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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
   FORM 10-Q x
    
    Quarterly report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934
 for the quarterly period ended: March 31, 2004
 or o
    
    Transition report pursuant to section 13 or 15(d) of the Securities Exchange Act of 1934
 for the transition period from        to Commission File Number: 000-31828   LUMINENT MORTGAGE CAPITAL, INC. (Exact name of registrant as specified in its charter) Maryland
    
    06-1694835(State or Other Jurisdiction of Incorporation or
    
    (I.R.S. EmployerOrganization)
    
    Identification No.)
 909 Montgomery Street, Suite 500, San Francisco, California
    
    94133(Address of Principal Executive Offices)
    
    (Zip Code)
 (415) 486-2110
(Registrants Telephone Number, Including Area Code) N/A
(Former Name, Former Address and Former Fiscal Year, if Changed Since Last Report)   Indicate by check mark whether the registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter
period that the registrant was required to file such reports) and (2) has
been subject to such filing requirements for the past 90 days. Yes x No o. Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act). Yes o No x. The number of shares of our common stock outstanding on April 30,
2004 was 36,927,339.




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INDEX PAGEPART IITEM 1.FINANCIAL STATEMENTS
    
    
    1ITEM 2.MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    17ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    46ITEM 4.CONTROLS AND PROCEDURES
    
    
    49PART IIITEM 1.LEGAL PROCEEDINGS
    
    
    49ITEM 2.CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
    
    
    49ITEM 3.DEFAULTS UPON SENIOR SECURITIES
    
    
    50ITEM 4.SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    50ITEM 5.OTHER INFORMATION
    
    
    50ITEM 6.EXHIBITS AND REPORTS ON FORM 8-K
    
    
    50SIGNATURES
    
    
    51EXHIBIT INDEX
    
    
    52Exhibit 31.1Exhibit 31.2Exhibit 32.1Exhibit 32.2
 i




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CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS This Quarterly Report on Form 10-Q contains certain forward-looking
statements. Forward looking statements are those which are not historical in
nature. They can often be identified by their inclusion of words such as
will, anticipate, estimate, should, expect, believe, intend and
similar expressions. Any projection of revenues, earnings or losses, capital
expenditures, distributions, capital structure or other financial terms is a
forward-looking statement. Our forward-looking statements are based upon our managements beliefs,
assumptions and expectations of our future operations and economic performance,
taking into account the information currently available to us. Forward-looking
statements involve risks and uncertainties, some of which are not currently
known to us, that might cause our actual results, performance or financial
condition to be materially different from the expectations of future results,
performance or financial condition we express or imply in any forward-looking
statements. Some of the important factors that could cause our actual results,
performance or financial condition to differ materially from expectations are:  
    
    our limited operating history and the lack of experience of Seneca Capital Management LLC in
managing a REIT;
    
    interest rate mismatches between our mortgage-backed securities and our borrowings used to fund
such purchases;
    
    changes in interest rates and mortgage prepayment rates;
    
    effects of interest rate caps on our adjustable-rate mortgage-backed securities;
    
    the degree to which our hedging strategies may or may not protect us from interest rate volatility;
    
    potential impacts of our leveraging policies on our net income and cash available for distribution;
    
    our ability to invest up to 10% of our investment portfolio in lower-credit quality
mortgage-backed securities which carry an increased likelihood of default or rating downgrade
relative to investment-grade securities;
    
    our boards ability to change our operating policies and strategies without notice to you or
stockholder approval;
    
    Seneca Capital Management LLCs motivation to recommend riskier investments in an effort to
maximize its incentive compensation under the management agreement;
    
    potential conflicts of interest arising out of our relationship with Seneca Capital Management
LLC, on the one hand, and Seneca Capital Management LLCs relation with other third parties, on
the other hand; and
    
    the other important factors described in this Quarterly Report on Form 10-Q, including those under
the captions Managements Discussion and Analysis of Financial Condition and Results of
Operations, Risk Factors, and Quantitative and Qualitative Disclosures about Market Risk. We undertake no obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise. In light of these risks, uncertainties and assumptions,
the events described by our forward-looking events might not occur. We qualify
any and all of our forward-looking statements by these cautionary factors. In
addition, you should carefully review the risk factors described in other
documents we file from time to time with the Securities and Exchange
Commission. This Quarterly Report on Form 10-Q contains market data, industry statistics
and other data that have been obtained from, or compiled from, information made
available by third parties. We have not independently verified their data. ii




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PART I FINANCIAL INFORMATION 
 ITEM 1. FINANCIAL STATEMENTS INDEX TO FINANCIAL STATEMENTS Condensed Financial Statements of Luminent Mortgage Capital, Inc. Condensed Balance Sheets as of March 31, 2004 and December 31, 2003 (unaudited)
    
    
    2Condensed Statement of Operations for the quarter ended March 31, 2004 (unaudited)
    
    
    3Condensed Statement of Stockholders Equity for the quarter ended March 31, 2004 (unaudited)
    
    
    4Condensed Statement of Cash Flows for the quarter ended March 31, 2004 (unaudited)
    
    
    5Notes to Financial Statements (unaudited)
    
    
    6
 1




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LUMINENT MORTGAGE CAPITAL, INC. 
 CONDENSED BALANCE SHEETS (Unaudited) March 31,
    
    December 31,(in thousands, except share and per share amounts)
    
    2004
    
    2003Assets:Cash and cash equivalents
    
    $
    8,669
    
    
    $
    7,219Mortgage-backed securities available-for-sale, at fair value
    
    
    1,231,822
    
    
    
    352,123Mortgage-backed securities available-for-sale, pledged as
collateral, at fair value
    
    
    2,839,550
    
    
    
    1,809,822Interest receivable
    
    
    13,152
    
    
    
    7,345Principal receivable
    
    
    5,723
    
    
    
    2,313Offering proceeds receivable
    
    
    157,865
    
    
    
    Other assets
    
    
    1,234
    
    
    
    518Total assets
    
    $
    4,258,015
    
    
    $
    2,179,340Liabilities:Repurchase agreements
    
    $
    2,695,774
    
    
    $
    1,728,973Unsettled security purchases
    
    
    1,079,154
    
    
    
    156,127Cash distribution payable
    
    
    10,433
    
    
    
    5,267Futures contracts, at fair value
    
    
    3,399
    
    
    
    157Accrued interest expense
    
    
    5,262
    
    
    
    3,777Management fee payable, incentive fee payable and other related party
liabilities
    
    
    2,172
    
    
    
    1,088Insurance note payable
    
    
    
    
    
    
    92Accounts payable and accrued expenses
    
    
    1,278
    
    
    
    1,363Total liabilities
    
    
    3,797,472
    
    
    
    1,896,844Stockholders Equity:Preferred stock, par value $0.001:10,000,000 shares authorized; no shares issued and outstanding as of
March 31, 2004 and December 31, 2003
    
    
    
    
    
    
    Common stock, par value $0.001:100,000,000 shares authorized; 36,841,146 and 24,814,000 shares
issued
and outstanding as of March 31, 2004 and December 31, 2003,
respectively
    
    
    37
    
    
    
    25Additional paid-in capital
    
    
    475,228
    
    
    
    317,339Deferred compensation
    
    
    (286
    )
    
    
    Accumulated other comprehensive loss
    
    
    (6,445
    )
    
    
    (26,510
    )Accumulated distributions in excess of accumulated earnings
    
    
    (7,991
    )
    
    
    (8,358
    )Total stockholders equity
    
    
    460,543
    
    
    
    282,496Total liabilities and stockholders equity
    
    $
    4,258,015
    
    
    $
    2,179,340
 See notes to financial statements 2




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LUMINENT MORTGAGE CAPITAL, INC. 
 CONDENSED STATEMENT OF OPERATIONS (Unaudited) For theQuarter EndedMarch 31,(in thousands, except share and per share amounts)
    
    2004Revenues:Net interest income:Interest income
    
    $
    20,204Interest expense
    
    
    6,827Net interest income
    
    
    13,377Expenses:Management fee expense to related party
    
    
    787Incentive fee expense to related parties
    
    
    846Salaries and benefits
    
    
    96Professional services
    
    
    417Board of directors expense
    
    
    56Insurance expense
    
    
    220Custody expense
    
    
    67Other general and administrative expenses
    
    
    88Total expenses
    
    
    2,577Net income
    
    $
    10,800Net income per share  basic
    
    $
    0.43Net income per share  diluted
    
    $
    0.43Weighted-average number of shares outstanding  basic
    
    
    25,077,736Weighted-average number of shares outstanding  diluted
    
    
    25,085,784
 See notes to financial statements 3




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LUMINENT MORTGAGE CAPITAL, INC.




CONDENSED STATEMENT OF
STOCKHOLDERS EQUITY(Unaudited)

AccumulatedAccumulated
    
    DistributionsCommon Stock
    
    Additional
    
    
    
    
    
    Other
    
    in Excess ofPaid-in
    
    Deferred
    
    Comprehensive
    
    Accumulated
    
    Comprehensive(in thousands)
    
    Shares
    
    Par Value
    
    Capital
    
    Compensation
    
    Income /(Loss)
    
    Earnings
    
    Income/(Loss)
    
    TotalBalance, December 31, 2003
    
    
    24,814
    
    
    $
    25
    
    
    $
    317,339
    
    
    $
    
    
    
    $
    (26,510
    )
    
    $
    (8,358
    )
    
    $
    
    
    
    $
    282,496Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    10,800
    
    
    
    10,800
    
    
    
    10,800Mortgage-backed securities
available-for-sale, fair value
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    23,710
    
    
    
    
    
    
    
    23,710
    
    
    
    23,710Futures contracts, fair value
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,645
    )
    
    
    
    
    
    
    (3,645
    )
    
    
    (3,645
    )Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    30,865Distributions to stockholders
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (10,433
    )
    
    
    
    
    
    
    (10,433
    )Issuance of common stock
    
    
    12,027
    
    
    
    12
    
    
    
    157,887
    
    
    
    (286
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    157,613Amortization of stock options
    
    
    
    
    
    
    
    
    
    
    2
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2Balance, March 31, 2004
    
    
    36,841
    
    
    $
    37
    
    
    $
    475,228
    
    
    $
    (286
    )
    
    $
    (6,445
    )
    
    $
    (7,991
    )
    
    
    
    
    
    $
    460,543


See notes to financial statements

4



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LUMINENT MORTGAGE CAPITAL, INC. 
 CONDENSED STATEMENT OF CASH FLOWS (Unaudited) For theQuarterEndedMarch 31,(in thousands)
    
    2004Cash flows from operating activities:Net income
    
    $
    10,800Adjustments to reconcile net income to net cash provided by operating activities:Amortization of premium/discount on mortgage-backed securities available-for-sale
    
    
    5,208Amortization of stock options
    
    
    2Ineffectiveness of cash flow hedges
    
    
    10Changes in operating assets and liabilities:Increase in interest receivable, net of purchased interest
    
    
    (632
    )Increase in other assets
    
    
    (1,003
    )Decrease in accounts payable and accrued expenses
    
    
    (85
    )Increase in interest payable
    
    
    1,485Increase in management fee payable, incentive fee payable and other related party liabilities
    
    
    1,474Net cash provided by operating activities
    
    
    17,259Cash flows from investing activities:Purchase of mortgage-backed securities available-for-sale
    
    
    (1,116,022
    )Principal payments of mortgage-backed securities
    
    
    139,539Realized losses on Eurodollar futures contracts
    
    
    (412
    )Net cash used in investing activities
    
    
    (976,895
    )Cash flows from financing activities:Offering costs related to issuance of common stock
    
    
    (356
    )Borrowings under repurchase agreements
    
    
    11,141,921Principal payments on repurchase agreements
    
    
    (10,175,120
    )Payment of cash dividends
    
    
    (5,267
    )Other
    
    
    (92
    )Net cash provided by financing activities
    
    
    961,086Net increase in cash and cash equivalents
    
    
    1,450Cash and cash equivalents, beginning of the period
    
    
    7,219Cash and cash equivalents, end of the period
    
    $
    8,669Supplemental disclosure of cash flow information:Interest paid
    
    $
    5,328Non-cash transactions:Increase in unsettled security purchases
    
    $
    923,026Increase in offering proceeds receivable
    
    
    (157,865
    )Increase in principal receivable
    
    
    (3,410
    )Distributions declared
    
    
    (10,433
    )Incentive fees payable settled through issuance of restricted stock
    
    
    390Deferred compensation reclassified to stockholders equity upon issuance of restricted stock
    
    
    (286
    )
 See notes to financial statements 5




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LUMINENT MORTGAGE CAPITAL, INC. 
 NOTES TO FINANCIAL STATEMENTS (Unaudited) NOTE 1-ACCOUNTING POLICIES Luminent Mortgage Capital, Inc., or the Company, is a real estate
investment trust which invests primarily in U.S. agency and other highly-rated
single-family, adjustable-rate, hybrid adjustable-rate and fixed rate
mortgage-backed securities. Seneca Capital Management LLC, or the Manager,
pursuant to a management agreement, or the Management Agreement, manages the
Company and its investment portfolio. The accounting and reporting policies of the Company conform with
accounting principles generally accepted in the United States of America, or
GAAP. Preparing the financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the reported amounts
of assets and liabilities at the date of the financial statements and income
and expenses during the reporting period. The information furnished in these unaudited condensed interim statements
reflects all adjustments that are, in the opinion of management, necessary for
a fair statement of the results for the periods presented. These adjustments
are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q.
The results of operations in the interim statements do not necessarily indicate
the results that may be expected for the full year. The interim financial
information should be read in conjunction with the Companys 2003 Annual Report
on Form 10-K filed with the Securities and Exchange Commission on March 3, 2004
(file number 001-31828). Descriptions of the significant accounting policies of the Company are
included in Note 1 to financial statements in the Companys 2003 Annual Report
on Form 10-K. There have been no significant changes to these policies during
2004. NOTE 2-MORTGAGE-BACKED SECURITIES The following table summarizes the Companys mortgage-backed securities
classified as available-for-sale as of March 31, 2004, which are carried at
fair value: Hybrid-Adjustable-
    
    Balloon
    
    Total Mortgage-Adjustable-
    
    Rate
    
    Maturity
    
    BackedRate Securities
    
    Securities
    
    Securities
    
    Securities(in thousands)Amortized cost
    
    $
    167,744
    
    
    $
    3,850,573
    
    
    $
    55,698
    
    
    $
    4,074,015Unrealized gains
    
    
    251
    
    
    
    13,692
    
    
    
    
    
    
    
    13,943Unrealized losses
    
    
    (1,733
    )
    
    
    (14,277
    )
    
    
    (576
    )
    
    
    (16,586
    )Fair value
    
    $
    166,262
    
    
    $
    3,849,988
    
    
    $
    55,122
    
    
    $
    4,071,372% of total
    
    
    4.1
    %
    
    
    94.6
    %
    
    
    1.3
    %
    
    
    100.0
    %
 6




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  Continued (Unaudited) Actual maturities of mortgage-backed securities are generally shorter than
stated contractual maturities. Actual maturities of the Companys
mortgage-backed securities are affected by the contractual lives of the
underlying mortgages, periodic payments of principal, and prepayments of
principal. The following table summarizes the Companys mortgage-backed
securities on March 31, 2004 according to their estimated weighted-average life
classifications: Weighted-Amortized
    
    AverageWeighted-Average Life
    
    Fair Value
    
    Cost
    
    Coupon(in thousands)Less than one year
    
    $
    345,832
    
    
    $
    348,251
    
    
    
    3.61
    %Greater than one year and less than five years
    
    
    3,725,540
    
    
    
    3,725,764
    
    
    
    3.97Greater than five years
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    4,071,372
    
    
    $
    4,074,015
    
    
    
    3.96
    %
 The weighted-average lives of the mortgage-backed securities at March 31,
2004 in the table above are based upon data provided through subscription-based
financial information services, assuming constant principal prepayment rates to
the balloon or reset date for each security. The prepayment model considers
current yield, forward yield, steepness of the yield curve, current mortgage
rates, mortgage rate of the outstanding loan, loan age, margin and volatility. The actual weighted-average lives of the mortgage-backed securities in the
Companys investment portfolio could be longer or shorter than the estimates in
the table above depending on the actual prepayment rates experienced over the
lives of the applicable securities and are sensitive to changes in both
prepayment rates and interest rates. At March 31, 2004, unsettled security purchases totaled $1.1 billion. The following table shows the Companys investments fair value and gross
unrealized losses, aggregated by investment category and length of time that
individual securities have been in a continuous unrealized loss position, at
March 31, 2004: Less than 12 Months
    
    12 Months or More
    
    TotalGross
    
    
    
    
    
    Gross
    
    
    
    
    
    GrossFair
    
    Unrealized
    
    Fair
    
    Unrealized
    
    Fair
    
    UnrealizedValue
    
    Losses
    
    Value
    
    Losses
    
    Value
    
    Losses(in thousands)Agency-backed
mortgage-backed securities
    
    $
    1,519,130
    
    
    $
    (11,633
    )
    
    $
    
    
    
    $
    
    
    
    $
    1,519,130
    
    
    $
    (11,633
    )Non-agency-backed
mortgage-backed securities
    
    
    599,462
    
    
    
    (4,953
    )
    
    
    
    
    
    
    
    
    
    
    599,462
    
    
    
    (4,953
    )Total temporarily impaired
securities
    
    $
    2,118,592
    
    
    $
    (16,586
    )
    
    $
    
    
    
    $
    
    
    
    $
    2,118,592
    
    
    $
    (16,586
    )
 At March 31, 2004, the Company was only invested in AAA-rated
non-agency-backed or agency-backed mortgage-backed securities. The temporary
impairment of the available-for-sale securities results from the fair value of
the securities falling below the amortized cost basis. As of March 31, 2004,
none of the securities held had been downgraded by a credit rating agency since
their purchase. Management intends to hold the securities until 7




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  Continued (Unaudited) maturity, allowing for the anticipated recovery in fair value of the
securities held. As such, management does not believe any of the securities
held are other-than-temporarily impaired at March 31, 2004. NOTE 3-REPURCHASE AGREEMENTS AND OTHER BORROWINGS The Company has entered into repurchase agreements with third party
financial institutions to finance most of its mortgage-backed securities. The
repurchase agreements are short-term borrowings that bear interest rates that
have historically moved in close relationship to the three-month London
Interbank Offered Rate, or LIBOR. At March 31, 2004, the Company had an
outstanding amount of $2.7 billion with weighted-average borrowing rates of
1.15%. At March 31, 2004 securities pledged as collateral for repurchase
agreements had estimated fair values of $2.8 billion. At March 31, 2004, the repurchase agreements had remaining maturities as
summarized below: Overnight
    
    Between
    
    Between
    
    Between(1 day or
    
    2 and 30
    
    31 and 90
    
    91 and 335less)
    
    days
    
    days
    
    days
    
    Total(in thousands)Agency-backed mortgage-backed securities:Amortized cost of securities sold,
including accrued interest
    
    $
    
    
    
    $
    61,787
    
    
    $
    970,726
    
    
    $
    883,482
    
    
    $
    1,915,995Fair market value of securities sold,
including accrued interest
    
    
    
    
    
    
    62,338
    
    
    
    976,324
    
    
    
    880,572
    
    
    
    1,919,234Repurchase agreement liabilities
associated with these securities
    
    
    
    
    
    
    60,207
    
    
    
    920,831
    
    
    
    846,895
    
    
    
    1,827,933Average interest rate of repurchase
agreement liabilities
    
    
    0.00
    %
    
    
    1.24
    %
    
    
    1.09
    %
    
    
    1.18
    %
    
    
    1.14
    %Non-agency-backed mortgage-backed
securities:Amortized cost of securities sold,
including accrued interest
    
    $
    31,134
    
    
    $
    31,828
    
    
    $
    597,230
    
    
    $
    272,408
    
    
    $
    932,600Fair market value of securities sold,
including accrued interest
    
    
    30,934
    
    
    
    31,797
    
    
    
    595,016
    
    
    
    272,587
    
    
    
    930,334Repurchase agreement liabilities
associated with these securities
    
    
    29,076
    
    
    
    30,352
    
    
    
    552,771
    
    
    
    255,642
    
    
    
    867,841Average interest rate of repurchase
agreement liabilities
    
    
    1.16
    %
    
    
    1.17
    %
    
    
    1.18
    %
    
    
    1.22
    %
    
    
    1.19
    %Total:Amortized cost of securities sold,
including accrued interest
    
    $
    31,134
    
    
    $
    93,615
    
    
    $
    1,567,956
    
    
    $
    1,155,890
    
    
    $
    2,848,595Fair market value of securities sold,
including accrued interest
    
    
    30,934
    
    
    
    94,135
    
    
    
    1,571,340
    
    
    
    1,153,159
    
    
    
    2,849,568Repurchase agreement liabilities
associated with these securities
    
    
    29,076
    
    
    
    90,559
    
    
    
    1,473,602
    
    
    
    1,102,537
    
    
    
    2,695,774Average interest rate of repurchase
agreement liabilities
    
    
    1.16
    %
    
    
    1.21
    %
    
    
    1.12
    %
    
    
    1.19
    %
    
    
    1.15
    %
 8




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  Continued (Unaudited) At March 31, 2004, the repurchase agreements had the following
counterparties, amounts at risk and weighted-average remaining maturities: Weighted-AverageMaturity ofAmount at
    
    RepurchaseRepurchase Agreement Counterparties
    
    Risk(1)
    
    Agreements(in thousands)
    
    (in days)Banc of America Securities LLC
    
    $
    12,703
    
    
    
    30Bear Stearns & Co.
    
