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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: September 30, 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.  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 October 31,
2004 was 37,002,696.




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INDEX PAGEPART IITEM 1. FINANCIAL STATEMENTS
    
    
    1ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
    
    
    21ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
    
    
    56ITEM 4. CONTROLS AND PROCEDURES
    
    
    59PART IIITEM 1. LEGAL PROCEEDINGS
    
    
    59ITEM 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES
    
    
    59ITEM 3. DEFAULTS UPON SENIOR SECURITIES
    
    
    59ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
    
    
    60ITEM 5. OTHER INFORMATION
    
    
    60ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
    
    
    60SIGNATURES
    
    
    61EXHIBIT INDEX
    
    
    62EXHIBIT 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 Seneca Capital Management LLCs limited experience 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
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 at September 30, 2004 and December 31, 2003 (unaudited)
    
    
    2Condensed Statements of Operations for the three and nine months ended
September 30, 2004, three months ended September 30, 2003, and the period from
April 26, 2003 through September 30, 2003 (unaudited)
    
    
    3Condensed Statement of Stockholders Equity for the nine months ended September
30, 2004 (unaudited)
    
    
    4Condensed Statements of Cash Flows for the nine months ended September 30, 2004
and the period from April 26, 2003 through September 30, 2003 (unaudited)
    
    
    5Notes to Financial Statements (unaudited)
    
    
    6
 1




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LUMINENT MORTGAGE CAPITAL, INC. CONDENSED BALANCE SHEETS (Unaudited) September 30,
    
    December 31,(in thousands, except share and per share amounts)
    
    2004
    
    2003Assets:Cash and cash equivalents
    
    $
    3,806
    
    
    $
    7,219Mortgage-backed securities available-for-sale, at fair value
    
    
    142,741
    
    
    
    352,123Mortgage-backed securities available-for-sale, pledged as collateral, at fair value
    
    
    4,385,354
    
    
    
    1,809,822Interest receivable
    
    
    17,208
    
    
    
    7,345Principal receivable
    
    
    15,521
    
    
    
    2,313Swap contracts, at fair value
    
    
    2,463
    
    
    
    Other assets
    
    
    3,406
    
    
    
    518Total assets
    
    $
    4,570,499
    
    
    $
    2,179,340Liabilities:Repurchase agreements
    
    $
    4,121,519
    
    
    $
    1,728,973Unsettled security purchases
    
    
    
    
    
    
    156,127Margin debt
    
    
    2,278
    
    
    
    Cash distribution payable
    
    
    15,911
    
    
    
    5,267Futures contracts, at fair value
    
    
    1,161
    
    
    
    157Accrued interest expense
    
    
    5,792
    
    
    
    3,777Management fee payable, incentive fees payable and other related party liabilities
    
    
    3,181
    
    
    
    1,088Insurance note payable
    
    
    
    
    
    
    92Accounts payable and accrued expenses
    
    
    379
    
    
    
    1,363Total liabilities
    
    
    4,150,221
    
    
    
    1,896,844Stockholders Equity:Preferred stock, par value $0.001:10,000,000 shares authorized; no shares issued and outstanding at September 30, 2004 and
December 31, 2003
    
    
    
    
    
    
    Common stock, par value $0.001:100,000,000 shares authorized; 37,002,696 and 24,814,000 shares issued and outstanding
at September 30, 2004 and December 31, 2003, respectively
    
    
    37
    
    
    
    25Additional paid-in capital
    
    
    477,224
    
    
    
    317,339Deferred compensation
    
    
    (1,588
    )
    
    
    Accumulated other comprehensive loss
    
    
    (45,074
    )
    
    
    (26,510
    )Accumulated distributions in excess of accumulated earnings
    
    
    (10,321
    )
    
    
    (8,358
    )Total stockholders equity
    
    
    420,278
    
    
    
    282,496Total liabilities and stockholders equity
    
    $
    4,570,499
    
    
    $
    2,179,340
 See notes to financial statements 2




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LUMINENT MORTGAGE CAPITAL, INC. CONDENSED STATEMENTS OF OPERATIONS (Unaudited) For the
    
    For the PeriodFor the Three Months Ended
    
    Nine Months
    
    fromEnded
    
    April 26, 2003 through(in thousands, except share and per share amounts)
    
    September 30, 2004
    
    September 30, 2003

    
    September 30, 2004
    
    September 30, 2003Revenues:Net interest income:Interest income
    
    $
    34,261
    
    
    $
    10,777
    
    
    $
    81,683
    
    
    $
    11,450Interest expense
    
    
    16,632
    
    
    
    4,327
    
    
    
    32,649
    
    
    
    4,492Net interest income
    
    
    17,629
    
    
    
    6,450
    
    
    
    49,034
    
    
    
    6,958Loss on sales of mortgage-backed securities
    
    
    
    
    
    
    (7,831
    )
    
    
    
    
    
    
    (7,831
    )Expenses:Management fee expense to related party
    
    
    1,096
    
    
    
    399
    
    
    
    2,969
    
    
    
    483Incentive fee expense to related parties
    
    
    1,367
    
    
    
    613
    
    
    
    3,463
    
    
    
    613Salaries and benefits
    
    
    112
    
    
    
    41
    
    
    
    318
    
    
    
    41Professional services
    
    
    191
    
    
    
    123
    
    
    
    836
    
    
    
    347Board of directors expense
    
    
    52
    
    
    
    40
    
    
    
    171
    
    
    
    61Insurance expense
    
    
    137
    
    
    
    127
    
    
    
    494
    
    
    
    163Custody expense
    
    
    113
    
    
    
    46
    
    
    
    274
    
    
    
    49Other general and administrative expenses
    
    
    67
    
    
    
    10
    
    
    
    261
    
    
    
    13Total expenses
    
    
    3,135
    
    
    
    1,399
    
    
    
    8,786
    
    
    
    1,770Net income/(loss)
    
    $
    14,494
    
    
    $
    (2,780
    )
    
    $
    40,248
    
    
    $
    (2,643
    )Net income/(loss) per share  basic
    
    $
    0.39
    
    
    $
    (0.24
    )
    
    $
    1.22
    
    
    $
    (0.32
    )Net income/(loss) per share  diluted
    
    $
    0.39
    
    
    $
    (0.24
    )
    
    $
    1.22
    
    
    $
    (0.32
    )Weighted-average number of shares outstanding  basic
    
    
    36,814,000
    
    
    
    11,704,000
    
    
    
    32,916,190
    
    
    
    8,232,481Weighted-average number of shares outstanding  diluted
    
    
    36,867,233
    
    
    
    11,704,000
    
    
    
    32,938,893
    
    
    
    8,232,481
 See notes to financial statements 3




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LUMINENT MORTGAGE CAPITAL, INC. CONDENSED STATEMENT OF STOCKHOLDERS EQUITY (Unaudited) AccumulatedCommon Stock
    
    
    
    
    
    
    
    
    
    Accumulated
    
    Distributions inAdditional
    
    
    
    
    
    Other
    
    Excess ofPar
    
    Paid-in
    
    Deferred
    
    Comprehensive
    
    Accumulated
    
    Comprehensive(in thousands)
    
    Shares
    
    Value
    
    Capital
    
    Compensation
    
    Income /(Loss)
    
    Earnings
    
    Income/(Loss)
    
    TotalBalance, January 1, 2004
    
    
    24,814
    
    
    $
    25
    
    
    $
    317,339
    
    
    $
    
    
    
    $
    (26,510
    )
    
    $
    (8,358
    )
    
    
    
    
    
    $
    282,496Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    40,248
    
    
    $
    40,248
    
    
    
    40,248Mortgage-backed securities
available-for-sale, fair
value
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (22,606
    )
    
    
    
    
    
    
    (22,606
    )
    
    
    (22,606
    )Futures contracts, fair value
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    1,686
    
    
    
    
    
    
    
    1,686
    
    
    
    1,686Swap contracts, fair value
adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    2,356
    
    
    
    
    
    
    
    2,356
    
    
    
    2,356Comprehensive income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    $
    21,684Distributions to stockholders
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (42,211
    )
    
    
    
    
    
    
    (42,211
    )Issuance of common stock
    
    
    12,189
    
    
    
    12
    
    
    
    159,881
    
    
    
    (1,588
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    158,305Amortization of stock options
    
    
    
    
    
    
    
    
    
    
    4
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    4Balance, September 30, 2004
    
    
    37,003
    
    
    $
    37
    
    
    $
    477,224
    
    
    $
    (1,588
    )
    
    $
    (45,074
    )
    
    $
    (10,321
    )
    
    
    
    
    
    $
    420,278
 See notes to financial statements 4




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LUMINENT MORTGAGE CAPITAL, INC. CONDENSED STATEMENTS OF CASH FLOWS (Unaudited) For the
    
    For theNine Months
    
    Period fromEnded
    
    April 26, 2003 throughSeptember 30,
    
    September 30,(in thousands)
    
    2004
    
    2003Cash flows from operating activities:Net income (loss)
    
    $
    40,248
    
    
    $
    (2,643
    )Adjustments to reconcile net income to net cash provided by operating activities:Amortization of premium/discount on mortgage-backed securities available-for-sale
    
    
    21,855
    
    
    
    4,278Losses on sales of mortgage-backed securities
    
    
    
    
    
    
    7,831Waiver of incentive fee expense by related party
    
    
    
    
    
    
    613Amortization of stock options
    
    
    4
    
    
    
    1Ineffectiveness of cash flow hedges
    
    
    108
    
    
    
    Changes in operating assets and liabilities:Increase in interest receivable, net of purchased interest
    
    
    (1,126
    )
    
    
    (870
    )Increase in other assets
    
    
    (4,476
    )
    
    
    (796
    )Increase (decrease) in accounts payable and accrued expenses
    
    
    (984
    )
    
    
    496Increase in interest payable
    
    
    2,015
    
    
    
    1,965Increase in management fee payable, incentive fees payable and other related party liabilities
    
    
    4,478
    
    
    
