**UNITED STATES SECURITIES AND EXCHANGE COMMISSION**

**Washington,D. C. 20549**

 

**FORM 10-K**

** **

| **(mark  one)** |                                                                                      |
|-----------------|-------------------------------------------------------------------------------------------|
| **ý**      | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|            |                                                                                      |
|            | **For  the fiscal year ended:  December 31,  2001**                                  |

 

**OR**

 

| **o**  | **TRANSITION REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                                                                                                                                                                           |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                           |
|   | **For  the transition period  from                      to                      ** |

 

**CommissionFile Number: 001-13637**

 

**APEX MORTGAGE CAPITAL, INC.**

(Exact name of Registrantas specified in its Charter)

 

| **Maryland**                                                                      |   | **95-4650863**                           |
|-----------------------------------------------------------------------------------|--------|------------------------------------------|
| (State or other  jurisdiction of incorporation  or organization)                  |   | (I.R.S. Employer  Identification Number) |
|                                                                              |   |                                     |
| **865  South Figueroa Street  Los Angeles, California**                           |   | **90017**                                |
| (Address of principal  executive offices)                                         |   | (Zip Code)                               |
|                                                                              |   |                                     |
| Registrant’s telephone  number, including area code  **(213) 244-0000** |

 

Securities registeredpursuant to Section 12(b) of the Act:

 

| **Title of Each Class**        |   | **Name of Exchange Which Registered** |
|--------------------------------|--------|---------------------------------------|
| Common Stock ($.01 par  value) |   | American Stock Exchange               |

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.

Yes  ý   No  o

 

Indicate by checkmark if disclosure of delinquent filers pursuant to Item 405 Regulation S-K isnot contained herein, and will not be contained, to the best of theRegistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K.  ý

 

At March 26, 2002, theaggregate market value of the voting stock held by non-affiliates was$274,477,027 based on the closing price of the Common Stock on the AmericanStock Exchange.

 

Number of shares ofCommon Stock outstanding at March 26, 2002: 24,755,500

 

DOCUMENTS INCORPORATED BY REFERENCE:

Portions of theRegistrant’s definitive Proxy Statement to be filed pursuant to Regulation 14Awithin 120 days from December 31, 2001, are incorporated by reference into PartIII.

 

 

 

**SAFEHARBOR STATEMENT UNDER**

**THEPRIVATE SECURITIES LITIGATION REFORM ACT OF 1995**

 

CERTAININFORMATION CONTAINED IN THIS REPORT CONSTITUTES ‘‘FORWARD-LOOKING STATEMENTS’’WHICH CAN BE IDENTIFIED BY THE USE OF FORWARD-LOOKING TERMINOLOGY SUCH AS‘‘MAY,’’ ‘‘WILL,’’ ‘‘SHOULD,’’ ‘‘EXPECT,’’ ‘‘ANTICIPATE,’’ ‘‘ESTIMATE,’’‘‘INTEND,’’ ‘‘CONTINUE,’’ OR ‘‘BELIEVES’’ OR THE NEGATIVES THEREOF OR OTHERVARIATIONS THEREON OR COMPARABLE TERMINOLOGY. SOME IMPORTANT FACTORS THAT WOULD CAUSE ACTUAL RESULTS TO DIFFERMATERIALLY FROM THOSE IN ANY FORWARD-LOOKING STATEMENTS INCLUDE: CHANGES IN INTERESTRATES; DOMESTIC AND FOREIGN BUSINESS, MARKET, FINANCIAL OR LEGAL CONDITIONS;DIFFERENCES IN THE ACTUAL ALLOCATION OF THE ASSETS OF THE COMPANY FROM THOSEASSUMED; AND THE DEGREE TO WHICH ASSETS ARE HEDGED AND THE EFFECTIVENESS OF THEHEDGE, AMONG OTHERS.  IN ADDITION, THEDEGREE OF RISK IS INCREASED BY THE COMPANY’S LEVERAGING OF ITS ASSETS.

 

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**ApexMortgage Capital, Inc.**

**2001Form 10-K Annual Report**

** **

**Table ofContents**

 
| ITEM 1.   | BUSINESS                                                                                    |   |
|-----------|---------------------------------------------------------------------------------------------|--------|
| ITEM 2.   | PROPERTIES                                                                                  |   |
| ITEM 3.   | LEGAL PROCEEDINGS                                                                           |   |
| ITEM  4.  | SUBMISSION  OF MATTERS TO A VOTE OF SECURITY HOLDERS                                        |   |
| ITEM  5.  | MARKET  FOR REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                 |   |
| ITEM 6    | SELECTED FINANCIAL  DATA                                                                    |   |
| ITEM  7.  | MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |   |
| ITEM  7A. | QUANTITATIVE  AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK                                 |   |
| ITEM  8.  | FINANCIAL  STATEMENTS AND SUPPLEMENTARY DATA                                                |   |
| ITEM  9.  | CHANGES  IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE       |   |
| ITEM  10. | DIRECTORS  AND EXECUTIVE OFFICERS OF THE REGISTRANT                                         |   |
| ITEM 11.  | EXECUTIVE COMPENSATION                                                                      |   |
| ITEM  12. | SECURITY  OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT                             |   |
| ITEM  13. | CERTAIN  RELATIONSHIPS AND RELATED TRANSACTIONS                                             |   |
| ITEM  14. | EXHIBITS,  FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K                            |   |

 

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***Certain capitalizedand other terms used herein shall have the meanings***

***assigned to them inthe glossary at the end of this report.***

 

**PART I**

 

**ITEM 1.  BUSINESS**

 

*Thefollowing description of our business should be read in conjunction with theinformation included elsewhere in this Annual Report on Form 10-K, including inthe section “Management’s Discussion and Analysis of Financial Condition andResults of Operations” and in our financial statements and notes thereto whichare included in this Annual Report on Form 10-K.*

 

**GENERAL**

 

Apex MortgageCapital, Inc.  (the ‘‘Company’’), aMaryland corporation, was formed on September 15, 1997, primarily to acquireUnited States agency and other highly rated, single-family real estate adjustableand fixed rate Mortgage Related Assets. The Company commenced operations on December 9, 1997, following theinitial public offering of the Company’s Common Stock.  The Company’s principal executive officesare located at 865 South Figueroa Street, Suite 1800, Los Angeles, California90017, and its telephone number is (213) 244-0000.

 

The Company usesits equity capital and borrowed funds to seek to generate income based on thedifference between the yield on its Mortgage Related Assets and the cost of itsborrowings.  The Company has elected tobe taxed as a real estate investment trust (‘‘REIT’’) under the InternalRevenue Code of 1986, as amended (the ‘‘Code’’).  The Company will not generally be subject to federal taxes on itsincome to the extent that it distributes its net income to its stockholders andmaintains its qualification as a REIT.

 

The day-to-dayoperations of the Company are managed by an external management company, TCWInvestment Management Company (the “Manager”), subject to the direction andoversight of the Company’s Board of Directors. A majority of the Board of Directors are unaffiliated with The TCWGroup, Inc.  (‘‘TCW’’ and, together withits subsidiaries and Affiliates, the ‘‘TCW Group’’) or the Manager.  The Manager is a wholly-owned subsidiary ofTCW.  The Manager was established in1987 and the TCW Group began operations in 1971 through one of itsaffiliates.  The Company’s investmentmanagement team are selected members of the TCW Group’s Mortgage-BackedSecurities Group (the ‘‘MBS Group’’), all of whom have over 13 years ofexperience in raising and managing mortgage capital.  The Company has elected to be externally managed by the Managerto take advantage of the existing operational systems, expertise and economiesof scale associated with the Manager’s current business operations, among otherreasons. The Manager’s key officers have experience in raising and managingmortgage capital, mortgage finance and the purchase and administration ofMortgage Related Assets.

 

**RECENT EVENTS**

 

*Dividend Declaration*.  On February 22, 2002, the Company’s Board ofDirectors declared a dividend distribution of $0.50 per share of Common Stockfor the first quarter of 2002.  Thedividend is payable on April 26, 2002, to stockholders of record on March 28,2002.

 

*Reporting Period*.  Unless otherwise noted, this Reportdescribes the Company’s operations and developments through the date hereof.

 

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**STRATEGY**

 

To achieve itsbusiness objective and generate dividend yields that provide a competitive rateof return for its stockholders, the Company’s strategy is to:

 

•       purchase primarily single-family fixedand adjustable rate Mortgage Related Assets;

 

•       manage the credit risk of its MortgageRelated Assets through, among other activities (i) carefully selecting MortgageRelated Assets to be acquired, (ii) complying with the Company’s investmentpolicy, (iii) actively monitoring the ongoing credit quality and servicing ofits Mortgage Related Assets, and (iv) maintaining appropriate capital levelsand allowances for possible credit losses;

 

•       finance purchases of Mortgage RelatedAssets with the net proceeds of equity offerings and, to the extent permittedby the Company’s leverage policy, to utilize leverage to increase potentialreturns to stockholders through borrowings (primarily reverse repurchaseagreements) with interest rates that will also reflect changes in short-termmarket interest rates;

 

•       seek to structure its borrowings inaccordance with its interest rate risk management policy;

 

•       utilize interest rate swaps, forwardcontracts on U.S. Treasury notes, interest rate caps and similar financialinstruments to mitigate interest rate risks; and

 

•       seek to minimize prepayment riskprimarily by structuring a diversified portfolio with a variety of prepaymentcharacteristics.

 

There can be noassurance that the Company will be able to generate competitive earnings anddividends while holding primarily High Quality Mortgage Related Assets andmaintaining a disciplined risk-control profile.

 

The Company mayattempt to increase the return to stockholders over time by: (i) raisingadditional capital in order to increase its ability to invest in additionalMortgage Related Assets; (ii) lowering its effective borrowing costs throughdirect funding with collateralized lenders, in addition to using Wall Streetintermediaries, and investigating the possibility of using collateralizedcommercial paper and medium-term note programs; and (iii) improving the efficiencyof its balance sheet structure by issuing uncollateralized subordinated debtand other forms of capital.

 

**Management Policies and Programs**

 

The Company is afinancial company that uses its equity capital and borrowed funds to seek togenerate net income based on the difference between the interest income on itsassets and the cost of its borrowings. The Company has elected to be taxed as a REIT under the Code.  The Company intends to operate in accordancewith its operating policies as approved by the Company’s Board of Directors atleast annually.

 

The Company hasestablished the following five primary operating policies to implement itsbusiness strategy of acquiring assets consisting primarily of United Statesagency and other highly rated single-family real estate mortgage securities andmortgage loans in order to generate dividend yields that provide a competitiverate of return for its stockholders:

 

**•**       InvestmentPolicy;

•       Leverage Policy;

•       Interest Rate Risk Management Policy;

•       REIT Compliance Policy; and

•       Hedging Strategy Policy.

 

Compliance withthe foregoing policy guidelines shall be determined by the Manager at the timeof the Company’s purchase of the Mortgage Related Assets (based on the mostrecent valuation thereof by the Company) and will not be affected by eventssubsequent to the purchase.  Such eventsinclude, without limitation, changes in characterization, value or 

 

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rating of any specificMortgage Related Assets or economic conditions or other events generallyaffecting any Mortgage Related Assets of the type held by the Company.

 

***Investment Policy***

 

The Companyintends to acquire investments that it believes will maximize returns oncapital invested, after considering (i) the amount and nature of theanticipated returns from the investment, (ii) the Company’s ability to pledgethe investment to secure collateralized borrowings, and (iii) the costsassociated with financing, hedging, managing, securitizing and reserving forsuch investments.

 

The Companygenerally expects to primarily invest in Mortgage Related Assets that mayinclude Short-Term Investments, Mortgage-Backed Securities, High Credit QualityMortgage Loans, Mortgage Derivative Securities and Other Investments.

 

The Company’sinvestment policy is intended to provide guidelines for the acquisition of itsinvestments.  Specifically, theinvestment policy provides that the Company intends to acquire a portfolio ofinvestments that can be segregated into specific categories.  Each category and its respective investmentlimitations are as follows:

 

*50%Category*

 

At least 50% ofthe Company’s total assets are expected to consist of (i) Short-TermInvestments, (ii) Mortgage-Backed Securities that are either issued orguaranteed by an agency of the U.S. government, (iii) Mortgage-BackedSecurities that are rated AAA by at least one nationally recognized ratingagency or (iv) High Credit Quality Mortgage Loans that are funded withCommitted Secured Borrowings.

 

*75%Category*

 

At least 75% ofthe Company’s total assets are expected to consist of investments that qualifyfor the 50% Category or other Mortgage-Backed Securities that have received aninvestment grade rating by at least one nationally recognized rating agency.

 

*90%Category*

 

At least 90% ofthe Company’s total assets are expected to consist of investments that qualifyfor the 75% Category or High Credit Quality Mortgage Loans that are not fundedby Committed Secured Borrowings.

 

*10%Category*

 

Not more than 10%of the Company’s total assets are expected to consist of (i) Mortgage-BackedSecurities rated below investment grade, (ii) Mortgage Derivative Securities or(iii) Other Investments.

 

***Leverage Policy***

 

The Companygenerally anticipates utilizing leverage to increase returns to itsstockholders.  The Company’s goal is tostrike a balance between the under-utilization of leverage, which reducespotential returns to stockholders, and the over-utilization of leverage, whichcould reduce the Company’s ability to meet its obligations during periods ofadverse market conditions. The Company has established a leverage policy tocontrol the type and amount of leverage used to fund the acquisition of itsMortgage Related Assets.  The Company’sleverage policy is intended to provide guidelines for utilizing securedborrowings in the form of Uncommitted Secured Borrowings and Committed SecuredBorrowings.

 

*Uncommitted Secured Borrowings*

 

The Companyexpects a substantial portion of its borrowings may consist of UncommittedSecured Borrowings including reverse repurchase agreements, lines of credit,Dollar-Roll Agreements, and other financing transactions.  Such funding sources generally do not committhe lender to continue to provide financing to the Company.  The Company intends to limit the amount ofUncommitted Secured Borrowings to 92% of its total assets, less any assets thatare funded

 

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with Committed SecuredBorrowings, plus the market value of any related hedging transactions.  If the amount of such borrowings exceeds92%, the Manager will be required to submit to the Company’s Board of Directorsa plan designed to bring the total amount of Uncommitted Secured Borrowingsbelow the 92% limitation.  It isanticipated that in many circumstances this goal will be achieved over timewithout active management through the natural process of mortgage principalrepayments and increases in the market value of the Company’s totalassets.  The Company anticipates that itwill only enter into repurchase agreements and other financing transactionswith counter-parties rated investment grade by a Rating Agency.

 

*CommittedSecured Borrowings*

 

The Company’sborrowings may consist of Committed Secured Borrowings, including the issuanceof CMOs, structured commercial paper programs, secured term notes and otherfinancing transactions.  Such fundingsources generally commit the lender to provide financing to the Company for aspecified period of time or to provide financing to the Company to fund specificassets until they mature.  The Companyintends to limit the amount of Committed Secured Borrowings to 97% of theassets funded with such borrowings at the time any corresponding transaction isentered into.

 

***Interest Rate Risk Management Policy***

 

The Company hasestablished an interest rate risk management policy that is intended tomitigate the negative impact of changing interest rates.  The Company generally intends to mitigateinterest rate risk by targeting the difference between the market weighted averageduration on its Mortgage Related Assets funded with secured borrowings to themarket weighted average duration of such borrowings to one year or less, takinginto account all hedging transactions. The Company generally does not intend to have any specific durationtarget for the portion of its Mortgage Related Assets that are not funded bysecured borrowings.  There can be noassurance that the Company will be able to limit such duration differences andthere may be periods of time when the duration difference will be greater thanone year.

 

The Company mayimplement its interest rate risk management policy by utilizing various hedgingtransactions, including interest rate swaps, interest rate swaptions, interestrate caps, interest rate floors, financial futures contracts, options onfinancial futures contracts, and other structured transactions.  The Company does not intend to enter intosuch transactions for speculative purposes.

 

***REIT Compliance Policy***

 

The Companyintends to operate its business in compliance with the REIT Provisions of theCode.  Accordingly, all of theprovisions outlined in the Company’s investment, leverage and interest raterisk management policies are subordinate to the REIT Provisions of the Code ifany conflicts arise.

 

To qualify for taxtreatment as a REIT, the Company must meet certain tests as fully described inSections 856 and 857 of the Code.  Asummary of the requirements for qualification as a REIT is describedimmediately below.

 

*Stock**OwnershipTests*.  The capital stock ofthe Company must be held by at least 100 persons and no more than 50% of thevalue of such capital stock may be owned, directly or indirectly, by five orfewer individuals at all times during the last half of the taxable year.  Tax-Exempt Entities, other than privatefoundations and certain unemployment compensation trusts, are generally nottreated as individuals for these purposes. The stock ownership requirements must be satisfied in the Company’s secondtaxable year and in each subsequent taxable year.

 

*Asset Tests.*  The Company must generally meet thefollowing asset tests at the close of each quarter of each taxable year.  At least 75% of the value of the Company’stotal assets must consist of Qualified REIT Real Estate Assets, U.S. Governmentsecurities, cash and cash items (the “75% Asset Test”).  In general, the value of securities held bythe Company but not taken into account for purposes of the 75% Asset Test mustnot exceed (i) 5% of the value of the Company’s total assets in the case ofsecurities of any one non-government issuer, or (ii) 10% of the outstandingvoting securities or value of such securities of any such issuer. An exceptionis provided, however, for the Company’s interest in a Taxable REIT Subsidiary.

 

*Income Tests*.  The Company must generally meet certaingross income tests for each taxable year. At least 75% of the Company’s gross income must be derived from certainspecified real estate sources, including interest income and gain 

 

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from the disposition ofQualified REIT Real Estate Assets or Qualified Temporary Investment Income (the“75% Gross Income Test”).  At least 95%of the Company’s gross income for each taxable year must be derived fromsources of income qualifying for the 75% Gross Income Test, dividends, interestunrelated to real estate, and gains from the sale of stock or other securities(including certain interest rate swap and cap agreements entered into to hedgevariable rate debt incurred to acquire Qualified REIT Real Estate Assets) notheld for sale in the ordinary course of business (the “95% Gross Income Test”).

 

*Dividend Distribution Requirements.*  The Company must generally distribute to itsstockholders an amount equal to at least 90% of the Company’s taxable incomebefore deductions of dividends paid and excluding net capital gains.  The Company has until January 31 followingthe end of the fiscal year to pay the dividends out to stockholders and is permittedto offer a special dividend in order to meet the 90% requirement.

 

***Hedging Strategy Policy***

 

The Companyutilizes interest rate swaps and other similar financial instruments tomitigate the risk of the cost of its variable-rate liabilities exceeding theearnings on its Mortgage Related Assets during the normal course ofbusiness.  The Company has established a Hedging Strategy Policy toprovide and maintain the information required to support the processes andaccounting for interest rate risk management activities subject to Statement ofFinancial Accounting Standards No. 133, “Accounting for Derivative Instrumentsand Hedging Activities” and Statement of Financial Accounting Standards No.138, “Accounting for Certain Derivative Instruments and Certain HedgingActivities,” and related Derivative Implementation Group pronouncements. The policy includes required documentation to be maintained for derivativehedging activities to qualify for hedge accounting including requireddescription of the hedging relationship and the risk management objectiveand strategy for undertaking specific hedges.

 

***Other Policies***

 

The Companyintends to operate in a manner that will not subject it to regulation under theInvestment Company Act.  The Companydoes not currently intend to (i) originate Mortgage Loans or (ii) offersecurities in exchange for real property. The Company will not purchase any Mortgage Related Assets from itsAffiliates other than mortgage securities that may be purchased from a taxablesubsidiary of the Company that may be formed in connection with thesecuritization of Mortgage Loans.

 

**Future Revisions in Policies andStrategies**

 

The Company’sBoard of Directors has established the policies and strategies set forth inthis Report.  The Board of Directors(subject to approval by a majority of Unaffiliated Directors) has the power tomodify or waive such policies and strategies without the consent of ourstockholders.  The Company’s Board ofDirectors will at least annually establish and approve (including approval by amajority of Unaffiliated Directors) the policies and strategies of the Company.

 

**Description of Mortgage RelatedAssets**

 

The Companyinvests principally in the following types of Mortgage Related Assets, subjectto the operating restrictions described in ‘‘Management Policies and Programs’’above.

 

***Primary Mortgage Securities***

 

*Pass-Through Certificates. *Pass-Through Certificatesare securities representing interests in “pools” of Mortgage Loans secured byresidential real property in which payments of both interest and principal onthe securities are generally made monthly, in effect “passing through” monthlypayments made by the individual borrowers on the Mortgage Loans which underliethe securities (net of fees paid to the issuer or guarantor of the securities).  Early repayment of principal on someMortgage Related Assets (arising from prepayments of principal due to sale ofthe underlying property, refinancing, or foreclosure, net of fees and costswhich may be incurred) may expose the Company to a lower rate of return upon reinvestmentof principal.  This is known asprepayment risk.  Also, if a securitysubject to prepayment has been purchased at a premium, the value of the premiumwould be lost in the event of prepayment. Like other fixed income securities, when interest rates rise, the valueof a Mortgage Related Asset generally will decline; however, when interestrates are declining, 

 

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the value of MortgageRelated Assets with prepayment features may not increase as much as other fixedincome securities.  The rate ofprepayments on underlying mortgages will affect the price and volatility of aMortgage Related Asset, and may have the effect of shortening or extending theeffective maturity of the security beyond what was anticipated at the time ofpurchase.  When interest rates rise, theholdings of Mortgage Related Assets by the Company can reduce returns if theowners of the underlying mortgages pay off their mortgages later thananticipated.  This is known as extensionrisk.

 

Payment ofprincipal and interest on some mortgage pass-through securities (but not themarket value of the securities themselves) may be guaranteed by the full faithand credit of the U.S. Government (in the case of securities guaranteed by theGovernment National Mortgage Association (“GNMA”)) or guaranteed by agencies orinstrumentalities of the U.S. Government (in the case of securities guaranteedby the federally chartered and privately owned corporation organized andexisting under the Federal National Mortgage Association Charter Act (12U.S.C., § 1716 et seq.), formerly known as the Federal National MortgageAssociation (“Fannie Mae”), or the Federal Home Loan Mortgage Corporation(“FHLMC”)) which are supported only by the discretionary authority of the U.S.Government to purchase the agency’s obligations.  Mortgage Related Assets created by non-governmental issuers (suchas commercial banks, savings and loan institutions, private mortgage insurancecompanies, mortgage bankers and other secondary market issuers) may besupported by various forms of insurance or guarantees, including individualloan, title, pool and hazard insurance and letters of credit, which may beissued by governmental entities, private insurers or the mortgage poolers.

 

*Collateralized MortgageObligations. *CollateralizedMortgage Obligations (“CMOs”) are hybrid mortgage related instruments.  Interest and pre-paid principal on a CMO arepaid, in most cases, on a monthly basis. CMOs may be collateralized by whole Mortgage Loans, but are moretypically collateralized by portfolios of mortgage pass-through securitiesguaranteed by GNMA, FHLMC or Fannie Mae. CMOs are structured into multiple classes, with each class bearing adifferent stated maturity.  Monthlypayments of principal, including prepayments, are first returned to investorsholding the shortest maturity class; investors holding the longer maturityclasses receive principal only after the first class has been retired.  CMOs that are issued or guaranteed by theU.S. Government or by any of its agencies or instrumentalities will beconsidered U.S. Government securities by the Company.

 

***Other Mortgage Securities***

 

*General. *The Company may acquire other mortgagesecurities such as non-High Quality Mortgage Related Assets and other mortgagesecurities collateralized by single-family Mortgage Loans, mortgage warehouseparticipations, Mortgage Derivative Securities, subordinated interests andother mortgage-backed and mortgage-collateralized obligations, other than pass-throughcertificates and CMOs.

 

*Mortgage Derivative Securities. *The Company may acquireMortgage Derivative Securities not to exceed 10% of its total assets.  Mortgage Derivative Securities provide forthe holder to receive interest only, principal only, or interest and principalin amounts that are disproportionate to those payable on the underlyingMortgage Loans.  Payments on MortgageDerivative Securities are highly sensitive to the rate of prepayments on theunderlying Mortgage Loans.  In the eventof more rapid (slower) than anticipated prepayments on such Mortgage Loans, therates of return on interests in Mortgage Derivative Securities representing theright to receive interest only or a disproportionately large amount of interest(‘‘Interest Only Derivatives’’) would be likely to decline (increase).  Conversely, the rates of return on MortgageDerivative Securities representing the right to receive principal only or adisproportionate amount of principal (‘‘Principal Only Derivatives’’) would belikely to increase (decrease) in the event of rapid (slow) prepayments.

 

The Company mayalso invest in Inverse Floaters, a class of CMOs with a coupon rate that resetsin the opposite direction from the market rate of interest to which it isindexed, such as the London Inter-Bank Offered Rate (“LIBOR”) or the 11thDistrict Cost of Funds Index (“COFI”). Any rise in the index rate (as a consequence of an increase in interestrates) causes a drop in the coupon rate of an Inverse Floater while any drop inthe index rate causes an increase in the coupon of an Inverse Floater.  An Inverse Floater may behave like asecurity that is leveraged since its interest rate usually varies by amagnitude much greater than the magnitude of the index rate of interest.  The “leverage-like” characteristics inherentin Inverse Floaters are associated with greater volatility in their marketprices.

 

The Company alsomay invest in other Mortgage Derivative Securities that may be developed in thefuture.

 

*Subordinated Interests. *The Company also mayacquire subordinated interests, which are classes of mortgage securities thatare junior to other classes of such series of mortgage securities in the rightto receive payments from the underlying Mortgage Loans.  The subordination may be for all paymentfailures on the Mortgage Loans securing or 

 

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underlying such series ofmortgage securities.  The subordinationwill not be limited to those resulting from certain types of risks, such as thoseresulting from war, earthquake or flood, or the bankruptcy of a borrower.  The subordination may be for the entireamount of the series of mortgage securities or may be limited in amount.

 

*Mortgage WarehouseParticipations. *TheCompany also may from time to time acquire mortgage warehouse participations asan additional means of diversifying its sources of income.  The Company anticipates that suchinvestments, together with its investments in Other Mortgage Assets, will notin the aggregate exceed 10% of its total Mortgage Related Assets.  These investments are participations inlines of credit to Mortgage Loan originators that are secured by recentlyoriginated Mortgage Loans that are in the process of being sold toinvestors.  Mortgage warehouse participationsdo not qualify as Qualified REIT Real Estate Assets.  Accordingly, this activity is limited by the REIT Provisions ofthe Code.

 

***Mortgage Loans***

 

*General. *The Company may acquire and accumulate MortgageLoans as part of its investment strategy until a sufficient quantity has beenaccumulated for securitization into High Credit Quality Mortgage Loans.  The Company anticipates that the MortgageLoans acquired by it and not yet securitized will not constitute more than 25%of the Company’s total Mortgage Related Assets at any time.  All Mortgage Loans will be acquired with theintention of securitizing them into High Credit Quality Mortgage Loans.  However, there can be no assurance that theCompany will be successful in securitizing the Mortgage Loans.  To meet the Company’s investment criteria,the Mortgage Loans to be acquired by the Company will generally conform to theunderwriting guidelines established by Fannie Mae, FHLMC or other creditinsurers.  Applicable banking lawsgenerally require that an appraisal be obtained in connection with the originalissuance of Mortgage Loans by the lending institution.  The Company does not intend to obtainadditional appraisals at the time of acquiring Mortgage Loans.

 

The Mortgage Loans may be originated by or purchasedfrom various suppliers of Mortgage Related Assets throughout the United States,such as savings and loan associations, banks, mortgage bankers, home-builders,insurance companies and other mortgage lenders.  The Company may acquire Mortgage Loans directly from originatorsand from entities holding Mortgage Loans originated by others.  The Board of Directors of the Company hasnot established any limits upon the geographic concentration of Mortgage Loans tobe acquired by the Company or the credit quality of suppliers of MortgageRelated Assets.

 

*Conforming and NonconformingMortgage Loans. *TheCompany may acquire both Conforming and Nonconforming Mortgage Loans forsecuritization.  Conforming MortgageLoans comply with the requirements for inclusion in a loan guarantee programsponsored by Fannie Mae, FHLMC or GNMA. Nonconforming Mortgage Loans areMortgage Loans that do not qualify in one or more respects for purchase byFannie Mae or FHLMC under their standard programs.  The Company expects that a majority of Nonconforming MortgageLoans it purchases will be nonconforming primarily because they have originalprincipal balances which exceed the requirements for FHLMC or Fannie Maeprograms.

