Real Estate Investments.”

Overall, the hotel portfolio experienced an average occupancy rate of 66% and an average room rate of $91.67 during fiscal 2004, compared to an average occupancy of 61% and an average room rate of $85.93 during the prior year. REVPAR (revenue per available room) was $60.52 for fiscal 2004, a 15.2% increase from REVPAR for fiscal 2003 of $52.52.

The Real Estate Trust’s hotel portfolio, and the hospitality sector in general, have experienced positive growth, both in occupancy and in average room rates, during fiscal year 2004 reflecting a strong increase in general business travel.

Office space in the Real Estate Trust’s office property portfolio was 90% leased at September 30, 2004, compared to a leasing rate of 85% at September 30, 2003. Although occupancy has increased in fiscal 2004, the Trust has been experiencing a downward trend in its leasing rates commensurate with the competitive commercial office markets in Northern Virginia and Atlanta, Georgia. At September 30, 2004, the Real Estate Trust’s office property portfolio consisted of 13 properties and had a total gross leasable area of 1,978,000 square feet, of which 227,000 square feet (11.5%) and 181,000 square feet (9.2%) are subject to leases expiring in fiscal 2005 and fiscal 2006.

BANKING

General. The Bank’s assets grew to $13.3 billion during fiscal year 2004, an increase of $1.5 billion from fiscal year 2003. The Bank recorded operating income of $231.2 million during fiscal year 2004, compared to operating income of $146.2 million during fiscal year 2003. The increase in income for fiscal year 2004 was primarily attributable to a $73.7 million increase in servicing, securitization and mortgage banking income, a $55.5 million decrease in depreciation and amortization expense, a $32.2 million increase in net interest income and a decrease of $32.9 million in the provision for loan losses. Partially offsetting these items were increases in salaries and employee benefits expense of $20.4 million, other (non-interest) expense of $8.6 million and a decrease in automobile rental income of $78.3 million. See “Results of Operations.”

Servicing, securitization and mortgage banking income increased $73.7 million, or 53.3%, during fiscal year 2004 primarily as a result of increased securitization activity. During fiscal year 2004, the Bank securitized and sold $4.9 billion of loan receivables and recognized a gain of $182.8 million compared to securitization and sale of $2.6 billion of loan receivables and a gain of $92.9 million in fiscal year 2003. See Notes 3 and 17 to the Consolidated Financial Statements in this report. See “Liquidity.” The Bank recognized net losses of $30.3 million and $12.5 million on its interest-only strips receivable during fiscal years 2004 and 2003, respectively, primarily due to increased estimates of future prepayments of the underlying loans.

Real estate owned, net of valuation allowances, decreased from $21.8 million at September 30, 2003 to $20.4 million at September 30, 2004. This reduction was primarily due to sales of properties, partially offset by capitalized costs. At September 30, 2003, based on an analysis of the value of REO and the prospect for recoveries of value, the Bank charged off its valuation allowances of REO in the amount of $71.7 million. See “Asset Quality – REO.”

At September 30, 2004, the Bank’s tangible, core, tier 1 risk-based and total risk-based regulatory capital ratios were 6.09%, 6.09%, 8.61% and 10.91%, respectively. The Bank’s capital ratios exceeded regulatory requirements as well as the standards established for well-capitalized institutions under OTS prompt corrective action regulations. See “Capital.”

In October 2003, the Bank issued $125.0 million of its 8% Preferred Stock and used the proceeds to redeem all of its 13% Preferred Stock on October 31, 2003. On December 2, 2003, the Bank issued $175.0 million of its 2003 Debentures. The net proceeds of the offering, along with short-term borrowings, were used to redeem all of the 1993 Debentures and the 1996 Debentures. The effect of those transactions increased the Bank’s Tier 1 Capital and reduced the dividend and interest rates associated with these capital instruments.

During fiscal year 2004, the Bank declared and paid, out of the retained earnings of the Bank, cash dividends on its Common Stock in the aggregate amount of $3,100 per share.

The Bank’s assets are subject to review and classification by the OTS upon examination. The OTS concluded its most recent safety and soundness examination of the Bank in March 2004.

Asset Quality. Non-Performing Assets. The Bank’s overall level of non-performing assets decreased during fiscal year 2004 due primarily to continued winding down of the Bank’s automobile loan portfolio. The following table sets forth information concerning the Bank’s non-performing assets at the dates indicated. The figures shown are after charge-offs and, in the case of real estate acquired in settlement of loans, after all valuation allowances.

Non-Performing Assets

(Dollars in thousands)


	September 30,
	2004		2003		2002			2001			2000
Non-performing assets:
Non-accrual loans:
Residential mortgage	$	8,993	$	6,567	$	12,731		$	6,011		$	4,207
Home equity		1,767		1,480		949			1,303			964
Real estate and construction and ground		—		1,004		653			—			70

Total non-accrual real estate loans		10,760		9,051		14,333			7,314			5,241
Commercial		242		249		2,329			—			—
Subprime automobile		1,164		4,372		7,755			13,379			12,026
Prime automobile		1,069		1,484		1,705			6,013			5,117
Other consumer		472		444		431			593			282

Total non-accrual loans ⁽¹⁾		13,707		15,600		26,553			27,299			22,666

Real estate acquired in settlement of loans		20,357		21,820		94,665			115,931			129,213
Allowance for losses on real estate acquired in settlement of loans		—		—		(71,293	)		(85,152	)		(80,752	)

Real estate acquired in settlement of loans, net		20,357		21,820		23,372			30,779			48,461

Total non-performing assets	$	34,064	$	37,420	$	49,925		$	58,078		$	71,127

Troubled debt restructurings	$	—	$	—	$	—		$	—		$	—

Allowance for losses on loans	$	37,750	$	58,397	$	66,079		$	57,018		$	52,518
Allowance for losses on real estate held for investment		202		202		202			202			202
Allowance for losses on real estate acquired in settlement of loans		—		—		71,293			85,152			80,752

Total allowances for losses	$	37,952	$	58,599	$	137,574		$	142,372		$	133,472

Interest income recorded
Non-accrual assets	$	180	$	39	$	279		$	358		$	4

Restructured loans	$	—	$	—	$	—		$	—		$	340

Interest income that would have been recorded had the loans been current in accordance with their original terms
Non-accrual assets	$	1,206	$	2,098	$	3,141		$	3,321		$	2,434

Restructured loans	$	—	$	—	$	—		$	—		$	1,323

⁽¹⁾	Before deduction of allowances for losses.

Non-Performing Assets (Continued)


	September 30,
	2004		2003		2002		2001		2000
Ratios:
Non-performing assets to total assets	0.26	%	0.32	%	0.44	%	0.51	%	0.66	%
Allowance for losses on real estate loans to non-accrual real estate loans ⁽¹⁾	91.02	%	75.65	%	44.05	%	70.86	%	167.60	%
Allowance for losses on loans to non-accrual loans ⁽¹⁾	275.41	%	374.34	%	248.86	%	208.86	%	231.70	%
Allowance for losses on loans to total loans receivable ⁽²⁾	0.36	%	0.65	%	0.85	%	0.77	%	0.67	%

⁽¹⁾	Before deduction of allowances for losses.

⁽²⁾	Includes loans receivable and loans held for securitization and/or sale, before deduction of allowance for losses.

Non-performing assets include non-accrual loans, non-accrual real estate held for investment, and REO, acquired either through foreclosure or deed-in-lieu of foreclosure, or pursuant to in-substance foreclosure. Non-accrual loans consist of loans contractually past due 90 days or more or with respect to which other factors indicate that full payment of principal and interest is unlikely.

Non-performing assets totaled $34.1 million at September 30, 2004, compared to $37.4 million, at September 30, 2003. The Bank maintained valuation allowances of $37.8 million and $58.4 million on its loan portfolio at September 30, 2004 and 2003, respectively. The $3.3 million decrease in non-performing assets reflected a net decrease in REO of $1.4 million and a net decrease in non-accrual loans of $1.9 million.