    322Net cash provided by operating activities
    
    
    62,122
    
    
    
    11,197Cash flows from investing activities:Purchase of mortgage-backed securities available-for-sale
    
    
    (3,378,328
    )
    
    
    (1,863,672
    )Proceeds from sales of mortgage-backed securities
    
    
    
    
    
    
    122,933Principal payments of mortgage-backed securities
    
    
    789,645
    
    
    
    96,712Net cash used in investing activities
    
    
    (2,588,683
    )
    
    
    (1,644,027
    )Cash flows from financing activities:Net proceeds from issuance of common stock
    
    
    157,508
    
    
    
    159,727Borrowings under repurchase agreements
    
    
    24,883,625
    
    
    
    6,831,275Principal payments on repurchase agreements
    
    
    (22,491,079
    )
    
    
    (5,358,399
    )Payment of cash dividends
    
    
    (31,567
    )
    
    
    Borrowings under margin loan
    
    
    2,278
    
    
    
    Borrowings under (paydown of) note payable
    
    
    (92
    )
    
    
    229Net realized gains on Eurodollar futures contracts
    
    
    2,475
    
    
    
    Net cash provided by financing activities
    
    
    2,523,148
    
    
    
    1,632,832Net decrease in cash and cash equivalents
    
    
    (3,413
    )
    
    
    2Cash and cash equivalents, beginning of the period
    
    
    7,219
    
    
    
    1Cash and cash equivalents, end of the period
    
    $
    3,806
    
    
    $
    3Supplemental disclosure of cash flow information:Interest paid
    
    $
    30,373
    
    
    $
    2,527Non-cash investing and financing activities:Increase (decrease) in unsettled security purchases
    
    $
    (156,127
    )
    
    $
    215,742Increase in unsettled security sales
    
    
    
    
    
    
    (215,950
    )Increase in principal receivable
    
    
    (13,208
    )
    
    
    (3,646
    )Incentive fees payable settled through issuance of restricted stock
    
    
    2,384
    
    
    
    Deferred compensation reclassified to stockholders equity upon issuance of restricted stock
    
    
    (1,588
    )
    
    
    
 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. Recent Accounting Pronouncements In March 2004, the Emerging Issues Task Force, or EITF, reached a
consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and
Its Application to Certain Investments. This Issue provides clarification with
respect to the meaning of other-than-temporary impairment and its application
to investments classified as either available-for-sale or held-to-maturity
under Statement of Financial Accounting Standards, or SFAS, No. 115, Accounting
for Certain Investments in Debt and Equity Securities,and investments
accounted for under the cost method. The guidance for evaluating whether an
investment is other-than-temporarily impaired in EITF 03-1, except for
paragraphs 10-20, must be applied in other-than-temporary impairment
evaluations made in reporting periods beginning after June 15, 2004. This Issue
did not have a material impact on the Companys financial statements. 6




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) NOTE 2MORTGAGE-BACKED SECURITIES The following table summarizes the Companys mortgage-backed securities
classified as available-for-sale at September 30, 2004, which are carried at
fair value: Hybrid
    
    Balloon
    
    TotalAdjustable-
    
    Adjustable-Rate
    
    Maturity
    
    Mortgage-Rate Securities
    
    Securities
    
    Securities
    
    Backed Securities(in thousands)Amortized cost
    
    $
    139,843
    
    
    $
    4,381,948
    
    
    $
    55,263
    
    
    $
    4,577,054Unrealized gains
    
    
    29
    
    
    
    1,410
    
    
    
    
    
    
    
    1,439Unrealized losses
    
    
    (2,148
    )
    
    
    (47,249
    )
    
    
    (1,001
    )
    
    
    (50,398
    )Fair value
    
    $
    137,724
    
    
    $
    4,336,109
    
    
    $
    54,262
    
    
    $
    4,528,095% of total
    
    
    3.0
    %
    
    
    95.8
    %
    
    
    1.2
    %
    
    
    100.0
    %
 The following table summarizes the Companys mortgage-backed securities
classified as available-for-sale at December 31, 2003, which are carried at
fair value: Hybrid
    
    Balloon
    
    TotalAdjustable-
    
    Adjustable-Rate
    
    Maturity
    
    Mortgage-Rate Securities
    
    Securities
    
    Securities
    
    Backed Securities(in thousands)Amortized cost
    
    $
    187,769
    
    
    $
    1,944,707
    
    
    $
    55,822
    
    
    $
    2,188,298Unrealized gains
    
    
    7
    
    
    
    1,061
    
    
    
    
    
    
    
    1,068Unrealized losses
    
    
    (2,463
    )
    
    
    (23,828
    )
    
    
    (1,130
    )
    
    
    (27,421
    )Fair value
    
    $
    185,313
    
    
    $
    1,921,940
    
    
    $
    54,692
    
    
    $
    2,161,945% of total
    
    
    8.6
    %
    
    
    88.9
    %
    
    
    2.5
    %
    
    
    100.0
    %
 At September 30, 2004 and December 31, 2003, 62.8% and 63.0%,
respectively, of the Companys mortgage-backed securities portfolio, as
measured by its fair value, was agency-guaranteed. 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 September 30, 2004 according to their estimated weighted-average
life classifications: Weighted-AverageWeighted-Average Life
    
    Fair Value
    
    Amortized Cost
    
    Coupon(in thousands)Less than one year
    
    $
    208,613
    
    
    $
    211,726
    
    
    
    3.55
    %Greater than one year and less than five years
    
    
    4,319,482
    
    
    
    4,365,328
    
    
    
    4.14
    %Greater than five years
    
    
    
    
    
    
    Total
    
    $
    4,528,095
    
    
    $
    4,577,054
    
    
    
    4.12
    %
 7




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) The following table summarizes the Companys mortgage-backed securities on
December 31, 2003 according to their estimated weighted-average life
classifications: Weighted-AverageWeighted-Average Life
    
    Fair Value
    
    Amortized Cost
    
    Coupon(in thousands)Less than one year
    
    $
    299,685
    
    
    $
    304,556
    
    
    
    4.07
    %Greater than one year and less than five years
    
    
    1,829,471
    
    
    
    1,850,899
    
    
    
    4.09
    %Greater than five years
    
    
    32,789
    
    
    
    32,843
    
    
    
    3.96
    %Total
    
    $
    2,161,945
    
    
    $
    2,188,298
    
    
    
    4.09
    %
 The weighted-average lives of the mortgage-backed securities at September
30, 2004 and December 31, 2003 in the tables above are based upon data provided
through subscription-based financial information services, assuming constant
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. 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
September 30, 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-backedMortgage-backed securities
    
    $
    2,254,322
    
    
    $
    (27,206
    )
    
    $
    415,752
    
    
    $
    (6,044
    )
    
    $
    2,670,074
    
    
    $
    (33,250
    )Non-agency-backedMortgage-backed securities
    
    
    1,110,593
    
    
    
    (10,918
    )
    
    
    279,641
    
    
    
    (6,230
    )
    
    
    1,390,234
    
    
    
    (17,148
    )Total temporarily impaired
securities
    
    $
    3,364,915
    
    
    $
    (38,124
    )
    
    $
    695,393
    
    
    $
    (12,274
    )
    
    $
    4,060,308
    
    
    $
    (50,398
    )
 8




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##### Table of Contents



LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) 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
December 31, 2003: Less than 12 Months
    
    12 Months or More
    
    TotalGross
    
    
    
    
    
    Gross
    
    
    
    
    
    GrossFair
    
    Unrealized
    
    Fair
    
    Unrealized
    
    Fair
    
    UnrealizedValue
    
    Losses
    
    Value
    
    Losses
    
    Value
    
    Losses(in thousands)Agency-backedMortgage-backed securities
    
    $
    1,109,858
    
    
    $
    (17,261
    )
    
    
    
    
    
    
    
    
    
    $
    1,109,858
    
    
    $
    (17,261
    )Non-agency-backedMortgage-backed securities
    
    
    644,448
    
    
    
    (10,160
    )
    
    
    
    
    
    
    
    
    
    
    644,448
    
    
    
    (10,160
    )Total temporarily impaired
securities
    
    $
    1,754,306
    
    
    $
    (27,421
    )
    
    
    
    
    
    
    
    
    
    $
    1,754,306
    
    
    $
    (27,421
    )
 At September 30, 2004 and December 31, 2003, 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 and is
solely attributed to changes in interest rates. At September 30, 2004 and
December 31, 2003, none of the securities held by the Company had been
downgraded by a credit rating agency since their purchase. Management intends
and has the ability to hold the securities for a period of time sufficient to
allow 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 September 30, 2004 or December 31, 2003. 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 September 30, 2004 and December 31, 2003,
the Company had repurchase agreements with an outstanding balance of $4.1
billion and $1.7 billion, respectively, and with weighted-average interest
rates of 2.05% and 1.19%, respectively. At September 30, 2004 and December 31,
2003, securities pledged as collateral for repurchase agreements had estimated
fair values of $4.4 billion and $1.8 billion, respectively. 9




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##### Table of Contents



LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) At September 30, 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 694less)
    
    days
    
    days
    
    days
    
    Total(in thousands)Agency-backed mortgage-backed securities:Amortized cost of securities sold,
including accrued interest
    
    $
    25,862
    
    
    $
    101,682
    
    
    $
    804,881
    
    
    $
    1,876,672
    
    
    $
    2,809,097Fair market value of securities sold,
including accrued interest
    
    
    25,691
    
    
    
    101,011
    
    
    
    796,795
    
    
    
    1,856,137
    
    
    
    2,779,634Repurchase agreement liabilities
associated with these securities
    
    
    24,052
    
    
    
    94,564
    
    
    
    742,419
    
    
    
    1,755,349
    
    
    
    2,616,384Weighted-average interest rate of
repurchase agreement liabilities
    
    
    2.05
    %
    
    
    1.85
    %
    
    
    1.89
    %
    
    
    2.20
    %
    
    
    2.10
    %Non-agency-backed mortgage-backed
securities:Amortized cost of securities sold,
including accrued interest
    
