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UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q [X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the quarterly period ended: June 30, 2004 OR [  ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 For the transition period
from ________ to ________ Commission File Number: 001-11914 THORNBURG MORTGAGE, INC.  Maryland
(State or other jurisdiction of
incorporation or organization)
    
    85-0404134
(IRS Employer
Identification Number)
 150 Washington Avenue
Santa Fe, New Mexico
(Address of principal executive offices)
    
    87501
(Zip Code)
 Registrants telephone number, including area code: (505) 989-1900 (Former name, former address and former fiscal year, if changed since last report)
Not applicable Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes       [X]      No [  ] Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes       [X]      No [  ] APPLICABLE ONLY TO CORPORATE ISSUERS: Indicate the number of shares outstanding of each of the issuers classes of
common stock, as of the latest practicable date. Common Stock ($.01 par value) 84,085,951 as of May 6, 2004




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INDEX PagePART I. FINANCIAL INFORMATIONItem 1. Financial StatementsConsolidated Balance Sheets at June 30, 2004 and December 31, 2003
    
    
    3Consolidated Income Statements for the three and six months ended June 30, 2004 and June 30, 2003
    
    
    4Consolidated Statements of Comprehensive Income for the three and six months ended June 30, 2004 and June 30, 2003
    
    
    5Consolidated Statement of Shareholders Equity for the six months ended June 30, 2004 and June 30, 2003
    
    
    6Consolidated Statements of Cash Flows for the three and six months ended June 30, 2004 and June 30, 2003
    
    
    7Notes to Consolidated Financial Statements
    
    
    8Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    25Item 3. Quantitative and Qualitative Disclosures About Market Risk
    
    
    58Item 4. Controls and Procedures
    
    
    58PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    58Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities
    
    
    58Item 3. Defaults Upon Senior Securities
    
    
    58Item 4. Submission of Matters to a Vote of Security Holders
    
    
    59Item 5. Other Information
    
    
    59Item 6. Exhibits and Reports on Form 8-K
    
    
    59SIGNATURES
    
    
    60EXHIBIT INDEX
    
    
    61Amended and Restated Management AgreementSecurities Sale and Contribution AgreementCertification of Chief Executive OfficerCertification of President and Chief Operating OfficerCertification of Executive VP and Chief Financial OfficerCertification of Chief Executive OfficerCertification of President and Chief Operating OfficerCertification of Executive VP and Chief Financial Officer
  2




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PART I. FINANCIAL INFORMATION 
 Item 1. FINANCIAL STATEMENTS THORNBURG MORTGAGE, INC. AND SUBSIDIARIES 
 CONSOLIDATED BALANCE SHEETS (Unaudited)
  June 30, 2004
    
    December 31, 2003ASSETSAdjustable-rate mortgage (ARM) assets:ARM securities, net
    
    $
    14,434,131
    
    
    $
    11,520,741ARM loans:Securitized ARM loans, net
    
    
    3,263,469
    
    
    
    3,687,466ARM loans collateralizing debt obligations, net
    
    
    4,872,050
    
    
    
    3,146,961ARM loans held for securitization, net
    
    
    520,470
    
    
    
    496,998ARM loans
    
    
    8,655,989
    
    
    
    7,331,425ARM assets
    
    
    23,090,120
    
    
    
    18,852,166Cash and cash equivalents
    
    
    875,838
    
    
    
    85,366Restricted cash and cash equivalents
    
    
    304,702
    
    
    
    51,600Hedging instruments
    
    
    156,228
    
    
    
    40,356Accrued interest receivable
    
    
    88,726
    
    
    
    73,702Prepaid expenses and other
    
    
    25,257
    
    
    
    15,609$
    24,540,871
    
    
    $
    19,118,799LIABILITIESReverse repurchase agreements
    
    $
    17,492,989
    
    
    $
    13,926,858Collateralized debt obligations (CDOs)
    
    
    4,823,351
    
    
    
    3,114,047Whole loan financing facilities
    
    
    294,763
    
    
    
    369,343Hedging instruments
    
    
    37,286
    
    
    
    113,518Senior notes
    
    
    251,263
    
    
    
    251,080Accrued interest payable
    
    
    27,065
    
    
    
    26,114Dividends payable
    
    
    
    
    
    
    47,350Payable for assets purchased
    
    
    23,071
    
    
    
    Accrued expenses and other
    
    
    35,156
    
    
    
    31,38522,984,944
    
    
    
    17,879,695COMMITMENTS AND CONTINGENCIESSHAREHOLDERS EQUITYCommon stock: par value $.01 per share;
499,978 shares authorized,
83,024 and 73,985 shares issued
and outstanding, respectively
    
    
    830
    
    
    
    740Additional paid-in-capital
    
    
    1,623,750
    
    
    
    1,376,879Accumulated other comprehensive loss
    
    
    (131,441
    )
    
    
    (142,778
    )Retained earnings
    
    
    62,788
    
    
    
    4,2631,555,927
    
    
    
    1,239,104$
    24,540,871
    
    
    $
    19,118,799
 See Notes to Consolidated Financial Statements. 3




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THORNBURG MORTGAGE, INC. AND SUBSIDIARIES 
 CONSOLIDATED INCOME STATEMENTS (Unaudited)
  Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Interest income from ARM assets and
cash equivalents
    
    $
    217,487
    
    
    $
    136,897
    
    
    $
    413,300
    
    
    $
    260,093Interest expense on borrowed funds
    
    
    (143,435
    )
    
    
    (82,166
    )
    
    
    (269,528
    )
    
    
    (153,328
    )Net interest income
    
    
    74,052
    
    
    
    54,731
    
    
    
    143,772
    
    
    
    106,765Servicing income, net
    
    
    1,370
    
    
    
    637
    
    
    
    2,192
    
    
    
    941Gain (loss) on ARM assets and
hedging instruments, net
instruments, net
    
    
    (896
    )
    
    
    2,574
    
    
    
    2,648
    
    
    
    2,574Hedging expense
    
    
    (149
    )
    
    
    (220
    )
    
    
    (307
    )
    
    
    (397
    )Provision for credit losses
    
    
    (391
    )
    
    
    
    
    
    
    (823
    )
    
    
    Management fee
    
    
    (3,936
    )
    
    
    (2,686
    )
    
    
    (7,563
    )
    
    
    (5,171
    )Performance fee
    
    
    (8,480
    )
    
    
    (6,924
    )
    
    
    (16,814
    )
    
    
    (13,111
    )Long-term incentive awards
    
    
    344
    
    
    
    (3,075
    )
    
    
    (4,151
    )
    
    
    (4,744
    )Other operating expenses
    
    
    (4,015
    )
    
    
    (2,845
    )
    
    
    (7,692
    )
    
    
    (5,591
    )NET INCOME
    
    $
    57,899
    
    
    $
    42,192
    
    
    $
    111,262
    
    
    $
    81,266Net income
    
    $
    57,899
    
    
    $
    42,192
    
    
    $
    111,262
    
    
    $
    81,266Dividends on preferred stock
    
    
    
    
    
    
    (1,670
    )
    
    
    
    
    
    
    (3,340
    )Net income available to common
shareholders
    
    $
    57,899
    
    
    $
    40,522
    
    
    $
    111,262
    
    
    $
    77,926Basic earnings per share:Net income
    
    $
    0.71
    
    
    $
    0.68
    
    
    $
    1.41
    
    
    $
    1.35Average number of shares outstanding
    
    
    81,373
    
    
    
    59,879
    
    
    
    79,002
    
    
    
    57,767Diluted earnings per share:Net income
    
    $
    0.71
    
    
    $
    0.67
    
    
    $
    1.41
    
    
    $
    1.34Average number of shares outstanding
    
    
    81,373
    
    
    
    62,639
    
    
    
    79,002
    
    
    
    60,527Dividends declared per common share
    
    $
    0.66
    
    
    $
    0.62
    
    
    $
    1.31
    
    
    $
    1.22
 See Notes to Consolidated Financial Statements. 4




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THORNBURG MORTGAGE, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (Unaudited)
  Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Net income
    
    $
    57,899
    
    
    $
    42,192
    
    
    $
    111,262
    
    
    $
    81,266Other comprehensive income:Unrealized gains (losses) on securities:Net unrealized holdings gains (losses)
arising during the period
    
    
    (254,061
    )
    
    
    11,617
    
    
    
    (167,007
    )
    
    
    15,467Reclassification adjustment for net (gains) losses
included in income
    
    
    149
    
    
    
    (2,425
    )
    
    
    (2,863
    )
    
    
    (2,425
    )Net change in unrealized gains (losses) on securities
    
    
    (253,912
    )
    
    
    9,192
    
    
    
    (169,870
    )
    
    
    13,042Unrealized gains (losses) on hedging instruments:Net unrealized gains (losses) arising during the period
    
    
    230,264
    
    
    
    (85,801
    )
    
    
    52,812
    
    
    
    (121,340
    )Reclassification adjustment for net losses
included in income
    
    
    66,916
    
    
    
    35,306
    
    
    
    128,395
    
    
    
    66,436Net change in unrealized gains (losses) on hybrid
hedging instruments
    
    
    297,180
    
    
    
    (50,495
    )
    
    
    181,207
    
    
    
    (54,904
    )Other comprehensive income
    
    $
    101,167
    
    
    $
    889
    
    
    $
    122,599
    
    
    $
    39,404
 See Notes to Consolidated Financial Statements. 5




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THORNBURG MORTGAGE, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENT OF SHAREHOLDERS EQUITY (Unaudited)
 
 Accum. Other
    
    NotesCompre-
    
    ReceivablePreferred
    
    Common
    
    Additional Paid-
    
    hensive
    
    From Stock
    
    RetainedStock
    
    Stock
    
    in Capital
    
    Income (Loss)
    
    Sales
    
    Earnings
    
    TotalBalance, December 31, 2002
    
    $
    65,805
    
    
    $
    528
    
    
    $
    878,929
    
    
    $
    (105,254
    )
    
    $
    (7,437
    )
    
    $
    471
    
    
    $
    833,042Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    81,266
    
    
    
    81,266Other comprehensive income (loss):Available-for-sale assets:Fair value adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    13,041
    
    
    
    
    
    
    
    
    
    
    
    13,041Hedging instruments:Fair value adjustment, net of
amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (54,903
    )
    
    
    
    
    
    
    
    
    
    
    (54,903
    )Issuance of common stock
    
    
    
    
    
    
    87
    
    
    
    178,567
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    178,654Interest and principal payments on
notes receivable from stock sales
    
    
    
    
    
    
    
    
    
    
    141
    
    
    
    
    
    
    
    420
    
    
    
    
    
    
    
    561Dividends declared on preferred
stock - $1.21 per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,340
    )
    
    
    (3,340
    )Dividends declared on common
stock - $0.60 per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (35,743
    )
    
    
    (35,743
    )Balance, June 30, 2003
    
    $
    65,805
    
    
    $
    615
    
    
    $
    1,057,637
    
    
    $
    (147,116
    )
    
    $
    (7,017
    )
    
    $
    42,654
    
    
    $
    1,012,578Balance, December 31, 2003
    
    $
    
    
    
    $
    740
    
    
    $
    1,376,879
    
    
    $
    (142,778
    )
    
    $
    
    
    
    $
    4,263
    
    
    $
    1,239,104Comprehensive income:Net income
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    111,262
    
    
    
    111,262Other comprehensive income (loss):Available-for-sale assets:Fair value adjustment
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (169,870
    )
    
    
    
    
    
    
    
    
    
    
    (169,870
    )Hedging instruments:Fair value adjustment, net of
amortization
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    181,207
    
    
    
    
    
    
    
    
    
    
    
    181,207Issuance of common stock
    
    
    
    
    
    
    90
    
    
    
    246,871
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    246,961Dividends declared on common
stock - $0.65 per share
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (52,737
    )
    
    
    (52,737
    )Balance, June 30, 2004
    
    $
    
    
    
    $
    830
    
    
    $
    1,623,750
    
    
    $
    (131,441
    )
    
    $
    
    
    
    $
    62,788
    
    
    $
    1,555,927
 See Notes to Consolidated Financial Statements. 6




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THORNBURG MORTGAGE, INC. AND SUBSIDIARIES 
 CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
  Three Months Ended
    
    Six Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Operating Activities:Net income
    
    $
    57,899
    
    
    $
    42,192
    
    
    $
    111,262
    
    
    $
    81,266Adjustments to reconcile net income to net cash provided
by operating activities:Amortization
    
    
    14,712
    
    
    
    10,546
    
    
    
    27,433
    
    
    
    18,713(Gain) loss on ARM assets and hedging instruments, net
    
    
    896
    
    
    
    (2,574
    )
    
    
    (2,648
    )
    
    
    (2,574
    )Provision for credit losses
    
    
    391
    
    
    
    
    
    
    
    823
    
    
    
    Hedging expense
    
    
    149
    
    
    
    220
    
    
    
    307
    
    
    
    397Change in assets and liabilities:Accrued interest receivable
    
    
    (6,633
    )
    
    
    (7,235
    )
    
    
    (15,024
    )
    
    
    (12,786
    )Prepaid expenses and other
    
    
    (8,067
    )
    
    
    (1,834
    )
    
    
    (12,640
    )
    
    
    343Accrued interest payable
    
    
    (3,652
    )
    
    
    3,925
    
    
    
    951
    
    
    
    5,587Accrued expenses and other
    
    
    236
    
    
    
    17,447
    
    
    
    3,771
    
    
    
    21,204Net cash provided by operating activities
    
    
    55,931
    
    
    
    62,687
    
    
    
    114,235
    
    
    
    112,150Investing Activities:ARM securities:Purchases
    
    
    (2,795,341
    )
    
    
    (3,115,786
    )
    
    
    (6,359,193
    )
    
    
    (4,963,138
    )Proceeds on sales
    
    
    
    
    
    
    
    
    
    
    348,709
    
    
    
    Principal payments
    
    
    2,062,190
    
    
    
    1,073,494
    
    
    
    3,084,024
    
    
    
    1,908,041Securitized ARM loans:Issuance costs
    
    
    
    
    
    
    (1,076
    )
    
    
    
    
    
    
    (2,108
    )Principal payments
    
    
    195,370
    
    
    
    394,344
    
    
    
    324,839
    
    
    
    698,005ARM loans collateralizing debt obligations:Principal payments
    
    
    320,251
    
    
    
    66,527
    
    
    
    437,047
    
    
    
    91,382ARM loans held for securitization:Purchases and originations
    
    
    (1,129,828
    )
    
    
    (1,146,227
    )
    
    
    (2,127,699
    )
    
    
    (2,350,716
    )Principal payments
    
    
    16,581
    
    
    
    6,684
    
    
    
    28,427
    
    
    
    16,087Termination of interest rate swap agreements
    
    
    2,144
    
    
    
    
    
    
    
    2,144Net cash used in investing activities
    
    
    (1,328,633
    )
    
    
    (2,722,040
    )
    
    
    (4,261,702
    )
    
    
    (4,602,447
    )Financing Activities:Net borrowings from reverse repurchase agreements
    
    
    1,095,910
    
    
    
    1,944,138
    
    
    
    3,415,560
    
    
    
    3,659,551Net borrowings of CDOs
    
    
    719,952
    
    
    
    967,485
    
    
    
    1,709,304
    
    
    
    712,070Net whole loan financing facilities (paydowns) borrowings
    
    
    188,858
    
    
    
    (447,734
    )
    
    
    (74,580
    )
    
    
    25,422Net senior unsecured debt proceeds
    
    
    
    
    
    
    194,340
    
    
    
    
    
    
    
    194,340Payments received (made) on Eurodollar contracts
    
    
    1,031
    
    
    
    (6,975
    )
    
    
    (1,223
    )
    
    
    (12,554
    )Proceeds from common stock issued, net
    
    
    78,630
    
    
    
    56,501
    
    
    
    246,961
    
    
    
    178,654Dividends paid
    
    
    (52,736
    )
    
    
    (37,411
    )
    
    
    (100,087
    )
    
    
    (69,947
    )Payments on notes receivable from stock sales
    
    
    
    
    
    
    390
    
    
    
    
    
    
    
    561Purchase of interest rate cap agreements
    
    
    (4,895
    )
    
    
    (8,940
    )
    
    
    (4,894
    )
    
    
    (8,940
    )Net increase in restricted cash and cash equivalents
    
    
    (181,656
    )
    
    
    (8,940
    )
    
    
    (253,102
    )
    
    
    (8,940
    )Net cash provided by financing activities
    
    
    1,845,094
    
    
    
    2,652,854
    
    
    
    4,937,939
    
    
    
    4,670,217Net increase (decrease) in cash and cash equivalents
    
    
    572,392
    
    
    
    (6,499
    )
    
    
    790,472
    
    
    
    179,920Cash and cash equivalents at beginning of period
    
    
    303,446
    
    
    
    308,639
    
    
    
    85,366
    
    
    
    122,220Cash and cash equivalents at end of period
    
    $
    875,838
    
    
    $
    302,140
    
    
    $
    875,838
    
    
    $
    302,140
 Supplemental disclosure of cash flow information and non-cash activities is included in Note 4.See Notes to Consolidated Financial Statements 7




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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS Note 1. Significant Accounting Policies The accompanying unaudited consolidated financial statements have been prepared
in accordance with generally accepted accounting principles for interim
financial information. In the opinion of management, all material adjustments, consisting of normal
recurring adjustments, considered necessary for a fair presentation have been
included. The operating results for the quarter ended June 30, 2004 are not
necessarily indicative of the results that may be expected for the calendar
year ending December 31, 2004. The interim financial information should be
read in conjunction with Thornburg Mortgage, Inc.s 2003 Annual Report on Form
10-K/A. Basis of presentation and principles of consolidation  The consolidated financial statements include the accounts of Thornburg
Mortgage, Inc. (together with its subsidiaries referred to hereafter as
the Company) and its wholly owned bankruptcy-remote special purpose
finance subsidiaries, Thornburg Mortgage Funding Corporation (TMFC),
Thornburg Mortgage Acceptance Corporation (TMAC), Thornburg Mortgage
Capital Resources, LLC (TMCR), and Thornburg Mortgage Depositor, LLC
(TMD), its wholly owned mortgage loan origination subsidiary, Thornburg
Mortgage Home Loans, Inc. (TMHL), and TMHLs two wholly owned special
purpose finance subsidiaries, Thornburg Mortgage Funding Corporation II
and Thornburg Mortgage Acceptance Corporation II. TMFC, TMAC, TMCR and
TMD are wholly owned qualified real estate investment trust (REIT)
subsidiaries and are consolidated with the Company for financial statement
and tax reporting purposes. TMFC and TMAC ceased operations on May 31,
2004 and were dissolved on June 25, 2004. As of the close of business on
May 31, 2004, TMHL and its subsidiaries made the election to be taxable
REIT subsidiaries and are consolidated with the Company for financial
statement purposes but are not consolidated with the Company for tax
reporting purposes from that date forward. All material intercompany
accounts and transactions are eliminated in consolidation. Certain prior
period amounts have been reclassified to conform to current period
classifications. Recently adopted accounting pronouncements  On March 9, 2004, the SEC released Staff Accounting Bulletin 105 (SAB
105) providing guidance on how to account for a commitment to purchase a
mortgage loan prior to funding the loan. SAB 105 requires that these
commitments be recorded at fair value with changes in fair value
recognized in current earnings and is intended to eliminate the current
diversity in practice that exists relating to the accounting for loan
commitments. SAB 105 is effective for loan commitments entered into after
March 31, 2004. Management believes that the Companys method of
accounting for loan commitments is consistent with the guidance provided
by SAB 105.In December 2003, the Accounting Standards Executive Committee of the
American Institute of Certified Public Accountants issued Statement of
Position 03-3, Accounting for Certain Loans or Debt Securities Acquired
in a Transfer (SOP 03-3). SOP 03-3 addresses the accounting for
acquired impaired loans, loans that show evidence of having deteriorated
in terms of credit quality since their origination. SOP 03-3 is effective
for loans acquired after December 31, 2004. Because the Company acquires
loans generally underwritten to A quality standards, the Company does
not expect the adoption of SOP 03-3 to have a material effect on the
financial condition, results of operations, or liquidity of the Company.In June 2004, the Financial Accounting Standards Board issued Emerging
Issues Task Force Abstract 03-01, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments (EITF 03-01).
EITF 03-01 requires an investor to determine when an investment is
considered impaired, evaluate whether that impairment is other than
temporary, and, if the impairment is other than temporary, recognize an
impairment loss equal to the difference between the investments cost and
its fair value. The guidance also includes accounting considerations
subsequent to the recognition of an other-than-temporary impairment and
requires certain disclosures about unrealized losses that have not been
recognized as other-than-temporary impairments. The impairment loss
recognition and measurement guidance is applicable to other-than-temporary
impairment evaluations in reporting periods beginning after June 15, 2004. The Company does not expect the
adoption of EITF 03-01 to have a material effect on the financial
condition, results of operations, or liquidity of the Company. EITF 03-01
also includes annual 8




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disclosure requirements for investments in an
unrealized loss position for which other-than-temporary impairments have
not been recognized. These disclosures were included in the Companys Form
10-K/A Annual Report for the year ended December 31, 2003 as required by
the EITF. Cash and cash equivalents  Cash and cash equivalents includes cash on hand and highly liquid
investments with original maturities of three months or less. The
carrying amount of cash equivalents approximates their fair value. Restricted cash and cash equivalents  Restricted cash and cash equivalents includes cash and highly liquid
investments with original maturities of three months or less that are held
by counter-parties as collateral for reverse repurchase agreements and
hedging instruments. The carrying amount of restricted cash and cash
equivalents approximates their fair value. Adjustable-rate mortgage (ARM) assets  The Companys ARM assets are comprised of ARM securities and securitized
ARM loans, ARM loans collateralizing long-term debt and ARM loans held for
securitization (the last three collectively referred to as ARM Loans).
All of the Companys ARM assets are either traditional ARM securities and
loans, meaning they have interest rates that reprice in a year or less
(Traditional ARMs), or hybrid ARM securities and loans that have a fixed
interest rate for an initial period of three to ten years and then convert
to Traditional ARMs for their remaining terms to maturity (Hybrid ARMs).ARM securities are composed mainly of ARM securities purchased from third
parties. The Company has designated all of its ARM securities as
available-for-sale. Therefore, they are reported at fair value, with
unrealized gains and losses reported in Accumulated other comprehensive
income (loss) as a separate component of shareholders equity. Any
unrealized loss deemed to be other than temporary is recorded as a
realized loss. Realized gains or losses on the sale of ARM securities are
recorded in earnings at the time of sale and are determined by the
difference between net sale proceeds and the amortized cost of the
securities.ARM Loans are designated as held-for-investment as the Company has the
intent and ability to hold them for the foreseeable future, and until
maturity or payoff. ARM Loans are carried at their unpaid principal
balances, including unamortized premium or discount, unamortized loan
origination costs, unamortized deferred loan origination fees and
allowance for loan losses.Securitized ARM loans are loans originated or acquired by the Company and
securitized by the Company with the Company retaining 100% of the
beneficial ownership interests.ARM loans collateralizing long-term debt are loans the Company has
securitized into sequentially rated classes with the lower rated classes
providing credit support for AAA certificates issued to third party
investors in structured financing arrangements.ARM loans held for securitization are loans the Company has acquired or
originated and are intended to be securitized and retained by the Company.The Company does not sell any of the securities created from its
securitizations to generate gain on sale income. The loan securitization
process benefits the Company by creating highly liquid securitized assets
that can be readily financed in the capital markets.Interest income on ARM assets is accrued based on the outstanding
principal amount and contractual terms of the assets. Premiums and discounts associated with the purchase of the ARM
assets are amortized into interest income over the lives of the assets
using the effective yield method, adjusted for the effects of estimated
prepayments. Estimating prepayments and estimating the remaining lives of
the Companys ARM assets requires management judgment, which involves
consideration of possible future interest rate environments and an
estimate of how borrowers will behave in those environments. The actual
lives could be more or less than the amount estimated by 9




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management. Loan origination fees, net of certain direct loan origination costs, are
deferred and amortized as an interest income yield adjustment over the
life of the related loans using the effective yield method. Mortgage servicing rights (MSRs)  The Company does not purchase MSRs, nor has the Company capitalized any
MSRs in connection with any sale transaction. MSRs are capitalized upon
the securitization of ARM loans as required by generally accepted
accounting principles by allocating a portion of the cost basis of the
securitized loans to the estimated value of the MSRs related to the loans
retained by the Company as collateral in securitizations. The servicing
spread, net of servicing costs and amortization, is recorded as Servicing
income, net on the Consolidated Income Statements, rather than being
accounted for as interest income.MSRs are carried at the lower of cost or fair value at the risk strata
level and are periodically evaluated for impairment using a discounted
future cash flow model that considers portfolio characteristics and
assumptions regarding prepayments speed, delinquency rates and other
economic factors. For purposes of evaluating and measuring impairment of
MSRs, the Company stratifies its portfolio on the basis of predominant
risk characteristics, including loan type (Traditional ARM or Hybrid ARM).MSRs are amortized in proportion to, and over the expected period of, the
estimated future net servicing income. Projected net servicing income is
determined by the estimated future balance of the underlying mortgage loan
portfolio, which declines over time from prepayments and scheduled loan
amortization. The Company estimates future prepayment rates based on
current interest rate levels, other economic conditions and market
forecasts, as well as relevant characteristics of the servicing portfolio,
such as loan types and recent prepayment experience. Estimating
prepayments and estimating the remaining lives of the Companys ARM assets
requires management judgment, which involves consideration of possible
future interest rate environments and an estimate of how borrowers will
behave in those environments. The actual lives could be more or less than
the amount estimated by management. Credit risk and allowance for loan losses  The Company limits its exposure to credit losses on its portfolio of ARM
securities by purchasing ARM securities that have an Investment Grade
rating at the time of purchase and have some form of credit enhancement,
or are guaranteed by an agency of the federal government (Ginnie Mae) or
a government-sponsored or federally-chartered corporation (Fannie Mae or
Freddie Mac) (collectively Agency Securities). An Investment Grade
security generally has a security rating of BBB, Baa or better by at least
one of two nationally recognized rating agencies, Standard & Poors, Inc.
or Moodys Investors Service, Inc. (the Rating Agencies). Additionally,
the Company purchases and originates ARM loans or purchases all classes of
a third party ARM loan securitization (including the classes rated less
than Investment Grade). When the Company acquires classes of securities
that are below Investment Grade the purchase price generally includes a
discount for probable credit losses. This reduction, or basis
adjustment, is recorded as part of the purchase price of that security.
Based upon managements use of analytical tools and judgment, a portion of
the purchase discount is subsequently accreted as interest income under
the effective yield method while the remaining portion of the purchase
discount is treated as a basis adjustment which reflects the estimated
unrealized loss on the securities due to credit loss and interest rate
exposure. In the event of impairment, the Company revises its estimate of
probable losses and any difference between the initial estimate and the
new estimate of losses is recorded in earnings. The Company limits its
exposure to credit losses by restricting its investment in Other
Investments to no more than 30% of total assets. Other Investments may
include, among other items, securities that are rated A or less by at
least one of the Rating Agencies at the time of purchase, including the
subordinate classes of securities retained as part of the Companys
securitization of loans or purchases of 100% of the classes from other
loan securitizations, and ARM loans held for securitization.The Company maintains an allowance for loan losses based on managements
estimate of credit losses inherent in the Companys portfolio of ARM
Loans. The estimation of the allowance is based on a variety of factors
including, but not limited to, current economic conditions, loan portfolio
composition, delinquency trends, credit losses to date on underlying loans
and remaining credit protection. If the credit performance of its ARM
Loans is different than expected, the Company adjusts the allowance for
loan losses to a level deemed appropriate by management to provide for
estimated losses inherent in its ARM Loan portfolio. Additionally, once a
loan is 90 days or more 10




