** **

**UNITED STATES SECURITIES ANDEXCHANGE COMMISSION**

**Washington, D. C. 20549**

 

 

**FORM 10-Q**

 

 

| **ý** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                       |
|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |                                                                                                                                                               |   |
|       | **For  the quarterly period ended:     SEPTEMBER 30, 2002**                                                                                    |
|       |                                                                                                                                                               |   |
| **OR**     |
|       |                                                                                                                                                               |   |
| **o**      | **TRANSITION REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934**                                                                               |
|       |                                                                                                                                                               |   |
|       | **For  the transition period from             to            ** |   |

 
| **Commission File Number: 001-13637**                   |
|---------------------------------------------------------|
|                                                    |
|                                                    |
| **APEX  MORTGAGE CAPITAL, INC.**                        |
| (Exact name of  Registrant as specified in its Charter) |

** **

| **Maryland**                                                     |   | **95-4650863**                           |
|------------------------------------------------------------------|--------|------------------------------------------|
| (State or other  jurisdiction of incorporation  or organization) |   | (I.R.S. Employer  Identification Number) |
|                                                             |   |                                     |
| **865 South Figueroa Street  Los Angeles, California**           |   | **90017**                                |
| (Address of principal  executive offices)                        |   | (Zip Code)                               |

 

Registrant’s telephonenumber, including area code **(213) 244-0000**

 

Indicate by check mark whether the Registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), (2) has been subject to suchfiling requirements for the past 90 days, and (3) is an accelerated filer (asdefined in Rule 12b-2 of the Exchange Act).

Yes    ý          Noo

 

**APPLICABLE ONLY TO CORPORATE ISSUERS:**

 

 

Indicate the number of shares outstanding of the issuer’s classes ofcommon stock, as of the last practicable date.

 

| Common Stock ($0.01 par value) |   | 29,857,000 as of  November 14, 2002 |
|--------------------------------|--------|-------------------------------------|

### ** **

 

### 

###  

### **APEX MORTGAGE CAPITAL, INC**.

# **FORM 10-Q**

 

**INDEX**

 
| PART I.    | FINANCIAL INFORMATION                                                                       |
|------------|---------------------------------------------------------------------------------------------|
|       |                                                                                        |
| Item 1.    | Financial Statements                                                                        |
|       |                                                                                        |   |
|       |                                                                                        | Balance Sheets at SEPTEMBER  30, 2002 (unaudited) and December 31, 2001 |
|       |                                                                                        |   |
|       |                                                                                        | Statements of  Operations for the NINE months ended SEPTEMBER 30, 2002 and SEPTEMBER 30,  2001 (unaudited) |
|       |                                                                                        |   |
|       |                                                                                        | Statement  of Stockholders’ Equity for the NINE months ended SEPTEMBER 30, 2002  (unaudited) |
|       |                                                                                        |   |
|       |                                                                                        | Statements of  Cash Flows for the NINE months ended SEPTEMBER 30, 2002 and SEPTEMBER 30,  2001 (unaudited) |
|       |                                                                                        |   |
|       |                                                                                        | Notes to  Financial Statements (unaudited) |
|       |                                                                                        |   |
| Item  2.   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |
|       |                                                                                        |
| Item  3.   | Quantitative  and Qualitative Disclosures About Market Risk                                 |
|       |                                                                                        |   |
| Item  4.   | CONTROLS  AND PROCEDURES                                                                    |
|       |                                                                                        |
|       |                                                                                        |
| PART II.   | OTHER INFORMATION                                                                           |
|       |                                                                                        |
| Item 1.    | Legal Proceedings                                                                           |
|       |                                                                                        |
| Item 2.    | Changes in Securities                                                                       |
|       |                                                                                        |
| Item 3.    | Defaults  Upon Senior Securities                                                            |
|       |                                                                                        |
| Item  4.   | Submission  of Matters to a Vote of Security Holders                                        |
|       |                                                                                        |
| Item 5.    | Other Information                                                                           |
|       |                                                                                        |
| Item 6.    | Exhibits  and Reports on Form 8-K                                                           |
|       |                                                                                        |
|       |                                                                                        |   |
| Signatures |
|            |                                                                                             |  |  |

 

2

----

 

**Apex Mortgage Capital, Inc.**

** **

**Balance Sheets**

**(Unaudited)**

 
|                                                                                                                                                                                |   | **September  30, 2002** |          | **December 31, 2001** |       |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|---------------|-----------------------|------------|
| **Assets**                                                                                                                                                                          |   |                    | ** **    |                  | ** ** |
|                                                                                                                                                                                |   |                    |          |                  |       |
| Cash and cash  equivalents                                                                                                                                                          |   | $                       | 4,201,000     |                  | $          | 4,330,000 |   |
| Fixed income  trading securities, at fair value (Note 3)                                                                                                                            |   | 1,054,311,000           |          | 437,954,000           |       |
| Fixed income  securities available-for-sale, at fair value (Note 3)                                                                                                                 |   | 2,391,092,000           |          | 1,067,575,000         |       |
| Equity  securities available-for-sale, at fair value (Note 3)                                                                                                                       |   | 4,241,000               |          | 6,028,000             |       |
| Interest rate  swaps, at fair value (Note 5)                                                                                                                                        |   | —                  |          | 4,620,000             |       |
| Accrued interest  receivable                                                                                                                                                        |   | 19,447,000              |          | 8,580,000             |       |
| Principal  payments receivable                                                                                                                                                      |   | 990,000                 |          | 485,000               |       |
| Receivable for  unsettled securities                                                                                                                                                |   | 336,087,000             |          | 5,520,000             |       |
| Other assets                                                                                                                                                                        |   | 95,000                  |          | 333,000               |       |
|                                                                                                                                                                                |   |                    |          |                  |       |
|                                                                                                                                                                                |   | $                       | 3,810,464,000 |                  | $          | 1,535,425,000 |   |
|                                                                                                                                                                                |   |                    |          |                  |       |
| **Liabilities  and Stockholders’ Equity**                                                                                                                                      |   |                    | ** **    |                  | ** ** |
|                                                                                                                                                                                |   |                    |          |                  |       |
| Liabilities                                                                                                                                                                         |   |                    |          |                  |       |
|                                                                                                                                                                                |   |                    |          |                  |       |
| Reverse  repurchase agreements (Note 4)                                                                                                                                             |   | $                       | 3,066,087,000 |                  | $          | 1,376,850,000 |   |
| Accrued interest  payable                                                                                                                                                           |   | 3,928,000               |          | 975,000               |       |
| Dividend payable                                                                                                                                                                    |   | 15,069,000              |          | 12,596,000            |       |
| Forward  contracts, at fair value (Note 5)                                                                                                                                          |   | —                  |          | 3,275,000             |       |
| TBA securities,  at fair value (Note 5)                                                                                                                                             |   | 874,000                 |          | —                |       |
| Interest rate  swaps, at fair value (Note 5)                                                                                                                                        |   | 131,323,000             |          | —                |       |
| Payable for  unsettled securities                                                                                                                                                   |   | 384,730,000             |          | —                |       |
| Accrued expenses  and other liabilities                                                                                                                                             |   | 2,227,000               |          | 11,699,000            |       |
|                                                                                                                                                                                |   |                    |          |                  |       |
|                                                                                                                                                                                |   | 3,604,238,000           |          | 1,405,395,000         |       |
|                                                                                                                                                                                |   |                    |          |                  |       |
| Stockholders’  Equity                                                                                                                                                          |   |                    |          |                  |       |
|                                                                                                                                                                                |   |                    |          |                  |       |
|                                                                                                                                                                                |   |                    |          |                  |       |
| Preferred stock,  par value $0.01 per share; 50,000,000 shares authorized; no shares  outstanding                                                                                   |   | —                  |          | —                |       |
| Common stock, par value $0.01 per share; 100,000,000  shares authorized; 29,857,000 and 15,555,500 shares outstanding as of  September 30, 2002 and December 31, 2001, respectively |   | 299,000                 |          | 155,000               |       |
| Additional  paid-in-capital                                                                                                                                                         |   | 331,480,000             |          | 175,802,000           |       |
| Accumulated  other comprehensive loss                                                                                                                                               |   | (79,711,000             | )             | (7,837,000            | )          |
| Accumulated  deficit                                                                                                                                                                |   | (45,842,000             | )             | (38,090,000           | )          |
|                                                                                                                                                                                |   |                    |          |                  |       |
|                                                                                                                                                                                |   | 206,226,000             |          | 130,030,000           |       |
|                                                                                                                                                                                |   | $                       | 3,810,464,000 |                  | $          | 1,535,425,000 |   |

 

See accompanying notes to financial statements

 

3

----

 

**Apex Mortgage Capital, Inc.**

** **

**Statementsof Operations**

***(Unaudited)***

 
|                                                                                      |   | **Three Months  Ended  September 30, 2002** |       | **Three Months  Ended  September 30, 2001** |   | **Nine Months  Ended  September 30, 2002** |   | **Nine Months  Ended  September 30, 2001** |        |
|-------------------------------------------------------------------------------------------|--------|---------------------------------------------|------------|---------------------------------------------|--------|--------------------------------------------|--------|--------------------------------------------|-------------|
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Interest  Income:**                                                                     |   |                                        |       |                                        |   |                                       |   |                                       |        |
| Fixed income  securities                                                                  |   | $                                           | 53,701,000 |                                        | $      | 9,809,000                                  |   | $                                          | 126,206,000 |   | $ | 30,517,000 |   |
| Cash and cash  equivalents                                                                |   | 14,000                                      |       | 24,000                                      |   | 87,000                                     |   | 95,000                                     |        |
|                                                                                      |   | 53,715,000                                  |       | 9,833,000                                   |   | 126,293,000                                |   | 30,612,000                                 |        |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Interest  Expense**                                                                     |   | 29,237,000                                  |       | 4,201,000                                   |   | 63,331,000                                 |   | 16,260,000                                 |        |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Net  Interest Income**                                                                  |   | 24,478,000                                  |       | 5,632,000                                   |   | 62,962,000                                 |   | 14,352,000                                 |        |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Dividend  Income**                                                                      |   | 106,000                                     |       | 162,000                                     |   | 341,000                                    |   | 656,000                                    |        |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Total  Operating Income**                                                               |   | 24,584,000                                  |       | 5,794,000                                   |   | 63,303,000                                 |   | 15,008,000                                 |        |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **General  and Administrative Expenses:**                                                 |   |                                        |       |                                        |   |                                       |   |                                       |        |
| Management fee                                                                            |   | 539,000                                     |       | 88,000                                      |   | 1,360,000                                  |   | 260,000                                    |        |
| Incentive fee                                                                             |   | (1,437,000                                  | )          | —                                      |   | —                                     |   | —                                     |        |
| Insurance                                                                                 |   | 83,000                                      |       | 83,000                                      |   | 250,000                                    |   | 250,000                                    |        |
| Professional  fees                                                                        |   | 62,000                                      |       | 56,000                                      |   | 161,000                                    |   | 103,000                                    |        |
| Directors’ fees                                                                      |   | 22,000                                      |       | 20,000                                      |   | 66,000                                     |   | 50,000                                     |        |
| Non-employee  stock options                                                               |   | 23,000                                      |       | 1,000                                       |   | 73,000                                     |   | 3,000                                      |        |
| Other                                                                                     |   | 151,000                                     |       | 119,000                                     |   | 550,000                                    |   | 270,000                                    |        |
|                                                                                      |   | (557,000                                    | )          | 367,000                                     |   | 2,460,000                                  |   | 936,000                                    |        |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Net  Operating Income**                                                                 |   | 25,141,000                                  |       | 5,427,000                                   |   | 60,843,000                                 |   | 14,072,000                                 |        |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Net  Gain (Loss) from Investment and Derivative Activities (Note 3)**                   |   | (15,645,000                                 | )          | 2,409,000                                   |   | (26,097,000                                | )      | (4,431,000                                 | )           |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Reclassification  of Previously Unrealized Gains (Note 2)**                             |   | —                                      |       | —                                      |   | —                                     |   | 1,742,000                                  |        |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Net  Income Before Cumulative Effect of Change in Accounting****Principle**             |   | 9,496,000                                   |       | 7,836,000                                   |   | 34,746,000                                 |   | 11,383,000                                 |        |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Cumulative  Effect of Change in Accounting Principle (Note 2)**                    |   | —                                      |       | —                                      |   | —                                     |   | (2,173,000                                 | )           |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Net  Income**                                                                           |   | $                                           | 9,496,000  |                                        | $      | 7,836,000                                  |   | $                                          | 34,746,000  |   | $ | 9,210,000 |   |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Net  Income Per Share Before Cumulative Effect of Change in****Accounting  Principle:** |   |                                        |       |                                        |   |                                       |   |                                       |        |
| Basic                                                                                     |   | $                                           | 0.32       |                                        | $      | 1.36                                       |   | $                                          | 1.39        |   | $ | 1.98 |   |
| Diluted                                                                                   |   | $                                           | 0.32       |                                        | $      | 1.34                                       |   | $                                          | 1.38        |   | $ | 1.95 |   |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Effect  of Accounting Change Per Share:**                                               |   |                                        |       |                                        |   |                                       |   |                                       |        |
| Basic                                                                                     |   | $                                           | —     |                                        | $      | —                                     |   | $                                          | —      |   | $ | (0.38 | ) |
| Diluted                                                                                   |   | $                                           | —     |                                        | $      | —                                     |   | $                                          | —      |   | $ | (0.37 | ) |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Net  Income Per Share:**                                                                |   |                                        |       |                                        |   |                                       |   |                                       |        |
| Basic                                                                                     |   | $                                           | 0.32       |                                        | $      | 1.36                                       |   | $                                          | 1.39        |   | $ | 1.60 |   |
| Diluted                                                                                   |   | $                                           | 0.32       |                                        | $      | 1.34                                       |   | $                                          | 1.38        |   | $ | 1.58 |   |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Weighted  Average Number of Shares****Outstanding:**                                    |   |                                        |       |                                        |   |                                       |   |                                       |        |
| Basic                                                                                     |   | 29,857,000                                  |       | 5,753,000                                   |   | 24,975,874                                 |   | 5,753,000                                  |        |
| Diluted                                                                                   |   | 29,991,913                                  |       | 5,846,000                                   |   | 25,105,294                                 |   | 5,846,000                                  |        |
|                                                                                      |   |                                        |       |                                        |   |                                       |   |                                       |        |
| **Dividends  Declared Per Share:**                                                        |   | $                                           | 0.50       |                                        | $      | 0.40                                       |   | $                                          | 1.50        |   | $ | 1.15 |   |

