**UNITED STATES SECURITIES ANDEXCHANGE 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, 2002** |
|           |   |
| **OR**         |
|           |   |
| **o**          | **TRANSITION  REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|           |   |
|           | **For the transition period from                     to                   ** |
|           |   |

 

**Commission FileNumber: 001-13637**

 

| **APEX  MORTGAGE CAPITAL, INC.**                       |
|--------------------------------------------------------|
| (Exact name of Registrant as 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  registered pursuant 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 mark whetherthe Registrant (1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (orfor such shorter period that the Registrant was required to file such reports),and (2) has been subject to such filing requirements for the past 90 days.

Yes    ý                                              No      o

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 Regulation S-K is notcontained herein, and will not be contained, to the best of the Registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form10-K.  ý

 

On June 28, 2002, which was thelast business day of Apex’s most recently completed second fiscal quarter,Apex’s public market value was approximately $445 million (based on 29,701,184shares of common stock then held by non-affiliates and a closing price that dayof $14.99 per share of Common Stock on the American Stock Exchange).  These public market value calculationsexclude shares held on the stated dates by Apex’s officers, directors and 5% orgreater stockholders.  (Exclusion fromthese public market value calculations does not imply affiliate status for any otherpurpose.)

 

At March 21, 2003, theaggregate market value of the voting stock held by non-affiliates was$196,040,024 based on the closing price of the Common Stock on the AmericanStock Exchange.

 

Number of shares of CommonStock outstanding at March 18, 2003: 29,857,000

 

DOCUMENTS INCORPORATED BYREFERENCE:

Portions ofthe Registrant’s definitive Proxy Statement to be filed pursuant to Regulation14A within 120 days from December 31, 2002, are incorporated by reference intoPart III.

 

 

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**SAFE HARBOR STATEMENTUNDERTHE PRIVATE 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 OTHER VARIATIONS THEREONOR COMPARABLE TERMINOLOGY.  SOMEIMPORTANT FACTORS THAT WOULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROMTHOSE IN ANY FORWARD-LOOKING STATEMENTS INCLUDE CHANGES IN INTEREST RATES;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 OTHER FACTORS.  INADDITION, THE DEGREE OF RISK IN THE COMPANY’S INVESTMENTS IS INCREASED BY THECOMPANY’S LEVERAGING OF ITS ASSETS.

 

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**Apex Mortgage Capital, Inc.**

 

**2002 Form 10-K Annual Report**

 

**Table of Contents**

 
| **PART I**   |                                                                                            |
|--------------|-------------------------------------------------------------------------------------------------|
|         |                                                                                            |
| ITEM  1.     | BUSINESS                                                                                        |
| ITEM 2.      | PROPERTIES                                                                                      |
| ITEM 3.      | LEGAL PROCEEDINGS                                                                               |
| ITEM 4.      | SUBMISSION OF MATTERS TO A VOTE OF SECURITY  HOLDERS                                            |
|         |                                                                                            |
| **PART II**  |                                                                                            |
|         |                                                                                            |
| 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           |
|         |                                                                                            |
| **PART III** |                                                                                            |
|         |                                                                                            |
| ITEM 10.     | DIRECTORS AND EXECUTIVE OFFICERS OF THE  REGISTRANT                                             |
| ITEM 11.     | EXECUTIVE COMPENSATION                                                                          |
| ITEM 12.     | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND  RELATED STOCKHOLDER MATTERS |
| ITEM 13.     | CERTAIN RELATIONSHIPS AND RELATED  TRANSACTIONS                                                 |
|         |                                                                                            |
| **PART IV**  |                                                                                            |
|         |                                                                                            |
| ITEM 14.     | CONTROLS AND PROCEDURES                                                                         |
| ITEM 15.     | EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND  REPORTS ON FORM 8K                                 |

 

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***Certain capitalizedand other terms used herein shall have the meaningsassigned to them in the glossary at the end of this report.***

 

**PART I**

 

# **ITEM 1.**                             BUSINESS

 

*The following description of our businessshould be read in conjunction with the information included elsewhere in thisAnnual Report on Form 10-K, including in the section “Management’s Discussionand Analysis of Financial Condition and Results of Operations” and in ourfinancial statements and notes thereto which are included in this Annual Reporton 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 estateadjustable and fixed rate mortgage related assets.  The Company commenced operations on December 9, 1997, followingthe initial 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 Companyuses its equity capital and borrowed funds to seek to generate income based onthe difference between the yield on its mortgage related assets and the cost ofits borrowings.  The Company has electedto be 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 its incometo 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 with its subsidiaries and affiliates, the “TCWGroup”), or the Manager.  The Manager isa wholly-owned subsidiary of TCW.  TheManager was established in 1987, and the TCW Group began operations in 1971through one of its affiliates.  TheCompany’s investment management team are selected members of the TCW Group’sMortgage-Backed Securities Group (the “MBS Group”), all of whom have overthirteen years of experience in raising and managing mortgage capital.  The Company has elected to be externallymanaged by the Manager to take advantage of the existing operational systems,expertise and economies of scale associated with the Manager’s current businessoperations, among other reasons. The Manager’s key officers have experience inraising and managing mortgage capital, mortgage finance and the purchase andadministration of mortgage related assets.

 

**WebsiteAccess to Our Periodic SEC Reports**

 

Our internetaddress is www.apexreit.com.  We makeour periodic SEC reports (Form 10-Q and Form 10-K) and current reports (Form8-K) available free of charge through our website as soon as reasonablypracticable after they are filed electronically with the SEC.  We may from time to time provide importantdisclosures to investors by posting them in the investor relations section ofour website, as allowed by SEC rules.

 

Materials wefile with the SEC may be read and copied at the SEC’s Public Reference Room at450 Fifth Street, N.W., Washington, D.C. 20549.  Information on the operation of the Public Reference Room may beobtained by calling the SEC at 1-800-SEC-0330. The SEC also maintains an Internet Website at www.sec.gov that containsreports, proxy and information statements, and other information regarding ourcompany that we file electronically with the SEC.

 

#### **RECENTEVENTS**

 

*Dividend Declaration*.  On March 13, 2003, the Company’s Board ofDirectors declared a dividend distribution of $0.25 per share.  The dividend is payable on April 30, 2003,to shareholders of record on March 28, 2003.

 

*Appointment of Samuel P. Bell to Fill Boardof Directors Vacancy.* Subsequent to the Annual Meetingof Shareholders at which he was reelected, John C. Argue passed away after aneight-month battle with leukemia. The Board of Directors elected Samuel P. Bellto fill the vacancy. Mr. Bell has served as President of Los Angeles BusinessAdvisors since 1996. Previously, Mr. Bell served as the Area Managing Partnerof Ernst & Young for the Pacific Southwest Area.

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*Exploration of Strategic Alternatives.*  On March 13, 2003, we announced that ourBoard of Directors has authorized our management to consider a full range ofstrategic alternatives for our Company in order to maximize stockholder value,including, but not limited to, the potential sale of the Company.  In this context, our Board of Directors hasappointed a special committee consisting of our independent directors.  In the event of a sale of the Company, theManager is entitled to receive a termination fee under the terms of ourmanagement agreement.  For this purpose,in the event of a termination, the Manager and our Board of Directors have agreedto limit the termination fee to an amount less than the fair market valuecontemplated to be paid under the management agreement.  In the event of a sale of the Company, thetermination fee will be an amount up to 50% of the premium over book value of themanagement agreement, not to exceed $10 million.

 

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

 

**STRATEGY**

 

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

 

•                  purchaseprimarily single-family real estate adjustable and fixed rate mortgage relatedassets;

 

•                  manage thecredit risk of its mortgage related assets through, among other activities (i)carefully selecting mortgage related assets to be acquired, (ii) complying withthe Company’s investment policy, (iii) actively monitoring the ongoing creditquality and servicing of its mortgage related assets, and (iv) maintainingappropriate capital levels and allowances for possible credit losses;

 

•                  financepurchases of mortgage related assets with the net proceeds of equity offeringsand, to the extent permitted by the Company’s leverage policy, to utilizeleverage to increase potential returns to stockholders through borrowings(primarily reverse repurchase agreements) with interest rates that will alsoreflect changes in short-term market interest rates;

 

•                  seek tostructure its borrowings in accordance with its interest rate risk managementpolicy;

 

•                  utilize interestrate swaps, forward contracts on U.S. Treasury notes, interest rate caps andsimilar financial instruments to mitigate interest rate risks;

 

•                  seek to minimizeprepayment risk primarily by structuring a diversified portfolio with a varietyof prepayment characteristics; and

 

•                  purchase equityand other securities issued by financial entities on an opportunistic basis.

 

There can beno assurance 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 Companymay attempt 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 theefficiency of its balance sheet structure by issuing uncollateralizedsubordinated debt and other forms of capital.

 

**Management Policies and Programs**

 

The Company isa financial 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.

 

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The Companyhas established 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 seek to generate dividend yields that provide acompetitive rate of return for its stockholders:

 

•                                          InvestmentPolicy;

•                                          LeveragePolicy;

•                                          InterestRate Risk Management Policy;

•                                          REITCompliance Policy; and

•                                          HedgingStrategy Policy.

 

Compliancewith the foregoing operating policies shall be determined by the Manager at thetime of the Company’s purchase of the mortgage related assets (based on themost recent valuation thereof by the Company) and will not be affected byevents subsequent to the purchase. Such events include, without limitation, changesin characterization, value or rating of any specific mortgage related assets oreconomic conditions or other events generally affecting any mortgage relatedassets of the type held by the Company.

 

***InvestmentPolicy***

 

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%of the 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%of the Company’s total assets are expected to consist of investments thatqualify for the 50% Category or other Mortgage-Backed Securities that have receivedan investment grade rating by at least one nationally recognized rating agency.

 

*90% Category*

 

At least 90%of the Company’s total assets are expected to consist of investments thatqualify for the 75% Category or High Credit Quality Mortgage Loans that are notfunded by Committed Secured Borrowings.

 

*10% Category*

 

Not more than10% of the Company’s total assets are expected to consist of (i)Mortgage-Backed Securities rated below investment grade, (ii) MortgageDerivative Securities or (iii) Other Investments.

 

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***LeveragePolicy***

 

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 SecuredBorrowings***

 

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 types of 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 of UncommittedSecured Borrowings to 92% of its total assets, less any assets that are fundedwith Committed Secured Borrowings, plus the market value of any related hedgingtransactions.  If the amount of suchborrowings exceeds 92%, the Manager will be required to submit to the Company’sBoard of Directors a plan designed to bring the total amount of UncommittedSecured Borrowings below the 92% limitation. It is anticipated that in many circumstances this goal will be achievedover time without active management through the natural process of mortgageprincipal repayments and increases in the market value of the Company’s totalassets.

 

Reverserepurchase agreements are a form of borrowing which are evidenced by anagreement by the Company to sell Mortgage-Backed Securities (or othersecurities) to a third party, coupled with a simultaneous agreement by theCompany to repurchase them at a specified future date and price. Basically, thereverse repurchase agreement is a collateralized loan. The difference betweenthe purchase (repurchase) price and the sale price is the dollar cost of theloan. The Company anticipates that it will only enter into reverse repurchaseagreements and other financing transactions with counterparties ratedinvestment grade by a Rating Agency and primarily with national broker-dealers,commercial banks and other lenders that offer such financing.

 

***Committed SecuredBorrowings***

 

The Company’sborrowings may consist of Committed Secured Borrowings, including the issuanceof CMOs, structured commercial paper programs, secured term notes and otherfinancing transactions. Such funding sources generally commit the lender toprovide financing to the Company for a specified period of time or to providefinancing to the Company to fund specific assets until the assets mature.  The Company intends to limit the amount ofCommitted Secured Borrowings to 97% of the assets funded with such borrowingsat the time any corresponding transaction is entered into.

 

***InterestRate Risk Management Policy***

 

The Companyhas established 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 of its mortgage related assets that are not funded bysecured borrowings. There can be no assurance that the Company will be able tolimit such duration differences and there may be periods of time when theduration difference will be greater than one year.

 

The Companymay implement its interest rate risk management policy by utilizing varioushedging transactions, including interest rate swaps, interest rate swaptions,interest rate caps, interest rate floors, financial futures contracts, optionson financial futures contracts, and other structured transactions.  The Company does not intend to enter intosuch transactions for speculative purposes.

 

***REITCompliance Policy***

 

The Companyintends to operate its business in compliance with the REIT Provisions of theCode.  Accordingly, all of the provisionsoutlined in the Company’s investment, leverage and interest rate riskmanagement policies are subordinate to the REIT Provisions of the Code if anyconflicts arise.

 

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To qualify fortax treatment as a REIT, the Company must meet certain tests as fully describedin sections 856 and 857 of the Code.  Asummary of the requirements for qualification as a REIT is describedimmediately below.

 

*Stock Ownership Tests*.  The capital stock of the Company must beheld by at least 100 persons and no more than 50% of the value of such capitalstock may be owned, directly or indirectly, by five or fewer individuals at alltimes during the last half of the taxable year.  Tax-Exempt Entities, other than private foundations and certainunemployment compensation trusts, are generally not treated as individuals forthese purposes.  The stock ownershiprequirements must be satisfied in the Company’s second taxable year and in eachsubsequent taxable year.

 

*Asset Tests.*  The Company must generally meet the followingasset 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 valueof securities held by the Company but not taken into account for purposes ofthe 75% Asset Test must not exceed (i) 5% of the value of the Company’s totalassets in the case of securities of any one impermissible issuer, or (ii) 10%of the outstanding voting securities or value of such securities of any suchissuer. An exception is provided, however, for the Company’s interest in aTaxable 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 from thedisposition of Qualified REIT Real Estate Assets or Qualified TemporaryInvestment Income (the “75% Gross Income Test”).  At least 95% of the Company’s gross income for each taxable yearmust be derived from sources of income qualifying for the 75% Gross IncomeTest, dividends, interest unrelated to real estate, and gains from the sale ofstock or other securities (including certain interest rate swap and capagreements entered into to hedge variable rate debt incurred to acquireQualified REIT Real Estate Assets) not held for sale in the ordinary course ofbusiness (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 in which the dividend is declared to pay thedividends to stockholders and is permitted to offer a special dividend in orderto 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, *Accountingfor Derivative Instruments and Hedging Activities* and Statement ofFinancial Accounting Standards No. 138, *Accountingfor Certain Derivative Instruments and Certain Hedging Activities*,and related Derivative Implementation Group pronouncements.  The hedgingstrategy 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.

 

***OtherPolicies***

 

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 and Strategies**

 

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.

 

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**Description of Mortgage Related Assets**

 

The Companyinvests principally in the following types of mortgage related assets, subjectto the operating restrictions described in “Management Policies and Programs”above.

 

***PrimaryMortgage Securities***

 

*Pass-Through Certificates. *Pass-ThroughCertificates are securities representing interests in “pools” of Mortgage Loanssecured by residential real property in which payments of both interest andprincipal on the securities are generally made monthly, in effect “passingthrough” monthly payments made by the individual borrowers on the MortgageLoans which underlie the securities (net of fees paid to the issuer orguarantor of the securities).  Earlyrepayment of principal on some mortgage related assets (arising fromprepayments of principal due to sale of the underlying property, refinancing,or foreclosure, net of fees and costs which may be incurred) may expose theCompany to a lower rate of return upon reinvestment of principal.  This is known as prepayment risk.  Also, if a security subject to prepaymenthas been purchased at a premium, the value of the premium would be lost in theevent of prepayment.  Like other fixedincome securities, when interest rates rise, the value of a mortgage relatedasset generally will decline; however, when interest rates are declining, thevalue of mortgage related assets with prepayment features may not increase asmuch as other fixed income securities. The rate of prepayments on underlying mortgages will affect the priceand volatility of a mortgage related asset, and may have the effect ofshortening or extending the effective maturity of the security beyond what wasanticipated at the time of purchase. When interest rates rise, the holdings of mortgage related assets by theCompany can reduce returns if the owners of the underlying mortgages pay offtheir mortgages later than anticipated. This is known as extension risk.

 

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 Mortgage Obligations. *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.

 

***OtherMortgage 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 thanpass-through certificates and CMOs.

 

*Mortgage Derivative Securities. *The Company mayacquire Mortgage Derivative Securities not to exceed 10% of its totalassets.  Mortgage Derivative Securitiesprovide for the holder to receive interest only, principal only, or interestand principal in amounts that are disproportionate to those payable on theunderlying Mortgage Loans.  Payments onMortgage Derivative Securities are highly sensitive to the rate of prepaymentson the underlying Mortgage Loans.  Inthe event of more rapid (slower) than anticipated prepayments on such MortgageLoans, the rates of return on interests in Mortgage Derivative Securitiesrepresenting the right to receive interest only or a disproportionately largeamount of interest (“Interest Only Derivatives”) would be likely to decline(increase).  Conversely, the rates ofreturn on Mortgage 

 

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Derivative Securitiesrepresenting the right to receive principal only or a disproportionate amountof principal (“Principal Only Derivatives”) would be likely to increase(decrease) in the event of rapid (slow) prepayments.

 

The Companymay also invest in Inverse Floaters, a class of CMOs with a coupon rate thatresets in the opposite direction from the market rate of interest to which itis indexed, 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 Companyalso may invest in other Mortgage Derivative Securities that may be developedin the future.

 

*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 underlying such series of mortgagesecurities.  The subordination will notbe limited to those resulting from certain types of risks, such as those resultingfrom 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 Warehouse Participations. *The Company alsomay from time to time acquire mortgage warehouse participations as anadditional 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 warehouseparticipations do not qualify as Qualified REIT Real Estate Assets.  Accordingly, this activity is limited by theREIT Provisions of the Code.

 

***MortgageLoans***

 

*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, theMortgage 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 MortgageLoans may be originated by or purchased from various suppliers of mortgagerelated assets throughout the United States, such as savings and loanassociations, banks, mortgage bankers, home-builders, insurance companies andother mortgage lenders.  The Company mayacquire Mortgage Loans directly from originators and from entities holdingMortgage Loans originated by others. The Board of Directors of the Company has not established any limitsupon the geographic concentration of Mortgage Loans to be acquired by theCompany or the credit quality of suppliers of mortgage related assets.

 

*Conforming and Nonconforming MortgageLoans. *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 that exceed the requirements for FHLMC or Fannie Maeprograms.

 

*Commitments to Mortgage Loan Sellers. *The Company mayissue commitments to originators and other sellers of Mortgage Loans who followpolicies 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 

 

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single-family (one-to-fourunits) residential properties.  Inaddition, commitments may be issued for agency certificates as well asprivately 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 Mortgage Loans. *The Company mayacquire 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 Company to complete the securitization for all MortgageLoans that the Company acquires, in which case the Company will continue tobear the risks of borrower defaults and special hazard losses.

 

*Protection Against Mortgage Loan Risks.*TheCompany anticipates that each Mortgage Loan purchased will have a commitmentfor mortgage pool insurance from a mortgage insurance company with aclaims-paying ability rated investment grade by either of the RatingAgencies.  Mortgage pool insuranceinsures the payment of certain portions of the principal and interest onMortgage Loans.  In lieu of mortgagepool insurance, the Company may arrange for other forms of credit enhancementsuch as letters of credit, subordination of cash flows, corporate guaranties,establishment of reserve accounts or over-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 will providesimilar representations and warranties when the Company sells or pledges theMortgage Loans as collateral for mortgage securities.  If a Mortgage Loan becomes delinquent and the pool insurer isable to prove that there was a fraud or misrepresentation in connection withthe origination of the Mortgage Loan, the pool insurer will not be liable forthe portion of the loss attributable to such fraud or misrepresentation.  Although the Company will generally have recourseto the seller based on the seller’s representations and warranties to theCompany, the Company will generally be at risk for loss to the extent theseller does not perform its repurchase obligations.

 

*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 mortgagerelated assets, (iv) commercial mortgage loans and securities, and (v)residential mortgage loans other than High Credit Quality Mortgage Loans.  Although the Company expects that its OtherInvestments will be limited to less than 10% of its total assets, there is nolimit to how much of the Company’s stockholders’ equity will be allocated toOther Investments.  There may be periodsin which Other Investments represent a large portion of the Company’sstockholders’ equity.

 

### **PRINCIPAL RISKS ANDSPECIAL CONSIDERATIONS**

 

***Leverage Risk****.*  The Company employs a leveraging strategy ofgenerally borrowing up to 92% of its total assets, less any assets that arefunded with committed secured borrowings, plus the market value of any relatedhedging transactions to finance the acquisition of additional mortgage related assets.  The Company’s borrowings may, from time totime, exceed 92% of its total assets. In the event borrowing costs exceed the income on its mortgage relatedassets, the Company will experience negative cash flow and incur losses.Another risk of leverage is the possibility that the value of the collateralsecuring the borrowings will decline. In such event, additional collateral or repayment of borrowings would berequired.  The Company could be requiredto sell mortgage related assets under adverse market conditions in order tomaintain liquidity.  If these sales weremade at prices lower than the carrying value of the mortgage related assets,the Company would experience losses.