    
    30,331
    
    
    
    73Countrywide Securities Corporation
    
    
    1,833
    
    
    
    1Credit Suisse First Boston LLC
    
    
    21,314
    
    
    
    97Deutsche Bank Securities Inc.
    
    
    1,518
    
    
    
    55Federal Home Loan Mortgage Corporation
    
    
    (94
    )
    
    
    62Goldman Sachs & Co.
    
    
    4,860
    
    
    
    58J.P. Morgan Securities Inc.
    
    
    1,293
    
    
    
    86Lehman Brothers Inc.
    
    
    2,689
    
    
    
    62Merrill Lynch Government Securities Inc./Merrill Lynch
Pierce, Fenner & Smith Inc.
    
    
    15,020
    
    
    
    66Morgan Stanley & Co. Inc.
    
    
    2,134
    
    
    
    62Salomon Smith Barney
    
    
    29,698
    
    
    
    164UBS Securities LLC
    
    
    19,379
    
    
    
    124Wachovia Securities, LLC
    
    
    5,853
    
    
    
    68Total
    
    $
    148,531
    
    
    
    97
  (1)
    
    Equal to the fair value of securities sold, plus accrued interest income, minus
(1) repurchase agreement liabilities, plus accrued interest expense. The Company has a margin lending facility with its primary custodian where
it may borrow money in connection with the purchase or sale of securities. The
terms of the borrowings, including the rate of interest payable, are agreed to
with the custodian for each amount borrowed. Borrowings are repayable
immediately upon demand of the custodian. At March 31, 2004, there were no
outstanding borrowings under the margin lending facility. NOTE 4-CAPITAL STOCK AND NET INCOME PER SHARE The Company had 100,000,000 shares of par value $0.001 common stock
authorized and 36,841,146 shares were issued and outstanding as of March 31,
2004. Of the 100,000,000 shares of par value $0.001 common stock authorized,
10,000,000 shares are reserved for issuance in order to pay incentive fees in
connection with the Management Agreement. As of March 31, 2004, 9,974,349
shares remain reserved for issuance. The Company had 10,000,000 shares of par
value $0.001 preferred stock authorized and none outstanding as of March 31,
2004. In two closings on June 11 and June 19, 2003, the Company completed a
private offering of 11,092,473 shares of common stock, $0.001 par value at an
offering price of $15.00 per share, including the exercise by the initial
purchaser/placement agent of its over-allotment option to purchase 1,500,000
shares of common stock. In addition, on June 11, 2003 the Company issued
407,527 shares of common stock, par value $0.001, at an offering price net of
the initial purchasers discount of $13.95 per share, to employees and
affiliates of the Manager, and other persons selected by the Manager. The
Company received proceeds from these transactions in the amount of $159.7
million, net of underwriting discount and other offering costs. 9




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  Continued (Unaudited) On December 18, 2003, the Company completed an initial public offering of
13,110,000 shares of its common stock, $0.001 par value at an offering price of
$13.00 per share, including the exercise by the underwriter of its
over-allotment option to purchase 1,710,000 shares of common stock. The
Company received proceeds from the initial public offering in the amount of
$157.0 million, net of underwriting discount and other offering costs. The Company filed a resale shelf registration statement with the SEC for
up to 11,500,000 shares of its common stock issued in the June 11, 2003 and
June 19, 2003 private offerings. The registration statement was declared
effective by the SEC on February 13, 2004. On March 29, 2004, the Company completed a public offering of 12,000,000
shares of its common stock, $0.001 par value at an offering price of $14.00 per
share. On April 2, 2004, the Company received proceeds from the public offering
in the amount of $157.5 million, net of underwriting discount and other
offering costs. The Company calculates basic net income per share by dividing net income
for the period by weighted-average shares of its common stock outstanding for
that period. Diluted net income per share takes into account the effect of
dilutive instruments, such as stock options and unvested restricted stock, but
uses the average share price for the period in determining the number of
incremental shares that are to be added to the weighted-average number of
shares outstanding. The following table presents a reconciliation of basic and diluted net
income per share for the quarter ended March 31, 2004: Basic
    
    DilutedNet income (in thousands)
    
    $
    10,800
    
    
    $
    10,800Weighted-average number of common shares outstanding
    
    
    25,077,736
    
    
    
    25,077,736Additional shares due to assumed conversion of dilutive
instruments
    
    
    
    
    
    
    8,048Adjusted weighted-average number of common shares outstanding
    
    
    25,077,736
    
    
    
    25,085,784Net income per share
    
    $
    0.43
    
    
    $
    0.43
 NOTE 5-2003 STOCK INCENTIVE PLANS The Company adopted a 2003 Stock Incentive Plan, effective June 4, 2003,
and a 2003 Outside Advisors Stock Incentive Plan, effective June 4, 2003,
pursuant to which up to 1,000,000 shares of the Companys common stock is
authorized to be awarded at the discretion of the Compensation Committee of the
Board of Directors. The plans provide for the grant of a variety of long-term
incentive awards to employees and officers of the Company, individual
consultants or advisors who render or have rendered bona fide services, and
officers, employees or directors of the Manager as an additional means to
attract, motivate, retain and reward eligible persons. These plans provide for
the grant of awards that meet the requirements of Section 422 of the Code,
non-qualified stock options, stock appreciation rights, restricted stock, stock
units and other stock-based awards, and dividend equivalent rights. The
maximum term of each grant is determined on the grant date by the Compensation
Committee and shall not exceed 10 years. The exercise price and the vesting
requirement of each grant is determined on the grant date by the Compensation
Committee. 10




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  Continued (Unaudited) The following table illustrates the common stock available for
grant as of March 31, 2004: 2003 Outside2003 Stock
    
    Advisors StockIncentive Plan
    
    Incentive Plan
    
    TotalShares reserved for issuance
    
    
    
    
    
    
    
    
    
    
    1,000,000
    (1)Granted
    
    
    56,495
    
    
    
    
    
    
    
    56,495Forfeited
    
    
    
    
    
    
    
    
    
    
    Expired
    
    
    
    
    
    
    
    
    
    
    Total available for grant
    
    
    
    
    
    
    
    
    
    
    943,505
    (2)
  (1)
    
    At June 4, 2003, adoption date of both stock incentive plans, the maximum number of shares of common stock that may
be delivered pursuant to awards granted under these combined plans is 1,000,000 shares.(2)
    
    At March 31, 2004, the maximum number of shares of common stock that may be delivered pursuant to awards granted
under these combined plans is 943,505 shares. At March 31, 2004, the Company had outstanding options under the plans
with expiration dates of 2013. The following table illustrates stock option
transactions during the quarter ended March 31, 2004: Weighted-Number of
    
    AverageOptions
    
    Exercise PriceOutstanding at December 31, 2003
    
    
    55,000
    
    
    $
    14.82Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Forfeited
    
    
    
    
    
    
    Outstanding at March 31, 2004
    
    
    55,000
    
    
    $
    14.82
 The following table illustrates information about stock options
outstanding at March 31, 2004: Outstanding
    
    ExercisableWeighted-Average
    
    Weighted-
    
    
    
    
    
    Weighted-Range of
    
    Number
    
    Remaining
    
    Average
    
    Number
    
    AverageExercise
    
    of
    
    Life (in
    
    Exercise
    
    of
    
    ExercisePrices
    
    Options
    
    years)
    
    Price
    
    Options
    
    Price$13.00-$14.00
    
    
    5,000
    
    
    
    9.8
    
    
    $
    13.00
    
    
    
    
    
    
    
    $14.01-$15.00
    
    
    50,000
    
    
    
    9.6
    
    
    $
    15.00
    
    
    
    
    
    
    
    $13.00-$15.00
    
    
    55,000
    
    
    
    
    
    
    
    
    
    
    
    
 Total stock-based employee compensation expense related to stock options
for the quarter ended March 31, 2004 was $2 thousand. 11




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  Continued (Unaudited) The following table illustrates restricted common stock transactions
during the quarter ended March 31, 2004: Number ofRestricted
    
    Weighted-Common
    
    Average IssueShares
    
    PriceOutstanding at December 31, 2003
    
    
    
    
    
    
    Issued
    
    
    1,495
    
    
    $
    13.90Repurchased
    
    
    
    
    
    
    Outstanding at March 31, 2004
    
    
    1,495
    
    
    $
    13.90
 NOTE 6-THE MANAGEMENT AGREEMENT The Company has entered into a Management Agreement with the Manager that
provides, among other things, that the Company will pay to the Manager, in
exchange for investment management and certain administrative services, certain
fees and reimbursements, summarized as follows:  
    
    a base management fee equal to a percentage of average net worth
during each fiscal year as defined in the Management Agreement (1% of
the first $300 million plus 0.8% of the amount in excess of $300
million);
    
    incentive compensation based on the excess of a tiered percentage
(as defined in the Management Agreement as the weighted-average of the
following rates based upon average net invested assets: (1) 20% for
the first $400 million of average net invested assets; and (2) 10% for
the average net invested assets in excess of $400 million) of the
difference between the Companys net income (defined in the Management
Agreement as taxable income before incentive compensation, net
operating losses from prior periods, and items permitted by the
Internal Revenue Code when calculating taxable income for a REIT) and
the threshold return (the amount of net income for the period that
would produce an annualized return on equity, calculated by dividing
the net income, as defined in the Management Agreement, by the average
net invested assets, as defined in the Management Agreement, equal to
the 10-year U.S. Treasury rate for the period plus 2.0%) for the
fiscal period; and
    
    out-of-pocket expenses and certain other costs incurred by the Manager
and related directly to the Company. The base management fee and incentive compensation will be paid quarterly
and are subject to adjustment at the end of each fiscal year based on annual
results. One-half of the incentive compensation will be paid to the Manager in
cash and one-half will be paid in the form of a restricted stock award. The
number of shares issued is based on (a) one-half of the total incentive
compensation for the period, divided by (b) the average of the closing prices
of the common stock over the 30-day period ending three days prior to the grant
date, less a fair market value discount determined by the Companys Board of
Directors. These shares are restricted shares for varying periods of time,
and are forfeitable if the Manager ceases to perform management services for
the Company before the end of the restriction periods. The Companys
restrictions lapse and full rights of ownership vest for one-third of the
shares on the first anniversary of the end of the period in which the incentive
compensation is calculated, for one-third of the shares on the second
anniversary and for the last one-third of the shares on the third anniversary.
Vesting is predicated on the continuing involvement of the Manager in providing
services to the Company. From and after June 11, 2004, the Company is entitled to terminate the
Management Agreement without cause provided that the Company gives the Manager
60 days prior written notice and pays a termination fee and 12




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  Continued (Unaudited) other unpaid costs and expenses reimbursable to the Manager. If the
Companys terminates the Management Agreement without cause, the Company is
required to pay the Manager a termination fee as follows:  
    
    If the Company terminates the Management Agreement without cause in
connection with a decision to manage its portfolio internally, rather
than by an external manager, the amount of the termination fee shall
be equal to the amount of the highest annual base fee and the highest
annual incentive compensation, for a particular year, earned by the
Manager during any of the three years (or on an annualized basis if a
lesser period) preceding the effective date of the termination, plus
accelerated vesting on the equity component of all incentive
compensation.
    
    If the Company terminates the Management Agreement without cause for
any other reason, the amount of the termination fee shall be equal to
two times the amount of the highest annual base fee and the highest
annual incentive compensation, for a particular year, earned by the
Manager during any of the three years (or on an annualized basis if a
lesser period) preceding the effective date of the termination, plus
all deferred payments, including accelerated vesting on the equity
component of all incentive compensation. The Company is also entitled to terminate the Management Agreement with
cause, in which case the Company is only obligated to reimburse the Manager for
its unpaid costs and expenses. The Management Agreement contains certain provisions requiring the Company
to indemnify the Manager for costs (e.g., legal costs) the Manager could
potentially incur in fulfilling its duties prescribed in the Management
Agreement or in other agreements related to the Companys activities. The
indemnification provisions do not apply under all circumstances (e.g., if the
Manager is grossly negligent, acted with reckless disregard or engaged in
willful misconduct or active fraud). The provisions contain no limitation on
maximum future payments. The Company has evaluated the impact of these
guarantees on its financial statements and determined that it is immaterial. The base management fee for the quarter ended March 31, 2004 was $787
thousand. Incentive compensation is earned by the Manager when REIT taxable net
income (before deducting incentive compensation, net operating losses and
certain other items) relative to the average net invested assets for the
period, as defined in the Management Agreement, exceeds the threshold return
taxable income that would have produced an annualized return on equity equal to
the sum of the 10-year U.S. Treasury rate plus 2.0% for the same period. For
the quarter ended March 31, 2004, REIT taxable net income (before deducting
incentive compensation, net operating losses and certain other items) was $11.2
million and was greater than the threshold return taxable income of $4.7
million. For the quarter ended March 31, 2004, total incentive fees earned by the
Manager were $1.3 million, one-half payable in cash and one-half payable in the
form of the Companys common stock as described above. The cash portion of the
incentive fee of $652 thousand for the quarter ended March 31, 2004 was
expensed in that period. In accordance with SFAS No. 123, and related
interpretations, and EITF 96-18, 15.2% of the restricted stock portion of the
incentive fees, or $99 thousand, was expensed in the quarter ended March 31,
2004. Included in other assets at March 31, 2004 is $553 thousand of deferred
compensation which will be reclassified to stockholders equity after the
restricted stock is issued and will be expensed over the three-year vesting
period of the restricted stock. In accordance with the terms of his employment agreement, the Companys
Chief Financial Officer earned an incentive fee of $65 thousand for the quarter
ended March 31, 2004. This incentive fee is also payable one-half in cash and
one-half in the form of a restricted stock award under the Companys 2003 Stock
Incentive Plan. The shares are payable and vest over the same vesting schedule
as the stock issued to the Manager. The cash portion of the incentive fee of
$33 thousand for the quarter ended March 31, 2004 was expensed in that period.
In accordance with SFAS No. 123, and related interpretations, and EITF 96-18,
15.2% of the restricted stock portion of the 13




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  Continued (Unaudited) incentive fees, or $5 thousand, was expensed in the quarter ended March
31, 2004. Included in other assets at March 31, 2004 is $28 thousand of
deferred compensation which will be reclassified to stockholders equity after
the restricted stock is issued and will be expensed over the three-year vesting
period of the restricted stock. NOTE 7-RELATED PARTY TRANSACTIONS At March 31, 2004, the Company was indebted to the Manager for base
management fees of $787 thousand and incentive fees of $1.3 million. At March
31, 2004, the Company was indebted to the Companys Chief Financial Officer for
incentive fees of $65 thousand and to officers and employees of the Company for
bonuses and expense reimbursement of $16 thousand. These amounts are included
in management fee payable, incentive fee payable and other related party
liabilities. The Managers financial relationship with the Company is governed by the
Management Agreement. Under the Management Agreement, the Manager shall be
responsible for all expenses of the personnel employed by the Manager, and all
facilities and overhead expenses of the Manager required for the day-to-day
operations of the Company, and the expenses of a sub-manager, if any. The
Company shall reimburse the Manager for its pro-rata portion of facilities and
overhead expenses to the extent that the Companys employees (who are not also
employed by the Manager) use such facilities or incur such expenses pursuant to
a cost-sharing agreement entered into between the Company and the Manager. As
of March 31, 2004, there were no expenses payable to the Manager pursuant to
the cost-sharing agreement. During the quarter ended March 31, 2004, the
Company paid the Manager $6 thousand pursuant to the cost-sharing agreement.
The Company shall pay all other expenses on behalf of the Company, and shall
reimburse the Manager for all direct expenses incurred on the Companys behalf
that are not the Managers specific responsibility as defined in the Management
Agreement. NOTE 8-FAIR VALUE OF FINANCIAL INSTRUMENTS SFAS No. 107, Disclosure About Fair Value of Financial Instruments,
requires disclosure of the fair value of financial instruments for which it is
practicable to estimate that value. The fair value of mortgage-backed
securities available-for-sale and futures contracts is equal to their carrying
value presented in the balance sheet. The fair value of cash and cash
equivalents, interest receivable, repurchase agreements, unsettled security
purchases, and accrued interest expense, approximates cost as of March 31, 2004
due to the short-term nature of these instruments. 14




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  Continued (Unaudited) NOTE 9-ACCUMULATED OTHER COMPREHENSIVE LOSS The following is a summary of the components of accumulated other
comprehensive loss as of March 31, 2004: Net UnrealizedGains/(Losses) on
    
    Net Realized and
    
    AccumulatedMortgage-backed
    
    Unrealized Losses
    
    OtherSecurities
    
    on Cash Flow
    
    ComprehensiveAvailable-for-Sale
    
    Hedges
    
    Income/(Loss)(in thousands)Beginning Balance
    
    $
    (26,353
    )
    