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##### Table of Contents



delinquent, or a borrower declares bankruptcy, the
Company adjusts the value of its accrued interest receivable to what it
believes to be collectible and stops accruing interest on that loan.Provisions for credit losses do not reduce taxable income and thus do not
affect the dividends paid by the Company to shareholders in the period the
provisions are taken. Actual losses realized by the Company do reduce
taxable income in the period the actual loss is realized and would affect
the dividends paid to shareholders for that tax year. Valuation methods  The fair values of the Companys ARM securities, securitized ARM loans and
ARM loans collateralizing debt obligations are generally based on market
prices provided by third party pricing services or by certain dealers who
make markets in these financial instruments. If the fair value of an ARM
security or securitized ARM loan is not reasonably available from a dealer
or a third party pricing service, management estimates the fair value
based on characteristics of the security that the Company receives from
the issuer and on available market information.The fair values of ARM loans held for securitization are estimated by the
Company by using the same pricing models employed by the Company in the
process of determining a price to bid for loans in the open market, taking
into consideration the aggregated characteristics of groups of loans such
as, but not limited to, collateral type, index, interest rate, margin,
length of fixed-rate period, life cap, periodic cap, underwriting
standards, age and credit.The net unrealized gain on commitments to purchase ARM loans from
correspondent lenders and bulk sellers is calculated using the same
methodologies that are used to value the Companys ARM Loans, adjusted for
anticipated fallout for interest rate lock commitments that will likely
not be funded. The Companys net unrealized gain (loss) on purchase loan
commitments is recorded as a component of ARM loans, net on the
Consolidated Balance Sheets with the change in fair value recorded in Gain
(loss) on ARM assets and hedging instruments, net on the Consolidated
Income Statements.The fair values of the Companys CDOs, senior unsecured notes (Senior
Notes), interest rate swap agreements (Swap Agreements) and interest
rate cap agreements (Cap Agreements) are based on market values provided
by dealers who are familiar with the terms of these instruments.The fair value of Eurodollar futures contracts (Eurodollar Transactions)
is determined on a daily basis by the closing price on the Chicago
Mercantile Exchange.The fair values reported reflect estimates and may not necessarily be
indicative of the amounts the Company could realize if these instruments
were sold. Cash and cash equivalents, restricted cash and cash
equivalents, interest receivable, reverse repurchase agreements, other
borrowings and other liabilities are reflected in the financial statements
at their amortized cost, which approximates their fair value because of
the short-term nature of these instruments. Hedging Instruments  All of the Companys hedging instruments are derivative financial
instruments (Cap Agreements, Swap Agreements and Eurodollar futures
contracts) (collectively, Hedging Instruments) and are carried on the
Consolidated Balance Sheets at their fair value as an asset, if their fair
value is positive, or as a liability, if their fair value is negative. In
general, most of the Companys Hedging Instruments are designated as
cash flow hedges, and the effective amount of change in the fair value
of the derivative instrument is recorded in Accumulated other
comprehensive income (loss) and transferred to earnings as the hedged item affects
earnings. The ineffective amount of all Hedging Instruments is recognized
in earnings each quarter. Generally, a hedging strategy is effective if
it achieves offsetting cash flows attributable to the risk being hedged,
but if the hedging strategy is not successful in achieving offsetting cash
flows, it is ineffective. Certain Eurodollar Transactions have not been
designated as cash flow hedges since they are an economic hedge, hedging
the fair value change of the Companys purchase loan commitments. As
such, the change in their fair value is recorded in the Consolidated
Income Statements as Gain (loss) on ARM assets and hedging instruments,
net. 11




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As the Company enters into hedging transactions, it formally documents the
relationship between the Hedging Instruments and the hedged items. The
Company has also documented its risk-management policies, including
objectives and strategies, as they relate to its hedging activities. The
Company assesses, both at inception of a hedging activity and on an
on-going basis, whether or not the hedging activity is highly effective.
If it is determined that a hedge has been highly effective, but will not
be prospectively, the Company discontinues hedge accounting prospectively.Hybrid Hedging InstrumentsThe Company enters into Swap Agreements, Eurodollar Transactions and Cap
Agreements in order to manage its interest rate exposure when financing
its Hybrid ARM assets (collectively, Hybrid Hedging Instruments). The
Company generally borrows money based on short-term interest rates. The
Companys Hybrid ARM assets have an initial fixed interest rate period of
three to ten years. As a result, the Companys existing and forecasted
borrowings reprice to a new rate on a more frequent basis than do the
Companys Hybrid ARM assets. These Hybrid Hedging Instruments are used to
fix the interest rate on the Companys borrowings during the expected
fixed-rate period of the Companys Hybrid ARM assets such that the Company
maintains a duration on the borrowings and Hybrid Hedging Instruments that
closely matches the duration of the Companys Hybrid ARM assets. The
notional balances of the Hybrid Hedging Instruments generally decline over
the life of these instruments approximating the declining balance of the
Hybrid ARM assets being financed.Swap Agreements and Eurodollar Transactions have the effect of converting
the Companys variable-rate debt into fixed-rate debt over the life of the
Swap Agreements and Eurodollar Transactions. When the Company enters into
a Swap Agreement, it agrees to pay a fixed rate of interest and to receive
a variable interest rate, generally based on the London InterBank Offer
Rate (LIBOR). The Company also enters into Eurodollar Transactions in
order to fix the interest rate on its forecasted three-month LIBOR-based
liabilities.The Company also purchases Cap Agreements by incurring a one-time fee or
premium. Pursuant to the terms of the Cap Agreements, the Company will
receive cash payments if the interest rate index specified in any such Cap
Agreement increases above contractually specified levels. Therefore, such
Cap Agreements have the effect of capping the interest rate on a portion
of the Companys borrowings above a level specified by the Cap Agreement.
The purchase price of these Cap Agreements is expensed over the life of
the Cap Agreements and the expense increases as the Cap Agreements
approach maturity. Therefore, the expense in future periods is expected
to be greater than that experienced currently.The Company designates its Hybrid Hedging Instruments used to manage
interest rate exposure when financing its Hybrid ARM assets as cash flow
hedges. All changes in the unrealized gains and losses on Hybrid Hedging
Instruments have been recorded in Accumulated other comprehensive income
(loss) and are reclassified to earnings as interest expense when each of
the forecasted financing transactions occurs. If it becomes probable that
the forecasted transaction, which in this case refers to interest payments
to be made under the Companys short-term borrowing agreements or its debt
obligations, will not occur by the end of the originally specified time
period, as documented at the inception of the hedging relationship, or
within an additional two-month time period thereafter, then the related
gain or loss in Accumulated other comprehensive income (loss) would be
reclassified to income. The carrying value of these Hybrid Hedging
Instruments is included in Hedging instruments on the Consolidated Balance
Sheets.The unrealized gain/(loss) on Swap Agreements is based on the discounted
value of the remaining future net interest payments expected to be made
over the remaining life of the Swap Agreements. Therefore, over time, as
the actual payments are made, the unrealized gain/(loss) in Accumulated
other comprehensive income (loss) and the carrying value of the Swap
Agreements adjust to zero and the Company realizes a fixed cost of money
over the life of the Hedging Instrument.Life Cap Hedging InstrumentsThe Company also purchases Cap Agreements to manage interest rate risk on
the financing of a portion of its Traditional ARM assets that have a
contractual maximum interest rate (Life Cap), which is a component of
the fair value of an ARM asset (Life Cap Hedging Instruments). 12




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The Company does not currently apply hedge accounting to its Life Cap
Hedging Instruments and, as a result, the Company records the change in
fair value of these Cap Agreements as hedging expense in current earnings.
The carrying value of the Life Cap Hedging Instruments is included in
Hedging instruments on the Consolidated Balance Sheets.Pipeline Hedging InstrumentsThe Company enters into Eurodollar Transactions to manage interest rate
risk associated with commitments to purchase ARM loans (Pipeline Hedging
Instruments). The Company does not currently apply hedge accounting to
its Pipeline Hedging Instruments and, therefore, the change in fair value
and the realized gains (losses) on these Pipeline Hedging Instruments are
recorded in current earnings. The net gain (loss) related to Pipeline
Hedging Instruments is reflected in Gain (loss) on ARM assets and hedging
instruments, net on the Consolidated Income Statements as an offset to the
net gain (loss) recorded for the change in fair value of the loan
commitments. Accumulated other comprehensive income (loss)  The Financial Accounting Standard Boards Statement 130, Reporting
Comprehensive Income, divides comprehensive income into net income and
other comprehensive income (loss), which includes unrealized gains and
losses on marketable securities defined as available-for-sale, and
unrealized gains and losses on derivative financial instruments that
qualify for hedge accounting under Financial Accounting Standard 133,
Accounting for Derivative Instruments and Hedging Activities.The net unrealized gain on the Companys ARM Loans of $20.0 million and
$7.9 million at June 30, 2004 and December 31, 2003, respectively, is not
included in Accumulated other comprehensive income (loss) because, in
accordance with generally accepted accounting principles, the ARM Loans
are carried at their amortized cost basis. Income taxes  The Company, excluding TMHL and its subsidiaries, elected to be taxed as a
REIT and believes it complies with the provisions of the Internal Revenue
Code of 1986, as amended (the Code) with respect thereto. Accordingly,
the Company will not be subject to Federal income tax on that portion of
its income that is distributed to shareholders, as long as certain asset,
income and stock ownership tests are met. TMHL and each of its
subsidiaries made the election to be taxable REIT subsidiaries as of the
close of business on May 31, 2004 and, as such, are subject to both
federal and state corporate income tax after that date. For the month
ended June 30, 2004, TMHL had an immaterial taxable loss and did not
record a tax provision. Net earnings per share  Basic earnings per share (EPS) amounts are computed by dividing net
income (adjusted for dividends declared on preferred stock) by the
weighted average number of common shares outstanding. Diluted EPS amounts
assume the conversion, exercise or issuance of all potential common stock
instruments, unless the effect is to reduce a loss or increase the
earnings per common share.Following is information about the computation of the EPS data for the
three- and six-month periods ended June 30, 2004 and 2003 (in thousands
except per share data): 13




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##### Table of Contents



EarningsIncome
    
    Shares
    
    Per ShareThree Months Ended June 30, 2004Net income
    
    $
    57,899Basic and Diluted EPS, income available to
common shareholders
    
    $
    57,899
    
    
    
    81,373
    
    
    $
    0.71Three Months Ended June 30, 2003Net income
    
    $
    42,192Less preferred stock dividends
    
    
    (1,670
    )Basic EPS, income available to common shareholders
    
    
    40,522
    
    
    
    59,879
    
    
    $
    0.68Effect of dilutive securities:Convertible preferred stock
    
    
    1,670
    
    
    
    2,760Diluted EPS
    
    $
    42,192
    
    
    
    62,639
    
    
    $
    0.67
 EarningsIncome
    
    Shares
    
    Per ShareSix Months Ended June 30, 2004Net income
    
    $
    111,262Basic and Diluted EPS, income available to
common shareholders
    
    $
    111,262
    
    
    
    79,002
    
    
    $
    1.41Six Months Ended June 30, 2003Net income
    
    $
    81,266Less preferred stock dividends
    
    
    (3,340
    )Basic EPS, income available to common shareholders
    
    
    77,926
    
    
    
    57,767
    
    
    $
    1.35Effect of dilutive securities:Convertible preferred stock
    
    
    3,340
    
    
    
    2,760Diluted EPS
    
    $
    81,266
    
    
    
    60,527
    
    
    $
    1.34
 Use of estimates  The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the
financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those
estimates. 14




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##### Table of Contents



Note 2. Adjustable-Rate Mortgage Assets  The following tables present the Companys ARM assets as of June 30,
2004 and December 31, 2003 (in thousands): ARM loans
    
    ARM loansARM
    
    Securitized
    
    collateralizing
    
    held forJune 30, 2004
    
    securities
    
    ARM loans
    
    debt obligations
    
    securitization
    
    TotalPrincipal balance outstanding
    
    $
    14,409,869
    
    
    $
    3,244,909
    
    
    $
    4,850,983
    
    
    $
    522,170
    
    
    $
    23,027,931Net unamortized premium (discount)
    
    
    217,396
    
    
    
    17,829
    
    
    
    22,441
    
    
    
    (2,378
    )
    
    
    255,288Loan loss reserves
    
    
    
    
    
    
    (7,194
    )
    
    
    (1,374
    )
    
    
    (250
    )
    
    
    (8,818
    )Basis adjustments
    
    
    (3,813
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,813
    )Net unrealized gain on purchase
loan commitments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    928
    
    
    
    928Principal payment receivable
    
    
    23,564
    
    
    
    7,925
    
    
    
    
    
    
    
    
    
    
    
    31,489Amortized cost, net
    
    
    14,647,016
    
    
    
    3,263,469
    
    
    
    4,872,050
    
    
    
    520,470
    
    
    
    23,303,005Gross unrealized gains
    
    
    13,762
    
    
    
    11,386
    
    
    
    40,901
    
    
    
    3,445
    
    
    
    69,494Gross unrealized losses
    
    
    (226,647
    )
    
    
    (34,513
    )
    
    
    
    
    
    
    (1,223
    )
    
    
    (262,383
    )Fair value
    
    $
    14,434,131
    
    
    $
    3,240,342
    
    
    $
    4,912,951
    
    
    $
    522,692
    
    
    $
    23,110,116Carrying value
    
    $
    14,434,131
    
    
    $
    3,263,469
    
    
    $
    4,872,050
    
    
    $
    520,470
    
    
    $
    23,090,120
 ARM loans
    
    ARM loansARM
    
    Securitized
    
    collateralizing
    
    held forDecember 30, 2003
    
    securities
    
    ARM loans
    
    debt obligations
    
    securitization
    
    TotalPrincipal balance outstanding
    
    $
    11,368,988
    
    
    $
    3,664,183
    
    
    $
    3,130,008
    
    
    $
    494,271
    
    
    $
    18,657,450Net unamortized premium
    
    
    183,559
    
    
    
    23,561
    
    
    
    18,036
    
    
    
    2,435
    
    
    
    227,591Loan loss reserves
    
    
    
    
    
    
    (6,660
    )
    
    
    (1,083
    )
    
    
    (250
    )
    
    
    (7,993
    )Basis adjustments
    
    
    (3,395
    )
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    (3,395
    )Net unrealized gain on purchase
loan commitments
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    542
    
    
    
    542Principal payment receivable
    
    
    14,306
    

    
    
    6,382
    
    
    
    
    
    
    
    
    
    
    
    20,688Amortized cost, net
    
    
    11,563,458
    
    
    
    3,687,466
    
    
    
    3,146,961
    
    
    
    496,998
    
    
    
    18,894,883Gross unrealized gains
    
    
    40,373
    
    
    
    28,988

    
    
    
    6,249
    
    
    
    1,158
    
    
    
    76,768Gross unrealized losses
    
    
    (83,090
    )
    
    
    (13,034
    )
    
    
    (14,576
    )
    
    
    (885
    )
    
    
    (111,585
    )Fair value
    
    $
    11,520,741
    
    
    $
    3,703,420
    
    
    $
    3,138,634
    
    
    $
    497,271
    
    
    $
    18,860,066Carrying value
    
    $
    11,520,741
    
    
    $
    3,687,466
    
    
    $
    3,146,961
    
    
    $
    496,998
    
    
    $
    18,852,166
  The Company recorded a net gain on ARM assets and hedging instruments
of $2.6 million during the six months ended June 30, 2004. This gain
consists of a $3.2 million gain on the sale of $345.5 million of ARM
assets, a gain of $6.5 million on Eurodollar Transactions hedging the
loan commitment pipeline and a $2.1 million realized gain on the
termination of three Swap Agreements, partially offset by a net loss of
$9.2 million on commitments to purchase loans from correspondent
lenders and bulk sellers. The Company realized a gain on ARM assets of
$2.6 million during the six months ended June 30, 2003. This gain
consists of a $1.7 million net recovery of estimated credit losses and
a $910.5 thousand gain upon the maturity of a collateralized bond
obligation.During the six months ended June 30, 2004, the Company securitized $2.2
billion of its ARM loans into a series of private-label multi-class ARM
securities. The Company retained $35.6 million of the securities
created for its securitized ARM loan portfolio and placed $2.1 billion
of the securities with third party investors, thereby providing
long-term collateralized financing for the Companys assets. Of the
securities retained by the Company, $27.5 million were rated Investment
Grade and $8.1 million were rated less than Investment Grade. These
securities and interest-only subordinate certificates also retained by
the Company provide credit support to the securitizations. The Company
did not account for these securitizations as sales and, therefore, did
not record any gain or loss in connection with the securitizations. As
of June 30, 2004, the Company had $8.2 billion of ARM assets that have
resulted from the Companys securitization efforts. 15




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MSRs capitalized upon the securitization of $2.2 billion of ARM loans
during the six months ended June 30, 2004 totaled $7.7 million. MSRs
of $14.4 million, net of amortization during the six months ended June
30, 2004 of $1.9 million, are included in Prepaid expenses and other on
the Consolidated Balance Sheets at June 30, 2004. MSRs of $8.6
million, net of amortization, are included in Prepaid expenses and
other on the Consolidated Balance Sheets at December 31, 2003. At
June 30, 2004, the fair value of the MSRs in each risk stratum exceeded
their cost basis.As of June 30, 2004 and December 31, 2003, the Company had basis
adjustments of $3.8 million and $3.4 million, respectively, on its ARM
securities due to estimated credit losses (other than temporary
declines in fair value) related to ARM securities purchased at a
discount. As part of its purchase price, the Company recorded basis
adjustments of $988.7 thousand related to ARM securities purchased
during the first six months of 2004 on which the Company had first loss
credit exposure. These securities were purchased as part of $1.1
billion of third party loan securitizations in which the Company
purchased all classes of the securitizations, including the
subordinated classes.During the six months ended June 30, 2004, the Company recorded loan
loss provisions totaling $822.8 thousand to reserve for estimated
credit losses on ARM Loans bringing its total loan loss reserve to $8.8
million.The following table shows the gross unrealized losses and fair value of
ARM securities, aggregated by credit rating and length of time that the
451 individual securities have been in a continuous unrealized loss
position, at June 30, 2004 (dollar amounts in thousands): Unrealized Losses on ARM Securities as of June 30, 2004 Less Than 12 Months
    
    12 Months or More
    
    TotalUnrealized
    
    
    
    
    
    Unrealized
    
    Fair
    
    UnrealizedFair Value
    
    Loss
    
    Fair Value
    
    Loss
    
    Value
    
    LossAgency Securities
    
    $
    1,722,016
    
    
    $
    (18,596
    )
    
    $
    258,527
    
    
    $
    (4,188
    )
    
    $
    1,980,543
    
    
    $
    (22,784
    )AAA/Aaa Rating
    
    
    8,635,316
    
    
    
    (142,352
    )
    
    
    1,340,701
    
    
    
    (47,842
    )
    
    
    9,976,017
    
    
    

    (190,194
    )AA/Aa Rating
    
    
    131,258
    
    
    
    (2,263
    )
    
    
    31,785
    
    
    
    (9,428
    )
    
    
    163,043
    
    
    
    (11,691
    )A Rating
    
    
    29,583
    
    
    
    (386
    )
    
    
    3,138
    
    
    
    (109
    )
    
    
    32,721
    
    
    
    (495
    )BBB/Baa Rating
    
    
    9,950
    
    
    
    (224
    )
    
    
    5,638
    
    
    
    (941
    )
    
    
    15,588
    
    
    
    (1,165
    )BB/Ba Rating and
Below
    
    
    7,899
    
    
    
    (265
    )
    
    
    484
    
    
    
    (53
    )
    
    
    8,383
    
    
    
    (318
    )Total
    
    $
    10,536,022
    
    
    $
    (164,086
    )
    
    $
    1,640,273
    
    
    $
    (62,561
    )
    
    $
    12,176,295
    
    
    $
    (226,647
    )
  The unrealized losses in the above table are temporary impairments due
to changes in market interest rates and, based upon review of credit
ratings, delinquency data and other information, are not reflective of
credit deterioration. As presented in Note 7, during the six-month
period ended June 30, 2004, the net unrealized loss of $43.3 million on
ARM securities increased by $169.9 million to a net unrealized loss of
$213.2 million. During the same six-month period, the net unrealized
loss on hedging instruments of $99.5 million improved by $181.2 million
to a net unrealized gain of $81.7 million, for a combined improvement
of the net unrealized loss on ARM securities and hedging instruments of
$11.3 million. Furthermore, although the Companys ARM securities are
designated as available-for-sale, the Company does not typically sell
its ARM securities and therefore does not expect to realize these gross
unrealized losses. 16




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##### Table of Contents



The Company has credit exposure on its ARM Loans. The following tables
summarize ARM Loan delinquency information as of June 30, 2004 and
December 31, 2003 (in thousands, except for loan count): June 30, 2004Percent of
    
    Percent ofLoan
    
    Loan
    
    ARM
    
    TotalDelinquency Status
    
    Count
    
    Balance
    
    Loans
    
    Assets60 to 89 days
    
    
    2
    
    
    $
    1,857
    
    
    
    0.02
    %
    
    
    0.00
    %90 days or more
    
    
    0
    
    
    
    
    
    
    
    0.00
    
    
    
    0.00In bankruptcy and
foreclosure
    
    
    9
    
    
    
    2,692
    
    
    
    0.03
    
    
    
    0.0111
    
    
    $
    4,549
    
    
    
    0.05
    %
    
    
    0.01
    %
 December 31, 2003Percent of
    
    Percent ofLoan
    
    Loan
    
    ARM
    
    TotalDelinquency Status
    
    Count
    
    Balance
    
    Loans
    
    Assets60 to 89 days
    
    
    0
    
    
    $
    
    
    
    
    0.00
    %
    
    
    0.00
    %90 days or more
    
    
    0
    
    
    
    
    
    
    
    0.00
    
    
    
    0.00In bankruptcy and
foreclosure
    
    
    12
    
    
    
    3,501
    
    
    
    0.05
    
    
    
    0.0212
    
    
    $
    3,501
    
    
    
    0.05
    %
    
    
    0.02
    %
  As of June 30, 2004, the Company had commitments to purchase or
originate the following amounts of ARM assets (in thousands): ARM securities  private high quality
    
    $
    332,836ARM loans  correspondent originations
    
    
    717,086ARM loans  direct originations
    
    
    85,821$
    1,135,743
  The Company has entered into transactions whereby the Company expects
to acquire the remaining balance of certain AAA-rated Hybrid ARM
securities, at a price of par, between 2004 and 2008, when the
fixed-rate period of the Hybrid ARM securities terminates and the
securities convert into Traditional ARM securities with characteristics
similar to the Traditional ARM securities held in the current
portfolio. The Company views these transactions as an alternative
source of Traditional ARM assets. The current balance of the Hybrid
ARM securities is approximately $1.8 billion, but is expected to be
less than 28% of that, and could be zero, at the time they convert into
Traditional ARM securities. If the Company decides not to acquire the
Hybrid ARM securities when they convert into Traditional ARM
securities, then it is committed to pay or receive the difference
between par and the fair value of the Traditional ARM securities at
that time, as determined by an auction of the Traditional ARM
securities. The Company received a premium of $2.3 million related to
these transactions, which is being amortized over the declining balance
of the related securities. As of June 30, 2004, the Company had
delivered ARM assets with a carrying value of $6.4 million and $3.1
million in cash as collateral in connection with these transactions. Note 3. Hedging Instruments Hybrid Hedging Instruments  As of June 30, 2004 and December 31, 2003, the Company was counterparty
to Swap Agreements and Eurodollar Transactions having aggregate current
notional balances of $15.7 billion and $12.5 billion, respectively. In
addition, as of June 30, 2004, the Company had entered into delayed
Swap Agreements with 17