Non-accrual Loans. The Bank’s non-accrual loans totaled $13.7 million at September 30, 2004, a decrease from $15.6 million at September 30, 2003. At September 30, 2004, non-accrual loans consisted of $10.8 million of non-accrual real estate loans and $2.9 million of non-accrual prime automobile, subprime automobile, commercial and other consumer loans compared to non-accrual real estate loans of $9.1 million and non-accrual prime automobile, subprime automobile, commercial and other consumer loans of $6.5 million at September 30, 2003. The decrease in non-accrual prime automobile and subprime automobile loans reflects the winding down of those portfolios.

REO. At September 30, 2004, the Bank’s REO totaled $20.4 million compared to $21.8 million at September 30, 2003. The $1.4 million decrease was primarily a result of sales in the communities and other properties, which was partially offset by additional capitalized costs.

The Bank continues to monitor closely its major non-performing and potential problem assets in light of current and anticipated market conditions. The Bank’s asset workout group focuses its efforts on resolving these problem assets as expeditiously as possible.

Potential Problem Assets. Although not considered non-performing assets, primarily because the loans are not 90 or more days past due and the borrowers have not abandoned control of the properties, potential problem assets are experiencing problems sufficient to cause management to have serious doubts as to the ability of the borrowers to comply with present repayment terms. At September 30, 2004 and 2003, potential problem assets totaled $0.7 million and $14.8 million, respectively. During fiscal year 2004, several potential problem loans were repaid in full.

The Bank’s Watch List Committee meets quarterly and reviews all commercial lending relationships which are rated vulnerable, criticized or classified and have commitments of $1.0 million or greater. This Committee reviews the current status of each

relationship, recent changes, performance against the corrective action plan presented at the prior meeting, and the current action plan for the relationship.

Delinquent Loans. At September 30, 2004, delinquent loans totaled $32.4 million, or 0.3% of loans, compared to $61.4 million, or 0.7% of loans, at September 30, 2003. The following table sets forth information regarding the Bank’s delinquent loans at September 30, 2004.


	Principal Balance (Dollars in thousands) Loans Delinquent for
	30-59 days			60-89 days			Total
Residential Mortgage	$	7,621		$	600		$	8,221
Home Equity		4,422			676			5,098
Commercial		3,046			—			3,046
Subprime Automobile		6,804			2,084			8,888
Other Consumer		5,343			1,805			7,148

Total	$	27,236		$	5,165		$	32,401

Total as a Percentage of Loans ⁽¹⁾		0.26	%		0.05	%		0.31	%

⁽¹⁾	Includes loans held for sale and/or securitization, before deduction of valuation allowances, unearned premiums and discounts and deferred loan origination fees (costs).

Total residential mortgage loans delinquent 30-89 days decreased to $8.2 million at September 30, 2004 from $9.7 million at September 30, 2003. Home equity loans delinquent 30-89 days decreased to $5.1 million at September 30, 2004 from $6.1 million at September 30, 2003.

Total delinquent commercial loans decreased to $3.0 million at September 30, 2004, from $10.8 million at September 30, 2003.

Total delinquent subprime automobile loans decreased to $8.9 million at September 30, 2004, from $23.8 million at September 30, 2003, primarily because the Bank’s portfolio of these loans continues to decline as a result of the Bank’s prior decision to discontinue origination of these loans.

Total delinquent other consumer loans decreased to $7.1 million at September 30, 2004, from $8.6 million at September 30, 2003, primarily because the Bank’s portfolio of indirect automobile loans continues to decline as a result of the Bank’s decision to discontinue origination of these loans.

Troubled Debt Restructurings. A troubled debt restructuring occurs when the Bank agrees to modify significant terms of a loan in favor of a borrower experiencing financial difficulties. The Bank had no troubled debt restructurings at September 30, 2004 and 2003.

Real Estate Held for Investment. At September 30, 2004 and 2003, real estate held for investment consisted of one property with book value of $0.9 million, net of a valuation allowance of $0.2 million.

Allowances for Losses. The following tables show loss experience by asset type and the components of the allowance for losses on loans and the allowance for losses on real estate held for investment or sale. These tables reflect charge-offs taken against assets during the years indicated and may include charge-offs taken against assets, which the Bank disposed of during such years.

Analysis of Allowance for and Charge-offs of Loans

(Dollars in thousands)


	Year Ended September 30,
	2004			2003			2002			2001			2000
Balance at beginning of year	$	58,397		$	66,079		$	57,018		$	52,518		$	57,839

Provision for loan losses		(14,522	)		18,422			51,367			59,496			47,940

Charge-offs:
Single family residential		(279	)		(273	)		(300	)		(99	)		(79	)
Home equity		(786	)		(759	)		(832	)		(687	)		(728	)
Commercial real estate and multifamily		—			(382	)		(27	)		—			(7,120	)
Subprime automobile		(15,596	)		(30,227	)		(40,695	)		(49,749	)		(40,110	)
Other consumer		(9,897	)		(13,316	)		(14,163	)		(13,706	)		(10,057	)

Total charge-offs		(26,558	)		(44,957	)		(56,017	)		(64,241	)		(58,094	)

Recoveries:
Home equity		340			248			76			80			78
Commercial real estate and multifamily		—			14			18			—			—
Subprime automobile		14,613			13,384			11,311			7,104			3,074
Other consumer		5,480			5,207			2,306			2,061			1,681

Total recoveries		20,433			18,853			13,711			9,245			4,833

Charge-offs, net of recoveries		(6,125	)		(26,104	)		(42,306	)		(54,996	)		(53,261	)

Balance at end of year	$	37,750		$	58,397		$	66,079		$	57,018		$	52,518

Provision for loan losses to average loans ⁽¹⁾		-0.14	%		0.22	%		0.70	%		0.76	%		0.66	%
Net loan charge-offs to average loans ⁽¹⁾		0.06	%		0.31	%		0.58	%		0.70	%		0.73	%
Ending allowance for losses on loans to total loans ^(1) (2)		0.36	%		0.65	%		0.85	%		0.77	%		0.67	%

⁽¹⁾	Includes loans held for securitization and/or sale.

⁽²⁾	Before deduction of allowance for losses.

Components of Allowance for Losses on Loans by Type

(Dollars in thousands)


	September 30,
	2004				2003				2002				2001				2000
	Amount		Percent of Loans to Total Loans		Amount		Percent of Loans to Total Loans		Amount		Percent of Loans to Total Loans		Amount		Percent of Loans to Total Loans		Amount		Percent of Loans to Total Loans

Balance at end of year allocated to:

Single family residential	$	4,275	68.6	%	$	2,161	64.7	%	$	1,953	59.0	%	$	2,127	60.9	%	$	2,127	62.9	%

Home equity		3,350	16.5			2,426	15.0			817	14.1			1,007	8.7			1,007	5.5

Commercial real estate and multifamily		144	0.4			162	0.2			124	0.3			197	0.4			893	0.5

Real estate construction and ground		2,025	2.1			2,098	2.6			3,419	3.4			1,852	3.6			4,757	3.8

Commercial		7,361	8.8			14,400	10.0			16,934	10.4			9,135	10.4			6,904	7.7

Prime automobile		5,400	2.6			7,013	5.5			4,150	8.0			7,034	8.1			6,034	10.0

Subprime automobile		4,920	0.3			16,000	1.1			32,000	3.0			32,000	5.8			28,782	8.0

Home improvement		1,795	0.3			1,049	0.5			1,151	1.3			1,523	1.6			1,523	1.2

Overdraft lines of credit and other consumer		1,620	0.4			2,020	0.4			1,635	0.5			491	0.5			491	0.4

Unallocated		6,860				11,068	—			3,896	—			1,652	—			—	—


Total	$	37,750			$	58,397			$	66,079			$	57,018			$	52,518

The Bank maintains allowances for estimated losses on loans and real estate. The Bank’s total allowances for losses on loans and real estate held for investment or sale decreased to $38.0 million at September 30, 2004, from $58.6 million at September 30, 2003. The allowance for losses on loans decreased to $37.8 million at September 30, 2004, from $58.4 million at September 30, 2003. Management reviews the adequacy of the delinquent status, current economic conditions, internal risk ratings and current underwriting policies and procedures. Using this analysis, management determines a range of acceptable valuation allowances. Management’s prior decisions to discontinue subprime automobile lending and indirect consumer lending, and focus more on residential mortgages, have contributed to the overall improvement in the credit quality of the Bank’s loan portfolio. As the balances of automobile loans continue to decline, charge-offs and delinquencies have also declined. Potential problem assets also declined during the year ended September 30, 2004. The combination of these factors contributed to the Bank’s decision to reduce the amount of its allowance for loan losses at September 30, 2004.