 

*Commitments to Mortgage LoanSellers. *The Companymay issue commitments to originators and other sellers of Mortgage Loans whofollow policies and procedures that generally comply with Fannie Mae and FHLMCregulations and guidelines and that comply with all applicable federal andstate laws and regulations for Mortgage Loans secured by single-family(one-to-four units) residential properties. In addition, commitments may be issued for agency certificates as wellas privately issued pass-through certificates and Mortgage Loans. Although theCompany may commit to acquire Mortgage Loans prior to funding, all MortgageLoans are to be fully funded prior to their acquisition by the Company.  Following the issuance of commitments, theCompany will be exposed to risks of interest rate fluctuations similar to thoserisks applicable to Mortgage Related Assets.

 

*Securitization of MortgageLoans. *The Companymay acquire and hold Mortgage Loans until a sufficient quantity has beenaccumulated for securitization.  Duringthe accumulation period, the Company will be subject to risks of borrowerdefaults and bankruptcies, fraud losses and special hazard losses (such asthose occurring from earthquakes or floods) that are not covered by standardhazard insurance.  In the event of adefault on any Mortgage Loan held by the Company, the Company will bear therisk of loss of principal to the extent of any deficiency between the value ofthe collateral underlying the Mortgage Loan and the principal amount of theMortgage Loan.  No assurance can begiven that any such mortgage, fraud or hazard insurance will adequately cover aloss suffered by the Company.  Alsoduring the accumulation period, the costs of financing the Mortgage Loansthrough reverse repurchase agreements and other borrowings and lines of creditwith warehouse lenders could exceed the interest income on the MortgageLoans.  It may not be possible oreconomical for the 

 

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Company to complete thesecuritization for all Mortgage Loans that the Company acquires, in which casethe Company will continue to bear the risks of borrower defaults and specialhazard losses.

 

*Protection Against Mortgage LoanRisks*.  The Company**anticipates that eachMortgage Loan purchased will have a commitment for mortgage pool insurance froma mortgage insurance company with a claims-paying ability rated investmentgrade by either of the Rating Agencies. Mortgage pool insurance insures the payment of certain portions of theprincipal and interest on Mortgage Loans. In lieu of mortgage pool insurance, the Company may arrange for otherforms of credit enhancement such as letters of credit, subordination of cashflows, corporate guaranties, establishment of reserve accounts orover-collateralization.

 

It is expectedthat when the Company acquires Mortgage Loans, the seller will generallyrepresent and warrant to the Company that there has been no fraud ormisrepresentation during the origination of the Mortgage Loans and generallyagree to repurchase any Mortgage Loan with respect to which there is fraud ormisrepresentation.  The Company willprovide similar representations and warranties when the Company sells orpledges the Mortgage Loans as collateral for mortgage securities.  If a Mortgage Loan becomes delinquent andthe pool insurer is able to prove that there was a fraud or misrepresentationin connection with the origination of the Mortgage Loan, the pool insurer willnot be liable for the portion of the loss attributable to such fraud ormisrepresentation.  Although the Companywill generally have recourse to the seller based on the seller’srepresentations and warranties to the Company, the Company will generally be atrisk for loss to the extent the seller does not perform its repurchaseobligations.

 

*Other Investments.*  The Company may acquire Other Investmentsthat include (i) equity and debt securities issued by other primarily mortgagerelated finance companies, (ii) interests in mortgage related collateralizedbond obligations, (iii) other subordinated interests in pools of mortgage relatedassets, (iv) commercial mortgage loans and securities, and (v) residentialmortgage loans other than High Credit Quality Mortgage Loans.  Although the Company expects that its OtherInvestments will be limited to less than 10% of total assets, there is no limitto how much of the Company’s stockholders’ equity will be allocated to OtherInvestments.  There may be periods inwhich Other Investments represent a large portion of the Company’sstockholders’ equity.

 

**PRINCIPAL RISKS AND SPECIAL CONSIDERATIONS**

 

***Leverage Risk****.*  The Company employs a leveraging strategy ofgenerally borrowing up to 92% of its total assets to finance the acquisition ofadditional Mortgage Related Assets.  TheCompany’s borrowing may, at times, exceed 92% of its total assets.  In the event borrowing costs exceed theincome on its Mortgage Related Assets, the Company will experience negativecash flow and incur losses. Another risk of leverage is the possibility thatthe value of the collateral securing the borrowings will decline.  In such event, additional collateral orrepayment of borrowings would be required. The Company could be required to sell Mortgage Related Assets underadverse market conditions in order to maintain liquidity.  If these sales were made at prices lower thanthe carrying value of the Mortgage Related Assets, the Company would experiencelosses.

 

***Interest Rate Risk****.*  There is the possibility that the value ofthe Company’s Mortgage Related Assets may fall since fixed income securitiesgenerally fall when interest rates rise. The longer the term of a fixed income instrument, the more sensitive itwill be to fluctuations in value from interest rate changes.  Changes in interest rates may have asignificant effect on the Company’s operations, because it may hold MortgageRelated Assets with long terms to maturity. Rising interest rates will negatively impact the Company’s borrowingssince the value of the collateral securing the borrowing will decline in value,requiring additional collateral or repayments of borrowing.  This could reduce the level of borrowingsand reduce returns.  Also, when interestrates rise, the Company’s holding of Mortgage Related Assets can reduce returnsif the owners of the underlying mortgages pay-off their mortgages later thananticipated.  This is known as *extensionrisk*.  When interest ratesdrop, the Company’s holdings of the Mortgage Related Assets can reduce returnsif the owners of the underlying mortgages pay off their mortgages sooner thananticipated since the funds prepaid will have to be invested at the then lowerprevailing rate.  This is known as *prepaymentrisk*.  In addition, wheninterest rates drop, not only can the value of Mortgage Related Assets drop,but the yield can drop, particularly where the yield on the security is tied tointerest rates, such as adjustable mortgages.

 

***Liquidity Risk****.*  There is the possibility that the Companymay lose money or be prevented from earning capital gains if it cannot sell aMortgage Related Asset at a time and price that is most beneficial to theCompany.  The Company is subject toliquidity risk because it invests in mortgage securities which have experiencedperiods of illiquidity.

 

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***Credit Risk****.*  Credit risk is the possibility that the Company could lose moneyif an issuer is unable to meet its financial obligations, such as the paymentof principal and/or interest on an instrument, or goes bankrupt.  The Company may invest a portion of itsassets in Mortgage Related Assets which are not guaranteed by the U.S.Government or investment grade, which may make the Company subject tosubstantial credit risk.  This isespecially true during periods of economic uncertainty or during economic down-turns.

 

***Equity Risk****.*  Equity risk is the possibility that theCompany could lose money if its equity investments decline in value.  Such a decline could be caused by a numberof factors, including, but not limited to, overall market conditions,suspension or omission of dividends, bankruptcies and litigation.  This is especially true during periods ofeconomic uncertainties and economic downturns.

 

***Failure to MaintainREIT Status Risk****.* Failure to maintain REIT status risk refers to the possibility that theCompany may become subject to federal income tax as a regular corporation.  The Company intends at all times to maintainsubstantially all of its investments in, and otherwise conduct its business ina manner consistent with, the REIT Provisions of the Code.  If the Company fails to qualify as a REIT,it would be treated as a regular corporation for federal tax purposes.  This would result in the Company beingsubject to federal income tax that would further result in a substantialreduction of cash available for distribution to stockholders.

 

***Failure to MaintainInvestment Company Act Exemption Risk****.*  The Company intends to conduct its business so as not to become a“regulated investment company” under the Investment Company Act.  As a result, the Company’s ownership  of certain Mortgage Related Assets may belimited by the Investment Company Act. This could have the effect of adversely affecting the Company’s operations and returns tostockholders.  In addition, if theCompany fails to qualify for  theexemption from registration as an investment company, its ability to useleverage would be substantially reduced. This could reduce income to the Company and returns to stockholders.

 

**FEDERALINCOME TAX CONSEQUENCES**

 

The followingdiscussion summarizes certain federal income tax consequences for theCompany.  This discussion is based oncurrent law.  The following discussionis not exhaustive of all possible tax considerations.  It does not give a detailed discussion of any state, local orforeign tax considerations, nor does it discuss all of the aspects of federal,state, local or foreign income taxation that may be relevant to a stockholderof the Company in light of such stockholder’s particular circumstances.

 

Prospectiveinvestors in the Company are urged to consult with their own tax advisorsregarding the specific consequences to each of them of the purchase, ownershipand sale of stock in an entity electing to be taxed as a REIT, including thefederal, state, local, foreign and other tax considerations of such purchase,ownership, sale and election and the potential changes in applicable tax laws.

 

**General**

 

The Code providesspecial tax treatment for organizations that qualify and elect to be taxed asREITs.  In brief, if certain specificconditions imposed by the Code are met, entities that invest primarily in realestate assets, including Mortgage Loans, that otherwise would be taxed ascorporations are generally not taxed at the corporate level on their taxableincome that is distributed to their stockholders.  This treatment eliminates most of the ‘‘double taxation’’ (at thecorporate level and then again at the stockholder level when the income isdistributed) that typically results from the use of corporate investmentvehicles.  A qualifying REIT, however,may be subject to certain excise and other taxes, as well as normal corporatetax, on Taxable Income that is not currently distributed to its stockholders.

 

The Company hasmade an election to be taxed as a REIT under the Code commencing with itstaxable year ended December 31, 1997.  Therecan be no assurance, however, that all qualification requirements for suchtreatment will be met.

 

In the event thatthe Company does not qualify as a REIT in any year, it will be subject tofederal income tax as a domestic corporation and its stockholders will be taxedin the same manner as stockholders of ordinary corporations.  To the extent that the Company would, as aconsequence, be subject to potentially significant tax liabilities, the amountof earnings and cash available for distribution to its stockholders would bereduced.

 

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**Requirements for Qualification as aREIT**

 

To qualify for taxtreatment as a REIT under the Code, the Company must meet certain tests.  The Company has adopted a policy to complywith the REIT Provisions of the Code.

 

**Termination or Revocation of REITStatus**

 

The Company’selection to be treated as a REIT will be terminated automatically if it failsto meet the Code’s requirements.  Ifthis occurs, the Company will not be eligible again to elect REIT status untilthe fifth taxable year that begins after the year for which its election wasterminated unless all of the following relief provisions apply: (i) the Companydid not willfully fail to file a timely return with respect to the terminationtaxable year; (ii) inclusion of incorrect information in such return was notdue to fraud with intent to evade tax; and (iii) the Company establishes thatits failure to meet the applicable requirements was due to reasonable cause andnot willful neglect.  The Company mayalso voluntarily revoke its election, although it has no intention of doing so,in which event it will be prohibited, without exception, from electing REITstatus for the year to which the revocation relates and the following fourtaxable years.

 

If the Companyfails to qualify for taxation as a REIT in any taxable year, and the reliefprovisions do not apply, the Company would be subject to tax (including anyapplicable alternative minimum tax) on its taxable income at regular corporaterates.  Distributions to stockholders ofthe Company with respect to any year in which it fails to qualify as a REITwould not be deductible by the Company nor would they be required to be made.  Failure to qualify as a REIT would result inthe Company’s reduction of its distributions to stockholders in order to paythe resulting taxes.  If, afterforfeiting REIT status, the Company later qualifies and elects to be taxed as aREIT again, the Company could face significant adverse tax consequences.

 

**Taxation of the Company**

 

In any year inwhich the Company qualifies as a REIT, it generally will not be subject tofederal income tax on that portion of its Taxable Income or net capital gainwhich is distributed to its stockholders. The Company will, however, be subject to tax at normal corporate ratesupon any net income or net capital gain not distributed with respect toundistributed income.  The Companyintends to distribute substantially all of its Taxable Income to itsstockholders on a pro rata basis in each year.

 

In addition, theCompany will also be subject to a tax of 100% of net income from any prohibitedtransaction under the Code and will be subject to a 100% tax on the amount bywhich it fails either the 75% or 95% Gross Income Tests, reduced byapproximated expenses, if the failure to satisfy such tests is due toreasonable cause and not willful neglect and if certain other requirements aremet.  The Company may also be subject tothe alternative minimum tax on certain items of tax preference with respect toundistributed income.

 

The Company maysecuritize Mortgage Loans and sell such mortgage securities through a TaxableREIT Subsidiary.  However, if theCompany itself were to sell such mortgage securities on a regular basis, thereis a substantial risk that they would be deemed dealer property and that all ofthe profits from such sales would be subject to tax at the rate of 100% asincome from prohibited transactions under the Code.  The Company therefore, intends to make any such sales through aTaxable REIT Subsidiary. The taxable subsidiary will not be subject to this100% tax on income from prohibited transactions under the Code, which is onlyapplicable to REITs.

 

The Company mayelect to retain and pay income tax on all or a portion of its net long-termcapital gains for any taxable year, in which case the Company’s stockholderswould include in their income as long-term capital gains their proportionateshare of such undistributed capital gains. The stockholders would be treated as having paid their proportionateshare of the capital gains tax paid by the Company, which amounts would becredited or refunded to the stockholders.

 

The Company willalso be subject to a nondeductible 4% excise tax if it fails to make timely dividenddistributions for each calendar year. The Company intends to declare its fourthregular annual dividend during the final quarter of the year and to make suchdividend distribution no later than 31 days after the end of the year in orderto avoid imposition of the 

 

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excise tax.  Such a distribution would be taxed to thestockholders in the year that the distribution was declared, not in the yearpaid.  Imposition of the excise tax onthe Company would reduce the amount of cash available for distribution to itsstockholders.

 

**Taxable REIT Subsidiaries**

 

The Company may,in the future, cause the creation and sale of mortgage securities through ataxable corporation.  The Company andone or more persons or entities may own all of the capital stock of thattaxable corporation, which will be structured so as to qualify as a TaxableREIT Subsidiary.  Any dividends that theTaxable REIT Subsidiary pays to the Company, however, will not qualify asincome from Qualified REIT Real Estate Assets for purposes of the 75% GrossIncome Test, and will have to be limited, along with the Company’s otherinterest, dividends, gains on the sale of securities, hedging income, and otherincome not derived from Qualified REIT Real Estate Assets to less than 25% ofthe Company’s gross revenues in each year.  If the Taxable REIT Subsidiary creates a taxable mortgage pool, suchpool itself will constitute a separate taxable subsidiary of the Taxable REITSubsidiary.  The Taxable REIT Subsidiarywould be unable to offset the income derived from such a taxable mortgage poolwith losses derived from any other activities.

 

**Taxation of Stockholders**

 

For any taxableyear in which the Company is treated as a REIT for federal income purposes,amounts distributed by the Company to its stockholders out of current oraccumulated earnings and profits will be includable by the stockholders asordinary income for federal income tax purposes unless properly designated byit as capital gain dividends.  In thelatter case, the distributions will be taxable to the stockholders as long-termcapital gains.

 

Distributions ofthe Company will not be eligible for the dividends received deduction forcorporations.  Stockholders may notdeduct any net operating losses or capital losses of the Company.

 

Any loss on thesale or exchange of shares of the Common Stock held by a stockholder for sixmonths or less will be treated as a long-term capital loss to the extent of anycapital gain dividend received on the Common Stock held by such stockholdersduring the six-month period.

 

If the Companymakes distributions to its stockholders in excess of its current andaccumulated earnings and profits, those distributions will be considered firsta tax-free return of capital, reducing the tax basis of a stockholder’s sharesuntil the tax basis is zero.  Suchdistributions in excess of the tax basis will be taxable as a gain realizedfrom the sale of the Company’s Common Stock.

 

The Company will notify stockholders after the closeof the Company’s taxable year as to the portions of the

distributions whichconstitute ordinary income, return of capital and capital gain.  Dividends and distributions declared in thelast quarter of any year payable to stockholders of record on a specified datein such month may be deemed to have been received by the stockholders and paidby the Company on December 31 of the record year, provided that such dividendsare paid before February 1 of the following year.

 

**Taxation of Tax-Exempt Entities**

 

In general, aTax-Exempt Entity that is a stockholder of the Company is not subject to tax ondistributions.  The IRS has ruled thatamounts distributed by a REIT to an exempt employees’ pension trust do notconstitute UBTI and thus should be nontaxable to such a Tax-Exempt Entity.  However, if a Tax-Exempt Entity has financedthe acquisition of any of its stock in the Company with ‘‘acquisitionindebtedness’’ within the meaning of the Code, distributions on such stockcould be treated as UBTI.  Under certainconditions, if a tax-exempt employee pension or profit sharing trust were toacquire more than 10% of the Company’s Common Stock, a portion of the dividendson such Common Stock could be treated as UBTI.

 

For social clubs,voluntary employee benefit associations, supplemental unemployment benefittrusts, and qualified group legal services plans exempt from federal incometaxation under Code Sections 501(c)(7), (c)(9), (c)(17) and (c)(20),respectively, income from an investment in the Company will constitute UBTIunless the organization is able to properly deduct amounts set aside or placedin reserve for certain purposes so as to offset the UBTI generated by itsinvestment in the

 

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Company.  Such entities should review Code Section512(a)(3) and should consult their own tax advisors concerning these ‘‘setaside’’ and reserve requirements.

 

**State and Local Taxes**

 

The Company andits stockholders may be subject to state or local taxation in various jurisdictions,including those in which it or they transact business or reside.  The state and local tax treatment of theCompany and its stockholders may not conform to the federal income taxconsequences discussed above. Consequently, prospective stockholders should consult their own taxadvisors regarding the effect of state and local tax laws on an investment inthe Common Stock.

 

**Certain United States Federal IncomeTax Consequences Applicable to Foreign Holders**

 

The followingdiscussion summarizes certain United States tax consequences of theacquisition, ownership and disposition of the Common Stock by a purchaser ofthe Common Stock that, for United States income tax purposes, is not a ‘‘UnitedStates Holder’’ (a ‘‘Foreign Holder’’). For purposes of discussion, a United States Holder means: a citizen orresident of the United States; a corporation, partnership, or other entitycreated or organized in the United States or under the laws of the UnitedStates or of any political subdivision thereof (unless, in the case of apartnership, the IRS provides otherwise by regulations); an estate whose incomeis includable in gross income for United States income tax purposes regardlessof its source; or, a trust if a court within the United States is able to exerciseprimary supervision over the administration of the trust and one or more UnitedStates persons have the authority to control all substantial decisions of thetrust.  This discussion does notconsider any specific facts or circumstances that may apply to a particularForeign Holder.  Prospective investorsare urged to consult their tax advisors regarding the United States taxconsequences of acquiring, holding and disposing of the Common Stock, as wellas any tax consequences that may arise under the laws of any foreign, state,local or other taxing jurisdiction.

 

*Dividends. *Dividends paid by the Company out of earningsand profits to a Foreign Holder will generally be subject to federal income taxwithholding at the rate of 30%, unless reduced or eliminated by an applicabletax treaty or unless such dividends are treated as effectively connected with aUnited States trade or business conducted by the Foreign Holder.  A Foreign Holder eligible for a reduction inwithholding under an applicable treaty must so notify the Company by completingthe appropriate IRS form.  Distributionspaid by the Company in excess of its earnings and profits will be treated as atax-free return of capital to the extent of the holder’s adjusted basis in hisCommon Stock and, thereafter, as gain from the sale or exchange of a capitalasset as described below.  If it cannotbe determined at the time a distribution is made whether such distribution willexceed the Company’s earnings and profits (which, under most circumstances,will correspond to the Company’s net income before the deduction for dividendspaid), the distribution will be subject to withholding at the same rate asdividends.  However, any amountswithheld will be refundable or creditable against the Foreign Holder’s UnitedStates tax liability if the Company subsequently determines that suchdistribution was, in fact, in excess of the earnings and profits of theCompany.  If the receipt of the dividendis treated as being effectively connected with the conduct of a trade orbusiness within the United States by a Foreign Holder, the dividend receivedwill be subject to the United States federal income tax on net income thatapplies to United States persons generally (and, in addition with respect toforeign corporate holders and under certain circumstances, the 30% branchprofits tax).

 

For any year inwhich the Company qualifies as a REIT, distributions to a Foreign Holder thatare attributable to gain from the sales or exchanges by the Company of ‘‘UnitedStates real property interests’’ will be treated as if such gain wereeffectively connected with a United States business and will thus be subject totax at the normal capital gain rates applicable to United States stockholders(subject to applicable alternative minimum tax) under the provisions of theForeign Investment in Real Property Tax Act of 1980 (‘‘FIRPTA’’).  Also, distributions subject to FIRPTA may besubject to a 30% branch profits tax in the hands of a foreign corporatestockholder not entitled to a treaty exemption.  The Company is required to withhold 35% of any distribution thatcould be designated by the Company as a capital gains dividend.  This amount may be credited against theForeign Holder’s FIRPTA tax liability.

 

*Gain on Disposition. *A Foreign Holder willgenerally not be subject to United States federal income tax on a gainrecognized on a sale or other disposition of the Common Stock unless (i) thegain is effectively connected with the conduct of a trade or business withinthe United States by the Foreign Holder, (ii) in the case of a Foreign Holderwho is a nonresident alien individual and holds the Common Stock as a capitalasset, such holder is present in the United States for 183 or more days(computed in part by reference to days present in the two prior years) in thetaxable year and certain other requirements are met, or (iii) the ForeignHolder is subject to tax under the FIRPTA rules discussed below.  Gain that is 

 

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effectively connectedwith the conduct of a United States Holder will be subject to the United Statesfederal income tax on net income that applies to United States personsgenerally (and, with respect to corporate holders and under certaincircumstances, the branch profits tax) but will not be subject towithholding.  Foreign Holders shouldconsult applicable treaties, which may provide for different rules.

 

Gain recognized bya Foreign Holder upon a sale of its Common Stock will generally not be subjectto tax under FIRPTA if the Company is a ‘‘domestically controlled REIT,’’ whichis defined generally as a REIT in which at all times during a specified testingperiod less than 50% in value of its shares were held directly or indirectly bynon-U.S.  persons.  Because only a minority of the Company’sstockholders are expected to be Foreign Holders, the Company anticipates thatit will qualify as a domestically controlled REIT. Accordingly, a ForeignHolder should not be subject to U.S. tax from gains recognized upon dispositionof the Common Stock.  However, becausethe Common Stock is publicly traded, no assurance can be given that the Companywill be a domestically controlled REIT.

 

*Information Reporting and BackupWithholding.*United States information reporting requirementsand backup withholding tax will generally not apply to dividends paid on theCommon Stock to a Foreign Holder at an address outside the United States.  Payments by a United States office of abroker of the proceeds of a sale of the Common Stock is subject to both backupwithholding  and information reportingunless the holder certifies its Foreign Holder status under penalties ofperjury or otherwise establishes an exemption. Information reporting requirements (but not backup withholding) willalso apply to payments of the proceeds of sales of the Common Stock by foreignoffices of United States brokers, or foreign brokers with certain types ofrelationships to the United States, unless the broker has documentary evidencein its records that the holder is a Foreign Holder and certain other conditionsare met, or the holder otherwise establishes an exemption.

 

Backup withholdingis not an additional tax.  Any amountswithheld under the backup withholding rules will be refunded or creditedagainst the Foreign Holder’s United States federal income tax liability,provided that the required information is furnished to the IRS.

 

**ERISACONSIDERATIONS**

 

In considering aninvestment in the Common Stock, a fiduciary of a profit-sharing, pension stockbonus plan or individual retirement account (‘‘IRA’’), including a plan forself-employed individuals and their employees or any other employee benefitplan subject to prohibited transaction provisions of the Code or the fiduciaryresponsibility provisions of ERISA (an ‘‘ERISA Plan’’) should consider (a)whether the ownership of Common Stock is in accordance with the documents andinstruments governing such ERISA Plan, (b) whether the ownership of CommonStock is consistent with the fiduciary’s responsibilities and satisfies therequirements of Part 4 of Subtitle B of Title I of ERISA (where applicable)and, in particular, the diversification, prudence and liquidity requirements ofSection 404 of ERISA, (c) ERISA’s prohibitions in improper delegation ofcontrol over, or responsibility for, ‘‘plan assets’’ and ERISA’s imposition ofco-fiduciary liability on a fiduciary who participates in, permits (by actionor inaction) the occurrence of, or fails to remedy a known breach of duty byanother fiduciary and (d) the need to value the assets of the ERISA Planannually.

 

In regard to the‘‘plan assets’’ issue noted in clause (c) above, O’Melveny & Myers LLP, theCompany’s counsel, at the time of the Company’s public offering was of theopinion that the Common Stock should qualify as a ‘‘publicly offeredsecurity,’’ and, therefore, the acquisition of such Common Stock by ERISA Plansshould not cause the Company’s assets to be treated as assets of such investingERISA Plans for purposes of the fiduciary responsibility provisions of ERISA orthe prohibited transaction provisions of the Code.  Fiduciaries of ERISA Plans and IRAs should consult with and relyupon their own advisors in evaluating the consequences under the fiduciaryprovisions of ERISA and the Code of an investment in Common Stock in light oftheir own circumstances.

 

**COMPETITION**

 

The Companybelieves that the principal competition in the business of acquiring andholding Mortgage Related Assets are financial institutions such as banks,savings and loans, life insurance companies, institutional investors such asmutual funds and pension funds, and certain other mortgage REITs.  The Company believes that it is able tocompete effectively and generate competitive rates of return for stockholdersdue to the Manager’s experience in managing mortgage capital, access to andexperience in secondary mortgage markets, relative freedom to securitize itsMortgage Related Assets, relatively low level of operating costs, ability toutilize prudent amounts of leverage through accessing the wholesale market forcollateralized borrowings, freedom from certain forms of regulation and the taxadvantages of its REIT status.

 

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**EMPLOYEES**

 

As of December 31,2001, the Company had no employees.  TheManager manages the day-to-day operations of the Company, subject to thedirection and oversight of the Company’s Board of Directors and under the termsof a Management Agreement discussed below.

 

**THE MANAGEMENT AGREEMENT**

 

The Company hasentered into a Management Agreement with the Manager which is currently subjectto a one year renewal term ending on December 31, 2002.  The Manager is primarily involved in twoactivities: (i) asset/liability management—acquisition, financing, hedging,management and disposition of Mortgage Related Assets, including credit andprepayment risk management; and (ii) capital management—oversight of theCompany’s structuring, analysis, capital raising and investor relationsactivities.  In conducting theseactivities, the Manager formulates operating strategies for the Company,arranges for the acquisition of Mortgage Related Assets by the Company,arranges for various types of financing for the Company, monitors theperformance of the Company’s Mortgage Related Assets and provides certainadministrative and managerial services in connection with the operation of theCompany.  The Manager is required tomanage the business affairs of the Company in conformity with the policies thatare approved and monitored by the Company’s Board of Directors.  The Manager is required to prepare regularreports for the Company’s Board of Directors that will review the Company’sacquisitions of Mortgage Related Assets, portfolio composition and characteristics,credit quality, performance and compliance with the policies approved by theCompany’s Board of Directors.

 

At all times, theManager is subject to the direction and oversight of the Company’s Board ofDirectors and will have only such functions and authority as the Company maydelegate to it.  The Manager isresponsible for the day-to-day operations of the Company.

 

The ManagementAgreement may be renewed for additional one-year terms at the discretion of theUnaffiliated Directors, unless previously terminated by the Company or theManager upon written notice.  Except inthe case of a termination or non-renewal by the Company for cause, upontermination or non-renewal of the Management Agreement by the Company, theCompany is obligated to pay the Manager a termination or non-renewal fee, whichmay be significant.  The termination ornon-renewal fee shall be equal to the fair market value of the ManagementAgreement without regard to the Company’s termination right, as determined byan independent appraisal.  The selectionof the independent appraiser shall be subject to the approval of theUnaffiliated Directors.  Neither thefair market value of the Management Agreement nor the various factors which theappraiser may find relevant in its determination of the fair market value canbe determined at this time.

 

The fair marketvalue of the Management Agreement will be affected by significant variables,including (i) the historical management fees paid to the Manager, (ii) anyprojections of future management fees to be paid to the Manager determined bythe independent appraiser, (iii) the relative valuations of agreements similarto the Management Agreement and (iv) other factors, all of which may beunrelated to the performance of the Manager.

 

The ManagementAgreement may be assigned by the Manager to an Affiliate of TCW without theconsent of the Company.  The ManagementAgreement may be assigned to a non-Affiliate of TCW only with the approval of amajority of the Unaffiliated Directors.

 

**Manager Compensation**

 

The Manager willreceive annual base management compensation based on the Average Net InvestedCapital of the Company, payable monthly in arrears, equal to 3/4 of 1% ofAverage Net Invested Capital.  The term “Average Net Invested Capital” means themonth end sum of (1) the Company’s total stockholders’ equity computed inaccordance with generally accepted accounting principles plus (2) any unsecureddebt that has been approved for inclusion by the Unaffiliated Directors atissuance plus or minus (3) an adjustment to exclude the impact of anyunrealized gains, losses or other items that do not affect realized net income.  Accordingly, incurring collateralized debtto finance specific investment purchases does not ordinarily increase AverageNet Invested Capital.