    $
    20,173
    
    
    $
    79,315
    
    
    $
    237,293
    
    
    $
    1,304,426
    
    
    $
    1,641,207Fair market value of securities sold,
including accrued interest
    
    
    20,044
    
    
    
    78,805
    
    
    
    235,905
    
    
    
    1,287,673
    
    
    
    1,622,427Repurchase agreement liabilities
associated with these securities
    
    
    18,764
    
    
    
    73,775
    
    
    
    220,705
    
    
    
    1,191,891
    
    
    
    1,505,135Weighted-average interest rate of
repurchase agreement liabilities
    
    
    2.05
    %
    
    
    1.85
    %
    
    
    1.89
    %
    
    
    1.96
    %
    
    
    1.96
    %Total:Amortized cost of securities sold,
including accrued interest
    
    $
    46,035
    
    
    $
    180,997
    
    
    $
    1,042,174
    
    
    $
    3,181,098
    
    
    $
    4,450,304Fair market value of securities sold,
including accrued interest
    
    
    45,735
    
    
    
    179,816
    
    
    
    1,032,700
    
    
    
    3,143,810
    
    
    
    4,402,061Repurchase agreement liabilities
associated with these securities
    
    
    42,816
    
    
    
    168,339
    
    
    
    963,124
    
    
    
    2,947,240
    
    
    
    4,121,519Weighted-average interest rate of
repurchase agreement liabilities
    
    
    2.05
    %
    
    
    1.85
    %
    
    
    1.91
    %
    
    
    2.10
    %
    
    
    2.05
    %
 10




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##### Table of Contents



LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) At December 31, 2003, the repurchase agreements had remaining maturities
as summarized below: Overnight
    
    Between
    
    Between
    
    Between 91(1 day or
    
    2 and 30
    
    31 and 90
    
    and 238less)
    
    days
    
    days
    
    days
    
    Total(in thousands)Agency-backed mortgage-backed securities:Amortized cost of securities sold,
including accrued interest
    
    $
    
    
    
    $
    14,299
    
    
    $
    302,538
    
    
    $
    1,010,586
    
    
    $
    1,327,423Fair market value of securities sold,
including accrued interest
    
    
    
    
    
    
    14,065
    
    
    
    302,272
    
    
    
    994,545
    
    
    
    1,310,882Repurchase agreement liabilities
associated with these securities
    
    
    
    
    
    
    12,865
    
    
    
    281,870
    
    
    
    952,532
    
    
    
    1,247,267Weighted-average interest rate of
repurchase agreement liabilities
    
    
    0.00
    %
    
    
    1.20
    %
    
    
    1.11
    %
    
    
    1.19
    %
    
    
    1.17
    %Non-agency-backed mortgage-backed
securities:Amortized cost of securities sold,
Including accrued interest
    
    $
    18,475
    
    
    $
    329,592
    
    
    $
    
    
    
    $
    165,608
    
    
    $
    513,675Fair market value of securities sold,
Including accrued interest
    
    
    18,431
    
    
    
    324,769
    
    
    
    
    
    
    
    161,881
    
    
    
    505,081Repurchase agreement liabilities
associated with these securities
    
    
    17,490
    
    
    
    306,911
    
    
    
    
    
    
    
    157,305
    
    
    
    481,706Weighted-average interest rate of
repurchase agreement liabilities
    
    
    1.20
    %
    
    
    1.21
    %
    
    
    0.00
    %
    
    
    1.29
    %
    
    
    1.23
    %Total:Amortized cost of securities sold,
Including accrued interest
    
    $
    18,475
    
    
    $
    343,891
    
    
    $
    302,538
    
    
    $
    1,176,194
    
    
    $
    1,841,098Fair market value of securities sold,
Including accrued interest
    
    
    18,431
    
    
    
    338,834
    
    
    
    302,272
    
    
    
    1,156,426
    
    
    
    1,815,963Repurchase agreement liabilities
associated with these securities
    
    
    17,490
    
    
    
    319,776
    
    
    
    281,870
    
    
    
    1,109,837
    
    
    
    1,728,973Weighted-average interest rate of
repurchase agreement liabilities
    
    
    1.20
    %
    
    
    1.21
    %
    
    
    1.11
    %
    
    
    1.20
    %
    
    
    1.19
    %
 11




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##### Table of Contents



LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) At September 30, 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
    
    $
    35,188
    
    
    
    153Bear Stearns & Co.
    
    
    85,583
    
    
    
    143Countrywide Securities Corporation
    
    
    6,629
    
    
    
    225Deutsche Bank Securities Inc.
    
    
    21,795
    
    
    
    244Federal Home Loan Mortgage Corporation
    
    
    18,792
    
    
    
    206Goldman Sachs & Co.
    
    
    24,078
    
    
    
    57Lehman Brothers Inc.
    
    
    6,505
    
    
    
    243Merrill Lynch Government Securities Inc./Merrill Lynch
Pierce, Fenner & Smith Inc.
    
    
    14,001
    
    
    
    184Morgan Stanley & Co. Inc.
    
    
    1,600
    
    
    
    246Nomura Securities International, Inc.
    
    
    4,893
    
    
    
    249Salomon Smith Barney
    
    
    20,725
    
    
    
    160UBS Securities LLC
    
    
    26,585
    
    
    
    392Wachovia Securities, LLC
    
    
    8,564
    
    
    
    249Total
    
    $
    274,938
    
    
    
    205
  (1)
    
    Equal to the sum of fair value of securities sold plus accrued
interest income minus the sum of repurchase agreement liabilities
plus accrued interest expense. At December 31, 2003, 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)Bear Stearns & Co.
    
    $
    8,423
    
    
    
    138Banc of America Securities LLC
    
    
    9,762
    
    
    
    26Countrywide Securities Corporation
    
    
    2,358
    
    
    
    23Credit Suisse First Boston LLC
    
    
    14,350
    
    
    
    130Deutsche Bank Securities Inc.
    
    
    2,350
    
    
    
    146Federal Home Loan Mortgage Corporation
    
    
    (279
    )
    
    
    61Goldman Sachs & Co.
    
    
    (390
    )
    
    
    58J.P. Morgan Securities Inc.
    
    
    1,649
    
    
    
    177Merrill Lynch Government Securities Inc./Merrill Lynch
Pierce, Fenner & Smith Inc.
    
    
    6,352
    
    
    
    189Morgan Stanley & Co. Inc.
    
    
    972
    
    
    
    61Salomon Smith Barney
    
    
    20,287
    
    
    
    163UBS Securities LLC
    
    
    17,379
    
    
    
    189Total
    
    $
    83,213
    
    
    
    145
  (1)
    
    Equal to the sum of fair value of securities sold plus accrued interest income
minus the sum of repurchase agreement liabilities plus accrued interest
expense. 12




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##### Table of Contents



LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) There were no notes payable at September 30, 2004. At December 31, 2003,
the Company had a note payable of $92 thousand. The purpose of the note
payable was to finance the Companys annual directors and officers insurance
premium at the annual interest rate of 6.50%. The note payable was paid in
full in August 2004. The Company has a margin lending facility with its primary custodian
whereby it may borrow money in connection with the purchase or sale of
securities. The terms of the borrowings, including the rate of interest
payable, will be agreed to with the custodian for each amount borrowed.
Borrowings are repayable immediately upon demand by the custodian. At
September 30, 2004, the Company had an outstanding balance against this
borrowing facility of $2.3 million at a rate of 2.40%. There were no
outstanding borrowings under the margin lending facility at December 31, 2003. 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 37,002,696 shares and 24,814,000 shares were issued and
outstanding at September 30, 2004 and December 31, 2003, respectively. 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. At September 30, 2004 and December 31, 2003,
9,821,203 shares and 10,000,000 shares, respectively, remain reserved for
issuance. The Company had 10,000,000 shares of par value $0.001 preferred stock
authorized and none outstanding at September 30, 2004 or December 31, 2003. 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. 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 the 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 three and nine months ended September 30, 2004: For the Three Months
    
    For the Nine MonthsEnded September 30, 2004
    
    Ended September 30, 2004Basic
    
    Diluted
    
    Basic
    
    DilutedNet income (in thousands)
    
    $
    14,494
    
    
    $
    14,494
    
    
    $
    40,248
    
    
    $
    40,248Weighted-average number
of common shares
outstanding
    
    
    36,814,000
    
    
    
    36,814,000
    
    
    
    32,916,190
    
    
    
    32,916,190Additional shares due to
assumed conversion of
dilutive instruments
    
    
    
    
    
    
    53,233
    
    
    
    
    
    
    
    22,703Adjusted
weighted-average number
of common shares
outstanding
    
    
    36,814,000
    
    
    
    36,867,233
    
    
    
    32,916,190
    
    
    
    32,938,893Net income per share
    
    $
    0.39
    
    
    $
    0.39
    
    
    $
    1.22
    
    
    $
    1.22
 13




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##### Table of Contents



LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) The following table presents a reconciliation of basic and diluted net
income per share for the three months ended September 30, 2003 and for the
period from April 26, 2003 through September 30, 2003: For the Period fromFor the Three Months
    
    April 26, 2003 throughEnded September 30, 2003
    
    September 30, 2003Basic
    
    Diluted
    
    Basic
    
    DilutedNet loss (in thousands)
    
    $
    (2,780
    )
    
    $
    (2,780
    )
    
    $
    (2,642
    )
    
    $
    (2,642
    )Weighted-average
number of common
shares outstanding
    
    
    11,704,000
    
    
    
    11,704,000
    
    
    
    8,232,481
    
    
    
    8,232,481Additional shares due
to assumed conversion
of dilutive
instruments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Adjusted
weighted-average
number of common
shares outstanding
    
    
    11,704,000
    
    
    
    11,704,000
    
    
    
    8,232,481
    
    
    
    8,232,481Net loss per share
    
    $
    (0.24
    )
    
    $
    (0.24
    )
    
    $
    (0.32
    )
    