    $
    (157
    )
    
    $
    (26,510
    )Change during the period
    
    
    23,710
    
    
    
    (3,645
    )
    
    
    20,065Ending Balance
    
    $
    (2,643
    )
    
    $
    (3,802
    )
    
    $
    (6,445
    )
 See Note 10 for further discussion regarding derivative instruments and
hedging activities. NOTE 10-DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES The Company seeks to manage its interest rate risk exposure to protect the
Companys repurchase agreement liabilities against the effects of major
interest rate changes. Such interest rate risk may arise from the issuance and
forecasted rollover and repricing of short-term liabilities with fixed rate
cash flows or from liabilities with a contractual variable rate based on LIBOR.
Among other strategies, the Company may use Eurodollar futures contracts and
interest rate swaps to manage this interest rate risk. Derivative instruments
are carried at fair value. The following table is a summary of derivative instruments held as of
March 31, 2004: Unrealized
    
    Unrealized
    
    EstimatedGains
    
    Losses
    
    Fair Value(in thousands)Eurodollar futures contracts sold short
    
    $
    
    
    
    $
    (3,399
    )
    
    $
    (3,399
    )
 Cash Flow Hedging Strategies Hedging instruments are designated as cash flow hedges, as appropriate,
based upon the specifically identified exposure, which may be an individual
item or a group of similar items. The hedged transaction is the forecasted
interest expense on forecasted rollover/reissuance of repurchase agreements or
the interest rate repricing of repurchase agreements for a specified future
time period and the hedged risk is the variability in those payments due to
changes in the benchmark rate. Hedging transactions are structured at inception
so that the notional amounts of the hedge are matched with an equal amount of
repurchase agreements forecasted to be outstanding in that specified period for
which the borrowing rate is not yet fixed. Cash flow hedging strategies
include the utilization of Eurodollar futures contracts and interest rate
swaps. Any ineffectiveness which arises during the hedging relationship is
recognized in interest expense during the period in which it arises. Prior to
the end of the specified hedge time period the effective portion of all
contract gains and losses (whether realized or unrealized) is recorded in other
comprehensive income or loss. Realized gains and losses are reclassified into
earnings as an adjustment to interest expense during the specified hedge time
period. Hedging instruments under these strategies are deemed to be broadly
designated to the outstanding repurchase portfolio and the forecasted rollover
thereof. Such forecasted rollovers would also include other types of borrowing
arrangements that may replace the repurchase funding during 15




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  Continued (Unaudited) the identified hedge time periods. At March 31, 2004, the maximum length of
time over which the Company is hedging its exposure is 12 months. The Company may use Eurodollar futures contracts to hedge the forecasted
interest expense associated with the benchmark rate on forecasted
rollover/reissuance of repurchase agreements or the interest rate repricing of
repurchase agreements for a specified future time period, which is defined as
the calendar quarter immediately following the contract expiration date. Gains
and losses on each contract are associated with forecasted interest expense for
the specified future period. The Company may use interest rate swaps to hedge the forecasted interest
expense associated with the benchmark rate on forecasted rollover/reissuance of
repurchase agreements or the interest rate repricing of repurchase agreements
for the period defined by maturity of the interest rate swap. Cash flows that
occur each time the swap is repriced will be associated with forecasted
interest expense for a specified future period, which is defined as the
calendar period preceding each repricing date with the same number of months as
the repricing frequency. For the quarter ended March 31, 2004, losses of $14 thousand were
recognized in interest expense due to ineffectiveness. Based upon the amounts
included in accumulated other comprehensive loss at March 31, 2004, the Company
expects to recognize an increase of $3.8 million in interest expense during
2004, of which $412 thousand is due to positions closed during the quarter and
$3.4 million is due to unrealized losses on open positions at March 31, 2004.
This amount could differ from amounts actually realized due to changes in the
benchmark rate between March 31, 2004 and when the Eurodollar futures contracts
held at March 31, 2004 are closed, as well as the addition of other hedges
subsequent to March 31, 2004. 16




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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS The following discussion of our financial condition and results of
operations should be read in conjunction with the financial statements and
notes to those statements included elsewhere in this document. This discussion
may contain forward-looking statements that involve risks and uncertainties.
The words believe, expect, anticipate, estimate, may, will, or
could and similar expressions or the negatives of these words or phrases are
intended to identify forward-looking statements. As a result of many factors,
such as those set forth under Risk Factors and elsewhere in this document,
our actual results may differ materially from those anticipated in such
forward-looking statements. General Luminent Mortgage Capital, Inc. is a REIT headquartered in San Francisco,
California. We were incorporated in April 2003 to invest primarily in U.S.
agency and other highly-rated, single-family, adjustable-rate, hybrid
adjustable-rate and fixed-rate mortgage-backed securities, which we acquire in
the secondary market. Substantive operations began mid-June 2003, after
completing two private placements of our common stock. Our strategy is to
acquire mortgage-related assets, finance these purchases in the capital markets
and use leverage in order to provide an attractive return on stockholders
equity. Through this strategy, we seek to earn income, which is generated from
the spread between the yield on our earning assets and our costs, including the
interest cost of the funds we borrow. We have acquired and will seek to acquire
additional assets that will produce competitive returns, taking into
consideration the amount and nature of the anticipated returns from the
investment, our ability to pledge the investment for secured, collateralized
borrowings and the costs associated with financing, managing, securitizing and
reserving for these investments. Our business is affected by a variety of economic and industry factors
which management considers. The most significant risk factors management
considers while managing the business which could have a material effect on the
financial condition and results of operations are:  
    
    interest rate mismatches between our adjustable-rate and hybrid adjustable-rate mortgage-backed
securities and our borrowings used to fund our purchases of mortgage-backed securities;
    
    increasing or decreasing levels of prepayments on the mortgages underlying our mortgage-backed
securities;
    
    the potential for increased borrowing costs related to repurchase agreements;
    
    interest rate caps related to our adjustable-rate and hybrid adjustable-rate mortgage-backed securities;
    
    the overall leverage of our portfolio;
    
    our ability or inability to use derivatives to mitigate our interest rate and prepayment risks;
    
    the impact that increases in interest rates would have on our book value;
    
    maintaining adequate borrowing capacity so that we can purchase mortgage-related assets and reach our
desired amount of leverage;
    
    if we fail to obtain or renew sufficient funding on favorable terms or at all, we will be limited in
our ability to acquire mortgage-related assets;
    
    possible market developments could cause our lenders to require us to pledge additional assets as
collateral. If our assets are insufficient to meet the collateral requirements, we might be compelled
to liquidate particular assets at inopportune times and at disadvantageous prices; 17




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
    
    competition might prevent us from acquiring mortgage-backed securities at favorable yields,
which would harm our results of operations;
    
    if we are disqualified as a REIT, we will be subject to tax as a regular corporation and
face substantial tax liability; and
    
    complying with REIT requirements might cause us to forego otherwise attractive opportunities. Management has established interest rate risk and other policies for
managing the portfolio of mortgage-backed securities and the related borrowings
outstanding. These policies include, without limitation, evaluating the level
of risk we assume when purchasing adjustable-rate or hybrid adjustable-rate
mortgage-backed securities which are subject to periodic and lifetime interest
rate caps, matching the interest rates on our assets and liabilities, acquiring
new mortgage-backed securities to replace prepaid securities, purchasing
mortgage-backed securities that we believe to have favorable-risk adjusted
expected returns relative to the market interest rates at the time of purchase,
borrowing between eight and 12 times the amount of our stockholders equity,
entering into derivative transactions to protect us from rising interest rates
on our repurchase agreements, and monitoring our qualification as a REIT. Refer to the section titled Risk Factors for additional discussion
regarding these and other risk factors which affect our business. Refer to the
section Interest Rate Risk of Item 3 of Part I, Quantitative and Qualitative
Disclosure About Market Risk, for additional interest rate risk discussion. Critical Accounting Policies Our financial statements are prepared in accordance with accounting
principles generally accepted in the United States of America, or GAAP. These
accounting principles require us to make some complex and subjective decisions
and assessments. Our most critical accounting policies involve decisions and
assessments which could significantly affect our reported assets and
liabilities, as well as our reported revenues and expenses. We believe that all
of the decisions and assessments upon which our financial statements are based
were reasonable at the time made based upon information available to us at that
time. Descriptions of the significant accounting policies of the Company are
included in Note 1 to financial statements in the Companys 2003 Annual Report
on Form 10-K. There have been no significant changes to these policies during
2004. Management has identified our most critical accounting policies to be
the following: Classifications of Investment Securities Our investments in mortgage-backed securities are classified as
available-for-sale securities which are carried on the balance sheet at their
fair value. The classification of the securities as available-for-sale results
in changes in fair value being recorded as adjustments to accumulated other
comprehensive loss, which is a component of stockholders equity, rather than
immediately through earnings. If available-for-sale securities were classified
as trading securities, there could be substantially greater volatility in
earnings from period-to-period. Valuations of Mortgage-backed Securities Our mortgage-backed securities have fair values as determined by
management with reference to price estimates provided by independent pricing
services and dealers in the securities. Because the price estimates may vary to
some degree between sources, management must make certain judgments and
assumptions about the appropriate price to use to calculate the fair values for
financial reporting purposes. Different judgments and assumptions could result
in different presentations of value. When the fair value of an available-for-sale security is less than
amortized cost, management considers whether there is an other-than-temporary
impairment in the value of the security. If, in managements judgment, an
other-than-temporary impairment exists, the cost basis of the security is
written down to the then-current fair value, 18




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and the unrealized loss is transferred from accumulated other
comprehensive loss as an immediate reduction of current earnings (as if the
loss had been realized in the period of impairment). The determination of
other-than-temporary impairment is a subjective process, and different
judgments and assumptions could affect the timing of loss realization. Management considers the following factors when evaluating the securities
for an other-than-temporary impairment:  
    
    the length of the time and the extent to which the market value has been less than the amortized cost;  
    
    whether the security has been downgraded by a rating agency; and  
    
    our intent to hold the security for a period of time sufficient to allow for any anticipated recovery
in market value. The determination of other-than-temporary impairment is evaluated at least
quarterly. If we determine an impairment to be permanent we may need to
realize a loss that would have an impact on future income. Interest Income Recognition Interest income on our mortgage-backed securities is accrued based on the
actual coupon rate and the outstanding principal amount of the underlying
mortgages. Premiums and discounts are amortized or accreted into interest
income over the lives of the securities using the effective yield method
adjusted for the effects of estimated prepayments based on Statement of
Financial Accounting Standards, or SFAS, No. 91, Accounting for Nonrefundable
Fees and Costs Associated with Originating or Acquiring Loans and Initial
Direct Costs of Leases.If our estimate of prepayments is incorrect, we may be
required to make an adjustment to the amortization or accretion of premiums and
discounts that would have an impact on future income. Accounting for Derivative Financial Instruments and Hedging Activities Our policies permit us to enter into derivative contracts, including
Eurodollar futures contracts and interest rate swaps, as a means of mitigating
our interest rate risk on forecasted interest expense associated with the
benchmark rate on forecasted rollover/reissuance of repurchase agreements or
the interest rate repricing of repurchase agreements, or hedged items, for a
specified future time period. At March 31, 2004, we have engaged in short sales of Eurodollar futures
contracts to mitigate our interest rate risk for the specified future time
period, which is defined as the calendar quarter immediately following the
contract expiration date. The value of these futures contracts is
marked-to-market daily in our margin account with the custodian. Based upon the
daily market value of these futures contracts, we either receive funds into, or
wire funds into, our margin account with the custodian to ensure that an
appropriate margin account balance is maintained at all times through the
expiration of the contracts. These contracts, or hedge instruments, have been designated as cash flow
hedges and are evaluated at inception and on an ongoing basis in order to
determine whether they qualify for hedge accounting under SFAS No. 133, as
amended and interpreted. The hedge instrument must be highly effective in
achieving offsetting changes in the hedged item attributable to the risk being
hedged in order to qualify for hedge accounting. In order to determine whether
the hedge instrument is highly effective, we use regression methodology to
assess the effectiveness of our hedging strategies. Specifically, at the
inception of each new hedge and on an ongoing basis, we assess effectiveness
using ordinary least squares regression to evaluate the correlation between
the rates consistent with the hedge instrument and the underlying hedged items.
A hedge instrument is highly effective if the changes in the fair value of the
derivative provide offset of at least 80% and not more than 120% of the changes
in fair value or cash flows of the hedged item attributable to the risk being
hedged. The futures contracts are carried on the balance sheet at fair value.
Any ineffectiveness which arises during the hedging relationship, is recognized
in interest expense during the period in which it arises. Prior to the end of
the specified hedge time period the effective portion of all contract gains and
losses (whether realized or unrealized) is recorded in other comprehensive
income or loss. Realized gains and 19




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losses are reclassified into earnings as an adjustment to interest expense
during the specified hedge time period. For REIT taxable net income purposes,
realized gains and losses are reclassified into earnings immediately when
positions are closed or have expired. We are not required to account for the futures contracts using hedge
accounting as described above. If we decided not to designate the futures
contracts as hedges and to monitor their effectiveness as hedges, or if we
entered into other types of financial instruments that did not meet the
criteria to be designated as hedges, changes in the fair values of these
instruments would affect periodic earnings immediately. Management Incentive Compensation Expense The Management Agreement provides for the payment of incentive
compensation to the Manager if our financial performance exceeds certain
benchmarks. Incentive compensation is calculated on a cumulative, quarterly
basis for GAAP purposes and on a stand-alone quarterly basis with an annual
cumulative reconciliation calculation for incentive compensation payment
purposes. During each quarter of the fiscal year, we will calculate the
incentive compensation expense quarterly, on a cumulative basis, making any
necessary adjustments for any expensed amounts that were recognized in previous
quarters. As a result, if we experience poor quarterly performance in a
particular quarter and this causes the cumulative incentive compensation
expense for the current quarter to be lower than the cumulative incentive
compensation for the prior quarter, we will record a negative incentive
compensation expense in the current quarter. The incentive compensation is
payable one-half in cash and one-half in the form of our restricted common
stock. For the first, second and third quarters of each fiscal year, incentive
compensation payments actually paid to the Manager are calculated based upon
the net income and relevant performance thresholds solely for the applicable
quarter, and a cumulative calculation is performed at the end of the fiscal
year. As a result, during the first three quarters of each fiscal year there
will be differences between incentive compensation expense, for GAAP purposes,
and the incentive compensation amounts actually paid to the Manager. Any
differences between these amounts will be reflected on the balance sheet as a
receivable due from or payable due to the Manager. In addition, when each
annual cumulative incentive compensation calculation and reconciliation is
performed, the Manager may be required to return cash incentive compensation
payments earlier received or shares of common stock earlier granted, as
applicable, to it as part of its incentive compensation payments for the first
three quarters of the fiscal year. The cash portion of the incentive compensation is accrued and expensed
during the period for which it is calculated and paid. We account for the
restricted stock portion of the incentive compensation in accordance with SFAS
No. 123, Accounting for Stock-based Compensation, and related interpretations,
and EITF 96-18, Accounting for Equity Instruments That Are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services. This restricted stock portion of the incentive compensation will be paid
or issued to the Manager on a quarterly basis pursuant to the terms of the
Management Agreement. The number of shares issued is based on (a) one-half of
the total incentive compensation for the period, divided by (b) the average of
the closing prices of the common stock over the 30-day period ending three days
prior to the grant date, less a fair market value discount determined by our
board of directors to account for the transfer restrictions during the vesting
period. During periods of lower stock prices, we will issue more restricted
common stock to the Manager under the Management Agreement to pay for the same
amount of incentive compensation earned in periods that had higher stock
prices. Over the vesting period, any additional shares issued would have a
dilutive effect on book value and net income per share. On the date of each restricted stock payment or issuance to the Manager
under the Management Agreement, the fair market value of the common stock shall
be recorded in the stockholders equity section of our balance sheet as common
stock and additional paid-in capital. The corresponding portion of any
restricted stock payment that is not expensed will be reflected in the
stockholders equity section of our balance sheet as deferred compensation.
Each quarters incentive compensation restricted stock payment or issuance to
the Manager will be divided into three tranches. The first tranche will vest
over a one-year period and be expensed over a five-quarter 20




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period, beginning in the quarter in which it was earned. The second
tranche will vest over a two-year period and be expensed over a nine-quarter
period beginning in the quarter in which it was earned. The third tranche will
vest over a three-year period and be expensed over a thirteen-quarter period
beginning in the quarter in which it was earned. As a result of this vesting
schedule for the restricted stock issued to the Manager, we will incur
incentive compensation expense in each of the periods following the issuance of
the restricted stock over a three-year period. We will continue to incur
incentive compensation expense related to each restricted stock payment, even
in subsequent periods in which the Manager did not earn incentive compensation
under the Management Agreement. As the price of our common stock changes in future periods, the fair value
of the unvested portions of shares paid to the Manager pursuant to the
Management Agreement shall be marked-to-market, with corresponding entries on
the balance sheet. The net effect of any mark-to-market adjustments to the
value of the unvested portions of the restricted stock shall be expensed in
future periods, on a ratable basis, according to the remaining vesting
schedules of each respective tranche of restricted common stock. Accordingly,
incentive compensation expense related to the portion of the incentive
compensation paid to the Manager in each restricted stock payment or issuance
may be higher or lower from one reporting period to the next, and may vary
throughout the vesting period. For example, future incentive compensation
expense related to previously issued but unvested restricted stock will be
higher during periods of increasing stock prices, and lower during periods of
decreasing stock prices. In addition, over the vesting period for each
restricted stock payment or issuance, our stockholders equity will increase or
decrease based upon the current market price of our stock. As a result, this
will have the effect of increasing or decreasing our net worth, the factor used
in calculating the Managers base management fee, and may increase or decrease
the amount of base management fees in future periods. Pursuant to the Management Agreement, it is possible for the Manager to
earn incentive compensation each quarter and, as a result, receive a restricted
stock payment each quarter. As the Manager is paid or issued multiple tranches
of restricted common stock for incentive compensation, we will experience
increasing management fee expense due to the cumulative impact of multiple
tranches and vesting schedules of restricted stock payments, and the
mark-to-market impact of the unvested portions of these payments. This will be
true even in periods where there is little change in our income or stock price. We also pay an incentive fee, in the form of cash and restricted stock, to
our Chief Financial Officer, in accordance with the terms of his employment
agreement. The incentive fee is accounted for in the same manner as the
incentive fee earned by the Manager. Financial Condition Mortgage-Backed Securities At March 31, 2004, we held $4.1 billion of mortgage-backed securities at
fair value, net of unrealized gains of $13.9 million and unrealized losses of
$16.6 million. As of March 31, 2004, all of the mortgage-backed securities in
our portfolio were purchased at a premium to their par value and our portfolio
had a weighted-average amortized cost of 101.8% of face amount. Certain of the securities held at March 31, 2004 are impaired as the fair
value of the securities is below amortized cost. At March 31, 2004, our entire
portfolio was invested in AAA-rated non-agency-backed or agency-backed
mortgage-backed securities. None of the securities held had been downgraded by
a credit rating agency since their purchase. In addition, we intend to hold the
securities until maturity, allowing for the anticipated recovery in fair value
of the securities held. As such, we do not believe any of the securities held
are other-than-temporarily impaired at March 31, 2004. 21