The allowance for losses on loans secured by real estate totaled $9.8 million at September 30, 2004, a $3.0 million increase from the September 30, 2003 level of $6.8 million. The increase is consistent with the growth in the portfolio. The allowance represented 91.0% and 75.7% of the amount of non-performing real estate loans at September 30, 2004 and 2003, respectively.

The allowance for losses on other consumer loans, including automobile, home improvement, overdraft lines of credit and other consumer loans, decreased to $13.7 million at September 30, 2004 from $26.1 million at September 30, 2003. Net charge-offs of subprime automobile loans during fiscal year 2004 were $1.0 million, compared to $16.8 million during fiscal year 2003. The decrease in the allowance and charge-offs was due to the decline in the Bank’s portfolio of these loans as a result of the Bank’s prior decision to discontinue origination of these loans.

The allowance for losses on commercial loans decreased to $7.4 million at September 30, 2004 from $14.4 million at September 30, 2003. The Bank’s interest in one syndicated loan, for which the Bank had established a loss allowance of $4.0 million, was repaid in full during the fiscal year ended September 30, 2004.

The unallocated allowance for losses decreased to $6.9 million at September 30, 2004 from $11.1 million at September 30, 2003. The unallocated allowance is based upon management’s evaluation and judgment of various conditions that are not directly measured in the determination of the allocated allowance. The conditions evaluated in connection with the unallocated allowance include existing general economic and business conditions affecting key lending areas of the Bank, credit quality trends, collateral volumes, loan volumes and concentrations, seasoning of the loan portfolio, specific industry conditions within portfolio segments, recent loss experience, regulatory examination results and findings of the Bank’s internal credit evaluations.

The Bank’s allowance for losses on real estate held for investment or sale was $0.2 million at September 30, 2004 and 2003.

Asset and Liability Management. A key element of banking is the monitoring and management of liquidity risk and interest-rate risk. The process of planning and controlling asset and liability mix, volume and maturity to stabilize the net interest spread is referred to as asset and liability management. The objective of asset and liability management is to maximize the net interest yield within the constraints imposed by prudent lending and investing practices, liquidity needs and capital planning.

The Bank’s assets and liabilities are inherently sensitive to changes in interest rates. These movements can result in variations to the overall level of income and market value of equity. Based on the characteristic of a specific asset or liability (including maturity, repricing frequency and interest rate caps) a change in interest rates can significantly affect the contribution to net income by, and market value of, the instrument. If, in the aggregate, the Bank’s assets mature or reprice more quickly or to a greater extent than its liabilities, the Bank is termed “asset sensitive” and will tend to experience an increase in interest income and market value during periods of rising interest rates and declining interest income and market value during periods of falling interest rates. Conversely, if the Bank’s liabilities mature or reprice more quickly or to a greater extent than its assets, the Bank is termed “liability sensitive” and will tend to experience a decrease in interest income and market value during periods of rising interest rates and increased interest income and market value during periods of falling interest rates.

The Bank pursues an asset-liability management strategy designed both to control risk from changes in market interest rates and to maximize interest income in its investment and loan portfolios. To achieve this strategy, the Bank emphasizes the origination and retention of a mix of both adjustable-rate and fixed-rate loan products.

Throughout fiscal year 2004, the Bank continued to originate and hold in its portfolio adjustable-rate loan products at a greater volume than those with fixed interest rates. At September 30, 2004, adjustable-rate loans accounted for 80.8% of total loans, compared to 68.8% at September 30, 2003. This increase was primarily due to increased originations of adjustable-rate mortgage products, which typically reprice monthly and bear interest at rates which are tied to the one-month LIBOR, and an increase in payoffs of fixed-rate mortgage loans due to refinancing activity resulting from continued low interest rates.

A traditional measure of interest-rate risk within the banking industry is the interest sensitivity “gap,” which is the sum of all interest-earning assets minus all interest-bearing liabilities subject to repricing within the same period. Gap analysis is a tool used by management to evaluate interest-rate risk which results from the difference between repricing and maturity characteristics of the Bank’s assets and those of the liabilities that fund them. By analyzing these differences, management can attempt to estimate how changes in interest rates may affect the Bank’s future net interest income. The Bank views control over interest rate sensitivity as a key element in its financial planning process and monitors interest rate sensitivity through its forecasting system. The Bank manages interest rate exposure and will narrow or widen its gap depending on its perception of interest rate movements and the composition of its balance sheet.

A number of asset and liability management strategies are available to the Bank in structuring its balance sheet. These include selling or retaining certain portions of the Bank’s current residential mortgage loan production; altering the Bank’s pricing on certain deposit products to emphasize particular maturity categories; altering the type and maturity of securities acquired for the Bank’s investment portfolio when replacing securities following normal portfolio maturation and turnover; lengthening or shortening the maturity or repricing terms for any current period asset securitizations; and altering the maturity or interest rate reset profile of borrowed funds, if any, including funds borrowed from the FHLB of Atlanta.

The following table presents the Bank’s interest rate sensitivity gap at September 30, 2004. Balances of interest-earning assets and interest-bearing liabilities are shown in the earlier of the period where contractual payments are due, interest rates adjust or prepayment is anticipated to occur. Adjustable and floating rate loans are included in the period in which their interest rates are next scheduled to adjust, and prepayment rates are assumed for all of the Bank’s loans based on management’s estimates. The Bank’s deposits with no stated maturity, including savings and transaction accounts, have interest rates that may reprice at any time. However, market experience has proven that these deposits adjust to market prices over a much longer period of time. The Bank considers these deposits to be relatively insensitive to interest rate changes. The table contains information of the Bank only and does not include consolidation or elimination entries required for the Trust’s financial presentation.

Interest Rate Sensitivity Table (Gap)

(Dollars in thousands)


	Six Months or Less			More than Six Months through One Year			More than One Year through Three Years			More than Three Years through Five Years			More than Five Years			Total
As of September 30, 2004
Real estate loans:
Adjustable-rate	$	3,377,555		$	401,112		$	741,330		$	830,640		$	292		$	5,350,929
Fixed-rate		35,781			29,190			67,520			28,278			7,806			168,575
Home equity credit lines and second mortgages		1,511,050			33,481			98,498			59,215			80,813			1,783,057
Commercial		738,502			14,107			46,521			33,894			85,762			918,786
Consumer and other		129,816			83,121			138,844			15,885			4,294			371,960
Loans held for securitization and/or sale		1,965,476			—			—			—			—			1,965,476
Mortgage-backed securities		66,447			61,600			80,925			119,832			80,499			409,303
Other investments		259,816			—			71,192			—			—			331,008

Total interest-earning assets		8,084,443			622,611			1,244,830			1,087,744			259,466			11,299,094
Total non-interest earning assets		—			—			—			—			1,971,753			1,971,753

Total assets	$	8,084,443		$	622,611		$	1,244,830		$	1,087,744		$	2,231,219		$	13,270,847

Deposits:
Fixed maturity deposits	$	873,117		$	423,195		$	434,830		$	118,455		$	—		$	1,849,597
NOW, statement and passbook accounts		—			56,874			114,291			115,268			3,193,979			3,480,412
Money market deposit accounts		2,364,768			—			—			—			—			2,364,768
Borrowings:
Capital notes - subordinated		—			—			—			—			175,000			175,000
Other		2,229,765			1,851			430,947			242,394			38,560			2,943,517

Total interest-bearing liabilities		5,467,650			481,920			980,068			476,117			3,407,539			10,813,294
Minority interest		—			—			—			—			175,391			175,391
Total non-interest bearing liabilities		—			—			—			—			1,570,301			1,570,301
Stockholders’ equity		—			—			—			—			711,861			711,861

Total liabilities & stockholders’ equity		5,467,650		$	481,920		$	980,068		$	476,117		$	5,865,092		$	13,270,847

Gap		2,616,793		$	140,691		$	264,762		$	611,627		$	(3,148,073	)
Cumulative gap		2,616,793		$	2,757,484		$	3,022,246		$	3,633,873		$	485,800
Cumulative gap as a percentage of total assets		19.7	%		20.8	%		22.8	%		27.4	%		3.7	%

The Bank’s one-year gap, as a percentage of total assets, was 20.8% at September 30, 2004, compared to 18.6% at September 30, 2003. The change in the Bank’s one-year gap during the year results from various initiatives undertaken by management in light of the current low interest rate environment, including increased origination of short-term adjustable rate loans which were mostly funded through the use of short-term borrowings.