    $
    (0.32
    )
 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 to
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 Internal
Revenue 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. The following table sets forth the common stock available for grant
at September 30, 2004: 2003 Outside2003 Stock
    
    Advisors StockIncentive Plan
    
    Incentive Plan
    
    TotalShares reserved for issuance
    
    
    
    
    
    
    
    
    
    
    1,000,000
    (1)Granted
    
    
    64,899
    
    
    
    
    
    
    
    64,899Forfeited
    
    
    
    
    
    
    
    
    
    
    Expired
    
    
    
    
    
    
    
    
    
    
    Total available for grant
    
    
    
    
    
    
    
    
    
    
    935,101
    (2)
  (1)
    
    At June 4, 2003, adoption date of both stock incentive plans, the maximum number of shares of common stock that may
be issued pursuant to awards granted under these combined plans is 1,000,000 shares.(2)
    
    At September 30, 2004, the maximum number of shares of common stock that may be issued pursuant to awards granted
under these combined plans is 935,101 shares. 14




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##### Table of Contents



LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) At September 30, 2004, the Company had outstanding options under the plans
with expiration dates of 2013. The following table summarizes all stock option
transactions during the nine months ended September 30, 2004: Weighted-Number of
    
    AverageOptions
    
    Exercise PriceOutstanding at January 1, 2004
    
    
    55,000
    
    
    $
    14.82Granted
    
    
    
    
    
    
    Exercised
    
    
    
    
    
    
    Forfeited
    
    
    
    
    
    
    Outstanding at September 30, 2004
    
    
    55,000
    
    
    $
    14.82
 During the period from June 4, 2003, the effective date of the 2003 Stock
Incentive Plan and the 2003 Outside Advisors Stock Incentive Plan, through
September 30, 2003, the Company granted 50,000 stock options. The following table summarizes certain information about stock options
outstanding at September 30, 2004: Outstanding
    
    ExercisableWeighted-Average
    
    Weighted-
    
    
    
    
    
    Weighted-Number
    
    Remaining
    
    Average
    
    Number
    
    AverageRange of
    
    of
    
    Life (in
    
    Exercise
    
    of
    
    ExerciseExercise Prices
    
    Options
    
    years)
    
    Price
    
    Options
    
    Price$13.00-$14.00
    
    
    5,000
    
    
    
    9.1
    
    
    $
    13.00
    
    
    
    
    
    
    
    $14.01-$15.00
    
    
    50,000
    
    
    
    8.8
    
    
    $
    15.00
    
    
    
    16,667
    
    
    $
    15.00$13.00-$15.00
    
    
    55,000
    
    
    
    
    
    
    
    
    
    
    
    16,667
 Total stock-based employee compensation expense related to stock options
for the three and nine months ended September 30, 2004 was $1 thousand and $4
thousand, respectively. The following table illustrates restricted common stock transactions
during the nine months ended September 30, 2004: Number of
    
    Weighted-Restricted
    
    AverageCommon Shares
    
    Issue PriceOutstanding at January 1, 2004
    
    
    
    
    
    
    Issued
    
    
    9,899
    
    
    $
    12.41Repurchased
    
    
    
    
    
    
    Outstanding at September 30, 2004
    
    
    9,899
    
    
    $
    12.41
 There were no restricted common stock transactions during the period from
June 4, 2003, the effective date of the 2003 Stock Incentive Plan and the 2003
Outside Advisors Stock Incentive Plan, through September 30, 2003. 15




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##### Table of Contents



LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) 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 calendar 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. In accordance with SFAS No. 123, and related
interpretations, and EITF 96-18, 15.2% of the restricted stock portion of the
incentive fees are expensed in the period incurred. The Company is entitled to terminate the Management Agreement without
cause provided that the Company gives the Manager at least 60 days prior
written notice and pays a termination fee and 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 16




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited)  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 three and nine months ended September 30,
2004 was $1.1 million and $3.0 million, respectively. The base management fee
for the three months ended September 30, 2003 and for the period from April 26,
2003 through September 30, 2003 was $399 thousand and $483 thousand,
respectively. For the three months ended September 30, 2004, REIT taxable income (before
deducting incentive compensation, net operating losses and certain other items)
was $16.9 million and was greater than the threshold return taxable income of
$7.7 million. For the nine months ended September 30, 2004, REIT taxable income
(before deducting incentive compensation, net operating losses and certain
other items) was $43.6 million and was greater than the threshold return
taxable income of $20.1 million. For the three and nine months ended September 30, 2004, total incentive
fees earned by the Manager were $1.9 million and $5.1 million, respectively.
The cash portion of the incentive fee of $950 thousand and $2.5 million for the
three and nine months ended September 30, 2004, respectively, was expensed in
the period incurred. In addition, $145 thousand and $384 thousand related to
the restricted stock portion of the incentive compensation for the three and
nine months ended September 30, 2004, respectively, was expensed. Included in
other assets at September 30, 2004 is $805 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. The Company did not pay incentive compensation to the Manager for the
three months ended September 30, 2003 or the period from April 26, 2003 through
September 30, 2003. Although the Company reported a net loss for the three
months ended September 30, 2003 of $2.8 million, REIT taxable net income for
the same period was $6.0 million. As a result, REIT taxable net income (before
deducting incentive compensation, net operating losses and certain other items)
was greater than the threshold return taxable income of $2.9 million and,
therefore, an incentive fee of $613 thousand was earned by the Manager.
Although the Manager was entitled to receive incentive compensation under the
Management Agreement for the three months ended September 30, 2003, because of
the net loss reported by the Company for the period, the Manager voluntarily
waived, on a one-time basis, its right to incentive compensation for the
period. Since the Manger waived its right to its incentive compensation for the
three months ended September 30, 2003, the waived incentive fee has been
accounted for as a capital contribution as of September 30, 2003. The incentive
fee of $613 thousand was expensed in the three months ended September 30, 2003. For the period from April 26, 2003 through June 30, 2003, REIT taxable net
income (before deducting incentive compensation, net operating losses and
certain other items) was $298 thousand and was less than the threshold return
net income of $426 thousand and, therefore, no incentive fee was earned by the
Manager or paid by the company for that period. Since the Manager waived the
incentive fee for the three months ended September 30, 2003, the Company did
not pay incentive compensation to the Manager for the period from April 26,
2003 through September 30, 2003. 17




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) In accordance with the terms of his employment agreement, the Companys
Chief Financial Officer earned incentive fees of $95 thousand and $253 thousand
for the three and nine months ended September 30, 2004, respectively. 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 $47 thousand and $126
thousand for the three and nine months ended September 30, 2004, respectively,
was expensed in the period incurred. In addition, $7 thousand and $19
thousand, related to the restricted stock portion of the incentive compensation
for the three and nine months ended September 30, 2004, respectively, was
expensed. Included in other assets at September 30, 2004 is $40 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. No incentive compensation was earned by or paid to the Chief Financial
Officer for the period from April 26, 2003 through September 30, 2003. NOTE 7RELATED PARTY TRANSACTIONS At September 30, 2004 and December 31, 2003, the Company was indebted to
the Manager for base management fees of $1.1 million and $418 thousand,
respectively, and incentive fees of $1.9 million and $606 thousand,
respectively. At September 30, 2004, the Company was not indebted to the
Manager for reimbursement of expenses. At December 31, 2003, the Company was
indebted to the Manager for reimbursement of expenses of $16 thousand. At
September 30, 2004 and December 31, 2003, the Company was indebted to the
Companys Chief Financial Officer for incentive fees of $174 thousand and $30
thousand, respectively, and to officers and employees of the Company for
bonuses and expense reimbursement of $12 thousand and $18 thousand,
respectively. These amounts are included in management fee payable, incentive
fees 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. At
September 30, 2004 and December 31, 2003, there were no expenses payable to the
Manager pursuant to the cost-sharing agreement. During the three and nine
months ended September 30, 2004, the Company paid the Manager $6 thousand and
$18 thousand pursuant to the cost-sharing agreement, respectively. For the
period from April 26, 2003 through September 30, 2003, there were no costs
incurred 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 at September 30,
2004 and December 31, 2003, due to the short-term nature of these instruments. 18




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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 at September 30, 2004 and December 31, 2003: September 30,
    
    December 31,2004
    
    2003(in thousands)Net unrealized losses on mortgage-backed securities available-for-sale
    
    $
    (48,959
    )
    
    $
    (26,353
    )Net deferred realized and unrealized gains/(losses) on cash flow hedges
    
    
    3,885
    
    
    
    (157
    )Accumulated other comprehensive loss
    
    $
    (45,074
    )
    
    $
    (26,510
    )
 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 and protect
the Companys repurchase agreement liabilities against the effects of major
interest rate changes upon their repricing/maturity. 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 at
September 30, 2004: Unrealized
    
    Unrealized
    
    EstimatedGains
    
    Losses
    
    Fair Value(in thousands)Eurodollar futures contracts sold short
    
    $
    1,287
    
    
    $
    (2,448
    )
    
    $
    (1,161
    )Interest rate swap contracts
    
    
    2,463
    
    
    
    
    
    
    
    2,463Total derivative instruments
    
    $
    3,750
    
    
    $
    (2,448
    )
    
    $
    1,302
 The following table is a summary of derivative instruments held at
December 31, 2003: Unrealized
    
    Unrealized
    
    EstimatedGains
    
    Losses
    
    Fair Value(in thousands)Eurodollar futures contracts sold short
    
    $
    3
    
    
    $
    (160
    )
    
    $
    (157
    )
 Cash Flow Hedging Strategies Hedging instruments are designated as cash flow hedges, as appropriate,
based upon the specifically identified exposure. 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. 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 swap contracts. Hedging instruments under these strategies are
deemed to be broadly designated to the outstanding repurchase 19