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The stated contractual final maturity of the mortgage loans underlying our
portfolio of mortgage-backed securities ranges up to 30 years, however, the
expected maturity is subject to change based on the prepayments of the
underlying mortgage loans. The following table sets forth the maturity dates,
by year, and percentage composition related to the assets that comprise our
investment portfolio as of March 31, 2004: Weighted-Average
    
    % ofAsset
    
    Final Maturity
    
    TotalAdjustable-Rate Mortgage-Backed Securities
    
    
    2033
    
    
    
    4.1
    %Hybrid Adjustable-Rate Mortgage-Backed Securities
    
    
    2033
    
    
    
    94.6
    %Balloon Mortgage-Backed Securities
    
    
    2033
    
    
    
    1.3
    %Fixed-Rate Mortgage-Backed Securities
    
    
    N/A
    
    
    
    N/A
 Actual maturities of mortgage-backed securities are generally shorter than
stated contractual maturities. Actual maturities of our mortgage-backed
securities are affected by the contractual lives of the underlying mortgages,
periodic payments of principal, and prepayments of principal. The principal payment rate on our mortgage-backed securities, an annual
rate of principal paydowns for our mortgage-backed securities relative to the
outstanding principal balance of our mortgage-backed securities, was 20% for
the quarter ended March 31, 2004. The principal payment rate attempts to
predict the percentage of principal that will paydown over the next 12 months
based on historical principal paydowns. As interest rates have risen, the rate
of refinancings has declined, which we believe may result in lower rates of
prepayments and, as a result, a lower portfolio principal payment rate. As of March 31, 2004, the weighted-average effective duration of the
securities in our overall investment portfolio, assuming constant prepayment
rates, or CPR, to the balloon or reset date, or the CPB duration, was 1.45
years. CPR is a measure of the rate of prepayment for our mortgage-backed
securities, expressed as an annual rate relative to the outstanding principal
balance of our mortgage-backed securities. CPB is similar to CPR except that it
also assumes that the hybrid adjustable-rate mortgage-backed securities prepay
in full at their next reset date. As of March 31, 2004, the mortgages
underlying our hybrid adjustable-rate mortgage-backed securities had fixed
interest rates for a weighted-average of approximately 43 months, after which
time the interest rates reset and become adjustable. The average length of time
until maturity of those mortgages was 30 years. Those mortgages are also
subject to interest rate caps that limit the amount that the applicable
interest rate can increase during any year, known as an annual cap, and through
the maturity of the applicable security, known as a lifetime cap. As of March
31, 2004, the mortgages underlying our hybrid adjustable-rate mortgage-backed
securities had average annual caps of 2.48% and average lifetime caps of
10.01%. The following table summarizes our mortgage-backed securities on March 31,
2004 according to their estimated weighted-average life classifications: Weighted-Amortized
    
    AverageWeighted-Average Life
    
    Fair Value
    
    Cost
    
    Coupon(in thousands)Less than one year
    
    $
    345,832
    
    
    $
    348,251
    
    
    
    3.61
    %Greater than one year and less than five years
    
    
    3,725,540
    
    
    
    3,725,764
    
    
    
    3.97Greater than five years
    
    
    
    
    
    
    
    
    
    
    Total
    
    $
    4,071,372
    
    
    $
    4,074,015
    
    
    
    3.96
    %
 The weighted-average lives of the mortgage-backed securities at March 31,
2004 in the table above are based upon data provided through a
subscription-based financial information service provided by a major investment
bank, assuming constant principal prepayment rates to the balloon or reset date
for each security. At March 31, 2004, the weighted-average lives were
calculated using estimated prepayment speeds or actual prepayment speed
history. The weighted-average lives for some of the mortgage-backed securities
included in the 22




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table above were estimated using expected prepayment speeds for pools,
since certain pools were new issues and did not have historical performance
data available. The prepayment model considers current yield, forward yield,
steepness of the yield curve, current mortgage rates, mortgage rate of the
outstanding loan, loan age, margin and volatility. The actual weighted-average lives of the mortgage-backed securities in our
investment portfolio could be longer or shorter than the estimates in the
tables above depending on the actual prepayment rates experienced over the life
of the applicable securities and is sensitive to changes in both prepayment
rates and interest rates. Equity Securities Our investment policies allow us to acquire a limited amount of equity
securities, including common and preferred shares issued by other real estate
investment trusts. At March 31, 2004, we did not hold any equity securities. Unsettled Securities Purchases At March 31, 2004, we had unsettled securities purchases of $1.1 billion.
Of the $1.1 billion of unsettled securities purchases, $942.6 million are
related to to be announced, or TBA, mortgage-backed securities. Other Assets We had other assets of $178.0 million at March 31, 2004. Other assets
consist primarily of offering proceeds receivable of $157.9 million, interest
receivable of $13.2 million, principal receivable of $5.7 million, prepaid
directors and officers liability insurance of $548 thousand and deferred
compensation of $585 thousand. On April 2, 2004, the Company received the
proceeds from the public offering which was completed on March 29, 2004. Hedging Instruments There can be no assurance that our hedging activities will have the
desired beneficial impact on our results of operations or financial condition.
Moreover, no hedging activity can completely insulate us from the risks
associated with changes in interest rates and prepayment rates. Hedging involves risk and typically involves costs, including transaction
costs. The costs of hedging increase dramatically as the period covered by the
hedging increases and during periods of rising and volatile interest rates. We
may increase our hedging activity and, thus, increase our hedging costs during
such periods when interest rates are volatile or rising. We generally intend to
hedge as much of the interest rate risk as our manager determines is in the
best interest of our stockholders, after considering the cost of such hedging
transactions and our desire to maintain our status as a REIT. Our policies do
not contain specific requirements as to the percentages or amount of interest
rate risk that our manager is required to hedge. At March 31, 2004, we have engaged in short sales of Eurodollar futures
contracts as a means of mitigating our interest rate risk on forecasted
interest expense associated with the benchmark rate on forecasted
rollover/reissuance of repurchase agreements or the interest rate repricing of
repurchase agreements, or hedged item, for a specified future time period,
which is defined as the calendar quarter immediately following the contract
expiration date. We sold short 9,600 Eurodollar futures contracts, which expire
in June 2004, September 2004 and December 2004 with a notional amount totaling
$9.6 billion. The value of these futures contracts is marked-to-market daily in
our margin account with the custodian. Based upon the daily market value of
these futures contracts, we either receive funds into, or wire funds into, our
margin account with the custodian to ensure that an appropriate margin account
balance is maintained at all times through the expiration of the contracts. At
March 31, 2004, the unrealized loss on the Eurodollar futures contracts was
$3.4 million. 23




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Liabilities We have entered into repurchase agreements to finance some of our
acquisitions of mortgage-backed securities. None of the counterparties to these
agreements are affiliates of the Manager or us. These agreements are secured by
our mortgage-backed securities and bear interest rates that have historically
moved in close relationship to LIBOR. As of March 31, 2004 we had established
17 borrowing arrangements with various investment banking firms and other
lenders, 14 of which were in use on March 31, 2004. At March 31, 2004, we had outstanding $2.7 billion of repurchase
agreements with a weighted-average current borrowing rate of 1.15%, $119.6
million of which matures within 30 days, $1.5 billion of which matures between
31 and 90 days and $1.1 billion of which matures in greater than 90 days. It is
our present intention to seek to renew these repurchase agreements as they
mature under the then-applicable borrowing terms of the counterparties to our
repurchase agreements. At March 31, 2004, the repurchase agreements were
secured by mortgage-backed securities with an estimated fair value of $2.8
billion and had a weighted-average maturity of 97 days. The net amount at
risk, defined as fair value of securities sold, plus accrued interest income,
minus repurchase agreement liabilities, plus accrued interest expense, with all
counterparties was $148.5 million. After consideration of the duration on our Eurodollar futures contracts,
our weighted-average maturity of our total liabilities was 313 days. We had $1.1 billion of other liabilities at March 31, 2004. Other
liabilities consisted primarily of $1.1 billion of unsettled securities
purchases, $10.4 million of cash distribution payable, $5.3 million of accrued
interest expense on repurchase agreements, and $2.2 million of management fee
payable, incentive fee payable and other related party liabilities. We have a margin lending facility with our primary custodian from which we
may borrow money in connection with the purchase or sale of securities. The
terms of the borrowings, including the rate of interest payable, are agreed to
with the custodian for each amount borrowed. Borrowings are repayable
immediately upon demand of the custodian. At March 31, 2004, there were no
outstanding borrowings under the margin lending facility. Stockholders Equity Stockholders equity at March 31, 2004 was $460.5 million and included
$2.6 million of unrealized losses on mortgage-backed securities
available-for-sale and $3.8 million of realized and unrealized losses on cash
flow hedges presented as accumulated other comprehensive loss. Weighted-average stockholders equity and return on average equity were $302.5
million and 14.36%, respectively, for the quarter ended
March 31, 2004. Return on average equity is defined as
annualized net income divided by weighted-average stockholders'
equity. Our book value at March 31, 2004 was as follows: TotalStockholders
    
    Book ValueEquity
    
    per Share (1)(in thousands)Total stockholders equity (GAAP)
    
    $
    460,543
    
    
    $
    12.50AddbackAccumulated other comprehensive loss on mortgage-backed securities
    
    
    2,643
    
    
    
    0.07Total stockholders equity, excluding accumulated other comprehensive
loss on mortgage-backed securities (NON-GAAP)
    
    $
    463,186
    
    
    $
    12.57
  (1)
    
    Based on 36,841,146 shares outstanding on March 31, 2004 24




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Management believes that total stockholders equity excluding accumulated
other comprehensive loss on mortgage-backed securities is a useful measure to
investors because book value unadjusted for temporary declines in the fair
values of securities more closely represents the cost basis of our invested
assets, net of our leverage, which is the basis for our net interest income and
our distributions to stockholders under the provisions of the Internal Revenue
Code governing REIT distributions. Results of Operations For the quarter ended March 31, 2004, net income was $10.8 million or
$0.43 per weighted-average share outstanding (basic and diluted). For the same
period, interest income, net of premium amortization, was approximately $20.2
million, and was primarily earned from investments in mortgage-backed
securities. Interest expense on short-term borrowings was $6.8 million. On
March 29, 2004, we completed a public offering of 12,000,000 shares of common
stock. Because of the timing of this offering, interest income for the quarter
ended March 31, 2004 does not reflect the impact of this offering. In addition,
prepayment activity declined due to the changing interest rate environment and
resulted in decreased premium amortization and increased yield on average
earning assets. For the quarter ended March 31, 2004, the weighted-average yield on
average earning assets, net of amortization of premium was 3.20% and the
weighted-average interest rate on our repurchase agreement liabilities was
1.20% resulting in a net interest spread of 2.00%, 39 basis points higher than
our net interest spread for the fourth quarter of 2003. Operating expenses for the quarter ended March 31, 2004 were $2.6 million. Base management fees to the Manager under the Management Agreement, which
were $787 thousand for the quarter ended March 31, 2004, are based on a
percentage of our average net worth. Average net worth for these purposes is
calculated on a monthly basis and equals the difference between the aggregate
book value of our consolidated assets prior to accumulated depreciation and
other non-cash items, including the fair market value adjustment on
mortgage-backed securities, minus the aggregate book value of our consolidated
liabilities. Incentive fee expense to related parties for the quarter ended March 31,
2004 was $846 thousand. Incentive compensation is earned by related parties
when REIT taxable net income (before deducting incentive compensation, net
operating losses and certain other items) relative to the average net invested
assets for the period, as defined in the Management Agreement, exceeds the
threshold return taxable income that would have produced an annualized return
on equity equal to the sum of the 10-year U.S. Treasury rate plus 2.0% for the
same period. For the quarter ended March 31, 2004, REIT taxable net income
(before deducting incentive compensation, net operating losses and certain
other items) was $11.2 million and was greater than the threshold return
taxable income of $4.7 million. For the quarter ended March 31, 2004, total incentive compensation earned
by the Manager was $1.3 million, one-half payable in cash and one-half payable
in the form of the Companys common stock as described above. The cash portion
of the incentive fee of $652 thousand for the quarter ended March 31, 2004 was
expensed in that period as well as 15.2% of the restricted stock portion of the
incentive fees, or $99 thousand. In accordance with the terms of his employment
agreement, the Companys Chief Financial Officer earned an incentive fee for
the quarter ended March 31, 2004 of $65 thousand. This portion of the
incentive fee is also payable one-half in cash and one-half in the form of a
restricted stock award under the Companys 2003 Stock Incentive Plan. The
shares are payable and vest over the same vesting schedule as the stock issued
to the Manager. The cash portion of the incentive fee of $33 thousand for the
quarter ended March 31, 2004 was expensed in that period as well as 15.2% of
the restricted stock portion of the incentive fees, or $5 thousand. The
remaining incentive fee for the quarter ended March 31, 2004 consists primarily
of the change in fair value of unvested restricted stock awards. Professional services expense for the quarter ended March 31, 2004 of $417
thousand includes legal, accounting and other professional services provided to
us. Included in this balance are costs related to the filing of our resale
shelf registration statement totaling $111 thousand. The insurance expense for
the same period of $220 thousand represents amortization of prepaid directors
and officers insurance. Custody expense of $67 thousand for the quarter ended
March 31, 2004 includes the services provided by our primary custodian. These
expenses may 25




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vary based on levels of activity within the portfolio. Included in the
other general and administrative expenses of $88 thousand for the quarter ended
March 31, 2004 are printing costs related to the filing of our resale shelf
registration statement totaling $18 thousand. REIT taxable net income is calculated according to the requirements of the
Internal Revenue Code, rather than GAAP. The following table reconciles GAAP
net income to REIT taxable net income for the quarter ended March 31, 2004 (in
thousands): GAAP net income
    
    $
    10,800Adjustments to GAAP net income:Amortization of organizational costs
    
    
    (8
    )Addback of stock compensation expense for unvested options
    
    
    2Addback of stock compensation expense for unvested restricted stock
    
    
    161Addback of hedge ineffectiveness expense
    
    
    10Subtract dividend equivalent rights on restricted stock
    
    
    (12
    )Subtract realized losses on Eurodollar futures contracts
    
    
    (412
    )Net adjustments to GAAP net income
    
    
    (259
    )REIT taxable net income
    
    $
    10,541
 We believe that the presentation of our REIT taxable net income is useful
to investors because it is directly related to the distributions we are
required to make in order to retain our REIT status and to the calculations of
the incentive compensation payable to related parties (before deducting
incentive compensation, net operating losses and certain other items). There
are limitations associated with REIT taxable net income. For example, this
measure does not reflect net capital losses during the period and, thus, by
itself is an incomplete measure of our financial performance over any period.
As a result, our REIT taxable net income should be considered in addition to,
and not as a substitute for, our GAAP-based net income as a measure of our
financial performance. Contractual Obligations and Commitments As of March 31, 2004, we had entered into a Management Agreement with our
Manager. See Note 6 to the financial statements for significant terms of the
Management Agreement. Off-Balance Sheet Arrangements Since inception, we have not maintained any relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance or special purpose entities, established for
the purpose of facilitating off-balance sheet arrangements or other
contractually narrow or limited purposes. Further, we have not guaranteed any
obligations of unconsolidated entities nor do we have any commitment or intent
to provide additional funding to any such entities. Accordingly, we are not
materially exposed to any market, credit, liquidity or financing risk that
could arise if we had engaged in such relationships. Liquidity and Capital Resources Our primary source of funds as of March 31, 2004 consisted of repurchase
agreements totaling $2.7 billion with a weighted-average current borrowing rate
of 1.15% which we used to finance acquisition of mortgage-related assets. We
expect to continue to borrow funds in the form of repurchase agreements. As of
March 31, 2004 we had established 17 borrowing arrangements with various
investment banking firms and other lenders, 14 of which were in use on March
31, 2004. Increases in short-term interest rates could negatively impact the
valuation of our mortgage-related assets, which could limit our borrowing
ability or cause our lenders to initiate margin calls. Amounts due upon
maturity of our repurchase agreements will be funded primarily through the
rollover/reissuance of repurchase agreements and monthly principal and interest
payments received on our mortgage-backed securities. 26




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We generally seek to borrow between eight and 12 times the amount of our
equity. Our leverage ratio, defined as total repurchase agreements divided by
total stockholders equity, at March 31, 2004 was 5.9. At March 31, 2004, net
proceeds of $157.9 million were receivable from the underwriter of our public
offering which was completed on March 29, 2004. The net proceeds were received
on April 2, 2004. At March 31, 2004, we had not fully levered our portfolio to
within our target range of eight to 12 times the amount of our equity. As a
result, the total amount of mortgage-backed securities and repurchase agreement
liabilities as of March 31, 2004 were lower than they will be once our
portfolio is fully levered through additional repurchase agreement liabilities
and related mortgage-backed security purchases. We have a margin lending facility with our primary custodian from which we
may borrow money in connection with the purchase or sale of securities. The
terms of the borrowings, including the rate of interest payable, are agreed to
with the custodian for each amount borrowed. Borrowings are repayable
immediately upon demand of the custodian. At March 31, 2004, there were no
outstanding borrowings under the margin lending facility. For liquidity, we also rely on the cash flow from operations, primarily
monthly principal and interest payments to be received on our mortgage-backed
securities, as well as any primary securities offerings authorized by our board
of directors. On April 26, 2004, we paid a cash distribution of $0.42 per share to our
stockholders of record on March 19, 2004. The distribution was paid to
stockholders of the 24,841,146 shares outstanding on the record date, which was
prior to the completion of our March 29, 2004 public offering. This
distribution is a taxable dividend and is not considered a return of capital.
This distribution was funded with cash flow from our ongoing operations,
including principal and interest payments received on our mortgage-backed
securities. We did not distribute $282 thousand of our REIT taxable net income
for the period from April 26, 2003 through December 31, 2003. We intend to
declare a spillback distribution in this amount during 2004. We believe that equity capital, combined with the cash flow from
operations and the utilization of borrowings, will be sufficient to enable us
to meet anticipated liquidity requirements. However, an increase in prepayment
rates substantially above our expectations could cause a liquidity shortfall.
If our cash resources are at any time insufficient to satisfy our liquidity
requirements, we may be required to liquidate mortgage-backed securities or
sell debt or additional equity securities. If required, the sale of
mortgage-backed securities at prices lower than the carrying value of such
assets would result in losses and reduced income. We intend to increase our capital resources by making additional offerings
of equity and debt securities, possibly including classes of preferred stock,
common stock, commercial paper, medium-term notes, collateralized mortgage
obligations and senior or subordinated notes. Such financing will depend on
market conditions for capital raises and for the investment of any proceeds.
All debt securities, other borrowings, and classes of preferred stock will be
senior to the common stock in a liquidation of our Company. Inflation Virtually all of our assets and liabilities are financial in nature. As a
result, interest rates and other factors influence our performance far more so
than does inflation. Changes in interest rates do not necessarily correlate
with inflation rates or changes in inflation rates. Our financial statements
are prepared in accordance with accounting principles generally accepted in the
United States and our distributions are determined by our board of directors
based primarily by our net income as calculated for tax purposes; in each case,
our activities and balance sheet are measured with reference to historical cost
and or fair market value without considering inflation. 27