 

See accompanying notes to financial statements

 

4

----

 

**Apex Mortgage Capital, Inc.**

** **

**Statement of Stockholders’ Equity**

**(Unaudited)**

 
|                                                                                 |   | **Common  Stock** |   | **Additional  Paid-in  Capital** |    | **Accumulated  Other  Comprehensive  Income (Loss)** |   | **Accumulated  Deficit** |   | **Total  Stockholders’  Equity** |        | **Comprehensive  Income / (Loss)** |   |
|--------------------------------------------------------------------------------------|--------|-------------------|--------|----------------------------------|---------|------------------------------------------------------|--------|--------------------------|--------|---------------------------------------|-------------|------------------------------------|--------|
| **Shares**                                                                           |   | **Amount**        |
| **Balance, December 31, 2001**                                                       |   | 15,555,500        |   | $                                | 155,000 |                                                 | $      | 175,802,000              |   | $                                     | (7,837,000  | )                                  | $      | (38,090,000 | ) | $ | 130,030,000 |   |   |   |
|                                                                                 |   |              |   |                             |    |                                                 |   |                     |   |                                  |        |                               |   |   |   |
| **Issuance of common stock**                                                         |   | 14,301,500        |   | 144,000                          |    | 155,605,000                                          |   | —                   |   | —                                |        | 155,749,000                        |   |   |   |
|                                                                                 |   |              |   |                             |    |                                                 |   |                     |   |                                  |        |                               |   |   |   |
| **Amortization of non-employees stock options**                                      |   | —            |   | —                           |    | 73,000                                               |   | —                   |   | —                                |        | 73,000                             |   |   |   |
|                                                                                 |   |              |   |                             |    |                                                 |   |                     |   |                                  |        |                               |   |   |   |
| **Net income**                                                                       |   | —            |   | —                           |    | —                                               |   | —                   |   | 34,746,000                            |        | 34,746,000                         |   | $ | 34,746,000 |   |
|                                                                                 |   |              |   |                             |    |                                                 |   |                     |   |                                  |        |                               |   |   |   |
| **Other comprehensive income (loss):**                                               |   |              |   |                             |    |                                                 |   |                     |   |                                  |        |                               |   |   |   |
| Net change in unrealized  gain on available-for-sale securities                      |   | —            |   | —                           |    | —                                               |   | 64,249,000               |   | —                                |        | 64,249,000                         |   | 64,249,000 |   |
|                                                                                 |   |              |   |                             |    |                                                 |   |                     |   |                                  |        |                               |   |   |   |
| Net change in deferred  gain on terminated interest rate swaps                       |   | —            |   | —                           |    | —                                               |   | (180,000                 | )      | —                                |        | (180,000                           | )      | (180,000 | ) |
|                                                                                 |   |              |   |                             |    |                                                 |   |                     |   |                                  |        |                               |   |   |   |
| Net change in unrealized  loss on interest rate swaps classified as cash flow hedges |   | —            |   | —                           |    | —                                               |   | (135,943,000             | )      | —                                |        | (135,943,000                       | )      | (135,943,000 | ) |
|                                                                                 |   |              |   |                             |    |                                                 |   |                     |   |                                  |        |                               |   |   |   |
| **Comprehensive loss**                                                               |   |              |   |                             |    |                                                 |   |                     |   |                                  |        |                               |   | $ | (37,128,000 | ) |
|                                                                                 |   |              |   |                             |    |                                                 |   |                     |   |                                  |        |                               |   |   |   |
| **Dividends declared**                                                               |   | —            |   | —                           |    | —                                               |   | —                   |   | (42,498,000                           | )           | (42,498,000                        | )      |   |   |
| **Balance, September 30, 2002**                                                      |   | 29,857,000        |   | $                                | 299,000 |                                                 | $      | 331,480,000              |   | $                                     | (79,711,000 | )                                  | $      | (45,842,000 | ) | $ | 206,226,000 |   |   |   |

 

See accompanying notes to financial statements

 

5

----

 

**Apex Mortgage Capital, Inc.**

** **

**Statements of Cash Flows**

**(Unaudited)**

 
|                                                                               |   | **Nine Months  Ended  September 30, 2002** |       | **Nine Months  Ended  September 30, 2001** |   |
|------------------------------------------------------------------------------------|--------|--------------------------------------------|------------|--------------------------------------------|--------|
|                                                                               |   |                                       |       |                                       |   |
| **Operating  Activities:**                                                         |   |                                       |       |                                       |   |
| Net income                                                                         |   | $                                          | 34,746,000 |                                       | $      | 9,210,000 |   |
| Adjustments to reconcile net income to net cash provided  by operating activities: |   |                                       |       |                                       |   |
| Amortization                                                                       |   | 669,000                                    |       | (3,730,000                                 | )      |
| Net loss on  investment and derivative activities                                  |   | 26,097,000                                 |       | 4,431,000                                  |   |
| Cumulative  effect of change in accounting principle                               |   | —                                     |       | 2,173,000                                  |   |
| Reclassification  of previously unrealized gains                                   |   | —                                     |       | (1,742,000                                 | )      |
| Trading  activities                                                                |   | (594,929,000                               | )          | 59,088,000                                 |   |
| Change in assets  and liabilities:                                                 |   |                                       |       |                                       |   |
| Accrued interest  receivable                                                       |   | (10,867,000                                | )          | 440,000                                    |   |
| Other assets                                                                       |   | 238,000                                    |       | 129,000                                    |   |
| Accrued interest  payable                                                          |   | 2,953,000                                  |       | (70,000                                    | )      |
| Accrued expenses  and other liabilities                                            |   | (9,542,000                                 | )          | 2,194,000                                  |   |
| Net cash (used  in) provided by operating activities                               |   | (550,635,000                               | )          | 72,123,000                                 |   |
|                                                                               |   |                                       |       |                                       |   |
| **Investing  Activities:**                                                         |   |                                       |       |                                       |   |
| Purchase of  fixed income securities available-for-sale                            |   | (1,503,945,000                             | )          | —                                     |   |
| Proceeds from  sales of fixed income securities available-for-sale                 |   | 109,153,000                                |       | —                                     |   |
| Proceeds from  sales of equity securities                                          |   | 1,937,000                                  |       | 1,712,000                                  |   |
| Principal payments  on fixed income securities available-for-sale                  |   | 138,330,000                                |       | —                                     |   |
| Net cash (used  in) provided by investing activities                               |   | (1,254,525,000                             | )          | 1,712,000                                  |   |
|                                                                               |   |                                       |       |                                       |   |
| **Financing  Activities:**                                                         |   |                                       |       |                                       |   |
| Net change in  reverse repurchase agreements                                       |   | 1,689,237,000                              |       | (65,644,000                                | )      |
| Dividend  distributions                                                            |   | (40,025,000                                | )          | (6,515,000                                 | )      |
| Issuance of  common stock                                                          |   | 155,819,000                                |       | 28,000                                     |   |
| Net cash  provided by (used in) financing activities                               |   | 1,805,031,000                              |       | (72,131,000                                | )      |
|                                                                               |   |                                       |       |                                       |   |
| **Net  (Decrease) Increase in Cash and Cash Equivalents**                          |   | (129,000                                   | )          | 1,704,000                                  |   |
|                                                                               |   |                                       |       |                                       |   |
| **Cash  and Cash Equivalents at Beginning of Period**                              |   | 4,330,000                                  |       | 140,000                                    |   |
|                                                                               |   |                                       |       |                                       |   |
| **Cash  and Cash Equivalents at End of Period**                                    |   | $                                          | 4,201,000  |                                       | $      | 1,844,000 |   |
|                                                                               |   |                                       |       |                                       |   |
|                                                                               |   |                                       |       |                                       |   |
| **Supplemental  Disclosure of Cash Flow Information:**                             |   |                                       |       |                                       |   |
| Cash paid for  interest                                                            |   | $                                          | 61,406,000 |                                       | $      | 18,577,337 |   |
| Noncash  Investing and Financing Activities:                                       |   |                                       |       |                                       |   |
| Change in  accumulated other comprehensive income                                  |   | (71,874,000                                | )          | 5,638,000                                  |   |
| Change in  principal payments receivable                                           |   | (505,000                                   | )          | 161,000                                    |   |
| Change in  receivable for unsettled securities                                     |   | 330,567,000                                |       | (14,160,000                                | )      |
| Change in  payable for unsettled securities                                        |   | (384,730,000                               | )          | —                                     |   |
| Change in  dividends declared, not yet paid                                        |   | 2,473,000                                  |       | 296,000                                    |   |

 

See accompanying notes to financial statements

 

6

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**ApexMortgage Capital, Inc.**

**Notes to Financial Statements**

**(Unaudited)**

 

 

# **Note 1 - The Company**

 

Apex Mortgage Capital, Inc. (the “Company”) wasincorporated in Maryland on September 15, 1997.  The Company commenced its operations of acquiring and managing aportfolio of mortgage-related assets on December 9, 1997, upon receipt of thenet proceeds from the initial public offering of the Company’s commonstock.  The Company uses its equitycapital and borrowed funds to seek to generate income based on the differencebetween the yield on its investments and the cost of its borrowings.  The Company is structured for tax purposesas a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986,as amended (the “Code”).

 

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

 

 

# **Note 2 - Summary Of Significant AccountingPolicies** And Certain Risks

 

*Overview*

 

Certain information and note disclosures normally includedin annual financial statements prepared in accordance with accountingprinciples generally accepted in the United States of America (“GAAP”) havebeen condensed or omitted pursuant to the rules and regulations of theSecurities and Exchange Commission (“SEC”) for interim financial statements.The unaudited financial statements should be read in conjunction with theaudited financial statements and notes thereto included in the Company’s AnnualReport on Form 10-K for the year ended December 31, 2001.  The accounting policies used in thepreparation of these interim financial statements were consistent with thoseused in the preparation of the financial statements for the year ended December31, 2001, unless otherwise noted.  Certain reclassifications may have been made to the prior periodfinancial statements to conform to the current period presentation.