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##### Table of Contents



notional balances totaling $661 million that
become effective in July 2004. As of June 30, 2004, these Swap
Agreements and Eurodollar Transactions had a weighted average maturity
of 3.3 years. In accordance with the Swap Agreements, the Company will
pay a fixed rate of interest during the term of these Swap Agreements
and receive a payment that varies monthly with the one-month LIBOR
rate. The combined weighted average fixed rate payable of the Swap
Agreements and Eurodollar Transactions was 2.99% and 3.02% at June 30,
2004 and December 31, 2003, respectively. As of June 30, 2004, ARM
assets with a carrying value of $84.1 million, including accrued
interest, and cash totaling $40.1 million collateralized the Swap
Agreements and Eurodollar Transactions.The net unrealized gain on Swap Agreements at June 30, 2004 of $95.0
million included Swap Agreements with gross unrealized gains of $129.2
million and gross unrealized losses of $34.2 million and is included in
Hedging instruments on the Consolidated Balance Sheets. As of December
31, 2003, the net unrealized loss of $85.5 million included Swap
Agreements with gross unrealized gains of $14.9 million and gross
unrealized losses of $100.4 million.As of June 30, 2004, the net unrealized gain on Swap Agreements and
deferred gains and losses on Eurodollar Transactions recorded in
Accumulated other comprehensive income (loss) was a net gain of $91.2
million. The Company estimates that over the next twelve months,
$104.3 million of these net unrealized gains will be reclassified from
Accumulated other comprehensive income (loss) to interest expense.As of June 30, 2004 and December 31, 2003, the Companys Cap
Agreements, used to manage its interest rate risk exposure on the
financing of the Hybrid ARM loans collateralizing the Companys CDOs,
had remaining notional amounts of $1.4 billion and $1.6 billion,
respectively. The Company has also entered into Cap Agreements that
have start dates ranging from 2006 to 2010 and notional balances
totaling $371.1 million. The fair value of all of these Cap Agreements
at June 30, 2004 and December 31, 2003 was $27.1 million and $25.4
million, respectively, and is included in Hedging instruments on the
Consolidated Balance Sheets. As of June 30, 2004, the unrealized loss
on these Cap Agreements of $9.4 million is included in Accumulated
other comprehensive income (loss). In the twelve month period
following June 30, 2004, $983.2 thousand of this unrealized loss is
expected to be realized. Pursuant to the terms of these Cap Agreements
and subject to future prepayment behavior, the notional amount of the
Cap Agreements declines such that it is expected to equal the balance
of the Hybrid ARM loans collateralizing the Companys CDOs. Under
these Cap Agreements, the Company will receive cash payments should the
one-month LIBOR increase above the contract rates of these Hedging
Instruments, which range from 3.25% to 11.50% and average 5.05%. The
Cap Agreements had an average maturity of 4.3 years as of June 30, 2004
and will expire between 2006 and 2013.The Company hedges the funding of its Hybrid ARM assets such that the
weighted average net duration of borrowed funds, Hybrid Hedging
Instruments and Hybrid ARM assets is less than one year. See a
discussion of duration and net duration under Portfolio Strategies on
page 31. At June 30, 2004, the financing and hedging of the Companys
Hybrid ARM assets resulted in a net duration of approximately 4.6
months while the financing and hedging of all of the Companys ARM
assets resulted in a net duration of approximately 4.2 months, which
suggests a very low degree of portfolio price change given increases in interest rates,
which implies that our cash flow and earning characteristics should be relatively stable for comparable changes in interest rates.Interest expense for the quarter and six-month period ended June 30,
2004 includes net payments on Hybrid Hedging Instruments of $66.8
million and $128.3 million, respectively. Interest expense for the
same periods in 2003 includes net payments on Hybrid Hedging
Instruments of $35.3 million and $66.7 million, respectively. Life Cap Hedging Instruments  The Life Cap Hedging Instruments had a fair value of $0 at June 30,
2004, compared to a fair value of $9.0 thousand at December 31, 2003,
and are included in Hedging instruments on the Consolidated Balance
Sheets. These Cap Agreements had a remaining notional amount of $440.0
million and $841.3 million as of June 30, 2004 and December 31, 2003,
respectively. The notional amount of the Life Cap Hedging Instruments
declines at a rate that is expected to approximate the amortization of the
Traditional ARM assets. The Company will receive cash payments should
the one-month or three-month LIBOR increase above the contract rates of
these Hedging Instruments, which range from 8.00% to 11.50% and average
9.90%. The Life Cap Hedging Instruments had an average final maturity
of 4 months as of June 30, 2004 and expire between 2004 and 2005. 18




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##### Table of Contents



During the three- and six-month periods ended June 30, 2004, the
Company recognized expenses of $149.2 thousand and $307.4 thousand,
respectively, which is reported as Hedging expense in the Companys
Consolidated Income Statements. During the three- and six-month
periods ended June 30, 2003, the Company recognized expenses of $219.8
thousand and $396.9 thousand, respectively. Pipeline Hedging Instruments  The fair value of the Pipeline Hedging Instruments at June 30, 2004 and
December 31, 2003 was $2.8 million and $953.4 thousand, respectively,
and is included in Hedging instruments on the Consolidated Balance
Sheets. Pipeline Hedging Instruments had remaining notional balances
of $465.0 million and $283.0 million at June 30, 2004 and December 31,
2003, respectively. During the three- and six-month periods ended June
30, 2004, the Company recognized a $10.0 million gain and a $6.5
million gain, respectively, on Pipeline Hedging Instruments, which is
included in Gain (loss) on ARM assets and hedging instruments, net in
the Companys Consolidated Income Statements and partially offsets the
$9.2 million loss recorded on loan commitments pursuant to SFAS 149,
Amendment of Statement 133 on Derivative Instruments and Hedging
Activities, issued by the Financial Accounting Standards Board in
April 2003. Note 4. Borrowings Reverse Repurchase Agreements  The Company has arrangements to enter into reverse repurchase
agreements, a form of collateralized short-term borrowing, with 24
different financial institutions, and as of June 30, 2004, had borrowed
funds from 18 of these firms. Because the Company borrows money under
these agreements based on the fair value of its ARM assets, and because
changes in interest rates can negatively impact the valuation of ARM
assets, the Companys borrowing ability under these agreements could be
limited and lenders could initiate margin calls in the event interest
rates change or the value of the Companys ARM assets declines for
other reasons.As of June 30, 2004, the Company had $17.5 billion of reverse
repurchase agreements outstanding with a weighted average borrowing
rate of 1.37% and a weighted average remaining maturity of 2.9 months.
As of December 31, 2003, the Company had $13.9 billion of reverse
repurchase agreements outstanding with a weighted average borrowing
rate of 1.25% and a weighted average remaining maturity of 4.9 months.
As of June 30, 2004, $13.3 billion of the Companys borrowings were
variable-rate term reverse repurchase agreements with original
maturities that range from one to twenty-five months. The interest
rates of these term reverse repurchase agreements are indexed to either
the one- or three-month LIBOR rate and reprice accordingly. ARM assets
with a carrying value of $18.3 billion, including accrued interest, and
cash totaling $257.0 million, collateralized the reverse repurchase
agreements at June 30, 2004. As of June 30, 2004, Citigroup Inc. holds
collateral with a fair value, in excess of reverse repurchase
borrowings with a weighted average maturity of 1.9 months, of $184.5
million.At June 30, 2004, the reverse repurchase agreements had the following
remaining maturities (in thousands): Within 30 days
    
    $
    5,822,19231 to 89 days
    
    
    3,011,98290 to 365 days
    
    
    8,553,340Over 365 days
    
    
    105,475$
    17,492,989
 CDOs  On June 30, 2004, $1.1 billion of ARM loans from the Companys ARM loan
portfolio were transferred to Thornburg Mortgage Securities Trust
2004-2 and were securitized. In this transaction, the Company issued
AAA-rated floating-rate pass-through certificates totaling $1.0 billion
to third party investors and retained the subordinated certificates,
which provide credit support to the AAA certificates. The interest
rates on the floating-rate pass-through certificates reset monthly and
are indexed to the one-month LIBOR rate. In 19




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##### Table of Contents



connection with the issuance of these CDOs, the Company incurred costs of $4.5 million,
which were deducted from the proceeds of the transaction and are being
amortized over the expected life of the CDOs. This transaction was
accounted for as a financing of loans and represents permanent
financing that is not subject to margin calls.All of the Companys CDOs were issued by trusts and are secured by its
ARM loans. For financial reporting and tax purposes, the trusts ARM
loans held as collateral are recorded as assets of the Company and the
CDOs are recorded as the Companys debt. In some transactions, Hedging
Instruments are held by the trusts and recorded as assets or
liabilities of the Company. The Hedging Instruments either fix the
interest rate of the pass-through certificates or cap the interest rate
exposure on these transactions. As of June 30, 2004, the following
CDOs were outstanding (in thousands): EffectiveInterestDescription
    
    Principal Balance
    
    Rate (1)Floating-rate financing (2)
    
    $
    2,895,312
    
    
    
    1.64
    %Fixed-rate financing
    
    
    1,928,039
    
    
    
    3.87
    %Total
    
    $
    4,823,351
    
    
    
    2.53
    %
  (1)
    
    Effective interest rate includes the impact of issuance
costs and Hedging Instruments.(2)
    
    Includes financing hedged with Cap Agreements with a
notional balance of $1.4 billion and a weighted average strike
price of 5.05% as of June 30, 2004.  As of June 30, 2004, the CDOs were collateralized by ARM loans
with a principal balance of $4.9 billion. The debt matures between
2033 and 2044 and is callable by the Company at par once the total
balance of the loans collateralizing the debt is reduced to 20% of
their original balance. The balance of this debt is reduced as the
underlying loan collateral is paid down and is expected to have an
average life of approximately four years. Whole Loan Financing Facilities  As of June 30, 2004, the Company had entered into four whole loan
financing facilities. The interest rates on these facilities are
indexed to one-month LIBOR and reprice accordingly. These facilities
have a total committed borrowing capacity of $1.1 billion and an
uncommitted capacity of $500 million and expire between September 2004
and March 2005. The Company expects to renew these facilities. As of
June 30, 2004, the Company had $294.8 million borrowed against these
whole loan financing facilities at an effective cost of 2.31%. As of
December 31, 2003, the Company had $369.3 million borrowed against
whole loan financing facilities at an effective cost of 2.32%. The
amount borrowed on the whole loan financing facilities at June 30, 2004
was collateralized by ARM loans with a carrying value of $304.8
million, including accrued interest. These facilities have covenants
that are standard for industry practice; the Company was in compliance
with all such covenants at June 30, 2004.One of the whole loan financing facilities discussed above (with a
committed borrowing capacity of $300 million and maturing in March
2005), is a securitization transaction in which the Company transfers
groups of whole loans to a wholly owned bankruptcy-remote special
purpose subsidiary. The subsidiary, in turn, simultaneously transfers
its interest in the loans to a trust, which issues beneficial interests
in the loans in the form of a note and a subordinated certificate. The
note is then used to collateralize borrowings. This whole loan
financing facility is similar to a secured line of credit whereby the
Company can deliver loans into the facility and take loans out of
the facility at the Companys discretion, subject to the terms and
conditions of the facility. This securitization transaction is
accounted for as a secured borrowing. Senior Notes  In 2003, the Company issued $255.0 million in Senior Notes. The Senior
Notes bear interest at 8.0%, payable each May 15 and November 15, and
mature on May 15, 2013. The Senior Notes are redeemable at a declining 20




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##### Table of Contents



premium, in whole or in part, beginning on May 15, 2008, and at par
beginning on May 15, 2011. The Senior Notes may also be redeemed under
limited circumstances on or before May 15, 2006. In connection with
the issuance of the Senior Notes, the Company incurred costs of $4.5
million, which are being amortized to interest expense over the
expected life of the Senior Notes. At June 30, 2004 and December 31,
2003, the balance of the Senior Notes outstanding, net of unamortized
issuance costs, was $251.3 million and $251.1 million, respectively.The Companys Senior Note obligations contain both financial and
non-financial covenants. Significant financial covenants include
limitations on the Companys ability to incur indebtedness beyond
specified levels, restrictions on the Companys ability to incur liens
on assets and limitations on the amount and type of restricted
payments, such as repurchases of its own equity securities, that the
Company makes. As of June 30, 2004, the Company was in compliance with
all financial and non-financial covenants on its Senior Note
obligations. Other  The total cash paid for interest was $145.7 million and $77.6 million
for the quarters ended June 30, 2004 and 2003, respectively, and $266.1
million and $146.6 million for the six months ended June 30, 2004 and
2003, respectively.On June 30, 2004, the Company established a new $5 billion asset-backed
commercial paper facility, which will provide an alternative way to
finance the Companys high quality ARM securities portfolio. Through a
wholly owned bankruptcyremote special purpose subsidiary, the Company
will issue asset-backed commercial paper in the form of secured
liquidity notes that will be recorded as borrowings on the Companys
Consolidated Balance Sheets and have been rated P-1 by Moodys
Investors Services and F1+ by Fitch Ratings to money market investors.
These notes are generally collateralized by agency and AAA-rated
mortgage-backed securities from the Companys ARM securities portfolio Contractual Obligations  As of June 30, 2004, the Company had the following contractual
obligations (in thousands): Payments Due by PeriodLess than
    
    
    
    
    
    3  5
    
    More thanTotal
    
    1 year
    
    1  3 years
    
    years
    
    5 yearsReverse repurchase agreements
    
    $
    17,492,989
    
    
    $
    17,387,514
    
    
    $
    105,475
    
    
    $
    
    
    
    $
    CDOs (1)
    
    
    4,823,351
    
    
    
    10,110
    
    
    
    22,755
    
    
    
    49,740
    
    
    
    4,740,746Whole loan financing facilities
    
    
    294,763
    
    
    
    294,763
    
    
    
    
    
    
    
    
    
    
    
    Senior Notes
    
    
    251,263
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    251,263Purchase commitments
    
    
    1,135,743
    
    
    
    1,135,743
    
    
    
    
    
    
    
    
    
    
    
    Total (2)
    
    $
    23,998,109
    
    
    $
    18,828,130
    
    
    $
    128,230
    
    
    $
    49,740
    
    
    $
    4,992,009
  (1)
    
    Maturities of the Companys CDOs are dependent upon cash
flows received from the underlying loans receivable. The estimate
of their repayment is based on scheduled principal payments on the
underlying loans receivable. This estimate will differ from actual
amounts to the extent prepayments and/or loan losses are
experienced.(2)
    
    The Consolidated Balance Sheets include a liability for
Hedging Instruments with negative market values, which are not
reflected in this table. 21




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##### Table of Contents



Note 5. Fair Value of Financial Instruments and Off-Balance Sheet Credit Risk  The following table presents the carrying amounts and estimated fair
values of the Companys financial instruments at June 30, 2004 and
December 31, 2003 (in thousands): June 30, 2004
    
    December 31, 2003Carrying
    
    Fair
    
    Carrying
    
    FairAmount
    
    Value
    
    Amount
    
    ValueAssets:ARM securities
    
    $
    14,434,131
    
    
    $
    14,434,131
    
    
    $
    11,520,741
    
    
    $
    11,520,741Securitized ARM loans
    
    
    3,263,469
    
    
    
    3,240,342
    
    
    
    3,687,466
    
    
    
    3,703,420ARM loans collateralizing CDOs
    
    
    4,872,050
    
    
    
    4,912,951
    
    
    
    3,146,961
    
    
    
    3,138,634ARM loans held for securitization
    
    
    520,470
    
    
    
    522,692
    
    
    
    496,998
    
    
    
    497,271Hedging instruments
    
    
    156,228
    
    
    
    156,228
    
    
    
    40,356
    
    
    
    40,356Liabilities:Reverse repurchase agreements
    
    
    17,492,989
    
    
    
    17,492,989
    
    
    
    13,926,858
    
    
    
    13,926,858CDOs
    
    
    4,823,351
    
    
    
    4,825,185
    
    
    
    3,114,047
    
    
    
    3,134,560Whole loan financing facilities
    
    
    294,763
    
    
    
    294,763
    
    
    
    369,343
    
    
    
    369,343Senior Notes
    
    
    251,263
    
    
    
    258,825
    
    
    
    251,080
    
    
    
    267,750Hedging instruments
    
    
    37,286
    
    
    
    37,286
    
    
    
    113,518
    
    
    
    113,518
 Note 6. Common Stock  During February 2004, the Company completed a public offering of
4,000,000 shares of common stock and received net proceeds of $110.1
million.During the three- and six-month periods ended June 30, 2004, the
Company issued 1,186,300 and 1,884,700 shares, respectively, of common
stock through at-market transactions and received net proceeds of $31.9
million and $51.1 million, respectively, under controlled equity
offering programs.During the three- and six-month periods ended June 30, 2004, the
Company issued 1,802,944 and 3,154,650 shares, respectively, of common
stock under the Dividend Reinvestment and Stock Purchase Plan (the
DRSPP) and received net proceeds of $46.7 million and $85.5 million,
respectively.As of June 30, 2004, $598.2 million of the Companys registered
securities remained available for future issuance and sale under its
shelf registration statement, declared effective on January 21, 2004.For federal income tax purposes, all dividends are expected to be
ordinary income to the Companys common shareholders, subject to
year-end allocations of the dividend between ordinary income, capital
gain income and non-taxable income as return of capital, depending on
the amount and character of the Companys full year taxable income. 22




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##### Table of Contents



Note 7. Comprehensive Income (Loss)  Comprehensive income is composed of net income and other comprehensive
income (loss), which includes the change in unrealized gains and losses
on available-for-sale ARM securities and Hedging Instruments. The
following table presents other comprehensive income (loss) (OCI)
balances (in thousands): Unrealized
    
    AccumulatedUnrealized
    
    (losses) gains
    
    Othergains (losses)
    
    on Hedging
    
    Comprehensiveon ARM securities
    
    Instruments
    
    LossBalance, December 31, 2002
    
    $
    43,489
    
    
    $
    (148,743
    )
    
    $
    (105,254
    )Net change
    
    
    13,042
    
    
    
    (54,904
    )
    
    
    (41,862
    )Balance, June 30, 2003
    
    $
    56,531
    
    
    $
    (203,647
    )
    
    $
    (147,116
    )Balance, December 31, 2003
    
    $
    (43,314
    )
    
    $
    (99,464
    )
    
    $
    (142,778
    )Net change
    
    
    (169,870
    )
    
    
    181,207
    
    
    
    11,337Balance, June 30, 2004
    
    $
    (213,184
    )
    
    $
    81,743
    
    
    $
    (131,441
    )
  The net unrealized gain on the Companys ARM Loans of $20.0 million and
$7.9 million at June 30, 2004 and December 31, 2003, respectively, is
not included in Accumulated other comprehensive income (loss) because,
in accordance with generally accepted accounting principles, the ARM
Loans are carried at their amortized cost basis. Note 8. Long-Term Incentive Awards  The Compensation Committee of the Companys Board of Directors is
authorized to grant Dividend Equivalent Rights (DERs), Stock
Appreciation Rights (SARs) and Phantom Stock Rights (PSRs) pursuant
to the Companys Amended and Restated 2002 Long-Term Incentive Plan, as
amended (the Plan).As of June 30, 2004, there were 1,493,772 DERs outstanding all of which
were vested, and 808,038 PSRs outstanding, of which 636,618 were
vested. The Company recorded income associated with DERs and PSRs of
$344.1 thousand and an expense of $3.1 million for the quarters ended
June 30, 2004 and 2003, respectively. Of the income recorded in the
second quarter of 2004, $2.3 million was the impact of the decrease in
the Companys common stock price on the value of the PSRs which was
recorded as a fair value adjustment, partially offset by a $1.4 million
expense associated with dividend equivalents paid on DERs and PSRs and
a $511.5 thousand expense related to the amortization of unvested PSRs.
Of the expense recorded in the second quarter of 2003, $1.2 million
was the amount of dividend equivalents paid on DERs and PSRs, $320.9
thousand was the amortization of unvested PSRs, and $1.6 million was
the impact of the increase in the Companys common stock price on the
value of the PSRs which was recorded as a fair value adjustment.
During the six-month periods ended June 30, 2004 and 2003, the Company
recorded an expense associated with DERs and PSRs in the amount of $4.2
million and $4.7 million, respectively. Note 9. Transactions with Related Parties  The Company is managed externally by Thornburg Mortgage Advisory
Corporation (the Manager) under the terms of a Management Agreement
(the Agreement). During the quarters ended June 30, 2004 and 2003,
the Company reimbursed the Manager $1.5 million and $1.1 million for
expenses, respectively, in accordance with the terms of the Agreement.
During the six-month periods ended June 30, 2004 and 2003, the Company
reimbursed the Manager and other Thornburg entities $2.8 million and
$2.2 million for expenses, respectively. As of June 30, 2004 and 2003,
$2.0 million and $1.4 million, respectively, was payable by the Company
to the Manager for these reimbursable expenses. 23




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For the quarters ended June 30, 2004 and 2003, the Company incurred
costs of $3.9 million and $2.7 million, respectively, in base
management fees in accordance with the terms of the Agreement. For the
six-month periods ended June 30, 2004 and 2003, the Company incurred
base management fees of $7.6 million and $5.2 million, respectively.
As of June 30, 2004 and 2003, $1.3 million and $918.6 thousand,
respectively, was payable by the Company to the Manager for the base
management fee.For the three-month periods ended June 30, 2004 and 2003, the Manager
earned performance-based compensation in the amount of $8.5 million and
$6.9 million, respectively, in accordance with the terms of the
Agreement. For the six-month periods ended June 30, 2004 and 2003, the
Manager earned performance-based compensation in the amount of $16.8
million and $13.1 million, respectively. As of June 30, 2004 and 2003,
$8.5 million and $6.9 million, respectively, was payable by the Company
to the Manager for performance-based compensation.The Company offers mortgage loans to directors and officers of the
Company, and to employees of the Manager and other Thornburg entities
in the ordinary course of business. As of June 30, 2004, the aggregate
balance of these mortgage loans outstanding amounted to $37.1 million,
had a weighted average interest rate of 3.65%, and maturities ranging
between 2030 and 2034. Note 10. Subsequent Events  In July 2004, the Management Agreement (the Agreement) between the
Company and the Manager was amended effective July 1, 2004. The term
of the amended Agreement was extended to July 1, 2014 and the formulas
used to calculate the base management and performance-based incentive
fees earned under the Agreement were revised such that the fees earned
by the Manager will be reduced from what they would have been under the
previous formulas. Specifically, the previous annual base management
fee formula provided that the Manager earned 1.23% on the first $300
million of Average Historical Equity, plus 0.90% on Average Historical
Equity above $300 million. The amended Agreement continues this
structure but limits the fee earned on Average Historical Equity over
$1.5 billion to 0.80% with the fee decreasing an additional 0.05% for
each additional $0.5 billion in Average Historical Equity thereafter
until reaching a fee of 0.65% on any Average Historical Equity greater
than $3.0 billion. The previous formula used to calculate the
performance fee provided that the Manager earned 20% of the Companys
annualized net income, before performance-based compensation, above an
annualized Return on Equity equal to the ten year U.S. Treasury Rate
plus 1%. The amended Agreement continues this structure but provides
that once the Manager has earned a performance fee of $30 million, the
performance fee percentage of 20% is reduced by 1% for each additional
$5 million earned in performance fee until reaching a performance fee
percentage of 15% for any amount greater than $50 million.The Company issued $1 billion of asset-backed commercial paper to
various third parties in July 2004. The yield on these notes is
approximately 1.51% with maturity dates ranging from August 2004 to
October 2004.On July 19, 2004, the Company declared the second quarter 2004
dividend of $0.66 per share of common stock, which is payable on August
17, 2004 to shareholders of record on August 4, 2004. 24




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Item 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS Executive Overview Our goal is to acquire or originate adjustable and variable rate mortgage
(ARM) assets for our portfolio and manage them in such a way that we can
create earnings and dividend stability in the near term and earnings and
dividend growth in future periods. In order to achieve these objectives, we
must mitigate key risks in the mortgage portfolio lending business and,
simultaneously, pursue earnings growth strategies. Two of the principal risks
in the mortgage lending business are credit risk and interest rate risk. Our
three primary growth strategies are (i) to increase our higher margin, more
profitable mortgage loan origination business; (ii) to raise new equity capital
at a premium to book value in order to grow our assets and book value over
time; and (iii) to better use our existing capital base by diversifying our
funding sources, relying less on reverse repurchase agreements and more on
long-term collateralized debt obligations (CDOs) to finance our balance
sheet. During the second quarter of 2004, our assets grew 10% from $22.4 billion at
March 31, 2004 to $24.5 billion at June 30, 2004. Our net earnings increased
6% from $0.67 for the second quarter of 2003 to $0.71 per share for the second
quarter of 2004. We raised $78.6 million of new equity capital during the
quarter by issuing 3.0 million common shares at an average net price of $26.30
per share. Primarily as a result of raising this new common equity and the
retention of earnings, our book value per common share rose 5% from $17.85 per
share at March 31, 2004 to $18.74 per share. Asset Growth and Channel Mix Our ability to raise new equity capital at a premium to book value resulted in
significant asset acquisition activity and growth during the second quarter.
We acquired $3.0 billion of ARM securities during the quarter, 99.7% of which
were High Quality, meaning they are rated AA/Aa or higher by at least one of
either Standard & Poors Corporation or Moodys Investors Service, Inc. (the
Rating Agencies) (see page 31 for definition of High Quality). Interest
rates declined somewhat during the quarter, after having moved upward during
the prior quarter, and our portfolio prepayment rate increased to an average of
35% Constant Prepayment Rate (CPR) from an average of 19% CPR in the prior
quarter. In the quarters to come, we anticipate that CPR speeds will moderate
due to the expected increase in interest rates. We also continued to develop
our A quality residential ARM loan origination business through approved
correspondents and by directly originating ARM loans to retail customers. This
source of ARM assets provided $1.1 billion in new assets during the quarter, an
increase of 39% from originations in the second quarter of 2003 of $815.2
million. As a result of these ARM loan originations and acquisitions, as of
June 30, 2004, we owned $8.7 billion in ARM Loans (see page 30 for definition
of ARM Loans), which amounted to 35% of our total assets. The Federal Reserve Boards recent decision to raise short-term interest rates,
and the expectation that it will continue to do so, should further boost ARM
loan production as a percentage of new loan origination. The Mortgage Bankers
Association (the MBA) currently projects that ARM loans will account for 35%
of the $2.5 trillion in mortgages anticipated to be originated in 2004. We
believe our traditional ARM products, which have interest rates that reprice in
a year or less (Traditional ARMs), and hybrid ARM products, which have fixed
interest rates for an initial period of three to ten years before converting to
Traditional ARMs for their remaining terms to maturity (Hybrid ARMs) provide
borrowers with more attractive financing options than fixed-rate mortgages and
that we are well-positioned to benefit from borrowers increased participation
in ARM loans. Based on second quarter loan production and a loan pipeline of
$802.9 million at June 30, 2004, we believe we are on track to achieve our $3.7
billion origination target for 2004. We believe we can continue to outperform
industry trends in the near term because, in addition to our already
competitive mortgage interest rates, our focus on ARM loans and our innovative
product menu, we now have completed the expansion of our lending approval to
all 50 states and the District of Columbia. In addition, we continue to
increase our network of approved and active correspondents, grow our internal
sales force to help generate more loan production through correspondents,
financial planners, corporate affinity groups and residential home builders,
and have increased our marketing budget from $2.1 million in 2003 to $4.0
million in 2004. We want to grow the percentage of originated assets in our
portfolio, because they have proven to be more profitable for us than purchased
mortgage assets. 25