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Risk Factors Risks Related to Our Business We have a limited operating history and might not be able to operate our
business or implement our operating policies and strategies successfully. We began operations in June of 2003, and we have a limited operating
history. The results of our operations will depend on many factors, including
the availability of opportunities for the acquisition of mortgage-related
assets, the level and volatility of interest rates, readily accessible short-
and long-term funding alternatives in the financial markets and economic
conditions. Moreover, delays in fully leveraging and investing our net proceeds
of our public offerings may cause our performance to be weaker than other fully
leveraged and invested mortgage REITs pursuing comparable investment
strategies. You will not have the opportunity to evaluate the manner in which
we invest or the economic merits of particular assets to be acquired.
Furthermore, we face the risk that we might not successfully operate our
business or implement our operating policies and strategies as described in
this Quarterly Report on Form 10-Q. Our investment guidelines permit us to invest up to 10% of our assets in
unrated mortgage-related assets, including mortgage-backed securities rated
below investment-grade, which carry a greater likelihood of default or rating
downgrade than investments in investment-grade mortgage-backed securities and
may cause us to suffer losses. Our asset acquisition policy provides us with the ability to acquire
significant amounts of lower credit quality mortgage-related assets, including
mortgage-backed securities that are not rated at least investment grade by at
least one nationally-recognized statistical rating organization. Under our
policy, up to 10% of our total assets may be non-investment grade
mortgage-backed securities or other investments such as leveraged mortgage
derivative securities, shares of other REITs, mortgage loans or other
mortgage-related investments. If we acquire non-investment-grade
mortgage-backed securities, we are more likely to incur losses because the
mortgages underlying those securities are made to borrowers possessing
lower-quality credit. While all agency certificates are subject to a risk of
default, that risk is greater with non-investment grade mortgage-backed
securities. In addition, the rating agencies are more likely to downgrade the
credit quality of those securities, which would reduce the value of those
securities. Interest rate mismatches between our adjustable-rate and hybrid adjustable-rate
mortgage-backed securities and the borrowings used to fund our purchases of
such mortgage-backed securities might reduce our net income or result in a loss
during periods of changing interest rates. We invest primarily in adjustable-rate and hybrid adjustable-rate
mortgage-backed securities. The mortgages underlying adjustable-rate
mortgage-backed securities have interest rates that reset periodically,
typically every six months or on an annual basis, based upon market-based
indices of interest rates such as U.S. Treasury bonds or LIBOR. The mortgages
underlying hybrid adjustable-rate mortgage-backed securities have interest
rates that are fixed for the first few years of the loan-typically three, five,
seven or 10 years-and thereafter their interest rates reset periodically
similar to the mortgages underlying adjustable-rate mortgage-backed securities.
We have funded our acquisitions and expect to fund our future acquisitions of
adjustable-rate and hybrid adjustable-rate mortgage-backed securities in part
with borrowings that have interest rates based on indices and repricing terms
similar to, but with shorter maturities than, the interest rate indices and
repricing terms of the adjustable-rate and hybrid adjustable-rate
mortgage-backed securities. On March 31, 2004, 98.7% of our investment
portfolio was invested in adjustable-rate or hybrid adjustable-rate
mortgage-backed securities having a weighted-average term to next rate
adjustment of approximately 42 months, while our borrowings had a
weighted-average term of approximately 97 days. After consideration of the
duration on our Eurodollar futures contracts, our weighted-average maturity was
313 days. The phrase weighted average term to next rate adjustment refers to
the average of the periods of time that must elapse before the interest rates
adjust for all of the mortgages underlying our adjustable-rate and hybrid
adjustable-rate mortgage-backed securities in our portfolio, which average is
weighted in proportion to the book values of the applicable securities. During
periods of changing interest rates, this interest rate 28




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mismatch between our assets and liabilities could reduce or eliminate our
net income and distributions to our stockholders and could cause us to suffer a
loss. Accordingly, in a period of rising interest rates, we could experience a
decrease in, or elimination of, net income or a net loss because the interest
rates on our borrowings adjust faster than the interest rates on our
adjustable-rate mortgage-backed securities. Increased levels of prepayments on the mortgages underlying our mortgage-backed
securities might decrease our net interest income or result in a net loss. The mortgage-backed securities that we acquire generally represent
interests in pools of mortgage loans. The principal and interest payments we
receive from our mortgage-backed securities are generally funded by the
payments that mortgage borrowers make on those underlying mortgage loans. When
borrowers pre-pay their mortgage loans sooner than expected, corresponding
prepayments on the mortgage-backed securities occur sooner than expected by the
marketplace. Sooner-than-expected prepayments could harm our results of
operations in the following ways, among others:  
    
    We seek to purchase mortgage-backed securities that we believe to have
favorable risk-adjusted expected returns relative to market interest
rates at the time of purchase. If the coupon interest rate for a
mortgage-backed security is higher than the market interest rate at
the time it is purchased, then that mortgage-backed security will be
acquired at a premium to its par value. In accordance with applicable
accounting rules, we are required to amortize any premiums or
discounts related to our mortgage-backed securities over their
expected terms. The amortization of a premium reduces interest income,
while the amortization of a discount increases interest income. The
expected terms for mortgage-backed securities are a function of the
prepayment rates for the mortgages underlying the mortgage-backed
securities. Mortgage-backed securities that are at a premium to their
par value are more likely to experience prepayment of some or all of
their principal through refinancings. If the mortgages underlying our
premium mortgage-backed securities are prepaid in whole or in part
more quickly than their respective maturity dates, then we must also
amortize their respective premiums more quickly, which would decrease
our net interest income and harm our profitability.
    
    A substantial portion of our adjustable-rate mortgage-backed
securities may bear interest at rates that are lower than their
fully-indexed rates, which refers to their applicable index rates
plus a margin. If an adjustable-rate mortgage-backed security is
prepaid prior to or soon after the time of adjustment to a
fully-indexed rate, we will have held that mortgage-backed security
while it was less profitable and lost the opportunity to receive
interest at the fully-indexed rate over the remainder of its expected
life.
    
    If we are unable to acquire new mortgage-backed securities to replace
the prepaid mortgage-backed securities, our financial condition,
results of operations and cash flow may suffer and we could incur
losses. Prepayment rates generally increase when interest rates fall and decrease
when interest rates rise, but changes in prepayment rates are difficult to
predict. Prepayment rates also may be affected by other factors, including,
without limitation, conditions in the housing and financial markets, general
economic conditions and the relative interest rates on adjustable-rate and
fixed-rate mortgage loans. While we seek to minimize prepayment risk, we must
balance prepayment risk against other risks and the potential returns of each
investment when selecting investments. No strategy can completely insulate us
from prepayment or other such risks. 29




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We may incur increased borrowing costs related to repurchase agreements that
would harm our results of operations. Our borrowing costs under repurchase agreements are generally adjustable
and correspond to short-term interest rates, such as LIBOR or a short-term
Treasury index, plus or minus a margin. The margins on these borrowings over or
under short-term interest rates may vary depending upon a number of factors,
including, without limitation:  
    
    the movement of interest rates;
    
    the availability of financing in the market; and
    
    the value and liquidity of our mortgage-backed securities. Most of our borrowings are collateralized borrowings in the form of
repurchase agreements. If the interest rates on these repurchase agreements
increase, our results of operations will be harmed and we may have losses. Interest rate caps related to our adjustable-rate and hybrid adjustable-rate
mortgage-backed securities may reduce our income or cause us to suffer a loss
during periods of rising interest rates. The mortgages underlying our adjustable-rate and hybrid adjustable-rate
mortgage-backed securities are typically subject to periodic and lifetime
interest rate caps. Periodic interest rate caps limit the amount that the
interest rate of a mortgage can increase during any given period. Lifetime
interest rate caps limit the amount an interest rate can increase through the
maturity of a mortgage. As of March 31, 2004, 98.7% of our mortgage-backed
securities were based on adjustable-rate or hybrid adjustable-rate mortgages,
substantially all of which were subject to interest rate caps. The percentage
of adjustable-rate and hybrid adjustable-rate mortgage-backed securities in our
investment portfolio which are subject to periodic interest rate caps every six
months or annually were 12.5% and 86.2%, respectively. Our borrowings are not subject to similar restrictions. The periodic
adjustments to the interest rates of the mortgages underlying our
adjustable-rate and hybrid adjustable-rate mortgage-backed securities are based
on changes in an objective index. Substantially all of the mortgages underlying
our adjustable-rate and hybrid adjustable-rate mortgage-backed securities
adjust their interest rates based on one of two main indices, the U.S. Treasury
index, a monthly or weekly average yield of benchmark U.S. Treasury securities
as published by the Federal Reserve Board, or LIBOR, the interest rate that
banks in London offer for deposits in London of U.S. dollars. The percentages
of the mortgages underlying the adjustable-rate and hybrid adjustable-rate
mortgage-backed securities in our investment portfolio as of March 31, 2004
with interest rates that reset based on the U.S. Treasury or LIBOR indices were
26.3% and 72.4%, respectively. Accordingly, in a period of rapidly increasing interest rates, the
interest rates paid on our borrowings could increase without limitation while
interest rate caps could limit the increases in the yields on our
adjustable-rate and hybrid adjustable-rate mortgage-backed securities. This
problem is magnified for adjustable-rate and hybrid adjustable-rate
mortgage-backed securities that are not fully indexed. Further, some of the
mortgages underlying our adjustable-rate and hybrid adjustable-rate
mortgage-backed securities may be subject to periodic payment caps that result
in a portion of the interest being deferred and added to the principal
outstanding. As a result, we may receive less cash income on adjustable-rate
and hybrid adjustable-rate mortgage-backed securities than we need to pay
interest on our related borrowings. These factors could reduce our net interest
income or cause us to suffer a net loss. We might experience reduced net interest income or a loss from holding
fixed-rate investments during periods of rising interest rates. A significant portion of our investment portfolio consists of hybrid
adjustable-rate mortgage-backed securities. As of March 31, 2004, 94.6% of our
investment portfolio consisted of hybrid adjustable-rate mortgage-backed
securities. We may also invest in fixed-rate mortgage-backed securities from
time to time, however, as of March 31, 2004, none of our portfolio consisted of
fixed-rate mortgage-backed securities. We fund our acquisition 30




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of fixed-rate mortgage-backed securities, including those based on balloon
maturity and hybrid adjustable-rate mortgages, in part with short-term
repurchase agreements and term loans. During periods of rising interest rates,
our costs associated with borrowings used to fund the acquisition of fixed-rate
mortgage-backed securities are subject to increases while the income we earn
from these assets remains substantially fixed. This would reduce and could
eliminate the net interest spread between the fixed-rate mortgage-backed
securities that we purchase and our borrowings used to purchase them, which
would reduce our net interest income and could cause us to suffer a loss. Our leverage strategy increases the risks of our operations, which could reduce
our net income and the amount available for distributions or cause us to suffer
a loss. We generally seek to borrow between eight and 12 times the amount of our
equity, although at times our borrowings may be above or below this amount. We
incur this indebtedness by borrowing against a substantial portion of the
market value of our mortgage-backed securities. Our total indebtedness,
however, is not expressly limited by our policies and will depend on our and
our prospective lenders estimate of the stability of our portfolios cash
flow. We face the risk that we might not be able to meet our debt service
obligations or a lenders margin requirements from our income and, to the
extent we cannot, we might be forced to liquidate some of our assets at
disadvantageous prices. Our use of leverage amplifies the risks associated with
other risk factors, which could reduce our net income and the amount available
for distributions or cause us to suffer a loss. For example:  
    
    A majority of our borrowings are secured by our mortgage-backed
securities, generally under repurchase agreements. A decline in the
market value of the mortgage-backed securities used to secure these
debt obligations could limit our ability to borrow or result in
lenders requiring us to pledge additional collateral to secure our
borrowings. In that situation, we could be required to sell
mortgage-backed securities under adverse market conditions in order to
obtain the additional collateral required by the lender. If these
sales are made at prices lower than the carrying value of the
mortgage-backed securities, we would experience losses.
    
    A default under a mortgage-related asset that constitutes collateral
for a loan could also result in an involuntary liquidation of the
mortgage-related asset, including any cross-collateralized
mortgage-backed securities. This would result in a loss to us of the
difference between the value of the mortgage-related asset upon
liquidation and the amount borrowed against the mortgage-related
asset.
    
    To the extent we are compelled to liquidate qualified REIT assets to
repay debts, our compliance with the REIT rules regarding our assets
and our sources of income could be negatively affected, which would
jeopardize our status as a REIT. Losing our REIT status would cause us
to lose tax advantages applicable to REITs and would decrease our
overall profitability and distributions to our stockholders.
    
    If we experience losses as a result of our leverage policy, such
losses would reduce the amounts available for distribution to our
stockholders. We might not be able to use derivatives to mitigate our interest rate and
prepayment risks. Our policies permit us to enter into interest rate swaps, caps and floors
and other derivative transactions to help us reduce our interest rate and
prepayment risks. As of March 31, 2004, we were engaged in short sales of
Eurodollar futures contracts in order to hedge the impact of changes in
interest rates on our liability costs. In the future, these transactions might
mitigate our interest rate and prepayment risks, but cannot eliminate these
risks. Moreover, the use of derivative transactions could have a negative
impact on our earnings and our status as a REIT, and, therefore, our use of
such derivatives could be limited. We may enter into ineffective derivative transactions or other hedging
activities that may reduce our net interest income or cause us to suffer
losses. Our policies permit us to, but we are not required to, enter into
derivative transactions such as interest rate swaps, caps and floors and other
derivative transactions to help us seek to reduce our interest rate and
prepayment risks. The effectiveness of any derivative transactions will depend
significantly upon whether we correctly quantify 31




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the interest rate or prepayment risks being hedged, our execution of and
ongoing monitoring of our hedging activities, and the treatment of such hedging
activities for GAAP accounting purposes. As of March 31, 2004, we were engaged in short sales of Eurodollar futures
contracts in order to hedge the impact of changes in interest rates on our
liability costs. In the case of these hedges, and any other future efforts to
hedge the effects of interest rate changes on our liability costs, if we enter
into hedging instruments that have higher interest rates embedded in them as a
result of the forward yield curve, and at the end of the term of these hedging
instruments the spot market interest rates for the liabilities that we hedged
are actually lower, then we will have locked in higher interest rates for our
liabilities than would be available in the spot market at the time and this
could result in a narrowing of our net interest rate spread or result in
losses. In some situations, we may sell assets or hedging instruments at a loss
in order to maintain adequate liquidity. In addition, we apply SFAS No. 133, Accounting for Derivative Instruments
and Hedging Activities, as amended and interpreted, and record derivatives at
fair value. If the derivatives meet the criteria to be accounted for as hedging
transactions, the effects of the transactions could be materially different as
to timing than if they do not qualify as hedges, and this may cause a narrowing
of our net interest rate spread or result in losses. An increase in interest rates might adversely affect our book value. We use changes in 10-year U.S. Treasury yields as a reference indicator
for changes in interest rates because it is a common market benchmark.
Increases in the general level of interest rates can cause the fair market
value of our assets to decline, particularly those mortgage-backed securities
whose underlying mortgages have fixed-rate components. Our fixed-rate mortgage
securities and our hybrid adjustable-rate mortgage-backed securities (during
the fixed-rate component of the mortgages underlying such securities) will
generally be more negatively affected by such increases than our
adjustable-rate mortgage securities. In accordance with GAAP, we will be
required to reduce the carrying value of our mortgage-backed securities by the
amount of any decrease in the fair value of our mortgage-backed securities
compared to their respective amortized costs. If unrealized losses in fair
value occur, we will have to either reduce current earnings or reduce
stockholders equity without immediately affecting current earnings, depending
on how we classify such mortgage-backed securities under GAAP. In either case,
our net book value will decrease to the extent of any realized or unrealized
losses in fair value. We may invest in leveraged mortgage derivative securities that generally
experience greater volatility in market prices, and thus expose us to greater
risk with respect to their rate of return. We may acquire leveraged mortgage derivative securities that expose us to
a high level of interest rate risk. The characteristics of leveraged mortgage
derivative securities cause those securities to experience greater volatility
in their market prices. Thus, acquisition of leveraged mortgage derivative
securities will expose us to the risk of greater volatility in our portfolio,
which could reduce our net income and harm our overall results of operations. We depend on borrowings to purchase mortgage-related assets and reach our
desired amount of leverage. If we fail to obtain or renew sufficient funding on
favorable terms or at all, we will be limited in our ability to acquire
mortgage-related assets, which will harm our results of operations. We depend on short-term borrowings to fund acquisitions of
mortgage-related assets and reach our desired amount of leverage. Accordingly,
our ability to achieve our investment and leverage objectives depends on our
ability to borrow money in sufficient amounts and on favorable terms. In
addition, we must be able to renew or replace our maturing short-term
borrowings on a continuous basis. We depend on a few lenders to provide the
primary credit facilities for our purchases of mortgage-related assets. In
addition, our existing indebtedness may limit our ability to make additional
borrowings. If our lenders do not allow us to renew our borrowings or we cannot
replace maturing borrowings on favorable terms or at all, we might have to sell
our mortgage-related assets under adverse market conditions, which would harm
our results of operations and may result in permanent losses. 32




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Possible market developments could cause our lenders to require us to pledge
additional assets as collateral. If our assets are insufficient to meet the
collateral requirements, we might be compelled to liquidate particular assets
at inopportune times and at disadvantageous prices. Possible market developments, including a sharp or prolonged rise in
interest rates, a change in prepayment rates or increasing market concern about
the value or liquidity of one or more types of mortgage-backed securities in
which our portfolio is concentrated, might reduce the market value of our
portfolio, which might cause our lenders to require additional collateral. Any
requirement for additional collateral might compel us to liquidate our assets
at inopportune times and at disadvantageous prices, thereby harming our
operating results. If we sell mortgage-backed securities at prices lower than
the carrying value of the mortgage-backed securities, we would experience
losses. Our use of repurchase agreements to borrow funds may give our lenders greater
rights in the event that either we or any of our lenders file for bankruptcy. Our borrowings under repurchase agreements may qualify for special
treatment under the bankruptcy code, giving our lenders the ability to avoid
the automatic stay provisions of the bankruptcy code and to take possession of
and liquidate our collateral under the repurchase agreements without delay if
we file for bankruptcy. Furthermore, the special treatment of repurchase
agreements under the bankruptcy code may make it difficult for us to recover
our pledged assets in the event that our lender files for bankruptcy. Thus, the
use of repurchase agreements exposes our pledged assets to risk in the event of
a bankruptcy filing by either our lender or us. Because the assets that we acquire might experience periods of illiquidity, we
might be prevented from selling our mortgage-related assets at opportune times
and prices. We bear the risk of being unable to dispose of our mortgage-related assets
at advantageous times and prices or in a timely manner because mortgage-related
assets generally experience periods of illiquidity. The lack of liquidity might
result from the absence of a willing buyer or an established market for these
assets, as well as legal or contractual restrictions on resale. If we are
unable to sell our mortgage-related assets at opportune times, we might suffer
a loss and/or reduce our distributions. Our board of directors may change our operating policies and strategies without
prior notice or stockholder approval and such changes could harm our business
and results of operations and the value of our stock. Our board of directors has the authority to modify or waive our current
operating policies and our strategies (including our election to operate as a
REIT) without prior notice and without stockholder approval. We cannot predict
the effect any changes to our current operating policies and strategies would
have on our business, operating results and value of our stock. However, the
effects might be adverse. Competition might prevent us from acquiring mortgage-backed securities at
favorable yields, which would harm our results of operations. Our net income depends on our ability to acquire mortgage-backed
securities at favorable spreads over our borrowing costs. In acquiring
mortgage-backed securities, we compete with other REITs, investment banking
firms, savings and loan associations, banks, insurance companies, mutual funds,
other lenders and other entities that purchase mortgage-backed securities, many
of which have greater financial resources than we do. As a result, we may not
be able to acquire sufficient mortgage-backed securities at favorable spreads
over our borrowing costs, which would harm our results of operations. Defaults on the mortgage loans underlying our mortgage-backed securities may
reduce the value of our investment portfolio and may harm our results of
operations. We bear the risk of any losses resulting from any defaults on the mortgage
loans underlying the mortgage-backed securities in our investment portfolio.
Many of the mortgage-backed securities that we obtain will have one or more
forms of credit enhancement provided by third parties, such as insurance
against risk of loss due to default on the underlying mortgage loans or
bankruptcy, fraud and special hazard losses. To the extent that third parties 33