## *** ***

*Derivativesand Hedging Transactions*

 

The Company may enter into interest rate swaps andother financial instruments in order to mitigate the impact of rising interestrates on the cost of its short-term borrowings and market value of itsportfolio securities.  The Company mayalso enter into forward contracts to sell U.S. Treasury securities and otherfinancial instruments in order to mitigate the negative impact of risinginterest rates on the fair value of its fixed income securities.   Such financial instruments are generallyreferred to as “derivatives.”

 

The Company adopted SFAS No. 133, *Accounting for Derivative Instrumentsand Hedging Activities*, as amended, on January 1, 2001.  Prior to adopting SFAS No. 133, the Companyaccounted for changes in fair values of the forward contracts throughadjustments to accumulated other comprehensive income (loss).  Following adoption of SFAS No. 133, the Companyrecognizes changes in fair values of forward contracts as a component of netgain (loss) on investment and derivative activities in the statements ofoperations.

 

Under SFAS No. 133, all derivatives are recorded atfair value and presented as either assets or liabilities on the Company’sbalance sheets.

 

During the nine months ended September 30, 2001, theadoption of SFAS No. 133 and the related amendments resulted in a transitionadjustment that reclassified $2,173,000 of net losses on unrealized anddeferred gains and losses on investment securities and forward contracts fromaccumulated other comprehensive income to current income.  Also, deferred gains on interest rate swapspreviously designated as hedges were reclassified from other liabilities toaccumulated other comprehensive income.

 

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As of September 30, 2002 and December 31, 2001, theCompany's interest rate swaps qualify as cash flow hedges under SFAS No.133.  Changes in fair values of theswaps are not reflected in current earnings, but are reflected in othercomprehensive income.  To the extentchanges in the fair value of the cash flow hedges are deemed to be due toineffectiveness of the hedges, such changes are reflected in net gain (loss) oninvestment and derivative activities in the statements of operations.  However, the Company’s swaps outstanding atSeptember 30, 2002 and December 31, 2001 are deemed to be fully effective ashedges.

 

Also during the nine months ended September 30, 2001,the Company reclassified $594,469,000 of its mortgage securities from theavailable-for-sale category to the trading category for investments accountedfor under SFAS No. 115.  This changeresulted in the reclassification of $1,742,000 of net unrealized gains fromaccumulated other comprehensive income to current income, in addition to netunrealized gains included in the SFAS No. 133 transition adjustment discussedabove.

 

No such accounting changes were made during the ninemonths ended September 30, 2002.

 

**Note 3– Fixed Income and Equity Securities**

** **

At September 30, 2002, fixed income and equitysecurities consisted of the following:

 
| **(in thousands)**             |   | **Fixed Income  Trading Securities** |      | **Fixed Income  Securities  Available-For-Sale** |   | **Equity Securities  Available-For-Sale** |   |
|--------------------------------|--------|--------------------------------------|-----------|--------------------------------------------------|--------|-------------------------------------------|--------|
| Principal Amount               |   | $                                    | 1,026,763 |                                             | $      | 2,311,140                                 |   | $ | 3,802 |   |
| Unamortized Premium (Discount) |   | 15,927                               |      | 29,737                                           |   | (958                                      | )      |
| Adjusted Cost                  |   | 1,042,690                            |      | 2,340,877                                        |   | 2,844                                     |   |
| Gross Unrealized Gains         |   | 11,693                               |      | 50,499                                           |   | 1,397                                     |   |
| Gross Unrealized Losses        |   | (72                                  | )         | (284                                             | )      | —                                    |   |
| Fair Value                     |   | $                                    | 1,054,311 |                                             | $      | 2,391,092                                 |   | $ | 4,241 |   |

 

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

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

 

The contractual final maturity of the mortgage loanssupporting fixed income mortgage securities is generally between 15 and 30years at origination.  Because ofprepayments on the underlying mortgage loans, the actual weighted averagematurity is expected to be substantially less. Fixed-rate mortgage securities comprised over 99% and 98% of theCompany’s portfolio of fixed income securities at September 30, 2002 andDecember 31, 2001, respectively.  Theexpected average remaining maturity of the Company’s other fixed incomesecurities at September 30, 2002 and December 31, 2001 was less than one year.

 

Adjustable-rate mortgage securities comprisedapproximately 0.3% and 1.1% of the Company’s portfolio of fixed incomesecurities at September 30, 2002 and December 31, 2001, respectively.  A portion of the adjustable-rate mortgagesecurities in the Company’s portfolio are backed by loans subject to periodicand lifetime caps that limit the amount the securities’ effective interestrates can change during any given period and over the lives of the

 

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assets.  Bothat September 30, 2002 and December 31, 2001, the portion of adjustable-ratemortgage securities subject to periodic and lifetime caps had an averageperiodic cap equal to 2.0% per annum and an average lifetime cap equal to11.3%.

 

During the nine months ended September 30, 2002, theCompany reported a net loss on investment transactions of $26,097,000 in thestatement of operations. The loss consisted of a $594,000 gain on the sale of$1,937,000 of equity securities, a realized $29,907,000 gain on the saleof  $894,372,000 of fixed income tradingsecurities, a realized loss of $229,000 on the sale of $98,634,000 of fixedincome securities classified as available-for-sale, an unrealized loss of$569,000 on fixed income trading securities, and a net realized loss of$55,800,000 on closed forward contracts.

 

During the nine months ended September 30, 2001, theCompany reported a net loss on investment transactions of $4,431,000 in thestatement of operations. The loss consisted of a $65,000 gain on the sale of$1,712,000 of equity securities, a realized $6,418,000 gain on the sale of$332,373,000 of fixed income trading securities, a reported gain of $11,603,000from the net increase in fair market value of fixed income trading securitiesand a realized $22,517,000 net loss on closed forward contracts.

 

 

# **Note 4 - ReverseRepurchase Agreements**

 

The Company has entered into reverse repurchaseagreements to finance certain of its investments.  These agreements are secured by a portion of the Company’sinvestments and bear interest rates that have historically moved in closerelationship to LIBOR.

 

At September 30, 2002, the Company had outstanding$3,066,087,000 of reverse repurchase agreements with a weighted average currentborrowing rate of 1.80% per annum and a maturity of 0.9 month.  The reverse repurchase agreements werecollateralized by securities with an estimated fair value of $3,180,945,000.

 

At December 31, 2001, the Company had outstanding$1,376,850,000 of reverse repurchase agreements with a weighted average currentborrowing rate of 1.89% per annum and a maturity of 1.0 month.  The reverse repurchase agreements werecollateralized by securities with an estimatedfair value of $1,440,014,000.

# ** **

 

# **Note 5 –** Derivative Financial InstrumentsAnd Hedging Activities

 

The Company has entered into interest rate swapagreements as summarized below.  Underthese agreements, the Company receives a floating rate and pays a fixedrate.  The swaps qualify as cash flowhedges for accounting purposes, and effectively fix the interest rate paid on$2,223,000,000, as of September 30, 2002, of current and anticipated futureborrowings under reverse repurchase agreements.  The Company estimates that approximately $37,000,000 of interestexpense or realized losses on interest rate swaps currently included inaccumulated other comprehensive loss will be recognized during the twelve monthperiod ending September 30, 2003.

 

Interest Rate Swaps at September 30, 2002:

 

 

**(Dollars inthousands)**

 
| **Current  Notional Amount** |      | **Average  Fixed Rate** |   | **Floating  Rate** |         | **Par  Weighted**

**Average  Maturity** |      | **Unrealized  Losses** |   |
|------------------------------|-----------|-------------------------|--------|--------------------|--------------|------------------------------------------|-----------|------------------------|--------|
|                         |      |                    |   |               |         |                                     |      |                   |   |
| $                            | 2,223,000 |                    | 4.380  | %                  | 1Month LIBOR |                                     | 3.9 years |                   | $      | (131,323 | ) |
|                              |           |                         |        |                    |              |                                          |           |                        |        |  |  |

 

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Interest Rate Swaps at December 31, 2001:

 

**(Dollars in thousands)**

 
| **Current  Notional Amount** |    | **Average  Fixed Rate** |   | **Floating  Rate** |         | **Par  Weighted**

**Average  Maturity** |      | **Unrealized  Gains** |   |
|------------------------------|---------|-------------------------|--------|--------------------|--------------|------------------------------------------|-----------|-----------------------|--------|
|                         |    |                    |   |               |         |                                     |      |                  |   |
| $                            | 850,000 |                    | 4.239  | %                  | 1Month LIBOR |                                     | 6.6 years |                  | $      | 4,620 |   |
|                              |         |                         |        |                    |              |                                          |           |                       |        |  |  |

 

During the yearended December 31, 2000, the Company terminated outstanding interest rate swapagreements with a combined notional amount of $386,213,000, which resulted in adeferred gain of $5,554,000.  Thedeferred gain is being amortized as an adjustment to interest expense over theremaining lives of the original swap agreements, and the remaining unamortizedamount is included in accumulated other comprehensive income (loss) as ofDecember 31, 2001.

 

During the nine months ended September 30, 2001,interest expense was decreased by $2,242,000 from amortization of deferredgains on terminated swap contracts. During the nine months ended September 30, 2002, interest expense wasincreased by $29,342,000 paid to swap counterparties and decreased by $180,000from amortization of deferred gains on terminated swap contracts.

 

At September 30, 2002, there was no cash collateralheld from a swap counterparty. At December 31, 2001, the Company held$2,500,000 in cash as collateral from a swap counterparty.

 

At September 30, 2002, the Company had no open forwardcontracts to sell U.S. Treasury notes.

 

At December 31, 2001, the Company had open forwardcontracts to sell U.S. Treasury notes with terms stated below:

 

**(Dollars in thousands)**

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

 

At September 30,2002, the Company had a short sale transaction to sell $200,000,000 par valueof FNMA 6.5% 10/1/2032 on a To-Be-Announced (TBA) basis with settlement date ofOctober 15, 2002. To comply with SFAS No. 133, the transaction was accountedfor as a derivative and therefore marked to market with an unrealized loss of$874,000. There was no TBA transaction at December 31, 2001.

 

**Note 6** – **SubsequentEvents**

 

On November 7,2002, the Company terminated outstanding interest rate swap agreements with acombined notional amount of $544,500,000, which resulted in a deferred loss ofapproximately $13,872,000 with an average term of 1.3 years and an average rateof 3.57%.  The ultimate recognition ofsuch loss will depend on certain factors including future transactions.

 

 

# **ITEM 2.**     MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

*Thefollowing discussion of our financial condition and results of operationsshould be read in conjunction with the financial statements and notes to thosestatements included elsewhere in this Quarterly Report on Form 10-Q and ouraudited financial statements for the year ended December 31, 2001 included inour Annual Report on Form 10-K previously filed with the SEC.*

 

**SAFE HARBOR/FORWARD LOOKINGSTATEMENTS**

 

Certain information contained in this Quarterly Reporton Form 10-Q constitutes “forward-looking statements” which can be identifiedby the use of forward-looking terminology such as “may,” “will,” “should,”“expect,” “anticipate,” “estimate,” “intend,” “continue,” or “believes” or thenegatives thereof or other variations thereon or comparable terminology.  Discussed below are some important factorsthat would cause actual results to differ materially from those in anyforward-looking statements, including changes in interest rates; domestic andforeign business, market, financial or 

 

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legal conditions; differences in the actual allocation of the assets ofthe Company from those assumed; and the degree to which assets are hedged andthe effectiveness of the hedge, among others. In addition, the degree of risk is increased by the Company’s leveragingof its assets.  For additionaldiscussion of factors that could cause actual results to differ from thosecontained in such forward-looking statements, see “Principal Risks and SpecialConsiderations”, “Item 7 Management’s Discussion and Analysis of FinancialConditions and Results of Operations” and “Item 7A Quantitative and QualitativeDisclosures About Market Risk” in the Company’s annual report on Form 10-K forthe year ended December 31, 2001. The Company does not undertake, andspecifically disclaims any obligation, to update any forward-looking statementsto reflect occurrences or unanticipated events or circumstances after the dateof such statements.