 

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The Manager shallalso be entitled to receive as incentive compensation for each fiscal quarter,an amount equal to 30% of the Net Income of the Company, before incentivecompensation, in excess of the amount that would produce an annualized Returnon Equity equal to the Ten-Year U.S. Treasury Rate plus 1%.  The incentive compensation calculation andpayment will be made quarterly in arrears. The term ‘‘Return on Equity’’ is calculated for any quarter by dividingthe Company’s Net Income for the quarter by its Average Net Worth for thequarter.  For purposes of calculatingthe incentive compensation payable, the definition ‘‘Return on Equity’’ is notrelated to the actual distributions received by stockholders or to anindividual investor’s actual return on investment.  For such calculations, the ‘‘Net Income’’ of the Company meansthe taxable income of the Company (including net capital gains, if any) beforethe Manager’s incentive compensation, net operating loss deductions arisingfrom losses in prior periods and deductions permitted by the Code incalculating taxable income for a REIT plus the effects of adjustments, if any,necessary to record hedging and interest transactions in accordance withgenerally accepted accounting principles. A deduction for all of the Company’s interest expenses for borrowedfunds is taken into account in calculating Net Income.  ‘‘Average Net Worth’’ for any period meansthe arithmetic average of the sum of the gross proceeds from any offering of itsequity securities by the Company, before deducting any underwriting discountsand commissions and other expenses and costs relating to the offerings, plusthe Company’s retained earnings (without taking into account any lossesincurred in prior periods) computed by taking the average of such values at theend of each month during such period, minus the cumulative amounts paid by theCompany to repurchase its shares.

 

The ability of theCompany to achieve an annualized Return on Equity in excess of the Ten-YearU.S.  Treasury Rate plus 1%, and of theManager to earn the incentive compensation described in the precedingparagraph, is dependent upon the level and volatility of interest rates, theCompany’s ability to react to changes in interest rates and to utilizesuccessfully the operating strategies described herein, and other factors, manyof which are not within the Company’s or the Manager’s control.  The Manager’s base compensation shall becalculated by the Manager within 15 days after the end of each month, and suchcalculation shall be promptly delivered to the Company.  The Company is obligated to pay the basecompensation within 30 days after the end of each month.  The Manager shall compute the quarterlyincentive compensation within 45 days after the end of each fiscal quarter, andthe Company shall pay the incentive compensation with respect to each fiscalquarter within 15 days following the delivery to the Company of the Manager’swritten statement setting forth the computation of the incentive compensationfor such quarter.  The Company’s Boardof Directors shall review and approve the calculation of base and incentivecompensations paid to the Manager quarterly, one quarter in arrears, duringeach scheduled quarterly Board of Directors meeting.  Quarterly incentive compensation is subject to an annualadjustment so that the incentive compensation is based on earnings for theentire year. The Company believes that this compensation arrangement benefits itsstockholders because it ties the Manager’s compensation to Return on Equityand, in periods of low earnings, the Manager’s incentive compensation isreduced or eliminated, thereby lowering the Company’s operating expenses.

 

**Expenses**

 

Subject to thelimitations set forth below, the Company will generally pay all its operatingexpenses, except those specifically required to be borne by the Manager underthe Management Agreement.  The operatingexpenses required to be borne by the Manager include the compensation of theCompany’s officers and the cost of office space, equipment and other personnelrequired for the Company’s day-to-day operations.  The expenses that are paid by the Company will include (but notnecessarily be limited to) the cost of money borrowed by the Company (includinginterest), taxes and license fees, issuance and transaction costs incident tothe acquisition, disposition and financing of investments, costs related tohedging transactions, legal, investigatory, accounting and auditing fees andexpenses, consultants’ advisory services with respect to REIT and othercompliance matters, the compensation and expenses of the Company’s UnaffiliatedDirectors, the costs of making distributions and printing and mailing proxiesand reports to stockholders, costs incurred by employees of the Manager fortravel on behalf of the Company, costs incident to the issuance of mortgagesecurities, costs incident to the accumulation and servicing of Mortgage Loans,costs associated with any computer software or hardware that is used solely forthe Company, costs to obtain liability insurance to indemnify the Manager, theCompany’s directors and officers, and the Company’s underwriters, thecompensation and expenses of the Company’s custodian, transfer agent andregistrar, and any extraordinary or non-recurring costs or charges incurred bythe Company, if any.  Certain Companyoperating expenses  shall be limited toan amount per year equal to the greater of 2% of the Average Net InvestedCapital of the Company or 25% of its Net Income for that year.  The operating expenses that are subject tothis limitation are:

 

(i)                   allinsurance costs incurred by the Company or any subsidiary of the Company,including any costs to obtain liability or other insurance to indemnify theManager and underwriters of any securities of the Company;

 

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(ii)                  expenses connected withpayments ofdividends or interest or distributions in any other form made orcaused to be made by the Board of Directors to holders of the securities of theCompany or any subsidiary of the Company;

 

(iii)                 all expenses of third partiespertaining to communications to holders of equity securities or debt securitiesof the Company or any subsidiary of the Company and the ther bookkeeping andclerical work necessary to maintain relations with holders of such securitiesand in complying with the continuous reporting and other requirements ofgovernmental bodies or agencies (these expenses include any costs of computerservices utilized in connection with these communications and reportingrequirements, the cost of printing and mailing certificates for such securitiesand proxy solicitation materials and reports to holders of the Company’s or anysubsidiary’s securities and reports to third parties required under anyindenture to which the Company or any subsidiary of the Company is a party);

 

(iv)                custodian’s, transfer agent’sand registrar’s fees and charges;

 

(v)                 compensation, fees and expensespaid to Unaffiliated Directors of the Company or any subsidiary of the Company,the cost of director and officer liability insurance and premiums for fidelityand errors and omissions insurance;

 

(vi)                legal, accounting and audiingfees and expenses relating to the Company’s or any subsidiary’s operations(excluding litigation-related fees and expenses);

 

(vii)               expenses relating to any officeor office facilities maintained by the Company or any subsidiary of theCompany, exclusive of the office of the Manager;

 

(viii)              travel andrelated expenses of directors, officers and employees of the Manager and ofdirectors, officers and employees of the Company or any subsidiary of theCompany who are also directors, officers or employees of the Manager, incurredin connection with attending meetings of the Board of Directors or holders ofsecurities of the Company or any subsidiary of the Company or performing otherbusiness activities that relate to the Company or any subsidiary of theCompany, including expenses allocable to such meetings or business activities;

 

(ix)                 costsassociated with computer hardware and software, third party informationservices and office expenses that relate solely to the business activities ofthe Company; and

 

(x)                  allother expenses regarded as ordinary operating expenses in accordance with generallyaccepted accounting principles, exclusive of certain specifically excludedexpenses as described below.

 

Expenses excludedfrom the expense limitation and wholly payable by the Company are (but are notlimited to) those incurred in connection with the accumulation and servicing ofMortgage Loans, the issuance and administration of mortgage securities frompools of Mortgage Loans, the raising of capital, the acquisition of MortgageRelated Assets, interest and hedging expenses, taxes and license fees, non-cashcosts, litigation, investigations in connection with litigation or threatenedlitigation, base and incentive management compensation and extraordinary andnon-recurring expenses.  Thedetermination of Net Income for purposes of calculating the expense limitationwill be the same as for calculating the Manager’s incentive compensation exceptthat it will include any incentive compensation payable for such period.

 

Expenses in excessof the expense limitation will be paid and shall not be recoverable (byreclassification as compensation or otherwise) by the Manager, unless theUnaffiliated Directors determine that, based upon unusual or non-recurringfactors, a higher level of expenses is justified for such fiscal year.  In that event, such expenses may berecovered by the Manager in succeeding years to the extent that expenses insucceeding quarters are below the limitation of expenses.  Expense reimbursement will be made monthly,subject to adjustment at the end of each year.

 

**Certain Relationships; Conflicts ofInterest**

 

In addition to itsbase management compensation under the Management Agreement, the Manager hasthe opportunity to earn incentive compensation for each fiscal quarter, subjectto an annual reconciliation so that the incentive compensation is based onearnings for the entire calendar year, in an amount equal to 30% of the NetIncome of the Company (before payment of such incentive compensation) in excessof the amount that would produce on annualized Return on Equity equal to theTen-Year U.S. Treasury Rate plus 1%.  Inevaluating Mortgage Related Assets for investment and in other operatingstrategies, an undue emphasis on the maximization of income at the expense ofother criteria, such as preservation of 

 

18

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capital, in order toachieve a higher incentive fee could result in increased risk to the value ofthe Company’s Mortgage Related Asset portfolio.

 

The Company, onthe one hand, and the Manager and its Affiliates, on the other hand, do notpresently expect to, but may in the future, enter into a number ofrelationships other than those governed by the Management Agreement, some ofwhich may give rise to conflicts of interest between the Manager and itsAffiliates and the Company.  The marketin which the Company will seek to purchase Mortgage Related Assets ischaracterized by rapid evolution of products and services and, thus, there mayin the future be relationships between the Company and the Manager and itsAffiliates in addition to those described herein.  Any such relationships or transactions will require the approvalof the Company’s Board of Directors, including a majority of the UnaffiliatedDirectors.

 

The Manager andits Affiliates may act as investment adviser or manager for other entities,which may or may not include services similar to those it renders to theCompany.  Pursuant to the terms of theManagement Agreement, the Manager and its Affiliates will agree on theallocation of mortgage securities between the Company and other accounts overwhich the Manager and its Affiliates have control.  The Manager will base allocation decisions on the procedures theManager considers fair and equitable, including, without limitation, suchconsiderations as investment objectives, restrictions and time horizon,availability of cash and the amount of existing holdings.

 

**Limits of Responsibility**

 

Pursuant to theManagement Agreement, the Manager does not assume any responsibility other thanto undertake the services called for thereunder and is not responsible for anyaction of the Company’s Board of Directors in following or declining to followits advice or recommendations.  TheManager, its directors and its officers will not be liable to the Company, anyissuer of mortgage securities, any subsidiary of the Company, the UnaffiliatedDirectors, the Company’s stockholders or any subsidiary’s stockholders for actsperformed in accordance with and pursuant to the Management Agreement, exceptby reason of acts constituting bad faith, willful misconduct, gross negligenceor reckless disregard of their duties under the Management Agreement.

 

The Company hasagreed to indemnify the Manager, its directors and its officers with respect toall expenses, losses, damages, liabilities, demands, charges and claims arisingfrom any acts or omissions of the Manager made in good faith in the performanceof its duties under the Management Agreement. The Management Agreement does not limit or restrict the right of theManager or any of its officers, directors, employees or Affiliates fromengaging in any business or rendering services of any kind to any other person,including the purchase of, or rendering advice to others purchasing MortgageRelated Assets that meet the Company’s policies and criteria.  The Manager may also advise or manage othermortgage related entities subject to certain limitations, including REITs, thatinvest in residential and commercial mortgages and other residential andnon-residential mortgage securities. The ability of the Manager and its officers and employees to engage inother business activities could reduce the time and effort spent on theCompany.  The Management Agreement doesnot specify a minimum amount of time or attention that the Manager or itsofficers or employees must devote to the Company’s business.

 

**ITEM 2.  PROPERTIES**

 

The Company doesnot own or lease any real property.  TheCompany’s principal executive offices are located at 865 South Figueroa Street,Suite 1800, Los Angeles, California  90017,telephone (213) 244-0000.  Such officesare provided by the Manager in accordance with the Management Agreement.

 

**ITEM 3.  LEGAL PROCEEDINGS**

 

There are no legalproceedings pending against the Company.

 

**ITEM4.  SUBMISSION OF MATTERS TO A VOTE OFSECURITY HOLDERS**

 

At the 2001 AnnualMeeting of Stockholders held June 26, 2001, stockholders of record as of April30, 2001 were asked to vote to ratify the selection of Deloitte & ToucheLLP as the Company’s independent auditors. 5,585,908 shares 

 

19

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were voted for theproposal, 27,200 shares were withheld, 17,300 shares abstained and no voteswere broker non-votes.  In addition, the above-describedstockholders were asked to vote on the two Class III Directors of the Company’sBoard of Directors to hold office until the Annual Meeting of Stockholders in2004. 5,590,284 shares were voted for John A. Gavin and 40,124 shares werevoted against or were withheld. 5,595,484 shares were voted for Marc I. Sternand 34,924 shares were voted against or were withheld.

 

**PART II**

 

**ITEM5.  MARKET FOR REGISTRANT’S COMMONEQUITY AND RELATED STOCKHOLDER MATTERS**

 

**EquityMarket Activity**

 

Commencing onDecember 4, 1997, the Company’s Common Stock began trading on the New YorkStock Exchange.  Effective February 8,2001, the Company ceased trading on the New York Stock Exchange and commencedtrading its Common Stock on the American Stock Exchange under the tradingsymbol “AXM.” As of December 31, 2001, the Company had 15,555,500 shares ofCommon Stock issued and outstanding.  InMarch 2002, the Company completed a follow-on offering of its Common Stockwhich increased the shares of Common Stock issued and outstanding to 24,755,500shares.  As of March 28, 2002, theapproximate number of record holders of our Common Stock was 99.

 

The followingtable sets forth the high, low and closing sales prices per share of CommonStock and the cash dividend declared per share of Common Stock.

 

|                                   |   | **Stock Price** |   | **Cash  Dividends  Declared  Per Share** |   |
|----------------------------------------|--------|-----------------|--------|------------------------------------------|--------|
|                                   |   | **High**        |   | **Low**                                  |   | **Close** |   |   |
| 2001                                   |   |            |   |                                     |   |   |   |   |   |
|                                   |   |            |   |                                     |   |   |   |   |   |
| Fourth Quarter ended December 31, 2001 |   | $               | 11.78  |                                     | $      | 10.05 |   | $ | 11.25 |   | $ | 0.80 |   |
| Third Quarter ended September 30, 2001 |   | $               | 12.46  |                                     | $      | 9.90 |   | $ | 10.40 |   | $ | 0.40 |   |
| Second Quarter ended June 30, 2001     |   | $               | 11.69  |                                     | $      | 9.10 |   | $ | 11.35 |   | $ | 0.40 |   |
| First Quarter ended March 31, 2001     |   | $               | 9.73   |                                     | $      | 6.90 |   | $ | 9.45 |   | $ | 0.35 |   |
|                                   |   |            |   |                                     |   |   |   |   |   |
| 2000                                   |   |            |   |                                     |   |   |   |   |   |
|                                   |   |            |   |                                     |   |   |   |   |   |
| Fourth Quarter ended December 31, 2000 |   | $               | 7.35   |                                     | $      | 6.80 |   | $ | 6.89 |   | $ | 0.35 |   |
| Third Quarter ended September 30, 2000 |   | $               | 9.00   |                                     | $      | 7.06 |   | $ | 7.30 |   | $ | 0.35 |   |
| Second Quarter ended June 30, 2000     |   | $               | 10.19  |                                     | $      | 8.50 |   | $ | 8.50 |   | $ | 0.35 |   |
| First Quarter ended March 31, 2000     |   | $               | 10.56  |                                     | $      | 8.75 |   | $ | 8.75 |   | $ | 0.46 |   |

 

On February 22,2002, the Company’s Board of Directors declared a dividend distribution of$0.50 per share of Common Stock for the first quarter of 2002.  Thedividend is payable on April 26, 2002 to stockholders of record on March 28,2002.

 

The Companyintends to pay quarterly dividends and to make distributions to its stockholdersof all or substantially all of its taxable income each year (subject to certainadjustments) so as to qualify for the tax benefits accorded to a REIT under theCode.  All distributions will be made bythe Company at the discretion of the Board of Directors and will depend on thetaxable earnings of the Company, financial condition of the Company,maintenance of REIT status and such other factors as the Board of Directors maydeem relevant from time to time.

 

**ShareRepurchase Program**

 

On January 13, 1998,the Company’s board of directors authorized a program to repurchase up to750,000 shares of the Company’s Common Stock. On September 16, 1998, the Company’s board of directors authorized aprogram to repurchase 

 

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up to an additional750,000 shares of the Company’s Common Stock having completed the originalrepurchase program of 750,000 shares.

 

The Companyrepurchased 947,100 shares during the year ended December 31, 1998.  The average price per share repurchased andretired during the year ended December 31, 1998 was $11.16.  No shares were repurchased during the yearsended December 31, 2001, 2000 and 1999.

 

An additional552,900 shares are currently authorized for potential repurchase in the future.  The Company may continue to repurchaseshares in the future when market conditions warrant.

 

**ITEM6.  SELECTED FINANCIAL DATA**

 

The following selectedfinancial data are derived from audited financial statements for the yearsended December 31, 2001, 2000, 1999, 1998, and the period from commencement ofoperations on December 9, 1997 to December 31, 1997.  The selected financial data should be read in conjunction withthe more detailed information contained in the financial statements and notesthereto and “Management’s Discussion and Analysis of Financial Condition andResults of Operations” included elsewhere in this report.

 
|                                                                                             |   | **Year Ended  December 31,  2001** |       | **Year Ended  December 31,  2000** |   | **Year Ended  December 31,  1999** |   | **Year Ended  December 31,  1998** |       | **Period from  December 9, 1997 to  December 31,  1997** |   |
|--------------------------------------------------------------------------------------------------|--------|------------------------------------|------------|------------------------------------|--------|------------------------------------|--------|------------------------------------|------------|----------------------------------------------------------|--------|
| **Statement of Operations Data:**                                                                |   |                               |       |                               |   |                               |   |                               |       |                                                     |   |
| Days in period                                                                                   |   | 365                                |       | 366                                |   | 365                                |   | 365                                |       | 22                                                       |   |
|                                                                                             |   |                               |       |                               |   |                               |   |                               |       |                                                     |   |
| Interest income                                                                                  |   | $                                  | 48,891,000 |                               | $      | 42,834,000                         |   | $                                  | 52,517,000 |                                                     | $      | 41,975,000 |   | $ | 428,000 |   |
| Interest expense                                                                                 |   | $                                  | 23,723,000 |                               | $      | 33,779,000                         |   | $                                  | 42,345,000 |                                                     | $      | 36,007,000 |   | $ | 111,000 |   |
| Net interest income                                                                              |   | $                                  | 25,168,000 |                               | $      | 9,055,000                          |   | $                                  | 10,172,000 |                                                     | $      | 5,968,000 |   | $ | 317,000 |   |
| Net (loss) gain from  investment and derivative activity                                         |   | $                                  | (5,015,000 | )                                  | $      | (36,703,000                        | )      | $                                  | 1,938,000  |                                                     | $      | 1,047,000 |   | — |   |
| General and administrative  expenses                                                             |   | $                                  | 1,823,000  |                               | $      | 1,734,000                          |   | $                                  | 3,385,000  |                                                     | $      | 2,104,000 |   | $ | 167,000 |   |
| Net income (loss) before  cumulative effect of change in accounting principle (see Note 1 below) |   | $                                  | 20,887,000 |                               | $      | (28,243,000                        | )      | $                                  | 11,112,000 |                                                     | $      | 5,547,000 |   | $ | 150,000 |   |
| Cumulative effect of change in  accounting principle                                             |   | $                                  | (2,173,000 | )                                  | — |                               | — |                               | —     |                                                     | — |   |
| Net income (loss)                                                                                |   | $                                  | 18,714,000 |                               | $      | (28,243,000                        | )      | $                                  | 11,112,000 |                                                     | $      | 5,547,000 |   | $ | 150,000 |   |
| Average number of shares outstanding                                                             |   | 7,235,000                          |       | 5,753,000                          |   | 5,753,000                          |   | 6,190,000                          |       | 6,700,100                                                |   |
| Basic net income (loss) per  share before cumulative effect of change in accounting principle    |   | $                                  | 2.89       |                               | $      | (4.91                              | )      | $                                  | 1.93       |                                                     | $      | 0.90 |   | $ | 0.02 |   |
| Diluted net income (loss) per  share before cumulative effect of change in accounting principle  |   | $                                  | 2.85       |                               | $      | (4.91                              | )      | $                                  | 1.92       |                                                     | $      | 0.90 |   | $ | 0.02 |   |
| Basic net income (loss) per  share                                                               |   | $                                  | 2.59       |                               | $      | (4.91                              | )      | $                                  | 1.93       |                                                     | $      | 0.90 |   | $ | 0.02 |   |
| Diluted net income per share                                                                     |   | $                                  | 2.55       |                               | $      | (4.91                              | )      | $                                  | 1.92       |                                                     | $      | 0.90 |   | $ | 0.02 |   |
| Dividends declared per share                                                                     |   | $                                  | 1.95       |                               | $      | 1.51                               |   | $                                  | 1.72       |                                                     | $      | 1.07 |   | $ | 0.04 |   |

 

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|                                                 |   | **At December 31,****2001** |          | **At December 31,    2000** |   | **At December 31,  1999** |      | **At December 31,   1998** |        | **At December 31,   1997** |   |
|------------------------------------------------------|--------|-----------------------------|---------------|----------------------------------|--------|---------------------------|-----------|----------------------------|-------------|----------------------------|--------|
| **Balance Sheet  Data:**                             |   |                        |          |                             |   |                      |      |                       |        |                       |   |
| Fixed income securities                              |   | $                           | 1,505,529,000 |                             | $      | 600,131,000               |      | $                          | 701,143,000 |                       | $      | 829,713,000 |   | $ | 265,880,000 |   |
| Equity securities                                    |   | $                           | 6,028,000     |                             | $      | 9,068,000                 |      | $                          | 17,481,000  |                       | $      | 16,422,000 |   | — |   |
| Total assets                                         |   | $                           | 1,535,425,000 |                             | $      | 614,073,000               |      | $                          | 735,745,000 |                       | $      | 865,478,000 |   | $ | 271,307,000 |   |
| Reverse repurchase agreements                        |   | $                           | 1,376,850,000 |                             | $      | 545,434,000               |      | $                          | 672,660,000 |                       | $      | 767,908,000 |   | $ | 87,818,000 |   |
| Total liabilities                                    |   | $                           | 1,405,395,000 |                             | $      | 569,690,000               |      | $                          | 679,704,000 |                       | $      | 777,448,000 |   | $ | 178,310,000 |   |
| Stockholders’ equity                            |   | $                           | 130,030,000   |                             | $      | 44,383,000                |      | $                          | 56,041,000  |                       | $      | 88,030,000 |   | $ | 92,997,000 |   |
| Book value per share                                 |   | $                           | 8.36          |                             | $      | 7.71                      |      | $                          | 9.74        |                       | $      | 15.30 |   | $ | 13.88 |   |
| Fair value of off balance  sheet hedging instruments |   | —                      |          | —                           |   | $                         | 3,815,000 |                       | $           | (9,994,000                 | )      | — |   |

 

Note (1)  The Company adopted SFAS No. 133, *Accountingfor Derivative Instruments and Hedging Activities*, as amended, onJanuary 1, 2001.  Adoption of SFAS No.133 resulted in a transition adjustment of $2,173,000, shown as the cumulativeeffect of change in accounting principle on the statement of operations for theyear ended December 31, 2001, to increase accumulated other comprehensiveincome and to decrease current earnings. The net transition adjustment arose because forward contracts previouslyused to manage the effects of interest rate changes on fair values of fixedincome available-for-sale securities and accounted for as hedges did notqualify for hedge accounting treatment under SFAS No. 133.  The net adjustment of $2,173,000 comprises$10,063,000 of unrealized gains on the investment securities whose values werehedged by forward contracts, $8,505,000 of deferred losses on previously closedforward contracts, and $3,731,000 of unrealized losses on open forward contracts.  Prior to adopting SFAS No. 133, the Companyaccounted for changes in fair values of the forward contracts throughadjustments to accumulated other comprehensive income (loss).  Following adoption of SFAS No. 133, theCompany recognizes changes in fair values of forward contracts as a componentof net gain (loss) on investment and derivative activities in the statements ofoperations.

 

**ITEM7.  MANAGEMENT’S DISCUSSION AND ANALYSISOF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

*Thefollowing discussion of our financial condition and results of operationsshould be read in conjunction with the financial statements and the notes tothose statements included elsewhere in this Annual Report on Form 10-K.*

 

**General**

 

The Company usesits equity capital and borrowed funds to seek to generate income based on thedifference between the yield on its Mortgage Related Assets and the cost of itsborrowings.  The Company will elect tobe taxed as a REIT under the Code.  TheCompany will not generally be subject to federal taxes on its income to theextent that it distributes its net income to its stockholders and maintains itsqualification as a REIT.

 

**Financial Condition**

** **

**Fixed Income Securities**

 

At December 31,2001 and 2000 the Company held $1,505,529,000 and $600,131,000 of Fixed IncomeSecurities, respectively.  The originalmaturity of a significant portion of the Fixed Income Securities ranges fromfifteen to thirty years; the actual maturity is subject to change based on theprepayments of the underlying Mortgage Loans.

 

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The followingtable is a schedule of Fixed Income Securities held listed by security type(dollars in thousands):

 
|                          |   | **December 31, 2001** |      | **December 31, 2000**     |   |
|-------------------------------|--------|-----------------------|-----------|---------------------------|--------|
| **Fixed Income Securities**   |   | **Carrying  Value**   |      | **Percent of  Portfolio** |   | **Carrying  Value** |   | **Percent of  Portfolio** |   |
| Mortgage Securities:          |   |                  |      |                      |   |   |   |   |   |
| Adjustable Rate (1)           |   | $                     | 16,196    |                      | 1.08   | % | $ | 40,253 |   | 6.71 | % |
| Fixed Rate                    |   | 1,483,881             |      | 98.56                     | %      | 554,216 |   | 92.35 | % |
| Other Fixed Income Securities |   | 5,452                 |      | 0.36                      | %      | 5,662 |   | 0.94 | % |
| Totals                        |   | $                     | 1,505,529 |                      | 100.00 | % | $ | 600,131 |   | 100.00 | % |

 

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(1)  AtDecember 31, 2001 and 2000, the interest rate indices for 98% and 2% of theadjustable rate mortgage securities were based on the one-year U.S. Treasuryrate and the six-month London Inter-Bank Offered Rate, respectively.

 

The followingtable shows various weighted average characteristics of the Fixed IncomeSecurities held by the Company at December 31, 2001 (dollars in thousands):

 
| **Security Type**             |   | **Par Amount** |      | **Percent of  Total Par  Amount** |   | **Adjusted Cost  Basis** |   | **Market  Price** |   | **Current  Coupon** |   | **Weighted  Average  Life (1)** |   |
|-------------------------------|--------|----------------|-----------|-----------------------------------|--------|--------------------------|--------|-------------------|--------|---------------------|--------|---------------------------------|--------|
| 20 Year Agency Pass-throughs  |   | $              | 187,529   |                              | 12.47  | %                        | 97.09  | %                 | 101.88 | %                   | 6.50   | %                               | 3.6    |   |
| 30 Year Agency Pass-throughs  |   | 1,203,215      |      | 80.02                             | %      | 101.25                   | %      | 100.15            | %      | 6.50                | %      | 6.8                             |   |
| AAA CMOs                      |   | 86,600         |      | 5.76                              | %      | 96.09                    | %      | 101.38            | %      | 6.69                | %      | 2.5                             |   |
| Total Fixed Rate Holdings     |   | 1,477,344      |      | 98.25                             | %      | 100.42                   | %      | 100.44            | %      | 6.51                | %      | 6.2                             |   |
|                          |   |           |      |                              |   |                     |   |              |   |                |   |                            |   |
| Other Fixed Income Securities |   | 10,400         |      | 0.69                              | %      | 60.33                    | %      | 52.42             | %      | 13.46               | %      | 0.8                             |   |
| Adjustable Rate Holdings      |   | 15,895         |      | 1.06                              | %      | 98.57                    | %      | 101.89            | %      | 7.07                | %      | 1.0                             |   |
|                          |   |           |      |                              |   |                     |   |              |   |                |   |                            |   |
| Total Portfolio               |   | $              | 1,503,639 |                              | 100.00 | %                        | 100.12 | %                 | 100.13 | %                   | 6.56   | %                               | 6.1    |   |

 

The followingtable shows various weighted average characteristics of the Fixed IncomeSecurities held by the Company at December 31, 2000 (dollars in thousands):

 
| **Security Type**                 |   | **Par Amount** |    | **Percent of  Total Par  Amount** |   | **Amortized  Cost Basis** |   | **Market Price** |   | **Current  Coupon** |   | **Weighted  Average  Life (1)** |   |
|-----------------------------------|--------|----------------|---------|-----------------------------------|--------|---------------------------|--------|------------------|--------|---------------------|--------|---------------------------------|--------|
| 15 Year Agency/AAA  Pass-throughs |   | $              | 145,251 |                              | 23.90  | %                         | 98.00  | %                | 99.90  | %                   | 6.50   | %                               | 4.5    |   |
| 20 Year Agency Pass-throughs      |   | 230,193        |    | 37.90                             | %      | 97.00                     | %      | 99.30            | %      | 6.50                | %      | 5.6                             |   |
| 30 Year Agency Pass-throughs      |   | 54,759         |    | 9.00                              | %      | 99.65                     | %      | 101.23           | %      | 7.41                | %      | 5.0                             |   |
| AAA CMOs                          |   | 127,759        |    | 21.00                             | %      | 95.68                     | %      | 97.92            | %      | 6.80                | %      | 6.4                             |   |
| Total Fixed Rate Holdings         |   | 557,962        |    | 91.80                             | %      | 97.22                     | %      | 99.33            | %      | 6.80                | %      | 5.4                             |   |
|                              |   |           |    |                              |   |                      |   |             |   |                |   |                            |   |
| Other Fixed Income Securities     |   | 10,400         |    | 1.70                              | %      | 64.31                     | %      | 54.44            | %      | 15.89               | %      | 1.8                             |   |
| Adjustable Rate Holdings          |   | 39,253         |    | 6.50                              | %      | 102.49                    | %      | 102.55           | %      | 8.00                | %      | 0.6                             |   |
|                              |   |           |    |                              |   |                      |   |             |   |                |   |                            |   |
| Total Portfolio                   |   | $              | 607,615 |                              | 100.00 | %                         | 96.99  | %                | 98.77  | %                   | 6.90   | %                               | 5.1    |   |

 

23

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(1)                                 Theweighted average life of the fixed rate Mortgage Securities is based uponmarket prepayment expectations as of the dates shown.  The actual weighted average life could be longer or shorterdepending on the actual prepayment rates experienced over the life of thesecurities.  The weighted average lifeshown for the adjustable rate mortgage assets represents the average time untilthe next coupon reset date.  Allaverages are shown in years.