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have been contracted to insure against these types of losses, the value of
such insurance will depend in part on the creditworthiness and claims-paying
ability of the insurer and the timeliness of reimbursement in the event of a
default on the underlying obligations. Further, the insurance coverage for
various types of losses is limited in amount, and losses in excess of these
limitations would be borne by us. Other mortgage-backed securities that we purchase will be subject to
limited guarantees of the payment of limited amounts of principal and interest
on mortgage loans underlying such mortgage-backed securities, either by federal
government agencies, including Ginnie Mae, by federally-chartered corporations,
including Fannie Mae and Freddie Mac, or by other corporate guarantors. While
Ginnie Maes obligations are backed by the full faith and credit of the United
States, the obligations of Fannie Mae and Freddie Mac and other corporate
guarantors are solely their own. As a result, a substantial deterioration in
the financial strength of Fannie Mae, Freddie Mac or other corporate guarantors
could increase our exposure to future delinquencies, defaults or credit losses
on our holdings of Fannie Mae or Freddie Mac-backed mortgage-backed securities
or other corporate-backed mortgage-backed securities, and could harm our
results of operations. In addition, while Freddie Mac guarantees the eventual
payment of principal, it does not guarantee the timely payment thereof, and our
results of operations may be harmed if borrowers are late or delinquent in
their payments on mortgages underlying Freddie Mac-backed mortgage-backed
securities. Moreover, Fannie Mae, Freddie Mac, Ginnie Mae and other corporate
guarantees relate only to payments of limited amounts of principal and interest
on the mortgages underlying such agency-backed or corporate-backed securities,
and do not guarantee the market value of such mortgage-backed securities or the
yields on such mortgage-backed securities. As a result, we remain subject to
interest rate risks, prepayment risks, extension risks and other risks
associated with our investment in such mortgage-backed securities and may
experience losses in our investment portfolio. We remain subject to losses despite our strategy of investing in highly-rated
mortgage-backed securities. Our investment guidelines provide that at least 90% of our assets must be
invested in mortgage-backed securities that are either agency-backed or are
rated at least investment grade by at least one rating agency. While
highly-rated mortgage-backed securities are generally subject to a lower risk
of default than lower credit quality mortgage-backed securities and may benefit
from third-party credit enhancements such as insurance or corporate guarantees,
there is no assurance that such mortgage-backed securities will not be subject
to credit losses. Furthermore, ratings are subject to change over time as a
result of a number of factors, including greater than expected delinquencies,
defaults or credit losses, or a deterioration in the financial strength of
corporate guarantors, any of which may reduce the market value of such
securities. Furthermore, ratings do not take into account the reasonableness of
the issue price, interest risks, prepayment risks, extension risks or other
risks associated with such mortgage-backed securities. As a result, while we
attempt to mitigate our exposure to credit risk on a relative basis by focusing
on highly-rated mortgage-backed securities, we cannot eliminate such credit
risks and remain subject to other risks to our investment portfolio and may
suffer losses, which may harm the market price of our common stock. Decreases in the value of the property underlying our mortgage-backed
securities might decrease the value of our assets. The mortgage-backed securities in which we invest are secured by
underlying real property interests. To the extent that the value of the
property underlying our mortgage-backed securities decreases, our security
might be impaired, which might decrease the value of our assets. Insurance will not cover all potential losses on the underlying real property
and the absence thereof may harm the value of our assets. Under our asset acquisition policy, we are permitted to invest up to a
maximum of 10% of our total assets in assets other than mortgage-backed
securities guaranteed by federal agencies or federally chartered entities such
as Fannie Mae, Freddie Mac or Ginnie Mae, or rated as at least investment grade
by a nationally recognized statistical rating agency. Mortgage loans fall
outside of this category of investments under our investment guidelines and are
subject to the 10% limitation. If we elect in the future to purchase mortgage
loans, we may require that each of the mortgage loans that we purchase include
comprehensive insurance covering the underlying real property, including 34




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liability, fire and extended coverage. There are certain types of losses,
however, generally of a catastrophic nature, such as earthquakes, floods and
hurricanes, that may be uninsurable or not economically insurable. Inflation,
changes in building codes and ordinances, environmental considerations, and
other factors also might make it infeasible to use insurance proceeds to
replace a property if it is damaged or destroyed. Under such circumstances, the
insurance proceeds, if any, might not be adequate to restore the economic value
of the underlying real property, which might impair our security and decrease
the value of our assets. Distressed mortgage loans have higher risk of future default. If we elect in the future to purchase mortgage loans, we may purchase
distressed mortgage loans as well as mortgage loans that have had a history of
delinquencies. These distressed mortgage loans may be in default or may have a
greater than normal risk of future defaults and delinquencies, as compared to a
pool of newly-originated, high quality loans of comparable type, size and
geographic concentration. Returns on an investment of this type depend on
accurate pricing of such investment, the borrowers ability to make required
payments or, in the event of default, the ability of the loans servicer to
foreclose and liquidate the mortgage loan. We cannot assure you that the
servicer will be able to liquidate a defaulted mortgage loan in a
cost-effective manner, at an advantageous price or in a timely manner. Subordinated loans on real estate are subject to higher risks. If we elect in the future to purchase mortgage loans, we may acquire loans
secured by commercial properties, including loans that are subordinate to first
liens on the underlying commercial real estate. Subordinated mortgage loans are
subject to greater risks of loss than first lien mortgage loans. An overall
decline in the real estate market could reduce the value of the real property
securing such loans such that the aggregate outstanding balance of the
second-lien loan and the balance of the more senior loan on the real property
exceed the value of the real property. We depend on our key personnel and the loss of any of our key personnel could
severely and detrimentally affect our operations. We depend on the diligence, experience and skill of our officers and the
people working on behalf of our manager for the selection, acquisition,
structuring and monitoring of our mortgage-related assets and associated
borrowings. Our key officers include Gail Seneca, Albert Gutierrez, Christopher
Zyda, Andrew Chow and Troy Grande. We have not entered into employment
agreements with our senior officers other than Mr. Zyda, who is our Senior Vice
President and Chief Financial Officer. With the exception of Mr. Zyda, we do
not currently employ other senior officers dedicated solely to our business,
and our officers are free to engage in competitive activities in our industry.
The loss of any key person could harm our business, financial condition, cash
flow and results of operations. Risks Related to Our Manager The Manager has not managed a REIT and we cannot assure you that the Managers
past experience will be sufficient to successfully manage our business as a
REIT. Seneca Capital Management LLC has not previously managed a REIT, and does
not have any experience in complying with the income, asset and other
limitations imposed by the REIT provisions of the Internal Revenue Code. Those
provisions are complex and the failure to comply with those provisions in a
timely manner could prevent us from qualifying as a REIT or could force us to
pay unexpected taxes and penalties. In such event, our net income would be
reduced and we could incur a loss. Our manager has significant influence over our affairs, and might cause us to
engage in transactions that are not in our or our stockholders best interests. In addition to managing us and having at least two of its designees as
members of our board, the Manager provides advice on our operating policies and
strategies. The Manager may also cause us to engage in future 35




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transactions with the Manager and its affiliates, subject to the approval
of, or guidelines approved by, the independent members of our board of
directors. Our directors, however, rely primarily on information supplied by
our manager in reaching their determinations. Accordingly, our manager has
significant influence over our affairs, and may cause us to engage in
transactions which are not in our best interest. Our manager and its affiliates might allocate mortgage-related opportunities to
other entities, and thus might divert attractive investment opportunities away
from us. Our operations and assets are managed by specified individuals at the
Manager. The Manager and its affiliates, including some of our officers, manage
portfolios for parties unrelated to us. These multiple responsibilities might
create conflicts of interest for the Manager and these individuals if they are
presented with opportunities that might benefit us and their other clients. The
Manager and these individuals must allocate investments among our portfolio and
their other clients by determining the entity or account for which the
investment is most suitable. In making this determination, the Manager and
these individuals consider the investment strategy and guidelines of each
entity or account with respect to acquisition of assets, leverage, liquidity
and other factors that the Manager and these individuals determine appropriate.
However, the Manager and those working on its behalf have no obligation to make
any specific investment opportunities available to us and the above-mentioned
conflicts of interest might result in decisions or allocations of investments
that are not in our or our stockholders best interests. We will pay the Manager incentive compensation based on our portfolios
performance. This arrangement may lead the Manager to recommend riskier or more
speculative investments in an effort to maximize its incentive compensation. In addition to its base management fee, the Manager earns incentive
compensation for each fiscal quarter equal to a specified percentage of the
amount by which our return on equity, before deducting incentive compensation,
exceeds a return based on the 10 year U.S. Treasury rate plus 2%. The
percentage for this calculation is the weighted average of the following
percentages based on our average net invested assets for the period:  
    
    20% for the first $400 million of our average net invested assets; and
    
    10% of our average net invested assets in excess of $400 million. Pursuant to the formula for calculating the Managers incentive
compensation, the Manager shares in our profits but not in our losses.
Consequently, as the Manager evaluates different mortgage-backed securities and
other investments for our account, there is a risk that the Manager will cause
us to assume more risk than is prudent in an attempt to increase its incentive
compensation. Other key criteria related to determining appropriate investments
and investment strategies, including the preservation of capital, might be
under-weighted if the Manager focuses exclusively or disproportionately on
maximizing its income. We may be obligated to pay the Manager incentive compensation even if we incur
a loss. Pursuant to the Management Agreement, the Manager is entitled to receive
incentive compensation for each fiscal quarter in an amount equal to a tiered
percentage of the excess of our taxable income for that quarter (before
deducting incentive compensation, net operating losses and certain other items)
above a threshold return for that quarter. In addition, the Management
Agreement further provides that our taxable income for incentive compensation
purposes excludes net capital losses that we may incur in the fiscal quarter,
even if such capital losses result in a net loss on our statement of operations
for that quarter. Thus, we may be required to pay the Manager incentive
compensation for a fiscal quarter even if there is a decline in the value of
our portfolio or we incur a net loss for that quarter. 36




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During periods of declining market prices for shares of our common stock, we
may be required to issue greater numbers of shares to the Manager for the same
amount of incentive compensation arising under the Management Agreement, which
will have a dilutive effect on our stockholders that may harm the market price
of our common stock. Pursuant to the terms of the Management Agreement, the incentive
compensation payable to the Manager for each fiscal quarter is paid one-half in
cash and one-half in restricted shares of our common stock. The number of
shares to be issued to the Manager is based on (a) one-half of the total
incentive compensation for the period, divided by (b) the average of the
closing prices of the common stock over the 30 day period ending three days
prior to the grant date, less a fair market value discount determined by our
board of directors. During periods of declining market prices for shares of our
common stock, we may be required to issue more shares to the Manager for the
same amount of incentive compensation. Although these shares will initially be
subject to restrictions on transfer which lapse ratably over a three-year
period, the issuance of these shares will have a dilutive effect on our
stockholders which may harm the market price of our common stock. Because the Manager might receive a significant fee if we terminate the
Management Agreement, economic considerations might preclude us from
terminating the Management Agreement in the event that the Manager fails to
meet our expectations. If we terminate the Management Agreement without cause or because we
decide to manage our company internally or if the Manager terminates the
management in the event of a change of control, then we will have to pay a
significant fee to the Manager. The amount of the fee depends on whether:  
    
    we terminate the Management Agreement without cause in connection with
a decision to manage our portfolio internally, in which case we will
be obligated to pay to the Manager a fee equal to the highest amount
of management fees incurred in a particular year during the then three
most recent years; or
    
    our decision to terminate the Management Agreement without cause is
for a reason other than our decision to manage our portfolio
internally, in which case we will be obligated to pay the Manager an
amount equal to two times the highest amount of management fees
incurred in a particular year during the then three most recent years. In each of the above cases, the Manager will also receive accelerated
vesting of the equity component of its incentive compensation. The actual
amount of such fee cannot be known at this time because it is based in part on
the performance of our portfolio of mortgage-backed securities. Paying this fee
would reduce significantly the cash available for distribution to our
stockholders and might cause us to suffer a net operating loss. Consequently,
terminating the Management Agreement might not be advisable even if we
determine that it would be more efficient to operate with an internal
management structure or if we are otherwise dissatisfied with the Managers
performance. Investors may not be able to estimate with certainty the aggregate fees and
expense reimbursements that will be paid to the Manager under the Management
Agreement and the cost-sharing agreement due to the time and manner in which
the Managers incentive compensation and expense reimbursements are determined. The Manager may be entitled to substantial fees pursuant to the Management
Agreement. The Managers base management fee is calculated as a percentage of
our average net worth. The Managers incentive compensation is calculated as a
tiered percentage of our taxable income (before deducting certain items) in
excess of a threshold amount of taxable income and is indeterminable in advance
of a particular period. Since future payments of base management fees,
incentive compensation and expense reimbursements are determined at future
dates based upon our then-applicable average net worth, results of operations
and actual expenses incurred by the Manager, such fees and expense
reimbursements cannot be estimated with mathematical certainty. Any base
management fees, incentive compensation or expense reimbursements payable to
the Manager may be materially greater or less than the historical amounts and
we can provide no assurance at this time as to the amount of any such base
management fee, incentive compensation or expense reimbursements that may be
payable to the Manager in the future. 37




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The Manager may render services to other mortgage investors, which could reduce
the amount of time and effort that the Manager devotes to us. Our Management Agreement with the Manager does not restrict the right of
the Manager, any persons working on its behalf or any of its affiliates, to
carry on their respective businesses, including the rendering of advice to
others regarding the purchase of mortgage-backed securities that would meet our
investment criteria. In addition, the Management Agreement does not specify a
minimum time period that the Manager and its personnel must devote to managing
our investments. The ability of the Manager to engage in these other business
activities, and specifically to manage mortgage-related assets for third
parties, could reduce the time and effort it spends managing our portfolio to
the detriment of our investment returns. The Managers liability is limited under the Management Agreement, and we have
agreed to indemnify the Manager against certain liabilities. The Manager has not assumed any responsibility to us other than to render
the services described in the Management Agreement, and will not be responsible
for any action of our board of directors in declining to follow the Managers
advice or recommendations. the Manager and its directors, officers and
employees will not be liable to us for acts performed by its officers,
directors, or employees in accordance with and pursuant to the Management
Agreement, except for acts constituting gross negligence, recklessness, willful
misconduct or active fraud in connection with their duties under the Management
Agreement. We have agreed to indemnify the Manager and its directors, officers
and employees with respect to all expenses, losses, damages, liabilities,
demands, charges and claims arising from acts of the Manager not constituting
gross negligence, recklessness, willful misconduct or active fraud. Legal and Tax Risks If we are disqualified as a REIT, we will be subject to tax as a regular
corporation and face substantial tax liability. Qualification as a REIT involves the application of highly technical and
complex U.S. federal income tax code provisions for which only a limited number
of judicial or administrative interpretations exist. Accordingly, it is not
certain we will be able to become and remain qualified as a REIT for U.S.
federal income tax purposes. Even a technical or inadvertent mistake could
jeopardize our REIT status. Furthermore, Congress or the Internal Revenue
Service, or IRS, might change tax laws or regulations and the courts might
issue new rulings, in each case potentially having retroactive effect, that
could make it more difficult or impossible for us to qualify as a REIT. If we
fail to qualify as a REIT in any tax year, then:  
    
    we would be taxed as a regular domestic corporation, which, among
other things, means that we would be unable to deduct distributions to
stockholders in computing taxable income and we would be subject to
U.S. federal income tax on our taxable income at regular corporate
rates;
    
    any resulting tax liability could be substantial, would reduce the
amount of cash available for distribution to stockholders, and could
force us to liquidate assets at inopportune times, causing lower
income or higher losses than would result if these assets were not
liquidated; and
    
    unless we were entitled to relief under applicable statutory
provisions, we would be disqualified from treatment as a REIT for the
subsequent four taxable years following the year during which we lost
our qualification and, thus, our cash available for distribution to
our stockholders would be reduced for each of the years during which
we did not qualify as a REIT. Even if we remain qualified as a REIT, we might face other tax liabilities
that reduce our cash flow. Further, we might be subject to federal, state and
local taxes on our income and property. Any of these taxes would decrease cash
available for distribution to our stockholders. 38