 

**GENERAL**

 

Apex Mortgage Capital, Inc.  (the ‘‘Company’’), a Maryland corporation, was formed onSeptember 15, 1997, primarily to acquire United States agency and other highlyrated, single-family real estate adjustable and fixed rate mortgage relatedassets.  The Company commencedoperations on December 9, 1997, following the initial public offering of theCompany’s common stock.  The Company’sprincipal executive offices are located at 865 South Figueroa Street, Suite1800, Los Angeles, California 90017, and its telephone number is (213)244-0000.

 

The Company uses its equity capital and borrowed fundsto seek to generate income based on the difference between the yield on itsmortgage related assets and the cost of its borrowings.  The Company has elected to be taxed as areal estate investment trust (‘‘REIT’’) under the Internal Revenue Code of1986, as amended (the ‘‘Code’’).  TheCompany will not generally be subject to federal taxes on its income to theextent that it distributes its net income to its stockholders and maintains itsqualification as a REIT.

 

The day-to-day operations of the Company are managedby an external management company, TCW Investment Management Company (the“Manager”), subject to the direction and oversight of the Company’s Board ofDirectors.  A majority of the Board ofDirectors are unaffiliated with The TCW Group, Inc.  (‘‘TCW’’ and, together with its subsidiaries and affiliates, the‘‘TCW Group’’), or the Manager.  TheManager is a wholly-owned subsidiary of TCW. The Manager was established in 1987 and the TCW Group began operationsin 1971 through one of its affiliates. The Company’s investment management team are selected members of the TCWGroup’s Mortgage-Backed Securities Group (the ‘‘MBS Group’’), all of whom haveover thirteen years of experience in raising and managing mortgagecapital.  The Company has elected to beexternally managed by the Manager to take advantage of the existing operationalsystems, expertise and economies of scale associated with the Manager’s currentbusiness operations, among other reasons. The Manager’s key officers haveexperience in raising and managing mortgage capital, mortgage finance and thepurchase and administration of mortgage related assets.

 

**RECENT EVENTS**

 

*Dividend Declaration*.  On September 19, 2002, the Company’s Boardof Directors declared a dividend distribution of $0.50 per common share.  The dividend was paid on October 29, 2002,to stockholders of record on September 30, 2002.

 

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

 

 

**STRATEGY**

 

To achieve its business objective and generatedividend yields that provide a competitive rate of return for its stockholders,the Company’s strategy is to:

 

•                  purchaseprimarily single-family fixed and adjustable rate mortgage related assets;

 

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

 

•                  financepurchases of mortgage related assets with the net proceeds of equity offeringsand, to the extent permitted by the Company’s leverage policy, to utilizeleverage to increase potential returns to stockholders through

 

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borrowings (primarilyreverse repurchase agreements) with interest rates that will also reflectchanges in short-term market interest rates;

 

•                  seekto structure its borrowings in accordance with its interest rate riskmanagement policy;

 

•                  utilizeinterest rate swaps, forward contracts on U.S. Treasury notes, interest ratecaps and similar financial instruments to mitigate interest rate risks;

 

•                  seekto minimize prepayment risk primarily by structuring a diversified portfoliowith a variety of prepayment characteristics; and

 

•                  purchaseequity and other securities issued by financial entities on an opportunisticbasis.

 

There can be no assurance that the Company will beable to generate competitive earnings and dividends while holding primarilyhigh quality mortgage related assets and maintaining a disciplined risk-controlprofile.

 

The Company may attempt to increase the return tostockholders over time by: (i) raising additional capital in order to increaseits ability to invest in additional mortgage related assets; (ii) lowering itseffective borrowing costs through direct funding with collateralized lenders,in addition to using Wall Street intermediaries, and investigating thepossibility of using collateralized commercial paper and medium-term noteprograms; and (iii) improving the efficiency of its balance sheet structure byissuing uncollateralized subordinated debt and other forms of capital.

 

 

**THE MANAGEMENT AGREEMENT**

 

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

 

At all times, the Manager is subject to the directionand oversight of the Company’s Board of Directors and has only such functionsand authority as the Company delegates to it. The Manager is responsible for the day-to-day operations of the Company.

 

The Management Agreement may be renewed for additionalone-year terms at the discretion of the unaffiliated directors, unlesspreviously terminated by the Company or the Manager upon written notice.  Except in the case of a termination ornon-renewal by the Company for cause, upon termination or non-renewal of theManagement Agreement by the Company, the Company is obligated to pay theManager a termination or non-renewal fee, which may be significant.  The termination or non-renewal fee shall beequal to the fair market value of the Management Agreement without regard tothe Company’s termination right, as determined by an independent appraisal.  The selection of the independent appraisershall be subject to the approval of the unaffiliated directors.  Neither the fair market value of theManagement Agreement nor the various factors which the appraiser may findrelevant in its determination of the fair market value can be determined atthis time.

 

The fair market value of the Management Agreement willbe affected by significant variables, including (i) the historical managementfees paid to the Manager, (ii) any projections of future management fees to bepaid to the Manager determined by the independent appraiser, (iii) the relativevaluations of agreements similar to the Management Agreement, and (iv) otherfactors, all of which may be unrelated to the performance of the Manager.

 

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The Management Agreement may be assigned by theManager to an affiliate of TCW without the consent of the Company.  The Management Agreement may be assigned toa non-affiliate of TCW only with the approval of a majority of the unaffiliateddirectors.

 

 

**ManagerCompensation**

 

The Manager will receive annual base managementcompensation based on the Average Net Invested Capital of the Company, payablemonthly in arrears, equal to 3/4 of 1% of Average Net Invested Capital.  The term“Average Net Invested Capital” means the month end sum of (1) the Company’stotal stockholders’ equity computed in accordance with accounting principlesgenerally accepted in the United States of America, plus (2) any unsecured debtthat has been approved for inclusion by the unaffiliated directors at issuance,plus or minus (3) an adjustment to exclude the impact of any unrealized gains,losses or other items that do not affect realized net income.  Accordingly, incurring collateralized debtto finance specific investment purchases does not ordinarily increase AverageNet Invested Capital.

 

The Manager shall also be entitled to receive asincentive compensation for each fiscal quarter, an amount equal to 30% of theNet Income of the Company, before incentive compensation, in excess of theamount that would produce an annualized Return on Equity equal to the Ten-YearU.S. Treasury Rate plus 1%.  Theincentive compensation calculation and payment will be made quarterly inarrears.  The term ‘‘Return on Equity’’is calculated for any quarter by dividing the Company’s Net Income for thequarter by its Average Net Worth for the quarter.  For purposes of calculating the incentive compensation payable,the definition ‘‘Return on Equity’’ is not related to the actual distributionsreceived by stockholders or to an individual investor’s actual return oninvestment.  For such calculations, the‘‘Net Income’’ of the Company means the taxable income of the Company(including net capital gains, if any) before the Manager’s incentivecompensation, net operating loss deductions arising from losses in priorperiods and deductions permitted by the Code in calculating taxable income fora REIT plus the effects of adjustments, if any, necessary to record hedging andinterest transactions in accordance with accounting principles generallyaccepted in the United States of America. A deduction for all of the Company’s interest expenses for borrowedfunds is taken into account in calculating Net Income.  ‘‘Average Net Worth’’ for any period meansthe arithmetic average of the sum of the gross proceeds from any offering ofits equity securities by the Company, before deducting any underwritingdiscounts and commissions and other expenses and costs relating to theofferings, plus the Company’s retained earnings (without taking into accountany losses incurred in prior periods) computed by taking the average of suchvalues at the end of each month during such period, minus the cumulativeamounts paid by the Company to repurchase its shares.

 

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

 

 

#### **POLICIES**

 

The Company’s current investment policies are setforth in its Annual Report on Form 10-K for the year ended December 31, 2001.

 

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**PRINCIPALRISKS AND SPECIAL CONSIDERATIONS**

 

***Leverage Risk****.*  The Company employs a leveraging strategy of generally borrowingup to 92% of its total assets, less any assets that are funded with committedsecured borrowings, plus the market value of any related hedging transactionsto finance the acquisition of additional mortgage related assets.  The Company’s borrowing may, at times,exceed 92% of its total assets.  In theevent borrowing costs exceed the income on its mortgage related assets, theCompany will experience negative cash flow and incur losses. Another risk ofleverage is the possibility that the value of the collateral securing theborrowings will decline.  In such event,additional collateral or repayment of borrowings would be required.  The Company could be required to sellmortgage related assets under adverse market conditions in order to maintainliquidity.  If these sales were made atprices lower than the carrying value of the mortgage related assets, theCompany would experience losses.

 

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

 

***Liquidity Risk****.*  There is the possibility that the Company may lose money or beprevented from realizing capital gains if it cannot sell a mortgage relatedasset at a time and price that is most beneficial to the Company.  The Company is subject to liquidity riskbecause it invests in mortgage securities which have experienced periods ofilliquidity.

 

***Credit Risk****.*  Credit risk is the possibility that the Company could lose moneyif an issuer is unable to meet its financial obligations, such as the paymentof principal and/or interest on an instrument, or goes bankrupt.  The Company may invest a portion of its assetsin mortgage related assets which are not guaranteed by the U.S. Government orinvestment grade, which may make the Company subject to substantial creditrisk.  This is especially true duringperiods of economic uncertainty or during economic downturns.

 

***Equity Risk.***  Equity risk is the possibility that the Company could lose moneyif its equity investments decline in value. Such a decline could be caused by a number of factors, including, butnot limited to, overall market conditions, suspension or omission of dividends,bankruptcies and litigation.  This isespecially true during periods of economic uncertainties and economicdownturns.

 

***Failure to Maintain REIT Status Risk****.*  Failure to maintain REIT status risk refersto the possibility that the Company may become subject to federal income tax asa regular corporation.  The Companyintends at all times to maintain substantially all of its investments in, andotherwise conduct its business in a manner consistent with, the REIT Provisionsof the Code.  If the Company fails toqualify as a REIT, it would be treated as a regular corporation for federal taxpurposes.  This would result in theCompany being subject to federal income tax that would further result in a substantialreduction of cash available for distribution to stockholders.

 

***Failure to Maintain Investment Company Act Exemption Risk****.*  The Company intends to conduct its businessso as not to become a “regulated investment company” under the InvestmentCompany Act.  As a result, the Company’sownership of certain mortgage related assets may be limited by the InvestmentCompany Act.  This could have the effectof  adversely affecting the Company’soperations and returns to stockholders. In addition, if the Company fails to qualify for the exemption fromregistration as an investment company, its ability to use leverage would besubstantially reduced.  This couldreduce income to the Company and returns to stockholders.

 

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**FINANCIALCONDITION**

 

**Fixed Income Securities**

 

At September 30, 2002 and December 31, 2001, theCompany held $3,445,403,000 and $1,505,529,000 of fixed income securities,respectively. The increase in fixed income securities held at September 30,2002 is primarily the result of two completed follow-on equity offerings duringthe nine months ended September 30, 2002. With the net proceeds from thoseofferings and the use of leverage, the Company increased its investments infixed income securities. The original maturity of a significant portion of thefixed income securities ranges from fifteen to thirty years; the actualmaturity is subject to change based on the prepayments of the underlyingmortgage loans.

 

The following table is a schedule of fixed incomesecurities held listed by security type (dollars in thousands):

 
|                          |   | **September  30, 2002** |      | **December 31, 2001**     |   |
|-------------------------------|--------|-------------------------|-----------|---------------------------|--------|
| **Fixed Income Securities**   |   | **Carrying  Value**     |      | **Percent of  Portfolio** |   | **Carrying  Value** |   | **Percent of  Portfolio** |   |
|                          |   |                    |      |                      |   |   |   |   |   |
| Mortgage Securities:          |   |                    |      |                      |   |   |   |   |   |
| Adjustable Rate (1)           |   | $                       | 11,194    |                      | 0.32   | % | $ | 16,196 |   | 1.08 | % |
| Fixed Rate                    |   | 3,433,984               |      | 99.67                     | %      | 1,483,881 |   | 98.56 | % |
| Other Fixed Income Securities |   | 225                     |      | 0.01                      | %      | 5,452 |   | 0.36 | % |
| Totals                        |   | $                       | 3,445,403 |                      | 100.00 | % | $ | 1,505,529 |   | 100.00 | % |

 

----

(1)  At September 30, 2002, the interestrate indices for 99.2% and 0.8% of the adjustable rate mortgage securities werebased on the one-year U.S. Treasury rate and the six-month London Inter-BankOffered Rate, respectively.