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Funding Diversification During the second quarter of 2004, we continued to strengthen our balance sheet
and improve our ability to grow earnings through better utilization of existing
capital and further diversification of our funding sources. We completed our
second securitization of the year during the second quarter. In this CDO
transaction, $1.1 billion of ARM loans were permanently financed through the
issuance of four classes of floating-rate, pass-through certificates rated AAA
by Standard and Poors and Aaa by Moodys Investors Service. In a CDO
securitization, a pool of ARM loans is converted into multiple classes of
securities and generally the AAA-rated classes are placed with fixed-income
investors such as insurance companies, pension funds and banks in the form of
pass-through certificates. The balance of the debt obligation is reduced as
the underlying loan collateral is paid down. For accounting purposes, we treat
CDO transactions as a financing of the loans and we do not account for any of
our ARM loan securitizations as sales. These securities receive principal and
interest payments from the ARM loans placed in a trust, and these financings
have no further recourse to us. Unlike reverse repurchase agreement borrowings
that are subject to margin calls based on the change in fair value of the
collateral or changes in margin requirements, CDOs are not subject to any
margin calls. A typical reverse repurchase agreement borrowing requires 4% to
5% of initial capital plus an additional capital reserve in order to meet any
margin calls. As a result, we have developed a policy to maintain no less than
8% of capital against our assets financed with recourse debt, which includes a
combination of our reverse repurchase agreement borrowings and our whole loan
financing lines. To the extent we have been able to fund a portion of our
balance sheet with CDOs, we have reduced our capital requirement and can
utilize freed up capital to acquire additional ARM assets. As of June 30,
2004, the $4.8 billion of CDO financing outstanding required approximately 2%
of equity capital, freeing up approximately $378 million of capital for the
acquisition of approximately $2.6 billion of additional ARM assets. CDOs
accounted for 21% of our borrowings as of June 30, 2004. On June 30, 2004, we established a new $5 billion asset-backed commercial paper
facility, which will provide us with an alternative way to finance our high
quality ARM securities portfolio. Through a wholly owned bankruptcy-remote
special purpose subsidiary, we will issue asset-backed commercial paper in the
form of secured liquidity notes that will be recorded as borrowings on our
Consolidated Balance Sheets, and have been rated P-1 by Moodys Investors
Service and F1+ by Fitch Ratings to money market investors. The notes are
generally collateralized by Agency Securities (see page 31 for definition of
Agency Securities) and AAA-rated, adjustable-rate mortgage-backed securities
(MBS) that we have either purchased or created through our loan
securitization process. Importantly, we can replace a portion of our reverse
repurchase agreement borrowings with the issuance of asset-backed commercial
paper under terms that we expect to be comparable to our existing reverse
repurchase agreement funding. Credit Quality We acquire excellent credit quality ARM assets and securitize the ARM loans we
either originate or acquire. These strategies create significant portfolio
liquidity and allow us to easily finance our portfolio. As of June 30, 2004,
96.8% of our ARM asset portfolio was High Quality as compared to 97.2% as of
March 31, 2004. Many of our High Quality ARM assets consist of ARM Loans that
we have either securitized for our own portfolio or have placed in a trust to
facilitate our CDO financings. We retain the risk of potential credit losses
on these loans. We did not experience any credit losses on ARM Loans during
the second quarter of 2004 and have only experienced $173.9 thousand in credit
losses since we began acquiring ARM loans in 1997. Although we believe our
credit performance is reflective of the high credit quality of our borrowers,
our prudent underwriting, and property appraisal methods and policies, we also
recognize that our ARM Loan portfolio was, on average, only approximately 15
months old at June 30, 2004. Due to this lack of seasoning and, therefore,
lack of relevant historical data, we have recorded a loan loss allowance of
$8.8 million as of June 30, 2004 based on managements expectations given
industry loss experience on similar loans. Interest Rate Risk Management We use interest rate swap agreements (Swap Agreements), interest rate cap
agreements (Cap Agreements) and Eurodollar futures contracts (Eurodollar
Transactions) (collectively, Hybrid Hedging Instruments), as hedges to fix,
or cap, the interest rates on the short-term borrowings and CDOs that finance
our Hybrid ARM assets. We continue our strategy of hedging our financing cost
such that we maintain a net duration of our Hybrid ARM assets, related
borrowings and Hybrid Hedging Instruments of less than one year. The lower the
duration gap, the less impact interest rate changes will have on earnings. As
of June 30, 2004, we had entered into Swap Agreements and Eurodollar
Transactions with a notional balance of $15.7 billion and delayed Swap
Agreements with notional balances totaling $661 million that become effective
in July 2004. Additionally, at June 30, 2004, we had Cap Agreements with a
notional balance of $1.4 billion. As a result, as of June 30, 26




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2004, we
measured the net duration applicable to our Hybrid ARM portfolio, related
borrowings and Hybrid Hedging Instruments at approximately 4.6 months while the
financing and hedging of all of the Companys ARM assets resulted in a net
duration of approximately 4.2 months. Although we experienced a declining
interest rate environment from 2001 to 2003, we continue to
employ a matched funding strategy as we acquire Hybrid ARM assets in order to
ensure stable earnings during periods of rising interest rates. In essence, as
we acquire ARM assets, we attempt to lock-in a spread that is expected to
provide a rate of return at or above our threshold requirement. In order to
stabilize the spread over the expected life of our ARM assets, we use hedging
instruments in conjunction with our borrowings to approximate the repricing
characteristics of our ARM assets. Given the prepayment uncertainties of our
ARM assets, there is no sure way to lock-in a spread between the yield on our
ARM assets and the related borrowing. However, through active management, we
believe we can continue to mitigate a significant amount of net interest income
volatility. See the discussion of Effects of Interest Rate Changes on page 57. Consistent Profitability We possess a number of strategic advantages that allow us to generate
consistent profitability. One of these strategic advantages is our low
operating expense structure. During the second quarter of 2004, our operating
expenses as a percent of average assets were 0.28%, compared to 0.47% for the
same quarter of 2003 and 0.40% during the first quarter of 2004. We are able
to operate at this low level of operating expenses relative to the size of our
portfolio because we do not operate like a traditional mortgage lender. We
acquire many of our assets through MBS purchases and originate loans by
developing strategic partnerships with correspondent lenders, financial
planners and other intermediaries. We also use web-based marketing and a third
party call center and we do not have a retail branch network or commissioned
loan officers. We also do not acquire loans through mortgage brokers. In
addition, we have developed other strategic partnerships that provide
outsourced services on a variable cost basis to our customers in the name of
Thornburg Mortgage. We believe that this low, variable-cost model has allowed
us to operate profitably with a lower interest rate spread on our portfolio,
enabling us to mitigate significant risks normally associated with mortgage
origination and portfolio lending activities. One of the strategic decisions
we have been able to make as a result of our low-cost operating model is to
invest primarily in Agency Securities, AAA- or AA-rated securities or A
quality ARM loans. This strategy has resulted in very low credit losses, a
very liquid and readily financeable portfolio, and a portfolio that has had low
price volatility as compared to a portfolio of 30-year, fixed-rate mortgage
assets. Additionally, we have been able to mitigate interest rate risk by
entering into hedging transactions and still achieve acceptable returns for our
shareholders. Finally, by employing a portfolio lending strategy, we do not
depend on gain on sale income, which can fluctuate significantly with loan
origination volume. The increase in our earnings in the second quarter of 2004 compared to the same
quarter of 2003 and the first quarter of 2004 can be attributed to a number of
factors, including selling additional shares of common stock at a premium to
book value and increasing our use of capital relative to the amount of common
equity outstanding through the use of CDOs as discussed above. Although we
experienced a decline in our portfolio margin from 1.40% for the first quarter
of 2004, to 1.31% during the second quarter, we generated a 6% increase in net
interest income due to our capital growth. This capital growth led to an
expansion of our balance sheet, and our ability to more efficiently use
shareholders equity. The decline in our net interest spread is generally the
result of additional hedging costs as we position ourselves for expected
increases in interest rates and the impact of higher portfolio prepayment
during the second quarter of 2004 that averaged 35% compared to 31% in the
second quarter of 2003. See further discussion of the change in our interest
rate spreads in Results of Operations For the Three Months Ended June 30,
2004, beginning on page 47 and Results of Operations For the Six Months Ended
June 30, 2004, beginning on page 53. Forward-Looking Statements Certain information contained in this Quarterly Report on Form 10-Q constitutes
forward-looking statements within the meaning of Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended, that are based on our current expectations, estimates
and projections. Pursuant to those sections, we may obtain a safe harbor for
forward-looking statements by identifying those statements and by accompanying
those statements with cautionary statements, which identify factors that could
cause actual results to differ from those expressed in the forward-looking
statements. Statements that are not historical facts, including statements
about our beliefs and expectations, are forward-looking statements. The words
believe, anticipate, intend, aim, expect, will, strive, target
and project and similar words identify forward-looking statements. Such
statements are not guarantees of future performance, events or results and
involve potential risks and uncertainties. Accordingly, our actual results may
differ from our current expectations, estimates and projections. Important
factors that may impact our actual results or may cause our actual results to 27




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differ materially from those expressed in any forward-looking statements made
by us or on our behalf include, but are not limited to, changes in interest
rates, changes in yields available for purchase on ARM assets, changes in the
yield curve, changes in prepayment rates, changes in the supply of MBS and
loans, our ability to obtain financing and the terms of any financing that we
do obtain. We do not undertake, and specifically disclaim, any obligation to
publicly release the result of any revisions that may be made to any
forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements. Corporate Governance We pride ourselves on maintaining an ethical workplace in which the highest
standards of professional conduct are practiced. Accordingly, we would like to
highlight the following facts relating to corporate governance:  
    
    Our Board of Directors is, and always has been, composed of a
majority of independent directors. The Audit, Nominating/Corporate
Governance and Compensation Committees of the Board of Directors are,
and always have been, composed exclusively of independent directors.
    
    We have a Code of Business Conduct and Ethics and Corporate
Governance Guidelines that cover a wide range of business practices and
procedures that apply to all of our employees, officers and directors
and the Manager that foster the highest standards of ethics and conduct
in all of our business relationships.
    
    We have an Insider Trading Policy that prohibits any of the
directors, officers or employees of the Company or the Manager from
buying or selling our stock on the basis of material nonpublic
information, and prohibits communicating material nonpublic information
to others.
    
    We are managed externally by Thornburg Mortgage Advisory Corporation
(the Manager) under the terms of a management agreement (the
Management Agreement), subject to the supervision of our Board of
Directors. The Managers compensation is based on formulas tied to our
success in increasing common equity capitalization and generating net
income above defined targets. The Compensation Committee and the
independent directors annually evaluate the Managers performance and
determine whether the compensation paid to the Manager is reasonable in
relation to the nature and quality of services performed.
    
    We have a formal internal audit function to further the effective
functioning of our internal controls and procedures. Our internal audit
plan is based on a formal risk assessment and is intended to provide
management and the Audit Committee with an effective tool to identify
and address areas of financial or operational concerns and ensure that
appropriate controls and procedures are in place. We are currently
implementing Section 404 of the Sarbanes-Oxley Act of 2002, which
requires an evaluation of internal control over financial reporting in
association with our financial statements for the year ending December
31, 2004. Our Internet website address is www.thornburgmortgage.com. We make available
free of charge, through our Internet website, our annual report on Form 10-K,
our quarterly reports on Form 10-Q, our current reports on Form 8-K and any
amendments to those reports that we file or furnish pursuant to Section 13(a)
or 15(d) of the Securities Exchange Act of 1934 as soon as reasonably
practicable after we electronically file such material with, or furnish it to,
the Securities and Exchange Commission (the SEC). You may also find our Code of Business Conduct and Ethics, Corporate Governance
Guidelines and the charters of the Audit Committee, Nominating/Corporate
Governance Committee and Compensation Committee of our Board of Directors at
our website. These documents are also available in print to anyone who
requests them by writing to us at the following address: 150 Washington
Avenue, Suite 302, Santa Fe, New Mexico, 87501, or by phoning us at (505)
989-1900. Please note that the reference to our website address is an inactive textual
reference made only for purposes of complying with SEC rules. 28




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Critical Accounting Policies and Estimates Our financial statements are prepared in conformity with generally accepted
accounting principles, many of which require the use of estimates and
assumptions. In accordance with recent SEC guidance, those material accounting
policies and estimates that we believe are the most critical to an investors
understanding of our financial results and condition and require complex
management judgment are discussed below.  
    
    Fair Value. We record our ARM securities, commitments to purchase ARM
loans and Hybrid Hedging Instruments at fair value. The fair values
of our ARM securities and Hybrid Hedging Instruments are generally
based on market prices provided by third party pricing services or
certain dealers who make markets in these financial instruments. If
the fair value of an ARM security, Hybrid Hedging Instrument or other
financial instrument is not reasonably available from a third party
pricing service or dealer, management estimates the fair value. This
requires management judgment in determining how the market would value
a particular ARM security, Hybrid Hedging Instrument or other
financial instrument, based on characteristics of the security we
receive from the issuer and available market information. The net
unrealized gain or loss on loans expected to be purchased from
correspondent lenders and bulk sellers is calculated using the same
methodologies that are used to value our ARM Loans, adjusted for
anticipated fallout for interest rate lock commitments that will
likely not be funded. The fair values reported reflect estimates and
may not necessarily be indicative of the amounts we could realize in a
current market exchange.  
    
    Loan Loss Reserves on ARM Loans. We maintain an allowance for loan
losses based on managements estimate of credit losses inherent in our
portfolio of ARM Loans. The estimation of the allowance is based on a
variety of factors including, but not limited to, industry statistics,
current economic conditions, loan portfolio composition, delinquency
trends, credit losses to date on underlying loans and remaining credit
protection. If the credit performance of our ARM Loans is different
than expected, we adjust the allowance for loan losses to a level
deemed appropriate by management to provide for estimated losses
inherent in our ARM Loan portfolio. Two critical assumptions used in
estimating the loan loss reserves are an assumed rate of default,
which is the expected rate at which loans go into foreclosure over the
life of the loans, and an assumed rate of loss severity, which
represents the expected rate of realized loss upon disposition of the
properties that have gone into foreclosure.  The following table presents a sensitivity analysis to show the impact on our
allowance for loan loss reserves of using different assumptions (in
thousands): Increase (Decrease)Changed Assumption
    
    in Loan Loss ReserveDefault assumption increased by 10%
    
    $
    1,471Default assumption decreased by 10%
    
    $
    (1,472
    )Loss severity assumption increased by 5%
    
    $
    1,771Loss severity assumption decreased by 5%
    
    $
    (1,771
    )
  The purpose of this analysis is to provide an indication of the impact
defaults and loss severity assumptions have on our estimate of the allowance
for loan losses. It is not intended to imply our expectation of future
default levels or changes in loss severity. We believe the current
assumptions used for defaults and loss severity are appropriate.  
    
    Basis Adjustments on ARM securities. Basis adjustments are a
designated component of the purchase discount on our ARM securities.
Certain of our ARM securities are rated less than Investment Grade and
represent subordinated interests in high-quality, first lien
residential mortgage loans where we own all of the securitized
classes. We generally purchase the less than Investment Grade classes
at a discount. Based upon managements use of analytical tools and
judgment, a portion of the purchase discount is subsequently accreted
as interest income under the effective yield method while the
remaining portion of the purchase discount is treated as a basis
adjustment which reflects the estimated unrealized loss on the
securities due to credit loss and interest rate exposure. Basis
adjustments are increased by recognizing an impairment loss when
management determines that there is a decline in the fair value of an
ARM security that is considered other than temporary and decreased
when there is improvement in the risk exposures. Any such
determinations are based on managements assessment of numerous
factors affecting the fair value of ARM securities, including, but not
limited to, current economic conditions, delinquency trends, credit
losses to date on underlying mortgages and remaining credit
protection. If management ultimately concludes that the basis
adjustments will not represent realized losses, the balances are
accreted into earnings over the remaining life of the security. 29




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
    
    Revenue Recognition. Interest income on ARM assets is a combination
of the interest earned based on the outstanding balance and
contractual terms of the assets and the amortization of yield
adjustments using generally accepted interest methods, principally the
amortization of purchase premiums and discounts. Premiums and
discounts associated with the purchase of ARM assets are amortized
into interest income over the lives of the assets using the effective
yield method adjusted for the effects of estimated prepayments.
Estimating prepayments and estimating the remaining lives of our ARM
assets requires management judgment, which involves consideration of
possible future interest rate environments and an estimate of how
borrowers will behave in those environments. The actual lives could
be more or less than the amount estimated by management at the time of
purchase of the ARM assets. For additional information on our significant accounting policies, see Note 1
to the Consolidated Financial Statements. General We are a single-family residential mortgage lender that originates, acquires
and retains investments in ARM assets, thereby providing capital to the
single-family residential housing market. Our ARM assets are comprised of
Traditional ARM and Hybrid ARM securities and loans. ARM securities represent
interests in pools of ARM loans, which are publicly rated and include
guarantees or other third party credit enhancements against losses from loan
defaults. ARM loans consist of securitized ARM loans, ARM loans
collateralizing long-term debt and ARM loans held for securitization (ARM
Loans). Like traditional banking institutions, our income is generated
primarily from the net spread or difference between the interest income we earn
on our ARM assets and the cost of our borrowings. Our strategy is to maximize
the long-term sustainable difference between the yield on our investments and
the cost of financing these assets, and to maintain that difference through
interest rate and credit cycles. While we are not a bank or savings and loan institution, our business purpose,
strategy, method of operation and risk profile are best understood in
comparison to such institutions. We finance the purchases and originations of
our ARM assets with equity capital, unsecured debt, short-term borrowings such
as reverse repurchase agreements, whole loan financing facilities, asset backed
commercial paper liquidity notes, CDOs and other collateralized financings that
we may establish with approved institutional lenders. When we borrow
short-term or floating-rate funds to finance our Hybrid ARM assets, we also
enter into interest rate hedging transactions, which fix our borrowing costs
during the fixed-rate period of the Hybrid ARM asset. We have a policy to
operate with an Adjusted Equity-to-Assets Ratio, a non-GAAP measurement, of
at least 8% and we typically operate with a 9 to 10% Adjusted Equity-to-Assets
Ratio. (See Capital Utilization on page 44 for a calculation of our Adjusted
Equity-to-Assets Ratio.) Since all of the assets we hold are ARM assets and we
pursue a matched funding strategy, we believe our exposure to changes in
interest rates can be prudently managed. Moreover, we focus on acquiring
primarily high quality assets to ensure our access to financing. Similarly, we
maintain strict credit underwriting standards and have experienced cumulative
credit losses of only $173.9 thousand on our loan portfolio since we began
acquiring loans in 1997. Our low cost operating structure has resulted in
operating costs well below those of other mortgage originators. We believe our
corporate structure differs from most lending institutions in that we are
organized for tax purposes as a real estate investment trust (REIT) and,
therefore, pay substantially all of our earnings in the form of dividends to
shareholders, without paying federal or state income tax at the corporate
level. Portfolio Strategies Our business strategy is to acquire and originate ARM assets to hold in our
portfolio, fund them using equity capital and borrowed funds, and generate
earnings from the difference, or spread, between the yield on our assets and
our cost of borrowings. We acquire ARM assets from investment banking firms, broker-dealers and similar
financial institutions that regularly make markets in these assets. We also
acquire ARM assets from other mortgage providers, including mortgage bankers,
banks, savings and loan institutions, home builders and other firms involved in
originating, packaging and selling mortgage loans. We believe we have a
competitive advantage in acquiring and investing in these ARM assets due to the
low cost of our operations relative to traditional mortgage investors and
originators. We originate ARM loans for our portfolio through our correspondent lending
program, which currently includes approximately 146 approved and active
correspondents, and we originate loans direct to consumers through our wholly
owned mortgage loan origination subsidiary, Thornburg Mortgage Home Loans, Inc.
(TMHL). Currently, TMHL is 30




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authorized to lend in all 50 states and the
District of Columbia. We believe that diversifying our sources for ARM Loans
and ARM securities will enable us to consistently find attractive opportunities
to acquire or create high quality assets at attractive yields and spreads for
our portfolio. We have a focused portfolio lending investment policy designed to minimize
credit risk and interest rate risk. Our mortgage assets portfolio may consist
of ARM securities guaranteed by an agency of the federal government (Ginnie
Mae) or a government-sponsored corporation or federally-chartered corporation
(Fannie Mae or Freddie Mac) (collectively, Agency Securities), or
privately issued (generally publicly registered) ARM pass-through securities,
multi-class pass-through securities, floating-rate classes of collateralized
mortgage obligations (CMOs), A or prime quality ARM loans that we intend to
securitize, securities issued by others where we have purchased all of the
resulting classes, fixed-rate MBS with an expected duration of one year or less
or other short-term investments that either mature within one year or have an
interest rate that reprices within one year. Our investment policy requires that we invest at least 70% of total assets in
High Quality ARM assets and short-term investments. High Quality means:  (1)
    
    Agency Securities; or(2)
    
    ARM securities and securitized ARM loans which are rated within one
of the two highest rating categories by at least one of the Rating
Agencies; or(3)
    
    securities and securitized loans that are unrated or whose ratings
have not been updated but are determined to be of comparable quality (by
the rating standards of at least one of the Rating Agencies) to a High
Quality rated mortgage security, as determined by the Manager and
approved by our Board of Directors; or(4)
    
    the portion of ARM loans that have been deposited into a trust and
have received a credit rating of AA or better from at least one Rating
Agency. The remainder of our ARM portfolio, comprising not more than 30% of total
assets, may consist of Other Investment assets, which may include:  (1)
    
    adjustable or variable rate pass-through certificates, multi-class
pass-through certificates or CMOs backed by loans that are rated at
least Investment Grade at the time of purchase. Investment Grade
generally means a security rating of BBB, Baa or better by at least one
of the Rating Agencies; or(2)
    
    ARM loans collateralized by first liens on single-family residential
properties, generally underwritten to A quality standards, and
acquired for the purpose of future securitization; or(3)
    
    fixed-rate mortgage loans collateralized by first liens on
single-family residential properties originated for sale to third
parties; or(4)
    
    real estate properties acquired as a result of foreclosing on our ARM
Loans; or(5)
    
    as authorized by our Board of Directors, ARM securities rated less
than Investment Grade that are created as a result of our loan
acquisition and securitization efforts or are acquired as part of a loan
securitization effected by third parties in which we purchase all of the
classes of the loan securitization, and that equal an amount no greater
than 17.5% of shareholders equity, measured on a historical cost basis. Our ARM assets include investments in Hybrid ARM assets, which are typically
30-year loans with a fixed rate of interest for an initial period, generally 3
to 10 years, and then convert to an adjustable-rate for the balance of their
term. We limit our ownership of Hybrid ARM assets with fixed-rate periods of
greater than five years to no more than 20% of our total assets. We also have
a policy to maintain a net duration, or duration gap, of one year or less on
our Hybrid ARM assets (including commitments to purchase Hybrid ARM assets),
related borrowings and Hybrid Hedging Instruments. Duration is a calculation
expressed in months or years that is a measure of the expected price change of
financial instruments based on changes in interest rates. We use a financial
model that simulates rate changes and calculates the impact of those changes on
the fair value of our Hybrid ARM portfolio. By maintaining a net duration of
less than one year, the combined price change of our Hybrid ARM portfolio,
associated Hybrid Hedging Instruments and other borrowings funding our Hybrid
ARM portfolio is expected to be a maximum of 1% for a 1% parallel shift in
interest rates. We use Hybrid Hedging Instruments as hedges to fix, or cap,
the interest rates on the short-term borrowings and CDOs financing our Hybrid
ARM assets. To mitigate the adverse effect of an increase in prepayments on our ARM assets,
we emphasize the purchase of ARM assets at prices close to or below par. We
amortize any premiums paid for our assets over their expected lives using the
effective yield method of accounting. To the extent that the prepayment rate
on our ARM assets differs from expectations, our net interest 31