 

***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 

 

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effect on the Company’soperations, because it may hold mortgage related assets with long terms tomaturity.  Rising interest rates willnegatively impact the Company’s borrowings since the value of the collateralsecuring the borrowing will decline in value, requiring additional collateralor repayments of borrowing.  This couldreduce the level of borrowings and reduce returns.  Also, when interest rates rise, the Company’s holdings ofmortgage related assets can reduce returns if the owners of the underlyingmortgages pay-off their mortgages later than anticipated.  This is known as *extension risk*.  When interest rates decline, the Company’sholdings of the mortgage related assets can reduce returns if the owners of theunderlying mortgages pay-off their mortgages sooner than anticipated since thefunds prepaid will have to be invested at the then lower prevailing rate.  This is known as *prepayment risk*.  In addition, when interest rates decline,not only can the value of mortgage related assets decline, but the yield candecline, particularly where the yield on the security is tied to interestrates, such as adjustable mortgages.

 

***Liquidity Risk****.*  There is the possibility that the Companymay lose money or be prevented from realizing capital gains if it cannot sell amortgage related asset at a time and price that is most beneficial to theCompany.  The Company is subject to liquidityrisk because it invests in mortgage securities which have experienced periodsof illiquidity.

 

***Credit Risk****.*  Credit risk is the possibility that theCompany could lose money if an issuer is unable to meet its financialobligations, such as the payment of principal and/or interest on an instrument,or goes bankrupt.  The Company mayinvest a portion of its assets in mortgage related assets which are notguaranteed by the U.S. Government or investment grade, which may make theCompany subject to substantial credit risk. This is especially true during periods of economic uncertainty or duringeconomic downturns.

 

***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 uncertainty or during economic downturns.

 

***Failure to MaintainREIT Status Risk****.*  Failure to maintain REIT status risk refers to the possibilitythat the Company may become subject to federal income tax as a regularcorporation.  The Company intends at alltimes to maintain substantially all of its investments in, and otherwiseconduct its business in a manner consistent with, the REIT Provisions of theCode.  If the Company fails to qualifyas a REIT, it would be treated as a regular corporation for federal taxpurposes.  This would result in theCompany being subject to federal income tax that would further result in asubstantial reduction of cash available for distribution to stockholders.

 

***Failure to MaintainInvestment Company Act Exemption Risk****.*  The Company intends to conduct its businessso as not to become a “regulated investment company” under the InvestmentCompany Act.  As a result, the Company’sownership of certain mortgage related assets may be limited by the InvestmentCompany Act.  This could have the effectof harming the Company’s operations and returns to stockholders.  In addition, if the Company fails to qualifyfor  the exemption from registration asan investment company, its ability to use leverage would be substantiallyreduced.  This could reduce income tothe Company and returns to stockholders.

 

***Risks Relating toExploration of Strategic Alternatives.***On March13, 2003, we announced that our Board of Directors has authorized management toconsider a full range of strategic alternatives for the Company in order tomaximize stockholder value, including, without limitation, the potential saleof the Company. We are uncertain as to what strategic alternatives may beavailable to us or what impact any particular strategic alternative will haveon our stock price if accomplished. Uncertainties and risks relating to ourexploration of strategic alternatives include:

 

•theexploration of strategic alternatives may disrupt our operations and distractmanagement, which could harm our operating results and the market price of ourcommon stock;

 

•the process of exploring strategicalternatives may be more time-consuming and expensive than we anticipate;

 

•we may not be able to identifystrategic alternatives that we believe are worth undertaking;

 

•we may notbe able to successfully execute or achieve the benefits of a strategicalternative which is approved by the Board or the independent committee thereofformed for that purpose;

 

•we mayincur significant financial advisory fees, legal and accounting fees and othergeneral and administrative expenses associated with exploring and/orimplementing various strategic alternatives, including possible termination orbreak-up fees with counter-parties; and

 

•we mayterminate our management agreement with the Manager upon the consummation ofany sale of the Company and, in such event, we will be obligated to pay theManager a termination fee which could be substantial.

 

 

#### **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 Codeprovides special tax treatment for organizations that qualify and elect to betaxed as REITs.  In brief, if certainspecific conditions imposed by the Code are met, entities that invest primarilyin real estate assets, including 

 

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Mortgage Loans, that otherwisewould be taxed as corporations are generally not taxed at the corporate levelon their taxable income that is distributed to their stockholders.  This treatment eliminates most of the“double taxation” (at the corporate level and then again at the stockholderlevel when the income is distributed) that typically results from the use ofcorporate investment vehicles.  Aqualifying REIT, however, may be subject to certain excise and other taxes, aswell as normal corporate tax, on Taxable Income that is not currentlydistributed to its stockholders.

 

The Companyhas made 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 eventthat the 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.

 

**Requirements for Qualification as a REIT**

 

To qualify fortax treatment as a REIT under the Code, the Company must meet certaintests.  The Company has adopted a policyto comply with the REIT Provisions of the Code.

 

**Termination or Revocation of REIT Status**

 

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 bemade.  Failure to qualify as a REITwould result in the Company’s reduction of its distributions to stockholders inorder to pay the resulting taxes.  If,after forfeiting REIT status, the Company later qualifies and elects to betaxed as a REIT again, the Company could face significant adverse taxconsequences.

 

**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,the Company will also be subject to a tax of 100% of net income from anyprohibited transaction under the Code and will be subject to a tax on theamount subject to the provisions of the Code by which it fails either the 75%or 95% Gross Income Tests, 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 Companymay securitize Mortgage Loans and sell such mortgage securities through aTaxable REIT Subsidiary.  However, ifthe Company itself were to sell such mortgage securities on a regular basis,there is a substantial risk that they would be deemed dealer property and thatall of the profits from such sales would be subject to tax at the 

 

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rate of 100% as income fromprohibited transactions under the Code. The Company, therefore, intends to make any such sales through a TaxableREIT Subsidiary. The taxable subsidiary will not be subject to this 100% tax onincome from prohibited transactions under the Code, which is only applicable toREITs.

 

The Companymay elect 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 Companywill also be subject to a nondeductible 4% excise tax if it fails to maketimely dividend distributions for each calendar year. The Company intends todeclare its fourth regular annual dividend during the final quarter of the yearand to make such dividend distribution no later than 31 days after the end ofthe year in order to avoid imposition of the 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 Companymay, in the future, cause the creation and sale of mortgage securities througha taxable 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 the Taxable REIT Subsidiary pays to theCompany, however, will not qualify as income from Qualified REIT Real EstateAssets for purposes of the 75% Gross Income Test, and will have to be limited,along with the Company’s other interest, dividends, gains on the sale ofsecurities, hedging income, and other income not derived from Qualified REITReal Estate Assets to less than 25% of the Company’s gross revenues in eachyear.   If the Taxable REIT Subsidiarycreates a taxable mortgage pool, such pool itself will constitute a separatetaxable subsidiary of the Taxable REIT Subsidiary.  The Taxable REIT Subsidiary would be unable to offset the income derivedfrom such a taxable mortgage pool with losses derived from any otheractivities.

 

**Taxation of Stockholders**

 

For anytaxable year in which the Company is treated as a REIT for federal incomepurposes, because the Company holds only mortgage related assets and not actualreal property in its portfolio, amounts distributed by the Company to itsstockholders out of current or accumulated earnings and profits will beincludable by the stockholders as ordinary income for federal income taxpurposes unless properly designated by the Company as capital gaindividends.  In the latter case, thedistributions will be taxable to the stockholders as long-term capital gains.

 

Distributionsof the 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 onthe sale or exchange of shares of the Common Stock held by a stockholder forsix months or less will be treated as a long-term capital loss to the extent ofany capital gain dividend received on the Common Stock held by suchstockholders during 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 Companywill notify stockholders after the close of the Company’s taxable year as tothe portions of the

distributions which constituteordinary income, return of capital and capital gain.  Dividends and distributions declared in the last quarter of anyyear payable to stockholders of record on a specified date in such month may bedeemed to have been received by the stockholders and paid by the Company onDecember 31 of the record year, provided that such dividends are paid beforeFebruary 1 of the following year.

 

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**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 stock couldbe 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 socialclubs, voluntary employee benefit associations, supplemental unemploymentbenefit trusts, and qualified group legal services plans exempt from federalincome taxation 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 Company.  Suchentities should review Code Section 512(a)(3) and should consult their own taxadvisors concerning these “set aside” and reserve requirements.

 

**State and Local Taxes**

 

The Companyand its stockholders may be subject to state or local taxation in variousjurisdictions, including those in which it or they transact business orreside.  The state and local taxtreatment of the Company and its stockholders may not conform to the federalincome tax consequences 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 Income TaxConsequences 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 United Statesor of any political subdivision thereof (unless, in the case of a partnership,the IRS provides otherwise by regulations); an estate whose income isincludable in gross income for United States income tax purposes regardless ofits 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 well asany tax consequences that may arise under the laws of any foreign, state, localor 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 yearin which the Company qualifies as a REIT, distributions to a Foreign Holderthat are attributable to gain from the sales or exchanges by the Company of“United States real property interests” will be treated as if such gain 

 

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were effectively connected witha United States business and will thus be subject to tax at the normal capitalgain rates applicable to United States stockholders (subject to applicablealternative minimum tax) under the provisions of the Foreign Investment in RealProperty Tax Act of 1980 (“FIRPTA”). Also, distributions subject to FIRPTA may be subject to a 30% branchprofits tax in the hands of a foreign corporate stockholder not entitled to atreaty exemption.  The Company isrequired to withhold 35% of any distribution that could be designated by theCompany as a capital gains dividend. This amount may be credited against the Foreign Holder’s FIRPTA taxliability.

 

*Gain on Disposition. *A Foreign Holderwill generally 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 effectively connected with theconduct of a United States Holder will be subject to the United States federalincome tax on net income that applies to United States persons generally (and,with respect to corporate holders and under certain circumstances, the branchprofits tax) but will not be subject to withholding.  Foreign Holders should consult applicable treaties, which mayprovide for different rules.

 

Gainrecognized by a Foreign Holder upon a sale of its Common Stock will generallynot be subject to tax under FIRPTA if the Company is a “domestically controlledREIT,” which is defined generally as a REIT in which at all times during aspecified testing period less than 50% in value of its shares were helddirectly or indirectly by non-U.S. persons.  Because only a minorityof the Company’s stockholders are expected to be Foreign Holders, the Companyanticipates that it will qualify as a domestically controlled REIT.Accordingly, a Foreign Holder should not be subject to U.S. tax from gainsrecognized upon disposition of the Common Stock.  However, because the Common Stock is publicly traded, noassurance can be given that the Company will be a domestically controlled REIT.

 

*Information Reporting and Backup Withholding.*United States information reporting requirements andbackup withholding tax will generally not apply to dividends paid on the CommonStock 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 reporting unless the holder certifies its ForeignHolder status under penalty of perjury or otherwise establishes anexemption.  Information reportingrequirements (but not backup withholding) will also apply to payments of theproceeds of sales of the Common Stock by foreign offices of United Statesbrokers, or foreign brokers with certain types of relationships to the UnitedStates, unless the broker has documentary evidence in its records that theholder is a Foreign Holder and certain other conditions are met, or the holderotherwise establishes an exemption.

 

Backupwithholding is not an additional tax. Any amounts withheld under the backup withholding rules will be refundedor credited against the Foreign Holder’s United States federal income taxliability, provided that the required information is furnished to the IRS.

 

**ERISA CONSIDERATIONS**

 

In consideringan investment in the Common Stock, a fiduciary of a profit-sharing, pensionstock bonus 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 tothe “plan assets” issue noted in clause (c) above, O’Melveny & Myers LLP,the Company’s counsel, at the time of the Company’s public offering was of theopinion that the Common Stock should qualify as a “publicly offered security,”and, therefore, the acquisition of such Common Stock by ERISA Plans should notcause the Company’s assets to be treated as assets of such investing ERISAPlans for purposes of the fiduciary responsibility provisions of ERISA or theprohibited transaction provisions of the Code. Fiduciaries of ERISA Plans and IRAs should 

 

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consult with and rely upontheir 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.

 

**EMPLOYEES**

 

As of December31, 2002, the Company had no employees. The Manager manages the day-to-day operations of the Company, subject tothe direction and oversight of the Company’s Board of Directors and under theterms of a Management Agreement discussed below.

 

### **THE MANAGEMENT AGREEMENT**

 

The Companyhas renewed its Management Agreement with the Manager for a one year termending on December 31, 2003.  TheManager is primarily involved in two activities: (i) asset/liabilitymanagement—acquisition, financing, hedging, management and disposition ofmortgage related assets, including credit and prepayment risk management; and(ii) capital management—oversight of the Company’s structuring, analysis,capital raising and investor relations activities.  In conducting these activities, the Manager formulates operatingstrategies for the Company, arranges for the acquisition of mortgage relatedassets by the Company, arranges for various types of financing for the Company,monitors the performance 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 andcharacteristics, credit quality, performance and compliance with the policiesapproved by the Company’s Board of Directors.

 

At all times,the Manager is subject to the direction and oversight of the Company’s Board ofDirectors and has only such functions and authority as the Company delegates toit.  The Manager is responsible for theday-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 fairmarket value of the Management Agreement will be affected by significantvariables, including (i) the historical management fees paid to the Manager,(ii) any projections of future management fees to be paid to the Managerdetermined by the independent appraiser, (iii) the relative valuations ofagreements similar to the Management Agreement and (iv) other factors, all ofwhich may be unrelated to the performance of the Manager.

 

16

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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 Managerwill receive annual base management compensation based on the Average NetInvested Capital of the Company, payable monthly in arrears, equal to 3/4 of 1%of Average Net Invested Capital.  The term “Average Net Invested Capital” means themonth end sum of (1) the Company’s total stockholders’ equity computed inaccordance with accounting principles generally accepted in the United Statesof America, plus (2) any unsecured debt that has been approved for inclusion bythe unaffiliated directors at issuance, plus or minus (3) an adjustment toexclude the impact of any unrealized gains, losses or other items that do notaffect realized net income. Accordingly, incurring collateralized debt to finance specificinvestment purchases does not ordinarily increase Average Net Invested Capital.

 

The Managershall also be entitled to receive as incentive compensation for each fiscalquarter, an amount equal to 30% of the Net Income of the Company, beforeincentive compensation, in excess of the amount that would produce anannualized Return on Equity equal to the Ten-Year U.S. Treasury Rate plus1%.  The incentive compensationcalculation and payment will be made quarterly in arrears.  The term “Return on Equity” is calculatedfor any quarter by dividing the Company’s Net Income for the quarter by itsAverage Net Worth for the quarter.  Forpurposes of calculating the incentive compensation payable, the definition“Return on Equity” is not related to the actual distributions received bystockholders or to an individual investor’s actual return on investment.  For such calculations, the “Net Income” ofthe Company means the taxable income of the Company (including net capitalgains, if any) before the Manager’s incentive compensation, net operating lossdeductions arising from losses in prior periods and deductions permitted by theCode in calculating taxable income for a REIT plus the effects of adjustments,if any, necessary to record hedging and interest transactions in accordancewith accounting principles generally accepted in the United States ofAmerica.  A deduction for all of theCompany’s interest expenses for borrowed funds is taken into account incalculating Net Income. “Average Net Worth” for any period means the arithmeticaverage of the sum of the gross proceeds from any offering of its equitysecurities by the Company, before deducting any underwriting discounts andcommissions and other expenses and costs relating to the offerings, plus theCompany’s retained earnings (without taking into account any losses incurred inprior periods) computed by taking the average of such values at the end of eachmonth during such period, minus the cumulative amounts paid by the Company torepurchase its shares.

 

The ability ofthe Company 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 quarterly incentivecompensation within 45 days after the end of each fiscal quarter, and theCompany 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.  Quarterly incentivecompensation is subject to an annual adjustment so that the incentivecompensation is based on earnings for the entire year. The Company believesthat this compensation arrangement benefits its stockholders because it tiesthe Manager’s compensation to Return on Equity and, in periods of low earnings,the Manager’s incentive compensation is reduced or eliminated, thereby loweringthe 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 

 

17

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unaffiliated directors, thecosts of making distributions and printing and mailing proxies and reports tostockholders, costs incurred by employees of the Manager for travel on behalfof the Company, costs incident to the issuance of mortgage securities, costsincident to the accumulation and servicing of Mortgage Loans, costs associatedwith any computer software or hardware that is used solely for the Company,costs to obtain liability insurance to indemnify the Manager, the Company’sdirectors and officers, and the Company’s underwriters, the compensations andexpenses of the Company’s custodian, transfer agent and registrar, and anyextraordinary or non-recurring costs or charges incurred by the Company, ifany.  Certain Company operatingexpenses  shall be limited to an amountper year equal to the greater of 2% of the Average Net Invested Capital of theCompany or 25% of its Net Income for that year.  The operating expenses that are subject to this limitation are:

 

(i)                                     all insurance 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;

 

(ii)                                  expensesconnected with payments of dividends or interest or distributions in any otherform made or caused to be made by the Board of Directors to holders of thesecurities of the Company or any subsidiary of the Company;

 

(iii)                               allexpenses of third parties pertaining to communications to holders of equitysecurities or debt securities of the Company or any subsidiary of the Companyand the other bookkeeping and clerical work necessary to maintain relationswith holders of such securities and in complying with the continuous reportingand other requirements of governmental bodies or agencies (these expensesinclude any costs of computer services utilized in connection with thesecommunications and reporting requirements, the cost of printing and mailingcertificates for such securities and proxy solicitation materials and reportsto holders of the Company’s or any subsidiary’s securities and reports to thirdparties required under any indenture to which the Company or any subsidiary ofthe Company is a party);

 

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

 

(v)                                 compensation,fees and expenses paid to unaffiliated directors of the Company or anysubsidiary of the Company, the cost of director and officer liability insuranceand premiums for fidelity and errors and omissions insurance;

 

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

 

(vii)                           expensesrelating to any office or office facilities maintained by the Company or anysubsidiary of the Company, exclusive of the office of the Manager;

 

(viii)                        traveland related 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 withaccounting principles generally accepted in the United States of America,exclusive of certain specifically excluded expenses as described below.

 

Expensesexcluded from the expense limitation and wholly payable by the Company are (butare not limited to) those incurred in connection with the accumulation andservicing of Mortgage Loans, the issuance and administration of mortgagesecurities from pools of Mortgage Loans, the raising of capital, theacquisition of mortgage related assets, interest and hedging expenses, taxesand license fees, non-cash costs, litigation, investigations in connection withlitigation or threatened litigation, base and incentive management compensationand extraordinary and non-recurring expenses. The determination of Net Income for purposes of calculating the expenselimitation will be the same as for calculating the Manager’s incentivecompensation except that it will include any incentive compensation payable forsuch period.

 

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Expenses inexcess of 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 of Interest**

 

In addition toits base management compensation under the Management Agreement, the Managerhas the opportunity to earn incentive compensation for each fiscal quarter,subject to an annual reconciliation so that the incentive compensation is basedon earnings 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 an 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 taxable income at theexpense of other criteria, such as preservation of capital, in order to achievea higher incentive fee could result in increased risk to the value of theCompany’s mortgage related asset portfolio.

 

The Company,on the 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 Managerand its 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 horizons,availability of cash and the amount of existing holdings.

 

**Limits of Responsibility**

 

Pursuant tothe Management Agreement, the Manager does not assume any responsibility otherthan to undertake the services called for thereunder and is not responsible forany action of the Company’s Board of Directors in following or declining tofollow its advice or recommendations. The Manager, its directors and its officers will not be liable to theCompany, any issuer of mortgage securities, any subsidiary of the Company, theunaffiliated directors, the Company’s stockholders or any subsidiary’sstockholders for acts performed in accordance with and pursuant to theManagement Agreement, except by reason of acts constituting bad faith, willfulmisconduct, gross negligence or reckless disregard of their duties under theManagement Agreement.

 

The Companyhas agreed to indemnify the Manager, its directors and its officers withrespect to all expenses, losses, damages, liabilities, demands, charges andclaims arising from any acts or omissions of the Manager made in good faith inthe performance of its duties under the Management Agreement.  The Management Agreement does not limit orrestrict the right of the Manager or any of its officers, directors, employeesor Affiliates from engaging in any business or rendering services of any kindto any other person, including the purchase of, or rendering advice to otherspurchasing mortgage related assets that meet the Company’s policies andcriteria.  The Manager may also adviseor manage other mortgage related entities subject to certain limitations,including REITs, that invest in residential and commercial mortgages and otherresidential and non-residential mortgage securities.  The ability of the Manager and its officers and employees toengage in other business activities could reduce the time and effort spent onthe Company.  The Management Agreementdoes not specify a minimum amount of time or attention that the Manager or itsofficers or employees must devote to the Company’s business.

 

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# **ITEM 2.**                             PROPERTIES

 

The Companydoes not own or lease any real property. The Company’s principal executive offices are located at 865 SouthFigueroa Street, Suite 1800, Los Angeles, California 90017, telephone (213)244-0000. Such offices are provided by the Manager in accordance with theManagement Agreement.

 

# **ITEM 3.**                             LEGAL PROCEEDINGS

 

There are nolegal proceedings pending against the Company.