In addition to gap measurements, the Bank measures and manages interest-rate risk with the extensive use of computer simulation. This simulation includes calculations of Market Value of Portfolio Equity and Net Interest Margin. The Bank established limits on the sensitivity of its net interest income and net portfolio value (“NPV”) to parallel changes in interest rates. Parallel changes in interest rates are defined as instantaneous and sustained movements of interest rates in 100 basis point increments. The Bank calculates its ratio of NPV to the present value of total assets (“NPV Ratio”) for each interest rate shock scenario. The following table shows the estimated impact of parallel shifts in interest rates at September 30, 2004.


	(Dollars in thousands)
(Basis Points) Change in Interest Rates	Changes in Net Interest Income ⁽¹⁾				Change in Net Portfolio Value ⁽²⁾					NPV Ratio
(Basis Points) Change in Interest Rates	Percent		Amount		Percent		Amount			NPV Ratio
+200	10.4	%	$40,029		-8.0	%	$	(111,506	)	8.8	%
+100	7.0	%	26,863		-2.9	%		(40,305	)	9.2	%
-100	-6.7	%	(25,720	)	-5.8	%		(80,744	)	8.9	%

⁽¹⁾	Represents the difference between net interest income for 12 months in a stable interest rate environment and the various interest rate scenarios.

⁽²⁾

Represents the difference between net portfolio value (NPV) of the Bank’s equity in a stable interest rate environment and the NPV in the various rate scenarios. NPV is defined as the present value of expected net cash flows from existing assets minus the present value of expected net cash flows from existing liabilities plus the present value of expected net cashflows from existing off-balance sheet contracts.

Computations of prospective effects of hypothetical interest rate changes are based on many assumptions, including relative levels of market interest rates, prepayments and deposit runoff and, therefore, should not be relied upon as indicative of actual results. Certain limitations are inherent in these computations. Although certain assets and liabilities may have similar maturities or periods of repricing, they may react at different times and in different degrees to changes in the market interest rates. The interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while rates on other types of assets and liabilities may lag behind changes in market interest rates. Certain assets, such as adjustable-rate mortgage loans, may have features which restrict interest rate changes on a short-term basis and over the life of the asset. In the event of a change in market interest rates, loan prepayments and early deposit withdrawal levels could deviate significantly from those assumed in making the calculations set forth above. Additionally, credit risk may increase if an interest rate increase adversely affects the ability of borrowers to service their debt.

Inflation. The impact of inflation on the Bank is different from the impact on an industrial company because substantially all of the assets and liabilities of the Bank are monetary in nature. The most direct impact of an extended period of inflation would be to increase interest rates and to place upward pressure on the operating expenses of the Bank. However, the actual effect of inflation on the net interest income of the Bank would depend on the extent to which the Bank was able to maintain a spread between the average yield on interest-earning assets and the average cost of interest-bearing liabilities, which would depend to a significant extent on its asset-liability sensitivity. The effect of inflation on the Bank’s results of operations for the past three fiscal years has been minimal.

Deferred Taxes. At September 30, 2004, the Bank recorded a net deferred tax liability of $85.0 million, which generally represents the cumulative excess of the Bank’s income tax expense for financial reporting purposes over its actual income tax liability. See Note 34 to the Consolidated Financial Statements in this report.

Capital. At September 30, 2004, the Bank was in compliance with all of its regulatory capital requirements under FIRREA, and its capital ratios exceeded the ratios established for “well-capitalized” institutions under OTS prompt corrective action regulations.

The following table shows the Bank’s regulatory capital levels at September 30, 2004, in relation to the regulatory requirements in effect at that date. The information below is based upon the Bank’s understanding of the regulations and interpretations currently in effect and may be subject to change. The table contains information of the Bank only and does not include consolidation or elimination entries required for the Trust’s financial presentation.

Regulatory Capital

(Dollars in thousands)


	Actual					Minimum Capital Requirement				Excess Capital
	Amount			As a % of Assets		Amount		As a % of Assets		Amount		As a % of Assets
Stockholders’ equity per financial statements	$	711,861
Minority interest in REIT Subsidiary ⁽¹⁾		144,000

		855,861
Adjustments for tangible and core capital:
Intangible assets		(42,372	)
Non-includable subsidiaries ⁽²⁾		(929	)
Non-qualifying purchased/originated
loan servicing rights		(7,048	)

Total tangible capital		805,512		6.09	%	$	198,556	1.50	%	$	606,956	4.59	%

Total core capital ⁽³⁾		805,512		6.09	%	$	529,482	4.00	%	$	276,030	2.09	%

Tier 1 risk-based capital ⁽³⁾		805,512		8.61	%	$	374,882	4.00	%	$	430,630	4.61	%

Adjustments for total risk-based capital:
Subordinated capital debentures		175,000
Allowance for general loan losses		37,750

Total supplementary capital		212,750

Total available capital		1,018,262
Equity investments ⁽²⁾⁽⁴⁾		(2,360	)

Total risk-based capital ⁽³⁾	$	1,015,902		10.91	%	$	749,764	8.00	%	$	266,138	2.91	%

⁽¹⁾	Eligible for inclusion in core capital in an amount up to 25% of the Bank’s core capital pursuant to authorization from the OTS.

⁽²⁾

Reflects an aggregate offset of $0.2 million representing the general allowance for losses maintained against the Bank’s equity investments and non-includable subsidiaries which, pursuant to OTS guidelines, is available as a “credit” against the deductions from capital otherwise required for such investments.

⁽³⁾	Under the OTS “prompt corrective action” regulations, the standards for classification as “well capitalized” are a leverage (or “core capital”) ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0% and a total risk-based capital ratio of at least 10.0%.

⁽⁴⁾	Includes one property classified as real estate held for sale which is treated as an equity investment for regulatory capital purposes.

Under the OTS prompt corrective action regulations, an institution is categorized as well capitalized if it has a leverage, or core, capital ratio of at least 5.0%, a tier 1 risk-based capital ratio of at least 6.0%, a total risk-based capital ratio of at least 10.0% and is not subject to any written agreement, order, capital directive or prompt corrective action directive to meet and maintain a specific capital level. At September 30, 2004, the Bank’s leverage, tier 1 risk-based and total risk-based capital ratios were 6.09%, 8.61% and 10.91%, respectively, which exceeded the ratios established for well-capitalized institutions. The OTS may reclassify an institution from one category to the next lower category, for example from well capitalized to adequately capitalized, if, after notice and an opportunity for a hearing, the OTS determines that the institution is in an unsafe or unsound condition or has received and has not corrected a less than satisfactory examination rating for asset quality, management, earnings or liquidity. The Bank has not received notice from the OTS of any potential downgrade.