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LUMINENT MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS  (Continued) (Unaudited) portfolio and the forecasted rollover thereof. Such forecasted rollovers would
also include other types of borrowing arrangements that may replace the
repurchase funding during the identified hedge time periods. At September 30,
2004 and December 31, 2003, the maximum length of time over which the Company
is hedging its exposure was 15 months and 12 months, respectively. 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. 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 swap 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 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. 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, the Company uses regression methodology to
assess the effectiveness of its hedging strategies. Specifically, at the
inception of each new hedge and on an ongoing basis, the Company assesses
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 and interest rate swap
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. Losses of $0.3 million and gains of $1.7 million and were recognized in
interest expense due to hedge ineffectiveness during the three and nine months
ended September 30, 2004, respectively. During both the three and nine months
ended September 30, 2004, interest expense was decreased by $685 thousand and
$272 thousand of amortization of net realized gains on futures contracts,
respectively, but was increased by $1.9 million and $2.4 million from payments
to swap contract counterparties, respectively. Based upon the combined amounts
of $2.5 million of net deferred realized gains and $0.9 million of net
unrealized losses from Eurodollar futures contracts included in accumulated
other comprehensive income and loss at September 30, 2004, the Company expects
to recognize lower interest expense during the remainder of 2004 and part of
2005. This amount could differ from amounts actually realized due to changes in
the benchmark rate between September 30, 2004 and when the Eurodollar futures
contracts sold short at September 30, 2004 are covered, as well as the addition
of other hedges subsequent to September 30, 2004. The Company was not engaged in derivative instruments and hedging
activities during the period from April 26, 2003 through September 30, 2003. 20




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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 in mid-June 2003, after
completing a private placement 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.
The most significant risk factors management considers while managing the
business which could have a material adverse 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; 21




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
    
    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;
    
    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 titled 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 the
Manager 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, the Manager 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. 22




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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, 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, among others, 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 and ability 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 in the future management determines an impairment to be
other-than-temporary 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 September 30, 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. At September 30, 2004, we have entered into interest rate swap contracts
to mitigate our interest rate risk for the period defined by the maturity of
the swap. Cash flows that occur each time the swap is repriced are 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. The futures and interest rate swap 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 23




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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 and
interest rate swap 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 losses on futures contracts are reclassified
into earnings as an adjustment to interest expense during the specified hedge
time period. Realized gains and losses on interest rate swap contracts are
reclassified into earnings as an adjustment to interest expense during the
period subsequent to the swap repricing date through the remaining maturity of
the swap. For REIT taxable net income purposes, realized gains and losses on
futures and interest rate swap contracts are reclassified into earnings
immediately when positions are closed or have expired. We are not required to account for the futures and interest rate swap
contracts using hedge accounting as described above. If we decided not to
designate the futures and interest rate swap 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 be recorded in the statement of
operations, potentially resulting in increased volatility in our earnings. 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
granted 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 24




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over the 30-day period ending three calendar 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 grant to the Manager under the
Management Agreement, the fair market value of the common stock is 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
grant that is not expensed is reflected in the stockholders equity section of
our balance sheet as deferred compensation. Each quarters incentive
compensation restricted stock grant to the Manager is divided into three
tranches. The first tranche will vest over a one-year period and be expensed
over a five-quarter 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 granted to the
Manager, we will incur incentive compensation expense in each of the periods
following the grant of the restricted stock over a three-year period. We will
continue to incur incentive compensation expense related to each restricted
stock grant, 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 grant 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 grant,
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 grant each quarter. As the Manager is granted 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 grants, and the
mark-to-market impact of the unvested portions of these grants. 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. Recent Accounting Pronouncements In March 2004, the Emerging Issues Task Force, or EITF, reached a
consensus on Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and
Its Application to Certain Investments. This Issue provides clarification with
respect to the meaning of other-than-temporary impairment and its application
to investments classified as either available-for-sale or held-to-maturity
under Statement of Financial Accounting Standard, or SFAS, No. 115, Accounting
for Certain Investments in Debt and Equity Securities), and investments
accounted for under the cost method. The guidance for evaluating whether an
investment is other-than-temporarily impaired in EITF 03-1, except for
paragraphs 10-20, must be applied in other-than-temporary impairment
evaluations made in 25




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reporting periods beginning after June 15, 2004. This Issue did not have a
material impact on the Companys financial statements. Financial Condition Mortgage-Backed Securities At September 30, 2004, we held $4.5 billion of mortgage-backed securities
at fair value, net of unrealized gains of $1.4 million and unrealized losses of
$50.4 million. At December 31, 2003, we held $2.2 billion of mortgage-backed
securities at fair value, net of unrealized gains of $1.1 million and
unrealized losses of $27.4 million. The increase in mortgage-backed securities
held is primarily the result of the public offering which was completed on
March 29, 2004. At September 30, 2004 and December 31, 2003, 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
101.7% and 102.2% of face amount, respectively. Fair value was below amortized cost for certain of the securities held at
September 30, 2004 and December 31, 2003. At September 30, 2004 and December
31, 2003, 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 and have the ability to hold the securities for a period of time
sufficient to allow 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 September 30, 2004 and December 31, 2003. The stated contractual final maturity of the mortgage loans underlying our
portfolio of mortgage-backed securities ranges up to 30 years, however, the
expected maturities are 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 at September 30, 2004: Weighted-AverageAsset
    
    Final Maturity
    
    % of TotalAdjustable-Rate Mortgage-Backed Securities
    
    
    2033
    
    
    
    3.0
    %Hybrid Adjustable-Rate Mortgage-Backed Securities
    
    
    2034
    
    
    
    95.8
    %Balloon Mortgage-Backed Securities
    
    
    2033
    
    
    
    1.2
    %Fixed-Rate Mortgage-Backed Securities
    
    
    N/A
    
    
    
    N/A
 The following table sets forth the maturity dates, by year, and percentage
composition related to the assets that comprise our investment portfolio at
December 31, 2003: Weighted-AverageAsset
    
    Final Maturity
    
    % of TotalAdjustable-Rate Mortgage-Backed Securities
    
    
    2033
    
    
    
    8.6
    %Hybrid Adjustable-Rate Mortgage-Backed Securities
    
    
    2033
    
    
    
    88.9
    %Balloon Mortgage-Backed Securities
    
    
    2033
    
    
    
    2.5
    %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 26% for
the three months ended September 30, 2004. The principal payment rate for the
three months ended September 30, 2003 was 20%. The principal payment rate
attempts to predict the percentage of principal that will paydown over the next
12 months based on historical principal paydowns. The principal payment rate
for the three months 26




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##### Table of Contents



ended September 30, 2004 decreased in comparison to the three months ended
June 30, 2004 primarily due to the lower principal prepayment activity. At September 30, 2004 and December 31, 2003, 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 1.76 years and 1.75 years, respectively. 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 duration 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. At September 30, 2004 and December 31, 2003, the
mortgages underlying our hybrid adjustable-rate mortgage-backed securities had
fixed interest rates for a weighted-average of approximately 39 months and 43
months, respectively, 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. At September 30, 2004 and December 31, 2003, the mortgages
underlying our hybrid adjustable-rate mortgage-backed securities had average
annual caps of 2.28% and 2.47%, respectively, and average lifetime caps of
9.96% and 10.03%, respectively. The following table summarizes our mortgage-backed securities at September
30, 2004, according to their estimated weighted-average life classifications: Weighted-AverageWeighted-Average Life
    
    Fair Value
    
    Amortized Cost
    
    Coupon(in thousands)Less than one year
    
    $
    208,613
    
    
    $
    211,726
    
    
    
    3.55
    %Greater than one year and less than five years
    
    
    4,319,482
    
    
    
    4,365,328
    
    
    
    4.14
    %Greater than five years
    
    
    
    
    
    
    Total
    
    $
    4,528,095
    
    
    $
    4,577,054
    
    
    
    4.12
    %
 The following table summarizes our mortgage-backed securities at December
31, 2003 according to their estimated weighted-average life classifications: Weighted-AverageWeighted-Average Life
    
    Fair Value
    
    Amortized Cost
    
    Coupon(in thousands)Less than one year
    
    $
    299,685
    
    
    $
    304,556
    
    
    
    4.07
    %Greater than one year and less than five years
    
    
    1,829,471
    
    
    
    1,850,899
    
    
    
    4.09
    %Greater than five years
    
    
    32,789
    
    
    
    32,843
    
    
    
    3.96
    %Total
    
    $
    2,161,945
    
    
    $
    2,188,298
    
    
    
    4.09
    %
 The weighted-average lives of the mortgage-backed securities at September
30, 2004 and December 31, 2003 in the tables above are based upon data provided
through a subscription-based financial information service provided by a major
investment bank, assuming constant prepayment rates to the balloon or reset
date for each security. At September 30, 2004 and December 31, 2003, 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 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, the mortgage rate of the outstanding loan, loan age, margin and
volatility. 27




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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 September 30, 2004 and December 31, 2003, we did not hold
any such equity securities. Unsettled Securities Purchases At September 30, 2004, we had no unsettled security trades. At December
31, 2003, we had unsettled securities purchases of $156.1 million. Of the
$156.1 million of unsettled securities purchases at December 31, 2003, $59.8
million were related to to be announced, or TBA, mortgage-backed securities.
These security purchases settled in January 2004. Other Assets We had other assets of $36.1 million and $10.2 million at September 30,
2004 and December 31, 2003, respectively. Other assets at September 30, 2004
consist primarily of interest receivable of $17.2 million, principal receivable
of $15.5 million, collateral posted with counterparties of $2.1 million,
prepaid directors and officers liability insurance of $274 thousand and
deferred compensation of $850 thousand. Other assets at December 31, 2003
consist primarily of interest receivable of $7.3 million and principal
receivable of $2.3 million. Hedging Instruments Hedging involves risk and typically involves costs, including transaction
costs. The costs of hedging can increase 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 the 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 the Manager is required to hedge. 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. At September 30, 2004 and December 31, 2003, 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. At September 30, 2004, we had short positions on
2,255 Eurodollar futures contracts, which expire in December 2004, March 2005,
and June 2005, with a notional amount totaling $2.3 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 December 31, 2003, we
had short positions on 2,090 Eurodollar futures contracts, which expire in
March 2004, June 2004, and September 2004, with a notional amount totaling $2.1
billion. At September 30, 2004 and December 31, 2003, the fair value of the
Eurodollar futures contracts was $1.2 million and $157 thousand recorded in
liabilities, respectively. At September 30, 2004, we have engaged in interest rate swap contracts to
mitigate our interest rate risk for the period defined by maturity of the
interest rate swap. Cash flows that occur each time the swap is repriced are
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. At September 30, 2004, 28