 

At December 31,2001, the interest rate indices for 98.0% and 2.0% of the adjustable ratemortgage securities were based on the one-year U.S. Treasury rate and thesix-month London Inter-Bank Offered Rate, respectively.

 

The following table shows various weighted averagecharacteristics of the fixed income securities held by the Company at September30, 2002 (dollars in thousands):

 
| **Security Type**             |   | **Par Amount** |      | **Par as a  Percent of  Category** |   | **Adjusted Cost  Basis** |   | **Market Price** |   | **Current  Coupon** |   | **Weighted  Average  Life (1)** |   |
|-------------------------------|--------|----------------|-----------|------------------------------------|--------|--------------------------|--------|------------------|--------|---------------------|--------|---------------------------------|--------|
|                          |   |           |      |                               |   |                     |   |             |   |                |   |                            |   |
| 30 Year Agency Pass-throughs  |   | $              | 3,307,004 |                               | 99.08  | %                        | 101.47 | %                | 103.29 | %                   | 6.36   | %                               | 2.7    |   |
| AAA CMOs                      |   | 17,444         |      | 0.52                               | %      | 96.86                    | %      | 103.79           | %      | 6.98                | %      | 2.4                             |   |
| Total Fixed Rate Holdings     |   | 3,324,448      |      | 99.60                              | %      | 101.44                   | %      | 103.29           | %      | 6.36                | %      | 2.7                             |   |
|                          |   |           |      |                               |   |                     |   |             |   |                |   |                            |   |
| Other Fixed Income Securities |   | 2,500          |      | 0.07                               | %      | 20.37                    | %      | 9.00             | %      | 18.36               | %      | 0.5                             |   |
| Adjustable Rate Holdings      |   | 10,954         |      | 0.33                               | %      | 97.33                    | %      | 102.18           | %      | 5.22                | %      | 1.0                             |   |
|                          |   |           |      |                               |   |                     |   |             |   |                |   |                            |   |
| Category Total                |   | $              | 3,337,902 |                               | 100.00 | %                        | 101.37 | %                | 103.22 | %                   | 6.37   | %                               | 2.7    |   |

 

----

(1)   Theweighted average life of the fixed rate mortgage securities is based uponmarket prepayment expectations as of the dates shown.  The actual weighted average life could be longer or shorterdepending on the actual prepayment rates experienced over the life of thesecurities and is sensitive to changes in both prepayment rates and interestrates.  The weighted average life shownfor the adjustable rate mortgage assets represents the average time until thenext coupon reset date.  All averages areshown in years.

 

15

----

 

The following table shows various weighted averagecharacteristics of the fixed income securities by the Company at December 31,2001 (dollars in thousands):

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

 

----

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

 

 

### **Equity Securities**

 

At September 30, 2002 and December 31, 2001, theCompany held $4,241,000 and $6,028,000 of equity securities, respectively.  The decrease in the value of equitysecurities at September 30, 2002 is primarily due to the sale of Capsteadconvertible preferred stock during the nine months ended September 30, 2002.Equity securities consist primarily of investments in equities issued by otherreal estate investment trusts.

 

At September 30, 2002, equity securities consisted of the following:

 
| **(In thousands)**                      |   | **Shares Held** |   | **Adjusted Cost** |   | **Fair Value** |   |
|-----------------------------------------|--------|-----------------|--------|-------------------|--------|----------------|--------|
|                                    |   |            |   |              |   |           |   |
| Common Stock:                           |   |            |   |              |   |           |   |
| Dynex Capital, Inc.                     |   | 75              |   | $                 | 122    |           | $      | 333 |   |
| Total Common Stock                      |   |            |   | 122               |   | 333            |   |
|                                    |   |            |   |              |   |           |   |
| Convertible Preferred Stock:            |   |            |   |              |   |           |   |
| Capstead Mortgage Corporation, Series B |   | 321             |   | 2,722             |   | 3,908          |   |
| Total Convertible Preferred Stock       |   |            |   | 2,722             |   | 3,908          |   |
|                                    |   |            |   |              |   |           |   |
| Total Equity Securities                 |   |            |   | $                 | 2,844  |           | $      | 4,241 |   |
|                                         |        |                 |        |                   |        |                |        |  |  |  |

 

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

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

 

16

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## **Other Assets**

 

The Company had other assets of $356,619,000 and$14,918,000 at September 30, 2002 and December 31, 2001, respectively. Theincrease in other assets is primarily due to a $336,087,000 receivable forunsettled securities at September 30, 2002. Other assets also consist ofaccrued interest receivable, principal payments receivable, and other assets.

 

## **Stockholders’ Equity**

 

The Company had stockholders’ equity of  $206,226,000 and $130,030,000 at September30, 2002 and December 30, 2001, respectively. The increase in stockholders’equity is primarily the result of the completion of two follow-on public equityofferings with total proceeds (net of underwriting discounts, commissions andother expenses) of $155,749,000 during the nine months ended September 30,2002. The increase in stockholders’ equity is partially offset by the change inaccumulated other comprehensive loss of $71,874,000 and accumulated deficit of$7,752,000 for the nine months ended September 30, 2002. The change inaccumulated other comprehensive loss is primarily the result of unrealizedgains on available-for-sale securities and unrealized losses on interest rateswaps. The change in accumulated deficit includes net income less dividendsdeclared for the nine months ended September 30, 2002.

 

 

**HedgingInstruments**

 

There can be no assurance that the Company will enterinto hedging activities or that, if entered into, such activities will have thedesired beneficial impact on the Company’s results of operations or financialcondition.  Moreover, no hedgingactivity can completely insulate the Company from the risks associated withchanges in interest rates and prepayment rates.

 

Hedging involves risk and typically involves costs,including transaction costs.  Such costsincrease dramatically as the period covered by the hedging increases and duringperiods of rising and volatile interest rates. The Company may increase its hedging activity and, thus, increase itshedging costs during such periods when interest rates are volatile or risingand hedging costs have increased.  TheCompany intends generally to hedge as much of the interest rate risk as theManager determines is in the best interest of the Company’s stockholders giventhe cost of such hedging transactions and the Company’s desire to maintain itsstatus as a REIT.  The Company’spolicies do not contain specific requirements as to the percentages or amountof interest rate risk that the Manager is required to hedge.

 

The Company utilizes interest rate swap agreements asa tool to manage interest rate risk. Under the swap agreements, the Company receives a floating rate and paysa fixed rate.  The notional amount ofeach agreement is matched against a like amount of current and anticipatedborrowings under reverse repurchase agreements to mitigate the potential effecton cash flows and net interest income of rising interest rates by effectivelyfixing the rate paid on the matched borrowings over the life of thecontract.  In the absence of suchfinancial instruments, interest expense on reverse repurchase agreements andsimilar short-term borrowings, which mature and reprice frequently, canincrease faster than the Company can adjust its interest-earning assets andincrease interest income, because the Company’s mortgage related securitiesgenerally have much longer maturities and have fixed rates of interest.

 

The interest rate swap agreements entered into by theCompany are classified as cash flow hedges for accounting purposes and meet therequirements of SFAS No. 133 for such classification.  Therefore, changes in the fair value of the agreements arereported in accumulated other comprehensive income, a component ofstockholders’ equity, and do not affect net income in the period of thechange.  Periodic exchanges of cash flowswith the counterparties to the agreements are recorded as adjustments tointerest expense.  If the Company wereto terminate the swap agreements prior to their contractual termination dates,or change current or anticipated borrowings so that they were no longerappropriately matched to the swap agreements, the agreements might not qualifyfor hedge accounting treatment.  In thiscase, changes in their fair values would affect net income.

 

17

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Borrowings hedged by interest rate swaps are used primarilyto acquire and hold fixed income securities available-for-sale.  Changes in the fair values of securitiesavailable-for-sale are also reported in accumulated other comprehensive income,a component of stockholders’ equity. Changes in fair values of the securities only affect periodic earningswhen they are sold or if they have an other-than-temporary impairment.   Therefore, earnings volatility is reducedby the use of the swap agreements as cash flow hedges and the acquisition ofavailable-for-sale securities with the borrowings hedged by theagreements.  Impairment of theavailable-for-sale securities or decisions to sell the securities prior totheir expected maturities could result in unanticipated earnings volatility.

 

At September 30, 2002, the Company had entered intointerest rate swap agreements summarized below:

 

**(Dollars in thousands)**

 
| **Current  Notional Amount** |      | **Par  Weighted**

**Average  Maturity** |      | **Average  Fixed Rate** |   | **Floating  Rate** |         | **Unrealized  Losses** |   |
|------------------------------|-----------|------------------------------------------|-----------|-------------------------|--------|--------------------|--------------|------------------------|--------|
|                         |      |                                     |      |                    |   |               |         |                   |   |
| $                            | 2,223,000 |                                     | 3.9 years |                    | 4.380  | %                  | 1Month LIBOR |                   | $      | (131,323 | ) |
|                              |           |                                          |           |                         |        |                    |              |                        |        |  |  |

 

At December 31, 2001, the Company had entered intointerest rate swap agreements summarized below:

 

**(Dollars in thousands)**

 
| **Current  Notional Amount** |    | **Par  Weighted**

**Average  Maturity** |      | **Average  Fixed Rate** |   | **Floating  Rate** |      | **Unrealized  Gains** |   |
|------------------------------|---------|------------------------------------------|-----------|-------------------------|--------|--------------------|-----------|-----------------------|--------|
|                         |    |                                     |      |                    |   |               |      |                  |   |
| $                            | 850,000 |                                     | 6.6 years |                    | 4.239  | %                  | 1Mo LIBOR |                  | $      | 4,620 |   |
|                              |         |                                          |           |                         |        |                    |           |                       |        |  |  |

 

At various times the Company has used forwardcontracts to sell U.S. Treasury securities as a means to mitigate the effect ofrising interest rates on the fair value of its mortgage relatedsecurities.   The fair values of theseforward contracts generally move in the opposite direction of the fair valuesof the mortgage related securities, and approximately in the same proportionwhen the maturities and other terms are appropriately matched.   When interest rates rise, the fair value ofthe mortgage related securities declines, but the increasing fair values of theforward contracts help to preserve net asset value relative to the changingfair value of the short-term borrowings used to fund them.

 

The Company’s forward contracts do not meet thecriteria for hedge accounting under SFAS No. 133.  Therefore, changes in their fair values affect current earnings,as do changes in the fair values of the securities to which they are matched –such securities are classified as trading securities.  Although the changes in the fair values of the forward contractsand the trading securities are offsetting, the contracts are not fullyeffective as hedges, and therefore there can be volatility in periodic earningsto the extent they are not effective.

 

At September 30, 2002, the Company had no open forward contracts tosell U.S. Treasury notes.

 

At December 31, 2001, the Company had open forward contracts to sellU.S. Treasury notes with the terms summarized below:

 

**(Dollars in thousands)**

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

 

18

----

 

The contracts were entered into to mitigate thenegative impact of rising interest rates on certain fixed income securitiesthat generally have a market weighted average duration approximately equal tothe contracts shown above.  It should benoted that average duration volatility of the mortgage-related securities canbe more volatile than that of the contracts which could result in losses ifinterest rate volatility is high.

 

 

**Liabilities**

 

The Company has entered into reverse repurchaseagreements to finance certain of its mortgage-backed securities.  These agreements are secured by a portion ofthe Company’s mortgage-backed securities and bear interest rates that have historicallymoved in close relationship to LIBOR.

 

At September 30, 2002, the Company had outstanding$3,066,087,000 of reverse repurchase agreements with a weighted average currentborrowing rate of 1.80% per annum and a maturity of 0.9 months.  The reverse repurchase agreements werecollateralized by securities with an estimated fair value of $3,180,945,000.