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income will be
affected. Prepayments generally increase when mortgage interest rates fall
below the interest rates on ARM loans. To the extent there is an increase in
prepayment rates, resulting in a shortening of the expected lives of our ARM
assets, our net income and, therefore, the amount available for dividends could
be adversely affected. We believe that our status as a mortgage REIT makes an investment in our equity
securities attractive for tax-exempt investors, such as pension plans, profit
sharing plans, 401(k) plans, Keogh plans and Individual Retirement Accounts.
We do
not invest in real estate mortgage investment conduit (REMIC) residuals or
other CMO residuals that would result in the creation of excess inclusion
income or unrelated business taxable income. Acquisition, Securitization and Retention of Traditional ARM and Hybrid ARM
Loans We acquire and originate A quality mortgage loans through TMHL from three
sources: (i) correspondent lending, (ii) direct retail loan originations, and
(iii) bulk acquisitions. Correspondent lending involves acquiring individual
loans from correspondent lenders whom we have approved and who originate the
individual loans using our product pricing, underwriting criteria and
guidelines, or criteria and guidelines that we have approved. Direct retail
loan originations are loans that we originate through intermediaries such as
financial advisors, corporate affinity clients and home builders or directly to
consumers via the Internet or by telephone. Bulk acquisitions involve
acquiring pools of whole loans, which are originated using the sellers
guidelines and underwriting criteria. The loans we acquire or originate are
financed through warehouse borrowing arrangements pending securitization for
our portfolio. The loans acquired or originated by TMHL are first lien, single-family
residential Traditional ARM and Hybrid ARM loans with original terms to
maturity of not more than forty years and are either fully amortizing or are
interest-only up to ten years, and fully amortizing thereafter. All ARM loans that we acquire or originate for our portfolio bear an interest
rate tied to an interest rate index. Most loans have periodic and lifetime
constraints on how much the loan interest rate can change on any predetermined
interest rate reset date. The interest rate on each Traditional ARM loan
resets monthly, semi-annually or annually. The Traditional ARM loans generally
adjust to a margin over a U.S. Treasury index or a LIBOR index. The Hybrid ARM
loans have a fixed rate for an initial period, generally 3 to 10 years, and
then convert to Traditional ARM loans for their remaining term to maturity. We acquire ARM loans for our portfolio with the intention of securitizing them
into pools of High Quality ARM securities and retaining them in our portfolio
as securitized ARM loans. Alternatively, we may also use our loans as
collateral for CDOs. In order to facilitate the securitization or financing of
our loans, we generally create subordinate certificates, which provide a
specified amount of credit enhancement. Upon securitization, we generally
retain the securities issued, including the subordinate certificates, and
either finance them in the repurchase agreement market or through the issuance
of CDOs in the capital markets. Our investment policy limits the amount we may
retain of these below Investment Grade subordinate certificates, and
subordinate classes that we purchase in connection with a whole pool
securitization effected by third parties, to 17.5% of shareholders equity,
measured on a historical cost basis. We believe the acquisition and origination of ARM loans for securitization
benefits us by providing: (i) greater control over the quality and types of ARM
assets acquired; (ii) the ability to acquire ARM assets at lower prices, so
that the amount of the premium to be amortized will be reduced in the event of
prepayment; (iii) additional sources of new whole-pool ARM assets; and (iv)
generally higher yielding investments in our portfolio. We offer a loan modification program on all loans we originate and certain
loans we acquire. We believe this program promotes customer retention and
reduces loan prepayments. Under the terms of this program, a borrower pays a
fee to modify the mortgage loan to any then-available Hybrid or Traditional ARM
product that we offer at the offered retail interest rate plus 1/8%. During
the second quarter of 2004, we modified 277 loans with balances totaling $156.0
million. At July 2, 2004, the pipeline of loans to be modified totaled $29.1
million. Financing Strategies We finance our ARM assets using equity capital, unsecured debt, short-term
borrowings such as reverse repurchase agreements, whole loan financing
facilities, CDOs, and other collateralized financings that we may establish
with approved institutional lenders. In July 2004 we also began using an
asset-backed commercial paper facility to finance ARM assets. See Hedging
Strategiesbelow for a discussion of how we convert short-term borrowings into
long-term fixed-rate financing for 32




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purposes of managing our interest rate risk.
We have established lines of credit and collateralized financing agreements
with 24 different financial institutions. Reverse repurchase agreements
involve a simultaneous sale of pledged assets to a lender at an agreed-upon
price in return for the lenders agreement to resell the same assets back to us
at a future date (the maturity of the borrowing) at a higher price. The price
difference is the cost of borrowing under these agreements. Because we borrow
money under these agreements based on the fair value of our ARM assets, our
borrowing ability under these agreements could be limited and lenders could
initiate margin calls in the event of interest rate changes or if the value of
our ARM assets declines for other reasons. We generally enter into two types of reverse repurchase agreements: variable
rate term reverse repurchase agreements and fixed-rate reverse repurchase
agreements. Our variable rate term reverse repurchase agreements are
financings with original maturities ranging from one to twenty-five months.
The interest rates on these variable rate term reverse repurchase agreements
are generally indexed to either the one-month or three-month LIBOR rate, and
reprice accordingly. The fixed-rate reverse repurchase agreements have
original maturities generally ranging from 30 to 180 days. Generally, upon
repayment of each reverse repurchase agreement, we immediately pledge the ARM
assets used to collateralize the financing to secure a new reverse repurchase
agreement. We have also financed the purchase of ARM assets by issuing floating-rate and
fixed-rate CDOs in the capital markets, which are collateralized by ARM loans
that are placed in a trust. The trust pays the principal and interest payments
on the debt out of the cash flows received on the collateral. This structure
enables us to make more efficient use of our capital because the capital
requirement to support these financings is less than the amount required to
support the same amount of financings in the reverse repurchase agreement
market. These transactions are a permanent form of financing and are not
subject to margin calls. We also have financing facilities, or credit lines, for whole loans. A whole
loan is the actual mortgage loan evidenced by a note and secured by a mortgage
or deed of trust. We use these whole loan financing facilities to finance our
acquisition of whole loans while we are accumulating loans for securitization. We have issued senior unsecured notes (Senior Notes) in the amount of $255
million. The Senior Notes bear interest at 8.0%, payable each May 15 and
November 15, and mature on May 15, 2013. The Senior Notes are redeemable at a
declining premium, in whole or in part, beginning on May 15, 2008, and at par
beginning on May 15, 2011. The Senior Notes may also be redeemed under limited
circumstances on or before May 15, 2006. On June 30, 2004, we established a new $5 billion asset-backed commercial paper
facility, which will provide us with an alternative way to finance our high
quality ARM securities portfolio. Through a bankruptcy-remote facility, we
will issue asset-backed commercial paper in the form of secured liquidity notes
that have been rated P-1 by Moodys Investors Service and F1+ by Fitch Ratings
to money market investors. The notes are generally collateralized by Agency
Securities and AAA-rated, adjustable-rate MBS that we have either purchased or
created through our loan securitization process. Importantly, we can replace a
portion of our reverse repurchase agreement borrowings with the issuance of
asset-backed commercial paper under terms that we expect to be comparable to
our existing reverse repurchase agreement funding. Capital Utilization Our Board has approved a policy that limits our capacity to borrow funds to
finance mortgage assets based on our equity capital and unsecured debt. We
monitor the relationship between our assets, borrowings and long-term capital
using a variety of different measures. The primary operating policy that
limits our borrowings and leverage is a requirement to maintain our Adjusted
Equity-to-Assets Ratio, a non-GAAP measurement, at a minimum of 8%. Our
Adjusted Equity-to-Assets Ratio represents the long-term capital (both equity
and Senior Notes) supporting our recourse or marginable debt. Recourse or
marginable debt generally consists of reverse repurchase agreements and whole
loan financing facilities. These forms of borrowing are short-term in nature,
mature on a frequent basis (weighted average maturity of 2.9 months as of June
30, 2004), need to be rolled over at each maturity and are subject to margin
call based on collateral value changes or changes in margin requirements.
Because of the short-term nature of these forms of financing, our policy
requires that we maintain significant excess capital and liquidity to meet
margin calls as a result of unexpected changes in margin requirements and
collateral value. Our policy is to maintain a capital cushion equal to
approximately twice the margin requirement when using these forms of
borrowings. Our margin requirements typically range between 4% and 5% for
these borrowings, so our policy requires that we maintain capital of at least
8%, and typically 9% to 10%, against the financing of these assets. This
capital 33




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cushion has proved to be more than adequate to support our borrowing
arrangements through a variety of interest rate and credit cycles. As we replace our reverse repurchase agreement borrowings with CDO financings,
the risk of margin calls, changes in margin requirements and potential rollover
risk is eliminated because CDO financings represent permanent, non-recourse
financing whose terms are established at the time of the financing and are not
subject to change. As a result, the need to maintain a capital cushion
comparable to what we maintain on our recourse borrowings is eliminated. For
purposes of maintaining an adequate capital cushion, our policy allows us to
eliminate all assets (and the associated equity capital) associated with CDO
financing from our operating capital ratio. Additionally, we eliminate from
our Adjusted Equity-to-Assets Ratio any unrealized market value adjustments,
recorded in Accumulated other comprehensive income (loss), from our equity
accounts, and we include our Senior Notes as an additional form of long-term
capital as if the notes were equity capital. (See calculation of the Adjusted
Equity-to-Assets Ratio on page 45.) Because the CDOs only require
approximately 2% of equity capital to support
the CDO financing, versus the 8% to 10% policy requirement on our recourse
borrowings, we are able to use this freed-up capital to acquire additional
assets. We expect that we will be able to retain and carry an increased amount
of assets in the future as a percentage of our equity capital base. Hedging Strategies We attempt to mitigate our interest rate risk by funding our ARM assets with
borrowings and hedging instruments (Hedging Instruments) whose combined
maturities approximately match the interest rate adjustment periods on our ARM
assets. Therefore, some of our borrowings bear variable or short-term (one
year or less) fixed interest rates because a portion of our ARM assets, the
Traditional ARMs, have interest rates that adjust within one year. However, we
finance our Hybrid ARM portfolio with borrowings hedged with Hybrid Hedging
Instruments that fix the interest rate on the borrowings such that the net
duration of the Hybrid ARM portfolio, the related borrowings and the associated
Hybrid Hedging Instruments is one year or less. A lower duration indicates a
lower expected volatility of earnings given future changes in interest rates.
When we enter into a Swap Agreement, we agree to pay a fixed rate of interest
and to receive a variable interest rate, generally based on LIBOR. We also
enter into Eurodollar Transactions in order to fix the interest rate changes on
our forecasted three-month LIBOR-based liabilities. Each Eurodollar futures
contract is a three-month contract with a price that represents the forecasted
three-month LIBOR rate. Selling Eurodollar futures contracts locks in a future
interest rate. The difference between these two values results in a gain or
loss that offsets the change in the three-month LIBOR rate and locks-in the
forecasted three-month LIBOR rate for financing purposes. We purchase Cap
Agreements by incurring a one-time fee or premium. Pursuant to the terms of
the Cap Agreements, we will receive cash payments if the interest rate index
specified in any such Cap Agreement increases above contractually specified
levels. Therefore, such Cap Agreements have the effect of capping the interest
rate on a portion of our borrowings above a level specified by the Cap
Agreement. The notional balances of the Hybrid Hedging Instruments generally
decline over the life of these instruments. As of June 30, 2004, our Hybrid
Hedging Instruments had a remaining average term to maturity of 3.4 years
before considering the effects of prepayments and when combined with our Hybrid
ARM assets and related borrowings had a net duration of approximately 4.6
months, including the effects of prepayments. In general, our Traditional ARM assets have a maximum lifetime interest rate
cap, or ceiling, meaning that each ARM asset contains a contractual maximum
interest rate. Since our borrowings are not subject to equivalent interest
rate caps, we have also entered into Cap Agreements, so that the net margin on
our Traditional ARM assets with maximum lifetime interest rate caps will be
protected in high interest rate environments. These Cap Agreements are
referred to as Life Cap Hedging Instruments. Pursuant to the terms of these
Life Cap Hedging Instruments owned as of June 30, 2004, we will receive cash
payments if the applicable index, generally the three-month or six-month LIBOR
index, increases above contractually specified levels. The fair value of these
Cap Agreements generally increases when general market interest rates increase
and decreases when market interest rates decrease, helping to partially offset
changes in the fair value of our ARM assets related to the effect of the
lifetime interest rate cap. We are not currently purchasing Life Cap Hedging
Instruments because current interest rates are significantly lower than the
contractual life caps on our ARM assets and our duration management strategies
incorporate these potential life cap risks. In addition, some Traditional ARM assets are subject to periodic caps.
Periodic caps generally limit the maximum interest rate coupon change on any
interest rate coupon adjustment date to either a maximum of 1.00% per
semiannual adjustment or 2.00% per annual adjustment. The borrowings that we
incur do not have similar periodic caps. However, we believe the impact of the
periodic caps is somewhat mitigated because we own our ARM assets at a net
price above par and, therefore, the yield on our ARM assets can change by an
amount greater than the associated periodic cap due to changes in the 34




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amortization of the net price above par. Further, the contractual future
interest rate adjustments on the ARM assets will cause their interest rates to
increase over time and reestablish the ARM assets interest rate to a spread
over the then current index rate. As of June 30, 2004, $2.8 billion of our
Traditional ARM assets have periodic caps, representing 12.0% of total ARM
assets. We also enter into Eurodollar Transactions to manage interest rate risk
associated with commitments to purchase ARM loans (Pipeline Hedging
Instruments.) The gain (loss) on the Pipeline Hedging Instruments offsets the
gain (loss) recorded for the change in fair value of the loan commitments. We may enter into other hedging-type transactions designed to protect our
borrowing costs or portfolio yields from interest rate changes. We may also
purchase interest-only mortgage derivative assets or other mortgage
derivative products for purposes of mitigating risk from interest rate changes,
although we have not, to date, entered into these types of transactions. We
may also use, from time to time, futures contracts and options on futures
contracts on the Eurodollar, Federal Funds, Treasury bills and Treasury notes
and similar financial instruments to mitigate risk from changing interest
rates. The hedging transactions that we currently use generally are designed to
protect our net interest income during periods of changing market interest
rates. We do not hedge for speculative purposes. Further, no hedging strategy
can completely insulate us from risk, and certain of the federal income tax
requirements that we must satisfy to qualify as a REIT may limit our ability to
hedge, particularly with respect to hedging against periodic cap risk. We
carefully monitor and may have to limit our hedging strategies to ensure that
we do not realize excessive hedging income or hold hedging assets having excess
value in relation to total assets. 35




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Financial Condition Asset Quality At June 30, 2004, we held total assets of $24.5 billion, $23.1 billion of which
consisted of ARM assets. That compares to $19.1 billion in total assets and
$18.9 billion of ARM assets at December 31, 2003. Since commencing operations,
we have purchased either ARM securities (backed by Agency Securities or
privately-issued MBS) or ARM loans generally originated to A quality
underwriting standards. At June 30, 2004, 96.8% of the assets we held,
including cash and cash equivalents, were High Quality assets, far exceeding
our investment policy minimum requirement of investing at least 70% of our
total assets in High Quality ARM assets and cash and cash equivalents. The following tables present schedules of ARM assets owned at June 30, 2004 and
December 31, 2003 classified by High Quality and Other Investment assets and
further classified by type of issuer and by ratings categories. All ARM
securities included in the tables have been rated by the Rating Agencies. ARM
Loans include securitized ARM loans that have been rated by the Rating
Agencies, ARM loans collateralizing debt obligations that have been stratified
by credit rating based on the ratings received from the Rating Agencies on the
respective CDOs and ARM loans held for securitization that have not been rated
by the Rating Agencies. ARM Assets by Issuer and Credit Rating
(in thousands) June 30, 2004ARM Securities
    
    ARM Loans
    
    TotalCarrying Value
    
    Portfolio Mix
    
    Carrying Value
    
    Portfolio Mix
    
    Carrying Value
    
    Portfolio MixHigh QualityAgency Securities
    
    $
    2,888,159
    
    
    
    20.0
    %
    
    $
    2,203
    
    
    
    0.0
    %
    
    $
    2,890,362
    
    
    
    12.5
    %Non-Agency ARM Assets:AAA/Aaa Rating
    
    
    11,268,952
    
    
    
    78.1
    
    
    
    7,872,784
    (1)
    
    
    91.0
    
    
    
    19,141,736
    (1)
    
    
    82.9AA/Aa Rating
    
    
    204,319
    
    
    
    1.4
    
    
    
    125,427
    
    
    
    1.4
    
    
    
    329,746
    
    
    
    1.4Total Non-Agency ARM Assets
    
    
    11,473,271
    
    
    
    79.5
    
    
    
    7,998,211
    
    
    
    92.4
    
    
    
    19,471,482
    
    
    
    84.3Total High Quality
    
    
    14,361,430
    
    
    
    99.5
    
    
    
    8,000,414
    
    
    
    92.4
    
    
    
    22,361,844
    
    
    
    96.8Other InvestmentsNon-Agency ARM Assets:A Rating
    
    
    41,842
    
    
    
    0.3
    
    
    
    71,021
    
    
    
    0.8
    
    
    
    112,863
    
    
    
    0.5BBB/Baa Rating
    
    
    17,632
    
    
    
    0.1
    
    
    
    31,874
    
    
    
    0.4
    
    
    
    49,506
    
    
    
    0.2BB/Ba Rating and Below
    
    
    13,227
    
    
    
    0.1
    
    
    
    40,779
    (1)
    
    
    0.5
    
    
    
    54,006
    (1)
    
    
    0.2ARM loans pending securitization
    
    
    
    
    
    
    0.0
    
    
    
    520,720
    
    
    
    6.0
    
    
    
    520,720
    
    
    
    2.3Total Other Investment
    
    
    72,701
    
    
    
    0.5
    
    
    
    664,394
    
    
    
    7.7
    
    
    
    737,095
    
    
    
    3.2Loan Loss Reserves
    
    
    
    
    
    
    0.0
    
    
    
    (8,819
    )
    
    
    (0.1
    )
    
    
    (8,819
    )
    
    
    (0.0
    )Total ARM Portfolio
    
    $
    14,434,131
    
    
    
    100.0
    %
    
    $
    8,655,989
    
    
    
    100.0
    %
    
    $
    23,090,120
    
    
    
    100.0
    %
 36




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December 31, 2003ARM Securities
    
    ARM Loans
    
    TotalCarrying Value
    
    Portfolio Mix
    
    Carrying Value
    
    Portfolio Mix
    
    Carrying Value
    
    Portfolio MixHigh QualityAgency Securities
    
    $
    2,321,013
    
    
    
    20.1
    %
    
    $
    2,961
    
    
    
    0.0
    %
    
    $
    2,323,974
    
    
    
    12.3
    %Non-Agency Issued ARM Assets:AAA/Aaa Rating
    
    
    8,809,567
    
    
    
    76.5
    
    
    
    6,588,471
    (2)
    
    
    89.9
    
    
    
    15,398,038
    (2)
    
    
    81.7AA/Aa Rating
    
    
    321,108
    
    
    
    2.8
    
    
    
    115,076
    
    
    
    1.5
    
    
    
    436,184
    
    
    
    2.3Total Non-Agency ARM Assets
    
    
    9,130,675
    
    
    
    79.3
    
    
    
    6,703,547
    
    
    
    91.4
    
    
    
    15,834,222
    
    
    
    84.0Total High Quality
    
    
    11,451,688
    
    
    
    99.4
    
    
    
    6,706,508
    
    
    
    91.4
    
    
    
    18,158,196
    
    
    
    96.3Other InvestmentsNon-Agency ARM Assets:A Rating
    
    
    46,287
    
    
    
    0.4
    
    
    
    64,795
    
    
    
    0.9
    
    
    
    111,082
    
    
    
    0.6BBB/Baa Rating
    
    
    14,577
    
    
    
    0.1
    
    
    
    29,210
    
    
    
    0.4
    
    
    
    43,787
    
    
    
    0.2BB/Ba Rating and Below
    
    
    8,189
    
    
    
    0.1
    
    
    
    41,657
    (2)
    
    
    0.6
    
    
    
    49,846
    (2)
    
    
    0.3ARM loans pending securitization
    
    
    
    
    
    
    0.0
    
    
    
    497,248
    
    
    
    6.8
    
    
    
    497,248
    
    
    
    2.6Total Other Investment
    
    
    69,053
    
    
    
    0.6
    
    
    
    632,910
    
    
    
    8.7
    
    
    
    701,963
    
    
    
    3.7Loan Loss Reserves
    
    
    
    
    
    
    0.0
    
    
    
    (7,993
    )
    
    
    (0.1
    )
    
    
    (7,993
    )
    
    
    (0.0
    )Total ARM Portfolio
    
    $
    11,520,741
    
    
    
    100.0
    %
    
    $
    7,331,425
    
    
    
    100.0
    %
    
    $
    18,852,166
    
    
    
    100.0
    %
  (1)
    
    As of June 30, 2004, the AAA Rating category includes $4.9 billion of
ARM loans collateralizing CDOs that have been credit enhanced to AAA
through overcollateralization in the amount of $34.1 million which is
included in the BB/Ba Rating and below category.(2)
    
    As of December 31, 2003, the AAA Rating category includes $3.1
billion of ARM loans collateralizing CDOs that have been credit enhanced
to AAA through overcollateralization in the amount of $24.1 million
which is included in the BB/Ba Rating and below category. As of June 30, 2004, 11 of the 19,037 loans in our ARM loan portfolio were
considered seriously delinquent (60 days or more delinquent) and had an
aggregate balance of $4.5 million. The average original effective
loan-to-value ratio on the delinquent loans and the acquired property was 76%.
We believe that our current level of basis adjustments and allowance for loan
losses is adequate to cover estimated losses from these loans. 37




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##### Table of Contents



ARM Loan Portfolio Characteristics The following table presents various characteristics of our ARM Loan portfolio
as of June 30, 2004. This information pertains to ARM loans held for
securitization, ARM loans held as collateral for CDOs and ARM loans securitized
for our own portfolio for which we retained credit loss exposure. The combined
unpaid principal balance of the loans included in this information is $8.6
billion. Average
    
    High
    
    LowOriginal loan balance
    
    $
    463,530
    
    
    $
    7,875,000
    
    
    $
    25,100Unpaid principal balance
    
    $
    453,328
    
    
    $
    7,875,000
    
    
    $
    381Coupon rate on loans
    
    
    4.26
    %
    
    
    9.13
    %
    
    
    1.50
    %Pass-through rate
    
    
    4.14
    %
    
    
    8.60
    %
    
    
    1.48
    %Pass-through margin
    
    
    1.92
    %
    
    
    4.73
    %
    
    
    0.23
    %Lifetime cap
    
    
    10.35
    %
    
    
    19.90
    %
    
    
    7.13
    %Original term (months)
    
    
    360
    
    
    
    480
    
    
    
    120Remaining term (months)
    
    
    344
    
    
    
    479
    
    
    
    24
 Geographic distribution (top 5 states):California
    
    
    25.9
    %Georgia
    
    
    11.2Florida
    
    
    7.7Colorado
    
    
    7.6New York
    
    
    7.5Occupancy status:Owner occupied
    
    
    81.3
    %Second home
    
    
    13.5Investor
    
    
    5.2Documentation type:Full/Alternative
    
    
    92.1
    %Other
    
    
    7.9Loan purpose:Purchase
    
    
    38.4
    %Cash out refinance
    
    
    30.1Rate & term refinance
    
    
    31.5Original effective loan-to-value:80.01% and over (2)
    
    
    2.8
    %70.01%-80.00%
    
    
    43.460.01%-70.00%
    
    
    24.550.01%-60.00%
    
    
    12.750.00% or less
    
    
    16.6Weighted average effective
original loan-to-value:
    
    
    65.9
    %Property type:Single-family
    
    
    85.5
    %Condominium
    
    
    12.6Other residential
    
    
    1.9ARM Loan type:Traditional ARM loans
    
    
    32.4
    %Hybrid ARM loans
    
    
    67.6ARM Interest Rate Caps:Initial Cap on Hybrid loans:3.00% or less
    
    
    2.2
    %3.01%-4.00%
    
    
    21.84.01%-5.00%
    
    
    61.85.01%-6.00%
    
    
    14.2Periodic Cap on Traditional ARM loans:None
    
    
    39.8
    %1.00% or less
    
    
    46.8Over 1.00%
    
    
    13.5Percent of interest-only loan balances
    
    
    87.1
    %Weighted average length of
interest-only period
    
    
    8.2 yearsFICO scores:801 and over
    
    
    2.4
    %751 to 800
    
    
    42.2701 to 750
    
    
    34.0651 to 700
    
    
    18.3650 or less
    
    
    3.1Weighted average FICO score:
    
    
    736
    (1)
 (1) FICO is a credit score, ranging from 300 to 850, with 850 being the
best score, based upon the credit evaluation methodology developed by Fair,
Isaac and Company, a consulting firm specializing in creating credit evaluation
models. 38




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(2) All loans with an effective original loan-to-value ratio over 80% have
mortgage insurance. As of June 30, 2004 and December 31, 2003, we serviced $6.0 billion and $4.7
billion of our loans, respectively, and had 13,067 and 10,223 customer
relationships, respectively. We hold all of the loans that we service in our
portfolio in the form of ARM Loans. Asset Repricing Characteristics The following table classifies our portfolio of ARM assets by type of interest
rate index and frequency of repricing. ARM Assets by Index and Repricing Frequency
(in thousands) June 30, 2004
    
    December 31, 2003Carrying
    
    Portfolio
    
    Carrying
    
    PortfolioValue
    
    Mix
    
    Value
    
    MixTraditional ARM assets:Index:One-month LIBOR
    
    $
    892,493
    
    
    
    3.9
    %
    
    $
    598,989
    
    
    
    3.2
    %Six-month LIBOR
    
    
    2,190,734
    
    
    
    9.5
    
    
    
    1,777,494
    
    
    
    9.4One-year Constant Maturity Treasury
    
    
    794,384
    
    
    
    3.4
    
    
    
    1,079,970
    
    
    
    5.7Other
    
    
    111,716
    
    
    
    0.5
    
    
    
    124,440
    
    
    
    0.73,989,327
    
    
    
    17.3
    
    
    
    3,580,893
    
    
    
    19.0Hybrid ARM assets:Remaining fixed period:3 years or less
    
    
    3,515,431
    
    
    
    15.1
    
    
    
    2,052,265
    
    
    
    10.9Over 3 years - 5 years
    
    
    11,908,387
    
    
    
    51.6
    
    
    
    10,639,463
    
    
    
    56.4Over 5 years
    
    
    3,685,794
    
    
    
    16.0
    
    
    
    2,587,538
    
    
    
    13.719,109,612
    
    
    
    82.7
    
    
    
    15,279,266
    
    
    
    81.0Loan Loss Reserves
    
    
    (8,819
    )
    
    
    (0.0
    )
    
    
    (7,993
    )
    
    
    (0.0
    )$
    23,090,120
    
    
    
    100.0
    %
    
    $
    18,852,166
    
    
    
    100.0
    %
 The ARM portfolio had a current weighted average coupon of 4.24% at June 30,
2004. This consisted of a weighted average coupon of 4.34% on the hybrid
portion of the portfolio and a weighted average coupon of 3.26% on the rest of
the portfolio. If the portfolio had been fully indexed, the weighted average
coupon of the portfolio would have been 4.27%, based upon the current
composition of the portfolio and the applicable indices. Additionally, if the
non-hybrid portion of the portfolio had been fully indexed, the weighted
average coupon of that portion of the portfolio would have been 3.63%, also
based upon the current composition of the portfolio and the applicable indices.
The term fully indexed refers to an ARM asset that has an interest rate
currently equal to its applicable index plus a margin to the index that is
specified by the terms of the ARM asset. As of December 31, 2003, the ARM portfolio had a weighted average coupon of
4.31%. This consisted of a weighted average coupon of 4.35% on the hybrid
portion of the portfolio and a weighted average coupon of 3.77% on the rest of
the portfolio. If the portfolio had been fully indexed, the weighted average
coupon of the portfolio would have been 4.28%, based upon the current
composition of the portfolio and the applicable indices. Additionally, if the
non-hybrid portion of the portfolio had been fully indexed, the weighted
average coupon of the ARM portfolio would have been 3.26%, based upon the
composition of the portfolio and the applicable indices at that time. At June 30, 2004, the current yield of the ARM assets portfolio was 3.88%, down
from 4.04% as of December 31, 2003. The decrease in the yield of 16 basis
points as of June 30, 2004, compared to December 31, 2003, is primarily due to the 39