OTS capital regulations provide a five-year holding period, or such longer period as may be approved by the OTS, for REO to qualify for an exception from treatment as an equity investment. If an REO property is considered an equity investment, its then-current book value is deducted from total risk-based capital. Accordingly, if the Bank is unable to dispose of any REO property, whether through bulk sales or otherwise, prior to the end of its applicable five-year holding period and is unable to obtain an extension of the five-year holding period from the OTS, the Bank could be required to deduct the then-current book value of such REO property from total risk-based capital. In April 2004, the Bank received from the OTS an extension of the holding periods for certain of its REO properties through April 7, 2005. The following table sets forth the Bank’s REO at September 30, 2004, by the fiscal year in which the property was acquired through foreclosure.


Fiscal Year	(In thousands)
1990	$	2,360	⁽¹⁾
1991		11,380	⁽²⁾
1995		4,948	⁽²⁾
2003		57
2004		1,612

Total REO	$	20,357

⁽¹⁾	The Bank treats this property as an equity investment for regulatory capital purposes.

⁽²⁾	The Bank received an extension of the holding periods for these properties through April 7, 2005.

Failure to obtain further REO extensions could adversely affect the Bank’s regulatory capital ratios. The Bank’s ability to maintain or increase its capital levels in future periods also will be subject to general economic conditions, particularly in the Bank’s local markets. Adverse general economic conditions or a downturn in local real estate markets could require further additions to the Bank’s allowances for losses and further charge-offs. Any of those developments would adversely affect the Bank’s earnings and thus its regulatory capital levels.

The Bank has historically relied on preferred stock and subordinated debt as significant components of its regulatory capital. Those instruments require significant fixed payments to holders, which increase the Bank’s expenses and reduce the amount of core capital that can be generated through retained earnings.

In October 2003, the Bank issued $125 million of its 8% Preferred Stock. The net proceeds from the issuance of the 8% Preferred Stock were used to redeem all of the 13% Preferred Stock on October 31, 2003.

On December 2, 2003, the Bank issued $175 million aggregate principal amount of its 2003 Debentures. The net proceeds of the offering, along with short-term borrowings, were used to redeem all of the 1993 Debentures and the 1996 Debentures.

Failure by the Bank to remain well capitalized could have a material adverse effect on certain aspects of the Bank’s operations, including its ability to pay dividends. See “Dividends and Other Capital Distributions.”

LIQUIDITY AND CAPITAL RESOURCES

REAL ESTATE

The Real Estate Trust’s cash flows from operating activities have been historically insufficient to meet all of its cash flow requirements. The Real Estate Trust’s internal source of funds, primarily cash flow generated by its income-producing properties, generally have been sufficient to meet its cash needs other than the repayment of principal on outstanding debt, including outstanding unsecured notes sold to the public, the payment of interest on its indebtedness, and the payment of capital improvement costs. In the past, the Real Estate Trust funded such shortfalls through a combination of external funding sources, primarily new financings, the sale of unsecured notes, refinancing of maturing mortgage debt, proceeds from asset sales, and dividends and tax sharing payments from the Bank. For the foreseeable future, the Real Estate Trust’s ability to generate positive cash flow from operating activities and to meet its liquidity needs, including debt service payments, repayment of debt principal and capital expenditures, will continue to depend on these available external sources. Dividends received from the Bank are a component of funding sources available to the Real Estate Trust. The availability and amount of dividends in future periods is dependent upon, among other things, the Bank’s operating performance and income, and regulatory restrictions on such payments. See also the discussion of potential limitations on the payment of dividends by the Bank contained in “Item 1. Business—Banking—Dividends and Other Capital Distributions.”

During fiscal 2004, the Bank made tax sharing payments totaling $8.8 million and dividend payments totaling $24.8 million to the Real Estate Trust.

In recent years, the operations of the Real Estate Trust have generated net operating losses while the Bank has reported net income. The Trust’s consolidation of the Bank’s operations into the Trust’s federal income tax return has resulted in the use of the Real Estate Trust’s net operating losses to reduce the federal income taxes the Bank would otherwise have owed. If in any future year, the Bank has taxable losses or unused credits, the Trust would be obligated to reimburse the Bank for the greater of (1) the tax benefit to the group using such tax losses or unused tax credits in the group’s consolidated federal income tax returns or (2) the amount of the refund which the Bank would otherwise have been able to claim if it were not being included in the consolidated federal income tax return of the group.

During fiscal 2004, the Real Estate Trust purchased, through dividend reinvestment and on the open market, approximately 345,000 shares of common stock of Saul Centers, and as of September 30, 2004, owns approximately 4,090,000 shares representing 25.1% of such company’s outstanding common stock. As of September 30, 2004, the market value of these shares was approximately $134.5 million. Substantially all of these shares have been pledged as collateral with the Real Estate Trust’s revolving credit lenders.

As the owner, directly and through two wholly-owned subsidiaries, of a limited partnership interest in Saul Holdings Partnership, the Real Estate Trust shares in cash distributions from operations and from capital transactions involving the sale of properties. The partnership agreement of Saul Holdings Partnership provides for quarterly cash distributions to the partners out of net cash flow. See “Item 1. Business — Real Estate — Investment in Saul Holdings Limited Partnership.” In fiscal 2004, the Real Estate Trust received total cash distributions of $6.5 million from Saul Holdings Partnership. Substantially all of the Real Estate Trust’s ownership interest in Saul Holdings Partnership has been pledged as collateral with the Real Estate Trust’s two revolving credit lenders.

In March 1998, the Real Estate Trust issued $200.0 million aggregate principal amount of 9.75% Senior Secured Notes due 2008, (the “1998 Notes”).

On February 25, 2004, the Real Estate Trust issued, in a private offering, $250.0 million aggregate principal amount of 7.50% Senior Secured Notes due 2014 (the “2004 Notes”). A substantial portion of the net proceeds of the offering were used to redeem the 1998 Notes, including accrued interest through March 31, 2004 and pay a redemption premium, for early redemption of the notes, of $6.5 million. These funds, totaling $216.25 million, which were escrowed at closing, were paid out on April 1, 2004. The Trust received approximately $28.1 million in proceeds from this offering after the redemption of the 1998 Notes, including accrued interest, the early redemption premium and after deducting costs associated with the offering. The 2004 Notes are nonrecourse obligations of the Real Estate Trust and are secured by a first priority perfected security interest in all of the common stock of the Bank held by the Real Estate Trust. The Real Estate Trust plans to use the net proceeds to fund renovation and construction activities as well as for general corporate purposes.

During fiscal 2004, the Real Estate Trust sold unsecured notes, with a maturity ranging from one to ten years, primarily to provide funds to repay maturing unsecured notes. During fiscal 2004, the Real Estate Trust sold notes amounting to $13.3 million, consisting of $6.9 million of new sales and $6.4 million of rollovers, at a weighted average interest rate of 6.7%. In addition, $5.8 million of unsecured notes were repaid during fiscal 2004. To the degree that the Real Estate Trust does not sell new unsecured notes in an amount sufficient to finance completely the scheduled repayment of outstanding unsecured notes as they mature, it will finance such repayments from other sources of funds.

The Real Estate Trust has an established $55.0 million secured revolving credit line with an unrelated bank that matures on December 12, 2006, with provisions for extending the term annually. This facility is secured by a portion of the Real Estate Trust’s

ownership in Saul Holdings Partnership and Saul Centers. Interest is computed by reference to a floating rate index. At September 30, 2004, the Real Estate Trust had no outstanding borrowings and unrestricted availability of $55.0 million.

The Real Estate Trust has also established an additional $45.0 million revolving credit line with an unrelated bank that matures on September 26, 2006. This facility is secured by a portion of the Real Estate Trust’s ownership in Saul Holdings Partnership and Saul Centers. Interest is computed by reference to a floating rate index. At September 30, 2004, the Real Estate Trust had no outstanding borrowings and unrestricted availability of $45.0 million.