 

# **ITEM 4.**                             SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS

 

At the 2002Annual Meeting of Shareholders held June 20, 2002, shareholders of record as ofApril 30, 2002 were asked to vote to ratify the selection of Deloitte &Touche LLP as the Company’s independent auditors. 23,400,987 shares were votedfor the proposal, 137,909 shares were voted against the proposal, no shareswere withheld, 40,226 shares abstained and no votes were broker non-votes. Inaddition, the above-described shareholders were asked to vote on the threeClass I Directors of the Company’s Board of Directors to hold office until theAnnual Meeting of Shareholders in 2005. 23,444,397 shares were voted for JohnC. Argue and 134,725 shares were voted against or were withheld. 23,455,506shares were voted for Carl C. Gregory III and 123,616 shares were voted againstor were withheld. 22,985,739 shares were voted for Jeffrey E. Gundlach and 593,383shares were voted against or were withheld.

 

**PART II**

 

# **ITEM 5.**                             MARKET FOR REGISTRANT’SCOMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

**Equity Market Activity**

 

Commencing onDecember 4, 1997, the Company’s Common Stock began trading on the New York StockExchange. Effective February 8, 2001, the Company ceased trading on the NewYork Stock Exchange and commenced trading its Common Stock on the AmericanStock Exchange under the trading symbol “AXM.” As of December 31, 2002, theCompany had 29,857,000 shares of Common Stock issued and outstanding.  As of March 18, 2003, the approximate numberof record holders of our Common Stock was 167.

 

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.

 
|                                   |   | ****    |       | **Cash  Dividends  Declared  Per Share** |   |
|----------------------------------------|--------|---------|------------|------------------------------------------|--------|
| **Stock  Price**                       |
| **High**                               |   | **Low** | ** ** | **Close**                                |
| 2002                                   |   |    |       |                                     |   |   |   |   |   |
|                                   |   |    |       |                                     |   |   |   |   |   |
| Fourth Quarter ended December 31, 2002 |   | $       | 10.91      |                                     | $      | 5.44 |   | $ | 6.54 |   | $ | 0.45 |   |
| Third Quarter ended September 30, 2002 |   | $       | 13.94      |                                     | $      | 10.12 |   | $ | 11.19 |   | $ | 0.50 |   |
| Second Quarter ended June 30, 2002     |   | $       | 16.00      |                                     | $      | 11.55 |   | $ | 14.99 |   | $ | 0.50 |   |
| First Quarter ended March 31, 2002     |   | $       | 12.03      |                                     | $      | 10.50 |   | $ | 11.59 |   | $ | 0.50 |   |
|                                   |   |    |       |                                     |   |   |   |   |   |
| 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 |   |

 

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On March 13,2003, the Company’s Board of Directors declared a dividend distribution of$0.25 per share.  The dividend is payable on April 30, 2003 toshareholders of record on March 28, 2003.

 

The Companyintends to pay quarterly dividends and to make distributions to itsstockholders of all or substantially all of its taxable income each year(subject to certain adjustments) so as to qualify for the tax benefits accordedto a REIT under the Code.  Alldistributions will be made by the Company at the discretion of the Board ofDirectors and will depend on the taxable earnings of the Company, financialcondition of the Company, maintenance of REIT status and such other factors asthe Board of Directors may deem relevant from time to time.

 

### **Share Repurchase 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 up to an additional 750,000 shares of the Company’sCommon Stock having completed the original repurchase program of 750,000shares.

 

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, 2002, 2001 and 2000.

 

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

 

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# **ITEM 6.**                             SELECTED FINANCIAL DATA

 

The followingselected financial data are derived from audited financial statements for theyears ended December 31, 2002, 2001, 2000, 1999, 1998. The selected financialdata should be read in conjunction with the more detailed information containedin the financial statements and notes thereto and “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” included elsewherein this report.

 
|                                                                                            |   | **Year Ended December 31,** |        |
|-------------------------------------------------------------------------------------------------|--------|-----------------------------|-------------|
|                                                                                            |   | **2002**                    |        | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
| **Statement of Operations Data:**                                                               |   |                        |        |   |   |   |   |   |   |   |   |
| Days in year                                                                                    |   | 365                         |        | 365 |   | 366 |   | 365 |   | 365 |   |
|                                                                                            |   |                        |        |   |   |   |   |   |   |   |   |
| Interest income                                                                                 |   | $                           | 163,545,000 |   | $ | 48,891,000 |   | $ | 42,834,000 |   | $ | 52,517,000 |   | $ | 41,975,000 |   |
| Interest expense                                                                                |   | $                           | 89,251,000  |   | $ | 23,723,000 |   | $ | 33,779,000 |   | $ | 42,345,000 |   | $ | 36,007,000 |   |
| Net interest income                                                                             |   | $                           | 74,294,000  |   | $ | 25,168,000 |   | $ | 9,055,000 |   | $ | 10,172,000 |   | $ | 5,968,000 |   |
| Net (loss) gain from investment  and derivative activity                                        |   | $                           | (16,388,000 | ) | $ | (5,015,000 | ) | $ | (36,703,000 | ) | $ | 1,938,000 |   | $ | 1,047,000 |   |
| General and administrative  expenses                                                            |   | $                           | 5,510,000   |   | $ | 1,823,000 |   | $ | 1,734,000 |   | $ | 3,385,000 |   | $ | 2,104,000 |   |
| Net income (loss) before  cumulative effect of change in accounting principle                   |   | $                           | 52,838,000  |   | $ | 20,887,000 |   | $ | (28,243,000 | ) | $ | 11,112,000 |   | $ | 5,547,000 |   |
| Cumulative effect of change in  accounting principle (See Note 1 below)                         |   | —                      |        | $ | (2,173,000 | ) | — |   | — |   | — |   |
| Net income (loss)                                                                               |   | $                           | 52,838,000  |   | $ | 18,714,000 |   | $ | (28,243,000 | ) | $ | 11,112,000 |   | $ | 5,547,000 |   |
| Average number of shares  outstanding                                                           |   | 26,206,000                  |        | 7,235,000 |   | 5,753,000 |   | 5,753,000 |   | 6,190,000 |   |
| Basic net income (loss) per  share before cumulative effect of change in accounting principle   |   | $                           | 2.02        |   | $ | 2.89 |   | $ | (4.91 | ) | $ | 1.93 |   | $ | 0.90 |   |
| Diluted net income (loss) per  share before cumulative effect of change in accounting principle |   | $                           | 2.01        |   | $ | 2.85 |   | $ | (4.91 | ) | $ | 1.92 |   | $ | 0.90 |   |
| Basic net income (loss) per  share                                                              |   | $                           | 2.02        |   | $ | 2.59 |   | $ | (4.91 | ) | $ | 1.93 |   | $ | 0.90 |   |
| Diluted net income (loss) per  share                                                            |   | $                           | 2.01        |   | $ | 2.55 |   | $ | (4.91 | ) | $ | 1.92 |   | $ | 0.90 |   |
| Dividends declared per share                                                                    |   | $                           | 1.95        |   | $ | 1.95 |   | $ | 1.51 |   | $ | 1.72 |   | $ | 1.07 |   |

 
|                                                                           |   | **At December 31,** | ** **    |
|--------------------------------------------------------------------------------|--------|---------------------|---------------|
|                                                                           |   | **2002**            |          | **2001** |   | **2000** |   | **1999** |   | **1998** | ** ** |
| **Balance Sheet Data:**                                                        |   |                |          |   |   |   |   |   |   |   |   |
| Fixed income securities                                                        |   | $                   | 2,424,907,000 |   | $ | 1,505,529,000 |   | $ | 600,131,000 |   | $ | 701,143,000 |   | $ | 829,713,000 |   |
| Equity securities                                                              |   | $                   | 4,168,000     |   | $ | 6,028,000 |   | $ | 9,068,000 |   | $ | 17,481,000 |   | $ | 16,422,000 |   |
| Total assets                                                                   |   | $                   | 2,445,378,000 |   | $ | 1,535,425,000 |   | $ | 614,073,000 |   | $ | 735,745,000 |   | $ | 865,478,000 |   |
| Reverse repurchase agreements                                                  |   | $                   | 2,112,444,000 |   | $ | 1,376,850,000 |   | $ | 545,434,000 |   | $ | 672,660,000 |   | $ | 767,908,000 |   |
| Total liabilities                                                              |   | $                   | 2,250,719,000 |   | $ | 1,405,395,000 |   | $ | 569,690,000 |   | $ | 679,704,000 |   | $ | 777,448,000 |   |
| Stockholders’ equity                                                      |   | $                   | 194,659,000   |   | $ | 130,030,000 |   | $ | 44,383,000 |   | $ | 56,041,000 |   | $ | 88,030,000 |   |
| Book value per share                                                           |   | $                   | 6.52          |   | $ | 8.36 |   | $ | 7.71 |   | $ | 9.74 |   | $ | 15.30 |   |
| Fair value of off balance sheet  hedging instruments  (pre SFAS No.  133) |   | —              |          | — |   | — |   | $ | 3,815,000 |   | $ | (9,994,000 | ) |

 

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Note (1)          The Company adopted SFAS No. 133*, Accounting for Derivative Instruments and HedgingActivities*, as amended, on January 1, 2001. Adoption of SFAS No. 133resulted 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, 

 

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to increase accumulated othercomprehensive income and to decrease current earnings. The net transitionadjustment arose because forward contracts previously used to manage the effectsof interest rate changes on fair values of fixed income available-for-salesecurities and accounted for as hedges did not qualify for hedge accountingtreatment 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 forwardcontracts. Prior to adopting SFAS No. 133, the Company accounted for changes infair values of the forward contracts through adjustments to accumulated othercomprehensive income (loss). Following adoption of SFAS No. 133, the Companyrecognizes changes in fair values of forward contracts as a component of netgain (loss) on investment and derivative activities in the statement ofoperations.

 

# **ITEM 7.**                             MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

*The followingdiscussion of our financial condition and results of operations should be readin conjunction with the financial statements and the notes to those statementsincluded elsewhere in this Annual Report on Form 10-K.*

 

#### **GENERAL**

 

The Companyuses its equity capital and borrowed funds to seek to generate income based onthe difference between the yield on its mortgage related assets and the cost ofits borrowings.  The Company has electedto be taxed as a real estate investment trust (“REIT”) under the InternalRevenue Code of 1986, as amended (the “Code”). The Company will not generallybe subject to federal taxes on its income to the extent that it distributes itsnet taxable income to its stockholders and maintains its qualification as aREIT.

 

**FINANCIAL CONDITION**

 

# **FixedIncome Securities**

 

At December31, 2002 and 2001, the Company held $2,424,907,000 and $1,505,529,000 of fixedincome securities, respectively. The increase in fixed income securities heldat December 31, 2002 was primarily the result of two completed follow-on equityofferings during 2002. With the net proceeds from those offerings and the useof leverage, the Company increased its investments in fixed income securities.The original maturity of a significant portion of the fixed income securitiesranges from fifteen to thirty years; the actual maturity is subject to changebased on the prepayments of the underlying mortgage loans.

 

The followingtable is a schedule of fixed income securities held and listed by security type(dollars in thousands):

 
|                          |   | **December 31, 2002** |      | **December 31, 2001**     |   |
|-------------------------------|--------|-----------------------|-----------|---------------------------|--------|
| **Fixed Income Securities**   |   | **Carrying  Value**   |      | **Percent of  Portfolio** |   | **Carrying  Value** |   | **Percent of  Portfolio** | ** ** |
|                          |   |                  |      |                      |   |   |   |   |   |
| Mortgage Securities:          |   |                  |      |                      |   |   |   |   |   |
| Adjustable Rate(1)            |   | $                     | 9,173     |                      | 0.38   | % | $ | 16,196 |   | 1.08 | % |
| Fixed Rate                    |   | 2,415,484             |      | 99.61                     | %      | 1,483,881 |   | 98.56 | % |
| Other Fixed Income Securities |   | 250                   |      | 0.01                      | %      | 5,452 |   | 0.36 | % |
| Totals                        |   | $                     | 2,424,907 |                      | 100.00 | % | $ | 1,505,529 |   | 100.00 | % |

 

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(1)          AtDecember 31, 2002, the interest rate indices for 99% and 1% of the adjustablerate mortgage securities were based on the one-year U.S. Treasury rate and thesix-month London Inter-Bank Offered Rate, respectively.

 

At December31, 2001, the interest rate indices for 98% and 2% of the adjustable ratemortgage securities were based on the one-year U.S. Treasury rate and thesix-month London Inter-Bank Offered Rate, respectively.

 

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The followingtable shows various weighted average characteristics of the fixed incomesecurities held by the Company at December 31, 2002 (dollars in thousands):

 
| **Security Type**             |   | **Par Amount** |      | **Par as a  Percent of  Category** |   | **Adjusted  Cost Basis** |   | **Market  Price** |   | **Current  Coupon** |   | **Weighted  Average  Life(1)** |   |
|-------------------------------|--------|----------------|-----------|------------------------------------|--------|--------------------------|--------|-------------------|--------|---------------------|--------|--------------------------------|--------|
|                          |   |           |      |                               |   |                     |   |              |   |                |   |                           |   |
| 30 Year Agency Pass-throughs  |   | $              | 2,327,391 |                               | 98.98  | %                        | 101.54 | %                 | 103.24 | %                   | 6.07   | %                              | 2.7    |   |
| AAA CMOs                      |   | 12,409         |      | 0.53                               | %      | 97.54                    | %      | 101.91            | %      | 7.10                | %      | 1.0                            |   |
| Total Fixed Rate Holdings     |   | 2,339,800      |      | 99.51                              | %      | 101.52                   | %      | 103.23            | %      | 6.08                | %      | 2.7                            |   |
|                          |   |           |      |                               |   |                     |   |              |   |                |   |                           |   |
| Other Fixed Income Securities |   | 2,500          |      | 0.11                               | %      | 16.04                    | %      | 10.00             | %      | 18.28               | %      | 0.3                            |   |
| Adjustable Rate Holdings      |   | 8,965          |      | 0.38                               | %      | 97.42                    | %      | 102.32            | %      | 5.12                | %      | 1.0                            |   |
|                          |   |           |      |                               |   |                     |   |              |   |                |   |                           |   |
| Category Total                |   | $              | 2,351,265 |                               | 100.00 | %                        | 101.41 | %                 | 103.13 | %                   | 6.09   | %                              | 2.7    |   |

 

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** |      | **Par as a  Percent of  Category** |   | **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                            |   |
|                          |   |           |      |                               |   |                     |   |              |   |                |   |                           |   |
| Category Total                |   | $              | 1,503,639 |                               | 100.00 | %                        | 100.12 | %                 | 100.13 | %                   | 6.56   | %                              | 6.1    |   |

 

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(1)          The weighted averagelife of the fixed rate mortgage securities is based upon market prepaymentexpectations as of the dates shown.  Theactual weighted average life could be longer or shorter depending on the actualprepayment rates experienced over the life of the securities and is sensitiveto changes in both prepayment rates and interest rates. The weighted averagelife shown for the adjustable rate mortgage assets represents the average timeuntil the next coupon reset date.  Allaverages are shown in years.

 

### **Equity Securities**

 

At December31, 2002 and 2001, the Company held $4,168,000 and $6,028,000 of equitysecurities, respectively. The decrease in the value of equity securities atDecember 31, 2002 was primarily due to the sale of a portion of convertiblepreferred stock in Capstead Mortgage Corporation during 2002. Equity securitiesconsist primarily of investment in equities issued by other real estateinvestment trusts.

 

24

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At December 31, 2002, equitysecurities consisted of the following:

 
| **(In thousands)**                       |   | **Shares Held** |   | **Adjusted Cost** |   | **Fair Value** |   |
|------------------------------------------|--------|-----------------|--------|-------------------|--------|----------------|--------|
|                                     |   |            |   |              |   |           |   |
| Common Stock:                            |   |            |   |              |   |           |   |
|                                     |   |            |   |              |   |           |   |
| Dynex Capital, Inc.                      |   | 75              |   | $                 | 122    |           | $      | 363 |   |
| Total Common Stock                       |   |            |   | 122               |   | 363            |   |
|                                     |   |            |   |              |   |           |   |
| Convertible Preferred Stock:             |   |            |   |              |   |           |   |
|                                     |   |            |   |              |   |           |   |
| Capstead Mortgage Corporation,  Series B |   | 321             |   | 2,722             |   | 3,805          |   |
| Total Convertible Preferred  Stock       |   |            |   | 2,722             |   | 3,805          |   |
|                                     |   |            |   |              |   |           |   |
| Total Equity Securities                  |   |            |   | $                 | 2,844  |           | $      | 4,168 |   |

 

At December 31, 2001, equitysecurities consisted of the following:

 
| **(In thousands)**                       |   | **Shares Held** |   | **Adjusted Cost** |   | **Fair Value** |   |
|------------------------------------------|--------|-----------------|--------|-------------------|--------|----------------|--------|
|                                     |   |            |   |              |   |           |   |
| 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 |   |

 

**Other Assets**

 

The Companyhad other assets of $14,847,000 and $14,918,000 at December 31, 2002 and 2001,respectively. The decrease in other assets was primarily due to a decrease inreceivable for unsettled securities offset by an increase in interestreceivable as a result of increased investments in fixed income securities during2002. Other assets also consist of principal payments receivable, deferredinsurance expense, deferred shareholder rights expense and other prepaidexpenses.

 

# **Stockholders’Equity**

 

The Company had stockholders’ equity of $194,659,000 and $130,030,000 atDecember 31, 2002 and 2001, respectively. The increase in stockholders’ equityat December 31, 2002 was primarily the result of the completion of twofollow-on public equity offerings with total proceeds (net of underwritingdiscounts, commissions and other expenses) of $155,601,000 during 2002. Theincrease was partially offset by an increase in accumulated other comprehensiveloss of $88,043,000 and accumulated deficit of $3,169,000 for the year endedDecember 31, 2002. The increase in accumulated other comprehensive lossincluded an increase in unrealized gains on available-for-sale securities, anincrease in unrealized losses on interest rate swaps, and an increase indeferred loss on terminated interest rate swaps. The increase in accumulateddeficit included net income less dividends declared for the year ended December31, 2002.

 

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**Hedging Instruments**

 

There can beno assurance 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.

 

Hedginginvolves risk 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 Company’s stockholders given the cost of suchhedging transactions and the Company’s desire to maintain its status as aREIT.  The Company’s policies do notcontain specific requirements as to the percentages or amount of interest raterisk that the Manager is required to hedge.

 

The Companyutilizes interest rate swap agreements as a tool to manage interest rate risk.Under the swap agreements, the Company receives a floating rate and pays afixed rate. The notional amount of each agreement is matched against a likeamount of current and anticipated borrowings under reverse repurchaseagreements to mitigate the potential effect on cash flows and net interestincome of rising interest rates by effectively fixing the rate paid on thematched borrowings over the life of the contract. In the absence of suchfinancial instruments, interest expense on reverse repurchase agreements andsimilar short-term borrowings, which mature and reprice frequently, canincrease faster than the Company can adjust its interest-earning assets andincrease interest income, because the Company’s mortgage related securitiesgenerally have much longer maturities and have fixed rates of interest.

 

The interestrate swap agreements entered into by the Company are classified as cash flowhedges for accounting purposes and meet the requirements of SFAS No. 133 forsuch classification.  Therefore, changesin the fair value of the agreements are reported in accumulated othercomprehensive income, a component of stockholders’ equity, and do not affectnet income in the period of the change. Periodic exchanges of cash flows with the counterparties to theagreements are recorded as adjustments to interest expense.  If the Company were to terminate the swapagreements prior to their contractual termination dates, or change current oranticipated borrowings so that they were no longer appropriately matched to theswap agreements, the agreements might not qualify for hedge accountingtreatment.  In that case, changes intheir fair values would affect net income.

 

Borrowingshedged by interest rate swaps are used primarily to acquire and hold fixedincome securities available-for-sale. Changes in the fair values of securities available-for-sale are alsoreported in accumulated other comprehensive income, a component ofstockholders’ equity.  Changes in fairvalues of the securities only affect periodic earnings when they are sold or ifthey have an other-than-temporary impairment.  Therefore, earnings volatility is reduced by the use of the swapagreements as cash flow hedges and the acquisition of available-for-salesecurities with the borrowings hedged by the agreements.  Impairment of the available-for-salesecurities or decisions to sell the securities prior to their expectedmaturities could result in unanticipated earnings volatility.

 

During thefourth quarter of 2002, the Company terminated a portion of the outstandinginterest rate swap agreements with a combined notional amount of $544,500,000,which resulted in a deferred loss of approximately $13,872,000 with an averageterm of 1.3 years and an average rate of 3.57%. As a result of decliningreverse repurchase agreement balances, the Company accelerated the deferredloss recognition and reclassified $2,593,000 from accumulated othercomprehensive income (loss) to net loss from investment and derivativeactivities for the year ended December 31, 2002. The acceleration of thedeferred loss recognition depends on the balance of reverse repurchaseagreements maintained by the Company. If the general level of reverse repurchase agreements were to declinefurther, the Company may be required to accelerate the deferred lossrecognition in the future. The remaining deferred loss is being amortized as anadjustment to interest expense over the remaining lives of the original swapagreements.