 

At December 31, 2001, the Company had outstanding$1,376,850,000 of reverse repurchase agreements with a weighted average currentborrowing rate of 1.89% per annum and a maturity of 1.0 month.  The reverse repurchase agreements werecollateralized by mortgage-backed securities with an estimated fair value of$1,440,014,000.

 

The increase in outstanding reverse repurchaseagreements at September 30, 2002 is the result of the Company’s follow-onequity offerings completed during the nine months ended September 30, 2002. TheCompany utilized the net proceeds of these follow-on equity offerings toincrease leverage. Such leverage is being used to seek to take advantage ofmarket opportunities and to invest the portfolio as fully as possible inanticipation of any future acceleration in prepayment rates, which would reduceleverage over time.

 

The Company had interest rate swaps with an unrealizedloss of $131,323,000 and an unrealized gain of $4,620,000 at September 30, 2002and December 31, 2001, respectively. The $135,943,000 decrease in value oninterest rate swaps is due to an increase in notional amount from $850,000,000to $2,223,000,000 at December 31, 2001 and September 30, 2002, respectively,combined with a decrease in the one-month LIBOR rate. Under the swapagreements, the Company receives a floating rate and pays a fixed rate.

 

The Company had $406,828,000 and $28,545,000 of otherliabilities at September 30, 2002 and December 31, 2001, respectively. Theincrease of other liabilities is primarily due to a $384,730,000 payable forunsettled securities at September 30, 2002. Other liabilities also consist ofaccrued interest payable, dividend payable, unrealized loss on forward contractsand TBA securities, and accrued expense and other liabilities. The Companyanticipates settling all other liabilities within one year.

 

At September 30, 2002, the Company had a short saletransaction to sell $200,000,000 par value of FNMA 6.5% 10/1/2032 on aTo-Be-Announced (TBA) basis with settlement date of October 15, 2002. To complywith SFAS No. 133, the transaction was accounted for as a derivative andtherefore marked to market with an unrealized loss of $874,000. There was noTBA transaction at December 31, 2001.

 

 

**Results of Operations for the ThreeMonths Ended September 30, 2002 Compared to the Three Months Ended September30, 2001**

 

*Overview*

 

For the quarter ended September 30, 2002, theCompany’s net income was $9,496,000, or $0.32 per common share both on a basicand a diluted basis, based on a weighted average of 29,857,000 and 29,991,913shares outstanding, respectively.  Thatcompares to net income of $7,836,000, or $1.36 per common share on a basic basisand $1.34 per common share on a diluted basis, based on a weighted average of5,753,000 and 5,846,000 shares outstanding for the quarter ended September 30,2001.  The weighted average number ofshares used to calculate net income per diluted share includes the effect ofthe assumed exercise of outstanding stock options.

 

19

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*Net Interest Income*

 

Net interest income for the quarter ended September30, 2002 was $24,478,000, consisting of interest income on fixed incomesecurities and cash balances less interest expense on reverse repurchaseagreements, compared to $5,632,000 for the quarter ended September 30, 2001.The increase in net interest income for the quarter ended September 30, 2002 isprimarily due to an increase in investments in fixed income securities with anet interest margin of approximately 2.82%. The Company reported dividend income of $106,000 from dividends onequity investments for the quarter ended September 30, 2002, compared to $162,000for the quarter ended September 30, 2001.

 

The following table reflects the average balances foreach category of the Company’s interest earning assets as well as the Company’sinterest bearing liabilities, with the corresponding effective rate of interestannualized:

 

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

(Dollarsin thousands)

 
|                                    |   | **For the Quarter Ended  September 30, 2002** |      | **For the Quarter Ended  September 30, 2001** |   |
|-----------------------------------------|--------|-----------------------------------------------|-----------|-----------------------------------------------|--------|
|                                    |   | **Average  Balance**                          |      | **Effective  Rate**                           |   | **Average  Balance** |   | **Effective  Rate** |   |
| Interest  Earning Assets:               |   |                                          |      |                                          |   |   |   |   |   |
| Mortgage  Securities                    |   | $                                             | 3,372,586 |                                          | 6.37   | % | $ | 507,784 |   | 7.73 | % |
| Cash  and Cash Equivalents              |   | 2,185                                         |      | 2.56                                          | %      | 2,173 |   | 4.42 | % |
| Total  Interest Earning Assets          |   | 3,374,771                                     |      | 6.37                                          | %      | 509,957 |   | 7.71 | % |
|                                    |   |                                          |      |                                          |   |   |   |   |   |
| Interest  Bearing Liabilities:          |   |                                          |      |                                          |   |   |   |   |   |
| Reverse  Repurchase Agreements          |   | 3,293,219                                     |      | 3.55                                          | %      | 491,563 |   | 3.42 | % |
|                                    |   |                                          |      |                                          |   |   |   |   |   |
| Net  Interest Earning Assets and Spread |   | $                                             | 81,552    |                                          | 2.82   | % | $ | 18,394 |   | 4.29 | % |

 

The effective yield data is computed by dividing theannualized net interest income or expense including hedging transactions asapplicable into the average daily balance shown.

 

The following table reflects the average balances forthe Company’s equity securities:

 

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

(Dollarsin thousands)

 
|               |   | **For the Quarter Ended  September 30, 2002** |   | **For the Quarter Ended  September 30, 2001** |   |
|--------------------|--------|-----------------------------------------------|--------|-----------------------------------------------|--------|
|               |   | **Average  Balance**                          |   | **Effective  Dividend  Yield**                |   | **Average  Balance** |   | **Effective  Dividend  Yield** |   |
|               |   |                                          |   |                                          |   |   |   |   |   |
| Equity  securities |   | $                                             | 3,931  |                                          | 10.79  | % | $ | 11,368 |   | 5.70 | % |
|                    |        |                                               |        |                                               |        |  |  |  |  |  |  |

 

20

----

 

The following table shows the approximate amounts ofthe change in interest income and expense between 2002 and 2001 that was afunction of rate and volume changes, and the amount of the change that cannotbe ascribed specifically to either rate or volume changes.

 

**RATE/ VOLUME TABLE**

(Dollars inthousands)

 
|                          |   | **Three  Months Ended****September 30****,  2002 compared to 2001** |   |
|-------------------------------|--------|---------------------------------------------------------------------|--------|
|                          |   | **Total**                                                           |   | **Changes Due  to** |   |
|                          |   | **Change**                                                          |   | **Volume (1)** |   | **Rates (1)** |   |
| Interest-Earning Assets       |   |                                                                |   |   |   |   |   |
| Fixed income securities       |   | $                                                                   | 43,892 |   | $ | 55,366 |   | $ | (11,474 | ) |
| Cash and cash equivalents     |   | (10                                                                 | )      | 1 |   | (11 | ) |
|                          |   |                                                                |   |   |   |   |   |
| Total interest income         |   | $                                                                   | 43,882 |   | $ | 55,367 |   | $ | (11,485 | ) |
|                          |   |                                                                |   |   |   |   |   |
| Interest-Bearing Liabilities  |   |                                                                |   |   |   |   |   |
| Reverse repurchase agreements |   | $                                                                   | 25,036 |   | $ | 24,582 |   | $ | 454 |   |
|                          |   |                                                                |   |   |   |   |   |
| Total interest expense        |   | $                                                                   | 25,036 |   | $ | 24,582 |   | $ | 454 |   |
|                          |   |                                                                |   |   |   |   |   |
| Change In Net Interest Income |   | $                                                                   | 18,846 |   | $ | 30,785 |   | $ | (11,939 | ) |

 

----

(1)  Changes in interest income/expense not arisingfrom volume or rate variances are allocated proportionately to rate and volume.

 

A portion of the change in interest expense in thetable above is related to the Company’s use of interest rate swaps.  Periodic settlements of the swap agreementswith their counterparties result in adjustments to interest expense associatedwith the reverse repurchase agreements hedged by the swaps.  During the quarter ended September 30, 2001,interest expense was decreased by $145,000 from amortization of deferred gainson terminated swap contracts.  Duringthe quarter ended September 30, 2002, interest expense was increased by$14,189,000 paid to swap counterparties.

 

*General and Administrative Expenses*

 

For the quarter ended September 30, 2002, the Companyincurred operating expenses consisting of management fees, professional,printing, insurance and other expenses aggregating $880,000, which were offsetby a $1,437,000 reversal of annual incentive fee expense for a net operatingexpense of ($557,000).  For the quarterended September 30, 2001, the Company incurred operating expenses of $367,000,consisting of management fees, professional, printing, insurance and otherexpenses.  The primary reason for loweroperating expenses in the quarter ended September 30, 2002, compared to thesame period in 2001, is due to the reversal of the annual incentive fee. Thedecrease in operating expenses is partially offset by the increase inmanagement fees as a result of increased average net invested capital.

 

During the quarter ended September 30, 2002,$1,437,000 of incentive fees previously earned and accrued during the year andan additional $3,795,000 earned during the third quarter was reversed andwaived by the Manager.

 

*Net Gain (Loss) on Investment andDerivative Activities*

 

During the quarter ended September 30, 2002, theCompany reported a net loss on investment and derivative activities of$15,645,000 in the statement of operations. This loss consisted of a net loss of $31,878,000 on closed forwardcontracts, an unrealized loss of $13,733,000 on fixed income tradingsecurities, a gain of $29,890,000 on the sale of $887,838,000 of fixed incometrading securities, and a gain of $76,000 on the sale of $242,000 of equitysecurities available-for-sale.

 

21

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During the quarter ended September 30, 2001, theCompany reported a net gain on investment and derivative activities of$2,409,000 in the statement of operations. This gain consisted of $2,107,000 in gains on the sale of $130,456,000 of fixed income tradingsecurities, $11,566,000 gain from the net increase in fair market value offixed income trading securities, and $11,264,000 in net losses on forwardcontracts.

 

 

**Resultsof Operations for the Nine Months Ended September 30, 2002 Compared to the NineMonths Ended September 30, 2001**

 

*Overview*

 

For the nine months ended September 30, 2002, theCompany’s net income was $34,746,000, or $1.39 per share on a basic basis and$1.38 per share on a diluted basis, based on a weighted average of 24,975,874and 25,105,294 shares outstanding, respectively.  That compares to net income of $9,210,000, or $1.60 per commonshare on a basic basis and $1.58 per common share on a diluted basis, based ona weighted average of 5,753,000 and 5,846,000 shares outstanding, respectively,for the nine months ended September 30, 2001.

 

*Net Interest Income*

 

Net interest income for the nine months endedSeptember 30, 2002 was $62,962,000, consisting of interest income on fixedincome securities and cash balances less interest expense on reverse repurchaseagreements compared to $14,352,000 for the nine months ended September 30,2001.  The increase in net interestincome for the nine months ended September 30, 2002 is primarily due to anincrease in investments in fixed income securities with a net interest marginof approximately 3.04%.  The Companyreported dividend income of $341,000 from dividends on equity investments forthe nine months ended September 30, 2002, compared to $656,000 for the ninemonths ended September 30, 2001.

 

The following table reflects the average balances foreach category of the Company’s interest earning assets as well as the Company’sinterest bearing liabilities, with the corresponding effective rate of interestannualized:

 

**AVERAGEBALANCE AND RATE TABLE**

(Dollarsin thousands)

 
|                                    |   | **For the Nine Months  Ended  September 30, 2002** |      | **For the Nine Months  Ended  September 30, 2001** |   |
|-----------------------------------------|--------|----------------------------------------------------|-----------|----------------------------------------------------|--------|
|                                    |   | **Average  Balance**                               |      | **Effective  Rate**                                |   | **Average  Balance** |   | **Effective  Rate** |   |
| Interest  Earning Assets:               |   |                                               |      |                                               |   |   |   |   |   |
| Mortgage  Securities                    |   | $                                                  | 2,615,606 |                                               | 6.43   | % | $ | 544,782 |   | 7.47 | % |
| Cash  and Cash Equivalents              |   | 6,442                                              |      | 1.80                                               | %      | 3,173 |   | 3.99 | % |
|                                    |   |                                               |      |                                               |   |   |   |   |   |
| Total  Interest Earning Assets          |   | 2,622,048                                          |      | 6.43                                               | %      | 547,955 |   | 7.45 | % |
|                                    |   |                                               |      |                                               |   |   |   |   |   |
| Interest  Bearing Liabilities:          |   |                                               |      |                                               |   |   |   |   |   |
| Reverse  Repurchase Agreements          |   | 2,493,296                                          |      | 3.39                                               | %      | 527,028 |   | 4.11 | % |
|                                    |   |                                               |      |                                               |   |   |   |   |   |
| Net  Interest Earning Assets and Spread |   | $                                                  | 128,752   |                                               | 3.04   | % | $ | 20,927 |   | 3.34 | % |

 

The effective yield data is computed by dividing theannualized net interest income or expense including certain hedgingtransactions as applicable into the average daily balance shown.