 

The followingtable shows various weighted average characteristics of the Fixed IncomeSecurities held by the Company at December 31, 1999 (dollars in thousands):

 
| **Security Type**                 |   | **Par Amount** |    | **Percent of  Total Par  Amount** |   | **Amortized  Cost Basis** |   | **Market Price** |   | **Current  Coupon** |   | **Weighted  Average  Life (1)** |   |
|-----------------------------------|--------|----------------|---------|-----------------------------------|--------|---------------------------|--------|------------------|--------|---------------------|--------|---------------------------------|--------|
| 15 Year Agency/AAA  Pass-throughs |   | $              | 167,717 |                              | 23.00  | %                         | 100.49 | %                | 97.30  | %                   | 6.50   | %                               | 5.1    |   |
| 20 Year Agency Pass-throughs      |   | 251,819        |    | 34.50                             | %      | 100.46                    | %      | 96.26            | %      | 6.50                | %      | 6.4                             |   |
| 30 Year Agency Pass-throughs      |   | 31,424         |    | 4.30                              | %      | 101.36                    | %      | 95.98            | %      | 6.99                | %      | 7.7                             |   |
| AAA CMOs                          |   | 237,202        |    | 32.40                             | %      | 99.76                     | %      | 95.53            | %      | 6.82                | %      | 7.2                             |   |
| Total Fixed Rate Holdings         |   | $              | 688,162 |                              | 94.20  | %                         | 100.26 | %                | 96.25  | %                   | 6.63   | %                               | 6.4    |   |
|                              |   |           |    |                              |   |                      |   |             |   |                |   |                            |   |
| Other Fixed Income Securities     |   | 10,400         |    | 1.40                              | %      | 69.38                     | %      | 62.88            | %      | 15.53               | %      | 2.1                             |   |
| Adjustable Rate Holdings          |   | 31,923         |    | 4.40                              | %      | 101.73                    | %      | 101.04           | %      | 6.62                | %      | 1.0                             |   |
|                              |   |           |    |                              |   |                      |   |             |   |                |   |                            |   |
| Total Portfolio                   |   | $              | 730,485 |                              | 100.00 | %                         | 99.89  | %                | 95.88  | %                   | 6.76   | %                               | 6.1    |   |

 

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(1)           The weighted average life of thefixed rate Mortgage Securities is based upon market prepayment expectations asof the dates shown.  The actual weightedaverage life could be longer or shorter depending on the actual prepaymentrates experienced over the life of the securities.  The weighted average life shown for the adjustable rate mortgageassets represents the average time until the next coupon reset date.  All averages are shown in years.

 

**EquitySecurities**

 

At December 31,2001, 2000 and 1999, the Company held $6,028,000, $9,068,000 and $17,481,000 ofequity securities, respectively.  Equitysecurities consist primarily of investment in equities issued by other realestate investment trusts.

 

At December 31, 2001,equity securities consisted of the following:

 
|                                     |   | **Shares Held** |   | **Adjusted Cost** |   | **Fair Value** |   |
|------------------------------------------|--------|-----------------|--------|-------------------|--------|----------------|--------|
| **(In  thousands)**                      |   |            |   |
| Common Stock:                            |   |            |   |              |   |           |   |
| Dynex Capital, Inc.                      |   | 75              |   | $                 | 122    |           | $      | 158 |   |
| Total Common Stock                       |   |            |   | 122               |   | 158            |   |
|                                     |   |            |   |              |   |           |   |
| Convertible Preferred Stock:             |   |            |   |              |   |           |   |
| Capstead Mortgage Corporation,  Series B |   | 480             |   | 4,065             |   | 5,870          |   |
| Total Convertible Preferred  Stock       |   |            |   | 4,065             |   | 5,870          |   |
|                                     |   |            |   |              |   |           |   |
| Total Equity Securities                  |   |            |   | $                 | 4,187  |           | $      | 6,028 |   |

 

24

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At December 31, 2000,equity securities consisted of the following:

 
|                                         |   | **Shares Held** |   | **Adjusted Cost** |   | **Fair Value** |   |
|----------------------------------------------|--------|-----------------|--------|-------------------|--------|----------------|--------|
| **(In  thousands)**                          |   |            |   |
| Common Stock:                                |   |            |   |              |   |           |   |
| American Residential  Investment Trust, Inc. |   | 109             |   | $                 | 611    |           | $      | 238 |   |
| Anworth Mortgage Asset  Corporation          |   | 222             |   | 994               |   | 900            |   |
| Dynex Capital, Inc.                          |   | 75              |   | 122               |   | 75             |   |
| Total Common Stock                           |   |            |   | 1,727             |   | 1,213          |   |
|                                         |   |            |   |              |   |           |   |
| Convertible Preferred Stock:                 |   |            |   |              |   |           |   |
| Capstead Mortgage Corporation,  Series B     |   | 520             |   | 4,408             |   | 5,492          |   |
| Dynex Capital, Inc., Series A                |   | 53              |   | 420               |   | 427            |   |
| Dynex Capital, Inc., Series B                |   | 150             |   | 1,167             |   | 1,088          |   |
| Dynex Capital, Inc.,  Series C          |   | 108             |   | 968               |   | 848            |   |
| Total Convertible Preferred  Stock           |   |            |   | 6,963             |   | 7,855          |   |
|                                         |   |            |   |              |   |           |   |
| Total Equity Securities                      |   |            |   | $                 | 8,690  |           | $      | 9,068 |   |

 

At December 31, 1999,equity securities consisted of the following:

 
|                                         |   | **Shares Held** |   | **Adjusted Cost** |   | **Fair Value** |   |
|----------------------------------------------|--------|-----------------|--------|-------------------|--------|----------------|--------|
| **(In  thousands)**                          |   |            |   |
| Common Stock:                                |   |            |   |              |   |           |   |
| American Residential  Investment Trust, Inc. |   | 109             |   | $                 | 611    |           | $      | 748 |   |
| Anthracite Capital, Inc.                     |   | 500             |   | 3,071             |   | 3,188          |   |
| Anworth Mortgage Asset  Corporation          |   | 222             |   | 994               |   | 997            |   |
| Dynex Capital, Inc.                          |   | 75              |   | 1,080             |   | 483            |   |
| Hanover Capital Mortgage  Holdings, Inc.     |   | 385             |   | 1,842             |   | 1,396          |   |
| Impac Commercial Holdings,  Inc.             |   | 249             |   | 1,441             |   | 1,307          |   |
| Total Common Stock                           |   |            |   | 9,039             |   | 8,119          |   |
|                                         |   |            |   |              |   |           |   |
| Convertible Preferred Stock:                 |   |            |   |              |   |           |   |
| Capstead Mortgage Corporation,  Series B     |   | 520             |   | 4,408             |   | 4,940          |   |
| Dynex Capital, Inc., Series A                |   | 53              |   | 920               |   | 715            |   |
| Dynex Capital, Inc., Series B                |   | 150             |   | 2,711             |   | 1,987          |   |
| Dynex Capital, Inc.,  Series C          |   | 108             |   | 2,292             |   | 1,720          |   |
| Total Convertible Preferred  Stock           |   |            |   | 10,331            |   | 9,362          |   |
|                                         |   |            |   |              |   |           |   |
| Total Equity Securities                      |   |            |   | $                 | 19,370 |           | $      | 17,481 |   |

 

At December 31,2001, the Company held equity securities and senior unsecured notes issued byDynex Capital, Inc. (“Dynex”) with fair market values of $158,000 and$4,550,000, respectively.  During theyear ended December 31, 1999, Dynex suspended the payment of dividends on itspreferred stock.  Accordingly, theCompany is no longer recognizing dividend income on its equity investments inDynex.  Dynex is currently payinginterest on its senior notes. Accordingly, the Company is recognizing interest income on the seniornote investments issued by Dynex.  IfDynex were to suspend payment of interest on its senior notes, interest incomerecognized by the Company would be negatively impacted.

 

25

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During the yearended December 31, 2000, the Company recorded impairment adjustments of$3,368,000 and $958,000 on its Dynex preferred stock and common stock holdings,respectively, which are included in net loss on investment and derivativeactivities in the statement of operations. The Company could also incur additional losses if the remaining Dynexinvestments are sold or written down further.

 

**Hedging Instruments**

 

There can be noassurance that the Company will enter into hedging activities or that, ifentered into, such activities will have the desired beneficial impact on theCompany’s results of operations or financial condition.  Moreover, no hedging activity can completelyinsulate the Company from the risks associated with changes in interest ratesand prepayment rates.

 

Hedging involvesrisk and typically involves costs, including transaction costs.  Such costs increase dramatically as theperiod covered by the hedging increases and during periods of rising andvolatile interest rates.  The Companymay increase its hedging activity and, thus, increase its hedging costs duringsuch periods when interest rates are volatile or rising and hedging costs haveincreased.  The Company intendsgenerally to hedge as much of the interest rate risk as the Manager determinesis in the best interest of the stockholders of the Company given the cost ofsuch hedging transactions and the Company’s desire to maintain its status as aREIT.  The Company’s policies do not containspecific requirements as to the percentages or amount of interest rate riskthat the Manager is required to hedge.

 

The Companyadopted SFAS No. 133, *Accounting forDerivative Instruments and Hedging Activities* and related amendmentsand interpretations on January 1, 2001. This adoption resulted in a transition adjustment that reclassified$2,173,000 of net losses on unrealized and deferred gains and losses oninvestment securities and forward contracts from accumulated othercomprehensive income to current income. Also, deferred gains on interest rate swaps previously designated ashedges were reclassified from other liabilities to accumulated othercomprehensive income.  Subsequent to theadoption of SFAS No. 133, the Company carries all derivative financialinstruments on its balance sheet at fair value.  Changes in fair values of the instruments are recorded asadjustments either to current earnings or to accumulated other comprehensiveincome, depending on whether such instruments qualify for hedge accountingtreatment, as discussed below.

 

In conjunctionwith the adoption of SFAS No. 133, the Company reclassified $594,469,000 of itsmortgage securities from the available-for-sale category to the tradingcategory for investments accounted for under SFAS No. 115.  This change resulted in the reclassificationof $1,742,000 net unrealized gains from accumulated other comprehensive incometo current income, in addition to net unrealized gains included in the SFAS No.133 transition adjustment discussed above.

 

At various timesduring 1999 and 2000, and again in the fourth quarter of 2001, the Companyutilized interest rate swap agreements as a tool to manage interest raterisk.  Under the swap agreements, theCompany receives a floating rate and pays a fixed rate.  The notional amount of each agreement ismatched against a like amount of current and anticipated borrowings underreverse repurchase agreements to mitigate the potential effect on cash flowsand net interest income of rising interest rates by effectively fixing the ratepaid on the matched borrowings over the life of the contract.  In the absence of such financialinstruments, interest expense on reverse repurchase agreements and similarshort-term borrowings, which mature and reprice frequently, can increase fasterthan the Company can adjust its interest-earning assets and increase interestincome, because the Company’s Mortgage Related Securities generally have muchlonger maturities and have fixed rates of interest.

 

The interest rateswap agreements entered into by the Company in the fourth quarter of 2001 areclassified as cash flow hedges for accounting purposes, and meet therequirements of SFAS No. 133 for such classification.  Therefore, changes in the fair value of the agreements are reportedin accumulated other comprehensive income, a component of stockholders’ equity,and do not affect net income in the period of the change to the extent theseswaps are highly effective.  Periodicexchanges of cash flows with the counterparties to the agreements are recordedas adjustments to interest expense.  Ifthe Company were to terminate the swap agreements prior to their contractualtermination dates, or change current or anticipated borrowings so that theywere no longer appropriately matched to the swap agreements, the agreementsmight no longer qualify for hedge accounting treatment.  In that case, changes in their fair valueswould affect net income.

 

 Borrowings hedged by interest rate swaps areused primarily to acquire and hold Fixed Income Securitiesavailable-for-sale.  Changes in the fairvalues of securities available-for-sale are also reported in accumulated othercomprehensive income, a component of stockholders’ equity.  Changes in fair values of the securitiesonly affect periodic 

 

26

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earnings when they aresold or if they have an other-than-temporary impairment.   Therefore, earnings volatility is reducedby the use of the swap agreements as cash flow hedges and the acquisition ofavailable-for-sale securities with the borrowings hedged by theagreements.  Impairment of theavailable-for-sale securities or decisions to sell the securities prior totheir expected maturities could result in unanticipated earnings volatility.

 

At December 31,2000, there were no outstanding interest rate swaps.  At December 31, 2001, the Company had entered into interest rateswap agreements summarized below.

 
| **Current  Notional Amount  (000)** |    | **Weighted  Average Life** |      | **Average  Fixed Rate** |   | **Floating  Rate** |      | **Average  Termination  Date** |     | **Unrealized  Gains  (000)** |   |
|-------------------------------------|---------|----------------------------|-----------|-------------------------|--------|--------------------|-----------|--------------------------------|----------|------------------------------|--------|
| $                                   | 850,000 |                       | 6.6 years |                    | 4.239  | %                  | 1Mo LIBOR |                           | 3/3/2008 |                         | $      | 4,620 |   |
|                                     |         |                            |           |                         |        |                    |           |                                |          |                              |        |  |  |

 

At various timesduring 2001 and in earlier years, the Company has used forward contracts tosell U.S. Treasury securities as a means to mitigate the effect of risinginterest rates on the fair value of its Mortgage Related Securities.   The fair values of these forward contractsgenerally move in the opposite direction of the fair values of the Mortgage RelatedSecurities, and approximately in the same proportion when the maturities andother terms are appropriately matched.  When interest rates rise, the fair value of the Mortgage Relatedsecurities declines, but the increasing fair values of the forward contractshelp to preserve net asset value relative to the changing fair value of theshort-term borrowings used to fund them.

 

The Company’sforward contracts do not meet the criteria for hedge accounting under SFAS No.133.  Therefore, changes in their fairvalues affect current earnings, as do changes in the fair values of thesecurities to which they are matched — such securities are classified astrading securities.  Although thechanges in the fair values of the forward contracts and the trading securitiesare offsetting, the contracts are not fully effective as hedges, and there canbe significant volatility in periodic earnings to the extent they are not.

 

At December 31, 2001, theCompany had open forward contracts to sell U.S. Treasury notes with termsstated below.

 
| **Current  Notional Amount  (000)** |    | **Average  Contract Price** |    | **Fair value  of  contracts  (000)** |   | **Average  Termination  Date** |   | **Unrealized  Gains (Losses)  (000)** |   |
|-------------------------------------|---------|-----------------------------|---------|--------------------------------------|--------|--------------------------------|--------|---------------------------------------|--------|
| $                                   | 359,000 |                        | 100.825 |                                 | $      | 365,235                        |   | 1/14/2002                             |   | $ | (3,275 | ) |
|                                     |         |                             |         |                                      |        |                                |        |                                       |        |  |  |  |

 

At December 31, 2000, theCompany had entered into open forward contracts to sell U.S. Treasury noteswith terms stated below.

 
| **Current  Notional Amount  (000)** |    | **Average  Contract Price** |    | **Fair value  of  contracts  (000)** |   | **Average  Termination  Date** |   | **Unrealized  Gains (Losses)  (000)** |   |
|-------------------------------------|---------|-----------------------------|---------|--------------------------------------|--------|--------------------------------|--------|---------------------------------------|--------|
| $                                   | 575,000 |                        | 101.099 |                                 | $      | 585,048                        |   | 1/19/2001                             |   | $ | (3,731 | ) |
|                                     |         |                             |         |                                      |        |                                |        |                                       |        |  |  |  |

 

27

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At December 31, 1999, theCompany had entered into open forward contracts to sell U.S. Treasury noteswith terms stated below.

 
| **Current  Notional Amount  (000)** |    | **Average  Contract  Price** |   | **Fair value  of  contracts  (000)** |   | **Average  Termination  Date** |   | **Unrealized  Gains (Losses)  (000)** |   |
|-------------------------------------|---------|------------------------------|--------|--------------------------------------|--------|--------------------------------|--------|---------------------------------------|--------|
| $                                   | 335,000 |                         | 99.278 |                                 | $      | 336,492                        |   | 2/12/2000                             |   | $ | 3,909 |   |
|                                     |         |                              |        |                                      |        |                                |        |                                       |        |  |  |  |

 

The contracts wereentered into to mitigate the negative impact of rising interest rates on fixedincome securities available-for-sale that generally have a market-weightedaverage duration approximately equal to the contracts shown above.

 

**Liabilities**

 

As noted above,the Company has entered into reverse repurchase agreements to finance certainof its Mortgage Related Securities. These agreements are secured by a portion of the Company’s securitiesand bear interest rates that have historically moved in close relationship toLIBOR.

 

At December 31,2001, the Company had outstanding $1,376,850,000 of reverse repurchaseagreements with a weighted average current borrowing rate of 1.89% and amaturity of 1.0 months.  The reverserepurchase agreements were collateralized by securities with an estimated fairvalue of $1,440,014,000.

 

At December 31,2000, the Company had outstanding $545,434,000 of reverse repurchase agreementswith a weighted average current borrowing rate of 6.61% and a maturity of 1.1months.  The reverse repurchaseagreements were collateralized by mortgage-backed securities with an estimatedfair value of $564,274,000.

 

At December 31,1999, the Company had outstanding $672,660,000 of reverse repurchase agreementswith a weighted average current borrowing rate of 5.98% and a maturity of 2.0months.  The reverse repurchaseagreements were collateralized by mortgage-backed securities with an estimatedfair value of $689,396,000.

 

The Company had$28,545,000, $24,256,000 and $7,044,000 of other liabilities at December 31,2001, 2000 and 1999, respectively, consisting primarily of dividend payable andaccrued expenses and other liabilities at December 31, 2001; deferred gain oninterest rate swaps, accrued interest payable and payables for unsettledsecurities at December 31, 2000; and accrued interest payable and payables forunsettled securities at December 31, 1999.

 

**Results of Operations**

 

**YearEnded December 31,  2001 Compared toYear Ended December 31, 2000**

 

*Overview*

 

For the year endedDecember 31, 2001, the Company’s net income was $18,714,000, or $2.59 per shareon a basic basis and $2.55 on a diluted basis, based on a weighted average of7,235,000 and 7,325,000 shares outstanding, respectively.  That compares to net loss of $28,243,000, or$4.91 per share on a basic and diluted basis, based on a weighted average of5,753,000 shares outstanding, for the year ended December 31, 2000.  The primary reasons for the substantialchange in operating results for 2001 compared to 2000 are:  (1) changes in interest rates and marketconditions affecting the fair values of the Company’s Mortgage RelatedSecurities and related derivative financial instruments and net interestincome, (2) related changes in investment and hedging strategies, especially inthe third quarter of 2000, and (3) substantial increases in the Company’sequity capital, borrowings and Mortgage Related Securities in the fourthquarter of 2001.

 

The FederalReserve Board reduced short-term rates 11 times, dropping the Fed Funds targetfrom 6.50% to 1.75%, during the calendar year ending December 31, 2001resulting in a steeper yield curve.  Theyields on three and six month 

 

28

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Treasury securities fellfrom 5.88% and 5.689% to 1.71% and 1.79%, respectively.  However, the yield on the 10-year Treasurybond remained relatively flat falling only 7 basis points from 5.10% to5.03%.  Also, the one-month LIBOR ratealso fell from 6.56% to 1.87% by year-end. The reduction in short term rates lowered the Company’s averageborrowing cost for the year ending December 31, 2001 to 3.63% down 223 basispoints from the year ending December 31, 2000 during which  the average borrowing rate was 5.86%.  During the year the Company benefited fromits strategy of investing in fixed-rate mortgages of the highest credit qualityand the decline in funding costs. Consequently, these lower short term rates increased the Company’s netprofit margin to 3.57% for the year compared to a net profit margin of 0.91%for the previous year.

 

During the fourth quarterof 2001 the Company completed two follow-on equity offerings of its common stock,issuing an additional 9,775,000 shares, bringing the Company’s totaloutstanding shares to 15,555,500 at December 31, 2001.  The Company used virtually all the proceedsof the equity offerings to invest in high-credit quality fixed ratemortgages.  Given the favorableoperating environment the Company used leverage to increase its assets to$1,535,425,000 on December 31, 2001 from $614,073,000 on December 31,2000.  Additionally, in recognition ofthese historically low short-term rates, the Company elected to effectivelyextend the term of its borrowings using hedging instruments.  In the fourth quarter of 2001, the Companyentered into $850 million of interest-rate swaps with an average term of 4.6years and average cost of 4.24%.  TheCompany’s reliance on short-term interest rates is reduced since a large shareof its liabilities are now fixed.

 

*NetInterest Income*

 

Net interestincome for the year ended December 31, 2001 was $25,168,000, compared to$9,055,000 for the year ended December 31, 2000, or an increase of 278%.  This change was the net result of anincrease in interest income of $6,057,000, or 14%, and a decrease in interestexpense of $10,056,000 or 30%.  Changesin interest income and expense are primarily a function of changes in averageeffective interest rates on the Company’s Fixed Income Securities and reverserepurchase agreements, and changes in the average amount of those assets andliabilities outstanding during each year.

 

The followingtable shows average balances and effective interest rates for the majorcategories of interest-earning assets and interest-bearing liabilities for theyears ended December 31, 2001 and 2000.

 

**AVERAGE BALANCE AND RATE TABLE**

**(Dollars in thousands)**

 
|                                   |   | **For the  Year Ended  December 31, 2001** |    | **For the  Year Ended  December 31, 2000** |   |
|----------------------------------------|--------|--------------------------------------------|---------|--------------------------------------------|--------|
|                                   |   | **Average  Balance**                       |    | **Effective  Rate**                        |   | **Average  Balance** |   | **Effective  Rate** |   |
| Interest-Earning Assets:               |   |                                       |    |                                       |   |   |   |   |   |
| Mortgage Securities                    |   | $                                          | 669,913 |                                       | 7.11   | % | $ | 622,350 |   | 6.67 | % |
| Other Fixed Income Assets              |   | 6,502                                      |    | 17.20                                      | %      | 6,945 |   | 16.09 | % |
| Cash and Cash Equivalents              |   | 2,943                                      |    | 3.81                                       | %      | 3,588 |   | 4.96 | % |
| Total Interest-Earning Assets          |   | 679,358                                    |    | 7.20                                       | %      | 632,883 |   | 6.76 | % |
|                                   |   |                                       |    |                                       |   |   |   |   |   |
| Interest-Bearing Liabilities:          |   |                                       |    |                                       |   |   |   |   |   |
| Reverse Repurchase Agreements          |   | 653,953                                    |    | 3.63                                       | %      | 576,190 |   | 5.86 | % |
| Net Interest-Earning Assets and Spread |   | $                                          | 25,405  |                                       | 3.57   | % | $ | 56,693 |   | 0.91 | % |

 

The effectiveyield data in the table above is computed by dividing the annualized netinterest income or expense including hedging transactions into the averagedaily balance shown.

 

29

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Following is atable that shows the approximate amounts of the change in interest income andexpense between 2001 and 2000 that was a function of rate and volume changes,and the amount of the change that cannot be ascribed specifically to eitherrate or volume changes.

 

**RATE / VOLUME TABLE**

**(Dollars in thousands)**

 
|                           |   | **Year Ended  December 31,  2001 compared to 2000** |           |
|--------------------------------|--------|-----------------------------------------------------|----------------|
|                           |   | **Total  Change**                                   |           | **Changes Due  to** |   |
|                           |   |                                                | **Volume (1)** |   | **Rates (1)** |   |
| Interest-Earning Assets        |   |                                                |           |   |   |   |   |
| Fixed income securities        |   | $                                                   | 6,161          |   | $ | 3,190 |   | $ | 2,976 |   |
| Cash and cash equivalents      |   | (104                                                | )              | (51 | ) | (53 | ) |
|                           |   |                                                |           |   |   |   |   |
| Total interest income          |   | $                                                   | 6,057          |   | $ | 3,139 |   | $ | 2,923 |   |
|                           |   |                                                |           |   |   |   |   |
| Interest-Bearing  Liabilities  |   |                                                |           |   |   |   |   |
| Reverse repurchase  agreements |   | $                                                   | (10,056        | ) | $ | 4,600 |   | $ | (14,656 | ) |
|                           |   |                                                |           |   |   |   |   |
| Total interest expense         |   | $                                                   | (10,056        | ) | $ | 4,600 |   | $ | (14,656 | ) |
|                           |   |                                                |           |   |   |   |   |
| Change In Net Interest  Income |   | $                                                   | 16,113         |   | $ | (1,461 | ) | $ | 17,579 |   |

 

----

(1)  Changes in interest income/expense notarising from volume or rate variances are allocated proportionately to rate andvolume.

 

A portion of thechange in interest expense in the table above is related to the Company’s useof interest rate swaps.  Periodicsettlements of the swap agreements with their counter-parties result inadjustments to interest expense associated with the reverse repurchaseagreements hedged by the swaps.  Duringthe year ended December 31, 2000, interest expense was reduced by $344,000received from swap counterparties and $2,984,000 from amortization of deferredgains on terminated swap contracts. During the year ended December 31, 2001, interest expense was increasedby $1,663,000 paid to swap counterparties and decreased by $2,366,000 fromamortization of deferred gains on terminated swap contracts.

 

*Dividend Income*

 

The Companyreported dividend income of $815,000 from dividends on equity investments forthe year ended December 31, 2001 compared to $1,139,000 for the year endedDecember 31, 2000, a decrease of 28%. The decrease was the result of the sale of $7,578,000 of equitysecurities available-for-sale during 2001.

 

*NetGain (Loss) on Investment and Derivative Activities*

 

During 2001, theCompany reported net losses on investment and derivative activities of$5,015,000, consisting primarily of a realized net loss of $19,007,000 onclosed forward contracts, a realized gain of $7,676,000 on the sale of$379,198,000 of fixed income trading securities, a gain of $3,076,000 on thesale of equity securities available-for-sale and an unrealized gain of$3,240,000 on trading securities during the year ended December 31, 2001.  During 2000, the Company realized a net lossof $36,703,000, primarily from impairment charges on certain fixed-ratemortgage securities ($18,284,000), certain equity securities ($4,326,000) andforward contracts ($8,424,000).  Theimpairment charges represented declines in fair values of these financialinstruments deemed to be other-than-temporary because of a change in theCompany’s investment and hedging strategies during the third quarter of2000.  The strategies were changed inresponse to the negative effects that unanticipated, rapid changes in interestrates had on the overall structure of the Company’s portfolio.  A substantial portion of the securitiesidentified as impaired were subsequently sold in the fourth quarter of 2000 andduring 2001.