 

26

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At December31, 2002, the Company had entered into interest rate swap agreements summarizedbelow:

 

(Dollars in thousands)

 
| **Current  Notional Amount** |      | **Average  Fixed Rate** |   | **Floating  Rate** |          | **Par  Weighted  Average Maturity** |      | **Unrealized  Losses** |   |
|------------------------------|-----------|-------------------------|--------|--------------------|---------------|-------------------------------------|-----------|------------------------|--------|
|                         |      |                    |   |               |          |                                |      |                   |   |
| $                            | 1,678,500 |                    | 4.643  | %                  | 1 Month LIBOR |                                | 4.4 years |                   | $      | 120,098 |   |
|                              |           |                         |        |                    |               |                                     |           |                        |        |  |  |

 

At December31, 2001, the Company had entered into interest rate swap agreements summarizedbelow:

 

(Dollars inthousands)

 
| **Current****Notional Amount** |    | **Average  Fixed Rate** |   | **Floating Rate** |          | **Par Weighted  Average Maturity** |      | **Unrealized  Gains** |   |
|--------------------------------|---------|-------------------------|--------|-------------------|---------------|------------------------------------|-----------|-----------------------|--------|
|                           |    |                    |   |              |          |                               |      |                  |   |
| $                              | 850,000 |                    | 4.239  | %                 | 1 Month LIBOR |                               | 6.6 years |                  | $      | 4,620 |   |
|                                |         |                         |        |                   |               |                                    |           |                       |        |  |  |

 

At varioustimes the Company has used forward contracts to sell U.S. Treasury securitiesas a means to mitigate the effect of rising interest rates on the fair value ofits mortgage related securities.   Thefair values of these forward contracts generally move in the opposite directionof the fair values of the mortgage related securities, and approximately in thesame proportion when the maturities and other terms are appropriatelymatched.   When interest rates rise, thefair value of the mortgage related securities declines, but the increasing fairvalues of the forward contracts help to preserve net asset value relative tothe changing fair value of the short-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, therefore,there can be volatility in periodic earnings to the extent they are noteffective.

 

At December31, 2002, the Company had no open forward contracts to sell U.S. Treasurynotes.

 

At December31, 2001, the Company had open forward contracts to sell U.S. Treasury noteswith the terms summarized below:

 

(Dollars inthousands)

 
| **Current****Notional Amount** |    | **AverageContract  Price** |    | **Fair Value of  Contracts** |   | **Average  Termination  Date** |   | **Unrealized  Losses** |   |
|--------------------------------|---------|----------------------------|---------|------------------------------|--------|--------------------------------|--------|------------------------|--------|
|                           |    |                       |    |                         |   |                           |   |                   |   |
| $                              | 359,000 |                       | 100.825 |                         | $      | 365,235                        |   | 1/14/2002              |   | $ | 3,275 |   |
|                                |         |                            |         |                              |        |                                |        |                        |        |  |  |  |

 

The contractswere entered into to mitigate the negative impact of rising interest rates oncertain fixed income securities that generally have a market weighted averageduration approximately equal to the contracts shown above. It should be notedthat average duration volatility of the mortgage related securities can be morevolatile than that of the contracts which could result in losses if interestrate volatility is high.

 

27

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# **Liabilities**

 

The Companyhas entered into reverse repurchase agreements to finance certain of itsmortgage-backed securities.  Theseagreements are secured by a portion of the Company’s mortgage-backed securitiesand bear interest rates that have historically moved in close relationship toLIBOR.

 

At December31, 2002, the Company had outstanding $2,112,444,000 of reverse repurchaseagreements with a weighted average current borrowing rate of 1.40% and amaturity of one month. The reverse repurchase agreements were collateralized bymortgage-backed securities with an estimated fair value of $2,199,852,000.

 

At December31, 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 one month.  The reverserepurchase agreements were collateralized by mortgage-backed securities with anestimated fair value of $1,440,014,000.

 

The increasein outstanding reverse repurchase agreements at December 31, 2002 was theresult of the Company’s follow-on equity offerings completed during 2002. TheCompany utilized the net proceeds of these follow-on equity offerings toincrease leverage. Such leverage was being used to take advantage of marketopportunities and to invest the portfolio as fully as possible in anticipationof any future acceleration in prepayment rates, which would reduce leverageover time.

 

The Companyhad interest rate swaps with an unrealized loss of $120,098,000 and anunrealized gain of $4,620,000 at December 31, 2002 and 2001, respectively. Thedecrease in value of interest rate swaps was due to an increase in the notionalamount from $850,000,000 to $1,678,500,000 during 2002, combined with adecrease in the one-month LIBOR rate. Under the swap agreements, the Companyreceives a floating rate and pays a fixed rate.

 

The Companyhad $18,177,000 and $28,545,000 of other liabilities at December 31, 2002 and2001, respectively. The decrease in other liabilities at December 31, 2002 wasprimarily due to a decrease of $9,475,000 in accrued expenses and otherliabilities during 2002. Other liabilities also consist of accrued interestpayable and dividend payable at December 31, 2002. The Company anticipatessettling all other liabilities within one year.

 

**RESULTS OF OPERATIONS**

** **

**YearEnded December 31, 2002 Compared To Year Ended December 31, 2001**

 

##### *Overview*

 

For the yearended December 31, 2002, the Company’s net income was $52,838,000, or $2.02 percommon share on a basic basis and $2.01 on a diluted basis, based on a weightedaverage of 26,206,000 and 26,300,000 shares outstanding, respectively. Thatcompares to net income of $18,714,000, or $2.59 per common share on a basicbasis and $2.55 on a diluted basis, based on a weighted average of 7,235,000and 7,325,000 shares outstanding, respectively, for the year ended December 31,2001. The weighted average number of shares used to calculate net income per dilutedshare includes the effect of the assumed exercise of outstanding stock options.

 

The primaryreasons for the substantial change in operating results for 2002 compared to2001 are:  (1) changes in interest ratesand market conditions affecting the fair values of the Company’s MortgageRelated Securities and related derivative financial instruments and netinterest income, (2) related changes in investment and hedging strategies, and(3) substantial increases in the Company’s equity capital, borrowings andMortgage Related Securities in the first and second quarter’s of 2002.

 

The FederalReserve Board reduced short-term rates one time, dropping the Fed funds targetfrom 1.75% to 1.25%, during the calendar year ended December 31, 2002. Yieldson three and six month Treasury securities fell from 1.71% and 1.79% to 1.19%and 1.20%, respectively. However, the yield on the 10-year Treasury fell 1.24%from 5.05% to 3.81%, thus flattening the yield curve. The one-month LIBOR ratefell from 1.87% to 1.38% by year-end. The reduction in short term rates loweredthe Company’s average borrowing cost for the year ended December 31, 2002 to3.50%, down 13 basis points from the year ended December 31, 2001 during whichthe average borrowing rate was 3.63%. Although borrowing rates fell during theyear, the flattening yield curve decreased the Company’s net profit margin to2.62% for the year compared to a net profit margin of 3.57% for the previousyear.

 

28

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##### *Net Interest Income*

 

Net interestincome for the year ended December 31, 2002 was $74,294,000, consisting ofinterest income on fixed income securities and cash balances less interestexpense on reverse repurchase agreements and interest rate swaps, compared to$25,168,000 for the year ended December 31, 2001, or an increase of 195%.   The increase in net interest income for theyear ended December 31, 2002 was primarily due to an increase in investments infixed income securities with a net interest margin of approximately 2.62%.Changes in interest income and expense are primarily a function of changes inaverage effective interest rates on the Company’s fixed income securities,reverse repurchase agreements and interest rate swaps, and changes in theaverage amount of those assets and liabilities outstanding during each year.

 

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:

 

#### **AVERAGEBALANCE AND RATE TABLE**

(Dollars in thousands)

 
|                                   |   | **For the  Year Ended  December 31, 2002** |      | **For the  Year Ended  December 31, 2001** |   |
|----------------------------------------|--------|--------------------------------------------|-----------|--------------------------------------------|--------|
|                                   |   | **Average  Balance**                       |      | **Effective  Rate**                        |   | **Average  Balance** |   | **Effective  Rate** |   |
| Interest-Earning Assets:               |   |                                       |      |                                       |   |   |   |   |   |
| Mortgage Securities                    |   | $                                          | 2,667,237 |                                       | 6.13   | % | $ | 676,415 |   | 7.21 | % |
| Cash and Cash Equivalents              |   | 6,758                                      |      | 1.44                                       | %      | 2,943 |   | 3.81 | % |
| Total Interest-Earning Assets          |   | 2,673,995                                  |      | 6.12                                       | %      | 679,358 |   | 7.20 | % |
|                                   |   |                                       |      |                                       |   |   |   |   |   |
| Interest-Bearing Liabilities:          |   |                                       |      |                                       |   |   |   |   |   |
| Reverse Repurchase Agreements          |   | 2,549,641                                  |      | 3.50                                       | %      | 653,953 |   | 3.63 | % |
|                                   |   |                                       |      |                                       |   |   |   |   |   |
| Net Interest-Earning Assets and Spread |   | $                                          | 124,354   |                                       | 2.62   | % | $ | 25,405 |   | 3.57 | % |

 

The effectiveyield data is computed by dividing the annualized net interest income orexpense, including the effect on interest expense of hedging transactions asapplicable into the average daily balance shown.

 

The followingtable reflects the average balances for the Company’s equity securities, withthe corresponding effective dividend yield annualized:

 

AVERAGE BALANCE AND RATE TABLE

(Dollars in thousands)

 
|              |   | **For the  Year Ended  December 31, 2002** |   | **For the  Year Ended  December 31, 2001** |   |
|-------------------|--------|--------------------------------------------|--------|--------------------------------------------|--------|
|              |   | **Average  Balance**                       |   | **Effective  Dividend  Yield**             |   | **Average  Balance** |   | **Effective  Dividend  Yield** |   |
|              |   |                                       |   |                                       |   |   |   |   |   |
| Equity securities |   | $                                          | 4,069  |                                       | 10.86  | % | $ | 11,984 |   | 6.80 | % |
|                   |        |                                            |        |                                            |        |  |  |  |  |  |  |

 

29

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The followingtable shows the approximate amounts of the change in interest income andexpense between 2002 and 2001 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,  2002 compared to 2001** |          |
|-------------------------------|--------|-----------------------------------------------------|---------------|
|                          |   | **Total  Change**                                   |          | **Changes Due  to** |   |
|                          |   |                                                | **Volume(1)** |   | **Rates(1)** |   |
| Interest-Earning Assets       |   |                                                |          |   |   |   |   |
| Fixed income securities       |   | $                                                   | 114,669       |   | $ | 143,459 |   | $ | (28,790 | ) |
| Cash and cash equivalents     |   | (15                                                 | )             | 145 |   | (160 | ) |
|                          |   |                                                |          |   |   |   |   |
| Total interest income         |   | 114,654                                             |          | 143,604 |   | (28,950 | ) |
|                          |   |                                                |          |   |   |   |   |
| Interest-Bearing Liabilities  |   |                                                |          |   |   |   |   |
| Reverse repurchase agreements |   | 65,528                                              |          | 68,844 |   | (3,316 | ) |
|                          |   |                                                |          |   |   |   |   |
| Total interest expense        |   | 65,528                                              |          | 68,844 |   | (3,316 | ) |
|                          |   |                                                |          |   |   |   |   |
| Change In Net Interest Income |   | $                                                   | 49,126        |   | $ | 74,760 |   | $ | (25,634 | ) |

 

----

(1)          Changesin interest income/expense not arising from volume or rate variances areallocated proportionately to rate and volume.

 

A portion ofthe change in interest expense in the table above is related to the Company’suse of interest rate swaps.  Periodicsettlements of the swap agreements with their counterparties result inadjustments to interest expense associated with the reverse repurchaseagreements hedged by the swaps.  During2002, interest expense was increased by $43,231,000 paid to swap counterpartiesand $920,000 from amortization of net deferred losses on terminated swapcontracts.

 

*Dividend Income*

 

The Companyreported dividend income of $442,000 from dividends on equity investments forthe year ended December 31, 2002, compared to $815,000 for the year ended December31, 2001, a decrease of 46%. The decrease was the result of the sale of$1,937,000 of equity securities available-for-sale during 2002.

 

*Net Gain (Loss) on Investment and DerivativeActivities*

 

During 2002,the Company reported net losses on investment and derivative activities of$16,388,000 in the statement of operations. This loss consisted of a net lossof $55,517,000 on closed forward contracts, a gain of $28,156,000 on the saleof $1,456,542,000 of fixed income trading securities, a gain of $16,929,000 onthe sale of $1,565,180,000 of fixed income available-for-sale securities, again of $593,000 on the sale of $1,937,000 equity securitiesavailable-for-sale, a loss of $2,593,000 on terminated swaps, and an unrealizedloss of $3,956,000 on fixed income trading securities.

 

During 2001,the Company 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.

 

##### *Generaland Administrative Expenses*

 

General andadministrative expenses increased to $5,510,000 for the year ended December 31,2002 from $1,823,000 for the year ended December 31, 2001. The primary reasonfor the increase was due to increased management fees as a result of increasednet invested capital and an increase in incentive fee expenses of $1,366,000for 2002. The 

 

30

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increase in net investedcapital was primarily the result of two additional follow-on offerings in2002.  An increase of  $700,000 in other expenses was primarily dueto increased custodian bank fees as a result of additional assets purchased in2002 after the two additional follow-on offerings.

 

# **YearEnded December 31, 2001 Compared to Year Ended December 31, 2000**

 

##### *Overview*

 

For the yearended December 31, 2001, the Company’s net income was $18,714,000, or $2.59 percommon share  on a basic basis and $2.55on a diluted basis, based on a weighted average of 7,235,000 and 7,325,000shares outstanding, respectively. That compares to a net loss of $28,243,000,or $4.91 per common share on a basic and diluted basis, based on a weightedaverage of 5,753,000 shares outstanding, for the year ended December 31, 2000.The primary reasons for the substantial change in operating results for 2001compared to 2000 are: (1) changes in interest rates and market conditionsaffecting the fair values of the Company’s Mortgage Related Securities andrelated derivative financial instruments and net interest income, (2) relatedchanges in investment and hedging strategies, especially in the third quarterof 2000, and (3) substantial increases in the Company’s equity capital,borrowings and Mortgage Related Securities in the fourth quarter 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. The yields on three and six month Treasurysecurities declined from 5.88% and 5.689% to 1.71% and 1.79%, respectively.However, the yield on the 10-year Treasury bond remained relatively flatdeclining only seven basis points from 5.10% to 5.03%. The one-month LIBOR ratealso declined from 6.56% to 1.87% by year-end. The reduction in short-termrates lowered the Company’s average borrowing cost for the year ending December31, 2001 to 3.63%, down 223 basis points from the year ending December 31,2000, during which the average borrowing rate was 5.86%. During the year, theCompany benefited from its strategy of investing in fixed rate mortgages ofhigh credit quality and the decline in funding costs. Consequently, these lowershort-term rates increased the Company’s net profit margin to 3.57% for theyear compared to a net profit margin of 0.91% for the previous year.

 

During thefourth quarter of 2001, the Company completed two follow-on equity offerings ofits Common Stock, issuing an additional 9,775,000 shares, bringing theCompany’s total outstanding shares to 15,555,500 at December 31, 2001. TheCompany used virtually all of the net proceeds of the equity offerings toinvest in high credit quality fixed rate mortgages. 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 of these historically low short-term rates, the Company electedto effectively extend the term of its borrowings using hedging instruments. Inthe fourth quarter of 2001, the Company entered into $850 million ofinterest-rate swaps with an average term of 4.6 years and average cost of4.24%. The Company’s reliance on short-term interest rates is reduced since alarge share of its liabilities are now fixed.

 

##### *Net Interest 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%. Thischange was the net result of an increase in interest income of $6,057,000, or14%, and a decrease in interest expense of $10,056,000, or 30%. Changes ininterest 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.

 

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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:

 

#### **AVERAGEBALANCE 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 |   | 0.90 | % |

 

The effectiveyield data is computed by dividing the annualized net interest income orexpense, including hedging transaction (as applicable) into the average dailybalance shown.

 

The followingtable shows the approximate amounts of the change in interest income and expensebetween 2001 and 2000 that was a function of rate and volume changes, and theamount of the change that cannot be ascribed specifically to either rate orvolume 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 |   |

 

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(1)          Changesin interest income/expense not arising from volume or rate variances areallocated proportionately to rate and volume.

 

A portion ofthe change in interest expense in the table above is related to the Company’suse of interest rate swaps. Periodic settlements of the swap agreements withtheir counterparties result in adjustments to interest expense associated withthe reverse repurchase agreements hedged by the swaps.  During the year ended December 31, 2000,interest 

 

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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 increased by $1,663,000 paid to swap counterparties anddecreased by $2,366,000 from amortization of deferred gains on terminated swapcontracts.

 

##### *DividendIncome*

 

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 saleof $7,578,000 of equity securities available-for-sale during 2001.

 

*Net Gain (Loss) on Investment and DerivativeActivities*

 

During 2001,the Company 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 $379,198,000of fixed income trading securities, a gain of $3,076,000 on the sale of equitysecurities available-for-sale and an unrealized gain of $3,240,000 on tradingsecurities during the year ended December 31, 2001. During 2000, the Companyrealized a net loss of $36,703,000, primarily from impairment charges oncertain fixed-rate mortgage securities ($18,284,000), certain equity securities($4,326,000) and forward contracts ($8,424,000). The impairment chargesrepresented declines in fair values of these financial instruments deemed to beother-than-temporary because of a change in the Company’s investment andhedging strategies during the third quarter of 2000. The strategies werechanged in response to the negative effects that unanticipated, rapid changesin interest rates had on the overall structure of the Company’s portfolio. Asubstantial portion of the securities identified as impaired was subsequentlysold in the fourth quarter of 2000 and during 2001.

 

*General and Administrative Expenses*

 

The Companyincurred general and administrative expenses of $1,823,000 for the year endedDecember 31, 2001 compared to $1,734,000 for the year ended December 31, 2000,or an increase of 5%. During 2001, the Company had earnings and a return onequity in excess of targets that caused it to incur incentive fees of $634,000to the Manager under the terms of the Management Agreement. In 2000, theCompany did not meet those targets and was not obligated to pay an incentivefee to the Manager. The increase in general and administrative expenses in 2001compared to 2000 caused by the incentive fee increase was offset by reductionsof $250,000 in professional fees and $213,000 in “other” general andadministrative expenses.  Professionalfees were higher in 2000 than in 2001 primarily because of legal expensesincurred in 2000 in connection with efforts to restructure the Company’soperations through combinations with other mortgage REITs. “Other” expenseswere lower in 2001 compared to 2000 primarily because of cost containmentefforts.

 

*Accounting Changes*

 

As previouslynoted, on January 1, 2001, the Company adopted SFAS No. 133 and the relatedamendments and interpretations. This adoption resulted in a transitionadjustment that reclassified $2,173,000 of net losses on unrealized anddeferred gains and losses on investment securities and forward contracts fromaccumulated other comprehensive income to current income.

 

Also onJanuary 1, 2001, the Company reclassified $594,469,000 of its mortgagesecurities from the available-for-sale category to the trading category forinvestments accounted for under SFAS No. 115. This change resulted in thereclassification of $1,742,000 net unrealized gains from accumulated othercomprehensive income to current income, in addition to net unrealized gainsincluded in the SFAS No. 133 transition adjustment discussed above.

 

**LIQUIDITY AND CAPITALRESOURCES**

 

The Company’sprimary sources of funds as of December 31, 2002 and December 31, 2001,consisted of reverse repurchase agreements totaling $2,112,444,000 and$1,376,850,000, respectively.  TheCompany expects to continue to borrow funds in the form of reverse repurchaseagreements.  At December 31, 2002, the Companyhad borrowing arrangements with approximately twenty different investmentbanking firms.  Increases in short-terminterest rates could 

 

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negatively impact the valuationof the Company’s mortgage assets, which could limit the Company’s borrowingability or cause its lenders to initiate margin calls.

 

For liquidity,the Company will also rely on the cash flow from operations, primarily monthlyprincipal and interest payments to be received on the mortgage assets.

 

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. However, an increase in prepayment rates substantially above theCompany’s expectations could cause a liquidity shortfall.  If the Company’s cash resources are at anytime insufficient to satisfy the Company’s liquidity requirements, the Companymay be required to liquidate mortgage assets or sell debt or additional equitysecurities.  If required, the sale ofmortgage assets at prices lower than the carrying value of such assets wouldresult in losses and reduced income.

 

The Companymay in the future increase its capital resources by making additional offeringsof equity and debt securities, including classes of preferred stock, commonstock, commercial paper, medium-term notes, collateralized mortgage obligationsand senior or subordinated notes.  Alldebt securities, other borrowings, and classes of preferred stock will be seniorto the Common Stock in a liquidation of the Company.  The effect of additional equity offerings may be the dilution ofstockholders’ equity in the Company or the reduction of the price of shares ofthe Common Stock, or both.  The Companyis unable to estimate the amount, timing or nature of any additional offeringsas they will depend upon market conditions and other factors.

 

**INFLATION**

 

Virtually allof the Company’s assets and liabilities are financial in nature.  As a result, interest rates and otherfactors drive the Company’s performance far more so than does inflation.  Changes in interest rates do not necessarilycorrelate with inflation rates or changes in inflation rates.  The Company’s financial statements areprepared in accordance with accounting principles generally accepted in theUnited States of America and the Company’s dividends are determined by theCompany’s net income as calculated for tax purposes; in each case, theCompany’s activities and balance sheet are measured with reference tohistorical cost and or fair market value without considering inflation.