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Complying with REIT requirements might cause us to forego otherwise attractive
opportunities. In order to qualify as a REIT for U.S. federal income tax purposes, we
must satisfy tests concerning, among other things, our sources of income, the
nature and diversification of our mortgage-backed securities, the amounts we
distribute to our stockholders and the ownership of our stock. We may also be
required to make distributions to our stockholders at disadvantageous times or
when we do not have funds readily available for distribution. Thus, compliance
with REIT requirements may cause us to forego opportunities we would otherwise
pursue. In addition, the REIT provisions of the Internal Revenue Code impose a
100% tax on income from prohibited transactions. Prohibited transactions
generally include sales of assets that constitute inventory or other property
held for sale in the ordinary course of a business, other than foreclosure
property. This 100% tax could impact our desire to sell mortgage-backed
securities at otherwise opportune times if we believe such sales could be
considered a prohibited transaction. Complying with REIT requirements may limit our ability to hedge effectively. The existing REIT provisions of the Internal Revenue Code substantially
limit our ability to hedge mortgage-backed securities and related borrowings.
Under these provisions, our annual income from qualified hedges, together with
any other income not generated from qualified REIT real estate assets, is
limited to less than 25% of our gross income. In addition, we must limit our
aggregate income from hedging and services from all sources, other than from
qualified REIT real estate assets or qualified hedges, to less than 5% of our
annual gross income. As a result, we might in the future have to limit our use
of advantageous hedging techniques. This could leave us exposed to greater
risks associated with changes in interest rates than we would otherwise want to
bear. If we were to violate the 25% or 5% limitations, we might have to pay a
penalty tax equal to the amount of our income in excess of those limitations,
multiplied by a fraction intended to reflect our profitability. If we fail to
satisfy the 25% or 5% limitations, unless our failure was due to reasonable
cause and not due to willful neglect, we could lose our REIT status for federal
income tax purposes. Complying with REIT requirements may force us to liquidate otherwise attractive
investments. In order to qualify as a REIT, we must ensure that at the end of each
calendar quarter at least 75% of the value of our assets consists of cash, cash
items, government securities and qualified REIT real estate assets. The
remainder of our investment in securities generally cannot include more than
10% of the outstanding voting securities of any one issuer or more than 10% of
the total value of the outstanding securities of any one issuer. In addition,
generally, no more than 5% of the value of our assets can consist of the
securities of any one issuer. If we fail to comply with these requirements, we
must dispose of a portion of our assets within 30 days after the end of the
calendar quarter in order to avoid losing our REIT status and suffering adverse
tax consequences. Complying with REIT requirements may force us to borrow to make distributions
to our stockholders. As a REIT, we must distribute 90% of our annual taxable income (subject to
certain adjustments) to our stockholders. From time to time, we might generate
taxable income greater than our net income for financial reporting purposes
from, among other things, amortization of capitalized purchase premiums, or our
taxable income might be greater than our cash flow available for distribution
to our stockholders. If we do not have other funds available in these
situations, we might be unable to distribute 90% of our taxable income as
required by the REIT rules. In that case, we would need to borrow funds, sell a
portion of our mortgage-backed securities potentially at disadvantageous prices
or find another alternative source of funds. These alternatives could increase
our costs or reduce our equity and reduce amounts available to invest in
mortgage-backed securities. 39




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Failure to maintain an exemption from the Investment Company Act, would harm
our results of operations. We intend to conduct our business so as not to become regulated as an
investment company under the Investment Company Act of 1940, as amended. If we
fail to qualify for this exemption, our ability to use leverage would be
substantially reduced and we would be unable to conduct our business as
described in this Quarterly Report on Form 10-Q. The Investment Company Act exempts entities that are primarily engaged in
the business of purchasing or otherwise acquiring mortgages and other liens on,
and interests in, real estate. Under the current interpretation of the SEC
staff, in order to qualify for this exemption, we must maintain at least 55% of
our assets directly in these qualifying real estate interests. Mortgage-backed
securities that do not represent all of the certificates issued with respect to
an underlying pool of mortgages may be treated as separate from the underlying
mortgage loans and, thus, may not qualify for purposes of the 55% requirement.
Therefore, our ownership of these mortgage-backed securities is limited by the
provisions of the Investment Company Act. In satisfying the 55% requirement under the Investment Company Act, we
treat as qualifying interests mortgage-backed securities issued with respect to
an underlying pool as to which we hold all issued certificates. If the SEC or
its staff adopts a contrary interpretation of such treatment, we could be
required to sell a substantial amount of our mortgage-backed securities under
potentially adverse market conditions. Further, in our attempts to ensure that
we at all times qualify for the exemption under the Investment Company Act, we
might be precluded from acquiring mortgage-backed securities if their yield is
higher than the yield on mortgage-backed securities that could be purchased in
a manner consistent with the exemption. These factors may lower or eliminate
our net income. Misplaced reliance on legal opinions or statements by issuers of
mortgage-backed securities could result in a failure to comply with REIT income
or assets tests. When purchasing mortgage-backed securities, we may rely on opinions of
counsel for the issuer or sponsor of such securities, or statements made in
related offering documents, for purposes of determining whether and to what
extent those securities constitute REIT real estate assets for purposes of the
REIT asset tests and produce income that qualifies under the REIT gross income
tests. The inaccuracy of any such opinions or statements may adversely affect
our REIT qualification and result in significant corporate-level tax. One-action rules may harm the value of the underlying property. Several states have laws that prohibit more than one action to enforce a
mortgage obligation, and some courts have construed the term action broadly.
In such jurisdictions, if the judicial action is not conducted according to
law, there may be no other recourse in enforcing a mortgage obligation, thereby
decreasing the value of the underlying property. We may be harmed by changes in various laws and regulations. Changes in the laws or regulations governing the Manager or its affiliates
may impair the Managers or its affiliates ability to perform services in
accordance with the Management Agreement. Our business may be harmed by changes
to the laws and regulations affecting our manager or us, including changes to
securities laws and changes to the Internal Revenue Code applicable to the
taxation of REITs. New legislation may be enacted into law or new
interpretations, rulings or regulations could be adopted, any of which could
harm us, our manager and our stockholders, potentially with retroactive effect. Legislation was recently enacted that reduces the maximum tax rate of
non-corporate taxpayers for capital gains (for taxable years ending on or after
May 6, 2003 and before January 1, 2009) and for dividends (for taxable years
beginning after December 31, 2002 and before January 1, 2009) to 15%.
Generally, dividends paid by REITs are not eligible for the new 15% federal
income tax rate, with certain exceptions discussed at United States Federal
Income Tax Considerations-Taxation of Taxable United States
Stockholders-Distributions Generally. Although this legislation does not
adversely affect the taxation of REITs or dividends paid by REITs, the more
favorable 40




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treatment of regular corporate dividends could cause investors who are
individuals to consider stocks of other corporations that pay dividends as more
attractive relative to stocks of REITs. It is not possible to predict whether
this change in perceived relative value will occur, or what the effect will be
on the market price of our common stock. In addition, legislation was recently introduced in the United States
House of Representatives and the United States Senate that would amend certain
rules relating to REITs. Among other changes, the proposed legislation would
provide the Internal Revenue Service with the ability to impose monetary
penalties, rather than a loss of REIT status, for reasonable cause violations
of certain tests relating to REIT qualification, and would change the formula
for calculating the tax imposed for certain violations of the income tests
discussed at United States Federal Income Tax Considerations-Requirements for
Qualification as a REIT-Income Tests. In general, the changes would apply to
taxable years beginning after the date the legislation is enacted. As of the
date hereof, it is not possible to predict with any certainty whether the
proposed legislation will be enacted in its current form. We may incur excess inclusion income that would increase the tax liability of
our stockholders. In general, dividend income that a tax-exempt entity receives from us
should not constitute unrelated business taxable income as defined in Section
512 of the Internal Revenue Code. If we realize excess inclusion income and
allocate it to stockholders, this income cannot be offset by net operating
losses. If the stockholder is a tax-exempt entity, then this income would be
fully taxable as unrelated business taxable income under Section 512 of the
Internal Revenue Code. If the stockholder is foreign, it would be subject to
U.S. federal income tax withholding on this income without reduction pursuant
to any otherwise applicable income-tax treaty. Excess inclusion income could result if we held a residual interest in a
real estate mortgage investment conduit, or REMIC. Excess inclusion income also
would be generated if we were to issue debt obligations with two or more
maturities and the terms of the payments on these obligations bore a
relationship to the payments that we received on our mortgage-backed securities
securing those debt obligations. We generally structure our borrowing
arrangements in a manner designed to avoid generating significant amounts of
excess inclusion income. We do, however, enter into various repurchase
agreements that have differing maturity dates and afford the lender the right
to sell any pledged mortgage securities if we default on our obligations. The
IRS may determine that these borrowings give rise to excess inclusion income
that should be allocated among stockholders. Furthermore, some types of
tax-exempt entities, including voluntary employee benefit associations and
entities that have borrowed funds to acquire their shares of our common stock,
may be required to treat a portion of or all of the dividends they may receive
from us as unrelated business taxable income. Finally, we may invest in equity
securities of other REITs and it is possible that we might receive excess
inclusion income from those investments. Risks Related to Investing in Our Common Stock We have not established a minimum distribution payment level, and we cannot
assure you of our ability to make distributions to our stockholders in the
future. We intend to make quarterly distributions to our stockholders in amounts
such that we distribute all or substantially all of our taxable income in each
year, subject to certain adjustments. This, along with other factors, should
enable us to qualify for the tax benefits accorded to a REIT under the Internal
Revenue Code. We have not established a minimum distribution payment level and
our ability to make distributions might be harmed by the risk factors described
in this prospectus. All distributions will be made at the discretion of our
board of directors and will depend on our earnings, our financial condition,
maintenance of our REIT status and such other factors as our board of directors
may deem relevant from time to time. We cannot assure you that we will have the
ability to make distributions to our stockholders in the future. Restrictions on ownership of a controlling percentage of our capital stock
might limit your opportunity to receive a premium on our stock. For the purpose of preserving our REIT qualification and for other
reasons, our charter prohibits direct or constructive ownership by any person
of more than 9.8% of the lesser of the total number or value of the outstanding 41




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shares of our common stock or more than 9.8% of the outstanding shares of our
preferred stock. The constructive ownership rules in our charter are complex
and may cause the outstanding stock owned by a group of related individuals or
entities to be deemed to be constructively owned by one individual or entity.
As a result, the acquisition of less than 9.8% of the outstanding stock by an
individual or entity could cause that individual or entity to own
constructively in excess of 9.8% of the outstanding stock, and thus be subject
to the ownership limit in our charter. Any attempt to own or transfer shares of
our common or preferred stock in excess of the ownership limit without the
consent of our board of directors shall be void, and will result in the shares
being transferred by operation of law to a charitable trust. These provisions
might inhibit market activity and the resulting opportunity for our
stockholders to receive a premium for their shares that might otherwise exist
if any person were to attempt to assemble a block of shares of our stock in
excess of the number of shares permitted under our charter and which may be in
the best interests of our stockholders. Certain provisions of Maryland law and our charter and bylaws could hinder,
delay or prevent a change in control of our company. Certain provisions of Maryland law, our charter and our bylaws have the
effect of discouraging, delaying or preventing transactions that involve an
actual or threatened change in control of our company. These provisions include
the following:  
    
    Classified Board of Directors.Our board of directors is divided into
three classes with staggered terms of office of three years each. The
classification and staggered terms of office of our directors make it
more difficult for a third party to gain control of our board of
directors. At least two annual meetings of stockholders, instead of
one, generally would be required to effect a change in a majority of
the board of directors.
    
    Removal of Directors.Under our charter, subject to the rights of one
or more classes or series of preferred stock to elect one or more
directors, a director may be removed only for cause and only by the
affirmative vote of at least two-thirds of all votes entitled to be
cast by our stockholders generally in the election of directors.
    
    Number of Directors, Board Vacancies, Term of Office.We have elected
to be subject to certain provisions of Maryland law which vest in the
board of directors the exclusive right to determine the number of
directors and the exclusive right, by the affirmative vote of a
majority of the remaining directors, to fill vacancies on the board
even if the remaining directors do not constitute a quorum. These
provisions of Maryland law, which are applicable even if other
provisions of Maryland law or the charter or bylaws provide to the
contrary, also provide that any director elected to fill a vacancy
shall hold office for the remainder of the full term of the class of
directors in which the vacancy occurred, rather than the next annual
meeting of stockholders as would otherwise be the case, and until his
or her successor is elected and qualifies.
    
    Limitation on Stockholder-Requested Special Meetings.Our bylaws
provide that our stockholders have the right to call a special meeting
only upon the written request of stockholders entitled to cast not
less than a majority of all the votes entitled to be cast by the
stockholders at such meeting.
    
    Advance Notice Provisions for Stockholder Nominations and Proposals.
Our bylaws require advance written notice for stockholders to nominate
persons for election as directors at, or to bring other business
before, any meeting of stockholders. This bylaw provision limits the
ability of stockholders to make nominations of persons for election as
directors or to introduce other proposals unless we are notified in a
timely manner prior to the meeting. 42




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
    
    Exclusive Authority of our Board to Amend the Bylaws.Our bylaws
provide that our board of directors has the exclusive power to adopt,
alter or repeal any provision of the bylaws or to make new bylaws.
Thus, our stockholders may not effect any changes to our bylaws.
    
    Preferred Stock.Under our charter, our board of directors has
authority to issue preferred stock from time to time in one or more
series and to establish the terms, preferences and rights of any such
series of preferred stock, all without approval of our stockholders.
    
    Duties of Directors with Respect to Unsolicited Takeovers. Maryland
law provides protection for Maryland corporations against unsolicited
takeovers by limiting, among other things, the duties of the directors
in unsolicited takeover situations. The duties of directors of
Maryland corporations do not require them to (1) accept, recommend or
respond to any proposal by a person seeking to acquire control of the
corporation, (2) authorize the corporation to redeem any rights under,
or modify or render inapplicable, any stockholders rights plan, (3)
make a determination under the Maryland Business Combination Act or
the Maryland Control Share Acquisition Act, or (4) act or fail to act
solely because of the effect of the act or failure to act may have on
an acquisition or potential acquisition of control of the corporation
or the amount or type of consideration that may be offered or paid to
the stockholders in an acquisition. Moreover, under Maryland law the
act of the directors of a Maryland corporation relating to or
affecting an acquisition or potential acquisition of control is not
subject to any higher duty or greater scrutiny than is applied to any
other act of a director. Maryland law also contains a statutory
presumption that an act of a director of a Maryland corporation
satisfies the applicable standards of conduct for directors under
Maryland law.
    
    Ownership Limit. In order to preserve our status as a REIT under the
Internal Revenue Code, our charter generally permits any single
stockholder, or any group of affiliated stockholders, from
beneficially owning more than 9.8% of our outstanding common or
preferred stock unless our board of directors waives or modifies this
ownership limit.
    
    Maryland Business Combination Act. The Maryland Business Combination
Act provides that unless exempted, a Maryland corporation may not
engage in business combinations, including mergers, dispositions of
10% or more of its assets, certain issuances of shares of stock and
other specified transactions, with an interested stockholder or an
affiliate of an interested stockholder for five years after the most
recent date on which the interested stockholder became an interested
stockholder, and thereafter unless specified criteria are met. An
interested stockholder is generally a person owning or controlling,
directly or indirectly, 10% or more of the voting power of the
outstanding stock of a Maryland corporation. Our board of directors
has adopted a resolution exempting our company from this statute.
However, our board of directors may repeal or modify this resolution
in the future, in which case the provisions of the Maryland Business
Combination Act will be applicable to business combinations between
our company and other persons.
    
    Maryland Control Share Acquisition Act. Maryland law provides that
control shares of a corporation acquired in a control share
acquisition shall have no voting rights except to the extent approved
by a vote of two-thirds of the votes eligible to be cast on the matter
under the Maryland Control Share Acquisition Act. Control shares
means shares of stock that, if aggregated with all other shares of
stock previously acquired by the acquiror, would entitle the acquiror
to exercise voting power in electing directors within one of the
following ranges of the voting power: one-tenth or more but less than
one-third, one-third or more but less than a majority or a majority or
more of all voting power. A control share acquisition means the
acquisition of control shares, subject to certain exceptions. If
voting rights of control shares acquired in a control share
acquisition are not approved at a stockholders meeting, then subject
to certain conditions and limitations, the issuer may redeem any or
all of the control shares for fair value. If voting rights of such
control shares are approved at a stockholders meeting and the
acquiror becomes entitled to vote a majority of the shares of stock
entitled to vote, all other stockholders may exercise appraisal
rights. Our bylaws contain a provision exempting acquisitions of our
            shares from the Maryland Control Share Acquisition Act. However, our
board of directors may amend our bylaws in the future to repeal or
modify this exemption, in which case any control shares of our company
acquired in a control share acquisition will be subject to the
Maryland Control Share Acquisition Act. 43




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Future offerings of debt securities, which would be senior to our common stock
upon liquidation, or equity securities, which would dilute our existing
stockholders and may be senior to our common stock for the purposes of
distributions, may harm the value of our common stock. In the future, we may attempt to increase our capital resources by making
additional offerings of debt or equity securities, including commercial paper,
medium-term notes, senior or subordinated notes and classes of preferred stock
or common stock. Upon the liquidation of our company, holders of our debt
securities and shares of preferred stock and lenders with respect to other
borrowings will receive a distribution of our available assets prior to the
holders of our common stock. Additional equity offerings by us may dilute the
holdings of our existing stockholders or reduce the value of our common stock,
or both. Our preferred stock, if issued, would have a preference on
distributions that could limit our ability to make distributions to the holders
of our common stock. Because our decision to issue securities in any future
offering will depend on market conditions and other factors beyond our control,
we cannot predict or estimate the amount, timing or nature of our future
offerings. Thus, our stockholders bear the risk of our future offerings
reducing the market price of our common stock and diluting their stock holdings
in us. The market price and trading volume of our common stock may be volatile. Even if an active trading market develops for our common stock after this
offering, the market price of our common stock may be highly volatile and be
subject to wide fluctuations. In addition, the trading volume in our common
stock may fluctuate and cause significant price variations to occur. If the
market price of our common stock declines significantly, you may be unable to
resell your shares at or above your purchase price. We cannot assure you that
the market price of our common stock will not fluctuate or decline
significantly in the future. Some of the factors that could negatively affect
our stock price or result in fluctuations in the price or trading volume of our
common stock include:  
    
    actual or anticipated variations in our quarterly operating results or distributions;
    
    changes in our funds from operations or earnings estimates or publication of
research reports about us or the real estate industry, although there can be no
assurance that any research reports about us will be published;
    
    increases in market interest rates that lead purchasers of our shares to demand a
higher yield;  changes in market valuations of similar companies;
    
    adverse market reaction to any increased indebtedness we incur in the future;
    
    additions or departures of key management personnel;
    
    actions by institutional stockholders;
    
    speculation in the press or investment community; and
    
    general market and economic conditions. Broad market fluctuations could harm the market price of our common stock. The stock market has experienced extreme price and volume fluctuations
that have affected the market price of many companies in industries similar or
related to ours and that have been unrelated to these companies operating
performances. These broad market fluctuations could reduce the market price of
our common stock. Furthermore, our operating results and prospects may be below
the expectations of public market analysts and investors or may be lower than
those of companies with comparable market capitalizations, which could harm the
market price of our common stock. 44




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Shares of our common stock eligible for future sale may harm our stock price. We cannot predict the effect, if any, of future sales of shares of our
common stock, or the availability of shares for future sales, on the market
price of our common stock. Sales of substantial amounts of these shares of
common stock, or the perception that these sales could occur, may harm
prevailing market prices for our common stock. As of March 31, 2004, there are:  
    