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the current notional amount of interest rate swap contracts totaled $1.6
billion and the fair value of the interest rate swap contracts was $2.5 million
recorded in assets. There were no interest rate swap contracts at December 31,
2003. 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. At September 30, 2004, we had established
18 borrowing arrangements with various investment banking firms and other
lenders, 13 of which were in use at September 30, 2004. At September 30, 2004, we had outstanding $4.1 billion of repurchase
agreements with a weighted-average current borrowing rate of 2.05%, $211.2
million of which matures within 30 days, $963.1 million of which matures
between 31 and 90 days, and $2.9 billion of which matures in greater than 90
days. At December 31, 2003, we had outstanding $1.7 billion of repurchase
agreements with a weighted-average current borrowing rate of 1.19%, $337.3
million of which matures within 30 days, $281.9 million of which matures
between 31 and 90 days, and $1.1 billion of which matures in greater than 90
days. The increase in outstanding repurchase agreements is primarily due to the
public offering which was completed on March 29, 2004. We used the net proceeds
of that follow-on equity offering to purchase mortgage-backed securities
through leverage. It is our present intention to seek to renew the repurchase
agreements outstanding at September 30, 2004 as they mature under the
then-applicable borrowing terms of the counterparties to our repurchase
agreements. At September 30, 2004 and December 31, 2003, the repurchase
agreements were secured by mortgage-backed securities with an estimated fair
value of $4.4 billion and $1.8 billion, respectively, and had a
weighted-average maturity of 205 days and 145 days, respectively. The net
amount at risk, defined as the sum of the fair value of securities sold plus
accrued interest income minus the sum of repurchase agreement liabilities plus
accrued interest expense, with all counterparties was $274.9 million and $83.2
million at September 30, 2004 and December 31, 2003, respectively. After consideration of the terms of our Eurodollar futures and interest
rate swap contracts, the weighted-average maturity/next rate reset of our total
liabilities was 314 days and 255 days at September 30, 2004 and December 31,
2003, respectively. The increase in the weighted-average maturity/next rate
reset of our total liabilities is primarily attributed to the use of interest
rate swap contracts to hedge the impact of changes in interest rates on our
liability costs. We had $25.3 million and $167.9 million of other liabilities at September
30, 2004 and December 31, 2003, respectively. Other liabilities at September
30, 2004 consisted primarily of $15.9 million of cash distribution payable,
$5.8 million of accrued interest expense on repurchase agreements and interest
rate swap contracts, and $3.2 million of management fees payable, incentive
fees payable and other related party liabilities. Other liabilities at December
31, 2003, consisted primarily of $156.1 million of unsettled securities
purchases, $5.3 million of cash distribution payable, $3.8 million of accrued
interest expense on repurchase agreements, $1.4 million of accounts payable and
accrued expenses, and $1.1 million of management fee payable, incentive fees
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 by the custodian. At September 30, 2004 we had an
outstanding balance against this borrowing facility of $2.3 million at a rate
of 2.40%. There were no outstanding borrowings under the margin lending
facility at December 31, 2003. Stockholders Equity Stockholders equity at September 30, 2004 and December 31, 2003 was
$420.3 million and $282.5 million, respectively, which included $49.0 million
and $26.3 million, respectively, of net unrealized losses on 29




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mortgage-backed securities available-for-sale and $3.9 million and ($157)
thousand, respectively, of net deferred realized and unrealized gains/(losses)
on cash flow hedges presented as accumulated other comprehensive loss. Weighted-average stockholders equity and return on average equity for the
three and nine months ended September 30, 2004 were $424.2 million and 13.59%,
and $379.8 million and 14.16%, respectively. Return on average equity is
defined as annualized net income divided by weighted-average stockholders
equity. Weighted-average stockholders equity and return on average equity for the
period from April 26, 2003 through September 30, 2003 is considered not
meaningful as the Company was organized on April 25, 2003 and substantive
operations did not begin until mid-June 2003. The weighted-average
shareholders equity and return on average equity for the three months ended
September 30, 2003 and for the period from June 11, 2003 (date on which
investment activities began) through September 30, 2003 were $132.6 million and
(7.90%), and $125.1 million and (6.89%), respectively. Our book value at September 30, 2004 was as follows: TotalStockholders
    
    Book ValueEquity
    
    per Share(1)(in thousands)Total stockholders equity (GAAP)
    
    $
    420,278
    
    
    $
    11.36Addback/(Subtract)Accumulated other comprehensive loss on mortgage-backed securities
    
    
    48,959
    
    
    
    1.32Accumulated other comprehensive income on interest rate swap
contracts
    
    
    (2,356
    )
    
    
    (0.06
    )Total stockholders equity, excluding accumulated other comprehensive
loss on mortgage-backed securities and interest rate swap
contracts (NON-GAAP)
    
    $
    466,881
    
    
    $
    12.62
 (1) Based on 37,002,696 shares outstanding at September 30, 2004 Our book value at December 31, 2003 was as follows: TotalStockholders
    
    Book ValueEquity
    
    per Share (1)(in thousands)Total stockholders equity (GAAP)
    
    $
    282,496
    
    
    $
    11.38AddbackAccumulated other comprehensive loss on mortgage-backed securities
    
    
    26,353
    
    
    
    1.07Total stockholders equity, excluding accumulated other comprehensive
loss on mortgage-backed securities (NON-GAAP)
    
    $
    308,849
    
    
    $
    12.45
 (1) Based on 24,814,000 shares outstanding at December 31, 2003 Management believes that total stockholders equity, excluding accumulated
other comprehensive income and loss on mortgage-backed securities and interest
rate swap contracts, is a useful measure to investors because book value
unadjusted for temporary changes in fair value 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 three months ended September 30, 2004, net income was $14.5
million or $0.39 per weighted-average share outstanding (basic and diluted).
For the same period, interest income, net of premium amortization, 30




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was approximately $34.3 million, and was primarily earned from investments
in mortgage-backed securities. Prepayment activity decreased during the three
months ended September 30, 2004 in comparison to the three months ended June
30, 2004 as a result of the increasing interest rate environment. Interest
expense for the three months ended September 30, 2004 was $16.6 million and was
primarily due to costs on short-term borrowings. For the nine months ended September 30, 2004, net income was $40.2 million
or $1.22 per weighted-average share outstanding (basic and diluted). For the
same period, interest income, net of premium amortization, was approximately
$81.7 million, and was primarily earned from investments in mortgage-backed
securities. Interest expense for the nine months ended September 30, 2004 was
$32.6 million and was primarily due to costs on short-term borrowings. For the three and nine months ended September 30, 2004, the
weighted-average yield on average earning assets, net of amortization of
premium, was 3.30% and 3.16%, respectively, and the cost of funds on our
repurchase agreement liabilities was 1.72% and 1.36%, respectively, resulting
in a net interest spread of 1.58% and 1.80%, respectively. Cost of funds is
defined as total interest expense divided by average repurchase agreement
liabilities. Refer to the section titled Critical Accounting Policies for a
description of our accounting policy for derivative instruments and hedging
activities and the impact on interest expense. Interest expense for the three
and nine months ended September 30, 2004 was calculated as follows: Percentage
    
    
    
    
    
    PercentageFor the Three
    
    of Average
    
    For the Nine
    
    of AverageMonths Ended
    
    Repurchase
    
    Months Ended
    
    RepurchaseSeptember 30,
    
    Agreement
    
    September 30,
    
    Agreement2004
    
    Liabilities
    
    2004
    
    Liabilities(in thousands)
    
    
    
    
    
    (in thousands)Interest expense on repurchase agreement liabilities
    
    $
    15,133
    
    
    
    1.56
    %
    
    $
    32,193
    
    
    
    1.34
    %Net hedge ineffectiveness (gains)/losses on futures and
interest rate swap contracts
    
    
    244
    
    
    
    0.03
    
    
    
    (1,740
    )
    
    
    (0.07
    )Amortization of net realized gains on futures
    
    
    (685
    )
    
    
    (0.07
    )
    
    
    (272
    )
    
    
    (0.01
    )Net interest expense on interest rate swap contracts
    
    
    1,901
    
    
    
    0.20
    
    
    
    2,412
    
    
    
    0.10Other
    
    
    39
    
    
    nm
    
    
    56
    
    
    nmTotal interest expense
    
    $
    16,632
    
    
    
    1.72
    %
    
    $
    32,649
    
    
    
    1.36
    %
 nm = not meaningful The net hedge ineffectiveness gains recognized in interest expense during
the nine months ended September 30, 2004 is primarily due to an adjustment to
the construction of the hypothetical derivative during the three months ended
June 30, 2004 in accordance with our SFAS No. 133 accounting policy which is
used to measure hedge ineffectiveness on our Eurodollar futures contracts. We
changed the term of our forecasted repurchase agreement liabilities to more
closely conform with common industry issuance terms. We do not anticipate
further changes to the term of our forecasted repurchase agreement liabilities,
and therefore we believe that we will incur no future ineffectiveness from this
change. As required by SFAS No. 133, we recognized one-time gains of $2.0
million in the form of hedge ineffectiveness on our Eurodollar futures
contracts during the three months ended June 30, 2004. The impact of this was
that a portion of the liabilities we had hedged in anticipation of rising
interest rates were recognized as gains or offsets to our interest expense in
the second quarter of 2004. At September 30, 2004, the maximum length of time
over which we were hedging our exposure was 15 months. Average repurchase agreement liabilities during the three months and nine
months ended September 30, 2004 were $3.8 billion and $3.1 billion,
respectively. For the three months ended September 30, 2003, net loss was $2.8 million
or $0.24 per weighted-average share outstanding (basic and diluted). For the
same period, interest income, net of premium amortization, was $10.8 million
and was primarily earned from investment in mortgage-backed securities.
Interest expense for three months ended September 30, 2003 was $4.3 million and
was primarily due to costs on short-term borrowings. 31