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decreased
weighted average interest rate coupon discussed above, which decreased by 7
basis points and the increased level of non-interest-earning principal payment
receivables, which decreased the yield by 6 basis points. Interest Rate Risk Management Our ARM asset portfolio had a weighted average term to the next repricing date
of 3.7 years as of June 30, 2004 and 3.7 years as of December 31, 2003. The
Traditional ARM portion of the portfolio had a weighted average term to the
next repricing date of 85 days and the Hybrid ARM portion had a weighted
average term to the next repricing date of 4.3 years at June 30, 2004. As of
June 30, 2004, the Hybrid ARM portfolio comprised 82.7% of the total ARM
portfolio, compared to 81.0% as of December 31, 2003. We attempt to mitigate
our interest rate risk by funding our ARM assets with borrowings and Hybrid
Hedging Instruments with maturities approximately matching the interest rate
adjustment periods on our ARM assets. Some of our borrowings bear variable or
short-term (one year or less) fixed interest rates because a portion of our ARM
assets have interest rates that adjust within one year. However, our Hybrid
ARM portfolio is financed with short-term borrowings that are hedged with
Hybrid Hedging Instruments that fix the interest rate on those borrowings such
that the net duration of the Hybrid ARM portfolio and the associated fixed-rate
hedged borrowings is one year or less. Duration is a calculation expressed in
months or years that is a measure of the expected price change of financial
instruments based on changes in interest rates. By maintaining a net duration
of less than one year, which is our maximum duration policy limit, the combined
price change of our Hybrid ARM portfolio, associated Hybrid Hedging Instruments
and other borrowings funding our Hybrid ARM portfolio is expected to be a
maximum of 1% for a 1% parallel shift in interest rates. A lower duration
indicates a lower expected volatility of earnings given future changes in
interest rates. As of June 30, 2004, the net duration applicable to our Hybrid
ARM portfolio was approximately 4.6 months while the net duration applicable to
all of our ARM assets was approximately 4.2 months. As of June 30, 2004 and December 31, 2003, we were counterparty to Swap
Agreements and Eurodollar Transactions having an aggregate current notional
balance of $15.7 billion and $12.5 billion, respectively. In addition, as of
June 30, 2004, the Company had entered into delayed Swap Agreements with
notional balances totaling $661 million that become effective in July 2004. As
of June 30, 2004, these Swap Agreements and Eurodollar Transactions had a
weighted average maturity of 3.3 years. In accordance with the Swap
Agreements, we will pay a fixed rate of interest during the term of these Swap
Agreements and receive a payment that varies monthly with the one-month LIBOR
rate. The combined weighted average fixed rate payable of the Swap Agreements
and Eurodollar Transactions was 2.99% and 3.02% at June 30, 2004 and December
31, 2003, respectively. As of June 30, 2004, ARM assets with a carrying value
of $84.1 million, including accrued interest, and cash totaling $40.1 million
collateralized the Swap Agreements. The net unrealized gain on Swap Agreements
at June 30, 2004 of $95.0 million included Swap Agreements with gross
unrealized gains of $129.2 million and gross unrealized losses of $34.2 million
and is included in Hedging instruments on the Consolidated Balance Sheets.
As of December 31, 2003, the net unrealized loss of $85.5 million included Swap
Agreements with gross unrealized gains of $14.9 million and gross unrealized
losses of $100.4 million. As of June 30, 2004, the net unrealized gain on Swap
Agreements, deferred gains from terminated Swap Agreements and deferred gains
and losses on Eurodollar Transactions recorded in Accumulated other
comprehensive income (loss) was a net gain of $91.2 million. We estimate that
over the next twelve months, $104.3 million of these net unrealized gains will
be reclassified from Accumulated other comprehensive income (loss) to interest
expense. As of June 30, 2004 and December, 31, 2003, our Cap Agreements, used to manage
our interest rate risk exposure on the financing of the Hybrid ARM loans
collateralizing our CDOs, had remaining notional amounts of $1.4 billion and
$1.6 billion, respectively. We also entered into Cap Agreements that have
start dates ranging from 2006 to 2010 and notional balances totaling $371.1
million. The fair value of all of our Cap Agreements at June 30, 2004 and
December 31, 2003 was $27.1 million and $25.4 million, respectively, and is
included in Hedging instruments on the Consolidated Balance Sheets. As of June
30, 2004, the unrealized loss on these Cap Agreements of $9.4 million was
included in Accumulated other comprehensive income (loss). In the twelve month
period following June 30, 2004, $983.2 thousand of this unrealized loss is
expected to be realized. Pursuant to the terms of these Cap Agreements, the
notional amount of the Cap Agreements declines such that it is expected to
equal the balance of the Hybrid ARM loans collateralizing our CDOs. Under
these Cap Agreements, we will receive cash payments should the one-month LIBOR
increase above the contract rates of these Hedging Instruments, which range
from 3.25% to 11.50% and average 5.05%. The Cap Agreements had an average
maturity of 4.3 years as of June 30, 2004 and will expire between 2006 and
2013. 40




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##### Table of Contents



The following table presents the outstanding notional balance of our Hybrid
Hedging Instruments as of June 30, 2004 and the balance of these same Hybrid
Hedging Instruments as of June 30 for each of the following five years, without
any assumption that additional Hybrid Hedging Instruments are added to the
portfolio in the future periods (amounts in thousands): As of June 30,2004
    
    2005
    
    2006
    
    2007
    
    2008
    
    2009Swap Agreements:Balance-guaranteed (1)(3)
    
    $
    1,242,653
    
    
    $
    988,775
    
    
    $
    791,020
    
    
    $
    516,616
    
    
    $
    198,517
    
    
    $
    60,696Other (2)
    
    
    14,000,248
    
    
    
    10,645,176
    
    
    
    5,052,805
    
    
    
    2,485,226
    
    
    
    848,478
    
    
    
    603,30615,242,901
    
    
    
    11,633,951
    
    
    
    5,843,825
    
    
    
    3,001,842
    
    
    
    1,046,995
    
    
    
    664,002Eurodollar Transactions (2)
    
    
    451,000
    
    
    
    375,000
    
    
    
    125,000
    
    
    
    
    
    
    
    
    
    
    
    Cap Agreements (1)(3)
    
    
    1,369,138
    
    
    
    1,099,079
    
    
    
    852,281
    
    
    
    700,560
    
    
    
    477,121
    
    
    
    310,948$
    17,063,039
    
    
    $
    13,108,030
    
    
    $
    6,821,106
    
    
    $
    3,702,402
    
    
    $
    1,524,116
    
    
    $
    974,950
  (1)
    
    These Swap Agreements and Cap Agreements have been entered into in
connection with our CDO transactions. The notional balances of these
agreements are guaranteed to match the balance of the Hybrid ARM
collateral in the respective CDO transactions, subject to a maximum
notional balance over the term of those agreements. The notional balances
presented in the table above for these balance-guaranteed agreements
represent forward-looking statements which are calculated based on a CPR
assumption of 20%. The actual balances will likely be different based on
the actual prepayment performance of the applicable Hybrid ARM collateral.
The final maturity of these agreements is 2013.  (2)
    
    These hedging instruments have a pre-determined schedule of notional
balances over the term of the respective instruments, based on the
expected decline in the balance of our short-term borrowings used to
finance our Hybrid ARM portfolio. The final maturity of these agreements
is 2013.  (3)
    
    The following table presents the maximum outstanding notional balance of
our balance-guaranteed Hybrid Hedging Instruments as of June 30, 2004 and
as of June 30 for each of the following five years (in thousands): As of June 30,2004
    
    2005
    
    2006
    
    2007
    
    2008
    
    2009Swap Agreements
    
    $
    1,242,653
    
    
    $
    1,094,476
    
    
    $
    928,385
    
    
    $
    633,916
    
    
    $
    265,556
    
    
    $
    85,389Cap Agreements
    
    
    1,369,138
    
    
    
    1,258,368
    
    
    
    977,599
    
    
    
    794,136
    
    
    
    499,415
    
    
    
    337,864$
    2,611,791
    
    
    $
    2,352,844
    
    
    $
    1,905,984
    
    
    $
    1,428,052
    
    
    $
    764,971
    
    
    $
    423,253
 Our Traditional ARM assets generally have a maximum lifetime interest rate cap
or ceiling, meaning that each Traditional ARM asset contains a contractual
maximum interest rate. Since our borrowings are not subject to equivalent
interest rate caps, we have entered into Cap Agreements that have the effect of
offsetting a portion of our borrowing costs above a level specified by the Cap
Agreement so that the net margin on our Traditional ARM assets will be
protected in high interest rate environments. As of June 30, 2004, our
Traditional ARM assets had an average lifetime interest rate cap of 11.36%, far
exceeding the current level of interest rates. At June 30, 2004, these Cap
Agreements had a remaining notional balance of $440.0 million with an average
final maturity of 4 months, compared to a remaining notional balance of $841.3
million with an average final maturity of 8 months at December 31, 2003. At
June 30, 2004, these Cap Agreements had a fair value of $0, compared to a fair
value of $9.0 thousand as of December 31, 2003. Pursuant to the terms of the
Cap Agreements, we will receive cash payments if the one month or three month
LIBOR indices increase above contractually specified levels, which range from
8.00% to 11.50% and average approximately 9.90%. We do not currently apply
hedge accounting to our Cap Agreements that are used to manage the interest
rate risk on our assets with contractual lifetime interest rate caps and, as a
result, we record the change in fair value of these Cap Agreements as hedging
expense in current earnings. The lifetime interest rate cap or ceiling is a
component of the duration of an ARM asset. As we manage the net duration of
our ARM asset portfolio and borrowings through our hedging activities, we are
implicitly managing all of the characteristics of our ARM assets and borrowings
that impact the measurement of duration, including the lifetime interest rate
cap that we had previously been hedging with Cap Agreements. 41




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The fair value of the net unrealized gain on Pipeline Hedging Instruments at
June 30, 2004 and December 31, 2003 was $2.8 million and $953.4 thousand,
respectively, and is included in Hedging instruments on the Consolidated
Balance Sheets. Pipeline Hedging Instruments had remaining notional balances
of $465.0 million and $283.0 million at June 30, 2004 and December 31, 2003,
respectively. The net gain of $6.5 million on Pipeline Hedging Instruments at
June 30, 2004 is reflected in
Gain (loss) on ARM assets and hedging instruments, net on the Consolidated
Income Statements and partially offsets the $9.2 million loss recorded on loan
commitments pursuant to SFAS 149, Amendment of Statement 133 on Derivative
Instruments and Hedging Activities. On March 9, 2004, the SEC released Staff Accounting Bulletin 105 (SAB 105)
providing guidance on how to account for a commitment to purchase a mortgage
loan prior to funding the loan. SAB 105 is intended to eliminate the current
diversity in practice that exists relating to the accounting for loan
commitments. SAB 105 is effective for loan commitments entered into after
March 31, 2004. Management believes that the Companys method of accounting
for loan commitments is consistent with the guidance provided by SAB 105. Asset Acquisitions During the quarter ended June 30, 2004, we purchased $3.0 billion of ARM
securities, 99.7% of which were High Quality assets and $1.1 billion of ARM
loans, generally originated to A quality underwriting standards. Of the ARM
assets acquired during the second quarter of 2004, 92.1% were Hybrid ARM assets
and 7.9% were Traditional ARM assets generally indexed to LIBOR. The following
table compares our ARM asset acquisition and origination activity for the
three- and six-month periods ended June 30, 2004 and 2003 (dollar amounts in
thousands): For the three months ended:
    
    For the six months ended:June 30, 2004
    
    June 30, 2003
    
    June 30, 2004
    
    June 30, 2003ARM securities:Agency Securities
    
    $
    271,023
    
    
    $
    155,203
    
    
    $
    1,054,570
    
    
    $
    348,211High Quality, non-Agency
    
    
    2,690,302
    
    
    
    2,955,289
    
    
    
    5,460,055
    
    
    
    4,395,529Other non-Agency
    
    
    7,658
    
    
    
    5,294
    
    
    
    18,210
    
    
    
    17,5862,968,983
    
    
    
    3,115,786
    
    
    
    6,532,835
    
    
    
    4,761,326ARM loans:Bulk acquisitions
    
    
    
    
    
    
    332,096
    
    
    
    88,959
    
    
    
    673,519Correspondent originations
    
    
    990,893
    
    
    
    704,547
    
    
    
    1,803,923
    
    
    
    1,467,397Direct retail originations
    
    
    138,935
    
    
    
    110,660
    
    
    
    234,817
    
    
    
    210,8761,129,828
    
    
    
    1,147,303
    
    
    
    2,127,699
    
    
    
    2,351,792Total acquisitions
    
    $
    4,098,811
    
    
    $
    4,263,089
    
    
    $
    8,660,534
    
    
    $
    7,113,118
 Since 1997, we have emphasized acquiring ARM assets at substantially lower
prices relative to par in order to reduce the potential impact on our earnings
as a result of rapid prepayments. In doing so, the average premium paid for
ARM assets acquired in the first six months of 2004 was 0.75% of par, as
compared to 3.29% of par in 1997. In part, as a result of this strategy, the
unamortized cost basis was 101.05% of par as of June 30, 2004, down from
102.77% of par as of the end of 1997. As of June 30, 2004, we had commitments to purchase $332.8 million of ARM
securities and $802.9 million of ARM loans through origination channels. We
use a 17.0% fallout assumption in the determination of our ARM loan
commitments. Securitization Activity On June 30, 2004, we completed a CDO transaction in which we securitized $1.1
billion of our ARM loans into a series of multi-class ARM securities. The
securitization process benefits us by enabling us to issue floating-rate and
fixed-rate CDOs that represent permanent financing and are not subject to
margin calls or by creating highly liquid assets that can be readily financed
in the reverse repurchase agreement market. While TMHL transferred
substantially all of the ARM loans to a 42




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separate bankruptcy-remote legal
entity, on a consolidated basis: (i) we did not account for this
securitization as a sale and (ii) we retained $35.6 million of subordinated
classes, of which $27.5 million were Investment Grade and $8.1 million were
below Investment Grade, to provide credit support to the securitization. Of
the loans that we securitized during the second quarter of 2004, 99.3% of our
resulting investment was rated at least Investment Grade and 0.7% of our
investment was rated below Investment Grade. All discussions relating to
securitizations in this Form 10-Q are on a consolidated basis and do not
reflect the separate legal ownership of the loans by various bankruptcy-remote
legal entities that are our wholly-owned subsidiaries. Prepayment Experience For the quarter ended June 30, 2004, our mortgage assets paid down at an
approximate average annualized Constant Prepayment Rate (CPR) of 35%,
compared to 19% for the quarter ended March 31, 2004 and 31% for the quarter
ended June 30, 2003. When prepayment expectations over the remaining life of
the assets increase, we have to amortize our premiums over a shorter time
period, resulting in a reduced yield to maturity on our ARM assets.
Conversely, if prepayment expectations decrease, we would amortize the premium
over a longer time period, resulting in a higher yield to maturity. We monitor
our prepayment experience on a monthly basis and adjust the amortization of the
net premium, as appropriate. Liquidity and Capital Resources We manage liquidity to ensure that we have the continuing ability to maintain
cash flows that are adequate to fund operations and meet commitments on a
timely and cost-effective basis. At June 30, 2004, we had unencumbered assets
of $825.6 million, consisting of unpledged ARM assets, cash and cash
equivalents, and other assets. We had unencumbered assets of $712.4 million at
December 31, 2003. Our principal sources of liquidity are the reverse
repurchase agreement market, the issuance of CDOs and whole loan financing
facilities, as well as principal and interest payments from ARM assets and in
the future will also include asset-backed commercial paper liquidity notes.
The reverse repurchase agreement market is a $4 trillion market that has been a
readily available source of financing for mortgage assets, particularly those
rated AA or better. There is also a robust market for AAA-rated CDOs of the
type that we issue and this type of financing effectively eliminates rollover
and margin call risk for the related portion of our balance sheet. To
supplement our funding sources, we also issue equity securities and unsecured
long-term debt. We believe that our liquidity level is in excess of that
necessary to satisfy our operating requirements and we expect to continue to
use diverse funding sources to maintain our financial flexibility. Sources of Funds Our primary sources of funds for the quarter ended June 30, 2004 consisted of
reverse repurchase agreements, CDOs, whole loan financing facilities and
payments of principal and interest from our ARM assets. In the future, we
expect our primary sources of funds to include those mentioned above along with
asset-backed commercial paper liquidity notes. We have arrangements to enter into reverse repurchase agreements with 24
different financial institutions and on June 30, 2004, had borrowed funds from
18 of these firms. Reverse repurchase agreement borrowings outstanding at June
30, 2004, had a weighted average effective cost of 1.37%. The reverse
repurchase agreements had a weighted average remaining term to maturity of 2.9
months, although we utilize Swap Agreements and Eurodollar Transactions to
extend the re-pricing characteristic of total borrowings to 2.5 years. As of
June 30, 2004, $13.3 billion of these borrowings were variable rate term
reverse repurchase agreements. Because we borrow money under these agreements
based on the fair value of our ARM assets, and because changes in interest
rates can negatively impact the valuation of ARM assets, our borrowing ability
under these agreements may be limited and lenders may initiate margin calls in
the event interest rates change or the value of our ARM assets declines for
other reasons. Additionally, 1.0% of our ARM securities are rated less than AA
by the Rating Agencies and have less liquidity than assets that are rated AA or
higher. Mortgage assets rated AA or higher by the Rating Agencies derive their
credit rating based on subordination, guarantees or other credit enhancements.
In the event of dramatic changes in interest rates or performance of credit
support, we might find it difficult to borrow against such assets. External
disruptions to credit markets might also impair access to additional liquidity
and, therefore, we might be required to sell certain mortgage assets in order
to maintain liquidity. If required, such sales might be at prices lower than
the carrying value of the assets, which would result in losses. We had
adequate liquidity throughout the quarter ended June 30, 2004. We believe we
will continue to have sufficient liquidity to meet our future cash requirements
from our primary sources of funds for the foreseeable future without needing to
sell assets. 43




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##### Table of Contents



On June 30, 2004, we completed a CDO transaction in which we permanently
financed $1.1 billion of ARM loans from our ARM loan portfolio. In this
transaction, we issued AAA-rated floating-rate pass-through certificates
totaling $1.0 billion to third party investors and retained the subordinated
certificates, which provide credit support to the loans collateralizing the
debt. The interest rates on the floating-rate pass-through certificates reset
monthly and are indexed to the one-month LIBOR rate. In connection with the
issuance of these CDOs, we incurred costs of $4.5 million, which were deducted
from the proceeds of the transaction and are being amortized over the expected
life of the CDOs. This transaction was accounted for as a financing of the
loans and represents permanent financing that is not subject to margin calls. All of our CDOs were issued by trusts and are secured by ARM loans. For
financial reporting and tax purposes, the trusts ARM loans held as collateral
are recorded as assets of the Company and the CDOs are recorded as the
Companys debt. In some transactions, Hedging Instruments are held by the
trusts and recorded as assets of the Company. The Hedging Instruments either
fix the interest rate of the pass-through certificates or cap the interest rate
exposure on these transactions. As of June 30, 2004, the following CDOs were
outstanding (in thousands): Effective InterestDescription
    
    Principal Balance
    
    Rate (1)Floating-rate financing (2)
    
    $
    2,895,312
    
    
    
    1.64
    %Fixed-rate financing
    
    
    1,928,039
    
    
    
    3.87
    %Total
    
    $
    4,823,351
    
    
    
    2.53
    %
  (1)
    
    Effective interest rate includes the impact of issuance costs and Hedging
Instruments.  (2)
    
    Includes financing hedged with Cap Agreements with a notional balance of
$1.4 billion and a weighted average strike price of 5.05% as of June 30,
2004. As of June 30, 2004, the CDOs were collateralized by ARM loans with a principal
balance of $4.9 billion. The debt matures between 2033 and 2044 and is
callable by the Company at par once the total balance of the loans
collateralizing the debt is reduced to 20% of their original balance. The
balance of this debt is reduced as the underlying loan collateral is paid down
and is expected to have an average life of approximately four years. As of June 30, 2004, we had entered into four whole loan financing facilities.
The interest rates on these facilities are indexed to one-month LIBOR and
reprice accordingly. These facilities have a total committed borrowing
capacity of $1.1 billion and an uncommitted capacity of $500 million and expire
between September 2004 and March 2005. We expect to renew these facilities in
the ordinary course of business. As of June 30, 2004, we had $294.8 million
borrowed against these whole loan financing facilities at an effective cost of
2.31%. Capital Utilization Our Board has approved a policy that limits our capacity to borrow funds to
finance mortgage assets based on our equity capital and unsecured debt. We
monitor the relationship between our assets, borrowings and long-term capital
using a variety of different measures. The primary operating policy that
limits our borrowings and leverage is a requirement to maintain our Adjusted
Equity-to-Assets Ratio, a non-GAAP measurement, at a minimum of 8%. Our
Adjusted Equity-to-Assets Ratio represents the long-term capital (both equity
and Senior Notes) supporting our recourse or marginable debt. Recourse or
marginable debt generally consists of reverse repurchase agreements and whole
loan financing facilities. These forms of borrowing are short-term in nature,
mature on a frequent basis (weighted average maturity of 2.9 months as of June
30, 2004), need to be rolled over at each maturity and are subject to margin
call based on collateral value changes or changes in margin requirements.
Because of the short-term nature of these forms of financing, our policy
requires that we maintain significant excess capital and liquidity to meet
margin calls as a result of unexpected changes in margin requirements and
collateral value. Our policy is to maintain a capital cushion equal to
approximately twice the margin requirement when using these forms of
borrowings. Our margin requirements typically range between 4% and 5% for
these borrowings, so our policy requires that we maintain capital of at least
8%, and typically 9% to 10%, against the financing of these assets. This
capital cushion has proved to be more than adequate to support our borrowing
arrangements through a variety of interest rate and credit cycles. 44




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##### Table of Contents



As we replace our reverse repurchase agreement borrowings with CDO financings,
the risk of margin calls, changes in margin requirements and potential rollover
risk is eliminated, because CDO financings represent permanent non-recourse
financing whose terms are established at the time of the financing and are not
subject to change. As a result, the need to maintain a capital cushion
comparable to what we maintain on our recourse borrowings is eliminated. For
purposes of maintaining an adequate capital cushion, our policy allows us to
eliminate all assets (and the associated equity capital) associated with CDO
financing from our operating capital ratio. Additionally, we eliminate from
our Adjusted Equity-to-Assets Ratio any unrealized market value adjustments,
recorded as Accumulated other comprehensive income (loss) from our equity
accounts, and we include our Senior Notes as an additional form of long-term
capital as if the notes were equity capital. Because the CDOs only require
approximately 2% of equity capital to support the CDO financing, versus the 8%
to 10% policy requirement on our recourse borrowings, we are able to use this
freed-up capital to acquire additional assets. We expect that we will be able
to retain and carry an increased amount of assets in the future as a percentage
of our equity capital base. Further, because we treat our Senior Notes as a
substitute form of equity capital, our asset base is expected to grow even
further. The following table presents the calculation of our Adjusted Equity-to-Assets
ratio, a non-GAAP measurement: (in thousands)
    
    June 30, 2004
    
    December 31, 2003Assets
    
    $
    24,540,871
    
    
    $
    19,118,799Adjustments:Net unrealized (gain) loss on ARM securities
    
    
    212,886
    
    
    
    42,717Net unrealized loss (gain) on hedging instruments
    
    
    (119,720
    )
    
    
    (8,655
    )ARM loans collateralizing CDOs
    
    
    (4,872,050
    )
    
    
    (3,146,961
    )Cap agreements
    
    
    (36,508
    )
    
    
    (31,692
    )Adjusted assets
    
    $
    19,725,479
    
    
    $
    15,974,208Shareholders equity
    
    $
    1,555,927
    
    
    $
    1,239,104Adjustments:Accumulated other comprehensive loss
    
    
    131,441
    
    
    
    142,778Equity supporting CDOs:CDOs
    
    
    4,823,351
    
    
    
    3,114,047ARM loans collateralizing CDOs
    
    
    (4,872,050
    )
    
    
    (3,146,961
    )Cap agreements
    
    
    (36,508
    )
    
    
    (31,692
    )(85,207
    )
    
    
    (64,606
    )Senior notes
    
    
    251,263
    
    
    
    251,080Adjusted shareholders equity
    
    $
    1,853,424
    
    
    $
    1,568,356Adjusted equity-to-assets ratio
    
    
    9.40
    %
    
    
    9.82
    %GAAP equity-to-assets ratio
    
    
    6.34
    %
    
    
    6.48
    %Ratio of historical equity
plus Senior Notes to
historical assets
    
    
    7.87
    %
    
    
    8.53
    %Estimated total risk-based
capital /risk-weighted assets
    
    
    24.10
    %
    
    
    26.26
    %
 45




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##### Table of Contents



The above table also presents three alternative capital utilization
measurements to our Adjusted Equity-to-Assets ratio. The first capital
utilization measurement is our GAAP equity-to-assets ratio, a calculation that
simply divides total equity by total assets. While the simplest of all
equity-to-assets calculations, it is not used by management to manage our
balance sheet because it includes factors such as unrealized gains and losses
on assets and Hedging Instruments deemed to be less important to the long-term
operating nature of our business, since our assets are not for sale and since
the unrealized gains and losses are not permanent impairments of our equity or
of these assets and Hedging Instruments. The second alternative capital utilization measurement is the ratio of
historical equity plus Senior Notes to historical assets. This is a non-GAAP
measurement that eliminates the market value adjustment of our assets and
Hedging Instruments included in Accumulated other comprehensive income (loss).
This calculation also includes Senior Notes as a component of our long-term
capital base. This measurement is calculated by dividing the sum of the
assets, net unrealized gain (loss) on ARM securities and net unrealized gain
(loss) on Hedging Instruments in the table above by the sum of shareholders
equity and Senior Notes in the table above. We monitor this ratio in order to
have a complete picture of the relationship between our total asset and
long-term capital position. The third alternative capital utilization measurement is a calculation of
estimated total risk-based capital divided by risk-weighted assets, a
regulatory calculation required to be made by banks and savings and loan
institutions that complies with Federal Reserve Board capital requirements.
Risk-based capital measures capital requirements for assets based on their
credit exposure as defined by the regulation, with lower credit risk assets
requiring less capital and higher credit risk assets requiring more capital.
Although we are not subject to these regulatory requirements, we focus our
efforts on only high quality assets.
Therefore, our risk-based capital ratio tends to be quite high when compared to
banking institutions, and well in excess of the regulatory minimum of 10%
required for banks and savings and loan institutions to qualify as
well-capitalized. Equity Transactions In February 2004, we completed a public offering of 4,000,000 shares of common
stock and received net proceeds of $110.1 million. During the quarter ended June 30, 2004, we issued 1,802,944 shares of common
stock under the Dividend Reinvestment and Stock Purchase Plan (the DRSPP) and
received net proceeds of $46.7 million. During the quarter ended June 30, 2004, we issued 1,186,300 shares of common
stock through a controlled equity offering program and received net proceeds of
$31.9 million. Off-Balance Sheet Commitments As of June 30, 2004, we had commitments in the ordinary course of business to
purchase or originate the following amounts of ARM assets (in thousands): ARM securities  private high quality
    