The maturity schedule for the Real Estate Trust’s outstanding debt, including mortgage notes payable for real estate held for sale, at September 30, 2004 for fiscal years commencing October 1, 2004 is set forth in the following table:

Debt Maturity Schedule


Fiscal Year	Mortgage Notes		Notes Payable–– Secured		Notes Payable–– Unsecured		Total
	(In thousands)
2005	$	16,455	$	—	$	11,579	$	28,034
2006		94,982		—		7,874		102,856
2007		5,521		—		6,499		12,020
2008		5,927		—		3,991		9,918
2009		15,768		—		4,981		20,749
Thereafter		172,663		250,000		21,504		444,167

Total	$	311,316	$	250,000	$	56,428	$	617,744

Of the $311.3 million of mortgage notes outstanding at September 30, 2004, $303.5 million was non-recourse to the Real Estate Trust.

In June 2003 the Real Estate Trust refinanced three hotels with a new fixed rate non-recourse financing. The financing consisted of three separate loans totaling $46 million, each with a term of 10 years and a 5.9% interest rate. The financing replaced $38.3 million in existing financing on the three hotels.

Real Estate Development and Capital Expenditures

On September 25, 2003, the Real Estate Trust sold 7.7 acres located in Rockville, Maryland, for $11.3 million, and recognized a gain of $9.1 million on the transaction.

During the quarter ended June 30, 2004 the Real Estate Trust received a refund of approximately $117,000 for an expenditure relating to the September 2003 land sale. The original gain on the sale of this parcel was recorded in the fiscal year ended September 30 2003. This refund has been recorded as an additional gain on sale of this land parcel in the year ended September 30, 2004.

The Real Estate Trust owns various land parcels with approximately 380 acres of available land. These parcels offer potential development opportunities for the Trust.

The Real Estate Trust believes that the capital improvement costs for its income-producing properties will be in the range of $12.0 to $19.0 million per year for the next several years.

Liquidity Requirements – Real Estate Trust

As of September 30, 2004 the Real Estate Trust had unfunded contractual payment obligations, excluding recurring operating obligations, of approximately $38.0 million due within the next twelve months. The table below specifies the total contractual payment obligations as of September 30, 2004.


(In thousands)	Total Cost		Less than 1 Year		1-3 Years		4-5 Years		After 5 Years
Contractual Obligations
Mortgage Notes Payable	$	311,316	$	16,455	$	100,503	$	21,695	$	172,663
Notes Payable – Secured		250,000		—		—		—		250,000
Notes Payable – Unsecured		56,428		11,579		14,373		8,972		21,504
Advisory Fee		5,844		5,844		—		—		—
Capital Leases		1,374		659		715		—		—
Development Obligations		3,421		3,421		—		—		—

Total Contractual Cash Obligations	$	628,383	$	37,958	$	115,591	$	30,667	$	444,167

As of September 30, 2004, the Real Estate Trust’s current contractual obligations, excluding recurring operating obligations, due within one year total approximately $38.0 million. In addition to these contractual obligations the Real Estate Trust has other short-term liquidity requirements consisting primarily of normal recurring operating expenses, regular debt service requirements (including debt service relating to additional and replacement debt), recurring corporate expenditures, non-recurring corporate expenditures (such as tenant improvements and hotel improvements) and dividends to common and preferred shareholders. Overall capital requirements in fiscal year 2005 will depend on any acquisition and development opportunities as well as the level of improvements and redevelopments on existing properties.

The Real Estate Trust expects to fund these capital requirements and normal recurring operating costs through a combination of cash provided by operating activities, cash on hand, new financings, refinancing of maturing debt, proceeds from asset sales and dividends and tax sharing payments from the Bank.

BANKING

Liquidity. The Bank is required to maintain sufficient liquidity to ensure its safe and sound operation. A standard measure of liquidity in the savings industry is the ratio of cash and short-term U.S. Government and other specified securities to net withdrawable accounts and borrowings payable in one year or less. See “BUSINESS – Regulation – Liquidity Requirements.”

The Bank’s primary sources of funds historically have consisted of:

•

principal and interest payments on loans and mortgage-backed securities;

•

savings deposits;

•

sales of loans and trading securities;

•

securitizations and sales of loans; and

•

borrowed funds, including funds borrowed from the FHLB of Atlanta.

The Bank’s holdings of readily marketable securities and eligible loans constitute another important source of liquidity. Approximately $670.8 million of these assets are pledged to the Federal Reserve Bank of Richmond, although there were no outstanding borrowings during fiscal year 2004. As of September 30, 2004, the estimated remaining borrowing capacity, after market value and other adjustments, against that portion of those assets that may be pledged to the FHLB of Atlanta and various securities dealers totaled $3.4 billion.

The Bank accesses the capital markets as an additional means of funding its operations and managing its capital ratios and asset growth. Specifically, the Bank has securitized financial assets, including home equity, home loan and automobile loan receivables, as well as single-family residential loans, because the securitizations provide the Bank with a source of financing at competitive rates and assist the Bank in maintaining compliance with regulatory capital requirements. Additionally, the securitizations have permitted the Bank to limit the credit risk associated with these assets while continuing to earn servicing fees and other income associated with the securitized assets.

Since 1988, the Bank has securitized approximately $23.5 billion of loan receivables. At September 30, 2004, the Bank continues to service $7.1 billion and $151.0 million of securitized residential mortgages and automobile loan receivables, respectively. Chevy Chase derives fee-based income from servicing these securitized portfolios. However, that fee-based income has been adversely affected in prior periods by increases in prepayments, delinquencies and charge-offs related to the receivables in these securitized pools.

The Bank securitized and sold $4.9 billion and $2.6 billion of loan receivables during fiscal year 2004 and 2003, respectively. At September 30, 2004 and 2003, the Bank had $2.0 billion and $1.4 billion, respectively, of loan receivables held for securitization and/or sale. The proceeds from the securitization and sale of various types of loan receivables will continue to be a significant source of liquidity for the Bank.

The Bank uses its liquidity primarily to meet its commitments to fund maturing savings certificates and deposit withdrawals, fund existing and continuing loan commitments, repay borrowings and meet operating expenses. During fiscal year 2004, the Bank used the cash provided by operating, investing and financing activities primarily to (i) fund maturing savings certificates and deposit withdrawals of $52.4 billion, (ii) fund existing and continuing loan commitments, including real estate held for investment or sale, of $3.5 billion, (iii) purchase investments and loans of $7.8 billion and (iv) meet operating expenses, before depreciation and amortization, of $440.5 million. These commitments were funded primarily through (i) proceeds from customer deposits and sales of certificates of deposit of $53.2 billion, (ii) proceeds from sales of loans, trading securities and real estate of $6.5 billion, (iii) principal and interest collected on investments, loans, and securities of $3.6 billion and (iv) proceeds from borrowings of $706.9 million, net of repayment of borrowings.

At September 30, 2004, repayments of borrowed money scheduled to occur during the next 12 months were $2.2 billion. Certificates of deposit maturing during the next 12 months amounted to $1.3 billion. The Bank expects that a significant portion of these maturing certificates of deposit will remain with the Bank. In the event that deposit withdrawals are greater than anticipated, the Bank may have to increase deposit interest rates or rely on alternative and potentially higher cost sources of funds in order to meet its liquidity needs.

The Bank’s liquidity requirements in years subsequent to fiscal year 2004 will continue to be affected both by the asset size of the Bank, the growth of which may be constrained by capital requirements, and the composition of the asset portfolio. Management believes that the Bank’s primary sources of funds, described above, will be sufficient to meet the Bank’s foreseeable liquidity needs. The mix of funding sources utilized from time to time will be determined by a number of factors, including capital planning objectives, lending and investment strategies and market conditions.

Commitments and Contingencies. The Bank periodically transfers loan receivables to special purpose entities that issue securities to investors. These investors are entitled to a return of cash flows, based on the principal and interest provided by the loan receivables transferred. This process is referred to as securitization. Since 1988, the Bank has securitized approximately $23.5 billion of loan receivables.