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For the period from April 26, 2003 through September 30, 2003, net loss
was $2.6 million or $0.32 per weighted-average share outstanding (basic and
diluted). For the same period, interest income, net of premium amortization,
was $11.4 million and was primarily earned from investment in mortgage-backed
securities. Interest expense for the period from April 26, 2003 through
September 30, 2003 was $4.5 million and was primarily due to costs on
short-term borrowings. For the three months ended September 30, 2003, the weighted-average yield
on average earning assets, net of amortization of premium, was 2.72% and the
cost of funds on our repurchase agreement liabilities was 1.15% resulting in a
net interest spread of 1.57%. Substantive operations began in mid-June, 2003, after completing a private
placement of our common stock. For the period June 16, 2003 (date of the first
security purchase settlement) through September 30, 2003, the weighted-average
yield on average earning assets, net of amortization of premium, was 2.91%. For
the period June 23, 2003 (date of the first security purchase financed through
leverage) through September 30, 2003, the cost of funds on our repurchase
agreement liabilities was 1.57%. The resulting net interest spread was 1.76%. Operating expenses for the three and nine months ended September 30, 2004
were $3.1 million and $8.8 million, respectively. Base management fees to the Manager under the Management Agreement, which
were $1.1 million and $3.0 million for the three and nine months ended
September 30, 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 three and nine months
ended September 30, 2004 was $1.4 million and $3.5 million, respectively.
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 three months ended September 30, 2004, total incentive
compensation earned by the Manager was $1.9 million, one-half payable in cash
and one-half payable in the form of the Companys common stock. The cash
portion of the incentive fee of $950 thousand for the three months ended
September 30, 2004 was expensed in that period as well as 15.2% of the
restricted stock portion of the incentive fees of $145 thousand. In accordance
with the terms of his employment agreement, the Companys Chief Financial
Officer earned an incentive fee for the three months ended September 30, 2004
of $95 thousand. 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
$47 thousand for the three months ended September 30, 2004 was expensed in that
period as well as 15.2% of the restricted stock portion of the incentive fees
of $7 thousand. The remaining incentive fee expense for the three months ended
September 30, 2004 consists primarily of the change in fair value of unvested
restricted stock awards. For the nine months ended September 30, 2004, total incentive compensation
earned by the Manager was $5.1 million, one-half payable in cash and one-half
payable in the form of the Companys common stock. The cash portion of the
incentive fee of $2.5 million for the nine months ended September 30, 2004 was
expensed in that period as well as 15.2% of the restricted stock portion of the
incentive fees of $384 thousand. In accordance with the terms of his employment
agreement, the Companys Chief Financial Officer earned an incentive fee for
the nine months ended September 30, 2004 of $253 thousand. 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 $126 thousand for the nine months ended
September 30, 2004 was expensed in that period as well as 15.2% of the 32




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restricted stock portion of the incentive fees of $19 thousand. The
remaining incentive fee expense for the nine months ended September 30, 2004
consists primarily of the change in fair value of unvested restricted stock
awards. Professional services expense for the three and nine months ended
September 30, 2004 of $191 thousand and $836 thousand, respectively, includes
legal, accounting and other professional services provided to us. Included in
the expense for the three and nine months ended September 30, 2004 were costs
related to the filing and maintenance of our resale shelf registration
statement totaling $17 thousand and $141 thousand, respectively. The
insurance expense of $137 thousand and $494 thousand consists primarily of
premium for directors and officers insurance. Custody expense of $113
thousand and $274 thousand for the three and nine months ended September 30,
2004 includes the services provided by our primary custodian. These expenses
may vary based on levels of activity within the portfolio. Other general and
administrative expenses of $67 thousand and $261 thousand for the three and
nine months ended September 30, 2004, respectively, consists primarily of
printing costs incurred in the first and second quarters of 2004 related to the
filing of our resale shelf registration statement, our annual report and proxy
and NYSE listing fees. Operating expenses for the three months ended September 30, 2003 and
period from April 26, 2003 through September 30, 2003 were $1.4 million and
$1.8 million, respectively. Base management fees to the Manager of $399 thousand $483 thousand for the
three months ended September 30, 2003 and the period from April 26, 2003
through September 30, 2003, respectively, are based on a percentage of our
average net worth as describe above. The base management fees for the period
from April 26, 2003 through December 31, 2003 were prorated for the portion of
the period following the completion of our June 2003 private placement. We did not pay incentive compensation to the Manager for the three months
ended September 30, 2003 or the period from April 26, 2003 through September
30, 2003. Although the Company reported a net loss for the three months ended
September 30, 2003 of $2.8 million, REIT taxable net income for the same period
was $6.0 million. As a result, REIT taxable net income (before deducting
incentive compensation, net operating losses and certain other items) was
greater than the threshold return taxable income of $2.9 million and,
therefore, an incentive fee of $613 thousand was earned by the Manager.
Although the Manager was entitled to receive incentive compensation under the
Management Agreement for the three months ended September 30, 2003, because of
the net loss reported by the Company for the period, the Manager voluntarily
waived, on a one-time basis, its right to incentive compensation for the
period. Since the Manager waived its right to its incentive compensation for
the three months ended September 30, 2003, the waived incentive fee has been
accounted for as a capital contribution as of September 30, 2003. The incentive
fee of $613 thousand was expensed in the three months ended September 30, 2003. Other operating expenses were $387 thousand and $674 for the three months
ended September 30, 2003 and for the period from April 26, 2003 through
September 30, 2003, respectively. Included in other operating expenses during
the three months ended September 30, 2003 and for the period from April 26,
2003 through September 30, 2003, were professional services expenses of $123
thousand and $347 thousand, respectively. These expenses include legal,
accounting and other professional services provided to us. These expenses were
high because of the costs of start-up activities involved in the formation of
our company. The insurance expense of $128 thousand and $163 thousand for the
three months ended September 30, 2003 and for the period from April 26, 2003
through September 30, 2003, respectively, consisted primarily of premium for
directors and officers insurance. Custody expense of $46 thousand and $49
thousand for the three months ended September 30, 2003 and for the period from
April 26, 2003 through September 30, 2003, respectively, includes the services
provided by our primary custodian. 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 three and nine months ended
September 30, 2004 and for the three months ended September 30, 2003 and for
the period from April 26, 2003 through September 30, 2004: 33




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For theFor the Three
    
    For the Nine
    
    For the Three
    
    Period fromMonths
    
    Months
    
    Months
    
    April 26, 2003Ended
    
    Ended
    
    Ended
    
    throughSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2004
    
    2003
    
    2003(in thousands)GAAP net income/(loss)
    
    $
    14,494
    
    
    $
    40,248
    
    
    $
    (2,780
    )
    
    $
    (2,643
    )Adjustments to GAAP net income/(loss):Addback of organizational costs expensed during the period
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    163Amortization of organizational costs
    
    
    (8
    )
    
    
    (24
    )
    
    
    (8
    )
    
    
    (10
    )Addback of stock compensation expense for unvested options
    
    
    1
    
    
    
    5
    
    
    
    1
    
    
    
    1Addback of stock compensation expense for unvested restricted stock
    
    
    458
    
    
    
    899
    
    
    
    
    
    
    
    Addback net hedge ineffectiveness losses on futures and interest
rate swap contracts
    
    
    244
    
    
    
    108
    
    
    
    
    
    
    
    Subtract dividend equivalent rights on restricted stock
    
    
    (81
    )
    
    
    (130
    )
    
    
    
    
    
    
    Addback net capital losses in the period
    
    
    
    
    
    
    
    
    
    
    7,831
    
    
    
    7,831Addback waived incentive fee
    
    
    
    
    
    
    
    
    
    
    613
    
    
    
    613Subtract amortization of net realized gains on futures contracts
    
    
    (685
    )
    
    
    
    
    
    
    
    
    
    
    Addback net realized gains on futures contracts
    
    
    2,514
    
    
    
    2,475
    
    
    
    
    
    
    
    Net adjustments to GAAP net income/(loss)
    
    
    2,443
    
    
    
    3,333
    
    
    
    8,437
    
    
    
    8,598REIT taxable net income
    
    $
    16,937
    
    
    $
    43,581
    
    
    $
    5,657
    
    
    $
    5,955
 Undistributed REIT taxable net income for the three and nine months ended
September 30, 2004 and for the three months ended September 30, 2003 and for
the period from April 26, 2003 through September 30, 2003 was as follows: For the PeriodFor the Three
    
    For the Nine
    
    For the Three
    
    from April 26,Months Ended
    
    Months Ended
    
    Months Ended
    
    2003 throughSeptember 30,
    
    September 30,
    
    September 30,
    
    September 30,2004
    
    2004
    
    2003
    
    2003(in thousands, except per share data)Undistributed REIT taxable net income, beginning of
period
    
    $
    673
    
    
    $
    281
    
    
    $
    289
    
    
    $
    REIT taxable net income earned during period
    
    
    16,937
    
    
    
    43,581
    
    
    
    5,657
    
    
    
    5,955Distributions declared during period, net of
dividend equivalent rights on restricted stock
    
    
    (15,830
    )
    
    
    (42,082
    )
    
    
    
    
    
    
    Undistributed REIT taxable net income, end of period
    
    $
    1,780
    
    
    $
    1,780
    
    
    $
    5,955
    
    
    $
    5,955Cash distributions per share declared during period
    
    $
    0.43
    
    
    $
    1.28
    
    
    
    
    
    
    
    Percentage of REIT taxable net income distributed
    
    
    93.5
    %
    
    
    96.6
    %
    
    
    
    
    
    
    
 We believe that these presentations of our REIT taxable net income are
useful to investors because they are 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, and by itself it 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 At September 30, 2004, we had entered into a Management Agreement with the
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 34