    $
    332,836ARM loans  correspondent originations
    
    
    717,086ARM loans  direct originations
    
    
    85,821$
    1,135,743
 We use a 17.0% fallout assumption in determining our ARM loan origination
commitments. We also have entered into transactions whereby we expect to
acquire the remaining balance of certain AAA-rated Hybrid ARM securities, at a
price of par, between 2004 and 2008, when the fixed-rate period of the Hybrid
ARM securities terminates and the securities convert into Traditional ARM
securities with characteristics similar to the Traditional ARM securities held
in the current portfolio. We view these transactions as an alternative source
of Traditional ARM assets. The current balance of the Hybrid ARM securities is
approximately $1.8 billion, but is expected to be less than 28% of that, and
could be zero, at the time they convert into Traditional ARM securities. If we
decide not to acquire the Hybrid ARM securities when they convert into
Traditional ARM securities, then we are committed to pay or receive the
difference between par and the fair value of the Traditional ARM securities at
that time, as determined by an auction of the Traditional ARM securities. 46




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##### Table of Contents



Contractual Obligations As of June 30, 2004, we had the following contractual obligations (in
thousands): Payments Due by PeriodLess than 1
    
    
    
    
    
    3  5
    
    More thanTotal
    
    year
    
    1  3 years
    
    years
    
    5 yearsReverse repurchase agreements
    
    $
    17,492,989
    
    
    $
    17,387,514
    
    
    $
    105,475
    
    
    $
    
    
    
    $
    CDOs (1)
    
    
    4,823,351
    
    
    
    10,110
    
    
    
    22,755
    
    
    
    49,740
    
    
    
    4,740,746Whole loan financing facilities
    
    
    294,763
    
    
    
    294,763
    
    
    
    
    
    
    
    
    
    
    
    Senior Notes
    
    
    251,263
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    251,263Purchase commitments
    
    
    1,135,743
    
    
    
    1,135,743
    
    
    
    
    
    
    
    
    
    
    
    Total (2)
    
    $
    23,998,109
    
    
    $
    18,828,130
    
    
    $
    128,230
    
    
    $
    49,740
    
    
    $
    4,992,009
  (1)
    
    Maturities of our CDOs are dependent upon cash flows received from the
underlying loans receivable. Our estimate of their repayment is based on
scheduled principal payments on the underlying loans receivable. This
estimate will differ from actual amounts to the extent we experience
prepayments and/or loan losses.  (2)
    
    Our Consolidated Balance Sheets include a liability for Hedging
Instruments with negative market values, which are not reflected in this
table. Results of Operations For the Three Months Ended June 30, 2004 For the quarter ended June 30, 2004, our net income was $57.9 million, or $0.71
basic and diluted earnings per share (EPS), based on a weighted average of
81,373,000 shares outstanding. That compares to $42.2 million, or $0.68 basic
EPS and $0.67 diluted EPS for the quarter ended June 30, 2003, based on
weighted average basic and diluted shares outstanding of 59,879,000 and
62,639,000, respectively, a 6.0% increase in our diluted EPS. The table below highlights the historical trend in the components of return on
average common equity (annualized) during each respective quarter: Components of Return on Average Common Equity G & ANet
    
    Expense,
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    NetFor the
    
    Interest
    
    net
    
    Mgmt
    
    Performance
    
    Other
    
    Preferred
    
    Income/Quarter
    
    Income/
    
    (1)/
    
    Fee/
    
    Fee/
    
    (2)/
    
    Dividend/
    
    EquityEnded
    
    Equity
    
    Equity
    
    Equity
    
    Equity
    
    Equity
    
    Equity
    
    (ROE)Jun 30, 2002
    
    
    23.80
    %
    
    
    1.84
    %
    
    
    1.23
    %
    
    
    2.40
    %
    
    
    0.33
    %
    
    
    1.08
    %
    
    
    16.92
    %Sep 30, 2002
    
    
    24.62
    %
    
    
    1.52
    %
    
    
    1.20
    %
    
    
    2.92
    %
    
    
    0.09
    %
    
    
    0.97
    %
    
    
    17.92
    %Dec 31, 2002
    
    
    24.90
    %
    
    
    2.32
    %
    
    
    1.17
    %
    
    
    2.96
    %
    
    
    (0.26
    )%
    
    
    0.89
    %
    
    
    17.82
    %Mar 31, 2003
    
    
    25.56
    %
    
    
    2.02
    %
    
    
    1.22
    %
    
    
    3.04
    %
    
    
    0.08
    %
    
    
    0.82
    %
    
    
    18.38
    %Jun 30, 2003
    
    
    23.93
    %
    
    
    2.31
    %
    
    
    1.17
    %
    
    
    3.03
    %
    
    
    (1.03
    )%
    
    
    0.73
    %
    
    
    17.72
    %Sep 30, 2003
    
    
    21.97
    %
    
    
    1.70
    %
    
    
    1.13
    %
    
    
    2.62
    %
    
    
    (0.27
    )%
    
    
    0.00
    %
    
    
    16.79
    %Dec 31, 2003
    
    
    22.79
    %
    
    
    2.10
    %
    
    
    1.11
    %
    
    
    2.59
    %
    
    
    0.23
    %
    
    
    0.00
    %
    
    
    16.76
    %Mar 31, 2004
    
    
    21.35
    %
    
    
    2.25
    %
    
    
    1.11
    %
    
    
    2.55
    %
    
    
    (0.90
    )%
    
    
    0.00
    %
    
    
    16.34
    %Jun 30, 2004
    
    
    19.98
    %
    
    
    0.62
    %
    
    
    1.06
    %
    
    
    2.29
    %
    
    
    0.39
    %
    
    
    0.00
    %
    
    
    15.62
    %
   (1)
    
    General and administrative (G & A) expense excludes management and
performance fees and is net of servicing income. 47




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##### Table of Contents



(2)
    
    Other includes gain on ARM assets and hedging instruments, hedging
expense and provision for credit losses. Our return on equity declined slightly in this past quarter compared to the
same period in 2003 primarily due to decreased yield on our ARM asset portfolio
and a net loss on commitments to purchase loans from correspondent lenders,
partially offset by
decreased long-term incentive award expense as a result of our decreased stock
price and gains on Eurodollar Transactions hedging the loan commitment pipeline
and the termination of three Swap Agreements. The decline in our net interest
spread was partially offset by more effective use of capital. The following table presents the components of our net interest income for the
quarters ended June 30, 2004 and 2003: Comparative Net Interest Income Components
(in thousands) For the quarters ended June 30,2004
    
    2003Coupon interest income on ARM assets
    
    $
    228,826
    
    
    $
    144,332Amortization of net premium
    
    
    (12,204
    )
    
    
    (8,244
    )Cash and cash equivalents
    
    
    865
    
    
    
    809Interest income
    
    
    217,487
    
    
    
    136,897Reverse repurchase agreements
    
    
    49,192
    
    
    
    37,066CDOs
    
    
    18,686
    
    
    
    4,320Whole loan financing facilities
    
    
    3,468
    
    
    
    3,385Senior notes
    
    
    5,237
    
    
    
    2,090Hedging instruments
    
    
    66,852
    
    
    
    35,305Interest expense
    
    
    143,435
    
    
    
    82,166Net interest income
    
    $
    74,052
    
    
    $
    54,731
 As presented in the table above, our net interest income increased by $19.3
million in the second quarter of 2004 compared to the second quarter of 2003.
The change was attributable to a $80.6 million increase in interest income
primarily due to an increased asset base, partially offset by a $61.3 million
increase in interest expense. Interest expense increased by $31.5 million due
to the impact of Swap Agreements and Eurodollar Transactions which is
commensurate with the increase in borrowings financing our Hybrid ARM assets.
Hybrid ARM assets totaled $19.1 billion and $11.5 billion at June 30, 2004 and
2003, respectively. Interest expense increased by $17.5 million due to our
issuance of additional CDOs and Senior Notes. The balance of our CDOs and
Senior Notes increased to $4.8 billion and $251.3 million, respectively, at
June 30, 2004 from $967.5 million and $194.3 million, respectively, at June 30,
2003. 48




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##### Table of Contents



The following table presents the average balances for each category of our
interest-earning assets as well as our interest-bearing liabilities, with the
corresponding annualized effective rate of interest and the related interest
income or expense: Average Balance, Rate and Interest Income/Expense Table
(Dollar amounts in thousands) For the quarters ended June 30,2004
    
    2003Interest
    
    
    
    
    
    
    
    
    
    InterestAverage
    
    Effective
    
    Income and
    
    Average
    
    Effective
    
    Income andBalance
    
    Rate
    
    Expense
    
    Balance
    
    Rate
    
    ExpenseInterest-Earning Assets:ARM assets
    
    $
    22,273,339
    
    
    
    3.89
    %
    
    $
    216,622
    
    
    $
    12,899,692
    
    
    
    4.22
    %
    
    $
    136,088Cash and cash equivalents
    
    
    354,455
    
    
    
    0.98
    
    
    
    865
    
    
    
    244,585
    
    
    
    1.32
    
    
    
    80922,627,794
    
    
    
    3.84
    
    
    
    217,487
    
    
    
    13,144,277
    
    
    
    4.17
    
    
    
    136,897Interest-Bearing Liabilities:Reverse repurchase agreements
    
    
    16,109,269
    
    
    
    1.22
    
    
    
    49,192
    
    
    
    10,299,582
    
    
    
    1.44
    
    
    
    37,066Plus: Cost of Hedging instruments (1)
    
    
    
    
    
    
    1.54
    
    
    
    61,877
    
    
    
    
    
    
    
    1.37
    
    
    
    35,305Hedged reverse repurchase agreements
    
    
    
    
    
    
    2.76
    
    
    
    111,069
    
    
    
    
    
    
    
    2.81
    
    
    
    72,371CDOs
    
    
    4,008,660
    
    
    
    1.86
    
    
    
    18,686
    
    
    
    987,299
    
    
    
    1.75
    
    
    
    4,320Plus: Cost of Hedging instruments (1)
    
    
    
    
    
    
    0.50
    
    
    
    4,975
    
    
    
    
    
    
    
    0.00Hedged CDOs
    
    
    
    
    
    
    2.36
    
    
    
    23,661
    
    
    
    
    
    
    
    1.75
    
    
    
    4,320Whole loan financing facilities
    
    
    741,542
    
    
    
    1.87
    
    
    
    3,468
    
    
    
    632,120
    
    
    
    2.14
    
    
    
    3,385Senior Notes
    
    
    251,174
    
    
    
    8.34
    
    
    
    5,237
    
    
    
    100,269
    
    
    
    8.34
    
    
    
    2,09021,110,645
    
    
    
    2.72
    
    
    
    143,435
    
    
    
    12,019,270
    
    
    
    2.73
    
    
    
    82,166Net Interest-Earning Assets
and Spread
    
    $
    1,517,149
    
    
    
    1.12
    %
    
    $
    74,052
    
    
    $
    1,125,007
    
    
    
    1.44
    %
    
    $
    54,731Yield on Net Interest-Earning Assets (2)
    
    
    
    
    
    
    1.31
    %
    
    
    
    
    
    
    
    
    
    
    1.67
    %
  (1)
    
    Includes Swap Agreements and Eurodollar Transactions with notional
balances of $15.7 billion and $11.6 billion as of June 30, 2004 and 2003,
respectively, and Cap Agreements with notional balances of $1.4 billion
and $557.5 million as of June 30, 2004 and 2003, respectively.  (2)
    
    Yield on Net Interest-Earning Assets is computed by dividing annualized
net interest income by the average daily balance of interest-earning
assets. 49




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##### Table of Contents



The following table presents the total amount of change in interest
income/expense from the table above and presents the amount of change due to
changes in interest rates, changes in volume and the combination of changes in
interest rates and volume (in thousands): Three Months ended June 30,2004 versus 2003Rate
    
    Volume
    
    Rate/Volume
    
    TotalInterest Income:ARM assets
    
    $
    (10,630
    )
    
    $
    98,889
    
    
    $
    (7,725
    )
    
    $
    80,534Cash and cash equivalents
    
    
    (212
    )
    
    
    363
    
    
    
    (95
    )
    
    
    56(10,842
    )
    
    
    99,252
    
    
    
    (7,820
    )
    
    
    80,590Interest Expense:Reverse repurchase agreements
    
    
    (1,358
    )
    
    
    40,822
    
    
    
    (766
    )
    
    
    38,698CDOs
    
    
    1,507
    
    
    
    13,223
    
    
    
    4,611
    
    
    
    19,341Whole loan financing facilities
    
    
    (429
    )
    
    
    586
    
    
    
    (74
    )
    
    
    83Senior Notes
    
    
    1
    
    
    
    3,145
    
    
    
    1
    
    
    
    3,147(279
    )
    
    
    57,776
    
    
    
    3,772
    
    
    
    61,269Net interest income
    
    $
    (10,563
    )
    
    $
    41,476
    
    
    $
    (11,592
    )
    
    $
    19,321
 As presented in the table above, net interest income increased by $19.3
million. This increase in net interest income is composed of a favorable
volume variance, partially offset by an unfavorable rate variance and an
unfavorable variance from the combination of rate and volume variance. The
increased average size of our portfolio during the second quarter of 2004
compared to the same period of 2003 increased net interest income in the amount
of $41.5 million. The average balance of our interest-earning assets was $22.6
billion during the quarter ended June 30, 2004, compared to $13.1 billion
during the same period of 2003  an increase of 72.1%. As a result of the
yield on our interest-earning assets decreasing to 3.84% during the second
quarter of 2004 from 4.17% during the same period of 2003, a decrease of 33
basis points, and our cost of funds decreasing to 2.72% from 2.73% during the
same time period, a decrease of 1 basis point, there was a net unfavorable rate
variance of $10.6 million. This was primarily due to an unfavorable rate
variance on our ARM assets portfolio and other interest-earning assets that
decreased net interest income by $10.8 million and an unfavorable rate variance
on borrowings in the amount of $279.5 thousand. The combination of changes in
rates and volume resulted in an $11.6 million decrease in net interest income. The following table highlights the components of net interest spread and the
annualized yield on net interest-earning assets as of each applicable quarter
end: Components of Net Interest Spread and Yield on Net Interest-Earning Assets (1)
(Dollar amounts in millions) Yield onAverage
    
    Historical
    
    
    
    
    
    Yield on
    
    
    
    
    
    
    
    
    
    NetAs of the
    
    Interest
    
    Weighted
    
    Yield
    
    Interest
    
    
    
    
    
    Net
    
    InterestQuarter
    
    Earning
    
    Average
    
    Adjust-
    
    Earning
    
    Cost of
    
    Interest
    
    EarningEnded
    
    Assets
    
    Coupon
    
    ment (2)
    
    Assets
    
    Funds
    
    Spread
    
    AssetsJun 30, 2002
    
    $
    7,846
    
    
    
    5.30
    %
    
    
    0.39
    %
    
    
    4.91
    %
    
    
    3.35
    %
    
    
    1.56
    %
    
    
    1.88
    %Sep 30, 2002
    
    $
    9,237
    
    
    
    5.16
    %
    
    
    0.42
    %
    
    
    4.75
    %
    
    
    3.19
    %
    
    
    1.56
    %
    
    
    1.84
    %Dec 31, 2002
    
    $
    10,105
    
    
    
    5.04
    %
    
    
    0.43
    %
    
    
    4.61
    %
    
    
    3.03
    %
    
    
    1.58
    %
    
    
    1.85
    %Mar 31, 2003
    
    $
    11,094
    
    
    
    4.96
    %
    
    
    0.52
    %
    
    
    4.44
    %
    
    
    2.82
    %
    
    
    1.62
    %
    
    
    1.88
    %Jun 30, 2003
    
    $
    13,144
    
    
    
    4.68
    %
    
    
    0.51
    %
    
    
    4.17
    %
    
    
    2.73
    %
    
    
    1.44
    %
    
    
    1.67
    %Sep 30, 2003
    
    $
    15,701
    
    
    
    4.41
    %
    
    
    0.56
    %
    
    
    3.85
    %
    
    
    2.53
    %
    
    
    1.32
    %
    
    
    1.53
    %Dec 31, 2003
    
    $
    18,327
    
    
    
    4.35
    %
    
    
    0.46
    %
    
    
    3.89
    %
    
    
    2.62
    %
    
    
    1.27
    %
    
    
    1.47
    %Mar 31, 2004
    
    $
    19,911
    
    
    
    4.29
    %
    
    
    0.36
    %
    
    
    3.93
    %
    
    
    2.73
    %
    
    
    1.20
    %
    
    
    1.40
    %Jun 30, 2004
    
    $
    22,628
    
    
    
    4.25
    %
    
    
    0.41
    %
    
    
    3.84
    %
    
    
    2.72
    %
    
    
    1.12
    %
    
    
    1.31
    %
   (1)
    
    Yield on Net Interest-Earning Assets is computed by dividing net
interest income by the average daily balance of interest-earning assets
during the quarter. 50




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##### Table of Contents



(2)
    
    Yield adjustments include the impact of amortizing premiums and
discounts, the impact of principal payment receivables and the impact of
interest-earning non-ARM assets. The following table presents these components of the yield adjustments for
the dates presented in the table above. Components of the Yield Adjustments on ARM Assets Impact ofAs of the
    
    Premium/
    
    Principal
    
    
    
    
    
    TotalQuarter
    
    Discount
    
    Payments
    
    
    
    
    
    YieldEnded
    
    Amortization
    
    Receivable
    
    Other(1)
    
    AdjustmentJun 30, 2002
    
    
    0.22
    %
    
    
    0.13
    %
    
    
    0.04
    %
    
    
    0.39
    %Sep 30, 2002
    
    
    0.26
    %
    
    
    0.13
    %
    
    
    0.03
    %
    
    
    0.42
    %Dec 31, 2002
    
    
    0.30
    %
    
    
    0.09
    %
    
    
    0.04
    %
    
    
    0.43
    %Mar 31, 2003
    
    
    0.34
    %
    
    
    0.15
    %
    
    
    0.03
    %
    
    
    0.52
    %Jun 30, 2003
    
    
    0.32
    %
    
    
    0.13
    %
    
    
    0.06
    %
    
    
    0.51
    %Sep 30, 2003
    
    
    0.34
    %
    
    
    0.14
    %
    
    
    0.08
    %
    
    
    0.56
    %Dec 31, 2003
    
    
    0.28
    %
    
    
    0.11
    %
    
    
    0.07
    %
    
    
    0.46
    %Mar 31, 2004
    
    
    0.27
    %
    
    
    0.06
    %
    
    
    0.03
    %
    
    
    0.36
    %Jun 30, 2004
    
    
    0.29
    %
    
    
    0.10
    %
    
    
    0.02
    %
    
    
    0.41
    %
 (1) Other includes the impact of interest-earning cash and cash equivalents
and restricted cash. We recorded hedging expense of $149.2 thousand during the second quarter of
2004 which was related to the transition adjustment recorded in Accumulated
other comprehensive income (loss) on January 1, 2002, in connection with the
implementation of Financial Accounting Standard 133, Accounting for Derivative
Instruments and Hedging Activities. For the quarter ended June 30, 2003, we
recorded hedging ineffectiveness in the amount of $67.6 thousand, hedging
expenses of $3.0 thousand related to Eurodollar Transactions and reclassified
to earnings $149.2 thousand of the transition adjustment, for total hedging
expense of $219.8 thousand. Since we began acquiring whole loans in 1997, we have only experienced losses
on three loans, for a total amount of $173.9 thousand. We continue to evaluate
our estimated credit losses on loans prior to their securitization and we may
readjust our current policy if the circumstances warrant. As of June 30, 2004,
our whole loans, including those that we have securitized, but with respect to
which we have retained credit loss exposure, accounted for 37.5% of our
portfolio of ARM assets or $8.7 billion. During the quarter ended June 30,
2004, we recorded loan loss provisions totaling $391.3 thousand to reserve for
estimated credit losses on loans. We recorded a net loss on ARM assets of $896.4 thousand during the second
quarter of 2004. This loss consists of a $13.0 million loss on commitments to
purchase loans from correspondent lenders, partially offset by a net gain of
$10.0 million on Eurodollar Transactions hedging the loan commitment pipeline
and a $2.1 million gain on the termination of Swap Agreements. We realized a
$2.6 million gain on ARM assets during the quarter ended June 30, 2003. This
gain consisted of a $1.7 million net recovery of estimated credit losses and a
$910.5 thousand gain upon the maturity of a collateralized bond obligation. 51




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##### Table of Contents



The following table highlights the quarterly trend of operating expenses as a
percent of average assets: Annualized Operating Expense Ratios Total OperatingFor the
    
    Management Fee/
    
    Performance Fee/
    
    Other Expenses/
    
    Expenses/Quarter Ended
    
    Average Assets
    
    Average Assets
    
    Average Assets
    
    Average AssetsJun 30, 2002
    
    
    0.10
    %
    
    
    0.19
    %
    
    
    0.14
    %
    
    
    0.43
    %Sep 30, 2002
    
    
    0.09
    %
    
    
    0.22
    %
    
    
    0.13
    %
    
    
    0.44
    %Dec 31, 2002
    
    
    0.09
    %
    
    
    0.22
    %
    
    
    0.18
    %
    
    
    0.49
    %Mar 31, 2003
    
    
    0.09
    %
    
    
    0.22
    %
    
    
    0.16
    %
    
    
    0.47
    %Jun 30, 2003
    
    
    0.08
    %
    
    
    0.21
    %
    
    
    0.18
    %
    
    
    0.47
    %Sep 30, 2003
    
    
    0.08
    %
    
    
    0.18
    %
    
    
    0.13
    %
    
    
    0.39
    %Dec 31, 2003
    
    
    0.07
    %
    
    
    0.17
    %
    
    
    0.14
    %
    
    
    0.38
    %Mar 31, 2004
    
    
    0.07
    %
    
    
    0.17
    %
    
    
    0.16
    %
    
    
    0.40
    %Jun 30, 2004
    
    
    0.07
    %
    
    
    0.15
    %
    
    
    0.06
    %
    
    
    0.28
    %
 The most significant increases to our operating expenses for the quarter ended
June 30, 2004 compared to June 30, 2003 were the $1.6 million increase in the
performance-based fee that the Manager earned as a result of our achieving a
return on shareholders equity in excess of the threshold as defined in the
Management Agreement with the Manager, the $1.3 million increase in expenses
related to expanded operations of TMHL and the $1.3 million increase in base
management fees. These increases were partially offset by a $3.4 million
decrease in the expenses associated with our Dividend Equivalent Rights
(DERs) and Phantom Stock Rights (PSRs), mainly due to the decrease in our
stock price from March 31, 2004 to June 30, 2004. Our return on equity prior
to the effect of the performance-based fee of $8.5 million for the second
quarter of 2004 was 17.91%, whereas the threshold, the average 10-year treasury
rate plus 1%, was 5.60%. Our expense ratios are among the lowest of any company originating and
investing in mortgage assets, giving us what we believe to be a significant
competitive advantage over more traditional mortgage portfolio lending
institutions such as banks and savings and loan institutions. This competitive
advantage enables us to operate with less risk, such as credit and interest
rate risk, and still generate an attractive long-term return on equity when
compared to more traditional mortgage portfolio lending institutions. We pay the Manager an annual base management fee, generally based on average
shareholders equity as defined in the Management Agreement, payable monthly in
arrears according to the following formula which was in effect through June 30,
2004: 1.23% of the first $300 million of average shareholders equity, plus
0.90% of average shareholders equity above $300 million, subject to an annual
inflation adjustment based on changes in the Consumer Price Index. Since the
management fee is based on shareholders equity and not assets, the fee
increases as we raise additional equity capital and thereby manage a larger
amount of invested capital on behalf of our shareholders. In order for the
Manager to earn a performance fee, the rate of return on the shareholders
investment, as defined in the Management Agreement, must exceed the average
10-year U.S. Treasury rate during the quarter plus 1%. In July 2004, the Management Agreement (the Agreement) between the Company
and the Manager was amended effective July 1, 2004. The term of the amended
Agreement was extended to July 1, 2014 and the formulas used to calculate the
base management and performance-based incentive fees earned under the Agreement
were revised such that the fees earned by the Manager will be reduced from what
they would have been under the previous formulas. Specifically, the previous
annual base management fee formula provided that the Manager earned 1.23% on
the first $300 million of Average Historical Equity, plus 0.90% on Average
Historical Equity above $300 million. The amended Agreement continues this
structure but limits the fee earned on Average Historical Equity over $1.5
billion to 0.80% with the fee decreasing an additional 0.05% for each
additional $0.5 billion in Average Historical Equity thereafter until reaching
a fee of 0.65% on any Average Historical Equity greater than $3.0 billion. The
previous formula used to calculate the performance fee provided that the
Manager earned 20% of the Companys annualized net income, before
performance-based compensation, above an annualized Return on Equity equal to
the ten year U.S. Treasury Rate plus 1%. The amended Agreement continues this
structure but provides that once the Manager has earned a performance fee of
$30 million, the performance fee percentage of 20% is reduced by 1% for each
additional $5 million earned in performance fee until reaching a performance
fee percentage of 15% for any amount greater than $50 million. 52