 

30

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*Generaland Administrative Expenses*

 

The Companyincurred general and administrative expenses of $1,823,000 for the year ended December31, 2001 compared to $1,734,000 for the year ended December 31, 2000, or anincrease of  5%.  During 2001, the Company had earnings and areturn on equity in excess of targets that caused it to incur incentive fees of$634,000 to the Manager under the terms of the Management Agreement.  In 2000, the Company did not meet thosetargets and was not obligated to pay an incentive fee to the Manager.  The increase in general and administrativeexpenses in 2001 *compared* to 2000caused by the incentive fee increase was offset by reductions of $250,000 inprofessional fees and $213,000 in “other” general and administrativeexpenses.   Professional fees werehigher in 2000 than in 2001 primarily because of legal expenses incurred in2000 in connection with efforts, now discontinued, to restructure the Company’soperations through combinations with other mortgage REITs.  “Other” expenses were lower in 2001 comparedto 2000 primarily because of cost containment efforts.

 

*Accounting Changes*

 

As previouslynoted, on January 1, 2001, the Company adopted SFAS No. 133 and the relatedamendments and interpretations.  Thisadoption resulted in a transition adjustment that reclassified $2,173,000 ofnet losses on unrealized and deferred gains and losses on investment securitiesand forward contracts from accumulated other comprehensive income to currentincome.

 

Also on January 1,2001, the Company reclassified $594,469,000 of its mortgage securities from theavailable-for-sale category to the trading category for investments accountedfor under SFAS No. 115.  This changeresulted in the reclassification of $1,742,000 net unrealized gains fromaccumulated other comprehensive income to current income, in addition to netunrealized gains included in the SFAS No. 133 transition adjustment discussedabove.

 

**Year Ended December 31, 2000 Comparedto Year Ended December 31, 1999**

 

*Overview*

 

For the year endedDecember 31, 2000, the Company’s net loss was $28,243,000, or $4.91 per shareon a basic and diluted basis, based on a weighted average of 5,753,000 sharesoutstanding.  That compares to netincome of $11,112,000, or $1.93 per share on a basic basis and $1.92 on adiluted basis, based on a weighted average of 5,753,000 and 5,779,000 sharesoutstanding, respectively, for the year ended December 31, 1999.   The primary reason for the substantialchange, and specifically the net loss in 2000, was an unanticipated, rapidchange in interest rates during the year that had a substantial negative impacton the fair value of the Company’s fixed income securities and on the netinterest margin.

 

*Net Interest Income*

 

Net interestincome for the year ended December 31, 2000 was $9,055,000, compared to$10,172,000 for the year ended December 31, 1999, or a decrease of 11%.   This change was the net result of adecrease in interest income of $9,683,000, or 18%, and a decrease in interestexpense of $8,566, or 20%, in interest expense.   Changes in interest income and expense are primarily a functionof changes in average effective interest rates on the Company’s Fixed IncomeSecurities and reverse repurchase agreements, and changes in the average amountof those assets and liabilities outstanding during each year.

 

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The followingtable reflects the average balances for each category of the Company’s interestearning assets as well as the Company’s interest bearing liabilities, with thecorresponding effective rate of interest annualized (dollars in thousands):

 

**AVERAGE BALANCE AND RATE TABLE**

**(Dollars in thousands)**

 
|                                   |   | **For the  Year Ended  December 31, 2000** |    | **For the  Year Ended  December 31, 1999** |   |
|----------------------------------------|--------|--------------------------------------------|---------|--------------------------------------------|--------|
|                                   |   | **Average  Balance**                       |    | **Effective  Rate**                        |   | **Average  Balance** |   | **Effective  Rate** |   |
| Interest Earning Assets:               |   |                                       |    |                                       |   |   |   |   |   |
| Mortgage Securities                    |   | $                                          | 622,350 |                                       | 6.67   | % | $ | 772,464 |   | 6.65 | % |
| Other Fixed Income Assets              |   | 6,945                                      |    | 16.09                                      | %      | 5,822 |   | 14.40 | % |
| Cash and Cash Equivalents              |   | 3,588                                      |    | 4.96                                       | %      | 6,322 |   | 4.76 | % |
| Total Interest Earning Assets          |   | 632,883                                    |    | 6.76                                       | %      | 784,608 |   | 6.69 | % |
|                                   |   |                                       |    |                                       |   |   |   |   |   |
| Interest Bearing Liabilities:          |   |                                       |    |                                       |   |   |   |   |   |
| Reverse Repurchase Agreements          |   | 576,190                                    |    | 5.86                                       | %      | 732,960 |   | 5.78 | % |
|                                   |   |                                       |    |                                       |   |   |   |   |   |
| Net Interest Earning Assets and Spread |   | $                                          | 56,693  |                                       | 0.91   | % | $ | 51,648 |   | 0.91 | % |

 

The effectiveyield data is computed by dividing the annualized net interest income orexpense including hedging transactions into the average daily balance shown.

 

Following is atable that shows the approximate amounts of the change in interest income andexpense between 2000 and 1999 that was a function of rate and volume changes,and the amount of the change that cannot be ascribed specifically to eitherrate or volume changes.

 
|                           |   | **Year Ended  December 31,  2000 compared to 1999** |           |
|--------------------------------|--------|-----------------------------------------------------|----------------|
|                           |   | **Total  Change**                                   |           | **Changes Due  to** |   |
|                           |   |                                                | **Volume (1)** |   | **Rates (1)** |   |
| Interest-Earning Assets        |   |                                                |           |   |   |   |   |
| Fixed income securities        |   | $                                                   | (9,598         | ) | $ | (9,975 | ) | $ | 377 |   |
| Cash and cash equivalents      |   | (85                                                 | )              | (91 | ) | 6 |   |
|                           |   |                                                |           |   |   |   |   |
| Total interest income          |   | $                                                   | (9,683         | ) | $ | (10,066 | ) | $ | 383 |   |
|                           |   |                                                |           |   |   |   |   |
| Interest-Bearing  Liabilities  |   |                                                |           |   |   |   |   |
| Reverse repurchase  agreements |   | $                                                   | (8,566         | ) | $ | (9,026 | ) | $ | 460 |   |
|                           |   |                                                |           |   |   |   |   |
| Total interest expense         |   | $                                                   | (8,566         | ) | $ | (9,026 | ) | $ | 460 |   |
|                           |   |                                                |           |   |   |   |   |
| Change In Net Interest  Income |   | $                                                   | (1,117         | ) | $ | (1,040 | ) | $ | (77 | ) |

 

----

(1)  Changes in interest income/expense notarising from volume or rate variances are allocated proportionately to rate andvolume.

 

32

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*Dividend Income*

 

The Companyreported dividend income of $1,139,000 from equity investments for the yearended December 31, 2000 compared to $2,387,000 for the year ended December 31, 1999.

 

*Net Gain (Loss) on Investment andDerivative Activities*

 

The Companyreported net losses on investment and derivative activities of $36,703,000 in2000, consisting of an impairment charge of $18,284,000 on certain fixed-rateMortgage Securities, an impairment charge of $4,326,000 on certain equitysecurities, the recognition of the associated unrealized loss and deferredhedging losses on the impaired assets of $8,424,000, a loss of $5,795,000 onthe sale of $193,953,000 of fixed income securities, and a gain of $127,000 onthe sale of equity securities during the year ended December 31, 2000.  The Company realized a net gain of$1,938,000 primarily from the sale of equity investments for the year endedDecember 31, 1999.  During the thirdquarter of 2000, management made a decision to significantly change itsinvestment and hedging strategy, and to dispose of a substantial portion of itsinvestment portfolio over a much shorter period that originallyanticipated.  This decision resulted inthe recognition of an impairment charge because the loss of fair value in theCompany’s investment securities portfolio and in certain derivative financialinstruments was deemed to be other-than-temporary.

 

*General and Administrative Expenses*

 

The Companyincurred general and administrative expenses of $1,734,000 for the year endedDecember 31, 2000 compared to $3,385,000 for the year ended December 31,1999.  The primary reason for thedecrease was that the Company incurred $1,714,000 of incentive fee expense in1999 under the terms of its Management Agreement, based on the Company’soperating results relative to certain targets. Because of the net loss in 2000, no incentive fee expense was incurred.

 

**Liquidity and Capital Resources**

 

The Company’sprimary source of funds is reverse repurchase agreements, which totaled$1,376,850,000 as of December 31, 2001. The Company expects to continue to borrow funds in the form of reverserepurchase agreements.  At December 31,2001, the Company had borrowing arrangements with over twenty differentinvestment banking firms.  As ofDecember 31, 2001, the Company had borrowed $850,000,000 of reverse repurchaseagreements which are hedged with interest rate swaps with notional amounts of$850,000,000 (see prior discussion of “Hedging Instruments”).  Increases in short-term interest rates couldnegatively impact the fair value of the Company’s Mortgage Related Securities,which could limit the Company’s borrowing ability or cause its lenders toinitiate margin calls.

 

The Company willalso rely on the cash flows from operations, primarily monthly principal andinterest payments to be received on the Fixed Income Securities, for liquidity.

 

The Companybelieves that equity capital, combined with the cash flow from operations andthe utilization of borrowings, will be sufficient to enable the Company to meetanticipated liquidity requirements.  Ifthe Company’s cash resources are at any time insufficient to satisfy theCompany’s liquidity requirements, the Company may be required to liquidateMortgage Related Securities or to sell debt or additional equitysecurities.  If required, the sale ofMortgage Related Securities at prices lower than the carrying value of suchsecurities would result in losses.

 

During the fourthquarter of 2001, the Company issued 9,802,000 of additional shares of CommonStock, primarily through two follow-on offerings to the public.  These offerings raised $93,095,000 of equitycapital, net of offering costs.  Shortlythereafter, in March 2002, the Company completed the sale of 9,200,000additional shares of Common Stock, raising $91,908,000 million of equitycapital, net of offering costs.

 

The Company may inthe future increase its capital resources by making additional offerings ofequity and debt securities, including classes of preferred stock, common stock,commercial paper, medium-term notes, CMOs and senior or subordinatednotes.  The Company may continue torepurchase shares in the future when market conditions warrant with its ShareRepurchase Program.  All debtsecurities, other borrowings, and classes of preferred stock will be senior tothe Common Stock in a liquidation of the Company.  The effect of additional equity offerings may be the dilution ofstockholders’ equity of the Company or the reduction of the price of shares ofthe Common Stock, or both.  The Companyis

 

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unable to estimate theamount, timing or nature of additional offerings as they will depend uponmarket conditions and other factors.

 

**CriticalAccounting Policies**

 

The Company’sfinancial statements are prepared in accordance with accounting principlesgenerally accepted in the United States of America.  The financial information contained within these financialstatements is, to a significant extent, financial information that is based onapproximate measures of the financial effects of transactions and events thathave already occurred.  Based on itsconsideration of accounting policies that involve the most complex andsubjective decisions and assessments, management has identified its mostcritical accounting policies to be the following:

 

*Classifications of  Investment Securities*

 

The Company’sinvestment securities are classified as either trading securities oravailable-for-sale securities, as discussed in Note 2 to the financialstatements.  Although all of theCompany’s investment securities are carried on the balance sheets at fairvalue, the classification of the securities as trading or as available-for-saledetermines whether changes in fair value are recorded immediately throughcurrent earnings, as they are for trading securities, or as adjustments toaccumulated other comprehensive income (loss), which is a component ofstockholders’ equity, as they are for available-for-sale securities.  If available-for-sale securities wereclassified as trading securities, there could be substantially greatervolatility in earnings from period-to-period.

 

*Valuations of Investment Securities*

 

As noted above,all investment securities are carried on the balance sheets at fair value.  Some of the Company’s securities,particularly the equity securities, have readily determinable fair values basedon quotes provided from recognized securities exchanges.  However, most of the Company’s fixed incomesecurities have fair values determined by management with reference to priceestimates provided by dealers in the securities, independent pricing services,and other sources.  Because the priceestimates may vary to some degree between sources, management must make certainjudgments and assumptions about the appropriate price to use to calculate thefair values for financial reporting purposes. Different judgments and assumptions could result in different presentationsof value.

 

*Accounting for Derivative FinancialInstruments and Hedging Activities*

 

The Companycurrently uses two types of derivative financial instruments, as discussed inNotes 2 and 5 to the financial statements. Both types are used fundamentally for the purpose of hedging the Company’sexposure to interest rate risk, and both are carried at fair value on thebalance sheets.  Forward contracts tosell U.S. Treasury securities are matched against a portion of the Company’sfixed income trading securities.  Thesecontracts do not qualify for hedge accounting and, therefore, changes in fairvalues of these instruments are recorded immediately through currentearnings.  Such changes tend to offsetfair value changes in the opposite direction for the fixed income tradingsecurities and help to reduce the volatility of periodic earnings.  Interest rate swap agreements are matchedagainst a portion of the Company’s current and anticipated reverse repurchaseagreements (borrowings), effectively fixing the rate of interest paid on thoseborrowings for longer durations.  Theseinstruments qualify for hedge accounting and are considered to be cash flowhedges.  To the extent that periodicchanges in fair values of the swap agreements are deemed to be the result oftheir effectiveness as hedges, such changes are recorded as adjustments toaccumulated other comprehensive income, a component of stockholders’ equity,rather than to current earnings.  If theswaps no longer qualified as cash flow hedges (for example, if the terms of theswaps were not matched appropriately to the terms of the borrowings, if theswaps were terminated or sold, or if anticipated borrowings matched to theswaps were not in fact made) all or a portion of the swaps’ fair values couldbecome adjustments to current earnings.

 

*Accounting for Stock Options*

 

The Company issuesstock options to its Directors and to certain employees of the Manager.  The stock options issued to Directors areaccounted for using the intrinsic-value method.  Because the options were issued with exercise prices no less thanthe market price of the common stock on the dates of grant, and because theirother key terms are fixed, use of the intrinsic-value method results in theCompany not recognizing compensation expense for these options.  Note 6 to the financial statements disclosesthe effects on recent earnings if these stock options were accounted for atfair value when granted and if compensation expense were recognized in periodicearnings over the vesting periods of the options.  If the

 

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terms of the options wereto be changed, variable accounting might need to be used, and the Company mightthen need to begin recognizing compensation expense for these options.

 

**ITEM7A.  QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK**

 

The Company’s twoprimary components of market risk are interest rate risk and equity price riskas discussed below.

 

**InterestRate Risk**

 

*Effect on Net Income. *The Company invests infixed-rate mortgage assets that are expected to be funded with short-termborrowings.  During periods of risinginterest rates, the borrowing costs associated with funding such fixed-rateassets are subject to increase while the income earned on such assets mayremain substantially unchanged.  Thiswould result in a narrowing of the net interest spread between the relatedassets and borrowings and may even result in losses. The Company may enter intoderivative transactions seeking to mitigate the negative impact of a risinginterest rate environment. Hedging techniques will be based, in part, onassumed levels of prepayments of the Company’s mortgage assets.  If prepayments are slower or faster thanassumed, the life of the mortgage assets will be longer or shorter which wouldreduce the effectiveness of the Company’s hedging techniques and may result inlosses on such transactions.  Hedgingtechniques involving the use of derivative securities are highly complex andmay produce volatile returns. The hedging activity of the Company will also belimited by the asset and sources of income requirements applicable to theCompany as a REIT.

 

*Extension Risk*.  Fixed-rate assets are generally acquiredwith a projected weighted average life based on certain assumptions regardingprepayments.  In general, when afixed-rate mortgage asset is acquired with borrowings, the Company may, but isnot required to, enter into an interest rate swap agreement or other hedginginstrument that effectively fixes the Company’s borrowing costs for a periodclose to the anticipated average life of the related asset.  This strategy is designed to protect theCompany from rising interest rates because the borrowing costs are fixed forthe duration of the asset.  However, ifprepayment rates decrease in a rising interest rate environment, the life ofthe mortgage asset could extend beyond the term of the swap agreement or otherhedging instrument.  This situationcould negatively impact the Company as borrowing costs would no longer be fixedafter the end of the hedging instrument while the income earned on the assetwould remain fixed.  This situation mayalso cause the market value of the Company’s mortgage assets to decline withlittle or no offsetting gain from the related hedging transactions.  In certain situations, the Company may beforced to sell assets and incur losses to maintain adequate liquidity.

 

*Prepayment Risk*.  Fixed-rate assets in combination withhedging instruments are also subject to prepayment risk.  In falling interest rate scenarios, thefixed-rate mortgage assets may prepay faster such that the average life becomesshorter than its related hedging instrument. If this were to happen, the Company would potentially need to reinvestat rates lower than that of the related hedging instrument.  This situation may result in the narrowingof interest rate spreads or may cause losses.

 

*Forward Contract Risk*.  The Company may also enter in forwardcontracts to sell U.S. Treasury notes in addition to or instead of interestrate swap agreements.  These forwardcontracts are generally expected to mitigate the impact of rising interestrates on the fair value of the Company’s fixed income securities.  However, if the interest rate spread betweenmortgage securities and U.S. Treasury notes were to widen, the fair value of theCompany’s portfolio would generally be expected to decline.  In addition, the use of forward contracts tosell U.S. Treasury notes generally does not directly impact borrowing costs inthe same manner as interest rate swap agreements.  Therefore, the use of such forward contracts could result in netincome volatility during periods of interest rate volatility.

 

The Company alsoinvests in adjustable-rate mortgage assets that are typically subject toperiodic and lifetime interest rate caps that limit the amount anadjustable-rate mortgage asset’s interest rate can change during any givenperiod, as well as the minimum rate payable. The Company’s borrowings will not be subject to similar restrictions.  Hence, in a period of increasing interestrates, interest rates on its borrowings could increase without limitation bycaps, while the interest rates on its mortgage assets are generally limited bycaps.  This problem will be magnified tothe extent the Company acquires mortgage assets that are not fully indexed.  Further, some adjustable-rate mortgageassets may be subject to periodic payment caps that result in some portion ofthe interest being deferred and added to the principal outstanding.  This could result in receipt by the Companyof less cash income on its adjustable-rate mortgage assets than is required topay interest on the related borrowings. These factors could lower the Company’s net interest income or cause anet loss during periods

 

35

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of rising interest rates,which would negatively impact the Company’s financial condition, cash flows andresults of operations.

 

The Companyintends to fund a substantial portion of its acquisitions of adjustable-ratemortgage assets with borrowings that have interest rates based on indices andrepricing terms similar to, but of somewhat shorter maturities than, theinterest rate indices and repricing terms of the mortgage assets.  Thus, the Company anticipates that in mostcases the interest rate indices and repricing terms of its mortgage assets andits funding sources will not be identical, thereby creating an interest ratemismatch between assets and liabilities. While the historical spread between relevant short-term interest rateindices has been relatively stable, there have been periods, especially duringthe 1979-1982 and 1994 interest rate environments, when the spread between suchindices was volatile.  During periods ofchanging interest rates, such interest rate mismatches could negatively impactthe Company’s financial condition, cash flows and results of operations.

 

Prepayment ratesgenerally increase when prevailing interest rates fall below the interest rateson existing mortgage assets.  Inaddition, prepayment rates generally increase when the difference betweenlong-term and short-term interest rates declines.  Prepayments of mortgage assets could adversely affect theCompany’s results of operations in several ways.  The Company anticipates that a substantial portion of itsadjustable-rate mortgage assets may bear initial ‘‘teaser’’ interest rates thatare lower than their ‘‘fully indexed’’ rates (the applicable index plus amargin).  In the event that such anadjustable-rate mortgage asset is prepaid prior to or soon after the time ofadjustment to a fully indexed rate, the Company will have held the mortgageasset while it was less profitable and lost the opportunity to receive interestat the fully indexed rate over the expected life of the adjustable-ratemortgage asset.  In addition, the prepaymentof any mortgage asset that had been purchased at a premium by the Company wouldresult in the immediate write-off of any remaining capitalized premium amountand consequent reduction of the Company’s net interest income by such amount.  Finally, in the event that the Company isunable to acquire new mortgage assets to replace the prepaid mortgage assets,its financial condition, cash flow and results of operations could bematerially adversely affected.

 

*Effect on Fair Value.* Another component of interest rate risk isthe effect changes in interest rates will have on the market value of theCompany’s assets*. *This is the riskthat the market value of the Company’s assets will increase or decrease atdifferent rates than that of the Company’s liabilities including its hedginginstruments.

 

The Companyprimarily assesses its interest rate risk by estimating the duration of itsassets and the duration of its liabilities including all hedginginstruments.  Duration essentiallymeasures the market price volatility of financial instruments as interest rateschange.  The Company generallycalculates duration using various financial models and empirical data.

 

The followingsensitivity analysis table shows the estimated impact on the fair value of theCompany’s interest rate sensitive investments net of its hedging instrumentsand reverse repurchase agreement liabilities assuming rates instantaneouslyfall one hundred basis points and rise one hundred basis points.  (Dollars are in thousands except per share amounts.)

 
|                                                                      |   | **Fair Value  for Scenario Shown**          |    |
|---------------------------------------------------------------------------|--------|---------------------------------------------|---------|
|                                                                      |   | **Interest  Rates Fall  100 Basis  Points** |    | **Unchanged** |   | **Interest  Rates Rise  100 Basis  Points** |   |
| Interest Rate Sensitive Instruments                                       |   | $                                           | 122,576 |   | $ | 130,023 |   | $ | 110,659 |   |
|                                                                      |   |                                        |    |   |   |   |   |
| Change in Fair Value                                                      |   | $                                           | (7,447  | ) | — |   | $ | (19,364 | ) |
| Change as a Percent of Fair Value                                         |   | (0.49                                       | )%      | — |   | (1.29 | )% |
| Change as a Percent of  Stockholders’ Equity as of December 31, 2001 |   | (5.73                                       | )%      | — |   | (14.89 | )% |
| Change on a Per Share Basis                                               |   | $                                           | (0.48   | ) | — |   | $ | (1.24 | ) |
|                                                                           |        |                                             |         |  |  |  |  |  |  |  |

 

It is important tonote that the impact of changing interest rates on fair value can changesignificantly when interest rates change beyond one hundred basis points fromcurrent levels.  Therefore, thevolatility in fair value for the Company could increase significantly wheninterest rates change beyond one hundred basis points.  In addition, there are other factors

 

36

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that impact the fairvalue of the Company’s interest rate sensitive investments and hedginginstruments such as the shape of the yield curve, market expectations as tofuture interest rate changes and other market conditions.  Accordingly, there may be differencesbetween the fair value changes shown above and actual changes in fair value asinterest rates change and those differences may be material.

 

The Company hasestablished an interest rate risk management policy that is intended tomitigate the negative impact of changing interest rates.  The Company generally intends to mitigateinterest rate risk by targeting the difference between the market weightedaverage duration on its mortgage related assets funded with secured borrowingsto the market weighted average duration of such borrowings to one year or less,taking into account all hedging transactions. The Company generally does not intend to have any specific durationtarget for the portion its mortgage related assets that are not funded bysecured borrowings.

 

There can be noassurance that the Company will be able to limit such duration differences andthere may be periods of time when the duration difference will be greater thanone year.

 

**Equity Price Risk**

 

Another componentof market risk for the Company is equity price risk.  This is the risk that the market value of the Company’s equityinvestments will decrease.  Thefollowing table shows the impact on the Company’s fair value as the price ofits equity securities change assuming price decreases of 10% and increases of10%.  Actual price decreases orincreases may be greater or smaller. (Dollars are in thousands except per shareamounts.)

 
|                                                                        |   | **Fair Value  for Scenario Shown** |   |
|-----------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                        |   | **Prices  Decrease  10%**          |   | **Unchanged** |   | **Prices  Increase  10%** |   |
| Equity Investments                                                          |   | $                                  | 5,425  |   | $ | 6,028 |   | $ | 6,631 |   |
|                                                                        |   |                               |   |   |   |   |   |
| Change in Fair Value                                                        |   | $                                  | (603   | ) | — |   | $ | 603 |   |
| Change as a Percent of Fair Value                                           |   | (10                                | )%     | — |   | 10 | % |
| Change as a Percent of  Stockholders’ Equity as of   December 31, 2001 |   | (0.5                               | )%     | — |   | 0.5 | % |
| Change on a Per Share Basis                                                 |   | (0.04                              | )      | — |   | 0.04 |   |
|                                                                             |        |                                    |        |  |  |  |  |  |  |  |

 

Although there isno direct link between changes in fair value and changes in earnings in many cases,a decline in fair value for the Company may translate into decreased earningsover the remaining life of the investment portfolio.

 

If the fair marketvalue of the Company’s portfolio were to decline significantly, the Company’soverall liquidity may be impaired which could result in the Company beingrequired to sell assets at losses.

 

**TheCompany’s analysis of risks is based on management’s experience, estimates,models and assumptions.  These analysesrely on models of financial information which utilize estimates of fair valueand interest rate sensitivity.  Actualeconomic conditions or implementation of investment decisions by the Managermay produce results that differ significantly from the estimates and assumptionsused in the Company’s models and the projected results shown in the abovetables and in this report.  Theseanalyses contain certain “forward-looking statements” and are subject to theSafe Harbor contained in the Private Securities Litigation Reform Act of 1995.**

 

**ITEM8.  FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

The financialstatements of the Company and the related notes, together with the IndependentAuditors’ Report thereon, are set forth on pages F-3 through F-20 on thisAnnual Report on Form 10-K.

 

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**ITEM9.  CHANGES IN AND DISAGREEMENTS WITHACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE**

 

None.

 

**PART III**

 

**ITEM10.  DIRECTORS AND EXECUTIVE OFFICERS OFTHE REGISTRANT**

 

The informationrequired by Item 10 is incorporated herein by reference from the Company’sdefinitive Proxy Statement to be filed within 120 days from December 31, 2001pursuant to general instruction G(3).

 

**ITEM11.  EXECUTIVE COMPENSATION**

 

The informationrequired by Item 11 is incorporated herein by reference from the Company’sdefinitive Proxy Statement to be filed within 120 days from December 31, 2001pursuant to general instruction G(3).

 

**ITEM12.  SECURITY OWNERSHIP OF CERTAINBENEFICIAL OWNERS AND MANAGEMENT**

 

The informationrequired by Item 12 is incorporated herein by reference from the Company’sdefinitive Proxy Statement to be filed within 120 days from December 31, 2001pursuant to general instruction G(3).

 

**ITEM13.  CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS**

 

The informationrequired by Item 13 is incorporated herein by reference from the Company’sdefinitive Proxy Statement to be filed within 120 days from December 31, 2001pursuant to general instruction G(3).

 

**PART IV**

 

**ITEM14.  EXHIBITS, FINANCIAL STATEMENTSCHEDULES AND REPORTS ON FORM 8-K**

 

Item 14(a)(1).  Documents filedas part of this report:

 

The followingfinancial statements of the Company are included in Part II, Item 8 of thisAnnual Report on Form 10-K:

 

•      Independent Auditors’ Report;

 

•      Balance Sheets as of December 31, 2001 and December 31, 2000;

 

•      Statements of Operations: Years Ended December 31, 2001,December 31, 2000 and December 31, 1999;

 

•      Statements of Stockholders’ Equity:  Years Ended December 31, 2001, December 31, 2000 and December 31,1999;

 

•      Statements of Cash Flows: Years Ended December 31, 2001,December 31, 2000 and December 31, 1999; and

 

•      Notes to Financial Statements.

 

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Item 14(a)(2).  Schedules tofinancial statements:

 

All financial statement schedules have been omittedbecause they are either inapplicable or the information required is provided inthe Company’s Financial Statements and Notes thereto, included in Part II, Item8 of this Annual Report on Form 10-K.