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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 at September 30, 2004 and December 31, 2003
consisted of repurchase agreements totaling $4.1 billion and $1.7 billion,
respectively, with a weighted-average current borrowing rate of 2.05% and
1.19%, respectively, which we used to finance acquisition of mortgage-related
assets. We expect to continue to borrow funds in the form of repurchase
agreements. At September 30, 2004, we had established 18 borrowing arrangements
with various investment banking firms and other lenders, 13 of which were in
use on September 30, 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. 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 September 30, 2004 and December 31, 2003, was 9.8 and
6.1 times, respectively. 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 by the custodian. At September 30, 2004 we had an
outstanding balance against this borrowing facility of $2.3 million at a rate
of 2.40%. There were no outstanding borrowings under the margin lending
facility at December 31, 2003. For liquidity, we also rely on cash flows 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. On August 17,
2004, we paid a cash distribution of $0.43 per share to our stockholders of
record on July 8, 2004. On September 28, 2004 we declared a cash distribution
of $0.43 per share to our stockholders of record on October 8, 2004. We will
pay the distribution on November 17, 2004. The distributions are taxable
dividends and are not considered a return of capital. Distributions are funded
with cash flows from our ongoing operations, including principal and interest
payments received on our mortgage-backed securities. We did not distribute $281
thousand of our REIT taxable net income for the period from April 26, 2003
through December 31, 2003. During 2004, a spillback distribution in this amount
was approved by our board of directors. We believe that equity capital, combined with the cash flows from
operations and the utilization of borrowings, will be sufficient to enable us
to meet anticipated liquidity requirements. However, an increase in interest
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 financings will depend on
market conditions for capital raises and for the investment of any net proceeds
therefrom. All debt securities, other borrowings, and classes of preferred
stock will be senior to the common stock in a liquidation of our Company. 35




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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. 36




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##### Table of Contents



Risk Factors As used in this Quarterly Report, Luminent, company, we, our, and
us, refer to Luminent Mortgage Capital, Inc., except where the context
otherwise requires. 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 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 the 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 losses
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 September 30, 2004, 98.8% 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 38 months, while our borrowings had a
weighted-average term to next rate adjustment of approximately 147 days. After
consideration of the duration on our Eurodollar futures and interest rate swap
contracts, our weighted-average maturity of our total liabilities was 314 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 37




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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 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 decline and
decrease when interest rates rise, however, changes in prepayment rates may lag
behind changes in interest rates and 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. 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 38




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borrowings over or under short-term interest rates may vary depending upon
a number of factors, including, without limitation the following:  
    
    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. At September 30, 2004, 98.8% 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 22.0% and 76.8%, 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 at September 30, 2004
with interest rates that reset based on the U.S. Treasury or LIBOR indices were
36.0% and 62.8%, 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. At September 30, 2004, 95.8% 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, at September 30, 2004, none of our portfolio consisted
of fixed-rate mortgage-backed securities. We fund our acquisition 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 39




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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 could
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. At September 30, 2004, we were engaged in short sales of
Eurodollar futures and interest rate swap 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 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. 40




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At September 30, 2004, we were engaged in short sales of Eurodollar
futures and interest rate swap 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. 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 41




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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 any of our lenders files for bankruptcy.
Thus, the use of repurchase agreements exposes our pledged assets to risk in
the event of a bankruptcy filing by either any of our lenders 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 acquire 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
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. 42




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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
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, 43




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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 a 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 the 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 The Manager The Manager has limited experience managing 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 limited experience managing a REIT, and
limited 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. The 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 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 the Manager in reaching
their determinations. Accordingly, the Manager has significant influence over
our affairs, and may cause us to engage in transactions which are not in our or
our stockholders best interests. 44




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The 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 the acquisition of assets, leverage,
liquidity and other factors that the Manager and these individuals determine to
be 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 in 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. 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, 45




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divided by (b) the average of the closing prices of the common stock over
the 30-day period ending three calendar 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. From time to time, we will assess whether we should be internally managed.
In May 2004, our board of directors formed a committee of independent directors
to assess the advisability of internalization. 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. 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, 46




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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 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 the 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. 47




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Complying with the 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 the 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 the 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 the 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. 48




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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 the 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 the 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, the 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 49




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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 IRS 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. At the date hereof, it is
not possible to predict with any certainty at this time 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 Quarterly Report on Form 10-Q. 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. Our declared cash distribution on November 17, 2004 may force us to liquidate
mortgage-backed securities or borrow additional funds. On September 28, 2004, our board of directors declared a cash distribution
of $0.43 per share for the third quarter of 2004, which will be paid on
November 17, 2004 to stockholders of record on October 8, 2004. This 50




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distribution declaration is irrevocable. If we do not have sufficient capital
to fund the distribution we will need to liquidate mortgage-backed securities
or borrow funds by entering into repurchase agreements or otherwise borrowing
funds under our line of credit to pay the distribution. 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. Additionally, if we were to
borrow funds on a regular basis to make distributions, it is likely that our
results of operations and our stock price would be harmed. 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
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. 51




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
    
    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.
    
    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. 52




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
    
    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. 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, 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; 53




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
    
    the termination of or resignation by the Manager;
    
    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. 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. At September 30, 2004, there
are:  
    
    37,002,696 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 935,101 shares of our common stock available for future
awards under our stock incentive plans. A total of 935,101 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. In
December 2003, we issued 13,110,000 shares of common stock in our initial
public offering. In March 2004, we issued 12,000,000 shares of common stock in
a public offering. All of these shares are eligible for immediate resale by
their holders. Additionally, in January 2004 we 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 54




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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 the market for
our common stock, the industry in which we operate, and our operations and
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, U.S. businesses or elsewhere in the world. 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. 55




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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 or to which we
are exposed. 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 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. At September 30,
2004, 95.8% 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 certain situations,
we may be forced to sell assets and incur losses to maintain adequate
liquidity. 56




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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 the Manager may produce results that
differ significantly from our expectations. 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. 57




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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 at September 30, 2004, the
estimated impact on the fair value of our interest rate-sensitive investments
and repurchase agreement liabilities, 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
    
    $
    138.1
    
    
    $
    137.7
    
    
    $
    137.0
    
    
    $
    136.2Change in fair value
    
    $
    0.3
    
    
    
    
    
    
    $
    (0.7
    )
    
    $
    (1.5
    )Change as a percent of fair value
    
    
    0.3
    %
    
    
    
    
    
    
    (0.5
    )%
    
    
    (1.1
    )%Hybrid Adjustable-Rate Mortgage-Backed
SecuritiesFair value
    
    $
    4,400.2
    
    
    $
    4,336.1
    
    
    $
    4,254.2
    
    
    $
    4,161.6Change in fair value
    
    $
    64.1
    
    
    
    
    
    
    $
    (81.9
    )
    
    $
    (174.5
    )Change as a percent of fair value
    
    
    1.5
    %
    
    
    
    
    
    
    (1.9
    )%
    
    
    (4.0
    )%Balloon Mortgage-Backed SecuritiesFair value
    
    $
    55.0
    
    
    $
    54.3
    
    
    $
    52.8
    
    
    $
    51.7Change in fair value
    
    $
    0.8
    
    
    
    
    
    
    $
    (1.4
    )
    
    $
    (2.6
    )Change as a percent of fair value
    
    
    1.4
    %
    
    
    
    
    
    
    (2.6
    )%
    
    
    (4.7
    )%Total Mortgage-Backed SecuritiesFair value
    
    $
    4,593.3
    
    
    $
    4,528.1
    
    
    $
    4,444.0
    
    
    $
    4,349.5Change in fair value
    
    $
    65.2
    
    
    
    
    
    
    $
    (84.0
    )
    
    $
    (178.6
    )Change as a percent of fair value
    
    
    1.9
    %
    
    
    
    
    
    
    (2.1
    )%
    
    
    (3.3
    )%Repurchase
Agreements (1)Fair value
    
    $
    4,121.5
    
    
    $
    4,121.5
    
    
    $
    4,121.5
    
    
    $
    4,121.5Change in fair value
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Change as a percent of fair value
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    Hedge InstrumentsFair value
    
    $
    (6.8
    )
    
    $
    1.2
    
    
    $
    4.5
    
    
    $
    10.1Change in fair value
    
    $
    (5.6
    )
    
    
    
    
    
    $
    5.7
    
    
    $
    11.3Change as a percent of fair value
    
    
    nm
    
    
    
    
    
    
    
    nm
    
    
    
    nm
 nm = not meaningful (1) The fair value of the repurchase agreements would not change materially due to the short-term nature of these instruments. 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. 58




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##### Table of Contents



Risk Management To the extent consistent with maintaining our status as a REIT, 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 At September 30, 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 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
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 September 30, 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 On August 10, 2004, the registrant issued 97,297 shares of its common
stock to Seneca Capital Management LLC (Seneca), in reliance on the exemption
from registration provided by Section 4(2) of the Securities Act and Rule 506
thereunder. Also, on August 10, 2004 the registrant issued 5,206 shares of
common stock to the registrants employees under the 2003 stock incentive plan.
The common stock issued to Seneca and the registrants employees was in
exchange for services, and was deemed to have an aggregate value of $923
thousand and $49 thousand, respectively. 
 ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. 59




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##### Table of Contents



ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None 
 ITEM 5. OTHER INFORMATION None. 
 ITEM 6. 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. 60




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##### Table of Contents



SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1394, 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:
    
    November 9, 2004By:
    
    /s/ CHRISTOPHER J. ZYDAChristopher J. ZydaChief Financial Officer(Principal Financial and Accounting Officer)Date:
    
    November 9, 2004
 61




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##### Table of Contents



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
    
    Second Articles of Amendment and Restatement (4)3.2
    
    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 At 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.(4)
    
    Incorporated by reference for our Quarterly Report on Form 10-Q for the quarter ended June 30, 2004.*
    
    Filed herewith.
    
    Denotes a management contract or compensatory plan. 62