 

22

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The following table reflects the average balances forthe Company’s equity securities:

 

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

(Dollarsin thousands)

 
|               |   | **For the Nine Months  Ended  September 30, 2002** |   | **For the Nine Months  Ended   September 30, 2001** |   |
|--------------------|--------|----------------------------------------------------|--------|-----------------------------------------------------|--------|
|               |   | **Average  Balance**                               |   | **Effective  Dividend  Yield**                      |   | **Average  Balance** |   | **Effective  Dividend  Yield** |   |
|               |   |                                               |   |                                                |   |   |   |   |   |
| Equity  securities |   | $                                                  | 4,159  |                                                | 10.93  | % | $ | 12,300 |   | 7.11 | % |
|                    |        |                                                    |        |                                                     |        |  |  |  |  |  |  |

 

The following table shows the approximate amounts ofthe change in interest income and expense between 2002 and 2001 that was afunction of rate and volume changes, and the amount of the change that cannotbe ascribed specifically to either rate or volume changes.

 

**RATE/ VOLUME TABLE**

(Dollars inthousands)

 
|                          |   | **Nine Months  Ended****September  30****,  2002 compared to 2001** |   |
|-------------------------------|--------|---------------------------------------------------------------------|--------|
|                          |   | **Total**                                                           |   | **Changes Due  to** |   |
|                          |   | **Change**                                                          |   | **Volume(1)** |   | **Rates(1)** |   |
| Interest-Earning Assets       |   |                                                                |   |   |   |   |   |
| Fixed income securities       |   | $                                                                   | 95,689 |   | $ | 116,022 |   | $ | (20,333 | ) |
| Cash and cash equivalents     |   | (8                                                                  | )      | 100 |   | (108 | ) |
|                          |   |                                                                |   |   |   |   |   |
| Total interest income         |   | $                                                                   | 95,681 |   | $ | 116,122 |   | $ | (20,441 | ) |
|                          |   |                                                                |   |   |   |   |   |
| Interest-Bearing Liabilities  |   |                                                                |   |   |   |   |   |
| Reverse repurchase agreements |   | $                                                                   | 47,071 |   | $ | 61,450 |   | $ | (14,379 | ) |
|                          |   |                                                                |   |   |   |   |   |
| Total interest expense        |   | $                                                                   | 47,071 |   | $ | 61,450 |   | $ | (14,379 | ) |
|                          |   |                                                                |   |   |   |   |   |
| Change In Net Interest Income |   | $                                                                   | 48,610 |   | $ | 54,672 |   | $ | (6,062 | ) |

 

----

(1)  Changes in interest income/expense not arisingfrom volume or rate variances are allocated proportionately to rate and volume.

 

A portion of the change in interest expense in thetable above is related to the Company’s use of interest rate swaps.  Periodic settlements of the swap agreementswith their counterparties result in adjustments to interest expense associatedwith the reverse repurchase agreements hedged by the swaps.  During the nine months ended September 30,2001, interest expense was decreased by $2,242,000 from amortization ofdeferred gains on terminated swap contracts. During the nine months ended September 30, 2002, interest expense wasincreased by $29,342,000 paid to swap counterparties and decreased by $180,000from amortization of deferred gains on terminated swap contracts.

 

23

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*General and Administrative Expenses*

 

The Company incurred operating expenses of $2,460,000for the nine months ended September 30, 2002, consisting of management fees,professional, printing, insurance and other expenses.  For the nine months ended September 30, 2001, the Companyincurred operating expenses of $936,000 consisting of management fees,professional, printing, insurance and other expenses. The primary reasons forthe higher operating expenses in the first nine months of 2002 compared to thefirst nine months of 2001 were that management fees were much higher due toincreased average net invested capital.

 

*Net Gain (Loss) on Investment andDerivative Activities*

 

During the nine months ended September 30, 2002, theCompany reported a net loss on investment transactions of $26,097,000 in thestatement of operations. The loss consisted of a $594,000 gain on the sale of$1,937,000 of equity securities, a realized gain of $29,907,000 on the saleof  $894,372,000 of fixed income tradingsecurities, a realized loss of $229,000 on the sale of $98,634,000 of fixedincome securities classified as available-for-sale, a unrealized loss of$569,000 on fixed income trading securities, and a realized net loss of$55,800,000 on closed forward contracts.

 

During the nine months ended September 30, 2001, theCompany reported a net loss on investment transactions of $4,431,000 in thestatement of operations. The loss consisted of a $65,000 gain on the sale of$1,712,000 of equity securities, a realized gain of $6,418,000 on the sale of$332,373,000 of fixed income trading securities, a reported gain of $11,603,000from the net increase in fair market value of fixed income trading securitiesand a realized net loss of $22,517,000 on closed forward contracts.

 

 

**Liquidityand Capital Resources**

 

The Company’s primary sources of funds as of September30, 2002 and December 31, 2001, consisted of reverse repurchase agreementstotaling $3,066,087,000 and $1,376,850,000, respectively.  The Company expects to continue to borrowfunds in the form of reverse repurchase agreements.  At September 30, 2002, the Company had borrowing arrangementswith approximately twenty different investment banking firms.  Increases in short-term interest rates couldnegatively impact the valuation of the Company’s mortgage assets which couldlimit the Company’s borrowing ability or cause its lenders to initiate margincalls.

 

For liquidity, the Company will also rely on the cashflow from operations, primarily monthly principal and interest payments to bereceived on the mortgage assets.

 

The Company believes that equity capital, combinedwith the cash flow from operations and the utilization of borrowings, will besufficient to enable the Company to meet anticipated liquidityrequirements.  However, an increase inprepayment rates substantially above the Company's expectations could cause aliquidity shortfall.  If the Company’scash resources are at any time insufficient to satisfy the Company’s liquidityrequirements, the Company may be required to liquidate mortgage assets or selldebt or additional equity securities. If required, the sale of mortgage assets at prices lower than thecarrying value of such assets would result in losses and reduced income.

 

The Company may in the future increase its capitalresources by making additional offerings of equity and debt securities, includingclasses of preferred stock, common stock, commercial paper, medium-term notes,collateralized mortgage obligations and senior or subordinated notes.  All debt securities, other borrowings, andclasses of preferred stock will be senior to the common stock in a liquidationof the Company.  The effect ofadditional equity offerings may be the dilution of stockholders’ equity of theCompany or the reduction of the price of shares of the common stock, or both.  The Company is unable to estimate the amount,timing or nature of additional offerings as they will depend upon marketconditions and other factors.

 

 

**Inflation**

 

Virtually all of the Company’s assets and liabilitiesare financial in nature.  As a result,interest rates and other factors drive the Company’s performance far more thandoes inflation.  Changes in interestrates do not necessarily correlate with inflation rates or changes in inflationrates.  The Company’s financialstatements are prepared in accordance with accounting principles generallyaccepted in the United States of America and the Company’s dividends aredetermined by the Company’s net income as calculated for tax purposes; in eachcase, the Company’s activities and balance sheet are measured with reference tohistorical cost and or fair market value without considering inflation.

 

24

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# **ITEM 3.     QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

**MARKETRISK**

 

The Company’s two primary components of market riskare interest rate risk and equity price risk, as discussed below.

### ** **

### **InterestRate Risk**

 

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

 

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

* *

*PrepaymentRisk*.  Fixed-rateassets in combination with hedging instruments are also subject to prepaymentrisk.  In falling interest ratescenarios, the fixed-rate mortgage assets may prepay faster such that theaverage life becomes shorter than its related hedging instrument.  If this were to happen, the Company wouldpotentially need to reinvest at rates lower than that of the related hedginginstrument.  This situation may resultin the narrowing of interest rate spreads or may cause losses.

* *

*ForwardContract Risk*.  TheCompany may also enter in forward contracts to sell U.S. Treasury notes inaddition to or instead of interest rate swap agreements.  These forward contracts are generallyexpected to mitigate the impact of rising interest rates on the fair value ofthe Company’s fixed income securities. However, if the duration mismatch between mortgage securities and U.S.Treasury notes were to widen, which could occur in both a rising and fallinginterest rate environment, the fair value of the Company’s portfolio wouldgenerally be expected to decline.  Inaddition, the use of forward contracts to sell U.S. Treasury notes generallydoes not directly impact borrowing costs in the same manner as interest rateswap agreements.  Therefore, the use ofsuch forward contracts could result in net income volatility during periods ofinterest rate volatility.

 

The Company also invests in adjustable-rate mortgageassets that are typically subject to periodic and lifetime interest rate capsthat limit the amount an adjustable-rate mortgage asset’s interest rate canchange during any given period, as well as the minimum rate payable.  The Company’s borrowings will not be subjectto similar restrictions.  Hence, in aperiod of increasing interest rates, interest rates on its borrowings couldincrease without limitation by caps, while the interest rates on its mortgageassets are generally limited by caps. This problem will be magnified to the extent the Company acquiresmortgage assets that are not fully indexed. Further, some adjustable-rate mortgage assets may be subject to periodicpayment caps that result in some portion of the interest being deferred andadded to the principal outstanding. This could result in receipt by the Company of less cash income on itsadjustable-rate mortgage assets than is required to pay interest

 

25

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on the relatedborrowings.  These factors could lowerthe Company’s net interest income or cause a net loss during periods of risinginterest rates, which would negatively impact the Company’s financialcondition, cash flows, and results of operations.

 

The Company intends to fund a substantial portion ofits acquisitions of adjustable-rate mortgage assets with borrowings that haveinterest rates based on indices and repricing terms similar to, but of somewhatshorter maturities than, the interest rate indices and repricing terms of themortgage assets.  Thus, the Companyanticipates that in most cases the interest rate indices and repricing terms ofits mortgage assets and its funding sources will not be identical, therebycreating an interest rate mismatch between assets and liabilities.  While the historical spread between relevantshort-term interest rate indices has been relatively stable, there have beenperiods, especially during the 1979-1982 and 1994 interest rate environments,when the spread between such indices was volatile.  During periods of changing interest rates, such interest ratemismatches could negatively impact the Company’s financial condition, cashflows and results of operations.

 

Prepayment rates generally increase when prevailinginterest rates fall below the interest rates on existing mortgage assets.  In addition, prepayment rates generallyincrease when the difference between long-term and short-term interest ratesdeclines.  Prepayments of mortgageassets could adversely affect the Company’s results of operations in severalways.  The Company anticipates that asubstantial portion of its adjustable-rate mortgage assets may bear initial‘‘teaser’’ interest rates that are lower than their ‘‘fully indexed’’ rates(the applicable index plus a margin). In the event that such an adjustable-rate mortgage asset is prepaidprior to or soon after the time of adjustment to a fully indexed rate, theCompany will have held the mortgage asset while it was less profitable and lostthe opportunity to receive interest at the fully indexed rate over the expectedlife of the adjustable-rate mortgage asset. In addition, the prepayment of any mortgage asset that had beenpurchased at a premium by the Company would result in the immediate write-offof any remaining capitalized premium amount and consequent reduction of theCompany’s net interest income by such amount. Finally, in the event that the Company is unable to acquire new mortgageassets to replace the prepaid mortgage assets, its financial condition, cashflow and results of operations could be materially adversely affected.

 

*Effecton Fair Value.* Another component of interest rate risk is the effect changes ininterest rates will have on the market value of the Company’s assets*. *This is the risk that the marketvalue of the Company’s assets will increase or decrease at different rates thanthat of the Company’s liabilities, including its hedging instruments.

 

The Company primarily assesses its interest rate riskby estimating the duration of its assets and the duration of its liabilities,including all hedging instruments. Duration essentially measures the market price volatility of financialinstruments as interest rates change. The Company generally calculates duration using various financial modelsand empirical data and different models and methodologies can produce differentduration numbers for the same securities.