 

**CRITICAL ACCOUNTING POLICIES**

 

The Company’sfinancial statements are prepared in accordance with accounting principlesgenerally accepted in the United States of America. The financial informationcontained within these financial statements is, to a significant extent,financial information that is based on approximate measures of the financialeffects of transactions and events that have already occurred. Based on itsconsideration of accounting policies that involve complex and subjectivedecisions and assessments, management has identified its most criticalaccounting policies to be the following:

 

##### *Classificationsof 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 the Company’s investment securities are carried onthe balance sheets at fair value, the classification of the securities astrading or as available-for-sale determines whether changes in fair value arerecorded immediately through current earnings, as they are for tradingsecurities, or as adjustments to accumulated other comprehensive income (loss),which is a component of stockholders’ equity, as they are foravailable-for-sale securities. If available-for-sale securities were classifiedas trading securities, there could be substantially greater volatility inearnings from period-to-period.

 

##### *Valuationsof Investment Securities*

 

As notedabove, all investment securities are carried on the balance sheets at fairvalue. Some of the Company’s securities, particularly the equity securities,have readily determinable fair values based on quotes provided from recognizedsecurities exchanges. However, most of the Company’s fixed income securitieshave fair values determined by management with reference to price estimatesprovided by dealers in the securities, independent pricing services, and othersources. Because the price estimates may vary to some degree between sources,management must make certain judgments and assumptions about the appropriateprice to use to calculate the fair values for financial reporting purposes.Different judgments and assumptions could result in different presentations ofvalue.

 

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When the fairvalue of an available-for-sale security is less than amortized cost, managementconsiders whether there is an other-than-temporary impairment in the value ofthe security (e.g., whether the security will be sold prior to the recovery offair value).  If, in management’sjudgment, an other-than-temporary impairment exists, the cost basis of thesecurity is written down to the then-current fair value, and the unrealizedloss is transferred from accumulated other comprehensive income as an immediatereduction of current earnings (i.e., as if the loss had been realized in theperiod of impairment).

 

*Interest Income and Dividend Recognition*

 

Interestincome on the Company’s mortgage securities and other fixed income securitiesis accrued based on the actual coupon rate and the outstanding principalamount.  Premiums and discounts areamortized or accreted into interest income over the lives of the securitiesusing the effective yield method adjusted for the effects of estimatedprepayments.  In the event that the costbasis of a security has been reduced below par because of another-than-temporary impairment in value, the difference is treated like adiscount in determining the appropriate amount of accretion to recognize asinterest income between the date when the cost is adjusted and when thesecurity is ultimately sold.  Also,dividends on equity securities are recognized as income on their declarationdates.

 

##### *Accountingfor Derivative Financial Instruments 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 fundamentallyfor the purpose of hedging the Company’s exposure to interest rate risk, andboth are carried at fair value on the balance sheets. Forward contracts to sellU.S. Treasury securities are matched against a portion of the Company’s fixedincome trading securities. These contracts do not qualify for hedge accounting and,therefore, changes in fair values of these instruments are recorded immediatelythrough current earnings. Such changes tend to offset fair value changes in theopposite direction for the fixed income trading securities and help to reducethe 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. These instruments qualify for hedge accountingand are considered to be cash flow hedges. To the extent that periodic changesin fair values of the swap agreements are deemed to be the result of theireffectiveness as hedges, such changes are recorded as adjustments toaccumulated other comprehensive income, a component of stockholders’ equity,rather than to current earnings. If the swaps no longer qualified as cash flowhedges (for example, if the terms of the swaps were not matched appropriatelyto the terms of the borrowings, 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.

 

##### *Accountingfor Stock Options*

 

The Companyissues stock options to its Directors and to certain employees of the Manager.The stock options issued to Directors are accounted for using theintrinsic-value method. Because the options were issued with exercise prices noless than the market price of the Common Stock on the dates of grant, andbecause the stock options key terms are fixed, use of the intrinsic-valuemethod results in the Company not recognizing compensation expense for thesestock options. Note 6 to the financial statements discloses the effects onrecent earnings if these stock options were accounted for at fair value whengranted and if compensation expense were recognized in periodic earnings overthe vesting periods of the options. If the terms of the options were to bechanged, variable accounting might need to be used, and the Company might thenneed to begin recognizing compensation expense for these options.  Options granted to persons other thanDirectors (i.e., to non-employees) are accounted for using the fair valuemethod; such stock options are measured at their fair value when they aregranted and are recognized as general and administrative expense during theperiods when the options are vested and the related services are performed.

 

*Off Balance Sheet Arrangements*

 

Subsequent toJanuary 1, 2002, the Company did not have any relationships with unconsolidatedentities or financial partnerships, such as entities often referred to asstructured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes.  Further, the Company has not guaranteed any obligations ofunconsolidated entities nor does it have any commitment or intent to provideadditional funding to any such entities. As such, the Company is not materially exposed to any market, credit,liquidity or financing risk that could arise if the Company had engaged in suchrelationships.

 

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# **ITEM 7A.**                    QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

 

**MARKET RISK**

 

The Company’stwo primary components of market risk are interest rate risk and equity pricerisk, as discussed below.

 

### **Interest Rate Risk**

 

*Effect on Net Interest Income. *The Company investsin fixed-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 rising interestrate environment. Hedging techniques will be based, in part, on assumed levelsof prepayments of the Company’s mortgage assets.  If prepayments are slower or faster than assumed, the life of themortgage assets will be longer or shorter which would reduce the effectivenessof the Company’s hedging techniques and may result in losses on suchtransactions.  Hedging techniquesinvolving the use of derivative securities are highly complex and may producevolatile returns. The hedging activity of the Company will also be limited bythe asset and sources of income requirements applicable to the Company as aREIT.

 

*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, the fixed-ratemortgage assets may prepay faster such that the average life becomes shorterthan its related hedging instrument.  Ifthis were to happen, the Company would potentially need to reinvest at rateslower than that of the related hedging instrument.  This situation may result in the narrowing of interest ratespreads 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 duration mismatch betweenmortgage securities and U.S. Treasury notes were to widen, which could occur inboth a rising and falling interest rate environment, 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 Companyalso invests 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 similarrestrictions.  Hence, in a period ofincreasing interest rates, interest rates on its borrowings could increasewithout limitation by caps, while the interest rates on its mortgage assets aregenerally limited by caps.  This problemwill be magnified to the extent the Company acquires mortgage assets that arenot fully indexed.  Further, someadjustable-rate mortgage assets may be subject to periodic payment caps thatresult in some portion of the interest being deferred and added to theprincipal 

 

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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 of rising interest rates, which would negatively impactthe Company’s financial condition, cash flows and results 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.

 

Prepaymentrates generally increase when prevailing interest rates fall below the interestrates on existing mortgage assets.  Inaddition, prepayment rates generally increase when the difference betweenlong-term and short-term interest rates declines.  Prepayments of mortgage assets could harm the Company’s resultsof operations in several ways.  TheCompany anticipates that a substantial portion of its adjustable-rate mortgageassets may bear initial “teaser” interest rates that are lower than their“fully indexed” rates (the applicable index plus a margin).  In the event that such an adjustable-ratemortgage asset is prepaid prior to or soon after the time of adjustment to afully indexed rate, the Company will have held the mortgage asset while it wasless profitable and lost the opportunity to receive interest at the fullyindexed rate over the expected life of the adjustable-rate mortgage asset.  In addition, the prepayment of any mortgageasset that had been purchased at a premium by the Company would result in theimmediate write-off of any remaining capitalized premium amount and consequent reductionof the Company’s net interest income by such amount.  Finally, in the event that the Company is unable to acquire newmortgage assets to replace the prepaid mortgage assets, its financialcondition, cash flow and results of operations could be harmed.

 

*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 hedging instruments.  Duration essentially measures the marketprice volatility of financial instruments as interest rates change.  The Company generally calculates durationusing various financial models and empirical data and different models andmethodologies can produce different duration numbers for the same securities.

 

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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 instantaneouslyrise and fall one hundred, two hundred, and three hundred basis points.Interest rate sensitive investments currently include fixed income trading andavailable-for-sale securities. (Dollars are in thousands except per shareamounts.)

 
|                                                                      |   | **Interest  Rates Fall  300 Basis  Points** |     | **Interest  Rates Fall  200 Basis  Points** |   | **Interest  Rates Fall  100 Basis  Points** |   | **Unchanged** |    | **Interest  Rates Rise  100 Basis  Points** |   | **Interest  Rates Rise  200 Basis  Points** |   | **Interest  Rates Rise  300 Basis  Points** |    |
|---------------------------------------------------------------------------|--------|---------------------------------------------|----------|---------------------------------------------|--------|---------------------------------------------|--------|---------------|---------|---------------------------------------------|--------|---------------------------------------------|--------|---------------------------------------------|---------|
|                                                                      |   |                                        |     |                                        |   |                                        |   |          |    |                                        |   |                                        |   |                                        |    |
| Interest Rate Sensitive Instruments After  Hedging Instruments            |   | $                                           | 60,759   |                                        | $      | 108,926                                     |   | $             | 159,251 |                                        | $      | 192,365                                     |   | $                                           | 179,010 |   | $ | 121,417 |   | $ | 51,225 |   |
|                                                                      |   |                                        |     |                                        |   |                                        |   |          |    |                                        |   |                                        |   |                                        |    |
| Change in Fair Value                                                      |   | $                                           | (131,607 | )                                           | $      | (83,439                                     | )      | $             | (33,114 | )                                           | — |                                        | $      | (13,355                                     | )       | $ | (70,948 | ) | $ | (141,140 | ) |
|                                                                      |   |                                        |     |                                        |   |                                        |   |          |    |                                        |   |                                        |   |                                        |    |
| Change as a Percent of Fair Value of  Interest Rate Sensitive Investments |   | (5.43                                       | )%       | (3.44                                       | )%     | (1.37                                       | )%     | —        |    | (0.55                                       | )%     | (2.93                                       | )%     | (5.82                                       | )%      |
|                                                                      |   |                                        |     |                                        |   |                                        |   |          |    |                                        |   |                                        |   |                                        |    |
| Change as a Percent of Stockholders’ Equity                          |   | (67.61                                      | )%       | (42.86                                      | )%     | (17.01                                      | )%     | —        |    | (6.86                                       | )%     | (36.45                                      | )%     | (72.51                                      | )%      |
|                                                                      |   |                                        |     |                                        |   |                                        |   |          |    |                                        |   |                                        |   |                                        |    |
| Change on a Per Share Basis                                               |   | $                                           | (4.41    | )                                           | $      | (2.79                                       | )      | $             | (1.11   | )                                           | — |                                        | $      | (0.45                                       | )       | $ | (2.38 | ) | $ | (4.73 | ) |
|                                                                           |        |                                             |          |                                             |        |                                             |        |               |         |                                             |        |                                             |        |                                             |         |  |  |  |  |  |  |  |

 

It isimportant to note that the impact of changing interest rates on fair value canchange significantly when interest rates change beyond one hundred basis pointsfrom current 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 thatimpact the fair value of the Company’s interest rate sensitive investments andhedging instruments, such as the shape of the yield curve, market expectationsas to future 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 and adverse.

 

The Companyhas established 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 plus or minus oneyear or less, taking into account all hedging transactions.  The Company generally does not intend tohave any specific duration target for the portion of its mortgage relatedassets that are not funded by secured borrowings.

 

There can beno assurance that the Company will be able to limit such duration differencesand there may be periods of time when the duration difference will be greaterthan one year.

 

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**Equity Price Risk**

 

Another component of market risk for the Company is equity pricerisk.  This is the risk that the marketvalue of the Company’s equity investments will decrease.  The following table shows the impact on theCompany’s fair value as the price of its equity securities change, assumingprice decreases of 10% and price increases of 10%.  Actual price decreases or increases may be greater orsmaller.  (Dollars are in thousandsexcept per share amounts.)

 

|                                             |   | **Fair Value  for Scenario Shown** |   |
|--------------------------------------------------|--------|------------------------------------|--------|
|                                             |   | **Prices  Decrease  10%**          |   | **Unchanged** |   | **Prices  Increase  10%** |   |
|                                             |   |                               |   |   |   |   |   |
| Equity Investments                               |   | $                                  | 3,751  |   | $ | 4,168 |   | $ | 4,585 |   |
|                                             |   |                               |   |   |   |   |   |
| Change in Fair Value                             |   | (417                               | )      | — |   | 417 |   |
| Change as a Percent of Fair Value                |   | (10                                | )%     | — |   | 10 | % |
| Change as a Percent of Stockholders’ Equity |   | (0.2                               | )%     | — |   | 0.2 | % |
| Change on a Per Share Basis                      |   | $                                  | (0.01  | ) | — |   | $ | 0.01 |   |
|                                                  |        |                                    |        |  |  |  |  |  |  |  |

 

Although thereis no direct link between changes in fair value and changes in earnings in manycases, a decline in fair value for the Company may translate into decreasedearnings over the remaining life of the investment portfolio.

 

If the fairmarket value of the Company’s portfolio were to decline significantly, theCompany’s overall liquidity may be impaired which could result in the Companybeing required to sell assets at losses.

 

**The Company’sanalysis of risks is based on management’s experience, estimates, models andassumptions.  These analyses rely onmodels of financial information which utilize estimates of fair value andinterest rate sensitivity.  Actualeconomic conditions or implementation of investment decisions by the Managermay produce results that differ significantly from the estimates andassumptions used in the Company’s models and the projected results shown in theabove tables 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.**

 

# **ITEM 8.**                             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-21 on thisAnnual Report on Form 10-K and are incorporated by reference herein in theirentirety.

 

# **ITEM 9.**                             CHANGESIN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIALDISCLOSURE

 

None.

**PART III**

 

# **ITEM 10.**                      DIRECTORS AND EXECUTIVE OFFICERSOF THE REGISTRANT

 

Theinformation required by Item 10 is incorporated herein by reference from theCompany’s definitive Proxy Statement to be filed within 120 days from December31, 2002 pursuant to general instruction G(3).

 

39

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# **ITEM 11.**                      EXECUTIVE COMPENSATION

 

Theinformation required by Item 11 is incorporated herein by reference from theCompany’s definitive Proxy Statement to be filed within 120 days from December31, 2002 pursuant to general instruction G(3).

 

# **ITEM 12.**                      SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS

 

Pursuant toGeneral Instructions G (3) to From 10-K, the information required by this itemis incorporated by reference to such information contained in the Company’sdefinitive Proxy Statement for the Annual meeting of Shareholders to be held onJune 19, 2003, filed with the Securities and Exchange Commission pursuant to

Regulation 14-A.

 

The followingtable sets forth the following information under the Company’s Stock OptionPlan: (i) the number of shares on Common Stock to be issued upon the exercisingof the Company’s outstanding options; (ii) the weighted-average exercise priceof the Company’s outstanding options; and (iii) the number of shares on CommonStock available for future issuance under the Company’s Stock Option Plan.

 

**Equity Compensation Plan Information**

 
| **Plan  Category**                                          |   | **Number of  securities to  be issued upon exercise  of outstanding options,  warrants and rights  (a)** |   | **Weighted-average  exercise price of  outstanding options,  warrants and rights  (b)** |   | **Number  of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  column (a))  (c)** |    |
|-------------------------------------------------------------|--------|----------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------|---------|
| Equity compensation plans approved by  security holders     |   | 791,000                                                                                                  |   | $                                                                                       | 11.58  |                                                                                                                                                             | 791,000 |   |
| Equity compensation plans not approved by  security holders |   | —                                                                                                   |   | —                                                                                  |   | —                                                                                                                                                           |    |
| Total                                                       |   | 791,000                                                                                                  |   | $                                                                                       | 11.58  |                                                                                                                                                             | 791,000 |   |

 

# **ITEM 13.**                      CERTAIN RELATIONSHIPS AND RELATEDTRANSACTIONS

 

Theinformation required by Item 13 is incorporated herein by reference from theCompany’s definitive Proxy Statement to be filed within 120 days from December31, 2002 pursuant to general instruction G(3).

 

**PART IV**

 

# **ITEM 14.**                      CONTROLS AND PROCEDURES

 

(a)                  Evaluation of disclosure controls andprocedures.

 

Under the supervision and with the participation of our management,including the Company’s Chief Executive Officer and Chief Financial Officer, weevaluated the effectiveness of the design and operation of our disclosurecontrols and procedures (as defined in Rule 13a-14(c) under the Exchange Act)as of a date (the “Evaluation Date”) within 90 days prior to the filing date ofthis annual report on Form 10K. Based upon that evaluation, the Chief ExecutiveOfficer and Chief Financial Officer concluded that, as of the Evaluation Date,our disclosure controls and

 

40

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procedures are effective in timely alerting them to the materialinformation relating to us required to be included in our periodic filings.

 

(b)                 Changes in disclosure controls andprocedures.

 

# **Therewere no significant changes made in our internal controls during the periodcovered by this report or, to our knowledge, in other factors that couldsignificantly affect these internal controls subsequent to September 30, 2002.**

 

# **ITEM 15.**                      EXHIBITS, FINANCIAL STATEMENTSCHEDULES AND REPORTS ON FORM 8-K

 

Item 15(a)(1).                           Documentsfiled as part of this report:

 

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

 

•                  IndependentAuditors’ Report;

•                  Balance Sheetsas of December 31, 2002 and December 31, 2001;

•                  Statements ofOperations: Years Ended December 31, 2002, December 31, 2001 and December 31,2000;

•                  Statements ofStockholders’ Equity:  Years EndedDecember 31, 2002, December 31, 2001 and December 31, 2000;

•                  Statements ofCash Flows: Years Ended December 31, 2002, December 31, 2001 and December 31,2000;

•                  Notes toFinancial Statements.

 

Item 15(a)(2).                           Schedulesto financial statements:

 

All financialstatement schedules have been omitted because they are either inapplicable orthe information required is provided in the Company’s Financial Statements andNotes thereto, included in Part II, Item 8 of this Annual Report on Form 10-K.

 

Item 15(a)(3).                           Exhibits:

 

The followingexhibits are part of this Annual Report on Form 10-K and are numbered inaccordance with Item 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).                                                                  |

 

41

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| 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).                                                                                                   |
| 23.1 |   | Deloitte &  Touche LLP’s Independent Auditors’ Consent (filed herewith).                                                                                                                                                                                                                                                                    |
| 24.1 |   | Powers of  Attorney (included on page 46).                                                                                                                                                                                                                                                                                                                     |
| 99.1 |   | Section 906  Certification (filed herewith) by Philip A. Barach.                                                                                                                                                                                                                                                                                               |
| 99.2 |   | Section 906  Certification (filed herewith) by David S. DeVito.                                                                                                                                                                                                                                                                                                |

 

 

 

 

Item 15(b)                                           Reportson Form 8-K.

 

None.

 

**GLOSSARY**

 

As used inthis Annual Report on Form 10-K, the capitalized and other terms listed belowhave the 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 withaccounting principles generally accepted in the Untied States of America plus(2) any unsecured debt that has been approved for inclusion by the unaffiliateddirectors at issuance plus or minus (3) an adjustment to exclude the impact ofany unrealized gains, losses or other items that do not affect realized netincome.

 

“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.

 

“BankruptcyCode” 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” meansthe Internal Revenue Code of 1986, as amended.

 

42

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“COFI” is the11th District Cost of Funds Index, the index made available monthly by theFederal Home Loan Bank Board of the cost of funds to members of the FederalHome Loan Bank 11th District.

 

“CommittedSecured Borrowings” means (i) CMOs, (ii) structured commercial paper programs,(iii) secured term notes and (iv) other secured financing transactions thatgenerally commit the lender to provide financing to the Company for a specifiedperiod of time or to provide financing to the Company to fund specific assetsuntil they mature.

 

“Common Stock”means the Company’s shares of Common Stock, $0.01 par value per share.

 

“Company”means Apex 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” meansthe United States Federal Housing Administration.

 

“FHA Loans”means Mortgage Loans insured by the FHA.

 

“FHLMC” meansthe Federal Home Loan Mortgage Corporation.

 

“ForeignHolder” means a purchaser of the Common Stock that, for United States incometax purposes, is not a United States person.

 

“GNMA” meansthe Government 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.

 

43

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“IRS” meansthe Internal Revenue Service.

 

“Keogh Plans”means H.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”means TCW 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.

 

“MortgageLoans” means Conforming and Nonconforming Mortgage Loans, FHA Loans and VALoans.

 

“MortgageRelated Assets” means (i) Short-Term Investments, (ii) Mortgage-BackedSecurities, (iii) High Credit Quality Mortgage Loans, (iv) Mortgage DerivativeSecurities and (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 accounting principles generallyaccepted in the United States of America.

 

“NonconformingMortgage Loans” means conventional Mortgage Loans that do not conform to one ormore 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.

 

“PrincipalOnly Derivatives” means Mortgage Derivative Securities representing the rightto receive principal only or a disproportionate amount of principal.

 

“QualifiedREIT Real Estate Assets” means pass-through certificates, Mortgage Loans,agency certificates, and other assets of the type described in Section856(c)(5)(B) of the 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.

 

“REITProvisions of 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.

 

44

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“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.

 

“TaxableIncome” means for any year the taxable income of the Company for such year(excluding any net income derived either from property held primarily for saleto customers or from foreclosure property) subject to certain adjustmentsprovided in the REIT Provisions of the Code.