 

Item 14(a)(3).  Exhibits:

 

The following exhibits arepart of this Annual Report on Form 10-K and are numbered in accordance withItem 601 of Regulation S-K.

 
| **Exhibit  No.** |   | **Description**                                                                                                                                                                                                                                                                                                                                                                                                          |
|------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                                     |
| 4.1              |   | Articles  of Amendment and Restatement of the Company, as filed with the State  Department of Assessments and Taxation of Maryland on November 25, 1997,  (previously filed as Exhibit 3.1 to the Company’s Registration Statement  on Form S-11, Commission File No. 333-36069, Amendment No. 3,  filed November 21, 1997 and incorporated herein by reference).                     |
| 4.2              |   | Articles  Supplementary relating to the Company’s Series A Junior Participating  Preferred Stock, as filed with the State Department of Assessments and  Taxation of the State of Maryland on July 26, 1999 (previously filed as  Exhibit 3.1 to the Company’s Current Report on Form 8-K, dated  June 30, 1999 and filed July 23, 1999, and incorporated herein by  reference). |
| 4.3              |   | Form  of Share Certificate for our common stock (previously filed as  Exhibit 4.3 to the Company’s Current Report on Form 8-K, dated  June 30, 1999 and filed July 27, 1999, and incorporated herein by  reference).                                                                                                                                                                            |
| 4.4              |   | Amended  and Restated Bylaws of the Company   (previously filed as Exhibit 4.4 to the Company’s S-3 filed on  November 27, 2001 and incorporated herein by reference).                                                                                                                                                                                                                                    |
| 4.5              |   | Shareholder  Rights Agreement between the Company and The Bank of New York, as Rights  Agent (including as Exhibit B the form of Rights Certificate)  (previously filed as Exhibit 4.1 to the Company’s Current Report on  Form 8-K, dated June 30, 1999 and filed July 27, 1999, and  incorporated herein by reference).                                                                  |
| 10.1             |   | Form  of Management Agreement between the Company and TCW Investment Management  Company (previously filed as Exhibit 10.1 to the Company’s Registration  Statement on Form S-11, Commission File No. 333-36069, Amendment  No. 3, filed November 21, 1997 and incorporated herein by  reference).                                                                                         |
| 10.2             |   | First  Amendment to Management Agreement between the Company and TCW Investment  Management Company dated December 16, 1998 (previously filed as  Exhibit 10.1 to the Company’s Annual Report on Form 10-K405 for the  year ended December 31, 1998, filed March 31, 1999, and  incorporated herein by reference).                                                                         |
| 10.3             |   | Second  Amendment to Management Agreement between the Company and TCW Investment  Management Company entered into as of December 16, 1999 (previously  filed as Exhibit 10.1 to the Company’s Annual Report on  Form 10-K405 for the year ended December 31, 1999, filed  March 31, 2000, and incorporated herein by reference).                                                           |
| 10.4             |   | 1997  Stock Option Plan, (previously filed as Exhibit 10.6 to the Company’s  Registration Statement on Form S-11, Commission File No. 333-36069,  Amendment No. 3, filed November 21, 1997 and incorporated herein by  reference).                                                                                                                                                         |
| 10.5             |   | Amended  and Restated 1997 Stock Option Plan, (previously filed as Exhibit 10.6  to the Company’s Annual Report on Form 10-K405 for the year ended  December 31, 1998, filed March 31, 1999 and incorporated herein by  reference).                                                                                                                                                             |
| 10.6*            |   | Amended  and Restated 1997 Stock Option Plan, as amended December 13, 2001.                                                                                                                                                                                                                                                                                                                                              |
| 23.1*            |   | Deloitte &  Touche LLP’s Independent Auditors’ Consent.                                                                                                                                                                                                                                                                                                                                               |
| 24.1*            |   | Powers  of Attorney.                                                                                                                                                                                                                                                                                                                                                                                                     |
|             |   |                                                                                                                                                                                                                                                                                                                                                                                                                     |

 

----

* Filed herewith.

 

Item 14(b)  Reports on Form 8-K.

 

None.

 

39

----

 

**GLOSSARY**

 

As used in thisAnnual Report on Form 10-K, the capitalized and other terms listed below havethe meanings indicated.

 

‘‘Affiliate’’means, when used with reference to a specified person, any person thatdirectly, or indirectly through one or more intermediaries, controls or iscontrolled by, or is under common control with the specified person.

 

‘‘Average NetInvested Capital’’ means the month end sumof (1) the Company’s total stockholders’ equity computed in accordance withgenerally accepted accounting principles plus (2) any unsecured debt that hasbeen approved for inclusion by the Unaffiliated Directors at issuance plus orminus (3) an adjustment to exclude the impact of any unrealized gains, lossesor other items that do not affect realized net income.

 

‘‘Average NetWorth’’ means for any period the arithmetic average of the sum of the grossproceeds from the offerings of its equity securities by the Company, beforededucting any underwriting discounts and commissions and other expenses andcosts relating to the offerings, plus the Company’s retained earnings (withouttaking into account any losses incurred in prior periods) computed by takingthe average of such values at the end of each month during such period, minusthe cumulative amounts paid by the Company to repurchase its shares.

 

“Bankruptcy Code”means Title 11 of the United States Code, as amended

 

‘‘CMOs’’ meansdebt obligations (bonds) that are collateralized by Mortgage Loans or mortgagecertificates other than Mortgage Derivative Securities and subordinatedinterests.  CMOs are structured so thatprincipal and interest payments received on the collateral are sufficient tomake principal and interest payments on the bonds.  Such bonds may be issued by United States government agencies orprivate issuers in one or more classes with fixed or variable interest rates,maturities and degrees of subordination that are characteristics designed forthe investment objectives of different bond purchasers.

 

‘‘Code’’ means theInternal Revenue Code of 1986, as amended.

 

“COFI” is the 11thDistrict Cost of Funds Index, the index made available monthly by the FederalHome Loan Bank Board of the cost of funds to members of the Federal Home LoanBank 11th District.

 

“Committed SecuredBorrowings” means (i) CMOs, (ii) structured commercial paper programs, (iii)secured term notes and (iv) other secured financing transactions that generallycommit the lender to provide financing to the Company for a specified period oftime or to provide financing to the Company to fund specific assets until theymature.

 

‘‘Common Stock’’ meansthe Company’s shares of Common Stock, $0.01 par value per share.

 

‘‘Company’’ meansApex Mortgage Capital, Inc., a Maryland corporation.

 

‘‘ConformingMortgage Loans’’ means conventional Mortgage Loans that either comply withrequirements for inclusion in credit support programs sponsored by Fannie Mae,FHLMC, or GNMA or are FHA or VA Loans, all of which are secured by firstmortgages or deeds of trust on single-family (one to four unit) residences.

 

‘‘Dollar-RollAgreement’’ means an agreement to sell a security for delivery on a specifiedfuture date and a simultaneous agreement to repurchase the same orsubstantially similar security on a specified future date.

 

‘‘ERISA’’ meansthe Employee Retirement Income Security Act of 1974, as amended.

 

‘‘ERISA Plan’’means a pension, profit-sharing, retirement or other employee benefit plan thatis subject to ERISA.

 

‘‘Fannie Mae’’means the federally chartered and privately owned corporation organized andexisting under the Federal National Mortgage Association Charter Act (12U.S.C., § 1716 et seq.), formerly known as the Federal National MortgageAssociation.

 

‘‘FHA’’ means theUnited States Federal Housing Administration.

 

‘‘FHA Loans’’means Mortgage Loans insured by the FHA.

 

40

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‘‘FHLMC’’ meansthe Federal Home Loan Mortgage Corporation.

 

‘‘Foreign Holder’’means a purchaser of the Common Stock that, for United States income taxpurposes, is not a United States person.

 

‘‘GNMA’’ means theGovernment National Mortgage Association.

 

“High CreditQuality Mortgage Loans” means individual loans secured by residential realproperty that are either underwritten to credit standards that generally complywith the credit standards approved by Fannie, Freddie Mac or GNMA or pools ofloans that have other credit support features that generally reduce theassociated credit risk to that of investment grade securities.

 

‘‘High Quality’’means either (i) securities that are rated investment grade or above by atleast one of the Rating Agencies, or (ii) securities that are unrated but areobligations of the United States or obligations guaranteed by the United Statesgovernment or an agency or instrumentality thereof.

 

‘‘Interest OnlyDerivatives’’ means Mortgage Derivative Securities representing the right toreceive interest only or a disproportionately large amount of interest.

 

‘‘InverseFloaters’’ means a class of CMOs with a coupon rate that moves inversely to adesignated index, such as LIBOR or COFI. Income floaters have coupon rates that typically change at a multiple ofthe changes at the relevant index rate. Any rise in the index rate (as a consequence of an increase in interestrates) causes a drop in the coupon rate of an Inverse Floater while any drop inthe index rate causes an increase in the coupon of an Inverse Floater.

 

‘‘InvestmentCompany Act’’ means the Investment Company Act of 1940, as amended.

 

‘‘IRAs’’ meansIndividual Retirement Accounts.

 

‘‘IRS’’ means theInternal Revenue Service.

 

‘‘Keogh Plans’’ meansH.R. 10 Plans.

 

‘‘LIBOR’’ meansthe London-Inter-Bank Offered Rate.

 

‘‘ManagementAgreement’’ means the agreement by and between the Company and the Managerwhereby the Manager agrees to perform certain services to the Company inexchange for certain compensation.

 

‘‘Manager’’ meansTCW Investment Management Company, a California corporation.

 

‘‘MBS Group’’means the TCW Group’s Mortgage-Backed Securities Group.

 

“Mortgage-BackedSecurities” means securities representing interests in, or secured by mortgageson residential real property that are not Mortgage Derivative Securities.

 

“MortgageDerivative Securities” means mortgage backed securities that are (i) InterestOnly Derivatives, (ii) Principal Only Derivatives, (iii) inverse interest onlyderivatives, (iv) Inverse Floaters and (v) other mortgage related derivativeinstruments.

 

‘‘Mortgage Loans’’means Conforming and Nonconforming Mortgage Loans, FHA Loans and VA Loans.

 

“Mortgage RelatedAssets” means (i) Short-Term Investments, (ii) Mortgage-Backed Securities,(iii) High Credit Quality Mortgage Loans, (iv) Mortgage Derivative Securitiesand (v) Other Investments.

 

‘‘Net Income’’means the taxable income of the Company before the Manager’s incentivecompensation, net operating loss deductions arising from losses in priorperiods and deductions permitted by the Code in calculating taxable income fora REIT, including a deduction for the Company’s interest expenses for borrowedfunds, plus the effects of adjustments, if any, necessary to record hedging andinterest transactions in accordance with generally accepted accountingprinciples.

 

41

----

 

‘‘NonconformingMortgage Loans’’ means conventional Mortgage Loans that do not conform to oneor more requirements of Fannie Mae, FHA, FHLMC, GNMA or VA for participation inone or more of such agencies’ mortgage loan credit support programs, such asthe principal amounts financed or the underwriting guidelines used in makingthe loan.

 

“OtherInvestments” means (i) equity and debt securities issued by other primarilymortgage related finance companies, (ii) interests in mortgage relatedcollateralized bond obligations, (iii) other subordinated interests in pools ofMortgage Related Assets, (iv) commercial mortgage loans and securities, and (v)residential mortgage loans other than High Credit Quality Mortgage Loans.

 

‘‘Principal OnlyDerivatives’’ means Mortgage Derivative Securities representing the right toreceive principal only or a disproportionate amount of principal.

 

‘‘Qualified REITReal Estate Assets’’ means pass-through certificates, Mortgage Loans, agencycertificates, and other assets of the type described in Section 856(c)(5)(B) ofthe Code.

 

‘‘QualifiedTemporary Investment Income’’ means income attributable to stock or debtinstruments acquired with new capital of the Company received during theone-year period beginning on the day such proceeds were received.

 

‘‘RatingAgencies’’ means any nationally recognized rating agency.

 

‘‘REIT’’ means areal estate investment trust as defined under Section 856 of the Code.

 

‘‘REIT Provisionsof the Code’’ means Sections 856 through 860 of the Code.

 

‘‘Return onEquity’’ means an amount calculated for any quarter by dividing the Company’sNet Income for the quarter by its Average Net Worth for the quarter.

 

‘‘Short-TermInvestments’’ means short-term bank certificates of deposit, short-term UnitedStates Treasury securities, short-term United States government agencysecurities, commercial paper, repurchase agreements, short-term CMOs,short-term asset-backed securities, and other similar types of short-terminvestment instruments.

 

‘‘Tax-ExemptEntity’’ means a qualified pension, profit-sharing or other employee retirementbenefit plans, Keogh plans, bank commingled trust funds for such plans, andIRAs, and other similar entities intended to be exempt from federal incometaxation.

 

‘‘Taxable Income’’means for any year the taxable income of the Company for such year (excludingany net income derived either from property held primarily for sale tocustomers or from foreclosure property) subject to certain adjustments providedin the REIT Provisions of the Code.

 

“Taxable REITSubsidiary” means a corporation satisfying the requirements of Section 856(l)of the Code, and with respect to which the requirements of Section 856(c)(4)(B)of the Code are satisfied.

 

‘‘TCW’’ means TheTCW Group, Inc.

 

‘‘TCW Group’’means TCW and its subsidiaries and Affiliates.

 

‘‘Ten-Year U.S.Treasury Rate’’ means the arithmetic average of the weekly average yield tomaturity for actively traded current coupon U.S.  Treasury fixed interest rate securities (adjusted to a constantmaturity of ten years) published by the Federal Reserve Board during a quarter,or, if such rate is not published by the Federal Reserve Board, any FederalReserve Bank or agency or department of the federal government selected by theCompany.  If the Company determines ingood faith that the Ten-Year U.S. Treasury Rate cannot be calculated asprovided above, then the rate shall be the arithmetic average of the per annumaverage yields to maturities, based upon closing asked prices on each businessday during a quarter, for each actively traded marketable U.S.  Treasury fixed interest rate security with afinal maturity date not less than eight nor more than twelve years from thedate of the closing asked prices as chosen and quoted for each business day ineach such quarter in New York City by at least three recognized dealers in U.S.government securities selected by the Company.

 

42

----

 

‘‘UBTI’’ means‘‘unrelated trade or business income’’ as defined in Section 512 of the Code.

 

‘‘UnaffiliatedDirectors’’ means those directors that are not affiliated, directly orindirectly, with the Manager or the TCW Group, whether by ownership of,ownership interest in, employment by, any material business or professionalrelationship with, or serving as an officer or director of the Manager or theTCW Group, and are not employed by or officers of the Company.

 

“UncommittedSecured Borrowings” means (i) reverse repurchase agreements, (ii) lines ofcredit, (iii) Dollar-Roll Agreements, and (iv) other secured financingtransactions that generally do not commit the lender to continue to providefinancing to the Company.

 

‘‘United StatesHolder’’ means a purchaser of the Common Stock that, for United States incometax purposes, is a United States person (i.e., is not a Foreign Holder).

 

‘‘VA’’ means theUnited States Veterans Administration.

 

‘‘VA Loans’’ meansMortgage Loans partially guaranteed by the VA under the Serviceman’sReadjustment Act of 1944, as amended.

 

43

----

 

**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934,the Registrant has duly caused this Report to be signed on its behalf by theundersigned, thereunto duly authorized.

 
|                  |   | Apex Mortgage Capital,  Inc.                                          |
|-----------------------|--------|-----------------------------------------------------------------------|
|                  |   | (Registrant)                                                          |
|                  |   |                                                                  |
| Dated: March 31, 2002 |   | /s/ Philip A. Barach                                                  |   |
|                  |   | Philip A. Barach                                                      |
|                  |   | President and Chief  Executive Officer  (Principal Executive Officer) |
|                  |   |                                                                  |
| Dated: March 31, 2002 |   | /s/ David S. DeVito                                                   |   |
|                  |   | David S. DeVito                                                       |
|                  |   | Chief Financial Officer  (Principal Accounting Officer)               |

 

Pursuant to therequirements of the Securities and Exchange Act of 1934, this Report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

 
| **Signature**             |                        | **Capacity**                                                         |   | **Date**       |
|---------------------------|-----------------------------|----------------------------------------------------------------------|--------|----------------|
|                      |                        |                                                                 |   |           |
| /s/ Marc I. Stern         |                        | Chairman of the Board                                                |   | March 31, 2002 |
| Marc I. Stern             |                        |                                                                 |   |           |
| /s/ Jeffrey E. Gundlach   |                        | Vice Chairman of the  Board  Chief Investment Officer                |   | March 31, 2002 |
| Jeffrey E. Gundlach       |                        |                                                                 |   |           |
|                      |                        |                                                                 |   |           |
| /s/ Philip A. Barach      |                        | President,                                                           |   | March 31, 2002 |
| Philip A. Barach          |                        | Chief Executive Officer  and Director  (Principal Executive Officer) |   |           |
|                      |                        |                                                                 |   |           |
| /s/ Peter G. Allen*       |                        | Director                                                             |   | March 31, 2002 |
| Peter G. Allen            |                        |                                                                 |   |           |
|                      |                        |                                                                 |   |           |
| /s/ John C. Argue*        |                        | Director                                                             |   | March 31, 2002 |
| John C. Argue             |                        |                                                                 |   |           |
|                      |                        |                                                                 |   |           |
| /s/ John A. Gavin*        |                        | Director                                                             |   | March 31, 2002 |
| John A. Gavin             |                        |                                                                 |   |           |
|                      |                        |                                                                 |   |           |
| /s/ Carl C. Gregory  III* |                        | Director                                                             |   | March 31, 2002 |
| Carl C. Gregory III       |                        |                                                                 |   |           |
|                      |                        |                                                                 |   |           |
| *By:                      |  /s/ Philip  A. Barach |                                                                 |   |           |   |
| Philip A. Barach          |                        |                                                                 |   |           |
| Attorney-in-Fact          |                        |                                                                 |   |           |
|                           |                             |                                                                      |        |                |  |

 

44

----

 

**ApexMortgage Capital, Inc.**

 

**FinancialStatements**

 

**and**

 

**IndependentAuditors’ Report**

 

**ForInclusion in Form 10-K**

 

**Filedwith**

 

**Securitiesand Exchange Commission**

 

**December31, 2001**

 

F-1

----

 

**ApexMortgage Capital, Inc.**

 

**Index toFinancial Statements**

 
| Independent Auditors’  Report       |   |
|------------------------------------------|--------|
|                                     |   |
| Balance Sheets                           |   |
|                                     |   |
| Statements of Operations                 |   |
|                                     |   |
| Statements of  Stockholders’ Equity |   |
|                                     |   |
| Statements of Cash Flows                 |   |
|                                     |   |
| Notes to Financial  Statements           |   |

 

F-2

----

 

INDEPENDENT AUDITORS’ REPORT

 

To the Stockholders of   Apex Mortgage Capital, Inc.

 

We have audited theaccompanying balance sheets of Apex Mortgage Capital, Inc. (the ”Company”)as of December 31, 2001 and 2000 and the related statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2001.  Thesefinancial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audits.

 

We conducted our auditsin accordance with auditing standards generally accepted in the United Statesof America.  Those standards requirethat we plan and perform the audit to obtain reasonable assurance about whetherthe financial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, suchfinancial statements present fairly, in all material respects, the financialposition of Apex Mortgage Capital, Inc. as of December 31, 2001 and 2000 andthe results of its operations and its cash flows for each of the three years inthe period ended December 31, 2001, in conformity with accounting principlesgenerally accepted in the United States of America.

 

As discussed in Note 2 tothe financial statements, effective January 1, 2001, the Company changed itsmethod of accounting for derivative financial instruments.

 

DELOITTE & TOUCHE LLP

 

Los Angeles, California

February 8, 2002 (andMarch 5, 2002 as to Note 13)

 

F-3

----

 

**ApexMortgage Capital, Inc.**

 

**Balance Sheets**

 
|                                                                                                                                |   | **December 31, 2001** |          | **December 31, 2000** |   |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|---------------|-----------------------|--------|
| **Assets**                                                                                                                          |   |                  |          |                  |   |
|                                                                                                                                |   |                  |          |                  |   |
| Cash and cash equivalents                                                                                                           |   | $                     | 4,330,000     |                  | $      | 140,000 |   |
| Fixed income trading securities, at fair value  (Notes 3, 4 and 5)                                                                  |   | 437,954,000           |          | —                |   |
| Fixed income securities available-for-sale, at fair  value (Notes 3, 4 and 5)                                                       |   | 1,067,575,000         |          | 600,131,000           |   |
| Equity securities available-for-sale, at fair value  (Notes 3, 4 and 5)                                                             |   | 6,028,000             |          | 9,068,000             |   |
| Interest rate swaps, at fair value (Note 5)                                                                                         |   | 4,620,000             |          | —                |   |
| Accrued interest receivable                                                                                                         |   | 8,580,000             |          | 3,734,000             |   |
| Principal payments receivable                                                                                                       |   | 485,000               |          | 288,000               |   |
| Receivable for unsettled securities                                                                                                 |   | 5,520,000             |          | —                |   |
| Other assets                                                                                                                        |   | 333,000               |          | 712,000               |   |
|                                                                                                                                |   |                  |          |                  |   |
|                                                                                                                                |   | $                     | 1,535,425,000 |                  | $      | 614,073,000 |   |
|                                                                                                                                |   |                  |          |                  |   |
| **Liabilities  and Stockholders’ Equity**                                                                                      |   |                  |          |                  |   |
|                                                                                                                                |   |                  |          |                  |   |
| Liabilities                                                                                                                         |   |                  |          |                  |   |
|                                                                                                                                |   |                  |          |                  |   |
| Reverse repurchase agreements (Note 4)                                                                                              |   | $                     | 1,376,850,000 |                  | $      | 545,434,000 |   |
| Payable for unsettled securities                                                                                                    |   | —                |          | 14,514,000            |   |
| Accrued interest payable                                                                                                            |   | 975,000               |          | 569,000               |   |
| Dividend payable                                                                                                                    |   | 12,596,000            |          | 2,073,000             |   |
| Forward contracts, at fair value (Note 5)                                                                                           |   | 3,275,000             |          | 3,731,000             |   |
| Deferred gain on interest rate swap contracts                                                                                       |   | —                |          | 2,546,000             |   |
| Accrued expenses and other liabilities (Note 9)                                                                                     |   | 11,699,000            |          | 823,000               |   |
|                                                                                                                                |   |                  |          |                  |   |
|                                                                                                                                |   | 1,405,395,000         |          | 569,690,000           |   |
| Commitments and contingencies (Note 10)                                                                                             |   |                  |          |                  |   |
|                                                                                                                                |   |                  |          |                  |   |
| Stockholders’ Equity (Notes 6, 7 and 10)                                                                                       |   |                  |          |                  |   |
|                                                                                                                                |   |                  |          |                  |   |
| Preferred stock, par value $0.01 per share; 50,000,000  shares authorized;   no shares outstanding                                  |   | —                |          | —                |   |
| Common stock, par value $0.01 per share; 100,000,000  shares  authorized; 15,555,500 (2001) and 5,753,000 (2000) shares outstanding |   | 155,000               |          | 58,000                |   |
| Additional paid-in-capital                                                                                                          |   | 175,802,000           |          | 82,800,000            |   |
| Accumulated other comprehensive loss (Note 11)                                                                                      |   | (7,837,000            | )             | (1,079,000            | )      |
| Accumulated deficit                                                                                                                 |   | (38,090,000           | )             | (37,396,000           | )      |
|                                                                                                                                |   |                  |          |                  |   |
|                                                                                                                                |   | 130,030,000           |          | 44,383,000            |   |
|                                                                                                                                |   |                  |          |                  |   |
|                                                                                                                                |   | $                     | 1,535,425,000 |                  | $      | 614,073,000 |   |

 

See accompanyingnotes to financial statements

 

F-4

----

 

**ApexMortgage Capital, Inc.**

 

**Statements of Operations**

 
|                                                                                          |   | **Year Ended December 31** |       |
|-----------------------------------------------------------------------------------------------|--------|----------------------------|------------|
|                                                                                          |   | **2001**                   |       | **2000** |   | **1999** |   |
| **Interest  Income:**                                                                         |   |                       |       |   |   |   |   |
| Fixed income securities                                                                       |   | $                          | 48,779,000 |   | $ | 42,618,000 |   | $ | 52,216,000 |   |
| Cash and cash equivalents                                                                     |   | 112,000                    |       | 216,000 |   | 301,000 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| Total interest income                                                                         |   | 48,891,000                 |       | 42,834,000 |   | 52,517,000 |   |
| **Interest  Expense**                                                                         |   | 23,723,000                 |       | 33,779,000 |   | 42,345,000 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Net  Interest Income**                                                                      |   | 25,168,000                 |       | 9,055,000 |   | 10,172,000 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Dividend  Income**                                                                          |   | 815,000                    |       | 1,139,000 |   | 2,387,000 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Operating  Income Before General and Administrative Expenses**                              |   | 25,983,000                 |       | 10,194,000 |   | 12,559,000 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **General  and Administrative Expenses:**                                                     |   |                       |       |   |   |   |   |
| Management fee (Note 9)                                                                       |   | 471,000                    |       | 512,000 |   | 629,000 |   |
| Incentive fee (Note 9)                                                                        |   | 634,000                    |       | — |   | 1,714,000 |   |
| Insurance                                                                                     |   | 333,000                    |       | 272,000 |   | 267,000 |   |
| Professional fees                                                                             |   | 132,000                    |       | 382,000 |   | 73,000 |   |
| Directors’ fees                                                                          |   | 65,000                     |       | 76,000 |   | 60,000 |   |
| Non-employee stock options                                                                    |   | 4,000                      |       | 95,000 |   | 287,000 |   |
| Other                                                                                         |   | 184,000                    |       | 397,000 |   | 355,000 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| Total general and administrative expense                                                      |   | 1,823,000                  |       | 1,734,000 |   | 3,385,000 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Operating  Income, Net of General and Administrative Expenses**                             |   | 24,160,000                 |       | 8,460,000 |   | 9,174,000 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Net  Gain (Loss) from Investment and Derivative Activities (Note 3)**                       |   | (5,015,000                 | )          | (36,703,000 | ) | 1,938,000 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Reclassification  of Previously Unrealized Gains (Note 2)**                                 |   | 1,742,000                  |       | — |   | — |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Net  Income (Loss) Before Cumulative Effect of Change in Accounting Principle**             |   | 20,887,000                 |       | (28,243,000 | ) | 11,112,000 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Cumulative  Effect of Change in Accounting Principle (Note 2)**                             |   | (2,173,000                 | )          | — |   | — |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Net  Income (Loss)**                                                                        |   | $                          | 18,714,000 |   | $ | (28,243,000 | ) | $ | 11,112,000 |   |
|                                                                                          |   |                       |       |   |   |   |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Net  Income (Loss) Per Share Before Cumulative Effect of Change in Accounting  Principle:** |   |                       |       |   |   |   |   |
| Basic                                                                                         |   | $                          | 2.89       |   | $ | (4.91 | ) | $ | 1.93 |   |
| Diluted                                                                                       |   | $                          | 2.85       |   | $ | (4.91 | ) | $ | 1.92 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Effect  of Accounting Change Per Share:**                                                   |   |                       |       |   |   |   |   |
| Basic                                                                                         |   | $                          | (0.30      | ) | $ | — |   | $ | — |   |
| Diluted                                                                                       |   | $                          | (0.30      | ) | $ | — |   | $ | — |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Net  Income (Loss) Per Share:**                                                             |   |                       |       |   |   |   |   |
| Basic                                                                                         |   | $                          | 2.59       |   | $ | (4.91 | ) | $ | 1.93 |   |
| Diluted                                                                                       |   | $                          | 2.55       |   | $ | (4.91 | ) | $ | 1.92 |   |
|                                                                                          |   |                       |       |   |   |   |   |
| **Weighted  Average Number of Shares Outstanding:**                                           |   |                       |       |   |   |   |   |
| Basic                                                                                         |   | 7,235,000                  |       | 5,753,000 |   | 5,753,000 |   |
| Diluted                                                                                       |   | 7,325,000                  |       | 5,753,000 |   | 5,779,000 |   |

 

See accompanyingnotes to financial statements

 

F-5

----

 

**ApexMortgage Capital, Inc.**

 