 

The following sensitivity analysis table shows theestimated impact on the fair value of the Company’s interest rate sensitiveinvestments, net of its hedging instruments and reverse repurchase agreementliabilities, assuming rates instantaneously fall one hundred basis points andrise one hundred basis points. Interest rate sensitive investments currentlyinclude fixed income trading and available-for-sale securities. (Dollars are inthousands except per share amounts.)

 
|                                                                      |   | **Fair Value for Scenario Shown**           |    |
|---------------------------------------------------------------------------|--------|---------------------------------------------|---------|
|                                                                      |   | **Interest  Rates Fall  100 Basis  Points** |    | **Unchanged** |   | **Interest  Rates Rise  100 Basis  Points** |   |
|                                                                      |   |                                        |    |   |   |   |   |
| Interest Rate Sensitive Instruments After Hedging  Instruments            |   | $                                           | 217,900 |   | $ | 247,993 |   | $ | 234,216 |   |
|                                                                      |   |                                        |    |   |   |   |   |
| Change in Fair Value                                                      |   | $                                           | (30,093 | ) | — |   | $ | (13,777 | ) |
| Change as a Percent of  Fair Value of Interest Rate Sensitive Investments |   | (0.87                                       | )%      | — |   | (0.40 | )% |
| Change as a Percent of  Stockholders’ Equity                         |   | (14.59                                      | )%      | — |   | (6.68 | )% |
| Change on a Per Share  Basis                                              |   | ($1.01                                      | )       | — |   | ($0.46 | ) |
|                                                                           |        |                                             |         |  |  |  |  |  |  |  |

 

 

It is important to note that the impact of changinginterest rates on fair value can change significantly when interest rateschange beyond one hundred basis points from current levels.  Therefore, the volatility in fair value forthe Company could increase significantly when interest rates change beyond onehundred basis points.  In addition,there are other factors 

 

26

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

 

The Company has established an interest rate riskmanagement policy that is intended to mitigate the negative impact of changinginterest rates.  The Company generallyintends to mitigate interest rate risk by targeting the difference between themarket weighted average duration on its mortgage related assets funded withsecured borrowings to the market weighted average duration of such borrowingsto plus or minus one year or less, taking into account all hedgingtransactions.  The Company generallydoes not intend to have any specific duration target for the portion itsmortgage related assets that are not funded by secured borrowings.

 

There can be no assurance that the Company will beable to limit such duration differences and there may be periods of time whenthe duration difference will be greater than one year.

 

**EquityPrice Risk**

 

Another component of market risk for the Company isequity price risk.  This is the riskthat the market value of the Company’s equity investments will decrease.  The following table shows the impact on theCompany’s fair value as the price of its equity securities change assumingprice decreases of 10% and increases of 10%. Actual price decreases or increases may be greater or smaller.  (Dollars are in thousands except per shareamounts.)

 
|                                              |   | **Fair Value for Scenario Shown** |   |
|---------------------------------------------------|--------|-----------------------------------|--------|
|                                              |   | **Prices  Decrease  10%**         |   | **Unchanged** |   | **Prices  Increase  10%** |   |
|                                              |   |                              |   |   |   |   |   |
| Equity Investments                                |   | $                                 | 3,817  |   | $ | 4,241 |   | $ | 4,665 |   |
|                                              |   |                              |   |   |   |   |   |
| Change in Fair Value                              |   | (424                              | )      | — |   | 424 |   |
| Change as a Percent of  Fair Value                |   | (10                               | )%     | — |   | 10 | % |
| Change as a Percent of  Stockholders’ Equity |   | (0.2                              | )%     | — |   | 0.2 | % |
| Change on a Per Share  Basis                      |   | (0.01                             | )      | — |   | 0.01 |   |
|                                                   |        |                                   |        |  |  |  |  |  |  |  |  |

 

 

Although there is no direct link between changes infair value and changes in earnings in many cases, a decline in fair value forthe Company may translate into decreased earnings over the remaining life ofthe investment portfolio.

 

If the fair market value of the Company’s portfoliowere to decline significantly, the Company’s overall liquidity may be impairedwhich could result in the Company being required to sell assets at losses.

 

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

# ** **

 

# **ITEM4.     CONTROLS AND PROCEDURES**

 

(a)          Evaluationof disclosure controls and procedures.

 

Under thesupervision and with the participation of our management, including theCompany’s Chief Executive Officer and Chief Financial Officer, we evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rule 13a-14(c) under the Exchange Act) as of a date(the “Evaluation Date”)

 

27

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within 90 daysprior to the filing date of this quarterly report on Form 10Q. Based upon thatevaluation, the Chief Executive Officer and Chief Financial Officer concludedthat, as of the Evaluation Date, our disclosure controls and procedures areeffective in timely alerting them to the material information relating to usrequired to be included in our periodic filings.

 

(b)         Changesin disclosure controls and procedures.

 

There were nosignificant changes made in our internal controls during the period covered bythis report or, to our knowledge, in other factors that could significantlyaffect these internal controls subsequent to the date of their evaluation.

 

28

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**PART II.    OTHERINFORMATION**

 

**ITEM1.    LEGAL PROCEEDINGS**

 

None.

 

**ITEM 2.    CHANGES IN SECURITIES**

 

None.

 

**ITEM 3.    DEFAULTS UPON SENIOR SECURITIES**

 

Not Applicable.

 

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

 

None.

 

**ITEM5.    OTHER INFORMATION**

 

None.

 

**ITEM6.    EXHIBITS AND REPORTS ON FORM 8-K**

 

*a)Exhibits*

 

The exhibits listed onthe Exhibit List, which appears below following the signature page, areincluded or incorporated by reference in this Quarterly Report.

 

*b)Reports on Form 8-K*

 

None.

 

29

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or 15(d) of the Securitiesand Exchange Act of 1934, the Registrant has duly caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|                     |   | Apex Mortgage Capital, Inc.           |
|--------------------------|--------|---------------------------------------|
|                     |   | (Registrant)                          |
|                     |   |                                  |   |
|                     |   |                                  |   |
| Dated: November 14, 2002 |   |                                  | /s/ Philip A. Barach |   |
|                     |   | Philip A. Barach                      |
|                     |   | President and Chief Executive Officer |
|                     |   | (Principal Executive Officer)         |
|                     |   |                                  |   |
|                     |   |                                  |   |
| Dated: November 14, 2002 |   |                                  | /s/ David S. DeVito |   |
|                     |   | David S. DeVito                       |
|                     |   | Chief Financial Officer               |
|                     |   | (Principal Accounting Officer)        |
|                          |        |                                       |  |  |  |  |

 

30

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CERTIFICATIONS

 

I, Philip A. Barach, certify that:

 

1.   I havereviewed this quarterly report on Form 10-Q of Apex Mortgage Capital, Inc.;

 

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

 

3.    Based on my knowledge, the financialstatements, and other financial information included in this quarterly report,fairly present in all material respects the financial condition, results ofoperations and cash flows of the registrant as of, and for, the periodspresented in this quarterly report;

 

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

 

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

 

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

 

c)   presented inthis quarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of  the Evaluation Date;

 

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

 

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

 

b)   any fraud,whether or not material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

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

 

 
| Date: November 14, 2002 | /s/ Philip A. Barach                     |   |
|-------------------------|------------------------------------------|--------|
|                    | Philip A. Barach                         |
|                    | *President and Chief Executive  Officer* |

 

31

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I, David S. DeVito, certify that:

 

1.   I havereviewed this quarterly report on Form 10-Q of Apex Mortgage Capital, Inc.;

 

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

 

3.    Based on myknowledge, the financial statements, and other financial information includedin this quarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the periods presented in this quarterly report;

 

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

 

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

 

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

 

c)   presented inthis quarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of  the Evaluation Date;

 

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

 

a)   all significantdeficiencies in the design or operation of internal controls which couldadversely affect the registrant’s ability to record, process, summarize andreport financial data and have identified for the registrant’s auditors anymaterial weaknesses in internal controls; and

 

b)   any fraud,whether or not material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

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

 

 
| Date: November 14, 2002 | /s/ David S. DeVito                       |   |
|-------------------------|-------------------------------------------|--------|
|                    | David S. DeVito                           |
|                    | *Chief Financial Officer and  Controller* |

 

32

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**EXHIBITINDEX**

 

Pursuant to Item 601(a)(2) of Regulation S-K, thisexhibit index immediately precedes the exhibits.

 

The following exhibits are part of this QuarterlyReport of Form 10-Q (and are numbered in accordance with Item 601 of RegulationS-K).

 

 

 
| **Exhibit  No.** |   | **Description**                                                                                                                                                                                                                                                                                                                                                                           |
|------------------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |   |                                                                                                                                                                                                                                                                                                                                                                                      |
| 3.1              |   | Articles of Amendment and Restatement of the  Company, as filed with the State Department of Assessments and Taxation of  Maryland on November 25, 1997, (previously filed as Exhibit 3.1 to the  Company’s Registration Statement on Form S-11, Commission File No. 333-36069,  Amendment No. 3, filed November 21, 1997 and incorporated herein by  reference).                    |
| 3.2              |   | Articles Supplementary relating to the Company’s  Series A Junior Participating Preferred Stock, as filed with the State  Department of Assessments and Taxation of the State of Maryland on July 26,  1999 (previously filed as Exhibit 3.1 to the Company’s Current Report on Form  8-K, dated June 30, 1999 and filed July 23, 1999, and incorporated herein by  reference). |
| 3.3              |   | Amended and Restated Bylaws of the Company  (previously filed as Exhibit 4.4 to the Company’s S-2/A filed on November 27,  2001 and incorporated herein by reference).                                                                                                                                                                                                               |
| 4.1              |   | Form of Share Certificate for our common stock  (previously filed as Exhibit 4.3 to the Company’s Current Report on Form 8-K,  dated June 30, 1999 and filed July 27, 1999, and incorporated herein by  reference).                                                                                                                                                                  |
| 4.2              |   | Shareholder Rights Agreement between the Company and  The Bank of New York, as Rights Agent (including as Exhibit B the form of  Rights Certificate) (previously filed as Exhibit 4.1 to the Company’s Current  Report on Form 8-K, dated June 30, 1999 and filed July 27, 1999, and  incorporated herein by reference).                                                             |
| 10.1             |   | Form of Management Agreement between the Company and  TCW Investment Management Company (previously filed as Exhibit 10.1 to the  Company’s Registration Statement on Form S-11, Commission File No. 333-36069,  Amendment No. 3, filed November 21, 1997 and incorporated herein by  reference).                                                                                    |
| 10.2             |   | First Amendment to Management Agreement between the  Company and TCW Investment Management Company dated December 16, 1998  (previously filed as Exhibit 10.1 to the Company’s Annual Report on Form  10-K405 for the year ended December 31, 1998, filed March 31, 1999, and  incorporated herein by reference).                                                                    |
| 10.3             |   | Second Amendment to Management Agreement between the  Company and TCW Investment Management Company entered into as of December 16,  1999 (previously filed as Exhibit 10.1 to the Company’s Annual Report on Form  10K405 for the year ended December 31, 1999, filed March 30, 2000, and  incorporated herein by reference).                                                       |
| 10.4             |   | 1997 Stock Option Plan, (previously filed as Exhibit  10.6 to the Company’s Registration Statement on Form S-11, Commission File  No. 333-36069, Amendment No. 3, filed November 21, 1997 and incorporated  herein by reference).                                                                                                                                                    |
| 10.5             |   | Amended and Restated 1997 Stock Option Plan,  (previously filed as Exhibit 10.6 to the Company’s Annual Report on Form  10K405 for the year ended December 31, 1998, filed March 31, 1999 and  incorporated herein by reference).                                                                                                                                                    |
| 10.6             |   | Amended and Restated 1997 Stock Option Plan, as  amended December 13, 2001 (previously filed as Exhibit 10.6 to the Company’s  Annual Report on Form 10-K405 for the year ended December 31, 2001, filed  April 1, 2002 and incorporated herein by reference).                                                                                                                       |
| 99.1             |   | Section 906 Certification (filed herewith).                                                                                                                                                                                                                                                                                                                                               |

 

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