The Bank transfers receivables from time to time to a special purpose entity commonly referred to as a depositor. The depositor then establishes a trust for each particular securitization, and transfers the related loans to that particular trust. The trust uses proceeds from the sale of the securities to pay the depositor for the loans sold to the trust, and the depositor in turn pays the proceeds over to the Bank. These securitization vehicles are not consolidated within the Bank’s consolidated financial statements since they satisfy the criteria established by Statement of Financial Accounting Standards No. 140, “Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.” In general, these criteria require the securitization vehicles to be legally isolated from the transferor (the Bank), be limited to permitted activities, and have defined limits on the assets they can hold and the permitted sales, exchanges or distribution of its assets.

When the Bank sells or securitizes loans, the Bank generally retains the right to service the loans. At September 30, 2004, the Bank continues to service $7.1 billion and $151.0 million of securitized residential mortgages and automotive loan receivables, respectively. In addition, when the Bank sells or securitizes loans, the Bank may retain a limited amount of recourse through one or more means, most often the establishment of reserve accounts, overcollateralization of receivables or retention of subordinated classes. At September 30, 2004 and 2003, total recourse to the Bank related to loan securitization transactions was $14.8 million and $31.7 million, respectively. See Note 8 to the Consolidated Financial Statements for additional information concerning loan securitization transactions.

The Bank is also obligated under recourse provisions related to the servicing of certain of its residential mortgage loans. At September 30, 2004 and 2003, the recourse to the Bank under these arrangements totaled $4.0 million and $3.4 million, respectively.

The Bank’s commitments to extend credit at September 30, 2004 are set forth in the following table.


	(In thousands)
Commitments to originate loans	$	807,347

Loans in process (collateralized loans):
Home equity		1,155,364
Real estate construction and ground		220,728
Commercial		457,253

Subtotal		1,833,345

Loans in process (unsecured loans):
Overdraft lines		139,335
Commercial		330,541

Subtotal		469,876

Total commitments to extend credit	$	3,110,568

Based on historical experience, the Bank expects to fund substantially less than the total amount of its outstanding overdraft line and home equity credit line commitments, which together accounted for 41.6% of commitments to extend credit at September 30, 2004.

The following table summarizes certain of our material contractual cash obligations associated with operating, investing and financing activities as of September 30, 2004:


	Payments due by period (In thousands)
	Total		Less than 1 year		1-3 years		3-5 years		More than 5 years
Long term debt obligations	$	2,003,987	$	621,109	$	829,221	$	348,532	$	205,125
Operating lease obligations		198,726		24,538		46,885		33,634		93,669

Total	$	2,202,713	$	645,647	$	876,106	$	382,166	$	298,794

Additionally, the Bank’s 8% Preferred Stock pays quarterly dividends in arrears at a yearly rate of $2.00 per share, totaling approximately $10.0 million in preferred stock dividends to be paid by the Bank on an annual basis. The preferred stock is redeemable for cash, at $25.00 per share plus any accrued and unpaid dividends, at the Bank’s option on or after October 1, 2008. The preferred stock has no stated maturity.

There were no material commitments for capital expenditures at September 30, 2004.

RESULTS OF OPERATIONS

The Real Estate Trust’s ability to generate revenues from property ownership and development is significantly influenced by a number of factors, including national and local economic conditions, the level of mortgage interest rates, governmental actions, such as changes in real estate tax rates, and the type, location, size and stage of development of the Real Estate Trust’s properties. Debt service payments and most of the operating expenses associated with income-producing properties are not decreased by reductions in occupancy or rental income. Therefore, the ability of the Real Estate Trust to produce net income in any year from its income-producing properties is highly dependent on the Real Estate Trust’s ability to maintain or increase the properties’ levels of gross income. The relative illiquidity of real estate investments tends to limit the ability of the Real Estate Trust to vary its portfolio promptly in response to changes in economic, demographic, social, financial and investment conditions. See “Financial Condition—Real Estate.”

The bank’s operating results historically have depended primarily on its “net interest spread,” which is the difference between the rates of interest earned on its loans and securities investments and the rates of interest paid on its deposits and borrowings. In recent periods, the bank has generated significant income from loan servicing and securities activities and deposit fees. In addition to interest paid on its interest-bearing liabilities, the bank’s principal expenses are operating expenses.

FISCAL 2004 COMPARED TO FISCAL 2003

REAL ESTATE

The Real Estate Trust recorded a loss from continuing operations before depreciation of $4.6 million and an operating loss from continuing operations of $23.4 million for fiscal 2004, compared to income from continuing operations before depreciation of $4.9 million and an operating loss from continuing operations of $14.0 million for fiscal 2003. The changes reflect improved operating results in the hotel portfolio and lower write-downs of the Real Estate Trust’s non-public investments which were offset by declining results in the office and industrial portfolio, increased interest expense, the write-off of unamortized debt costs of $2.4 million, the early redemption premium of $6.5 million, included in interest and amortization of debt expense, associated with the payoff of the Real Estate Trust’s $200 million Senior Secured Notes and differences in the respective gains recognized on property sales, $9.1 million in fiscal 2003 compared to $2.8 million in fiscal 2004.

Income after direct operating expenses from hotels increased $6.3 million, or 22.9%, in fiscal 2004 from the level achieved in fiscal 2003. Total revenue increased $11.3 million, or 13.3%, as the overall occupancy percentage for the hotel properties increased from 61.1% in fiscal 2003 to 66.0% in fiscal 2004 while the average room rate increased $5.74, or 6.7% from $85.93 in fiscal 2003 to $91.67 in fiscal 2004, reflecting improved demand at the Real Estate Trust’s hotel properties, particularly the Northern Virginia and Florida properties. Room sales for fiscal 2004 increased $10.3 million, or 15.5%, from fiscal year 2003, while food, beverage and other sales increased $956,000, or 5.2%. Direct operating expenses increased $5.0 million, or 8.7%, reflecting increased operating costs, such as payroll, advertising and other operating costs associated with the increased hotel occupancy.

Income after direct operating expenses from office and industrial properties decreased $1.2 million, or 4.4%, in fiscal 2004 compared to fiscal 2003. Total revenue decreased $896,000, or 2.3%, in fiscal 2004 as increased vacancy during the first and second fiscal quarters of 2004, specifically at two of the Trust’s office properties, offset contractual rent increases. In addition, leased space is turning over at lower rental rates in the current fiscal period. Direct operating expenses increased $321,000, or 2.8% in fiscal 2004 as increased bad debt, repair and maintenance and utility costs were slightly offset by lower property taxes.

Other income, which includes interest income, income from other real estate properties and other miscellaneous income, increased $329,000, or 25.3%, in fiscal 2004 principally due to increased revenue from the Real Estate Trust’s other real estate investments and higher interest income in the 2004 period reflecting the increased invested cash balance resulting from the net proceeds received from the $250 million Senior Secured Debt offering.

Land parcels and other expense increased $158,000, or 13.4%, in fiscal 2004 when compared to fiscal 2003 as a result of increased operating expenses at the Real Estate Trust’s other real estate investments.

Interest and amortization of debt expense increased $9.6 million, or 19.0%, from $50.5 million in the fiscal 2003 period to $60.1 million in the fiscal 2004 period. The fiscal 2004 period includes the $6.5 million redemption premium paid as a result of the early redemption of the $200 million Senior Secured Notes. Other interest expense, which increased $884,000 in the fiscal 2004 period, includes interest on the new $250 million Senior Secured Notes which were issued on February 25, 2004 and interest is payable from that date, therefore interest expense includes interest on both the $200 million and the $250 million Senior Secured Debt from February 25, 2004 through March 31, 2004. This overlap in interest resulted in additional interest charges of approximately $1.9 million in the fiscal 2004 period. This increase in interest expense was slightly offset by lower interest expense on other debt due to lower mortgage and line of credit balances and lower interest rates on those borrowings. The average balance of outstanding borrowings increased to $638.1 million in the fiscal 2004 period from $585.1 million in the fiscal 2003 period, reflecting the overlap period of the Senior Secured Debt which offset lower mortgage and line of credit balances. The average cost of borrowings was 9.06% in the fiscal 2004 period and 8.68% in the fiscal 2003 period, reflecting the $6.5 million redemption premium paid in fiscal 2004 which offset the 225 basis point reduction in the outstanding Senior Secured Note debt. Amortization of debt expense increased $2.2 million, reflecting the write-off of unamortized debt costs of $2.4 million relating to the $200 million Senior Secured Notes. This increase was slightly offset by lower other debt cost amortization reflecting debt refinancing and extensions which settled during the 2003 fiscal year.