**Statementsof Stockholders’ Equity**

 
|                                                                                            |   |             |   |       |    | **Additional  Paid-in  Capital** |   | **Acccumulated  Other  Comprehensive  Income (Loss)** |   | **Accumulated  Deficit** |       | **Total  Stockholders’  Equity** |   | **Comprehensive  Income / (Loss)** |        |
|-------------------------------------------------------------------------------------------------|--------|------------------|--------|------------|---------|----------------------------------|--------|-------------------------------------------------------|--------|--------------------------|------------|---------------------------------------|--------|------------------------------------|-------------|
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |
|                                                                                            |   | **Common Stock** |   |       |    |                             |   |                                                  |
|                                                                                            |   | **Shares**       |   | **Amount** |    |                             |   |                                                  |   |                     |
| **Balance, January 1, 1999**                                                                    |   | 5,753,000        |   | $          | 58,000  |                             | $      | 82,418,000                                            |   | $                        | 6,689,000  |                                  | $      | (1,135,000                         | )           | $ | 88,030,000 |   |   |   |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Issuance of stock options  to non-employees (Note 6)**                                        |   | —           |   | —     |    | 287,000                          |   | —                                                |   | —                   |       | 287,000                               |   |                               |        |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Net income**                                                                                  |   | —           |   | —     |    | —                           |   | —                                                |   | 11,112,000               |       | 11,112,000                            |   | $                                  | 11,112,000  |   |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Other comprehensive income (loss):**                                                          |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| Net change in unrealized gain  (loss) on available-for-sale  securities (Note 11)               |   | —           |   | —     |    | —                           |   | (37,111,000                                           | )      | —                   |       | (37,111,000                           | )      | (37,111,000                        | )           |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| Net change in unrealized and  deferred losses on forward  contracts (Note 11)                   |   | —           |   | —     |    | —                           |   | 3,909,000                                             |   |                     |       | 3,909,000                             |   | 3,909,000                          |        |
| **Comprehensive loss**                                                                          |   | —           |   | —     |    | —                           |   | —                                                |   | —                   |       | —                                |   | $                                  | (22,090,000 | ) |
| **Dividends declared**                                                                          |   | —           |   | —     |    | —                           |   | —                                                |   | (10,186,000              | )          | (10,186,000                           | )      |                               |        |
| **Balance, December 31, 1999**                                                                  |   | 5,753,000        |   | 58,000     |    | 82,705,000                       |   | (26,513,000                                           | )      | (209,000                 | )          | 56,041,000                            |   |                               |        |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Issuance of stock options  to non-employees (Note 6)**                                        |   | —           |   | —     |    | 95,000                           |   | —                                                |   | —                   |       | 95,000                                |   |                               |        |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Net loss**                                                                                    |   | —           |   | —     |    | —                           |   | —                                                |   | (28,243,000              | )          | (28,243,000                           | )      | $                                  | (28,243,000 | ) |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Other comprehensive income (loss):**                                                          |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| Net change in unrealized gain  (loss) on available-for-sale  securities (Note 11)               |   | —           |   | —     |    | —                           |   | 32,860,000                                            |   | —                   |       | 32,860,000                            |   | 32,860,000                         |        |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| Net change in unrealized and  deferred losses on forward  contracts (Note 11)                   |   | —           |   | —     |    | —                           |   | (7,426,000                                            | )      | —                   |       | (7,426,000                            | )      | (7,426,000                         | )           |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Comprehensive loss**                                                                          |   | —           |   | —     |    | —                           |   | —                                                |   | —                   |       |                                  |   | $                                  | (2,809,000  | ) |
| **Dividends declared**                                                                          |   | —           |   | —     |    | —                           |   | —                                                |   | (8,944,000               | )          | (8,944,000                            | )      |                               |        |
| **Balance, December 31, 2000**                                                                  |   | 5,753,000        |   | 58,000     |    | 82,800,000                       |   | (1,079,000                                            | )      | (37,396,000              | )          | 44,383,000                            |   |                               |        |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Issuance of common stock**                                                                    |   | 9,802,500        |   | 97,000     |    | 92,998,000                       |   | —                                                |   | —                   |       | 93,095,000                            |   |                               |        |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Issuance of stock options  to non-employees (Note 6)**                                        |   | —           |   | —     |    | 4,000                            |   | —                                                |   |                     |       | 4,000                                 |   |                               |        |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Net income**                                                                                  |   | —           |   | —     |    | —                           |   | —                                                |   | 18,714,000               |       | 18,714,000                            |   | $                                  | 18,714,000  |   |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Other comprehensive income (loss):**                                                          |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| Net change in unrealized gain  (loss) on available-for-sale  securities (Note 11)               |   | —           |   | —     |    | —                           |   | (23,793,000                                           | )      | —                   |       | (23,793,000                           | )      | (23,793,000                        | )           |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| Net change in unrealized and  deferred losses on forward  contracts (Note 11)                   |   | —           |   | —     |    | —                           |   | 12,236,000                                            |   | —                   |       | 12,236,000                            |   | 12,236,000                         |        |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| Net change in unrealized gain  on terminated interest rate  swaps (Note 11)                     |   | —           |   | —     |    | —                           |   | 179,000                                               |   | —                   |       | 179,000                               |   | 179,000                            |        |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| Net change in unrealized gain on  interest rate swaps classified  as cash flow hedges (Note 11) |   | —           |   | —     |    | —                           |   | 4,620,000                                             |   | —                   |       | 4,620,000                             |   | 4,620,000                          |        |
|                                                                                            |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   |                               |        |
| **Comprehensive income**                                                                        |   |             |   |       |    |                             |   |                                                  |   |                     |       |                                  |   | $                                  | 11,956,000  |   |
| **Dividends declared**                                                                          |   | —           |   | —     |    | —                           |   | —                                                |   | (19,408,000              | )          | (19,408,000                           | )      |                               |        |
| **Balance, December 31, 2001**                                                                  |   | 15,555,500       |   | $          | 155,000 |                             | $      | 175,802,000                                           |   | $                        | (7,837,000 | )                                     | $      | (38,090,000                        | )           | $ | 130,030,000 |   |   |   |

 

See accompanyingnotes to financial statements

 

F-6

----

 

**ApexMortgage Capital, Inc.**

 

**Statements of Cash Flows**

 
|                                                                                       |   | **Year Ended December 31,** |       |
|--------------------------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                                       |   | **2001**                    |       | **2000** |   | **1999** |   |
| **Operating  Activities:**                                                                 |   |                        |       |   |   |   |   |
| Net income (loss)                                                                          |   | $                           | 18,714,000 |   | $ | (28,243,000 | ) | $ | 11,112,000 |   |
| Adjustments to  reconcile net income (loss) to net cash  provided by operating activities: |   |                        |       |   |   |   |   |
| Amortization                                                                               |   | (4,189,000                  | )          | (2,559,000 | ) | 668,000 |   |
| Net (gain) loss on investment and derivative  activities                                   |   | 5,015,000                   |       | 36,703,000 |   | (1,938,000 | ) |
| Cumulative effect of change in accounting principle                                        |   | 2,173,000                   |       | — |   | — |   |
| Reclassification of previously unrealized gains                                            |   | (1,742,000                  | )          | — |   | — |   |
| Trading activities                                                                         |   | 135,650,000                 |       | — |   | — |   |
| Change in assets and liabilities:                                                          |   |                        |       |   |   |   |   |
| Accrued interest receivable                                                                |   | (4,846,000                  | )          | 2,520,000 |   | (1,103,000 | ) |
| Other assets                                                                               |   | 379,000                     |       | 104,000 |   | (239,000 | ) |
| Accrued interest payable                                                                   |   | 406,000                     |       | (3,091,000 | ) | (2,513,000 | ) |
| Accrued expenses and other liabilities                                                     |   | 10,876,000                  |       | 163,000 |   | (92,000 | ) |
| Net cash provided by operating activities                                                  |   | 162,436,000                 |       | 5,597,000 |   | 5,895,000 |   |
|                                                                                       |   |                        |       |   |   |   |   |
| **Investing  Activities:**                                                                 |   |                        |       |   |   |   |   |
| Purchase of fixed income securities  available-for-sale                                    |   | (1,081,801,000              | )          | (133,930,000 | ) | (117,094,000 | ) |
| Purchase of equity securities available-for-sale                                           |   | —                      |       | — |   | (12,946,000 | ) |
| Principal payments on fixed income securities  available-for-sale                          |   | 350,000                     |       | 73,893,000 |   | 168,516,000 |   |
| Proceeds from sales of fixed income securities  available-for-sale                         |   | —                      |       | 193,953,000 |   | 40,406,000 |   |
| Proceeds from sales of equity securities                                                   |   | 7,578,000                   |       | 6,481,000 |   | 9,636,000 |   |
| Net payments on closed forward contracts                                                   |   | —                      |       | (17,192,000 | ) | — |   |
| Proceeds from terminated interest rate swaps                                               |   | —                      |       | 5,554,000 |   | — |   |
| Net cash (used in) provided by investing activities                                        |   | (1,073,873,000              | )          | 128,759,000 |   | 88,518,000 |   |
|                                                                                       |   |                        |       |   |   |   |   |
| **Financing  Activities:**                                                                 |   |                        |       |   |   |   |   |
| Net change in reverse repurchase agreements                                                |   | 831,416,000                 |       | (127,226,000 | ) | (95,248,000 | ) |
| Dividend distributions                                                                     |   | (8,884,000                  | )          | (9,595,000 | ) | (9,239,000 | ) |
| Issuance of common stock                                                                   |   | 93,095,000                  |       |   |   |   |   |
| Net cash provided by (used in) financing activities                                        |   | 915,627,000                 |       | (136,821,000 | ) | (104,487,000 | ) |
|                                                                                       |   |                        |       |   |   |   |   |
| **Net  Increase (Decrease) in Cash and Cash Equivalents**                                  |   | 4,190,000                   |       | (2,465,000 | ) | (10,074,000 | ) |
|                                                                                       |   |                        |       |   |   |   |   |
| **Cash  and Cash Equivalents at Beginning of Year**                                        |   | 140,000                     |       | 2,605,000 |   | 12,679,000 |   |
|                                                                                       |   |                        |       |   |   |   |   |
| **Cash  and Cash Equivalents at End of Year**                                              |   | $                           | 4,330,000  |   | $ | 140,000 |   | $ | 2,605,000 |   |
|                                                                                       |   |                        |       |   |   |   |   |
| **Supplemental  Disclosure of Cash Flow Information:**                                     |   |                        |       |   |   |   |   |
| Cash paid for  interest   Noncash investing and financing activities:                      |   | $                           | 24,339,00  |   | $ | 39,711,000 |   | $ | 44,970,000 |   |
| Change in accumulated other comprehensive income                                           |   | (6,758,000                  | )          | 25,434,000 |   | (33,202,000 | ) |
| Change in principal payments receivable                                                    |   | (197,000                    | )          | 3,249,000 |   | 2,600,000 |   |
| Change in receivable for unsettled securities                                              |   | 5,520,000                   |       | — |   | — |   |
| Change in payable for unsettled securities                                                 |   | (14,514,000                 | )          | 14,514,000 |   | 838,000 |   |
| Change in dividends declared, not yet paid                                                 |   | 10,523,000                  |       | 2,073,000 |   | 2,724,000 |   |

 

See accompanyingnotes to financial statements

 

F-7

----

 

**ApexMortgage Capital, Inc.**

**Notes to Financial Statements**

 

**Note 1 - The Company**

 

Apex MortgageCapital, Inc. (the “Company”) was incorporated in Maryland on September 15,1997.  The Company commenced itsoperations of acquiring and managing a portfolio of mortgage-related assets onDecember 9, 1997, upon receipt of the net proceeds from the initial public offeringof the Company’s common stock.  The Companyuses its equity capital and borrowed funds to seek to generate income based onthe difference between the yield on its investments and the cost of itsborrowings.  The Company is structuredfor tax purposes as a real estate investment trust (“REIT”) under the InternalRevenue Code of 1986, as amended (the “Code”).

 

The Company hasentered into a Management Agreement (the “Management Agreement”), as amended,with TCW Investment Management Company (the “Manager”), a wholly ownedsubsidiary of The TCW Group, Inc., under which the Manager manages theCompany’s day-to-day operations, subject to the direction and oversight of theCompany’s Board of Directors.

 

**Note 2 - Summary of SignificantAccounting Policies snd Certain Risks**

 

    *Cash and Cash Equivalents*

 

Cash and cashequivalents include cash and highly liquid investments with original maturitiesof three months or less.  The carryingamount of cash equivalents approximates their fair value.

* *

*    Investment Securities*

 

Fixed incomesecurities consist primarily of residential mortgage securities and other fixedincome securities.  Equity securitiesconsist primarily of equity securities issued by other real estate investmenttrusts.  All fixed income and equitysecurities are initially recorded at cost on the date they are purchased.  A majority of the Company’s securities areexpected to qualify as real estate assets under the REIT Provisions of theCode.

 

Interest income onthe Company’s mortgage securities and other fixed income securities is accrued basedon the actual coupon rate and the outstanding principal amount.  Premiums and discounts are amortized intointerest income over the lives of the securities using the effective yieldmethod adjusted for the effects of estimated prepayments.  Dividends on equity securities arerecognized as income on their declaration dates.

 

When securitiesare deemed to have an other-than-temporary impairment, the cost basis of thesecurities is adjusted to their fair value on the impairment measurement date,and a corresponding charge to net loss from investment activities is made tothe extent unrealized losses on such securities have not already been reflectedin earnings.  The difference between theadjusted cost basis and the outstanding principal on impaired fixed incomesecurities is accreted into income on the same basis as original discounts.

 

Securities areclassified as either trading or available-for-sale.  Securities that management actively considers for near-termdisposition because of earnings volatility associated with the interest-raterisk hedging strategies used in connection with those securities or for otherreasons are classified as trading securities. Other securities are classified as available-for-sale.  Trading securities are reported at fair value,and changes in fair value are reported in net gain (loss) from investmentactivities in the statements of

 

F-8

----

 

operations.  Available-for sale securities are reportedat fair value, with unrealized gains and losses excluded from earnings andreported in accumulated other comprehensive income.  Realized gains and losses on sales of both trading andavailable-for-sale securities are determined on an average cost basis andincluded in net gain (loss) from investment and derivative activities.

 

    *Derivatives and Hedging Transactions*

 

The Company mayenter into interest rate swaps and other financial instruments in order tomitigate the impact of rising interest rates on the cost of its short-termborrowings.  The Company may also enterinto forward contracts to sell U.S. Treasury securities and other financialinstruments in order to mitigate the negative impact of rising interest rateson the fair value of its fixed income securities.   Such financial instruments are generally referred to as“derivatives.”

 

The Companyadopted SFAS No. 133, *Accounting for Derivative Instruments and HedgingActivities*, as amended, on January 1, 2001.  Adoption of SFAS No. 133 resulted in atransition adjustment of $2,173,000, shown as the cumulative effect of changein accounting principle on the statement of operations for the year endedDecember 31, 2001, to increase accumulated other comprehensive income and todecrease current earnings.  The nettransition adjustment arose because forward contracts previously used to managethe effects of interest rate changes on fair values of fixed incomeavailable-for-sale securities and accounted for as hedges did not qualify forhedge accounting treatment under SFAS No. 133. The net adjustment of $2,173,000 comprises $10,063,000 of unrealizedgains on the investment securities whose values were hedged by forwardcontracts, $8,505,000 of deferred losses on previously closed forwardcontracts, and $3,731,000 of unrealized losses on open forward contracts.  Prior to adopting SFAS No. 133, the Companyaccounted for changes in fair values of the forward contracts throughadjustments to accumulated other comprehensive income (loss).  Following adoption of SFAS No. 133, theCompany recognizes changes in fair values of forward contracts as a componentof net gain (loss) on investment and derivative activities in the statements ofoperations.

 

Also as a resultof adopting SFAS No. 133, The Company reclassified deferred gains totaling$2,546,000 on terminated interest rate swaps previously designated as hedges ofshort-term borrowings from other liabilities to accumulated other comprehensiveincome (loss).  Deferred gains onterminated swaps are amortized into earnings over their original lives asadjustments to interest expense.

 

In conjunctionwith adopting SFAS No. 133, the Company reclassified $594,469,000 of its fixedincome mortgage securities from the available-for-sale category to the tradingcategory on January 1, 2001.  Thischange resulted in the reclassification of $1,742,000 of net unrealized gainsfrom accumulated other comprehensive income (loss) to current earnings.  Such amount is reported as reclassificationof previously unrealized gains on the statement of operations for the yearended December 31, 2001.

 

Under SFAS No.133, all derivatives are recorded at fair value and presented as either assetsor liabilities on the Company’s balance sheets.  As of December 31, 2001, the Company has interest rate swaps thatqualify as cash flow hedges under SFAS No. 133.  Changes in fair values of the swaps are not reflected in currentearnings, but are reflected in other comprehensive income.  To the extent changes in the fair value ofthe cash flow hedges are deemed to be due to ineffectiveness of the hedges,such changes are reflected in net gain (loss) on investment and derivativeactivities in the statements of operations. However, the Company’s swaps outstanding at December 31, 2001 aregenerally deemed to be fully effective as hedges.

 

Notes 5 and 11contain additional information about the Company’s derivative and hedgingactivities, including additional details about changes to accumulated othercomprehensive income (loss) relating to the accounting changes summarizedabove.

 

*   Stock-based Compensation*

 

The Company grantsstock options to its directors and to certain directors, officers and employeesof the Manager, as discussed in Note 6. Options granted to directors of the Company are accounted for using theintrinsic value method, and generally no compensation expense is recognized inthe statements of

 

F-9

----

 

operations forsuch options.  Options granted topersons other than directors (i.e., to non-employees) are accounted for using thefair value method; such options are measured at their fair value when they aregranted and are recognized as general and administrative expense during theperiods when the options vest and the related services are performed.

 

    *Federal and State Income Taxes*

 

The Company haselected to be taxed as a REIT and generally is not subject to federal and statetaxes on its income to the extent it distributes annually 90% of itspredistribution taxable income to stockholders and meets certain other asset,income and stock ownership tests. Therefore, no provision for income taxes has been included in thefinancial statements.

 

*   Net Income Per Share*

 

Basic net incomeper share is calculated on the basis of the weighted average number of commonshares outstanding during each period. Diluted net income per share includes the additional dilutive effect ofoutstanding stock options as calculated using the treasury stock method.

 

Theweighted-average number of shares used as the denominator in the computation ofdiluted net income per share was 90,000 and 26,000 more than the number used inthe computation of basic net income per share for 2001 and 1999,respectively.  Stock options that couldpotentially dilute net income per share in the future were not included in thecomputation of diluted net income per share in 2000 because they would havebeen antidilutive for that period.

 

*    Interest Rate Risk*

 

The principal riskaffecting the Company’s net income, including operating earnings distributableas dividends to the Company’s stockholders under the REIT provisions of theCode, is interest rate risk.  TheCompany’s assets are principally fixed-rate mortgage securities withweighted-average maturities of several years or more (approximately 6.1 yearsas of December 31, 2001).  Such assetsare funded primarily with short-term reverse repurchase agreements subject torepricing as they mature.  As notedabove, the Company may engage in, and has engaged in, various hedgingstrategies to mitigate the effects of changes in interest rates.  The Company’s net income, distributableoperating earnings, and net book value are highly dependent on its ability tomanage interest rate risk, and on the availability of reverse repurchase agreementsor similar forms of financing in the future.

 

*   Credit Risk*

 

The Company haslimited its exposure to credit losses on its portfolio of fixed incomesecurities by purchasing securities that are either rated “AAA” by at least onenationally recognized rating agency or are issued by the Federal Home LoanMortgage Corporation (“FHLMC”), Fannie Mae (formerly known as the FederalNational Mortgage Corporation) or the Government National Mortgage Association(“GNMA”).  The payment of principal andinterest on the FHLMC, Fannie Mae and GNMA securities are guaranteed by thoserespective agencies.  In addition, theCompany has the ability to purchase up to 10% of the portfolio inbelow-investment- grade securities.

 

The Company isalso exposed to credit risk with respect to amounts due from counterparties toderivative financial instruments.  TheCompany has limited its exposure to credit losses on derivatives by enteringinto agreements only with nationally-recognized, highly-rated counterparties.

 

    *Use of Estimates*

 

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities atthe date of the financial statements and the reported amounts of revenues andexpenses during the reporting period. Actual results could differ from those estimates.  Estimates most

 

F-10

----

 

significant to theCompany’s financial statements are related to the fair values of certaininvestment securities.  The majority ofthe Company’s fixed income securities are priced by management based oninformation obtained from national pricing services, market-makers in thesecurities, management’s knowledge about the markets for the securities, andother factors deemed by management to be significant.

 

*   Recently Issued Accounting Standards*

 

In 2001, theCompany adopted the provisions of SFAS No. 140, *Accounting for Transfers and Servicingof Financial Assets and Extinguishments of Liabilities*.  This statement revises the standards foraccounting for securitizations and other transfers of financial assets andcollateral and requires certain disclosures, but otherwise carries over most ofthe provisions of SFAS No. 125 without reconsideration.  The adoption of SFAS No. 140 had noimmediate effect on the results of operations, financial position or cash flowsof the Company.  The future effect, ifany, will depend on whether the Company enters into any securitizationtransactions or other financial transactions to which SFAS No. 140 provisionsmay apply.

 

Recently-issuedaccounting standards required to be adopted by the Company in 2002 and futureyears are either not applicable to the Company or are not expected to have amaterial effect on the Company’s results of operations, financial position orcash flows, based on the current and anticipated nature of the Company’soperations.

 

**Note 3 – Fixed Income and EquitySecurities**

 

At December 31,2001, fixed income and equity securities consisted of the following:

 
|                           |   | **Fixed  Income   Trading Securities** |    | **Fixed Income  Securities  Available-For-Sale** |   | **Equity Securities  Available-For-Sale** |   |
|--------------------------------|--------|---------------------------------------------|---------|--------------------------------------------------|--------|-------------------------------------------|--------|
| **(in  thousands)**            |   |                                        |    |
| Principal Amount               |   | $                                           | 432,630 |                                             | $      | 1,071,009                                 |   | $ | 5,145 |   |
| Unamortized Premium (Discount) |   | (9,266                                      | )       | 11,044                                           |   | (958                                      | )      |
| Adjusted Cost                  |   | 423,364                                     |    | 1,082,053                                        |   | 4,187                                     |   |
| Gross Unrealized Gains         |   | 14,725                                      |    | 180                                              |   | 1,841                                     |   |
| Gross Unrealized Losses        |   | (135                                        | )       | (14,658                                          | )      | —                                    |   |
| Fair Value                     |   | $                                           | 437,954 |                                             | $      | 1,067,575                                 |   | $ | 6,028 |   |

 

At December 31, 2000,fixed income and equity securities consisted of the following:

 
|                           |   | **Fixed  Income  Trading Securities** |   | **Fixed Income  Securities  Available-For-Sale** |   | **Equity Securities  Available-For-Sale** |   |
|--------------------------------|--------|--------------------------------------------|--------|--------------------------------------------------|--------|-------------------------------------------|--------|
| **(in  thousands)**            |   |                                       |   |
| Principal Amount               |   | $                                          | — |                                             | $      | 607,615                                   |   | $ | 13,016 |   |
| Unamortized Premium (Discount) |   | —                                     |   | (18,263                                          | )      | (4,326                                    | )      |
| Adjusted Cost                  |   | —                                     |   | 589,352                                          |   | 8,690                                     |   |
| Gross Unrealized Gains         |   | —                                     |   | 11,829                                           |   | 1,091                                     |   |
| Gross Unrealized Losses        |   | —                                     |   | (1,050                                           | )      | (713                                      | )      |
| Fair Value                     |   | $                                          | — |                                             | $      | 600,131                                   |   | $ | 9,068 |   |

 

F-11

----

 

The contractualfinal maturity of the mortgage loans supporting fixed income mortgagesecurities is generally between 15 and 30 years at origination.  Because of prepayments on the underlyingmortgage loans, the actual weighted-average maturity is expected to besubstantially less.  Fixed-rate mortgagesecurities composed over 98% and 91% of the Company’s portfolio of fixed incomesecurities at December 31, 2001 and 2000, respectively.  The expected average remaining maturity ofthe Company’s other fixed income securities at December 31, 2001 and 2000 wasless than one year and less than two years, respectively.

 

Adjustable-ratemortgage securities composed approximately 1.1% and 6.5% of the Company’sportfolio of fixed income securities at December 31, 2001 and 2000,respectively.  A portion of theadjustable-rate mortgage securities in the Company’s portfolio are backed byloans subject to periodic and lifetime caps that limit the amount the securities’effective interest rates can change during any given period and over the livesof the assets.  At December 31, 2001 and2000, the portion of adjustable-rate mortgage securities subject to periodicand lifetime caps had an average periodic cap equal to 2.0% per annum and anaverage lifetime cap equal to 11.3%.

 

During the yearended December 31, 2001, the Company reported a net loss on investment andderivative activities of $5,015,000 in the statement of operations.  This loss consisted of a net loss of$19,007,000 on closed forward contracts, a gain of $7,676,000 on the sale of$379,198,000 of fixed income trading securities, a gain of $3,076,000 on thesale of $7,578,000 of equity securities available-for-sale, and an unrealizedgain of $3,240,000 on fixed income trading securities.  There were no sales of available-for-salefixed income securities during 2001.

 

During the yearended December 31, 2000, the Company realized $741,000 and $6,536,000 in grossgains and losses, respectively, on the sale of $97,440,000 and $96,513,000 offixed income securities available-for-sale, respectively.  During the year ended December 31, 1999, theCompany realized $219,000 and $25,000 in gross gains and losses, respectively,on the sale of $5,684,000 and $34,722,000 of fixed income securities available-for-sale,respectively.  These gains and lossesare components of net gain (loss) on investment and derivative activities for2000 and 1999.

 

During the yearended December 31, 2000, the Company recorded an impairment adjustment of$18,284,000 on its fixed-rate mortgage securities, which is included in netloss on investment and derivative activities in the statement ofoperations.  The impairment adjustmentrepresents an other-than-temporary decline in the fair value, as of September30, 2000, of investments held that the Company no longer intended to hold.  A substantial portion of these investmentswere sold in the fourth quarter of 2000 and during 2001.

 

The net deferredloss and unrealized loss of $7,345,000 and $1,079,000, respectively, on forwardcontracts were reclassified from other comprehensive income into net loss oninvestment and derivative activities in the statement of operations during theyear ended December 31, 2000 as part of the impairment charge recorded on theunderlying assets being hedged.

 

During the yearended December 31, 2000, the Company realized $348,000 and $221,000 in grossgains and losses, respectively, on the sale of $3,419,000 and $3,062,000 ofequity securities, respectively, which were classified as available-for-sale.  During the year ended December 31, 1999, theCompany realized $1,916,000 and $10,000 in gross gains and losses,respectively, on the sale of $9,495,000 and $141,000 of equity securities,respectively, which were classified as available-for-sale.  These gains and losses are components of netgain (loss) on investment and derivative activities for 2000 and 1999.

 

At December 31,2001, the Company held equity securities and senior unsecured notes issued byDynex Capital, Inc. (“Dynex”) with fair market values of $158,000 and$4,550,000, respectively.  During theyear ended December 31, 1999, Dynex suspended the payment of dividends on itspreferred stock.  Accordingly, theCompany is no longer recognizing dividend income on its equity investments inDynex.  Dynex is currently payinginterest on its senior notes. Accordingly, the Company is recognizing interest income on the seniornote investments issued by Dynex.  IfDynex were to suspend payment of interest on its senior notes, interest incomerecognized by the Company would be negatively impacted.  During the year ended

 

F-12

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December 31, 2000,the Company recorded impairment adjustments of $3,368,000 and $958,000 on itsDynex preferred stock and common stock holdings, respectively, which areincluded in net loss on investment and derivative activities in the statementof operations.

 

For the yearsended December 31, 2000 and 1999, net gain (loss) on investment and derivativeactivities also includes a realized gain of $172,000 from the sale of interestrate caps and a realized loss of $334,000 from expired forward contracts,respectively.

 

**Note 4 - Reverse RepurchaseAgreements**

 

The Company hasentered into reverse repurchase agreements to finance certain of itsinvestments.  These agreements aresecured by a portion of the Company’s investments and bear interest rates thathave historically moved in close relationship to LIBOR.

 

At December 31,2001, the Company had outstanding $1,376,850,000 of reverse repurchaseagreements with a weighted average current borrowing rate of 1.89% and amaturity of 1.0 months.  The reverserepurchase agreements were collateralized by securities with an estimated fairvalue of $1,440,014,000.

 

At December 31,2000, the Company had outstanding $545,434,000 of reverse repurchase agreementswith a weighted average current borrowing rate of 6.61% and a maturity of 1.1months.  The reverse repurchaseagreements were collateralized by securities with an estimated fair value of$564,274,000.

 

At December 31,1999, the Company had outstanding $672,660,000 of reverse repurchase agreementswith a weighted average current borrowing rate of 5.98% and a maturity of 2.0months.  The reverse repurchaseagreements were collateralized by securities with an estimated fair value of$689,396,000.

 

For the year endedDecember 31, 2001, the average reverse repurchase agreement balance was$635,954,000 with a weighted average interest cost of  3.9%.  The maximum reverserepurchase agreement balance outstanding during the year ended December 31,2001 was $1,376,850,000.

 

For the year endedDecember 31, 2000, the average reverse repurchase agreement balance was$576,190,000 with a weighted average interest cost of 6.33%.  The maximum reverse repurchase agreementbalance outstanding during the year ended December 31, 2000 was $672,660,000.

 

For the year endedDecember 31, 1999, the average reverse repurchase agreement balance was$732,960,000 with a weighted average interest cost of 5.28%.  The maximum reverse repurchase agreementbalance outstanding during the year ended December 31, 1999 was $812,019,000.

 

**Note 5 – Derivative FinancialInstruments and Hedging Activities**

 

During the fourthquarter of 2001, the Company entered into interest rate swap agreements assummarized below.  Under theseagreements, the Company receives a floating rate and pays a fixed rate.  The swaps qualify as cash flow hedges foraccounting purposes, and effectively fix the interest rate paid on $850,000,000of current and anticipated future borrowings under reverse repurchaseagreements.