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##### Table of Contents



Results of Operations for the Six Months Ended June 30, 2004 For the six months ended June 30, 2004, our net income was $111.3 million, or
$1.41 Basic and Diluted EPS, based on a weighted average of 79,002,000 shares
outstanding. That compares to $81.3 million, or $1.35 Basic EPS and $1.34
Diluted EPS, for the same period in 2003, based on a weighted average of
57,767,000 and 60,527,000 shares outstanding, respectively, a 5.2% increase in
our Diluted earnings per share. Our return on average common equity was 15.96% for the six months ended June
30, 2004 compared to 18.03% for the six months ended June 30, 2003. The following table presents the components of our net interest income: Comparative Net Interest Income Components
(Dollar amounts in thousands) For the six months ended June 30,2004
    
    2003Coupon interest income on ARM assets
    
    $
    434,574
    
    
    $
    274,315Amortization of net premium
    
    
    (22,520
    )
    
    
    (15,431
    )Cash and cash equivalents
    
    
    1,246
    
    
    
    1,209Interest income
    
    
    413,300
    
    
    
    260,093Reverse repurchase agreements
    
    
    93,305
    
    
    
    72,495CDOs
    
    
    30,591
    
    
    
    4,906Whole loan financing facilities
    
    
    6,846
    
    
    
    7,106Senior notes
    
    
    10,472
    
    
    
    2,090Hedging instruments
    
    
    128,314
    
    
    
    66,731Interest expense
    
    
    269,528
    
    
    
    153,328Net interest income
    
    $
    143,772
    
    
    $
    106,765
 As presented in the table above, our net interest income increased by $37.0
million in the first half of 2004 compared to the same period of 2003. The
change was attributable to a $153.2 million increase in interest income
primarily due to an increased asset base, partially offset by a $116.2 million
increase in interest expense. Interest expense increased by $61.6 million due
to the impact of Swap Agreements and Eurodollar Transactions which is
commensurate with the increase in borrowings financing our Hybrid ARM assets.
Hybrid ARM assets totaled $19.1 billion and $11.5 billion at June 30, 2004 and
2003, respectively. Interest expense increased by $34.1 million due to our
issuance of additional CDOs and Senior Notes. The balance of our CDOs and
Senior Notes increased to $4.8 billion and $251.3 million, respectively, at
June 30, 2004 from $967.5 million and $194.3 million, respectively, at June 30,
2003. 53




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##### Table of Contents



The following table presents the average balances for each category of our
interest-earning assets as well as our interest-bearing liabilities, with the
corresponding annualized effective rate of interest and the related interest
income or expense: Average Balance, Rate, Interest Income and Interest Expense Table
(Dollar amounts in thousands) For the six months ended June 30,2004
    
    2003Interest
    
    
    
    
    
    
    
    
    
    InterestAverage
    
    Effective
    
    Income and
    
    Average
    
    Effective
    
    Income andBalance
    
    Rate
    
    Expense
    
    Balance
    
    Rate
    
    ExpenseInterest-Earning Assets:ARM assets
    
    $
    20,986,617
    
    
    
    3.93
    %
    
    $
    412,054
    
    
    $
    11,930,751
    
    
    
    4.34
    %
    
    $
    258,884Cash and cash equivalents
    
    
    282,644
    
    
    
    0.88
    
    
    
    1,246
    
    
    
    188,352
    
    
    
    1.28
    
    
    
    1,20921,269,261
    
    
    
    3.89
    
    
    
    413,300
    
    
    
    12,119,103
    
    
    
    4.29
    
    
    
    260,093Interest-Bearing Liabilities:Reverse repurchase agreements
    
    
    15,247,161
    
    
    
    1.22
    
    
    
    93,305
    
    
    
    9,814,820
    
    
    
    1.48
    
    
    
    72,495Plus: Cost of Hedging instruments (1)
    
    
    
    
    
    
    1.55
    
    
    
    118,181
    
    
    
    
    
    
    
    1.36
    
    
    
    66,731Hedged reverse repurchase agreements
    
    
    
    
    
    
    2.77
    
    
    
    211,486
    
    
    
    
    
    
    
    2.84
    
    
    
    139,226CDOs
    
    
    3,547,859
    
    
    
    1.72
    
    
    
    30,591
    
    
    
    503,087
    
    
    
    1.95
    
    
    
    4,906Plus: Cost of Hedging instruments (1)
    
    
    
    
    
    
    0.58
    
    
    
    10,133
    
    
    
    
    
    
    
    0.00Hedged CDOs
    
    
    
    
    
    
    2.30
    
    
    
    40,724
    
    
    
    
    
    
    
    1.95
    
    
    
    4,906Whole loan financing facilities
    
    
    746,191
    
    
    
    1.83
    
    
    
    6,846
    
    
    
    683,769
    
    
    
    2.08
    
    
    
    7,106Senior notes
    
    
    251,135
    
    
    
    8.34
    
    
    
    10,472
    
    
    
    50,135
    
    
    
    8.34
    
    
    
    2,09019,792,346
    
    
    
    2.72
    
    
    
    269,528
    
    
    
    11,051,811
    
    
    
    2.77
    
    
    
    153,328Net Interest Earning-Assets
and Spread
    
    $
    1,476,915
    
    
    
    1.17
    %
    
    $
    143,772
    
    
    $
    1,067,292
    
    
    
    1.52
    %
    
    $
    106,765Yield on Net Interest-Earning Assets (2)
    
    
    
    
    
    
    1.35
    %
    
    
    
    
    
    
    
    
    
    
    1.76
    %
  (1)
    
    Includes Swap Agreements and Eurodollar Transactions with notional
balances of $15.7 billion and $11.6 billion as of June 30, 2004 and 2003,
respectively, and Cap Agreements with notional balances of $1.4 billion
and $557.5 million as of June 30, 2004 and 2003, respectively.  (2)
    
    Yield on Net Interest-Earning Assets is computed by dividing annualized
net interest income by the average daily balance of interest-earning
assets. The following table presents the total amount of change in interest
income/expense from the table above and presents the amount of change due to
changes in interest rates, changes in volume and the combination of changes in
interest rates and volume (in thousands): Six Months ended June 30,2004 versus 2003Rate
    
    Volume
    
    Rate/Volume
    
    TotalInterest Income:ARM assets
    
    $
    (24,634
    )
    
    $
    196,502
    
    
    $
    (18,698
    )
    
    $
    153,170Cash and cash equivalents
    
    
    (379
    )
    
    
    606
    
    
    
    (190
    )
    
    
    37(25,013
    )
    
    
    197,108
    
    
    
    (18,888
    )
    
    
    153,207Interest Expense:Reverse repurchase agreements
    
    
    (3,091
    )
    
    
    77,062
    
    
    
    (1,711
    )
    
    
    72,260CDOs
    
    
    869
    
    
    
    29,691
    
    
    
    5,258
    
    
    
    35,818Whole loan financing facilities
    
    
    (833
    )
    
    
    649
    
    
    
    (76
    )
    
    
    (260
    )Senior notes
    
    
    1
    
    
    
    8,378
    
    
    
    3
    
    
    
    8,382(3,054
    )
    
    
    115,780
    
    
    
    3,474
    
    
    
    116,200Net interest income
    
    $
    (21,959
    )
    
    $
    81,328
    
    
    $
    (22,362
    )
    
    $
    37,007
 54




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##### Table of Contents



As presented in the table above, net interest income increased by $37.0
million. This increase in net interest income is composed of a favorable
volume variance, partially offset by an unfavorable rate variance and an
unfavorable variance from the combination of rate and volume. The increased
average size of our portfolio during the first six months of 2004 compared to
the same period of 2003 increased net interest income in the amount of $81.3
million. The average balance of our interest-earning assets was $21.3 billion
during the six months ended June 30, 2004, compared to $12.1 billion during the
same period of 2003  an increase of 76.0%. As a result of the yield on our
interest-earning assets decreasing to 3.89% during the first six months of 2004
from 4.29% during the same period of 2003, a decrease of 40 basis points, and
our cost of funds decreasing to 2.72% from 2.77% during the same time period, a
decrease of 5 basis points, there was a net unfavorable rate variance of $22.0
million. This was primarily due to an unfavorable rate variance on our ARM
assets portfolio and other interest-earning assets that decreased net interest
income by $25.0 million, partially offset by a favorable rate variance on
borrowings in the amount of $3.1 million. The combination of changes in rates
and volume generated a $22.4 million decrease in net interest income. For the six months ended June 30, 2004, our ratio of operating expenses to
average assets was 0.34%, compared to 0.47% for the same period in 2003. The
most significant single increase to our expenses was the $3.7 million increase
in the performance-based fee that the Manager earned during the first six
months of 2004 as a result of our achieving a return on shareholders equity in
excess of the threshold as defined in the Management Agreement with the
Manager. Our return on equity prior to the effect of the performance-based fee
was 18.37%, whereas the threshold, the average 10-year treasury rate plus 1%,
was 5.04%. Our other expenses increased by approximately $3.9 million from the
first six months of 2003 to the same period of 2004, primarily due to increased
base management fees and expenses of TMHLs operations, partially offset by
decreased expenses associated with our DERs and PSRs. The base management fee
paid to the Manager increased $2.4 million, TMHLs operations increased $2.1
million, and our DERs and PSRs expense decreased by $593.5 thousand. Market Risks The market risk management discussion and the amounts estimated from the
analysis that follows are forward-looking statements that assume that certain
market conditions occur. Actual results may differ materially from these
projected results due to changes in our ARM portfolio and borrowings mix and
due to developments in the domestic and global financial and real estate
markets. Developments in the financial markets include the likelihood of
changing interest rates and the relationship of various interest rates and
their impact on our ARM portfolio yield, cost of funds and cash flows. As a financial institution that has only invested in U.S.-dollar denominated
instruments (primarily residential mortgage instruments) and has only borrowed
money in the domestic market, we are not subject to foreign currency exchange
or commodity price risk. Our market risk exposure is largely due to interest
rate risk. Interest rate risk is defined as the sensitivity of our current and
future earnings to interest rate volatility, variability of spread
relationships, the difference in repricing intervals between our assets and
liabilities and the effect that interest rates may have on our cash flows,
especially ARM portfolio prepayments. Interest rate risk impacts our interest
income, interest expense and the market value on a large portion of our assets
and liabilities. The management of interest rate risk attempts to maximize
earnings and to preserve capital by minimizing the negative impacts of changing
market rates, asset and liability mix, and prepayment activity. The table below presents an approximation of the sensitivity of the market
value of our portfolio using a discounted cash flow simulation model.
Application of this method results in an estimation of the percentage change in
the market value of our assets, liabilities and Hedging Instruments per 100
basis point (bp) shift in interest rates expressed in yearsa measure
commonly referred to as duration. Positive portfolio duration indicates that
the market value of the total portfolio will decline if interest rates rise and
increase if interest rates decline. The closer duration is to zero, the less
interest rate changes are expected to affect earnings. Included in the table is
a Base Case duration calculation for an interest rate scenario that assumes
future rates are those implied by the yield curve as of June 30, 2004. The
other three scenarios assume interest rates are instantaneously 100, 200 and
300 bps higher than those implied by market rates as of June 30, 2004. The use of Hybrid Hedging Instruments is a critical part of our interest rate
risk management strategies, and the effects of these Hybrid Hedging Instruments
on the market value of the portfolio are reflected in the models output. This
analysis also takes into consideration the value of options embedded in our
mortgage assets including constraints on the repricing of the interest rates of
ARM assets resulting from periodic and lifetime cap features, as well as
prepayment options. Assets and liabilities that are not interest
rate-sensitive such as cash, payment receivables, prepaid expenses, payables
and accrued 55




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expenses are excluded. The duration calculated from this model is
a key measure of the effectiveness of our interest rate risk management
strategies. Net Portfolio Duration
June 30, 2004 Base Case
    
    Parallel +100 bps
    
    Parallel +200 bps
    
    Parallel +300 bpsAssets:Traditional ARMs
    
    
    0.47
    
    
    Years
    
    
    0.58
    
    
    Years
    
    
    0.86
    
    
    Years
    
    
    1.09
    
    
    YearsHybrid ARMs
    
    
    2.65
    
    
    
    
    
    
    
    2.84
    
    
    
    
    
    
    
    3.08
    
    
    
    
    
    
    
    3.00Total ARM assets
    
    
    2.31
    
    
    
    
    
    
    
    2.48
    
    
    
    
    
    
    
    2.74
    
    
    
    
    
    
    
    2.70Borrowings and hedges
    
    
    (1.73
    )
    
    
    
    
    
    
    (1.75
    )
    
    
    
    
    
    
    (1.74
    )
    
    
    
    
    
    
    (1.67
    )Net portfolio duration
    
    
    0.35
    
    
    Years
    
    
    0.43
    
    
    Years
    
    
    0.57
    
    
    Years
    
    
    0.58
    
    
    Years
 Based on the assumptions used, the model output suggests a very low degree of
portfolio price change given increases in interest rates, which implies that
our cash flow and earning characteristics should be relatively stable for
comparable changes in interest rates. As a comparison, the approximate base
case duration of an unhedged 10 year treasury, a conforming 30-year fixed
mortgage and a conforming 5/1 Hybrid ARM are 7.7, 5.1 and 2.2 years
respectively. Changes in assumptions including, but not limited to, volatility, mortgage and
financing spreads, prepayment behavior and defaults, as well as the timing and
level of interest rate changes, will affect the results of the model.
Therefore, actual results are likely to vary from modeled results. Although market value sensitivity analysis is widely accepted in identifying
interest rate risk, it does not take into consideration changes that may occur
such as, but not limited to, changes in investment and financing strategies,
changes in market spreads, and changes in business volumes. Accordingly, we
make extensive use of an earnings simulation model to further analyze our level
of interest rate risk. There are a number of key assumptions in our earnings simulation model. These
key assumptions include changes in market conditions that affect interest
rates, the pricing of ARM products, the availability of ARM products, and the
availability and the cost of financing for ARM products. Other key assumptions
made in using the simulation model include prepayment speeds and managements
investment, financing and hedging strategies, and the issuance of new equity.
We typically run the simulation model under a variety of hypothetical business
scenarios that may include different interest rate scenarios, different
investment strategies, different prepayment possibilities and other scenarios
that provide us with a range of possible earnings outcomes in order to assess
potential interest rate risk. The assumptions used represent our estimate of
the likely effect of changes in interest rates and do not necessarily reflect
actual results. The earnings simulation model takes into account periodic and
lifetime caps embedded in our ARM assets in determining the earnings at risk. At June 30, 2004, based on the earnings simulation model, our potential
earnings increase (decrease) from our base case earnings forecast for a
parallel 100, 200 and 300 basis point rise in market interest rates over the
next twelve months and a commensurate slowdown in prepayment speeds as interest
rates rise, was 1.4%, 0.5% and (1.5%), respectively, of projected net income
for the twelve months ended June 30, 2005. All of these earnings projections
result in earnings that provide sufficient coverage of dividends at their
current level. The assumptions used in the earnings simulation model are
inherently uncertain and, as a result, the analysis cannot precisely predict
the impact of higher interest rates on net income. Actual results could differ
from simulated results due to timing, magnitude and frequency of interest rate
changes, changes in prepayment speed other than what was assumed in the model,
and changes in other market conditions and management strategies to offset our
potential exposure, among other factors. This measure of risk represents our
exposure to higher interest rates at a particular point in time. Our actual
risk is always changing. We continuously monitor our risk profile and alter
our strategies as appropriate based on our view of interest rates and other
developments in our business. 56




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Effects of Interest Rate Changes Changes in interest rates impact our earnings in various ways. While we invest
primarily in ARM assets, rising short-term interest rates may temporarily
negatively affect our earnings, and, conversely, falling short-term interest
rates may temporarily increase our earnings. This impact can occur for several
reasons and may be mitigated by portfolio prepayment activity and portfolio
funding strategies as discussed below. First, our borrowings may react to
changes in interest rates sooner than our ARM assets because the weighted
average next repricing dates of the borrowings may be shorter time periods than
that of the ARM assets. Second, interest rates on Traditional ARM assets may
be limited to an increase of either 1% or 2% per adjustment period (commonly
referred to as the periodic cap), while our borrowings do not have similar
limitations. At June 30, 2004, 12.0% of our total ARM assets were Traditional
ARM assets subject to periodic caps. Third, our ARM assets typically lag
changes in the applicable interest rate indices by 45 days, due to the notice
period provided to ARM borrowers when the interest rates on their loans are
scheduled to change. Interest rates can also affect our net return on Hybrid ARM assets (net of the
cost of financing Hybrid ARM assets). We estimate the duration of our Hybrid
ARM assets and have a policy to hedge the financing of the Hybrid ARM assets
such that the net duration of our borrowed funds, Hybrid Hedging Instruments
and the Hybrid ARM assets is less than one year. During a declining interest
rate environment, the prepayment of Hybrid ARM assets may accelerate causing
the amount of fixed-rate financing to increase relative to the amount of Hybrid
ARM assets, possibly resulting in a decline in our net return on Hybrid ARM
assets as replacement Hybrid ARM assets may have a lower yield than the ones
paying off. In contrast, during an increasing interest rate environment,
Hybrid ARM assets may prepay slower than expected, requiring us to finance a
higher amount of Hybrid ARM assets than originally anticipated at a time when
interest rates may be higher, resulting in a decline in our net return on
Hybrid ARM assets. In order to manage our exposure to changes in the
prepayment speed of Hybrid ARM assets, we regularly monitor the balance of
Hybrid ARM assets and make adjustments to the amounts anticipated to be
outstanding in future periods and, on a regular basis, make adjustments to the
amount of our fixed-rate borrowing obligations in future periods. Interest rate changes can also affect the availability and pricing of ARM
assets, which affects our investment opportunities. During a rising interest
rate environment, there may be less total loan origination and refinance
activity. At the same time, a rising interest rate environment may result in a
larger percentage of ARM products being originated, mitigating the impact of
lower overall loan origination and refinance activity. Conversely, during a
declining interest rate environment, consumers, in general, may favor
fixed-rate mortgage products, but there may be above average loan origination
and refinancing volume in the industry such that even a small percentage of ARM
product volume may result in sufficient investment opportunities.
Additionally, a flat yield curve may be an adverse environment for ARM products
because there may be little incentive for a consumer to choose an ARM product
over a 30 year fixed-rate mortgage loan and, conversely, in a steep yield curve
environment, ARM products may enjoy an above average advantage over 30 year
fixed-rate mortgage loans, increasing our investment opportunities. The
availability and fluctuations in the volume of ARM loans being originated can
also affect their yield to us as an investment opportunity. During periods of
time when there is a shortage of ARM products, their yield as an investment may
decline due to market forces and conversely, when there is an above average
supply of ARM products, their yield to us as an investment may improve due to
the same market forces. To date, we have always been able to find sufficient
investment and loan origination opportunities at attractive prices in all
interest rate environments we have faced so that we have been able to generate
positive earnings and grow our portfolio as appropriate. The rate of prepayment on our mortgage assets may increase if interest rates
decline or if the difference between long-term and short-term interest rates
diminishes. Increased prepayments would cause us to amortize the premiums paid
for our mortgage assets faster, resulting in a reduced yield on our mortgage
assets. Additionally, to the extent proceeds of prepayments cannot be
reinvested at a rate of interest at least equal to the rate previously earned
on such mortgage assets, our earnings may be adversely affected. Conversely, the rate of prepayment on our mortgage assets may decrease if
interest rates rise or if the difference between long-term and short-term
interest rates increases. Decreased prepayments would cause us to amortize the
premiums paid for our ARM assets over a longer time period, resulting in an
increased yield on our mortgage assets. Therefore, in rising interest rate
environments where prepayments are declining, not only would the interest rate
on the ARM assets portfolio increase to re-establish a spread over the higher
interest rates, but the yield also would rise due to slower prepayments. The
combined effect could significantly mitigate other negative effects that rising
short-term interest rates might have on earnings. 57




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Lastly, because we invest primarily in ARM assets, and a portion of such assets
are purchased with shareholders equity, our earnings, over time, will tend to
increase, after an initial short-term decline, following periods when
short-term interest rates have risen, and decrease after an initial short-term
increase, following periods when short-term interest rates have declined. This
is because the financed portion of our portfolio of ARM assets will, over time,
reprice to a spread over our cost of funds,
while the portion of our portfolio of ARM assets purchased with shareholders
equity will generally have a higher yield in a higher interest rate environment
and a lower yield in a lower interest rate environment. Other Matters The Internal Revenue Code of 1986, as amended (the Code) requires that at
least 75% of our total assets must be qualified REIT assets, as defined by the
Code. The Code also requires that we meet a defined 75% source of income test
and a 95% source of income test. As of June 30, 2004, we calculated that we
were in compliance with all of these requirements. We also met all REIT
requirements regarding the ownership of our common stock and the distributions
of our net income. Therefore, as of June 30, 2004, we believe that we continue
to qualify as a REIT under the provisions of the Code. We intend to conduct our business so as not to become regulated as an
investment company under the Investment Company Act of 1940. If we were to
become regulated as an investment company, our use of leverage would be
substantially reduced. The Investment Company Act exempts entities that are
primarily engaged in the business of purchasing or otherwise acquiring
mortgages and other liens on and interests in real estate (Qualifying
Interests). Under current interpretation of the staff of the SEC, in order to
qualify for this exemption, we must maintain at least 55% of our assets
directly in Qualifying Interests as defined in the Code. In addition, unless
certain mortgage securities represent all the certificates issued with respect
to an underlying pool of mortgages, such mortgage securities may be treated as
securities separate from the underlying mortgage loans and, thus, may not be
considered Qualifying Interests for purposes of the 55% requirement. As of
June 30, 2004, we calculated that we were in compliance with this requirement. 
 Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The information called for by Item 3 is incorporated by reference from the
information in Part I, Item 2 under the captions Hedging Strategies,
Interest Rate Risk Management and Market Risks. 
 Item 4. CONTROLS AND PROCEDURES We carried out an evaluation as of the end of the period covered by this
report, under the supervision and with the participation of the Companys
management, including our Chief Executive Officer, Chief Operating Officer and
Chief Financial Officer, of the effectiveness of the design and operation of
our disclosure controls and procedures as defined in Exchange Act Rules
13a-15(e) and 15d-15(e). Based upon that evaluation, the Chief Executive
Officer, the Chief Operating Officer and the Chief Financial Officer concluded
that our disclosure controls and procedures are effective to timely alert them
to any material information relating to the Company (including its consolidated
subsidiaries) that must be included in our periodic SEC filings. In addition,
during the quarter ended June 30, 2004, there has been no significant change in
the Companys internal control over financial reporting that has materially
affected, or is reasonably likely to materially affect, the Companys internal
control over financial reporting. 
 PART II            OTHER INFORMATION 
 Item 1. LEGAL PROCEEDINGS At June 30, 2004, there were no pending legal proceedings to which we
were a party or of which any of our property was subject. 
 Item 2. CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF
EQUITY SECURITIES Not applicable 
 Item 3. DEFAULTS UPON SENIOR SECURITIES Not applicable 58




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##### Table of Contents



Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS  (a)
    
    Our Annual Meeting of Shareholders was held on April 20,
2004.(b)
    
    Election of Class III Directors VotesNominee
    
    For
    
    WithheldAnne-Drue Anderson
    
    
    76,165,483
    
    
    
    263,206David A. Ater
    
    
    68,409,812
    
    
    
    8,018,877Larry A. Goldstone
    
    
    68,304,791
    
    
    
    8,123,898Ike Kalangis
    
    
    68,655,364
    
    
    
    7,773,324
 
 Item 5. OTHER INFORMATION None 
 Item 6. EXHIBITS AND REPORTS ON FORM 8-K  (a)
    
    ExhibitsSee Exhibit Index(b)
    
    Reports on Form 8-KThe Company filed or furnished the following Current Reports on Form
8-K with the SEC during the quarter ended June 30, 2004:  (i)
    
    Current Report on Form 8-K, filed on April
19, 2004, regarding the securitization of approximately $1.1
billion of mortgage loans by TMHL, a portion of which were
subsequently sold to third party investors (Thornburg
Mortgage Securities Trust 2004-1).(ii)
    
    Current Report on Form 8-K, furnished on
April 20, 2004, attaching the Companys Press Release of
April 20, 2004 announcing the Companys earnings for the
quarter ending March 31, 2004. 59




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##### Table of Contents



SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized. THORNBURG MORTGAGE, INC.(Registrant)Dated: August 9, 2004
    
    /s/ Garrett ThornburgGarrett ThornburgChairman of the Board and Chief Executive Officer(Principal Executive Officer)Dated: August 9, 2004
    
    /s/ Larry A. GoldstoneLarry A. GoldstonePresident and Chief Operating Officer(authorized officer of registrant)Dated: August 9, 2004
    
    /s/ Richard P. StoryRichard P. StoryExecutive Vice President and Chief Financial Officer(Principal Financial and Accounting Officer)
 60




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Exhibit Index Exhibit Number
    
    Exhibit Description10.1
    
    Amended and Restated Management Agreement between the
Registrant and Thornburg Mortgage Advisory Corporation
dated as of July 1, 2004*10.9
    
    Securities Sale and Contribution Agreement between
Thornburg Mortgage Depositor, L.L.C. and the Registrant
dated as of June 30, 2004*31.1
    
    Certification of Chief Executive Officer pursuant to Rule
13a-14(a) and 15d-14(a) of the Securities Exchange Act of
1934*31.2
    
    Certification of President and Chief Operating Officer
pursuant to Rule 13a-14(a) and 15d-14(a) of the Securities
Exchange Act of 1934*31.3
    
    Certification of Executive Vice President and Chief
Financial Officer pursuant to Rule 13a-14(a) and 15d-14(a)
of the Securities Exchange Act of 1934*32.1
    
    Certification of Chief Executive Officer pursuant to 18
U.S.C. Section 1350, as adopted pursuant to Section 906 of
the Sarbanes-Oxley Act of 2002*32.2
    
    Certification of President and Chief Operating Officer
pursuant to 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002*32.3
    
    Certification of Executive Vice President and Chief
Financial Officer pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002*
  *
    
    Being filed herewith. 61