 

“Taxable REITSubsidiary” means a corporation satisfying the requirements of Section 856(1)of the Code, and with respect to which the requirements of Section 856(c)(4)(B)of the Code are satisfied.

 

“TCW” meansThe TCW 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.

 

“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”means Mortgage Loans partially guaranteed by the VA under the Serviceman'sReadjustment Act of 1944, as amended.

 

45

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**SIGNATURES**

 

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

 

 
|                   |   | Apex  Mortgage Capital, Inc.                                          |   |
|------------------------|--------|-----------------------------------------------------------------------|--------|
|                   |   | (Registrant)                                                          |   |
|                   |   |                                                                  |
|                   |   |                                                                  |
| Dated: March  27, 2003 |   | /s/ Philip  A. Barach                                                 |   |
|                   |   | Philip A.  Barach                                                     |
|                   |   | President  and Chief Executive Officer  (Principal Executive Officer) |   |
|                   |   |                                                                  |   |
|                   |   |                                                                  |
| Dated: March  27, 2003 |   | /s/ David S.  DeVito                                                  |   |
|                   |   | David S.  DeVito                                                      |
|                   |   | Chief  Financial Officer  (Principal Accounting Officer)              |   |
|                        |        |                                                                       |        |  |

 

KNOW ALL PERSONS BY THESEPRESENTS, that each person whose signature appears below with an asteriskconstitutes and appoints Philip A. Barach, David S. DeVito and Philip K. Holl,as his attorneys-in-fact, each with the power of substitution, for him in anyand all capacities, to sign any amendment to this Report on Form 10-K, and tofile the same, with exhibits thereto and other documents in connectiontherewith with the Securities and Exchange Commission, hereby ratifying andconfirming all that each of said attorneys-in-fact, or his substitute orsubstitutes may do or cause to be done by virtue hereof.

 

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

 
| **Signature**            |                    | **Capacity**                                            |            | **Date** |
|--------------------------|-------------------------|---------------------------------------------------------|-----------------|----------|
|                     |                    |                                                    |            |
| /s/Marc I.  Stern        |                    | Chairman of  the Board                                  | March 27,  2003 |
| Marc I.  Stern           |                    |                                                    |            |
|                     |                    |                                                    |            |
| /s/Jeffrey  E. Gundlach  |                    | Vice  Chairman of the Board                             | March 27,  2003 |
| Jeffrey E.  Gundlach     |                    | Chief  Investment Officer                               |            |
|                     |                    |                                                    |            |
| /s/Philip A.  Barach     |                    | President  and                                          | March 27,  2003 |
| Philip A.  Barach        |                    | Chief  Executive Officer  (Principal Executive Officer) |            |
|                     |                    |                                                    |            |
| /s/Peter G.  Allen*      |                    | Director                                                | March 27,  2003 |
| Peter G.  Allen          |                    |                                                    |            |
|                     |                    |                                                    |            |
| /s/Samuel P.  Bell*      |                    | Director                                                | March 27,  2003 |
| Samuel P.  Bell          |                    |                                                    |            |
|                     |                    |                                                    |            |
| /s/John A.  Gavin*       |                    | Director                                                | March 27,  2003 |
| John A.  Gavin           |                    |                                                    |            |
|                     |                    |                                                    |            |
| /s/Carl C.  Gregory III* |                    | Director                                                | March 27,  2003 |
| Carl C.  Gregory III     |                    |                                                    |            |
|                     |                    |                                                    |            |
|                     | *By: /s/David S. DeVito |                                                    |            |     |
|                     | David S.  DeVito        |                                                    |            |     |
|                     | Attorney-in-Fact        |                                                    |            |     |
|                          |                         |                                                         |                 |          |  |  |

 

46

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CERTIFICATIONS

 

I, Philip A. Barach, certifythat:

 

1.                                       I have reviewed this annual report on Form 10-K of Apex Mortgage Capital, Inc.;

 

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

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this annual report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this annual report;

 

4.                                     Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

a)                                    designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this annual report is being prepared;

 

b)                                   evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c)                                    presentedin this annual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of  the Evaluation Date;

 

5.                                     Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (and persons performing the equivalentfunction):

 

a)                                    allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                   anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                     Theregistrant’s other certifying officers and I have indicated in this annualreport whether there were significant changes in internal controls or in otherfactors that could significantly affect internal controls subsequent to thedate of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| Date: March  27, 2003 |   | /s/ Philip  A. Barach                   |   |
|-----------------------|--------|-----------------------------------------|--------|
|                  |   | Philip A.  Barach                       |
|                  |   | *President and Chief Executive Officer* |

 

47

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I, David S. DeVito, certifythat:

 

1.                                       Ihave reviewed this annual report on Form 10-K of Apex Mortgage Capital, Inc.;

 

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

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this annual report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the registrant asof, and for, the periods presented in this annual report;

 

4.                                     Theregistrant’s other certifying officers and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the registrant and have:

 

a)                                    designedsuch disclosure controls and procedures to ensure that material informationrelating to the registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this annual report is being prepared;

 

b)                                   evaluatedthe effectiveness of the registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

c)                                    presentedin this annual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of  the Evaluation Date;

 

5.                                     Theregistrant’s other certifying officers and I have disclosed, based on our mostrecent evaluation, to the registrant’s auditors and the audit committee ofregistrant’s board of directors (and persons performing the equivalentfunction):

 

a)                                    allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the registrant’s ability to record, process, summarizeand report financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)                                   anyfraud, whether or not material, that involves management or other employees whohave a significant role in the registrant’s internal controls; and

 

6.                                     Theregistrant’s other certifying officers and I have indicated in this annualreport whether there were significant changes in internal controls or in otherfactors that could significantly affect internal controls subsequent to thedate of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 

 
| Date: March  27, 2003 |   | /s/ David S.  DeVito                     |   |
|-----------------------|--------|------------------------------------------|--------|
|                  |   | David S.  DeVito                         |
|                  |   | *Chief Financial Officer and Controller* |

 

48

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**Apex MortgageCapital, Inc.**

 

 

**Financial Statements**

 

**and**

 

**Independent Auditors’Report**

 

 

**For Inclusion in Form10-K**

 

**Filed with**

 

**Securities andExchange Commission**

 

**December 31, 2002**

** **

 

F-1

----

 

**Apex MortgageCapital, Inc.**

 

**Index to FinancialStatements**

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

 

F-2

----

 

INDEPENDENTAUDITORS’ REPORT

 

To the Stockholders of   Apex Mortgage Capital, Inc.

 

We have audited theaccompanying balance sheets of Apex Mortgage Capital, Inc. (the “Company”) asof December 31, 2002 and 2001 and the related statements of operations,stockholders’ equity, and cash flows for each of the three years in the periodended December 31, 2002.  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 audits inaccordance with auditing standards generally accepted in the United States ofAmerica.  Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial 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 by management,as well as evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, such financialstatements present fairly, in all material respects, the financial position ofApex Mortgage Capital, Inc. as of December 31, 2002 and 2001 and the results ofits operations and its cash flows for each of the three years in the periodended December 31, 2002, in conformity with accounting principles generallyaccepted in the United States of America.

 

As discussed in Note 2 to thefinancial statements, effective January 1, 2001, the Company changed its methodof accounting for derivative financial instruments.

 

/s/ Deloitte& ToucheLLP

Los Angeles, California

March 6, 2003  (March 13, 2003 as to Note 13)

 

F-3

----

 

**Apex MortgageCapital, Inc.**

 

**BalanceSheets**

 
|                                                                                                                                                                  |   | **December 31, 2002** |          | **December 31, 2001** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|---------------|-----------------------|--------|
| **Assets**                                                                                                                                                            |   |                  |          |                  |   |
|                                                                                                                                                                  |   |                  |          |                  |   |
| Cash and cash equivalents                                                                                                                                             |   | $                     | 1,456,000     |                  | $      | 4,330,000 |   |
| Fixed income trading securities, at fair value                                                                                                                        |   | 606,014,000           |          | 437,954,000           |   |
| Fixed income securities available-for-sale, at fair value                                                                                                             |   | 1,818,893,000         |          | 1,067,575,000         |   |
| Equity securities available-for-sale, at fair value                                                                                                                   |   | 4,168,000             |          | 6,028,000             |   |
| Interest rate swaps, at fair value                                                                                                                                    |   | —                |          | 4,620,000             |   |
| Accrued interest receivable                                                                                                                                           |   | 12,012,000            |          | 8,580,000             |   |
| Principal payments receivable                                                                                                                                         |   | 248,000               |          | 485,000               |   |
| Receivable for unsettled securities                                                                                                                                   |   | —                |          | 5,520,000             |   |
| Other assets                                                                                                                                                          |   | 2,587,000             |          | 333,000               |   |
|                                                                                                                                                                  |   |                  |          |                  |   |
|                                                                                                                                                                  |   | $                     | 2,445,378,000 |                  | $      | 1,535,425,000 |   |
|                                                                                                                                                                  |   |                  |          |                  |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                         |   |                  |          |                  |   |
|                                                                                                                                                                  |   |                  |          |                  |   |
| Liabilities                                                                                                                                                           |   |                  |          |                  |   |
|                                                                                                                                                                  |   |                  |          |                  |   |
| Reverse repurchase agreements                                                                                                                                         |   | $                     | 2,112,444,000 |                  | $      | 1,376,850,000 |   |
| Accrued interest payable                                                                                                                                              |   | 2,444,000             |          | 975,000               |   |
| Dividend payable                                                                                                                                                      |   | 13,509,000            |          | 12,596,000            |   |
| Forward contracts, at fair value                                                                                                                                      |   | —                |          | 3,275,000             |   |
| Interest rate swaps, at fair value                                                                                                                                    |   | 120,098,000           |          | —                |   |
| Accrued expenses and other liabilities                                                                                                                                |   | 2,224,000             |          | 11,699,000            |   |
|                                                                                                                                                                  |   |                  |          |                  |   |
|                                                                                                                                                                  |   | 2,250,719,000         |          | 1,405,395,000         |   |
|                                                                                                                                                                  |   |                  |          |                  |   |
| Commitments and contingencies (Note 10)                                                                                                                               |   |                  |          |                  |   |
|                                                                                                                                                                  |   |                  |          |                  |   |
| Stockholders’ Equity                                                                                                                                             |   |                  |          |                  |   |
|                                                                                                                                                                  |   |                  |          |                  |   |
| 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; 29,857,000 and 15,555,500 shares outstanding as of December 31,  2002 and 2001, respectively |   | 299,000               |          | 155,000               |   |
| Additional paid-in-capital                                                                                                                                            |   | 331,499,000           |          | 175,802,000           |   |
| Accumulated other comprehensive loss                                                                                                                                  |   | (95,880,000           | )             | (7,837,000            | )      |
| Accumulated deficit                                                                                                                                                   |   | (41,259,000           | )             | (38,090,000           | )      |
|                                                                                                                                                                  |   |                  |          |                  |   |
|                                                                                                                                                                  |   | 194,659,000           |          | 130,030,000           |   |
|                                                                                                                                                                  |   | $                     | 2,445,378,000 |                  | $      | 1,535,425,000 |   |

 

See accompanying notes to financialstatements

 

F-4

----

 

**Apex MortgageCapital, Inc.**

 

**Statementsof Operations**

 
|                                                                                         |   | **Year Ended December 31,** |        |
|----------------------------------------------------------------------------------------------|--------|-----------------------------|-------------|
|                                                                                         |   | **2002**                    |        | **2001** |   | **2000** |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **Interest Income:**                                                                         |   |                        |        |   |   |   |   |
| Fixed income securities                                                                      |   | $                           | 163,448,000 |   | $ | 48,779,000 |   | $ | 42,618,000 |   |
| Cash and cash equivalents                                                                    |   | 97,000                      |        | 112,000 |   | 216,000 |   |
|                                                                                         |   | 163,545,000                 |        | 48,891,000 |   | 42,834,000 |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **Interest Expense**                                                                         |   | 89,251,000                  |        | 23,723,000 |   | 33,779,000 |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **Net Interest Income**                                                                      |   | 74,294,000                  |        | 25,168,000 |   | 9,055,000 |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **Dividend Income**                                                                          |   | 442,000                     |        | 815,000 |   | 1,139,000 |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **Net Interest and Dividend Income**                                                         |   | 74,736,000                  |        | 25,983,000 |   | 10,194,000 |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **General and Administrative Expenses:**                                                     |   |                        |        |   |   |   |   |
| Management fee                                                                               |   | 1,912,000                   |        | 471,000 |   | 512,000 |   |
| Incentive fee                                                                                |   | 2,000,000                   |        | 634,000 |   | — |   |
| Insurance                                                                                    |   | 357,000                     |        | 333,000 |   | 272,000 |   |
| Professional fees                                                                            |   | 204,000                     |        | 132,000 |   | 382,000 |   |
| Directors’ fees                                                                         |   | 57,000                      |        | 65,000 |   | 76,000 |   |
| Non-employee stock options                                                                   |   | 96,000                      |        | 4,000 |   | 95,000 |   |
| Other                                                                                        |   | 884,000                     |        | 184,000 |   | 397,000 |   |
|                                                                                         |   | 5,510,000                   |        | 1,823,000 |   | 1,734,000 |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **Net Interest and Dividend Income After General and  Administrative Expenses**              |   | 69,226,000                  |        | 24,160,000 |   | 8,460,000 |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **Net Loss from Investment and Derivative Activities**                                       |   | (16,388,000                 | )           | (5,015,000 | ) | (36,703,000 | ) |
|                                                                                         |   |                        |        |   |   |   |   |
| **Reclassification of Previously Unrealized Gains**                                          |   | —                      |        | 1,742,000 |   | — |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **Net Income (Loss) Before Cumulative Effect of Change  in Accounting Principle**            |   | 52,838,000                  |        | 20,887,000 |   | (28,243,000 | ) |
|                                                                                         |   |                        |        |   |   |   |   |
| **Cumulative Effect of Change in Accounting Principle**                                      |   | —                      |        | (2,173,000 | ) | — |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **Net Income (Loss)**                                                                        |   | $                           | 52,838,000  |   | $ | 18,714,000 |   | $ | (28,243,000 | ) |
|                                                                                         |   |                        |        |   |   |   |   |
| **Net Income (Loss) Per Share Before Cumulative Effect  of Change in Accounting Principle:** |   |                        |        |   |   |   |   |
| Basic                                                                                        |   | $                           | 2.02        |   | $ | 2.89 |   | $ | (4.91 | ) |
| Diluted                                                                                      |   | $                           | 2.01        |   | $ | 2.85 |   | $ | (4.91 | ) |
|                                                                                         |   |                        |        |   |   |   |   |
| **Effect of Accounting Change Per Share:**                                                   |   |                        |        |   |   |   |   |
| Basic                                                                                        |   | $                           | —      |   | $ | (0.30 | ) | $ | — |   |
| Diluted                                                                                      |   | $                           | —      |   | $ | (0.30 | ) | $ | — |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **Net Income (Loss) Per Share:**                                                             |   |                        |        |   |   |   |   |
| Basic                                                                                        |   | $                           | 2.02        |   | $ | 2.59 |   | $ | (4.91 | ) |
| Diluted                                                                                      |   | $                           | 2.01        |   | $ | 2.55 |   | $ | (4.91 | ) |
|                                                                                         |   |                        |        |   |   |   |   |
| **Weighted Average Number of Shares Outstanding:**                                           |   |                        |        |   |   |   |   |
| Basic                                                                                        |   | 26,206,000                  |        | 7,235,000 |   | 5,753,000 |   |
| Diluted                                                                                      |   | 26,300,000                  |        | 7,325,000 |   | 5,753,000 |   |
|                                                                                         |   |                        |        |   |   |   |   |
| **Dividends Declared Per Share:**                                                            |   | $                           | 1.95        |   | $ | 1.95 |   | $ | 1.51 |   |

 

See accompanying notes to financialstatements

 

F-5

----

 

**Apex MortgageCapital, Inc.**

 

**Statementsof Stockholders Equity**

 
|                                                                                 |                               |       |   | **Additional  Paid-in  Capital** | ** ** | **Accumulated  Other  Comprehensive  Income (Loss)** | ** ** | **Accumulated  Deficit** |   | **Total  Stockholders’  Equity** |        |         |   |
|--------------------------------------------------------------------------------------|------------------------------------|------------|--------|----------------------------------|------------|------------------------------------------------------|------------|--------------------------|--------|---------------------------------------|-------------|--------------|--------|
|                                                                                 |                               |
|                                                                                 |                               |
| **Common  Stock**                                                                    | **Comprehensive  Income / (Loss)** |       |
| **Shares**                                                                           |                               | **Amount** |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Balance, January 1, 2000**                                                         |                               | 5,753,000  |   | $                                | 58,000     |                                                 | $          | 82,705,000               |   | $                                     | (26,513,000 | )            | $      | (209,000 | ) | $ | 56,041,000 |   |   |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Amortization of non-employees stock options**                                      |                               | —     |   | —                           |       | 95,000                                               |       | —                   |   | —                                |        | 95,000       |   |   |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Net loss**                                                                         |                               | —     |   | —                           |       | —                                               |       | —                   |   | (28,243,000                           | )           | (28,243,000  | )      | $ | (28,243,000 | ) |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Other comprehensive income (loss):**                                               |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| Net change in unrealized gain on available-for-sale securities                       |                               | —     |   | —                           |       | —                                               |       | 32,860,000               |   | —                                |        | 32,860,000   |   | 32,860,000 |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| Net change in unrealized and deferred losses on forward contracts                    |                               | —     |   | —                           |       | —                                               |       | (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   |   |   |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Amortization of non-employees stock options**                                      |                               | —     |   | —                           |       | 4,000                                                |       | —                   |   | —                                |        | 4,000        |   |   |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Net income**                                                                       |                               | —     |   | —                           |       | —                                               |       | —                   |   | 18,714,000                            |        | 18,714,000   |   | $ | 18,714,000 |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Other comprehensive income (loss):**                                               |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| Net change in unrealized loss on available-for-sale securities                       |                               | —     |   | —                           |       | —                                               |       | (23,793,000              | )      | —                                |        | (23,793,000  | )      | (23,793,000 | ) |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| Net change in unrealized and deferred losses on forward contracts                    |                               | —     |   | —                           |       | —                                               |       | 12,236,000               |   | —                                |        | 12,236,000   |   | 12,236,000 |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| Net change in unrealized gain on terminated interest rate swaps                      |                               | —     |   | —                           |       | —                                               |       | 179,000                  |   | —                                |        | 179,000      |   | 179,000 |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| Net change in unrealized gain on interest rate swaps classified as  cash flow hedges |                               | —     |   | —                           |       | —                                               |       | 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  |   |   |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Issuance of common stock**                                                         |                               | 14,301,500 |   | 144,000                          |       | 155,601,000                                          |       | —                   |   | —                                |        | 155,745,000  |   |   |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Amortization of non-employees stock options**                                      |                               | —     |   | —                           |       | 96,000                                               |       | —                   |   | —                                |        | 96,000       |   |   |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Net income**                                                                       |                               | —     |   | —                           |       | —                                               |       | —                   |   | 52,838,000                            |        | 52,838,000   |   | $ | 52,838,000 |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Other comprehensive income (loss):**                                               |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| Net change in unrealized gain on available-for-sale securities                       |                               | —     |   | —                           |       | —                                               |       | 47,034,000               |   | —                                |        | 47,034,000   |   | 47,034,000 |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| Net change in deferred loss on terminated interest rate swaps                        |                               | —     |   | —                           |       | —                                               |       | (10,359,000              | )      | —                                |        | (10,359,000  | )      | (10,359,000 | ) |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| Net change in unrealized loss on interest rate swaps classified as  cash flow hedges |                               | —     |   | —                           |       | —                                               |       | (124,718,000             | )      | —                                |        | (124,718,000 | )      | (124,718,000 | ) |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Comprehensive loss**                                                               |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   | $ | (35,205,000 | ) |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Dividends declared**                                                               |                               | —     |   | —                           |       | —                                               |       | —                   |   | (56,007,000                           | )           | (56,007,000  | )      |   |   |
|                                                                                 |                               |       |   |                             |       |                                                 |       |                     |   |                                  |        |         |   |   |   |
| **Balance, December 31, 2002**                                                       |                               | 29,857,000 |   | $                                | 299,000    |                                                 | $          | 331,499,000              |   | $                                     | (95,880,000 | )            | $      | (41,259,000 | ) | $ | 194,659,000 |   |   |   |

 

See accompanying notes tofinancial statements.