    36,841,146 shares of outstanding common stock;
    
    outstanding options to purchase 55,000 shares of our common stock at a
weighted-average exercise price of $14.82 per share; and
    
    an additional 943,505 shares of our common stock available for future
awards under our stock incentive plans. A total of 943,505 shares of our common stock, or 1% of our current total
authorized shares, are reserved for future awards and grants under our stock
incentive plans. In January 2004, we filed a registration statement on Form S-8
under the Securities Act covering the 1.0 million shares of our common stock
issued or reserved for issuance under our stock incentive plans and/or subject
to outstanding options under our stock incentive plans. Shares of our common
stock issued upon exercise of options under the Form S-8 will be available for
sale in the public market, subject to Rule 144 volume limitations applicable to
affiliates and subject to the contractual restrictions described above. We
recently issued 13,110,000 shares of common stock in our initial public
offering. All of those shares are eligible for immediate resale by their
holders. Additionally, we recently filed a registration statement covering the
resale of up to 11,500,000 shares of our common stock by the selling
stockholders named in the prospectus which is a part of such resale
registration statement. All of the shares sold from time to time pursuant to
our resale registration statement will be eligible for immediate resale by
their holders. If any or all of the above holders sell a large number of
securities in the public market, the sale could reduce the market price of our
common stock and could impede our ability to raise future capital through a
sale of additional equity securities. Changes in yields may harm the market price of our common stock. Our earnings are derived primarily from the expected positive spread
between the yield on our assets and the cost of our borrowings. This spread
will not necessarily be larger in high interest rate environments than in low
interest rate environments and may also be negative. In addition, during
periods of high interest rates, our net income, and therefore the amount of any
distributions on our common stock, might be less attractive compared to
alternative investments of equal or lower risk. Each of these factors could harm the market price of our common stock. Terrorist attacks and other acts of violence or war may affect any market for
our common stock, the industry in which we operate, our operations and our
profitability. Terrorist attacks may harm our results of operations and your investment.
We cannot assure you that there will not be further terrorist attacks against
the United States or U.S. businesses. These attacks or armed conflicts may
impact the property underlying our mortgage-backed securities directly or
indirectly, by undermining economic conditions in the United States. Losses
resulting from terrorist events are generally uninsurable. 45




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##### Table of Contents



ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our primary component of market risk is interest rate risk, as described
below. While we do not seek to avoid risk completely, we do seek to assume risk
that can be quantified from historical experience, to actively manage that
risk, to earn sufficient compensation to justify taking those risks and to
maintain capital levels consistent with the risks we undertake. Interest Rate Risk We are subject to interest rate risk in connection with our investments in
fixed-rate, adjustable-rate and hybrid adjustable-rate mortgage-backed
securities and our related debt obligations, which are generally repurchase
agreements of limited duration that are periodically refinanced at current
market rates, and our derivative contracts. Effect on Net Interest Income We fund our investments in some long-term, fixed-rate and hybrid
adjustable-rate mortgage-backed securities with short-term borrowings under
repurchase agreements. During periods of rising interest rates, the borrowing
costs associated with those fixed-rate and hybrid-adjustable rate
mortgage-backed securities tend to increase while the income earned on such
fixed-rate and hybrid adjustable-rate mortgage-backed securities (during the
fixed-rate component of such securities) may remain substantially unchanged.
This results in a narrowing of the net interest spread between the related
assets and borrowings and may even result in losses. As a means to mitigate the negative impact of a rising interest rate
environment, we have entered into derivative transactions, specifically
Eurodollar futures contracts. Hedging techniques are based, in part, on assumed
levels of prepayments of our fixed-rate and hybrid adjustable-rate
mortgage-backed securities. If prepayments are slower or faster than assumed,
the life of the mortgage-backed securities will be longer or shorter which
would reduce the effectiveness of any hedging strategies we may utilize and may
result in losses on such transactions. Hedging strategies involving the use of
derivative securities are highly complex and may produce volatile returns. Our
hedging activity will also be limited by the asset and sources-of-income
requirements applicable to us as a REIT. Extension Risk We invest in fixed-rate and hybrid adjustable-rate mortgage-backed
securities. Hybrid adjustable-rate mortgage-backed securities have interest
rates that are fixed for the first few years of the loan-typically three, five,
seven or 10 years-and thereafter their interest rates reset periodically on the
same basis as adjustable-rate mortgage-backed securities. As of March 31, 2004,
94.6% of our investment portfolio was comprised of hybrid adjustable-rate
mortgage-backed securities. We compute the projected weighted-average life of
our fixed-rate and hybrid adjustable-rate mortgage-backed securities based on
the markets assumptions regarding the rate at which the borrowers will prepay
the underlying mortgages. In general, when a fixed-rate or hybrid
adjustable-rate mortgage-backed security is acquired with borrowings, we may,
but are not required to, enter into an interest rate swap agreement or other
hedging instrument that effectively fixes our borrowing costs for a period
close to the anticipated average life of the fixed-rate portion of the related
mortgage-backed security. This strategy is designed to protect us from rising
interest rates because the borrowing costs are fixed for the duration of the
fixed-rate portion of the related mortgage-backed security. However, if
prepayment rates decrease in a rising interest rate environment, the life of
the fixed-rate portion of the related mortgage-backed security could extend
beyond the term of the swap agreement or other hedging instrument. This
situation could negatively impact us as borrowing costs would no longer be
fixed after the end of the hedging instrument while the income earned on the
fixed-rate or hybrid adjustable-rate mortgage-backed security would remain
fixed. This situation may also cause the market value of our fixed-rate and
hybrid adjustable-rate mortgage-backed securities to decline with little or no
offsetting gain from the related hedging transactions. In extreme situations,
we may be forced to sell assets and incur losses to maintain adequate
liquidity. 46




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Adjustable-Rate and Hybrid Adjustable-Rate Mortgage-Backed Security
Interest Rate Cap Risk We also invest in adjustable-rate and hybrid adjustable-rate
mortgage-backed securities which are based on mortgages that are typically
subject to periodic and lifetime interest rate caps and floors, which limit the
amount by which an adjustable-rate or hybrid adjustable-rate mortgage-backed
securitys interest yield may change during any given period. However, our
borrowing costs pursuant to our repurchase agreements will not be subject to
similar restrictions. Therefore, in a period of increasing interest rates,
interest rate costs on our borrowings could increase without limitation by
caps, while the interest-rate yields on our adjustable-rate and hybrid
adjustable-rate mortgage-backed securities would effectively be limited by
caps. This problem will be magnified to the extent we acquire adjustable-rate
and hybrid adjustable-rate mortgage-backed securities that are not based on
mortgages which are fully-indexed. In addition, the underlying mortgages may
be subject to periodic payment caps that result in some portion of the interest
being deferred and added to the principal outstanding. This could result in our
receipt of less cash income on our adjustable-rate and hybrid adjustable-rate
mortgage-backed securities than we need in order to pay the interest cost on
our related borrowings. These factors could lower our net interest income or
cause a net loss during periods of rising interest rates, which would
negatively impact our financial condition, cash flows and results of
operations. Interest Rate Mismatch Risk We intend to fund a substantial portion of our acquisitions of
adjustable-rate and hybrid adjustable-rate mortgage-backed securities with
borrowings that have interest rates based on indices and repricing terms
similar to, but of somewhat shorter maturities than, the interest rate indices
and repricing terms of the mortgage-backed securities. Thus, we anticipate that
in most cases the interest rate indices and repricing terms of our mortgage
assets and our funding sources will not be identical, thereby creating an
interest rate mismatch between assets and liabilities. Therefore, our cost of
funds would likely rise or fall more quickly than would our earnings rate on
assets. During periods of changing interest rates, such interest rate
mismatches could negatively impact our financial condition, cash flows and
results of operations. To mitigate interest rate mismatches, we may utilize
hedging strategies discussed above. Our analysis of risks is based on managements experience, estimates,
models and assumptions. These analyses rely on models which utilize estimates
of fair value and interest rate sensitivity. Actual economic conditions or
implementation of investment decisions by our management may produce results
that differ significantly from the estimates and assumptions used in our models
and the projected results shown in this report. Prepayment Risk Prepayments are the full or partial repayment of principal prior to the
original term to maturity of a mortgage loan and typically occur due to
refinancing of mortgage loans. Prepayment rates for existing mortgage-backed
securities generally increase when prevailing interest rates fall below the
market rate existing when the underlying mortgages were originated. In
addition, prepayment rates on adjustable-rate and hybrid adjustable-rate
mortgage-backed securities generally increase when the difference between
long-term and short-term interest rates declines or becomes negative.
Prepayments of mortgage-backed securities could harm our results of operations
in several ways. Some adjustable-rate mortgages underlying our adjustable-rate
mortgage-backed securities may bear initial teaser interest rates that are
lower than their fully-indexed rates, which refers to the applicable index
rates plus a margin. In the event that such an adjustable-rate mortgage is
prepaid prior to or soon after the time of adjustment to a fully-indexed rate,
the holder of the related mortgage-backed security would have held such
security while it was less profitable and lost the opportunity to receive
interest at the fully-indexed rate over the expected life of the
adjustable-rate mortgage-backed security. Although we currently do not own any
adjustable-rate mortgage-backed securities with teaser rates, we may obtain
some in the future which would expose us to this prepayment risk. Additionally,
we currently own mortgage-backed securities that were purchased at a premium.
The prepayment of such mortgage-backed securities at a rate faster than
anticipated would result in a write-off of any remaining capitalized premium
amount and a consequent reduction of our net interest income by such amount.
Finally, in the event that we are unable to acquire new mortgage-backed
securities to replace the prepaid mortgage-backed securities, our financial
condition, cash flow and results of operations could be negatively impacted. 47




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Effect on Fair Value Another component of interest rate risk is the effect changes in interest
rates will have on the market value of our assets. We face the risk that the
market value of our assets will increase or decrease at different rates than
that of our liabilities, including our hedging instruments. We primarily assess our interest rate risk by estimating the duration of
our assets and the duration of our liabilities. Duration essentially measures
the market price volatility of financial instruments as interest rates change.
We generally calculate duration using various financial models and empirical
data. Different models and methodologies can produce different duration numbers
for the same securities. The following sensitivity analysis table shows the estimated impact on the
fair value of our interest rate-sensitive investments and repurchase agreement
liabilities, at March 31, 2004, assuming rates instantaneously fall 100 basis
points, rise 100 basis points and rise 200 basis points: InterestInterest Rates
    
    
    
    
    
    Interest Rates
    
    RatesFall 100
    
    
    
    
    
    Rise 100
    
    Rise 200Basis Points
    
    Unchanged
    
    Basis Points
    
    Basis Points(in millions)Adjustable-Rate Mortgage-Backed
SecuritiesFair value
    
    $
    166.4
    
    
    $
    166.3
    
    
    $
    165.8
    
    
    $
    165.4Change in fair value
    
    $
    0.1
    
    
    
    
    
    
    $
    (0.5
    )
    
    $
    (0.9
    )Change as a percent of fair value
    
    
    0.1
    %
    
    
    
    
    
    
    (0.3
    )%
    
    
    (0.5
    )%Hybrid Adjustable-Rate Mortgage-Backed
SecuritiesFair value
    
    $
    3,892.8
    
    
    $
    3,850.0
    
    
    $
    3,784.2
    
    
    $
    3,712.3Change in fair value
    
    $
    42.8
    
    
    
    
    
    
    $
    (65.8
    )
    
    $
    (137.7
    )Change as a percent of fair value
    
    
    1.1
    %
    
    
    
    
    
    
    (1.7
    )%
    
    
    (3.6
    )%Balloon Mortgage-Backed SecuritiesFair value
    
    $
    56.3
    
    
    $
    55.1
    
    
    $
    52.6
    
    
    $
    53.2Change in fair value
    
    $
    1.2
    
    
    
    
    
    
    $
    (1.5
    )
    
    $
    (1.9
    )Change as a percent of fair value
    
    
    2.2
    %
    
    
    
    
    
    
    (2.7
    )%
    
    
    (3.4
    )%Total Mortgage-Backed SecuritiesFair value
    
    $
    4,115.5
    
    
    $
    4,071.4
    
    
    $
    4,003.6
    
    
    $
    3,930.9Change in fair value
    
    $
    44.1
    
    
    
    
    
    
    $
    (67.8
    )
    
    $
    (140.5
    )Change as a percent of fair value
    
    
    1.1
    %
    
    
    
    
    
    
    (1.7
    )%
    
    
    (3.5
    )%Repurchase Agreements (1)Fair value
    
    $
    2,695.8
    
    
    $
    2,695.8
    
    
    $
    2,695.8
    
    
    $
    2,695.8Change in fair value
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Change as a percent of fair value
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Hedge InstrumentsFair value
    
    $
    (27.4
    )
    
    $
    (3.4
    )
    
    $
    20.6
    
    
    $
    44.6Change in fair value
    
    $
    (24.0
    )
    
    
    
    
    
    $
    24.0
    
    
    $
    48.0Change as a percent of fair value
    
    
    n/m
    
    
    
    
    
    
    
    n/m
    
    
    
    n/m
 (1) The fair value of the repurchase agreements would not change materially due to the short-term nature of these instruments. n/m = not meaningful It is important to note that the impact of changing interest rates on fair
value can change significantly when interest rates change beyond 100 basis
points from current levels. Therefore, the volatility in the fair value of our
assets could increase significantly when interest rates change beyond 100 basis
points. In addition, other factors impact the fair value of our interest
rate-sensitive investments and hedging instruments, such as the shape of the
yield curve, market expectations as to future interest rate changes and other
market conditions. Accordingly, in the event of changes in actual interest
rates, the change in the fair value of our assets would likely differ from that
shown above, and such difference might be material and adverse to our
stockholders. 48




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Risk Management To the extent consistent with maintaining our REIT status, we seek to
manage our interest rate risk exposure to protect our portfolio of
mortgage-backed securities and related debt against the effects of major
interest rate changes. We generally seek to manage our interest rate risk by:  
    
    monitoring and adjusting, if necessary, the reset index and interest
rate related to our mortgage-backed securities and our borrowings;
    
    attempting to structure our borrowing agreements to have a range of
different maturities, terms, amortizations and interest rate
adjustment periods;
    
    using derivatives, financial futures, swaps, options, caps, floors and
forward sales, to adjust the interest rate sensitivity of our
mortgage-backed securities and our borrowings; and
    
    actively managing, on an aggregate basis, the interest rate indices,
interest rate adjustment periods, and gross reset margins of our
mortgage-backed securities and the interest rate indices and
adjustment periods of our borrowings. 
 ITEM 4. CONTROLS AND PROCEDURES As of March 31, 2004, our principal executive officer and our principal
financial officer have performed an evaluation of the effectiveness of our
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
of the Securities Exchange Act of 1934, or Exchange Act,) and concluded that
our disclosure controls and procedures are effective to ensure that information
required to be disclosed by the issuer in the reports that it files or submits
under the Exchange Act is recorded, processed, summarized and reported, within
the time periods specified in the Securities and Exchange Commission, or SEC,
rules and forms. These officers have also concluded that there were no changes
in our internal control over financial reporting that have materially affected
or are reasonably likely to materially affect the Companys internal control
over financial reporting. 
 PART II OTHER INFORMATION 
 ITEM 1. LEGAL PROCEEDINGS At March 31, 2004, there were no pending legal proceedings to which we
were party or of which any of our properties were subject. 
 ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF
SECURITIES Use of Proceeds from Registered Securities In December 2003, we completed an initial public offering of 13,110,000
shares common stock, $0.001 par value at an offering price of $13.00 per share,
including the exercise by the underwriter of its over-allotment option to
purchase 1,710,000 shares of common stock. Our registration statement was
declared effective by the SEC on December 18, 2003 (Registration No.
333-107984). We received aggregate gross offering proceeds of $170.4 million
from these transactions and paid aggregate underwriting commissions of $11.9
million. Aggregate other offering costs paid totaled $1.5 million. Net
offering proceeds after deducting underwriting commissions and other offering
costs was $157.0 million. At March 31, 2004, all of the net offering proceeds
had been used to purchase mortgage-backed securities. 49




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##### Table of Contents



ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. 
 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. 
 ITEM 5. OTHER INFORMATION None. 
 ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits The exhibits listed on the Exhibit Index (following the Signatures section
of this report) are included, or incorporated by reference, in this Quarterly
Report on Form 10-Q. (b) Reports on Form 8-K On January 26, 2004, we filed a Current Report on Form 8-K under Item 7,
and furnished information to the SEC on such report under Item 12, to announce
the issuance of our press release regarding our financial results for the
fourth quarter of 2003 and for the period from April 26, 2003 through December
31, 2003. The information provided on such report shall not be deemed filed
for the purposes of Section 18 of the Securities Exchange Act of 1934, as
amended, or otherwise subject to the liabilities of that Section. 50




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SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Act
of 1934, the registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized. LUMINENT MORTGAGE CAPITAL, INC.
(Registrant)By:
    
    /s/ GAIL P. SENECAGail P. SenecaChief Executive Officer(Principal Executive Officer)Date:
    
    May 7, 2004By:
    
    /s/ CHRISTOPHER J. ZYDAChristopher J. ZydaChief Financial Officer(Principal Financial and Accounting Officer)Date:
    
    May 7, 2004
 51




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EXHIBIT INDEX Pursuant to Item 601(a)(2) of Regulation S-K, this exhibit index
immediately precedes the exhibits. The following exhibits are included, or incorporated by reference, in this
Quarterly Report on Form 10-Q and are numbered in accordance with Item 601 of
Regulation S-K. ExhibitNumber
    
    Description3.1
    
    Articles of Amendment and Restatement (1)3.2
    
    Articles Supplementary (2)3.3
    
    Amended and Restated Bylaws (1)3.4
    
    Second Amended and Restated Bylaws (1)4.1
    
    Form of Common Stock Certificate (1)4.2
    
    Registration Rights Agreement, dated as of June 11, 2003, by and between the Registrant and Friedman,
Billings, Ramsey & Co., Inc. (for itself and for the benefit of the holders from time to time of
registrable securities issued in the Registrants June 2003 private offering) (1)10.1
    
    Management Agreement, dated as of June 11, 2003, by and between the Registrant and Seneca Capital
Management LLC (Seneca) (1)10.2
    
    Cost-Sharing Agreement, dated as of June 11, 2003, by and between the Registrant and Seneca (1)10.3
    
    2003 Stock Incentive Plan (1)10.4
    
    Form of Incentive Stock Option under the 2003 Stock Incentive Plan (1)10.5
    
    Form of Non Qualified Stock Option under the 2003 Stock Incentive Plan (1)10.6
    
    2003 Outside Advisors Stock Incentive Plan of the Registrant (1)10.7
    
    Form of Non Qualified Stock Option under the 2003 Outside Advisors Stock Incentive Plan (1)10.8
    
    Form of Indemnity Agreement (1)10.9
    
    Employment Agreement dated as of August 4, 2003 by and between the Registrant and Christopher J. Zyda (1)10.10
    
    Form of Restricted Stock Award Agreement for Christopher J. Zyda (1)10.11
    
    Form of Restricted Stock Award Agreement for Seneca (3)31.1*
    
    Rule 13a-14(a)/15d-14(a) Certification of Gail P. Seneca, Chief Executive Officer of the Registrant31.2*
    
    Rule 13a-14(a)/15d-14(a) Certification of Christopher J. Zyda, Chief Financial Officer of the Registrant32.1*
    
    Section 1350 Certification of Gail P. Seneca, Chief Executive Officer of the Registrant32.2*
    
    Section 1350 Certification of Christopher J. Zyda, Chief Financial Officer of the Registrant
  (1)
    
    Incorporated by reference from our Registration Statement on Form S-11 (Registration No. 333-107984) which became effective under the Securities Act of 1933, as amended, on
December 18, 2003.(2)
    
    Incorporated by reference from our Current Report on Form 8-K filed on December 23, 2003.(3)
    
    Incorporated by reference from our Registration Statement on Form S-11 (Registration No. 333-107981) which became effective under the Securities Act of 1933, as amended, on
February 13, 2004.*
    
    Filed herewith.
    
    Denotes a management contract or compensatory plan. 52