 

Interest RateSwaps at December 31, 2001:

 
| **Current  Notional Amount (000)** |    | **Average  Fixed Rate** |   | **Floating  Rate** |      | **Average  Termination Date** |     | **Unrealized  Gains (000)** |   |
|------------------------------------|---------|-------------------------|--------|--------------------|-----------|-------------------------------|----------|-----------------------------|--------|
| $                                  | 850,000 |                    | 4.239  | %                  | 1Mo LIBOR |                          | 3/3/2008 |                        | $      | 4,620 |  

  |
|                                    |         |                         |        |                    |           |                               |          |                             |        |  |  |

 

F-13

----

 

Interest rateswaps were previously used for hedging purposes during 2000 and 1999, and wereaccounted for using the settlement method. There were no interest rate swap agreements outstanding at December 31,2000.  The Company paid $1,663,000 to,received $334,000 from, and paid $3,614,000 to swap counterparties during theyears ended December 31, 2001, 2000 and 1999, respectively.  These amounts were recorded as adjustmentsto interest expense in the statements of operations.

 

During the yearended December 31, 2000, the Company terminated outstanding interest rate swapagreements with a combined notional amount of $386,213,000, which resulted in adeferred gain of $5,554,000.  The deferredgain is being amortized as an adjustment to interest expense over the remaininglives of the original swap agreements, and the remaining unamortized amount isincluded in accumulated other comprehensive income (loss) as of December 31,2001.   During the years ended December31, 2001 and 2000, $2,367,000 and $3,808,000, respectively, of the deferredgain was amortized.  The remainingdeferred gain will be fully amortized by May 31, 2002.  During the years ended December 31, 2000 and1999, $23,000 and $42,000, respectively of amortization was recognized from netlosses on interest rate swaps terminated during 1999.

 

During the yearsended December 31, 2001 and 2000, the Company entered into forward contracts tosell U.S. Treasury securities.  Thecontracts are utilized to hedge changes in fair values of the Company’s fixedincome securities, including a portion of those securities reclassified astrading securities as of January 1, 2001, as discussed in Note 2.   Also see Note 2 for a discussion of the SFASNo. 133 transition adjustment recognized on January 1, 2001 relating to theforward contracts and the securities to which those contracts were matched.

 

At December 31,2001 and 2000, the Company had open forward contracts to sell U.S. Treasurynotes with terms stated below:

 
| **As of  December 31** |   | **Current  Notional Amount   ($000)** |    | **Average  Termination  Date** |      | **Net  Unrealized  Losses  ($000)** |   | **Average  Maturity of  Underlying  Securities** |   |
|-----------------------------|--------|---------------------------------------|---------|--------------------------------|-----------|-------------------------------------|--------|--------------------------------------------------|--------|
| 2001                        |   | $                                     | 359,000 |                           | 1/14/2002 |                                | $      | (3,275                                           | )      | 5.57 Years |   |
| 2000                        |   | $                                     | 575,000 |                           | 1/19/2001 |                                | $      | (3,731                                           | )      | 2.99 Years |   |

 

At December 31,2001, the Company held $2,500,000 in cash as collateral from a swapcounterparty.

 

**Note 6 – Stock Option Plan**

 

The Company hasadopted a stock option plan (the ‘‘Amended and Restated 1997 Stock OptionPlan’’) that provides for the grant of both qualified incentive stock optionsthat meet the requirements of Section 422 of the Code, and non-qualified stockoptions, stock appreciation rights and dividend equivalent rights.  Stock options may be granted to directors ofthe Company (“employees”), and to the directors, officers and key employees ofthe Manager (“non-employees”).  TheManager is not eligible to be a recipient of options.

 

The exercise pricefor any stock option granted under the Amended and Restated 1997 Stock OptionPlan may not be less than 100% of the fair market value of the shares of commonstock at the time the option is granted. Each option must terminate no more than ten years from the date it isgranted.  Subject to anti-dilutionprovisions for stock splits, stock dividends and similar events, the Amendedand Restated 1997 Stock Option Plan authorizes the grant of options to purchasean aggregate of 1,000,000 shares of common stock.

 

F-14

----

 

Informationregarding stock option activity during the years ended December 31, 2001, 2000,and 1999 is as follows:

 
|                                                    |   | **Shares** |   | **Weighted  Average  Exercise Price** |   |
|---------------------------------------------------------|--------|------------|--------|---------------------------------------|--------|
| Options Outstanding at January 1 and December 31,  1999 |   | 570,000    |   | $                                     | 13.62  |   |
|                                                    |   |       |   |                                  |   |
| Granted During 2000                                     |   | 305,000    |   | 6.98                                  |   |
| Options Outstanding at December 31, 2000                |   | 875,000    |   | 11.29                                 |   |
|                                                    |   |       |   |                                  |   |
| Granted During 2001                                     |   | 56,000     |   | 11.18                                 |   |
| Exercised During 2001                                   |   | (27,500    | )      | 6.98                                  |   |
| Options Outstanding at December 31, 2001                |   | 903,500    |   | $                                     | 11.43  |   |

 

Informationregarding stock options outstanding at December 31, 2001 is as follows:

 
|                      |          | **Options  Outstanding** |    | **Options  Exercisable**               |      |
|---------------------------|---------------|--------------------------|---------|----------------------------------------|-----------|
| **Exercise Price  Range** |          | **Number of  Options**   |    | **Weighted-average  Contractual Life** |      | **Weighted-   average  Exercise Price** |   | **Number of   Options** |   | **Weighted-  average  Exercise Price** |   |
| $                         | 6.98          |                     | 277,500 |                                   | 9 years   |   | $ | 6.98 |   | 152,500 |   | $ | 6.98 |   |
| $                         | 10.38         |                     | 170,000 |                                   | 7 years   |   | $ | 10.38 |   | 170,000 |   | $ | 10.38 |   |
| $                         | 11.18         |                     | 56,000  |                                   | 10 years  |   | $ | 11.18 |   | — |   | $ | — |   |
| $                         | 15.00         |                     | 400,000 |                                   | 6 years   |   | $ | 15.00 |   | 400,000 |   | $ | 15.00 |   |
| $                         | 6.98 - $15.00 |                     | 903,500 |                                   | 7.3 years |   | $ | 11.43 |   | 722,500 |   | $ | 12.22 |   |
|                           |               |                          |         |                                        |           |  |  |  |  |  |  |  |  |  |  |

 

Of the optionsoutstanding summarized in the tables above, 502,000 are held by directors ofthe Company and the remainder are held by non-employees.  The Company recognized expense (included inother general and administrative expense) relating to options granted tonon-employees of $4,000, $95,000, and $287,000 during the years ended December31, 2001, 2000, and 1999, respectively.

 

190,000 of theoptions summarized above have dividend equivalent rights that entitle eachoption holder to receive a cash payment equal to the dividends declared on theCompany’s common stock multiplied by the number of options held until theoptions are exercised or expire. Dividends paid on options with dividend equivalentrights are charged to accumulated deficit in the balance sheet.

 

F-15

----

 

The followingtable presents the pro forma effects on net income (loss) and net income (loss)per share if compensation costs related to the employee stock options weremeasured using the fair value method as prescribed under SFAS No. 123, *Accountingfor Stock-based Compensation:*

 
|                                      |   | **Year Ended****December 31,  2001** |       | **Year Ended  December 31,  2000** |   | **Year Ended  December 31,  1999** |   |
|-------------------------------------------|--------|--------------------------------------|------------|------------------------------------|--------|------------------------------------|--------|
| Net (loss) income - as  reported          |   | $                                    | 18,714,000 |                               | $      | (28,243,000                        | )      | $ | 11,112,000 |   |
| Net (loss) income - pro forma             |   | $                                    | 18,709,000 |                               | $      | (28,409,000                        | )      | 10,611,000 |   |
|                                      |   |                                 |       |                               |   |                               |   |
| Basic earnings per share - as  reported   |   | $                                    | 2.59       |                               | $      | (4.91                              | )      | $ | 1.93 |   |
| Diluted earnings per share -  as reported |   | $                                    | 2.55       |                               | $      | (4.91                              | )      | $ | 1.92 |   |
| Basic earnings per share - pro  forma     |   | $                                    | 2.59       |                               | $      | (4.94                              | )      | $ | 1.84 |   |
| Diluted earnings per share -  pro forma   |   | $                                    | 2.55       |                               | $      | (4.94                              | )      | $ | 1.84 |   |

 

The fair value ofthe options granted was estimated using the Black-Scholes option-pricing modelwith the following assumptions (where dividend yield is shown as zero in thetable, the options have dividend equivalent rights as discussed above, and theassumption of no dividends adjusts for that factor and increases the estimatedfair value):

 
|                    |   | **Year Ended  December 31, 2001** |            | **Year Ended****December 31,   2000** |   |
|-------------------------|--------|-----------------------------------|-----------------|---------------------------------------|--------|
| Estimated fair value    |   | $                                 | 0.14  and $5.95 |                                  | $      | 0.04 |   |
| Dividend yield          |   | 18%  and 0                        | %               | 20                                    | %      |
| Volatility              |   | 30                                | %               | 30                                    | %      |
| Risk-free interest rate |   | 5.27                              | %               | 5.22                                  | %      |
| Expected life           |   | 10                                |            | 10                                    |   |
|                         |        |                                   |                 |                                       |        |  |  |

 

No options weregranted during the year ended December 31, 1999.

 

**Note 7 – Shareholders’ Rights Plan**

 

On June 30, 1999,the Board of Directors of the Company declared a dividend distribution of oneRight for each outstanding share of Company common stock to stockholders ofrecord at the close of business on July 30, 1999 (the “Record Date”).  Each Right entitles the registered holder topurchase from the Company one one-hundredth of a share of Series A JuniorParticipating Preferred Stock, par value $0.01 per share (the “PreferredStock”), at a Purchase Price of $50, subject to adjustment.  The description and terms of the Rights areset forth in a Shareholder Rights Agreement (the “Rights Agreement”) betweenthe Company and The Bank of New York, as Rights Agent.

 

Initially, theRights will be attached to all common stock certificates representing sharesthen outstanding, and no separate Rights Certificates will be distributed.  Subject to certain exceptions specified inthe Rights Agreement, the Rights will separate from the common stock and aDistribution Date will occur upon the earlier of (i) 10 business days followinga public announcement that a person or group of affiliated or associatedpersons (an “Acquiring Person”) has acquired, or obtained the right to acquire,beneficial ownership of 15% or more of the outstanding shares of common stock(the “Stock Acquisition Date”),

 

F-16

----

 

other than as aresult of repurchases of stock by the Company or certain inadvertent actions byinstitutional or certain other stockholders or (ii) 10 business days (or suchlater date as the Board shall determine) following the commencement of a tenderoffer or exchange offer that would result in a person or group becoming an AcquiringPerson.  Until the Distribution Date,(i) the Rights will be evidenced by the common stock certificates and will betransferred with and only with such common stock certificates, (ii) new commonstock certificates issued after the Record Date will contain a notationincorporating the Rights Agreement by reference and (iii) the surrender fortransfer of any certificates for common stock outstanding will also constitutethe transfer of the Rights associated with the common stock represented by suchcertificate.  Pursuant to the RightsAgreement, the Company reserves the right to require that, prior to theoccurrence of a triggering event, upon any exercise of Rights, a number ofRights be exercised so that only whole shares of Preferred Stock will be issued.

 

The Rights are notexercisable until the Distribution Date and will expire on July 30, 2009,unless earlier redeemed or exchanged by the Company.

 

**Note 8 - Fair Value of FinancialInstruments**

 

The followingtable presents the carrying values and estimated fair values of the Company’sfinancial instruments.  SFAS No. 107, *DisclosuresAbout Fair Value of Financial Instruments*, defines the fair value ofa financial instrument as the amount at which the instrument could be exchangedin a current transaction between willing parties, other than in a forced orliquidation sale (dollars in thousands):

 
|                                     |   | **At December 31, 2001** |      | **At December 31, 2000** |   |
|------------------------------------------|--------|--------------------------|-----------|--------------------------|--------|
|                                     |   | **Carrying Value**       |      | **Fair Value**           |   | **Carrying Value** |   | **Fair Value** |   |
| Mortgage-related securities              |   | $                        | 1,500,077 |                     | $      | 1,500,077 |   | $ | 594,469 |   | $ | 594,469 |   |
|                                     |   |                     |      |                     |   |   |   |   |   |
| Equity securities                        |   | 6,028                    |      | 6,028                    |   | 9,068 |   | 9,068 |   |
|                                     |   |                     |      |                     |   |   |   |   |   |
| Other fixed income securities            |   | 5,452                    |      | 5,452                    |   | 5,662 |   | 5,662 |   |
|                                     |   |                     |      |                     |   |   |   |   |   |
| Cash and cash equivalents                |   | 4,330                    |      | 4,330                    |   | 140 |   | 140 |   |
|                                     |   |                     |      |                     |   |   |   |   |   |
| Accrued interest receivable  and payable |   | 7,605                    |      | 7,605                    |   | 3,165 |   | 3,165 |   |
|                                     |   |                     |      |                     |   |   |   |   |   |
| Reverse repurchase agreements            |   | 1,376,850                |      | 1,376,850                |   | 545,434 |   | 545,434 |   |
|                                     |   |                     |      |                     |   |   |   |   |   |
| Payable for unsettled  securities        |   | —                   |      | —                   |   | 14,514,000 |   | 14,514,000 |   |
|                                     |   |                     |      |                     |   |   |   |   |   |
| Receivable for unsettled  securities     |   | 5,520                    |      | 5,520                    |   | — |   | — |   |
|                                     |   |                     |      |                     |   |   |   |   |   |
| Interest rate swaps                      |   | 4,620                    |      | 4,620                    |   | — |   | — |   |
|                                     |   |                     |      |                     |   |   |   |   |   |
| Forward contracts                        |   | (3,275                   | )         | (3,275                   | )      | (3,731 | ) | (3,731 | ) |
|                                          |        |                          |           |                          |        |  |  |  |  |  |  |  |  |

 

Substantially allthe Company’s assets are carried at their fair values on the balance sheets.The Company bases its fair value estimates for mortgage-related securities,equity securities, other fixed income securities, interest rate swaps, andforward contracts primarily on third party price indications provided bydealers who make markets in these financial instruments when such indicationsare available.  However, the fair valuereported reflects estimates and may not necessarily be indicative of theamounts the Company could realize in a current market exchange.  Cash and cash equivalents, interestreceivable and payable, and

 

F-17

----

 

reverse repurchaseagreements are reflected in the financial statements at their costs, whichapproximates their fair value because of the short-term nature of thoseinstruments.

 

**Note 9 – Related Party Transactions**

 

The Company paysthe Manager annual base management compensation, payable monthly in arrears,equal to 3/4 of 1% of the Average Net Invested Capital as defined in theManagement Agreement.  The Companyrecorded expense of $471,000, $512,000, and $629,000 in base managementcompensation to the Manager during the years ended December 31, 2001, 2000, and1999, respectively.  The accruedliability for base management compensation, included in accrued expenses andother liabilities in the balance sheets, was $144,000 and $85,000 at December31, 2001 and 2000, respectively.

 

The Company alsopays the Manager, as incentive compensation, an amount equal to 30% of the NetIncome of the Company, as defined in the Management Agreement, before incentivecompensation, in excess of the amount that would produce an annualized Returnon Equity, as defined in the Management Agreement, equal to the ten-year U.S.Treasury rate plus 1%.  The Companyrecorded expense of $634,000 and $1,714,000 for incentive compensation to theManager for the years ended December 31, 2001 and 1999, respectively.  No incentive compensation was incurred forthe year ended December 31, 2000.  Theaccrued liability for incentive compensation, included in accrued expenses andother liabilities in the balance sheets, was $634,000 at December 31,2001.  There was no accrued liabilityfor incentive compensation at December 31, 2000.

 

The Company’sother fixed income investments include securities that are issued by specialpurpose entities that invest primarily in mortgage-related assets.  The Manager serves as the investment managerto these companies and is paid fees in connection with such services.  The Company does not anticipate paying anymanagement fees directly to the Manager in connection with these investments.

 

**Note 10 – Commitments andContingencies**

 

The Company’sBoard of Directors has authorized a program to repurchase shares of theCompany’s common stock.   As of December31, 2001, the Company was authorized to repurchase an additional 552,900 sharesof the Company’s common stock pursuant to this program.  Shares repurchased are retiredimmediately.  No shares were repurchasedduring 2001 or 2000.

 

The ManagementAgreement between the Company and the Manager may be renewed each year at thediscretion of the Company’s Board of Directors, unless previously terminated bythe Company or the Manager upon written notice. Except in the case of atermination or non-renewal by the Company for cause, upon termination ornon-renewal of the Management Agreement by the Company, the Company isobligated to pay the Manager a termination or non-renewal fee, which may besignificant. The termination or non-renewal fee shall be equal to the fairmarket value of the Management Agreement without regard to the Company’stermination right, as determined by an independent appraisal.  Neither the fair market value of theManagement Agreement nor the various factors that an appraiser may findrelevant in its determination of the fair market value can be determined atthis time.  The fair market value of theManagement Agreement will be affected by significant variables, including (i)the historical management fees paid to the Manager, (ii) any projections offuture management fees to be paid to the Manager determined by the independentappraiser, (iii) the relative valuations of agreements similar to theManagement Agreement and (iv) other factors, all of which may be unrelated tothe performance of the Manager.  Similarmanagement agreements have been valued at as much as eight times the historicalannual fees paid under such agreements. Any termination or non-renewal fee paid may be materially greater thaneight times historical fees and the Company can provide no assurance at thistime as to the amount of any such fee.

 

F-18

----

 

**Note 11 – Accumulated OtherComprehensive Income (Loss)**

 

The following is apresentation of the changes in accumulated other comprehensive income (loss)for the years ended December 31, 2001, 2000, and 1999, including the cumulativeeffects of the change in accounting principle relating to the adoption of SFASNo. 133 on January 1, 2001 (see Note 2), and other adjustments to reclassifyamounts from accumulated other comprehensive income (loss) into the statementsof operations during each year:

 
|                                                                                                                                |   | **Year Ended  December 31, 2001** |        | **Year Ended  December 31, 2000** |   | **Year Ended  December 31, 1999** |   |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|-------------|-----------------------------------|--------|-----------------------------------|--------|
| *Unrealized Gains (Losses) on  Available-for-Sale Securities:*                                                                      |   |                              |        |                              |   |                              |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Unrealized  gains (losses) arising during the year                                                                                  |   | $                                 | (15,064,000 | )                                 | $      | 1,315,000                         |   | $ | (36,212,000 | ) |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Reclassification  of impairment losses to net loss on investment and derivative activities                                          |   | —                            |        | 22,610,000                        |   | —                            |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Reclassification  of net (gains) losses resulting from securities sales to net gain (loss) on  investment and derivative activities |   | 3,076,000                         |        | 8,935,000                         |   | (899,000                          | )      |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Cumulative  effect of change in accounting principle - SFAS No. 133 transition adjustment                                           |   | (10,063,000                       | )           |                              |   |                              |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Reclassification  of net gains relating to reclassification of securities to trading                                                |   | (1,742,000                        | )           |                              |   |                              |   |
| Net  change in unrealized gains (losses) on available-for-sale securities                                                           |   | $                                 | (23,793,000 | )                                 | $      | 32,860,000                        |   | $ | (37,111,000 | ) |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| *Unrealized and Deferred Gains  (Losses) on Forward Contracts:*                                                                     |   |                              |        |                              |   |                              |   |
| Net  deferred gain (loss) from forward contracts closed during the year                                                             |   | $                                 | —      |                              | $      | (16,860,000                       | )      | $ | 3,909,000 |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Reclassification  of impairment losses to net loss on investment and derivative activities                                          |   | —                            |        | 8,424,000                         |   | —                            |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Reclassification  of deferred losses included in interest income                                                                    |   | —                            |        | 346,000                           |   | —                            |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Reclassification  of net losses resulting from sales to net gain (loss) on investment and derivative  activities                    |   | —                            |        | 664,000                           |   | —                            |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Cumulative  effect of change in accounting principle - SFAS No. 133 transition adjustment                                           |   | 12,236,000                        |        | —                            |   | —                            |   |
| Net  change in unrealized and deferred gains (losses) on forward contracts                                                          |   | $                                 | (12,236,000 | )                                 | $      | (7,426,000                        |   | $ | 3,909,000 |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |   |   |   |
| *Deferred Gain on Terminated Interest  Rate Swaps:*                                                                                 |   |                              |        |                              |   |                              |   |
| Cumulative  effect of change in accounting principle - SFAS No. 133 transition adjustment                                           |   | $                                 | 2,546,000   |                              | $      | —                            |   | $ | — |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Reclassification  for amortization into interest expense                                                                            |   | (2,367,000                        | )           | —                            |   | —                            |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Net  change in deferred gain on terminated interest rate swaps                                                                      |   | $                                 | 179,000     |                              | $      | —                            |   | $ | — |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| *Unrealized Gain on Interest Rate  Swaps Classified as Cash Flow Hedges:*                                                           |   |                              |        |                              |   |                              |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Net  unrealized gain on interest rate swaps classified as cash flow hedges                                                          |   | $                                 | 6,283,000   |                              | $      | —                            |   | $ | — |   |
|                                                                                                                                |   |                              |        |                              |   |                              |   |
| Reclassification  for adjustments to interest expense                                                                               |   | (1,663,000                        | )           | —                            |   | —                            |   |
| Net  change in unrealized gain on interest rate swaps classified as cash flow  hedges                                               |   | $                                 | 4,620,000   |                              | $      | —                            |   | $ | — |   |

 

F-19

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The following is asummary of the amounts included in accumulated other comprehensive income(loss) as of December 31, 2001 and 2000:

 
|                                                                        |   | **As of  December 31, 2001** |        | **As of  December 31, 2000** |   |
|-----------------------------------------------------------------------------|--------|------------------------------|-------------|------------------------------|--------|
| Net  unrealized gains (losses) on available-for-sale securities             |   | $                            | (12,636,000 | )                            | $      | 11,157,000 |   |
| Net  deferred and unrealized gains (losses) on forward contracts            |   | —                       |        | (12,236,000                  | )      |
| Net  deferred gains on terminated interest rate swaps                       |   | 179,000                      |        | —                       |   |
| Net  unrealized gains on interest rate swaps classified as cash flow hedges |   | 4,620,000                    |        | —                       |   |
| Accumulated  Other Comprehensive Loss                                       |   | $                            | (7,837,000  | )                            | $      | (1,079,000 | ) |

 

F-20

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**Note 12 – Summarized QuarterlyResults (Unaudited)**

 

The following is apresentation of the quarterly results of operations (amounts are in thousandsexcept per share amounts):

 
|                                                           |   | **Year Ended December 31, 2001** |   |
|----------------------------------------------------------------|--------|----------------------------------|--------|
|                                                           |   | **Fourth  Quarter**              |   | **Third  Quarter** |   | **Second  Quarter** |   | **First  Quarter** |   |
| Interest Income                                                |   | $                                | 18,274 |   | $ | 9,833 |   | $ | 9,764 |   | $ | 11,020 |   |
|                                                           |   |                             |   |   |   |   |   |   |   |
| Interest Expense                                               |   | 7,458                            |   | 4,201 |   | 4,988 |   | 7,076 |   |
| Net Interest Income                                            |   | 10,816                           |   | 5,632 |   | 4,776 |   | 3,944 |   |
|                                                           |   |                             |   |   |   |   |   |   |   |
| Net Gain (Loss) on Investment  and  Derivative Activities |   | (584                             | )      | 2,409 |   | (4,382 | ) | (2,458 | ) |
| Dividend Income                                                |   | 159                              |   | 162 |   | 306 |   | 188 |   |
|                                                           |   |                             |   |   |   |   |   |   |   |
| General and Administrative  Expenses                           |   | (887                             | )      | (367 | ) | (300 | ) | (269 | ) |
|                                                           |   |                             |   |   |   |   |   |   |   |
| Reclassification of Previously  Unrealized Gains               |   | —                           |   | — |   | — |   | 1,742 |   |
| Cumulative Effect of Change in  Accounting Principle           |   | —                           |   | — |   | — |   | (2,173 | ) |
| Net (Loss) Income                                              |   | $                                | 9,504  |   | $ | 7,836 |   | $ | 400 |   | $ | 974 |   |
|                                                           |   |                             |   |   |   |   |   |   |   |
| Basic Net Income per Share                                     |   | $                                | 0.82   |   | $ | 1.36 |   | $ | 0.07 |   | $ | 0.17 |   |
|                                                           |   |                             |   |   |   |   |   |   |   |
| Diluted Net Income per Share                                   |   | $                                | 0.81   |   | $ | 1.34 |   | $ | 0.07 |   | $ | 0.17 |   |
| Average Number of Shares  Outstanding:                         |   |                             |   |   |   |   |   |   |   |
| Basic                                                          |   | 11,631                           |   | 5,753 |   | 5,753 |   | 5,753 |   |
|                                                           |   |                             |   |   |   |   |   |   |   |
| Diluted                                                        |   | 11,739                           |   | 5,846 |   | 5,819 |   | 5,783 |   |
|                                                           |   |                             |   |   |   |   |   |   |   |
| Dividends Declared Per Share                                   |   | $                                | 0.80   |   | $ | 0.40 |   | $ | 0.40 |   | $ | 0.35 |   |

 

F-21

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|                                                          |   | **Year Ended December 31, 2000** |   |
|---------------------------------------------------------------|--------|----------------------------------|--------|
|                                                          |   | **Fourth  Quarter**              |   | **Third  Quarter** |   | **Second  Quarter** |   | **First  Quarter** |   |
| Interest  Income                                              |   | $                                | 10,224 |   | $ | 9,580 |   | $ | 10,893 |   | $ | 12,137 |   |
| Interest  Expense                                             |   | 7,901                            |   | 7,600 |   | 8,590 |   | 9,688 |   |
| Net Interest Income                                           |   | 2,323                            |   | 1,980 |   | 2,303 |   | 2,449 |   |
|                                                          |   |                             |   |   |   |   |   |   |   |
| Net  Gain (Loss) on Investment and Derivatives Activities (1) |   | 741                              |   | (29,912 | ) | (7,532 | ) | — |   |
| Dividend  Income                                              |   | 230                              |   | 185 |   | 354 |   | 370 |   |
| General  and Administrative Expenses                          |   | (290                             | )      | (680 | ) | (241 | ) | (523 | ) |
| Net (Loss) Income                                             |   | $                                | 3,004  |   | $ | (28,427 | ) | $ | (5,116 | ) | $ | 2,296 |   |
|                                                          |   |                             |   |   |   |   |   |   |   |
| Basic  Net Income per Share                                   |   | $                                | 0.52   |   | $ | (4.94 | ) | $ | (0.89 | ) | $ | 0.40 |   |
|                                                          |   |                             |   |   |   |   |   |   |   |
| Diluted  Net Income per Share                                 |   | $                                | 0.52   |   | $ | (4.94 | ) | $ | (0.89 | ) | $ | 0.40 |   |
|                                                          |   |                             |   |   |   |   |   |   |   |
| Average  Number of Shares Outstanding:                        |   |                             |   |   |   |   |   |   |   |
| Basic                                                         |   | 5,753                            |   | 5,753 |   | 5,753 |   | 5,753 |   |
|                                                          |   |                             |   |   |   |   |   |   |   |
| Diluted                                                       |   | 5,753                            |   | 5,753 |   | 5,753 |   | 5,753 |   |
|                                                          |   |                             |   |   |   |   |   |   |   |
| Dividends  Declared Per Share                                 |   | $                                | 0.35   |   | $ | 0.35 |   | $ | 0.35 |   | $ | 0.46 |   |

 

----

(1)  For the quarter ended September 30, 2000,the loss of $29,912,000 consisted of an impairment charge on certain fixed-ratemortgage securities that may be sold prior to maturity of $21,652,000, therecognition of the associated unrealized loss and deferred hedging losses onthe impaired assets of $8,425,000, and $165,000 of net gains on the sale of$1,393,000 equity securities that were classified as available-for-sale.

 

**Note 13 - Subsequent Events**

 

On March 5, 2002,the Company issued 9,200,000 shares of common stock in a follow-on publicoffering.  The Company received proceeds(net of underwriting discounts and commissions) of $91,908,000 from thisoffering.  The Company leveraged the newequity by entering into additional reverse repurchase agreements, and used thecombined proceeds from the offering and the new borrowings primarily topurchase additional mortgage-related securities.

 

On February 22,2002, the Board of Directors of the Company declared a dividend of $0.50 percommon share for the first quarter of 2002, payable on April 26, 2002 tostockholders of record on March 28, 2002.

 

F-22

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