 

 

F-6

----

 

**Apex MortgageCapital, Inc.**

 

**Statementsof Cash Flows**

 
|                                                                               |   | **Year Ended December 31,** |       |
|------------------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                               |   | **2002**                    |       | **2001** |   | **2000** |   |
|                                                                               |   |                        |       |   |   |   |   |
| **Operating Activities:**                                                          |   |                        |       |   |   |   |   |
| Net income (Loss)                                                                  |   | $                           | 52,838,000 |   | $ | 18,714,000 |   | $ | (28,243,000 | ) |
| Adjustments to reconcile net income to net cash provided by operating  activities: |   |                        |       |   |   |   |   |
| Net amortization                                                                   |   | 6,687,000                   |       | (4,189,000 | ) | (2,559,000 | ) |
| Net loss on investment and derivative activities                                   |   | 16,388,000                  |       | 5,015,000 |   | 36,703,000 |   |
| Cumulative effect of change in accounting principle                                |   | —                      |       | 2,173,000 |   | — |   |
| Reclassification of previously unrealized gains                                    |   | —                      |       | (1,742,000 | ) | — |   |
| Trading activities                                                                 |   | (1,313,445,000              | )          | 135,650,000 |   | — |   |
| Change in assets and liabilities:                                                  |   |                        |       |   |   |   |   |
| Accrued interest receivable                                                        |   | (3,432,000                  | )          | (4,846,000 | ) | 2,520,000 |   |
| Other assets                                                                       |   | (2,254,000                  | )          | 379,000 |   | 104,000 |   |
| Accrued interest payable                                                           |   | 1,469,000                   |       | 406,000 |   | (3,091,000 | ) |
| Accrued expenses and other liabilities                                             |   | (9,475,000                  | )          | 10,876,000 |   | 163,000 |   |
| Net cash (used in) provided by operating activities                                |   | (1,251,224,000              | )          | 162,436,000 |   | 5,597,000 |   |
|                                                                               |   |                        |       |   |   |   |   |
| **Investing Activities:**                                                          |   |                        |       |   |   |   |   |
| Purchase of fixed income securities available-for-sale                             |   | (1,503,945,000              | )          | (1,081,801,000 | ) | (133,930,000 | ) |
| Proceeds from sales of fixed income securities available-for-sale                  |   | 1,570,699,000               |       | — |   | 193,953,000 |   |
| Proceeds from maturities of fixed income  securities available-for-sale       |   | 5,000,000                   |       | — |   | — |   |
| Proceeds from sales of equity securities                                           |   | 1,937,000                   |       | 7,578,000 |   | 6,481,000 |   |
| Principal payments on fixed income securities available-for-sale                   |   | 338,414,000                 |       | 350,000 |   | 73,893,000 |   |
| Net payments on closed forward contracts                                           |   | —                      |       | — |   | (17,192,000 | ) |
| Proceeds from terminated interest rate swaps                                       |   | —                      |       | — |   | 5,554,000 |   |
| Net cash provided by (used in) investing activities                                |   | 412,105,000                 |       | (1,073,873,000 | ) | 128,759,000 |   |
|                                                                               |   |                        |       |   |   |   |   |
| **Financing Activities:**                                                          |   |                        |       |   |   |   |   |
| Net change in reverse repurchase agreements                                        |   | 735,594,000                 |       | 831,416,000 |   | (127,226,000 | ) |
| Dividend distributions                                                             |   | (55,094,000                 | )          | (8,884,000 | ) | (9,595,000 | ) |
| Issuance of common stock                                                           |   | 155,745,000                 |       | 93,095,000 |   | — |   |
| Net cash provided by (used in) financing activities                                |   | 836,245,000                 |       | 915,627,000 |   | (136,821,000 | ) |
|                                                                               |   |                        |       |   |   |   |   |
| **Net (Decrease) Increase in Cash and Cash Equivalents**                           |   | (2,874,000                  | )          | 4,190,000 |   | (2,465,000 | ) |
|                                                                               |   |                        |       |   |   |   |   |
| **Cash and Cash Equivalents at Beginning of Year**                                 |   | 4,330,000                   |       | 140,000 |   | 2,605,000 |   |
|                                                                               |   |                        |       |   |   |   |   |
| **Cash and Cash Equivalents at End of Year**                                       |   | $                           | 1,456,000  |   | $ | 4,330,000 |   | $ | 140,000 |   |
|                                                                               |   |                        |       |   |   |   |   |
| **Supplemental Disclosure of Cash Flow Information:**                              |   |                        |       |   |   |   |   |
| Cash paid for interest                                                             |   | $                           | 86,863,000 |   | $ | 24,339,000 |   | $ | 39,711,000 |   |
| Noncash Investing and Financing Activities:                                        |   |                        |       |   |   |   |   |
| Change in accumulated other comprehensive loss                                     |   | (88,043,000                 | )          | (6,758,000 | ) | 25,434,000 |   |
| Change in receivable for unsettled securities                                      |   | (5,520,000                  | )          | 5,520,000 |   | — |   |
| Change in payable for unsettled securities                                         |   | —                      |       | (14,514,000 | ) | 14,514,000 |   |
| Change in dividends declared, not yet paid                                         |   | 913,000                     |       | 10,523,000 |   | 2,073,000 |   |

 

See accompanying notes tofinancial statements.

 

 

F-7

----

 

**Apex Mortgage Capital, Inc.**

**Notesto Financial Statements**

 

**Note1 - The Company**

 

Apex MortgageCapital, Inc. (the “Company”) was incorporated in Maryland on September 15,1997. The Company commenced its operations of acquiring and managing a portfolioof mortgage related assets on December 9, 1997, upon receipt of the netproceeds from the initial public offering of the Company’s Common Stock. TheCompany uses its equity capital and borrowed funds to seek to generate incomebased on the difference between the yield on its investments and the cost ofits borrowings.  The Company isstructured for tax purposes as a real estate investment trust (“REIT”) underthe Internal Revenue Code of 1986, as amended (the “Code”).

 

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

 

**Note2 - Summary of Significant Accounting Policies and 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 securities consistprimarily 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.

 

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 fairvalue, and changes in fair value are reported in net gain (loss) frominvestment and derivative activities in the statements of operations.  Available-for-sale securities are reportedat fair value, with unrealized gains and losses excluded from earnings andreported in accumulated other comprehensive loss.  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.

 

When the fairvalue of an available-for-sale security is less than amortized cost, managementconsiders whether there is an other-than-temporary impairment in the value ofthe security (e.g., whether the security will be sold prior to the recovery offair value).  If, in management’s judgment,an other-than-temporary impairment exists, the cost basis of the security iswritten down to the then-current fair value, and the unrealized loss istransferred from accumulated other comprehensive income as an immediatereduction of current earnings (i.e., as if the loss had been realized in theperiod of impairment).

 

*Interest Income and Dividend Recognition*

 

Interestincome on the Company’s mortgage securities and other fixed income securitiesis accrued based on the actual coupon rate and the outstanding principalamount.  Premiums and discounts areamortized or accreted into interest income over the lives of the securitiesusing the effective yield method adjusted for the effects of estimatedprepayments.  In the event that the costbasis of a security has been reduced below par because of another-than-temporary impairment in value, the difference is treated like adiscount in

 

F-8

----

 

determiningthe appropriate amount of accretion to recognize as interest income between thedate when the cost is adjusted and when the security is ultimately sold.  Also, dividends on equity securities arerecognized as income on their declaration dates.

 

*Derivatives and Hedging Transactions*

 

The Companymay enter into interest rate swaps and other financial instruments in order tomitigate the impact of rising interest rates on the cost of its short-termborrowings and market value of its portfolio securities.  The Company may also enter into forwardcontracts to sell U.S. Treasury securities and other financial instruments inorder to mitigate the negative impact of rising interest rates on the fairvalue 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. Under SFAS No. 133, allderivatives are recorded at fair value and presented as either assets orliabilities on the Company’s balance sheets. If the Company were to changecurrent or anticipated borrowings so that they were no longer appropriatelymatched to the swap agreements, the agreements might no longer qualify forhedge accounting treatment. In that case, changes in their fair values wouldaffect net income.

 

Prior toadopting SFAS No. 133, the Company accounted for changes in fair values of theforward contracts through adjustments to accumulated other comprehensiveincome. Following adoption of SFAS No. 133, the Company recognizes changes infair values of forward contracts as a component of net gain (loss) oninvestment and derivative activities in the statements of operations.

 

At December31, 2002 and 2001, the Company’s outstanding interest rate swaps qualify ascash flow hedges and are deemed to be fully effective as hedges under SFAS No.133.  Changes in fair values of suchswaps are not reflected in current earnings, but are reflected in othercomprehensive income.  Currently, fairvalue of the interest rate swaps is determined by the average of valuesobtained from two market analytics systems, The Yield Book and Bloomberg.

 

During 2001,the adoption of SFAS No. 133 and the related amendments resulted in atransition adjustment that reclassified $2,173,000 of net losses on unrealizedand deferred gains and losses on investment securities and forward contractsfrom accumulated other comprehensive income to earnings. The Company alsoreclassified deferred gains totaling $2,546,000 on terminated interest rateswaps previously designated as hedges of short-term borrowings from otherliabilities to accumulated other comprehensive income.  Deferred gains on terminated swaps areamortized into earnings over their original lives as adjustments to interestexpense.

 

In conjunctionwith adopting SFAS No. 133, the Company reclassified $594,469,000 of itsmortgage securities from the available-for-sale category to the tradingcategory on January 1, 2001 for investments accounted for under SFAS No. 115.This change resulted in the reclassification of $1,742,000 of net unrealizedgains from accumulated other comprehensive income to earnings, in addition tonet unrealized gains included in the SFAS No. 133 transition adjustmentdiscussed above.

 

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

 

*Stock-based Compensation*

 

The Companygrants stock options to its Directors and to certain directors, officers andemployees of the Manager, as discussed in Note 6.  Options granted to Directors of the Company are accounted forusing the intrinsic-value method, and generally no compensation expense isrecognized in the statements of operations for such options.  Options granted to persons other thanDirectors (i.e., to non-employees) are accounted for using the fair valuemethod; such stock options are measured at their fair value when they aregranted and are recognized as general and administrative expense during theperiods when the options are vested and the related services are performed.

 

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

* *
|                                                                                                                                         |   | **Year Ended December 31,** |       |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|------------|
|                                                                                                                                         |   | **2002**                    |       | **2001** |   | **2000** |   |
|                                                                                                                                         |   |                        |       |   |   |   |   |
| Reported net income (loss)                                                                                                                   |   | $                           | 52,838,000 |   | $ | 18,714,000 |   | $ | (28,243,000 | ) |
| Deduct: Total stock-based employee compensation expense determined  under fair value based method for all awards, net of related tax effects |   | (2,000                      | )     | (5,000 | )  | (166,000 | )  |
| Pro forma net income (loss)                                                                                                                  |   | $                           | 52,836,000 |   | $ | 18,709,000 |   | $ | (28,409,000 | ) |
|                                                                                                                                         |   |                        |       |   |   |   |   |
| Earnings per share:                                                                                                                          |   |                        |       |   |   |   |   |
| Basic - as reported                                                                                                                          |   | $                           | 2.02       |   | $ | 2.59 |   | $ | (4.91 | ) |
| Basic - pro forma                                                                                                                            |   | $                           | 2.02       |   | $ | 2.59 |   | $ | (4.94 | ) |
|                                                                                                                                         |   |                        |       |   |   |   |   |
| Diluted - as reported                                                                                                                        |   | $                           | 2.01       |   | $ | 2.55 |   | $ | (4.91 | ) |
| Diluted - pro forma                                                                                                                          |   | $                           | 2.01       |   | $ | 2.55 |   | $ | (4.94 | ) |
|                                                                                                                                         |   |                        |       |   |   |   |   |

 

 

F-9

----

 

*Federal and State Income Taxes*

 

The Companyhas elected to be taxed as a REIT and generally is not subject to federal andstate taxes on its income to the extent it distributes annually 90% of itspre-distribution 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. Also, since the Company holds only mortgage-relatedassets and not actual real property in its portfolio, 100% of the Company’sdistributions are ordinary taxable income to stockholders of the Company.

 

*Net Income Per Share*

 

Basic netincome per share is calculated on the basis of the weighted average number ofcommon shares outstanding during each period. Diluted net income per share includes the additional dilutive effect ofoutstanding stock options as calculated using the treasury stock method.  The weighted average number of shares usedto calculate net income per diluted share includes the effect of the assumedexercise of outstanding stock options that have exercise prices less than theaverage market price of the stock.

 

*Interest Rate Risk*

 

The principalrisk affecting the Company’s net income, including operating earningsdistributable as dividends to the Company’s stockholders under the REITprovisions of the Code, is interest rate risk. The Company’s assets are principally fixed-rate mortgage securities withweighted average maturities of several years or more (approximately 2.7 yearsas of December 31, 2002).  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 repurchaseagreements or similar forms of financing in the future.

 

*Credit Risk*

 

The Companyhas limited 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 its portfolio inbelow-investment-grade securities, although it holds no such securities as ofDecember 31, 2002.

 

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*

 

Thepreparation of financial statements in conformity with accounting principlesgenerally accepted in the United States of America requires management to makeestimates and assumptions that affect the reported amounts of assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Actual results could differ from those estimates.  Estimates most significant to the Company’sfinancial statements are related to the fair values of certain investmentsecurities.  The majority of theCompany’s fixed income securities are priced by management based on informationobtained from national pricing services, market-makers in the securities,management’s knowledge about the markets for the securities, and other factorsdeemed by management to be significant.

 

*Recently IssuedAccounting Standards*

 

During theyear ended December 31, 2002, the Company has not adopted any new accountingstandards that would have a material effect on the Company’s results ofoperations, financial position and cash flows. Recently issued accountingstandards required to be adopted by the Company in 2003 and future years are eithernot applicable to the Company or are not expected to have a material effect onthe Company’s results

 

F-10

----

 

of operations,financial position or cash flows, based on the current and anticipated nature ofthe Company’s operations.

 

The FinancialAccounting Standards Board (FASB) issued Interpretation (FIN) No. 45, *Guarantors Accounting and Disclosure Requirements forGuarantees, Including Indirect Guarantees and Indebtedness of Other*,an interpretation of SFAS Nos. 5, 57 and 107, and rescission of FIN No. 34, *Disclosure of Indirect Guarantees of Indebtedness ofOthers*, in November 2002. FIN No. 45 elaborates on the disclosures to be made by the guarantor inits interim and annual financial statements about its obligations under certainguarantees that it has issued.  It alsorequires that a guarantor recognize, at the inception of a guarantee, aliability for the fair value of the obligation undertaken in issuing theguarantee.  The initial recognition andmeasurement provisions of the interpretation are applicable on a prospectivebasis to guarantees issued or modified after December 31, 2002, while theprovision of the disclosure requirements are effective for financialsstatements of interim or annual periods ending after December 15, 2002.  The Company believes the adoption of suchinterpretation will not have a material impact on its results of operations,financials position or cash flows.

 

Statement ofFinancial Accounting Standards (“SFAS”) No. 148, *Accounting for Stock-based Compensation - Transition and Disclosure, anamendment of FASB Statement No. 123, amends SFAS No. 123* to providealternative methods of transition for a voluntary change to the fair valuebased method of accounting for stock-based employee compensation.  It also amends the disclosure provisions ofSFAS No. 123 to require prominent disclosure in both annual and interimfinancials statements about the method of accounting for stock-based employeecompensation and the effect of the method used on reported results.  The provisions of SFAS No. 148 are effectivefor annual financials statements for fiscal years ending after December 15,2002, and for financials reports containing condensed financials statements forinterim periods beginning after December 15, 2002.  The Company has not determined whether it will adopt the fairvalue based method of accounting for stock-based employee compensation.

 

**Note3 – Fixed Income and Equity Securities**

 

At December31, 2002, fixed income and equity securities consisted of the following:

 
| **(in thousands)**             |   | **Fixed Income  Trading Securities** |    | **Fixed Income  Securities  Available-For-Sale** |   | **Equity Securities  Available-For-Sale** |   |
|--------------------------------|--------|--------------------------------------|---------|--------------------------------------------------|--------|-------------------------------------------|--------|
| Principal Amount               |   | $                                    | 585,817 |                                             | $      | 1,765,448                                 |   |   |   |
| Unamortized Premium (Discount) |   | 12,838                               |    | 20,371                                           |   |                                      |   |
| Adjusted Cost                  |   | 598,655                              |    | 1,785,819                                        |   | $                                         | 2,844  |   |
| Gross Unrealized Gains         |   | 7,359                                |    | 33,225                                           |   | 1,324                                     |   |
| Gross Unrealized Losses        |   | —                               |    | (151                                             | )      | —                                    |   |
| Fair Value                     |   | $                                    | 606,014 |                                             | $      | 1,818,893                                 |   | $ | 4,168 |   |

 

At December31, 2001, fixed income and equity securities consisted of the following:

 
| **(in thousands)**             |   | **Fixed  Income  Trading Securities** |    | **Fixed Income  Securities  Available-For-Sale** |   | **Equity Securities  Available-For-Sale** |   |
|--------------------------------|--------|--------------------------------------------|---------|--------------------------------------------------|--------|-------------------------------------------|--------|
| Principal Amount               |   | $                                          | 432,630 |                                             | $      | 1,071,009                                 |   |   |   |
| Unamortized Premium (Discount) |   | (9,266                                     | )       | 11,044                                           |   |                                      |   |
| 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 |   |

 

F-11

----

 

Thecontractual final maturity of the mortgage loans supporting fixed incomemortgage securities is generally between 15 and 30 years atorigination.  Because of prepayments onthe underlying mortgage loans, the actual weighted average maturity is expectedto be substantially less.

 

Fixed-ratemortgage securities composed over 99% and 98% of the Company’s portfolio offixed income securities at December 31, 2002 and 2001, respectively.  The expected average remaining maturity ofthe Company’s other fixed income securities as of December 31, 2002 and 2001was less than one year.

 

Adjustable-ratemortgage securities comprised approximately 0.4% and 1.1% of the Company’sportfolio of fixed income securities at December 31, 2002 and 2001,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 thesecurities’ effective interest rates can change during any given period andover the lives of the assets.  Both atDecember 31, 2002 and 2001, the portion of adjustable-rate mortgage securitiessubject to periodic and lifetime caps had an average periodic cap equal to 2.0%and an average lifetime cap equal to 11.3%.

 

During 2002,the Company reported a net loss on investment and derivative activities of$16,388,000 in the statement of operations. This loss consisted of a net loss of $55,517,000 on closed forwardcontracts, a gain of $28,156,000 on the sale of $1,456,542,000 of fixed incometrading securities, a gain of $16,929,000 on the sale of $1,565,180,000 offixed income available-for-sale securities, a gain of $593,000 on the sale of$1,937,000 equity securities available-for-sale, a loss of $2,593,000 onterminated swaps, and an unrealized loss of $3,956,000 on fixed income tradingsecurities.

 

During 2001,the Company reported a net loss on investment and derivative 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 tradingsecurities, a gain of $3,076,000 on the sale of $7,578,000 of equity securitiesavailable-for-sale, and an unrealized gain of $3,240,000 on fixed incometrading securities.  There were no salesof available-for-sale fixed income securities during 2001.

 

During 2000,the Company realized $741,000 and $6,536,000 in gross gains and losses,respectively, on the sale of $97,440,000 and $96,513,000 of fixed incomesecurities available-for-sale, respectively. During 2000, the Company realized $348,000 and $221,000 in gross gainsand losses, respectively, on the sale of $3,419,000 and $3,062,000 of equitysecurities, respectively, which were classified as available-for-sale.  During 2000, the Company realized a gain of$172,000 from the sale of interest rate caps.

 

During 2000,the Company recorded an impairment adjustment of $18,284,000 on its fixed-ratemortgage securities, which was included in net loss on investment and derivativeactivities in the statement of operations. The impairment adjustment represents an other-than-temporary decline inthe fair value, as of September 30, 2000, of investments held that the Companyno longer intended to hold. A substantial portion of these investments weresold in the fourth quarter of 2000 and during 2001 and 2002.

 

Net deferredlosses and unrealized losses of $7,345,000 and $1,079,000, respectively, onforward contracts were reclassified from other comprehensive income into netloss on investment and derivative activities in the statement of operationsduring 2000 as part of the impairment charge recorded on the underlying assetsbeing hedged.

 

The Companyalso recorded impairment adjustments of $3,368,000 and $958,000 on its DynexCapital Inc. preferred stock and common stock holdings, respectively, whichwere included in net loss on investment and derivative activity in thestatement of operations.

** **

**Note4 - Reverse Repurchase Agreements**

 

The Companyhas entered 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. Reverse repurchaseagreements are accounted for as short-term borrowings and recorded as aliability on the balance sheet.

 

F-12

----

 

At December31, 2002, the Company had outstanding $2,112,444,000 of reverse repurchaseagreements with a weighted average current borrowing rate of 1.40% and aweighted average maturity of 1.0 month. The reverse repurchase agreements were collateralized by securities withan estimated fair value of $2,199,852,000.

 

At December31, 2001, the Company had outstanding $1,376,850,000 of reverse repurchaseagreements with a weighted average current borrowing rate of 1.89% and aweighted average maturity of 1.0 month. The reverse repurchase agreements were collateralized by securities withan estimated fair value of $1,440,014,000.

 

For the yearended December 31, 2002, the average reverse repurchase agreement balance was$2,549,641,000 with a weighted average interest cost of 3.5% inclusive of theeffect of interest rate swaps.  Themaximum reverse repurchase agreement balance outstanding during 2002 was$3,704,177,000.

 

For the yearended December 31, 2001, the average reverse repurchase agreement balance was$635,954,000 with a weighted average interest cost of 3.9% inclusive of theeffect of interest rate swaps.  Themaximum reverse repurchase agreement balance outstanding during the year endedDecember 31, 2001 was $1,376,850,000.

 

For the yearended December 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.