Depreciation expense decreased $153,000, or 0.8%, as a result of the retirement of certain office and hotel improvements in fiscal 2003 which offset the additional depreciation expense of new income-producing assets and tenant improvements placed into service in fiscal 2004.

Advisory, management and leasing fees paid to related parties increased $747,000, or 6.1%, in the fiscal 2004 period when compared to the fiscal 2003 period. The advisory fee in fiscal 2004 was $472,000 per month compared to $458,000 per month for fiscal 2003, an aggregate increase of $168,000. The remainder of the cost increase, totaling $579,000, was due to higher hotel management fees reflecting the 13.3% increase in hotel revenue and increased office leasing costs paid.

General and administrative expense decreased $380,000, or 13.5%, from $2.8 million in the fiscal 2003 period to $2.4 million in the fiscal 2004 period. Lower legal and licensing costs were slightly offset by other increases, such as the write-off of certain acquisition and development costs for projects that the Real Estate Trust has determined not to pursue.

Equity in earnings of unconsolidated entities reflected net earnings of $7.8 million in the fiscal 2004 period as compared to $7.2 million in the fiscal 2003 period, an increase of approximately $600,000. Earnings from Saul Holdings Partnership and Saul Centers were lower by $239,000 in fiscal 2004 primarily due to the dilution caused by the November 2003 Saul Centers preferred stock offering. Losses from other investments totaled $616,000 in fiscal 2004 as compared to losses of $1.4 million in fiscal 2003. These losses are a result of write-downs of a certain non-public investment accounted for under the equity method.

The Real Estate Trust recorded an impairment charge of $998,000 in the fiscal 2003 period due to write-downs of certain non-public investments accounted for under the cost method. No impairment charges were recorded in the fiscal 2004 period.

In February 2004 the Commonwealth of Virginia acquired 7.93 acres of land owned by the Real Estate Trust for use in a highway project. The Commonwealth of Virginia has paid $3.6 million which has resulted in an initial gain of approximately $2.7 million. In addition, during the quarter ended June 30, 2004 the Real Estate Trust received a refund of approximately $117,000 for an expenditure relating to a September 2003 land sale. The original gain on the sale of this parcel was recorded in the fiscal year ended September 30 2003. This refund has been recorded as an additional gain on sale of this land parcel in the fiscal year ended September 30, 2004.

On September 25, 2003 the Real Estate Trust sold a land parcel in Rockville, Maryland for $11.3 million resulting in a gain of $9.1 million.

The Real Estate Trust has placed one of its hotel properties on the market for sale and has written down its investment in this asset by $310,000 to arrive at its estimated fair value, less cost to sell, of $2.1 million. Included in the fiscal 2004 period Loss from Operations of Discontinued Real Estate Asset of $1.0 million is the $310,000 write-down. The sale of this asset closed on December 9, 2004.

BANKING

Overview. The Bank recorded operating income of $231.2 million for the year ended September 30, 2004, compared to operating income of $146.2 million for the year ended September 30, 2003. The improvement in income in fiscal year 2004 was primarily due to increases in servicing, securitization and mortgage banking income, as well as net interest income and decreases in the provision for loan losses and depreciation and amortization expense. A decrease in automobile rental income and increases in salaries and employee benefits and other (non-interest) expenses partially offset the increased income. The Bank’s net income in future periods will continue to be affected by increased operating expenses associated with expansion of the Bank’s branch network and other areas of business and potential use of relatively higher cost sources of funding to support continued growth.

Net Interest Income. Net interest income, before the provision for loan losses, increased $32.2 million (or 13.1%) in fiscal year 2004 from fiscal year 2003. Interest income recorded on non-accrual assets and restructured loans totaled $0.2 million during fiscal year 2004. The Bank would have recorded interest income of $1.2 million in fiscal year 2004 if non-accrual assets and restructured loans had been current in accordance with their original terms. The Bank’s net interest income in future periods will continue to be adversely affected by the Bank’s non-performing assets. See “Financial Condition – Asset Quality – Non-Performing Assets.”

The following table sets forth, for the periods indicated, information regarding the total amount of income from interest-earning assets and the resulting yields, the interest expense associated with interest-bearing liabilities, expressed in dollars and rates, and the net interest spread and net yield on interest-earning assets. The table contains information of the Bank only and does not include consolidation or elimination entries required for the Trust’s financial presentation.

Net Interest Margin Analysis

(Dollars in thousands)


	Year Ended September 30,
	2004						2003						2002
	Average Balances		Interest		Yield/ Rate		Average Balances		Interest		Yield/ Rate		Average Balances		Interest		Yield/ Rate
Assets:
Interest-earning assets:
Loans receivable, net ⁽¹⁾	$	10,081,196	$	411,640	4.08	%	$	8,512,601	$	402,405	4.73	%	$	7,349,188	$	454,297	6.18	%
Mortgage-backed securities		435,313		20,505	4.71			682,799		36,625	5.36			1,233,159		74,358	6.03
Federal funds sold and securities
purchased under agreements to resell		67,738		748	1.10			70,282		885	1.26			48,022		857	1.78
Trading securities		27,079		1,355	5.00			87,247		4,801	5.50			47,241		2,988	6.33
Investment securities		58,488		1,163	1.99			46,399		1,192	2.57			46,206		1,527	3.30
Other interest-earning assets		219,553		5,860	2.67			191,318		5,643	2.95			200,286		7,372	3.68

Total		10,889,367		441,271	4.05			9,590,646		451,551	4.71			8,924,102		541,399	6.07

Non-interest earning assets:
Cash		287,557						298,697						257,790
Real estate held for investment or sale		20,785						24,597						27,693
Property and equipment, net		482,874						471,845						454,282
Automobiles subject to lease, net		635,526						1,039,802						1,110,660
Goodwill and other intangible assets, net		24,181						24,597						25,832
Other assets		480,141						355,771						294,457

Total assets	$	12,820,431					$	11,805,955					$	11,094,816

Liabilities and stockholders’ equity:
Interest-bearing liabilities:
Deposit accounts:
Demand deposits	$	2,094,878		4,351	0.21		$	1,799,489		4,601	0.26		$	1,537,403		4,792	0.31
Savings deposits		1,200,609		3,294	0.27			1,099,990		4,921	0.45			974,371		9,346	0.96
Time deposits		1,746,956		33,447	1.91			1,925,830		49,195	2.55			2,370,643		98,262	4.14
Money market deposits		2,322,983		17,159	0.74			2,114,947		21,405	1.01			1,813,702		31,512	1.74

Total deposits		7,365,426		58,251	0.79			6,940,256		80,122	1.15			6,696,119		143,912	2.15
Borrowings		3,173,104		104,771	3.30			2,769,252		125,357	4.53			2,688,025		129,274	4.81

Total liabilities		10,538,530		163,022	1.55			9,709,508		205,479	2.12			9,384,144		273,186	2.91

Non-interest-bearing items:
Non-interest bearing deposits		1,146,484						1,091,918						845,455
Other liabilities		302,171						317,225						221,286
Minority interest		175,391						146,580						144,000
Stockholders’ equity		657,855						540,724						499,931

Total liabilities and stockholders’ equity	$	12,820,431					$	11,805,955					$	11,094,816

Net interest income			$	278,249					$	246,072					$	268,213

Net interest spread ⁽²⁾					2.51	%					2.59	%					3.16	%

Net yield on interest-earning assets ⁽³⁾					2.56	%					2.57	%					3.01	%

Interest-earning assets to interest-bearing liabilities					103.33	%					98.78	%					95.10	%

SAUL B F REAL ESTATE INVESTMENT TRUST 10-K