 

**Note5 – Derivative Financial Instruments and Hedging Activities**

 

The Companyhas entered into interest rate swap agreements as summarized below.  Under these agreements, the Company receivesa floating rate and pays a fixed rate. The swaps qualify as cash flow hedges for accounting purposes, andeffectively fix the interest rate paid on $1,678,500,000, as of December 31,2002, of current and anticipated future borrowings under reverse repurchaseagreements. The Company estimates that approximately $39,600,000 of unrealizedand deferred realized losses on interest rate swaps currently included inaccumulated other comprehensive loss will be reclassified into interest expensewithin the next twelve months as net settlements occur. As of December 31,2002, the maximum length of time over which the Company is hedging its exposureto the variability in future cash flows for current and anticipated futuretransactions is approximately 9.5 years.

 

Interest RateSwaps at December 31, 2002:

 

(Dollars inthousands)

 
| **Current  Notional Amount** |      | **Average  Fixed Rate** |   | **Floating  Rate** |         | **Par  Weighted  Average Maturity** |      | **Unrealized  Losses** |   |
|------------------------------|-----------|-------------------------|--------|--------------------|--------------|-------------------------------------|-----------|------------------------|--------|
|                         |      |                    |   |               |         |                                |      |                   |   |
| $                            | 1,678,500 |                    | 4.643  | %                  | 1Month LIBOR |                                | 4.4 years |                   | $      | 120,098 |   |
|                              |           |                         |        |                    |              |                                     |           |                        |        |  |  |

 

Interest Rate Swaps atDecember 31, 2001:

 

(Dollars inthousands)

 
| **Current  Notional Amount** |    | **Average  Fixed Rate** |   | **Floating  Rate** |         | **Par  Weighted  Average Maturity** |      | **Unrealized  Gains** |   |
|------------------------------|---------|-------------------------|--------|--------------------|--------------|-------------------------------------|-----------|-----------------------|--------|
|                         |    |                    |   |               |         |                                |      |                  |   |
| $                            | 850,000 |                    | 4.239  | %                  | 1Month LIBOR |                                | 6.6 years |                  | $      | 4,620 |   |
|                              |         |                         |        |                    |              |                                     |           |                       |        |  |  |

 

F-13

----

 

During thefourth quarter of 2002, the Company terminated a portion of the outstandinginterest rate swap agreements with a combined notional amount of $544,500,000,which resulted in a deferred loss of approximately $13,872,000 with an averageterm of 1.3 years and an average rate of 3.57%. As a result of decliningreverse repurchase agreements, the Company accelerated the deferred lossrecognition and reclassified $2,593,000 from accumulated other comprehensiveincome (loss) into earnings. The loss reclassification was included in net lossfrom investment and derivative activities for the year ended December 31, 2002.The acceleration of the deferred loss recognition depends on the balance ofreverse repurchase agreements maintained by the Company.  If the general level of reverse repurchaseagreements decline further, the Company may be required to accelerate thedeferred loss recognition in the future. The remaining deferred loss is beingamortized as an adjustment to interest expense over the remaining lives of theoriginal swap agreements.

 

During 2000,the Company terminated outstanding interest rate swap agreements with acombined notional amount of $386,213,000, which resulted in a deferred gain of$5,554,000.  The deferred gain was beingamortized as an adjustment to interest expense over the remaining lives of theoriginal swap agreements, and the remaining unamortized amount was 1included inaccumulated other comprehensive income (loss) as of December 31, 2001. Thedeferred gain was fully amortized in 2002.

 

During 2002,interest expense was increased by $43,231,000 paid to swap counterparties and$920,000 from amortization of net deferred losses on terminated swap contracts.During 2001, interest expense was increased by $1,663,000 paid to swapcounterparties and decreased by $2,367,000 from amortization of deferred gainson terminated swap contracts. During 2000, interest expense was decreased by$334,000 received from swap counterparties and $3,808,000 from amortization ofdeferred gains on terminated swap contracts.

 

At December31, 2002, there was no cash collateral held from a swap counterparty. AtDecember 31, 2001, the Company held $2,500,000 in cash as collateral from aswap counterparty.

 

At December31, 2002, the Company had no open forward contracts to sell U.S. Treasurynotes.

 

At December31, 2001, the Company had open forward contracts to sell U.S. Treasury noteswith terms stated below:

 

(Dollars inthousands)

 
| **Current  Notional Amount** |    | **Average  Termination  Date** |      | **Net  Unrealized  Losses** |   | **Average  Maturity of  Underlying  Securities** |   |
|------------------------------|---------|--------------------------------|-----------|-----------------------------|--------|--------------------------------------------------|--------|
|                         |    |                           |      |                        |   |                                             |   |
| $                            | 359,000 |                           | 1/14/2002 |                        | $      | 3,275                                            |   | 5.57 Years |   |
|                              |         |                                |           |                             |        |                                                  |        |  |  |

 

**Note6 – Stock Option Plan**

 

The Companyhas adopted 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 stock options.

 

The exerciseprice for any stock option granted under the Amended and Restated 1997 StockOption Plan may not be less than 100% of the fair market value of the shares ofCommon Stock at the time the option is granted.  Each option must terminate no more than ten years from the dateit is granted.  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

----

 

Stock optionactivity during 2002, 2001, and 2000 was as follows:

 
|                                     |   | **Options** |   | **Weighted  Average  Exercise  Price** |   |
|------------------------------------------|--------|-------------|--------|----------------------------------------|--------|
| Options Outstanding at January 1, 2000   |   | 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                                  |   |
|                                     |   |        |   |                                   |   |
|                                     |   |        |   |                                   |   |
| Exercised During 2002                    |   | (41,500     | )      | 9.11                                   |   |
| Forfeited During 2002                    |   | (71,000     | )      | 11.16                                  |   |
| Options Outstanding at December 31, 2002 |   | 791,000     |   | $                                      | 11.58  |   |

** **

Stock optionsoutstanding at December 31, 2002 are 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                      |   | 228,000                  |   | 8 years                                |   | $ | 6.98 |   | 228,000 |   | $ | 6.98 |   |
| $10.38                     |   | 144,000                  |   | 6 years                                |   | $ | 10.38 |   | 144,000 |   | $ | 10.38 |   |
| $11.18                     |   | 56,000                   |   | 9 years                                |   | $ | 11.18 |   | 28,000 |   | $ | 11.18 |   |
| $15.00                     |   | 363,000                  |   | 5 years                                |   | $ | 15.00 |   | 363,000 |   | $ | 15.00 |   |
| $6.98-$15.00               |   | 791,000                  |   | 6.3 years                              |   | $ | 11.58 |   | 763,000 |   | $ | 11.59 |   |

 

Of the stockoptions outstanding summarized in the tables above, 489,000 are held byDirectors of the 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 $96,000, $4,000, and $95,000 during 2002, 2001, and 2000,respectively.

 

164,000 of thestock options summarized above have dividend equivalent rights that entitleeach option holder to receive a cash payment equal to the dividends declared onthe Company’s Common Stock multiplied by the number of stock options held untilthe stock options are exercised or expire. Under the terms of the Company’soutstanding dividend equivalent rights, dividends are payable on the dividendequivalent rights prior to the vesting of the related stock options. Dividendspaid on stock options with dividend equivalent rights are charged toaccumulated deficit in the balance sheet. As of December 31, 2002, there were10,000 outstanding dividend equivalent rights related to unvested stockoptions.

 

F-15

----

 

 

The fair valueof the stock options granted was estimated using the Black-Scholesoption-pricing model with the following assumptions (where dividend yield isshown as zero in the table, the stock options have dividend equivalent rightsas discussed above, and the assumption of no dividends adjusts for that factorand increases the estimated fair value):

 
|                    |   | **Year Ended December 31,** |           |
|-------------------------|--------|-----------------------------|----------------|
|                    |   | **2001**                    |           | **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 stockoptions were granted during 2002.

 

**Note7 – Shareholders’ Rights Plan**

 

On June 30,1999, the Board of Directors of the Company declared a dividend distribution ofone Right for each outstanding share of the Company’s Common Stock tostockholders of record at the close of business on July 30, 1999 (the “RecordDate”).  Each Right entitles theregistered holder to purchase from the Company one one-hundredth of a share ofSeries A Junior Participating Preferred Stock, par value $0.01 per share (the“Preferred Stock”), 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”), other than as a result of repurchases of stockby the Company or certain inadvertent actions by institutional or certain otherstockholders or (ii) 10 business days (or such later date as the Board shalldetermine) following the commencement of a tender offer or exchange offer thatwould result in a person or group becoming an Acquiring Person.  Until the Distribution Date, (i) the Rightswill be evidenced by the

 

F-16

----

 

common stockcertificates and will be transferred with and only with such common stockcertificates, (ii) new common stock certificates issued after the Record Datewill contain a notation incorporating the Rights Agreement by reference and(iii) the surrender for transfer of any certificates for common stock outstandingwill also constitute the transfer of the Rights associated with the commonstock represented by such certificate. Pursuant to the Rights Agreement, the Company reserves the right torequire that, prior to the occurrence of a triggering event, upon any exerciseof Rights, a number of Rights be exercised so that only whole shares ofPreferred Stock will be issued.

 

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

 

**Note8 - Fair Value of Financial Instruments**

 

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)

 
|                                 |   | **December 31,**   |      |
|--------------------------------------|--------|--------------------|-----------|
|                                 |   | **2002**           |      | **2001** |   |
|                                 |   | **Carrying Value** |      | **Fair Value** |   | **Carrying Value** |   | **Fair Value** |   |
|                                 |   |               |      |   |   |   |   |   |   |
| Mortgage-related securities          |   | $                  | 2,424,657 |   | $ | 2,424,657 |   | $ | 1,500,077 |   | $ | 1,500,077 |   |
|                                 |   |               |      |   |   |   |   |   |   |
| Equity securities                    |   | 4,168              |      | 4,168 |   | 6,028 |   | 6,028 |   |
|                                 |   |               |      |   |   |   |   |   |   |
| Other fixed income securities        |   | 250                |      | 250 |   | 5,452 |   | 5,452 |   |
|                                 |   |               |      |   |   |   |   |   |   |
| Cash and cash equivalents            |   | 1,456              |      | 1,456 |   | 4,330 |   | 4,330 |   |
|                                 |   |               |      |   |   |   |   |   |   |
| Receivable for unsettled  securities |   | —             |      | — |   | 5,520 |   | 5,520 |   |
|                                 |   |               |      |   |   |   |   |   |   |
| Accrued interest receivable          |   | 12,012             |      | 12,012 |   | 8,580 |   | 8,580 |   |
|                                 |   |               |      |   |   |   |   |   |   |
| Accrued interest payable             |   | 2,444              |      | 2,444 |   | 975 |   | 975 |   |
|                                 |   |               |      |   |   |   |   |   |   |
| Reverse repurchase agreements        |   | 2,112,444          |      | 2,112,444 |   | 1,376,850 |   | 1,376,850 |   |
|                                 |   |               |      |   |   |   |   |   |   |
| Interest rate swaps                  |   | (120,098           | )         | (120,098 | ) | 4,620 |   | 4,620 |   |
|                                 |   |               |      |   |   |   |   |   |   |
| Forward contracts                    |   | —             |      | — |   | (3,275 | ) | (3,275 | ) |
|                                      |        |                    |           |  |  |  |  |  |  |  |  |  |  |

 

Substantiallyall the Company’s assets are carried at their fair values on the balancesheets. The Company bases its fair value estimates for mortgage relatedsecurities, equity securities, other fixed income securities, interest rate swaps,and forward 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. Because theprice estimates may vary to some degree between sources, management must makecertain judgments and assumptions about the appropriate price to use tocalculate the fair value of investments for financial reporting purposes.Different judgments and assumptions could result in different presentations ofvalue. Cash and cash equivalents, interest receivable and payable, and reverserepurchase agreements are reflected in the financial statements at their costs,which approximates their fair value because of the short-term nature of thoseinstruments.

 

F-17

----

 

 

**Note9 – Related Party Transactions**

 

The Companypays the Manager annual base management compensation, payable monthly inarrears, equal to 3/4 of 1% of the Average Net Invested Capital as defined inthe Management Agreement.  The Companyrecorded expense of $1,912,000, $471,000, and $512,000 in base managementcompensation to the Manager during 2002, 2001, and 2000, respectively.  The accrued liability for base managementcompensation, included in accrued expenses and other liabilities in the balancesheets, was $1,593,000 and $144,000 at December 31, 2002 and 2001, respectively.

 

The Companyalso pays the Manager, as incentive compensation, an amount equal to 30% of theNet Income of the Company, as defined in the Management Agreement, beforeincentive compensation, in excess of the amount that would produce an annualizedReturn on Equity, as defined in the Management Agreement, equal to the ten-yearU.S. Treasury rate plus 1%.  The Companyrecorded expense of $2,000,000 and $634,000 for incentive compensation to theManager for the years ended December 31, 2002 and 2001, respectively.  No incentive compensation was incurred forthe year ended December 31, 2000.

 

During 2002,the incentive fee calculated using the formula summarized above was$10,982,000.  However, the Managerwaived all but $2,000,000 of the incentive fee.  Because the Company had previously paid the Manager incentivefees exceeding that amount during 2002, the excess of $650,000 is receivablefrom the Manager and is included in Other Assets in the accompanying balancesheets as of December 31, 2002.

 

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.

 

**Note10 – Commitments and Contingencies**

 

The Company’sBoard of Directors has authorized a program to repurchase shares of theCompany’s Common Stock.   As of December31, 2002, 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 2002, 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.  Anytermination or non-renewal fee paid may be materially greater than eight timeshistorical fees and the Company can provide no assurance at this time as to theamount of any such fee.

 

 

**Note11 – Accumulated Other Comprehensive Income (Loss)**

 

The followingis a presentation of the changes in accumulated other comprehensive income(loss) for the years ended December 31, 2002, 2001, and 2000, including thecumulative effects of the change in

 

F-18

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accountingprinciple relating to the adoption of SFAS No. 133 on January 1, 2001 (see Note2), and other adjustments to reclassify amounts from accumulated othercomprehensive income (loss) into the statements of operations during each year:

 
|                                                                                                                                |   | **Year Ended December 31,** |         |
|-------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------------|
|                                                                                                                                |   | **2002**                    |         | **2001** |   | **2000** |   |
| *Unrealized Gains (Losses) on  Available-for-Sale Securities:*                                                                      |   |                        |         |   |   |   |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| Unrealized gains (losses)  arising during the year                                                                                  |   | $                           | 64,556,000   |   | $ | (8,912,000 | ) | $ | 1,315,000 |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| 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 |   | (17,522,000                 | )       | (3,076,000 | )  | 8,935,000 |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| 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                                                           |   | $                           | 47,034,000   |   | $ | (23,793,000 | ) | $ | 32,860,000 |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| *Unrealized and Deferred Gains (Losses) on  Forward Contracts:*                                                                     |   |                        |         |   |   |   |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| Net deferred gain (loss) from  forward contracts closed during the year                                                             |   | $                           | —       |   | $ | — |   | $ | (16,860,000 | ) |
|                                                                                                                                |   |                        |         |   |   |   |   |
| 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 | ) |
|                                                                                                                                |   |                        |         |   |   |   |   |
| *Deferred Gain (Loss) on Terminated Interest  Rate Swaps:*                                                                          |   |                        |         |   |   |   |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| Cumulative effect of change in  accounting principle – SFAS No. 133 transition adjustment                                      |   | $                           | —       |   | $ | 2,546,000 |   | $ | — |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| Deferred loss from terminated  interest rate swaps                                                                                  |   | (13,872,000                 | )            | — |   | — |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| Reclassification of deferred  loss to net gain (loss) from investment and derivative activities                                     |   | 2,593,000                   |         | — |   | — |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| Reclassification for  amortization into interest expense                                                                            |   | 920,000                     |         | (2,367,000 | ) | — |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| Net change in deferred gain  (loss) on terminated interest rate swaps                                                               |   | $                           | (10,359,000  | ) | $ | 179,000 |   | $ | — |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| *Unrealized Gain (Loss) on Interest Rate  Swaps Classified as Cash Flow Hedges:*                                                    |   |                        |         |   |   |   |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| Net unrealized gain (loss) on  interest rate swaps classified as cash flow hedges                                                   |   | $                           | (167,949,000 | ) | $ | 2,957,000 |   | $ | — |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| Reclassification for  adjustments to interest expense                                                                               |   | 43,231,000                  |         | 1,663,000 |   | — |   |
|                                                                                                                                |   |                        |         |   |   |   |   |
| Net change in unrealized gain  (loss) on interest rate swaps classified as cash flow hedges                                         |   | $                           | (124,718,000 | ) | $ | 4,620,000 |   | $ | — |   |

 

F-19

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The followingis a summary of the amounts included in accumulated other comprehensive income(loss) as of December 31, 2002 and 2001:

 
|                                                                                 |   | **December 31,** |        |
|--------------------------------------------------------------------------------------|--------|------------------|-------------|
|                                                                                 |   | **2002**         |        | **2001** |   |
|                                                                                 |   |             |        |   |   |
| Net unrealized gains (losses)  on available-for-sale securities                      |   | $                | 34,398,000  |   | $ | (12,636,000 | ) |
|                                                                                 |   |             |        |   |   |
| Net deferred gains (losses) on  terminated interest rate swaps                       |   | (10,180,000      | )           | 179,000 |   |
|                                                                                 |   |             |        |   |   |
| Net unrealized gains (losses)  on interest rate swaps classified as cash flow hedges |   | (120,098,000     | )           | 4,620,000 |   |
|                                                                                 |   |             |        |   |   |
| Accumulated Other Comprehensive  Loss                                                |   | $                | (95,880,000 | ) | $ | (7,837,000 | ) |

 

**Note12 – Summarized Quarterly Results (Unaudited)**

 

The followingis a presentation of the quarterly results of operations (amounts are inthousands except per share amounts):

 
|                                                     |   | **Year Ended December 31, 2002,** |   |
|----------------------------------------------------------|--------|-----------------------------------|--------|
|                                                     |   | **Fourth  Quarter**               |   | **Third  Quarter** |   | **Second  Quarter** |   | **First  Quarter** |   |
|                                                     |   |                              |   |   |   |   |   |   |   |
| Interest Income                                          |   | $                                 | 37,252 |   | $ | 53,715 |   | $ | 45,270 |   | $ | 27,308 |   |
| Interest Expense                                         |   | 25,920                            |   | 29,237 |   | 21,390 |   | 12,704 |   |
| Net Interest Income                                      |   | 11,332                            |   | 24,478 |   | 23,880 |   | 14,604 |   |
|                                                     |   |                              |   |   |   |   |   |   |   |
| Net Gain (Loss) on Investment  and Derivative Activities |   | 9,709                             |   | (15,645 | ) | (8,748 | ) | (1,704 | ) |
| Dividend Income                                          |   | 101                               |   | 106 |   | 109 |   | 126 |   |
| General and Administrative  Expenses                     |   | 3,050                             |   | (557 | ) | (280 | ) | 3,297 |   |
| Net Income                                               |   | $                                 | 18,092 |   | $ | 9,496 |   | $ | 15,521 |   | $ | 9,729 |   |
|                                                     |   |                              |   |   |   |   |   |   |   |
| Basic Net Income per Share                               |   | $                                 | 0.61   |   | $ | 0.32 |   | $ | 0.58 |   | $ | 0.53 |   |
|                                                     |   |                              |   |   |   |   |   |   |   |
| Diluted Net Income per Share                             |   | $                                 | 0.61   |   | $ | 0.32 |   | $ | 0.58 |   | $ | 0.53 |   |
|                                                     |   |                              |   |   |   |   |   |   |   |
| Average Number of Shares  Outstanding:                   |   |                              |   |   |   |   |   |   |   |
| Basic                                                    |   | 29,857                            |   | 29,857 |   | 26,628 |   | 18,316 |   |
|                                                     |   |                              |   |   |   |   |   |   |   |
| Diluted                                                  |   | 29,865                            |   | 29,992 |   | 26,796 |   | 18,428 |   |
|                                                     |   |                              |   |   |   |   |   |   |   |
| Dividends Declared Per Share                             |   | $                                 | 0.45   |   | $ | 0.50 |   | $ | 0.50 |   | $ | 0.50 |   |

 

F-20

----

 
|                                                     |   | **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 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 |   |

 

**13.          SubsequentEvents**

 

On March 13,2003, the Board of Directors of the Company declared a dividend of $0.25 percommon share for the first quarter of 2003, payable on April 30, 2003 tostockholders of record on March 28, 2003. The Company’s policy is to accruecash dividend payments once declared by the Board of Directors and, as such, thedividend declared on March 13, 2003 is not reflected in the accompanyingfinancial statements.

 

On March 13,2003, the Board of Directors authorized management to consider a full range ofstrategic alternatives for the Company in order to maximize shareholder value,including the potential sale of the Company. In this context, the Board ofDirectors has appointed a special committee consisting of the independentdirectors. In the event of a sale of the Company, the Manager is entitled toreceive a termination fee under the terms of the Management Agreement.  In the event of a termination, the Managerand the Board of Directors have agreed to limit the termination fee to anamount less than the fair market value contemplated to be paid under theManagement Agreement. In the event of a sale of the Company, the terminationfee will be an amount up to fifty percent of the premium over book value, notto exceed $10 million.

 

F-21

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